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Why Watson Is Looking Anemic

By Amy Tsao When Watson Pharmaceutical (WPI) reports earnings on Aug. 3, Wall Street won't be expecting much in the way of positive news. The Corona (Calif.)-based Watson, one of the top makers of generic and specialty drugs, has seen its stock fall 30% in the past three months, despite a strong market.

Al Rauch, an analyst at A.G. Edwards, figures that over the next year, the industry will have a hard time keeping margins from sliding as increasingly desperate pharmaceutical companies find aggressive new ways to protect their patents on blockbuster drugs. Also, as the market for generic drugs has grown, so has the competition. Rauch has no buy ratings in the generics sector. On Tuesday's conference call, he will be listening for talk of gross-margin contraction and clues to how well the company will grow in 2005. (Rauch does not own shares in the company, and his firm has no banking business with Watson.)

BITTER PILL. Indeed, most analysts don't see many reasons for Watson stock to climb. Among the reasons: After years of enjoying much of the market to itself, Watson said in June that its oral contraceptives are under pricing pressure now that rivals Teva (TEVA) and Andrx (ADRX) are bringing their own products to market. Birth-control pills are Watson's single biggest business, comprising around $350 million of total 2003 revenues of $1.45 billion.

Troubles with its birth-control franchise come on top of a relatively weak generic pipeline. And that has many analysts skeptical that the company can grow very much in the next couple of years. Andrew Forman, an analyst at Advest, a division of AXA Financial, notes that Teva has 94 applications planned and Ivax (IVX) has 47. Watson has 25, and it has the potential to offer the first generic to market on only two of those. Forman rates Watson a sell, with a target price of $20. (It's currently trading at just under $25.)

Also, he believes that consensus expectations of earnings per share of $1.83 in 2004 and $2.06 in 2005 may turn out to be too high. The company will likely struggle to grow revenues until 2006, when it is scheduled to bring some new, higher-profit drugs to market. (Forman does not own shares in the company, and Advest does not have a banking business.)

PAIN RELIEVER? Like most large generic-drug manufacturers, Watson also has a "branded" drugs business, which offers higher margins. But sales for Oxytrol, a skin patch for overactive bladder, have been lackluster since its launch last year. This is especially disappointing, as it was thought to be Watson's most promising product. "It's a huge market, but in reality none of these incontinence drugs works that well," says Rauch. Oxytrol brought in $23 million in revenues in 2003, which was well short of original expectations of $50 million, says Rauch. The already-crowded market will become more so as two additional companies enter the fray later this year, which may well mean Watson won't sell $50 million worth of the drug this year either.

Dermal patches such as Oxytrol have long been an area of expertise for Watson, but that part of the business is under pressure as well, says Forman. For example, Watson makes a testosterone patch, but with gel products now available, "the market has gone away from them," he says. And its estrogen patch has faltered, as have all hormone-replacement therapy products since the release two years ago of a disturbing long-term government study.

Watson could possibly see some improvement if it brings a generic version of Duragesic, a blockbuster pain patch made by Johnson & Johnson (JNJ) to market. Duragesic goes off-patent next January. "If they have a plan to do this, sales could be meaningful," says Forman. "Enough so that 2005 won't be so bad." Even if Watson isn't first to bring a generic Duragesic to market, it will be a solid boost. Watson hasn't yet disclosed whether it plans to do a filing on such a product, but some analysts expect it will.

DOMESTIC PROBLEMS. The long-term outlook is clouded by the fact that the U.S. market has too many players and too much capacity and that Big Pharma continues to find ways to cut into generic drugmakers' profitability. All that makes a global strategy critical. The strongest generic companies, says Forman, will have the ability to manufacture and sell "in multiple countries to extend their product lifecycles." Watson currently has little business outside of the U.S.

Ultimately, Watson is in the thick of a shift in how the generics industry operates: As the U.S. market gets more and more competitive, companies must increasingly rely on broader sources of income and international markets. Until it better addresses these issues, Watson's stock could be stuck. Tsao covers the markets for Business Week Online

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