Fitch Downgrades Watson's Ratings to 'BBB-'

CHICAGO--(BUSINESS WIRE)--Fitch has downgraded Watson Pharmaceuticals Inc.'s (Watson) ratings as follows:

-- Issuer Default Rating (IDR) to 'BBB-' from 'BBB';

-- Senior unsecured to 'BBB-' from 'BBB';

-- Bank loan to 'BBB-' from 'BBB'.

The ratings will be removed from Rating Watch Negative, where they were originally placed on March 10, 2006. The ratings apply to approximately $1.2 billion of long-term debt instruments. The Rating Outlook is Stable.

The rating action reflects the company's higher leverage needed to complete the acquisition of Andrx Corp. (Andrx) for $1.87 billion. Leverage (total debt to EBITDA) is projected to rise to greater than 3.0 times (x) at the end of 2006 with minimal EBITDA contribution from Andrx given the recent completion of the transaction. However, Fitch anticipates gross debt to decrease in the near term from sustained solid free cash flow generation to a level more appropriate for the new rating category. Additionally, amortization of the term loan supports rapid debt reduction, which Fitch expects to lead to a drop in leverage to approximately 2.5x by the end of 2007. In the intermediate term, further reduction of leverage is expected given solid free cash flow generation and significant amortization of the term loan.

The ratings reflect the company's solid cash generating ability as demonstrated by improving free cash flow generation over the past few years. Free cash flow improved to $283.9 million (cash flow from operations of $342.8 million less capital spending of $58.9 million) for the latest 12 months (LTM) period ending June 30, 2006 from $246.7 million (cash flow from operations of $325.5 million less capital spending of $78.8 million) in 2005. Watson expects cash flow from operations to fall between $325 million-$340 million and capital spending to approximate $50 million in 2006. Free cash flow margin improved to 16.3% for the LTM period ending June 30, 2006 despite the contraction of operating margins during 2006. Fitch anticipates strengthening operating cash flows through the intermediate term.

The acquisition of Andrx brings additional controlled release technologies beyond Watson's current capabilities which were supplemented by the purchase of Amarin Development Group in October 2003. The company will be able to better concentrate R&D efforts on semi-exclusive generic products, those with only two-three competitors, given Andrx's sustained release drug delivery technology required to manufacture difficult-to-replicate pharmaceutical products.

The combined company had greater than 60 abbreviated new drug applications (ANDAs) filed with the FDA by June 30, 2006. The generic pipeline now includes Andrx's controlled-release generic projects, including potential first-to-file and semi-exclusive opportunities, most notably generic versions of Toprol XL, 50mg; Biaxin XL; Concerta; Cardizem LA; Lovenox (with Amphastar); and Prilosec delayed-release. The majority of the R&D investment will be directed toward generic products; however, the R&D program includes promising branded pharmaceuticals, such as silodosin (with Kissei Pharmaceutical Co., Ltd.), the next generation of Oxytrol, a new indication for Ferrlecit, and a fixed dose combination of Actos and extended-release metformin. Fitch will monitor the company's efforts toward lifting the Official Action Indicated (OAI) status placed on the Davie, FL, facility by the FDA in September 2005, effectively placing a hold on all pending product approvals, generic Toprol, and the ActosPlus branded pharmaceutical.

Watson, including Andrx, is now the third largest U.S. generic manufacturer (based on prescriptions dispensed). Operational improvement is expected to be driven by improving sales growth coupled with modest margin gains. EBITDA margins compressed to 23.0% for the LTM period ending June 30, 2006 from 27.4% at the end of 2005, the result of declining operating margins due to an increase in lower margin revenues from the launch of an authorized generic version of Pravachol in April 2006 coupled with steady R&D investment offset by reduced sales and marketing expenses and productivity initiatives. Generic product margin will benefit from vertical integration efforts and cost savings from raw material supply sourcing in the long term. Overall operating margin will benefit from the launch of higher margin branded drug products in 2008-2010.

Watson's credit profile is supported by positive industry factors, including a significant rise in patent expirations of blockbuster-level pharmaceuticals in the 2006-2008 timeframe, consumer and political environments amenable to controlling health care costs by shifting away from higher cost brand-name pharmaceuticals to lower cost generic drug products, and an aging baby-boomer demographic. Generic substitution is occurring earlier and to a greater degree as third-party payors control overall health care costs through favorable formulary status (lowest co-payment tier). Greater generic drug utilization is being derived from prescription drug plans contracted by Medicare to provide low-income seniors with services under Part D of the Medicare Modernization Act, and Prescription Drug Benefit of 2003, which emphasize generics drugs at the lowest co-payment level.

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