GunnAllen Financial Initiates Coverage On Watson Pharmaceuticals, Inc. WPI) With 'Buy' Rating
TAMPA, Fla., April 15 /PRNewswire/ -- The following is being issued by GunnAllen Financial, a member of the National Association of Securities Dealers, CRD number 17609:
Investment Thesis: Over the recent past, Watson (NYSE: WPI) has made a series of strategic acquisitions of niche drug manufacturers with unique products and/or delivery technologies, announced FDA approval on a number of potentially significant products (including the first generic form of Nicorette gum), and increased its sales force from 20 in 1997 to more than 350 today. As a result, the company appears better positioned than ever to capitalize on the growing demand for both generic and branded pharmaceutical products, and yet the stock recently suffered through a 40% peak-to-trough pullback without any apparent erosion of fundamentals. In our opinion, the stock had simply gotten ahead of itself, having increased in excess of 50% in 1997 and over 90% in 1998. Early previews of first quarter results have been favorable for both Watson and the majority of generic pharmaceutical companies, and we would look for a positive earnings release from the company later this month (Apr. 30) to allay any remaining investor concerns.
Today, with the company's outlook as strong as ever and the stock trading at an unwarranted discount to its larger peers, WPI appears to offer a compelling combination of near-term price appreciation potential and tremendous long-term growth opportunities. Indeed, the stock has begun a nice recovery over the past couple of weeks, supported in part by its recent addition to the S&P 500 Index, yet it is still trading more than 25% off its 52-week high of $63. Accordingly, we recommend aggressive purchase of WPI today, followed by continued accumulation on future pullbacks as part of a long-term portfolio strategy. Four basic points outline our investment thesis:
a. Prescription drug use is on the rise, supported by an aging population, pharmaceutical innovation, increased managed care sponsorship of the lion's share of pharmacy costs to the consumer, and relaxed legislation that allows for increased direct to consumer marketing by drug manufacturers. Managed care, which now covers a full three-quarters of all prescriptions written in the United States, has used its growing leverage to emphasize therapeutic switching to generic drugs to help control soaring health care costs. Generics now account for nearly 45% of all prescriptions written, compared to 18% in 1984.
b. Watson has become strategically differentiated from other generic manufacturers through an introduction of higher margin proprietary (branded) products to complement its extensive line of difficult to produce, niche generic drugs. Branded drugs, which carry gross margins near 70%, or roughly twice those of generics, now make up nearly 50% of revenues. Watson targets small, yet very profitable pockets of branded drug therapies that the big manufacturers (Pfizer, Merck, etc.) tend to overlook in their search for blockbuster formulations (Prozac, Viagra, etc.). Of the more than 6,000 drugs on the market, only 200 have annual sales more than $100 million, leaving a large market for smaller players like Watson. Within generics, Watson focuses on difficult compounds and delivery technologies that other generic competitors may not be able, or willing, to duplicate. Watson makes a living bringing drugs to the market that are difficult to mimic because those products are less prone to intense competitive conditions and subsequent margin pressure. For example, Watson recently won approval from the Food and Drug Administration for the first generic version of SmithKline Beechman's Nicorette gum. The market for the product is estimated at $200 million, and because only a small handful of manufacturers worldwide possess the technology and FDA approval to produce nicotine gum, Watson will likely experience limited competition from other generic manufacturers well after its 6-month market exclusivity expires.
c. Watson's gross margins are trending higher (a combination of increased branded sales and an easing of generic price deflation), and importantly, the company generates significant amounts of excess cash. Strong cash flows allow for increased allocations to R&D to ensure a rich product pipeline and for further opportunistic acquisition and/or joint venture possibilities. Accordingly, Watson stands to become an increasingly important player in what is a fundamentally attractive industry.
d. Watson is a great way to play the strength in pharmaceuticals at a discount valuation. The pharmaceuticals have been strong market performers in part because investors typically assign a premium to the group's earnings consistency and defensibility. As with most industries, the leaders carry the torch for the group, and Pfizer, Merck, and the like have certainly done it well. Still, Watson has shown a similar consistency of revenue and earnings growth as have the higher profile pharmaceutical companies, yet its stock price and P/E multiple have systematically contracted in the face of attractive fundamentals. A recent recovery in the shares has done little to erode the widening multiple gap between Watson and "Big Pharma". Indeed, at 25.7x forward EPS estimates, WPI still trades at nearly a 60% discount to Pfizer, whereas it once commanded a premium to PFE. While it is unlikely that WPI will ever command the 59x P/E multiple that PFE now enjoys, WPI once routinely traded at a low-30's multiple, a level we believe to be justified. Just a 10% multiple recovery relative to PFE (still a substantial discount to the S&P 500 multiple and a 50% discount to PFE) equates to $10 in incremental WPI share price today. We look for WPI to trade significantly higher over the next year, supported by a combination of P/E multiple recovery relative to the group as discussed above and continued EPS growth in excess of 20%, and believe our 12-month price target of $65 may prove materially conservative.
SOURCE GunnAllen Financial
CO: GunnAllen Financial; Watson Pharmaceuticals, Inc.
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