**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 

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**ý****QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**FOR THEQUARTERLY PERIOD ENDED JUNE 30, 2005**

 

**or**

 

**o****TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from        to          **

 

**Commissionfile number 0-20045**

 

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**WATSON PHARMACEUTICALS, INC.**

(Exact name ofregistrant as specified in its charter)

 
| **Nevada**                                                       | ** ** | **95-3872914**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |

 

**311Bonnie Circle**

**Corona,CA 92880-2882**

(Address ofprincipal executive offices, including zip code)

 

**(951)493-5300**

(Registrant’stelephone number, including area code)

 

Indicate by check mark whether the Registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90days.   Yes ý   No o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act).  Yes ý  No o

 

The number of shares outstanding of the Registrant’s only class ofcommon stock as of June 30, 2005 was approximately 104,230,000.

 

 

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**WATSONPHARMACEUTICALS, INC.**

** **

**TABLE OFCONTENTS**

** **

**FORM 10-QFOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005**

 

 

**Part I.FINANCIAL INFORMATION**

 
| Item 1. Condensed Consolidated Financial Statements  (Unaudited):                                    | ** **                                                                                                   |
|------------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------|
|                                                                                                 |                                                                                                         |   |   |
|                                                                                                 | Condensed  Consolidated Balance Sheets as of June 30, 2005 and December 31,  2004                  |   |   |
|                                                                                                 |                                                                                                         |   |   |
|                                                                                                 | Condensed  Consolidated Statements of Income for the Three and Six Months Ended  June 30, 2005 and 2004 |   |   |
|                                                                                                 |                                                                                                         |   |   |
|                                                                                                 | Condensed  Consolidated Statements of Cash Flows for the Six Months Ended June 30,  2005 and 2004       |   |   |
|                                                                                                 |                                                                                                         |   |   |
|                                                                                                 | Notes  to Condensed Consolidated Financial Statements                                                        |   |   |
|                                                                                                 |                                                                                                         |   |   |
| Item  2. Management’s Discussion and Analysis of Financial Condition and Results of  Operations |                                                                                                         |   |
|                                                                                                 |                                                                                                         |   |
| Item 3.  Quantitative and Qualitative Disclosure about Market Risk                                   |                                                                                                         |   |
|                                                                                                 |                                                                                                         |   |
| Item 4. Controls  and Procedures                                                                     |                                                                                                         |   |
|                                                                                                 |                                                                                                         |   |
| **Part II.  OTHER INFORMATION AND SIGNATURES**                                                  | ** **                                                                                                   | ** ** |
|                                                                                                 |                                                                                                         |   |
| Item 1. Legal  Proceedings                                                                           |                                                                                                         |   |
|                                                                                                 |                                                                                                         |   |
| Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds                                 |                                                                                                         |   |
|                                                                                                 |                                                                                                         |   |
| Item 4.  Submission of Matters to a Vote of Security Holders                                         |                                                                                                         |   |
|                                                                                                 |                                                                                                         |   |
| Item 6.  Exhibits                                                                                    |                                                                                                         |   |
|                                                                                                 |                                                                                                         |   |
| Signatures                                                                                           |                                                                                                         |   |

 

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**WATSONPHARMACEUTICALS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(Unaudited;in thousands, except share amounts)**

