For Watson, It's Elementary -- Don't Mess With the FDA

Watson Pharmaceuticals gets another warning letter from the FDA about manufacturing and quality control problems.
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Things appear to be getting worse for

Watson Pharmaceuticals

(WPI)

.

The

Food and Drug Administration

sent a letter May 11 to the $3.8-billion-market-cap generic drug company, nailing it for its response to a March warning from the agency about myriad manufacturing and quality control problems. The letter was circulating on Wall Street Thursday.

The FDA's not happy with Watson. The agency says pending drug applications may be delayed if the violations it has found are related to products waiting for approval, according to the letter.

Among the most worrisome issues is that the FDA wonders whether Watson hid negative information on quality control and manufacturing conditions, according to the May 11 letter. The letter, citing several lapses, says, "Negative information was not reported in the official notebooks." Oops. The company blamed rookie quality control folks, the letter says. The FDA counters that several such analysts had been at the company for years.

The FDA continues to have problems with Watson's laboratory controls, its investigative practices, its reviews of lab data, its training and its manufacturing. The FDA reviewer's favorite phrase appears to be: "The response is not adequate."

Watson officials didn't return repeated phone calls. The letter was first reported on

Bloomberg

on Thursday. Watson's problem with lapses in noting problems officially was alluded to in an earlier

TSC

story.

As the FDA's May response circulated Thursday, someone made a huge bet that Watson's stock will fall further. Watson Aug 35 puts were popular, gaining 1 1/8 ($112.50) to 3 1/8 ($312.50) on volume of 988 contracts, triple the current open interest. The stock caught up with the options. Flat early Thursday, it closed down 2 11/16, or 6.7%, to 37 3/16. The stock has fallen over 30% this year.

Yeah, FDA warning letters are routine and plentiful. Sure,

Pfizer

(PFE) - Get Report

gets them from time to time. Investors typically ignore them, since the FDA rarely takes extreme action and the costs of compliance aren't typically overwhelming. FDA warning letters can cover the gamut of problems, from advertising that crosses the line to failure to adhere to manufacturing standards. Letters are publicly disclosed several weeks after companies have received them.

But Watson is getting a lot of them, one on top of another, and for more than one facility, suggesting there may be a systemic problem. And its never good to get into a chest-thumping match with the FDA. The FDA doesn't like it.

All of this adds up to a bad scenario. Watson has a classic problem: It rolled up one time too much. "They bought too many companies in too short a period of time. They are paying the price now," says a manager of a small New York hedge fund, who thought highly of Watson till Thursday, when he blew out his long position and went short.

Earlier this month, the company attempted to address the problems by reorganizing its quality control and research and development departments. The reorganization appeared to be in response to an April 16 letter concerning a Miami facility. Previous concerns have been with a Corona, Calif., plant.

The April letter concerns adulterated products made from a facility once operated by

Royce Laboratories

, which Watson acquired in 1997. In the April 16

letter, the FDA says "the ongoing nature of these

problems is a cause for concern on the part of the FDA that needs to be brought to your attention for necessary corrective action."

Meanwhile, other rumors have been circulating during the last couple of days. One New York short-seller says that the company appeared to have a problem with a contract with

Rite-Aid

(RAD) - Get Report

, a major pharmacy chain. According to the short-seller, several Rite-Aids in Manhattan aren't carrying Watson drugs in stock, including hydrocodone, a pain reliever which has been the subject of earlier FDA concerns. A Rite-Aid spokeswoman didn't have knowledge of the contract and couldn't respond to inquiries.