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Watson Pharma Strikes First

The company agrees to buy Andrx, but some had expected Watson to be the one that was acquired.

Updated from 1:50 p.m. EST

Watson Pharmaceuticals


made a $1.9 billion bid for



Monday, as the generic-drug industry continues to consolidate.

A combination of cutthroat pricing and acquisitions by the biggest members of the group is forcing midsized companies like Watson to get bigger or risk being taken over.

Still, the combination of Watson and Andrx, with estimated revenue of $2.7 billion a year, will be smaller than the industry leaders.

Teva Pharmaceutical Industries

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which recently acquired


for $7.4 billion, and the Sandoz unit of


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, which spent $8.3 billion last year to buy U.S. and German generic-drug companies, are both bigger.

The proposed merger of Watson and Andrx would create the third-largest U.S. generic-drug maker in terms of prescriptions dispensed, the companies said.

Watson executives say the deal should increase earnings per share in 2007. They expect to complete the transaction within six months.

Shares of Andrx gained $2.14, or 9.9%, to close at $23.73 in response to Watson's $25-a-share, all-cash bid. The stock climbed as high as $24.29, setting a 52-week high. Nearly 19.3 million shares were traded. The average daily volume for the last three months is nearly 806,000 shares.

Watson's stock dropped 55 cents, or 1.9%, closing at $29. The stock fell as low as $27.90. Trading volume of 4.5 million shares was five times the daily average.

The combination of Watson and Andrx is a marriage of less-than-stellar performers as far as Wall Street is concerned.

Before Monday, Watson's stock was off about 20% in the last six months. It has six sell ratings and two buy ratings, as well as 15 neutral ratings, according to Thomson First Call. Andrx gets better reviews, with five buy ratings, two sell recommendations and nine hold ratings.

The biggest drawback to Andrx is the fact that the Food and Drug Administration has halted reviewing any new drug applications until the company develops an acceptable plan to fix problems at a plant in Davie, Fla. The problems were cited after a May 2005 FDA inspection.

Andrx has said that it had been placed on what the FDA calls "official action indicated" status, meaning that the manufacturing issues are sufficiently severe to warrant action ranging from fines to product seizures.

"We believe we have provided complete responses to the May 2005 inspectional observations and to date, the FDA has not commented on our responses," says a Nov. 7 filing Andrx made with the

Securities and Exchange Commission

. "If the FDA initiates an enforcement action against us ... such enforcement action could have a material adverse effect on our business and our consolidated financial statements."

The company subsequently reported that it met with FDA representatives on Dec. 14 to present responses to a plant-inspection report and to update the agency on corrective actions.

Analysts peppered Watson and Andrx executives with questions about the plant and the FDA during a telephone conference call Monday. Thomas Rice, CEO of Andrx, said the agency recently began an inspection of the Davie plant, adding that the onsite review will take three to four weeks. Rice said it may take several more weeks for the agency to determine how well Andrx is complying with the agency's requests for improvements.

Allen Chao, Watson's chairman and CEO, said his company had done due diligence on the plant and Andrx's response to the FDA. "We felt it was appropriate to proceed

with the takeover bid," he said. Chao added that he didn't believe completing the acquisition should be dependent on the closing of the FDA's probe.

Chao declined to say what the management lineup would look like when the companies are combined. The merger agreement calls for Andrx to pay Watson a breakup fee of $70.8 million if the arrangement falls through for certain reasons.

Despite Andrx's manufacturing woes, its stock had been up about 45% since mid-October, even before the Watson takeover announcement. But that requires some context -- 24 months ago, the stock was trading at $30.

Although Andrx shareholders enjoyed a big jump in the price of their stock, some analysts who follow Watson aren't so sure this is a good deal.

"We believe Watson shareholders had been expecting to be bought out, not the other way around," says Megan Murphy of Lazard Capital Markets. Murphy, who has a hold rating on Watson, told clients that the acquisition probably will require Watson to raise $1 billion in debt "and will further dilute its already-industry-lowest margins."

Murphy doesn't own shares in Watson, and her firm doesn't have a banking relationship with the company.

Credit Suisse cut its rating on Watson to neutral from outperform, as analyst Ken Kulju cited Andrx's manufacturing and FDA-related problems. He told clients that his reduced rating reflects the fact that Andrx's profit margins are below those of Watson, that Watson's generic-product profit trends are "stagnant." He doesn't own shares in Watson.

Charles P. Slacik, Watson's chief financial officer, said he didn't expect the deal to affect the company's credit rating. However,

Standard & Poor's

placed the company's ratings on its CreditWatch list with negative implications. That means Watson could face a downgrade from its BBB-minus rating, which is the minimum investment grade.

"Any potential downgrade would depend on the level of financial strain placed on the company, as well as our assessment of the challenges associated with integrating Andrx's troubled operations," said credit analyst Arthur Wong. "We will monitor developments with the acquisition bid in conjunction with our ratings review of the company."

The generic-drug market has been roiled in recent years as more companies enter the field and as more competition squeezes profit margins. Last year, there was a drought of brand-name products going off-patent, but 2006 and 2007 should provide many big targets.

For example, Pravachol, the cholesterol drug from

Bristol-Myers Squibb

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, loses U.S. patent protection next month. The bigger cholesterol drug, Zocor from


(MRK) - Get Merck & Co., Inc. Report

, goes off-patent in June.

Some generic-drug companies have tried to diversify by adding or expanding their menu of higher-margin brand-name drugs. Andrx tried this strategy, but its board decided in December 2004 to focus on generics. Andrx sold its brand-name products division 12 months ago.

Watson's brand-name drugs accounted for about one-fourth of last year's revenue of $1.65 billion. Andrx hasn't released fourth-quarter and full-year 2005 financial results yet, but analysts surveyed by Thomson First Call expect that sales will be just over $1 billion.

Some analysts say the combined company's revenue may be less than Watson and Andrx predict if the Federal Trade Commission rules that the merger would cause overlap in products, most notably oral contraceptives. Chao said he expected "no changes," but indicated that he will have to wait for the FTC.

If the deal is successful, it may put pressure on two prominent generic-drug makers,

Barr Pharmaceuticals



Mylan Laboratories

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. Barr is expected to have sales of $1.28 billion for the fiscal year ending June 30, and Mylan should have revenue of $1.25 billion for the year ending March 31, according to the consensus forecasts.

However, as testimony to what Wall Street thinks of the respective companies, Barr's market capitalization of $6.82 billion is greater than those of Watson, at $3.16 billion, and Andrx, $1.76 billion, combined. Mylan's market value is $4.85 billion.