 
| ** **                                                                                                                 | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                 |       |                    |       |                        |       |
| Current assets:                                                                                                            |       |                    |       |                        |       |
| Cash and cash  equivalents                                                                                                 |       | $                       | 488,735    |                        | $          | 298,653 |   |
| Marketable  securities                                                                                                     |       | 161,049                 |       | 381,679                     |       |
| Accounts  receivable, net                                                                                                  |       | 271,258                 |       | 251,459                     |       |
| Inventories                                                                                                                |       | 289,308                 |       | 321,299                     |       |
| Prepaid expenses  and other current assets                                                                                 |       | 20,542                  |       | 26,894                      |       |
| Deferred tax  assets                                                                                                       |       | 90,181                  |       | 90,202                      |       |
| Total current  assets                                                                                                      |       | 1,321,073               |       | 1,370,186                   |       |
|                                                                                                                       |       |                    |       |                        |       |
| Property and  equipment, net                                                                                               |       | 445,221                 |       | 427,377                     |       |
| Investments and  other assets                                                                                              |       | 42,061                  |       | 47,499                      |       |
| Deferred tax  assets                                                                                                       |       | 29,523                  |       | 30,280                      |       |
| Product rights  and other intangibles, net                                                                                 |       | 831,434                 |       | 912,746                     |       |
| Goodwill                                                                                                                   |       | 455,595                 |       | 455,595                     |       |
| Total assets                                                                                                               |       | $                       | 3,124,907  |                        | $          | 3,243,683 |   |
|                                                                                                                       |       |                    |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                              |       |                    |       |                        |       |
| Current  liabilities:                                                                                                      |       |                    |       |                        |       |
| Accounts payable  and accrued expenses                                                                                     |       | $                       | 186,808    |                        | $          | 192,701 |   |
| Income taxes  payable                                                                                                      |       | 49,310                  |       | 57,851                      |       |
| Deferred revenue                                                                                                           |       | 4,024                   |       | 5,077                       |       |
| Total current  liabilities                                                                                                 |       | 240,142                 |       | 255,629                     |       |
|                                                                                                                       |       |                    |       |                        |       |
| Long-term debt                                                                                                             |       | 587,794                 |       | 587,653                     |       |
| Deferred revenue                                                                                                           |       | 16,468                  |       | 11,557                      |       |
| Other long-term  liabilities                                                                                               |       | 3,895                   |       | 4,736                       |       |
| Deferred tax  liabilities                                                                                                  |       | 126,376                 |       | 140,959                     |       |
| Total  liabilities                                                                                                         |       | 974,675                 |       | 1,000,534                   |       |
|                                                                                                                       |       |                    |       |                        |       |
| Commitments and  contingencies                                                                                             |       |                    |       |                        |       |
|                                                                                                                       |       |                    |       |                        |       |
| Stockholders’  equity:                                                                                                |       |                    |       |                        |       |
| Preferred stock;  no par value per share; 2,500,000 shares authorized; none issued                                         |       | —                  |       | —                      |       |
| Common stock;  $0.0033 par value per share; 500,000,000 shares authorized; 110,240,600 and  109,719,900 shares outstanding |       | 364                     |       | 362                         |       |
| Additional  paid-in capital                                                                                                |       | 893,408                 |       | 880,202                     |       |
| Retained  earnings                                                                                                         |       | 1,432,826               |       | 1,353,047                   |       |
| Accumulated  other comprehensive income                                                                                    |       | 6,219                   |       | 9,538                       |       |
| Treasury stock,  at cost: 6,010,600 shares and zero shares, respectively                                                   |       | (182,585                | )          | —                      |       |
| Total  stockholders’ equity                                                                                           |       | 2,150,232               |       | 2,243,149                   |       |
| Total  liabilities and stockholders’ equity                                                                           |       | $                       | 3,124,907  |                        | $          | 3,243,683 |   |

 

*See accompanying Notes to CondensedConsolidated Financial Statements.*

 

1

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**WATSONPHARMACEUTICALS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF INCOME**

**(Unaudited;in thousands, except per share amounts)**

 
| ** **                                                     | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                           |       |                                  |       |                                |       |   |   |   |   |
| Net revenues                                                   |       | $                                     | 416,266    |                                | $          | 399,368 |   | $ | 817,094 |   | $ | 809,026 |   |
| Cost of sales                                                  |       | 211,213                               |       | 198,854                             |       | 418,163 |   | 395,335 |   |
| Gross profit                                                   |       | 205,053                               |       | 200,514                             |       | 398,931 |   | 413,691 |   |
|                                                           |       |                                  |       |                                |       |   |   |   |   |
| Operating expenses:                                            |       |                                  |       |                                |       |   |   |   |   |
| Research and  development                                      |       | 31,486                                |       | 42,529                              |       | 60,324 |   | 72,210 |   |
| Selling, general  and administrative                           |       | 68,125                                |       | 79,169                              |       | 131,776 |   | 156,580 |   |
| Amortization                                                   |       | 41,101                                |       | 17,983                              |       | 81,739 |   | 35,915 |   |
| Total operating  expenses                                      |       | 140,712                               |       | 139,681                             |       | 273,839 |   | 264,705 |   |
| Operating income                                               |       | 64,341                                |       | 60,833                              |       | 125,092 |   | 148,986 |   |
|                                                           |       |                                  |       |                                |       |   |   |   |   |
| Other income  (expense):                                       |       |                                  |       |                                |       |   |   |   |   |
| Equity in losses  of joint ventures                            |       | (578                                  | )          | (1,700                              | )          | (158 | ) | (3,279 | ) |
| Loss on  impairment of investments and other assets            |       | —                                |       | —                              |       | — |   | (891 | ) |
| Gain on sales of  securities                                   |       | —                                |       | —                              |       | — |   | 3,938 |   |
| Loss on early  extinguishment of debt                          |       | —                                |       | (3,746                              | )          | — |   | (17,752 | ) |
| Interest income                                                |       | 4,546                                 |       | 1,015                               |       | 8,652 |   | 2,222 |   |
| Interest expense                                               |       | (3,624                                | )          | (1,647                              | )          | (6,914 | ) | (5,390 | ) |
| Other income (expense)                                         |       | 185                                   |       | (176                                | )          | (39 | ) | (340 | ) |
| Total other  income (expense), net                             |       | 529                                   |       | (6,254                              | )          | 1,541 |   | (21,492 | ) |
| Income before  income taxes                                    |       | 64,870                                |       | 54,579                              |       | 126,633 |   | 127,494 |   |
| Provision for  income taxes                                    |       | 24,002                                |       | 19,652                              |       | 46,854 |   | 45,908 |   |
| Net income                                                     |       | $                                     | 40,868     |                                | $          | 34,927 |   | $ | 79,779 |   | $ | 81,586 |   |
|                                                           |       |                                  |       |                                |       |   |   |   |   |
| Earnings per  share (as restated per Note 1):                  |       |                                  |       |                                |       |   |   |   |   |
| Basic                                                          |       | $                                     | 0.38       |                                | $          | 0.32 |   | $ | 0.74 |   | $ | 0.75 |   |
| Diluted                                                        |       | $                                     | 0.35       |                                | $          | 0.29 |   | $ | 0.68 |   | $ | 0.67 |   |
|                                                           |       |                                  |       |                                |       |   |   |   |   |
| Weighted average  shares outstanding (as restated per Note 1): |       |                                  |       |                                |       |   |   |   |   |
| Basic                                                          |       | 106,359                               |       | 109,049                             |       | 107,740 |   | 108,839 |   |
| Diluted                                                        |       | 121,253                               |       | 124,682                             |       | 122,671 |   | 124,973 |   |

 

*See accompanying Notes to CondensedConsolidated Financial Statements.*

 

2

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**WATSONPHARMACEUTICALS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited; in thousands)

 
| ** **                                                    | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                    |       |                                |       |   |   |
| Net income                                                    |       | $                                   | 79,779     |   | $ | 81,586 |   |
| Reconciliation  to net cash provided by operating activities: |       |                                |       |   |   |
| Depreciation                                                  |       | 19,639                              |       | 15,075 |   |
| Amortization                                                  |       | 81,739                              |       | 35,915 |   |
| Deferred income  tax (provision) benefit                      |       | (12,130                             | )          | 16,434 |   |
| Equity in losses  of joint ventures                           |       | 158                                 |       | 3,279 |   |
| Gain on sales of  securities                                  |       | —                              |       | (3,938 | ) |
| Loss on early  extinguishment of debt                         |       | —                              |       | 17,752 |   |
| Loss on sale of  fixed assets                                 |       | 620                                 |       | — |   |
| Loss on  impairment of investments and other assets           |       | —                              |       | 891 |   |
| Tax benefits  from employee stock plans                       |       | 1,606                               |       | 5,854 |   |
| Mark to market  on derivative                                 |       | (841                                | )          | (3,154 | ) |
| Other                                                         |       | (1,006                              | )          | (626 | ) |
| Changes in  assets and liabilities:                           |       |                                |       |   |   |
| Accounts  receivable, net                                     |       | (19,799                             | )          | 555 |   |
| Inventories                                                   |       | 31,991                              |       | 8,274 |   |
| Prepaid expenses  and other current assets                    |       | 6,352                               |       | (5,355 | ) |
| Accounts payable  and accrued expenses                        |       | (5,893                              | )          | (4,715 | ) |
| Deferred revenue                                              |       | 3,858                               |       | (6,433 | ) |
| Income taxes  payable                                         |       | (8,541                              | )          | (65,781 | ) |
| Other assets                                                  |       | 1,412                               |       | 933 |   |
| Total  adjustments                                            |       | 99,165                              |       | 14,960 |   |
| Net cash  provided by operating activities                    |       | 178,944                             |       | 96,546 |   |
|                                                          |       |                                |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                    |       |                                |       |   |   |
| Additions to  property and equipment                          |       | (38,103                             | )          | (43,094 | ) |
| Acquisitions of  product rights                               |       | (427                                | )          | (5,627 | ) |
| Additions to  long-term investments                           |       | (1,500                              | )          | (10,590 | ) |
| Distribution  from joint venture                              |       | 2,500                               |       | — |   |
| Proceeds from  sales of marketable securities                 |       | 220,083                             |       | 26,706 |   |
| Proceeds from  sale of Halsey note receivable                 |       | —                              |       | 5,381 |   |
| Other investing  activities, net                              |       | —                              |       | 1,983 |   |
| Net cash  provided by (used in) investing activities          |       | 182,553                             |       | (25,241 | ) |
|                                                          |       |                                |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                    |       |                                |       |   |   |
| Payments to  repurchase 1998 Senior Notes                     |       | —                              |       | (135,905 | ) |
| Premium paid on  1998 Senior Notes repurchase                 |       | —                              |       | (17,072 | ) |
| Repurchase of  common stock                                   |       | (182,585                            | )          | — |   |
| Principal  payments on acquisition liabilities                |       | (5                                  | )          | (5 | ) |
| Proceeds from stock  plans                                    |       | 11,175                              |       | 22,663 |   |
| Net cash used in  financing activities                        |       | (171,415                            | )          | (130,319 | ) |
| Net increase (decrease)  in cash and cash equivalents         |       | 190,082                             |       | (59,014 | ) |
| Cash and cash  equivalents at beginning of period             |       | 298,653                             |       | 318,043 |   |
| Cash and cash  equivalents at end of period                   |       | $                                   | 488,735    |   | $ | 259,029 |   |

 

*Seeaccompanying Notes to Condensed Consolidated Financial Statements.*

 

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**WATSONPHARMACEUTICALS, INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1 – GENERAL**

 

Watson Pharmaceuticals, Inc.(Watson or the Company) is primarily engaged in the development, manufacture,marketing, sale and distribution of brand and off-patent (generic)pharmaceutical products.  Watson wasincorporated in 1985 and began operations as a manufacturer and marketer ofoff-patent pharmaceuticals.  Throughinternal product development and synergistic acquisitions of products andbusinesses, the Company has grown into a diversified specialty pharmaceuticalcompany.  Watson operates manufacturing,distribution, research and development and administrative facilities primarilyin the United States of America (U.S.).

 

The accompanyingcondensed consolidated financial statements should be read in conjunction withthe Company’s Annual Report on Form 10-K for the year ended December 31,2004.  Certain information and footnotedisclosures normally included in annual financial statements prepared inaccordance with generally accepted accounting principles have been condensed oromitted from the accompanying condensed consolidated financial statements.  The year end balance sheet was derived fromthe audited financial statements.  Theaccompanying interim financial statements are unaudited, but reflect alladjustments which are, in the opinion of management, necessary to fairly state Watson’sconsolidated financial position, results of operations and cash flows for theperiods presented.  Unless otherwisenoted, all such adjustments are of a normal, recurring nature. Certainreclassifications, none of which affected net income or retained earnings, havebeen made to prior period amounts to conform to current periodpresentation.  The Company’s results ofoperations and cash flows for the interim periods are not necessarilyindicative of the results of operations and cash flows that it may achieve infuture periods or for the full year.

 

*Comprehensive income*

 

Comprehensive incomeincludes all changes in equity during a period except those that resulted frominvestments by or distributions to the Company’s stockholders.  Other comprehensive loss refers to revenues,expenses, gains and losses that, under generally accepted accountingprinciples, are included in comprehensive income, but excluded from net incomeas these amounts are recorded directly as an adjustment to stockholders’equity.  Watson’s other comprehensiveloss is comprised of unrealized losses on its holdings of publicly traded debtand equity securities, net of realized losses included in net income.  The components of comprehensive income andrelated income taxes consisted of the following (in thousands):

 
| ** **                                          | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                          | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income                                          |       | $                                     | 40,868     |                                | $          | 34,927 |   | $ | 79,779 |   | $ | 81,586 |   |
|                                                |       |                                  |       |                                |       |   |   |   |   |
| Other comprehensive  loss:                          |       |                                  |       |                                |       |   |   |   |   |
| Unrealized  holding loss on securities              |       | (1,794                                | )          | (686                                | )          | (5,293 | ) | (783 | ) |
| Less related  income taxes                          |       | 669                                   |       | 247                                 |       | 1,974 |   | 282 |   |
| Total unrealized  loss on securities, net           |       | (1,125                                | )          | (439                                | )          | (3,319 | ) | (501 | ) |
|                                                |       |                                  |       |                                |       |   |   |   |   |
| Reclassification  for losses included in net income |       | —                                |       | —                              |       | — |   | (1,092 | ) |
| Less related  income taxes                          |       | —                                |       | —                              |       | — |   | 393 |   |
| Total  reclassification, net                        |       | —                                |       | —                              |       | — |   | (699 | ) |
| Total other  comprehensive loss                     |       | (1,125                                | )          | (439                                | )          | (3,319 | ) | (1,200 | ) |
| Total  comprehensive income                         |       | $                                     | 39,743     |                                | $          | 34,488 |   | $ | 76,460 |   | $ | 80,386 |   |

 

4

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*Earnings per share*

 

Basic earnings per shareis computed by dividing net income by the weighted average common sharesoutstanding during a period.  Dilutedearnings per share is based on the treasury stock method and includes theeffect from potential issuance of common stock, such as shares issuable uponconversion of the $575 million convertible contingent senior debentures(CODES), and shares issuable pursuant to the exercise of stock options,assuming the exercise of all in-the-money stock options.  Common share equivalents have been excludedwhere their inclusion would be antidilutive. In accordance with Emerging Issues Task Force (EITF) Issue No. 04-8,“The Effect of Contingently Convertible Debt on Diluted Earnings per Share,” (EITFNo. 04-8) the Company is required to add approximately 14.4 million sharesassociated with the conversion of the CODES to the number of shares outstandingfor the calculation of diluted earnings per share for all periods in which thesecurities were outstanding.  Priorperiod comparatives have been restated to conform to the requirements of EITF No. 04-8.A reconciliation of the numerators and denominators of basic and dilutedearnings per share consisted of the following (in thousands, except per shareamounts):

 
| ** **                                          | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                          | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                |       |                                  |       |                                |       |   |   |   |   |
| **Earnings  per share - basic**                     |       |                                  |       |                                |       |   |   |   |   |
| Net income                                          |       | $                                     | 40,868     |                                | $          | 34,927 |   | $ | 79,779 |   | $ | 81,586 |   |
|                                                |       |                                  |       |                                |       |   |   |   |   |
| Basic weighted  average common shares outstanding   |       | 106,359                               |       | 109,049                             |       | 107,740 |   | 108,839 |   |
|                                                |       |                                  |       |                                |       |   |   |   |   |
| Earnings per  share - basic                         |       | $                                     | 0.38       |                                | $          | 0.32 |   | $ | 0.74 |   | $ | 0.75 |   |
|                                                |       |                                  |       |                                |       |   |   |   |   |
| **Earnings  per share - assuming dilution**         |       |                                  |       |                                |       |   |   |   |   |
| Net income                                          |       | $                                     | 40,868     |                                | $          | 34,927 |   | $ | 79,779 |   | $ | 81,586 |   |
| Add: Interest  expense on CODES, net of tax         |       | 1,814                                 |       | 639                                 |       | 3,441 |   | 2,512 |   |
| Net income,  adjusted                               |       | $                                     | 42,682     |                                | $          | 35,566 |   | $ | 83,220 |   | $ | 84,098 |   |
|                                                |       |                                  |       |                                |       |   |   |   |   |
| Basic weighted  average common shares outstanding   |       | 106,359                               |       | 109,049                             |       | 107,740 |   | 108,839 |   |
| Effect of  dilutive securities:                     |       |                                  |       |                                |       |   |   |   |   |
| Conversion of  CODES                                |       | 14,357                                |       | 14,357                              |       | 14,357 |   | 14,357 |   |
| Dilutive stock  options                             |       | 537                                   |       | 1,276                               |       | 574 |   | 1,777 |   |
| Diluted weighted  average common shares outstanding |       | 121,253                               |       | 124,682                             |       | 122,671 |   | 124,973 |   |
|                                                |       |                                  |       |                                |       |   |   |   |   |
| Earnings per  share - diluted                       |       | $                                     | 0.35       |                                | $          | 0.29 |   | $ | 0.68 |   | $ | 0.67 |   |

 

Excluded from thecomputation of diluted earnings per share are outstanding common stock optionswith an exercise price greater than the average market price of the commonshares for the periods reported.  Foreach of the three month periods ended June 30, 2005 and 2004, stockoptions to purchase 6.5 million common shares were outstanding but were notincluded in the computation of diluted earnings per share because the optionswere antidilutive.  For the six monthperiods ended June 30, 2005 and 2004 stock options to purchase 6.5 millionand 6.1 million common shares, respectively, were outstanding but were not includedin the computation of diluted earnings per share because they wereanti-dilutive.

 

*Stock-based compensation*

 

The Company accounts forits stock-based employee compensation plans using the recognition andmeasurement principles of Accounting Principles Board (APB) Opinion No. 25,“Accounting for Stock Issued to Employees” (APB 25) and relatedinterpretations.  No stock-based employeecompensation expense has been recognized for the options in the accompanyingcondensed consolidated statements of income, as all options granted under theplans had an exercise price equal to the market value of the underlying commonstock on the date of grant.

 

5

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The Company has electedto use the intrinsic value method under APB 25 as permitted by Statement ofFinancial Accounting Standards (SFAS) No. 123, “Accounting for Stock-BasedCompensation” (SFAS 123), subsequently amended by SFAS No. 148, “Accountingfor Stock-Based Compensation-Transition and Disclosure” (SFAS 148) toaccount for stock options issued to its employees.  The Company makes pro forma fair valuedisclosures required by SFAS 123 which reflect the impact on net income andearnings per share had the Company applied the fair value method of accountingfor its stock-based awards to employees. The Company estimates the fair value of its stock-based awards toemployees using the Black-Scholes option pricing model.  The pro forma effects on net income andearnings per share are as follows (in thousands, except per share amounts):

 
| ** **                                                                                                                                     | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                                     | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income, as  reported                                                                                                                       |       | $                                     | 40,868     |                                | $          | 34,927 |   | $ | 79,779 |   | $ | 81,586 |   |
| Deduct: Total  stock-based employee compensation  expense determined under fair value based method for all awards, net of  related tax effects |       | 2,869                                 |       | 4,103                               |       | 5,967 |   | 8,592 |   |
| Pro forma net  income                                                                                                                          |       | 37,999                                |       | 30,824                              |       | 73,812 |   | 72,994 |   |
| Add: Interest  expense on CODES                                                                                                                |       | 1,814                                 |       | 639                                 |       | 3,441 |   | 2,512 |   |
| Pro forma net  income, adjusted                                                                                                                |       | $                                     | 39,813     |                                | $          | 31,463 |   | $ | 77,253 |   | $ | 75,506 |   |
| Earnings per  share:                                                                                                                           |       |                                  |       |                                |       |   |   |   |   |
| Basic - as  reported                                                                                                                           |       | $                                     | 0.38       |                                | $          | 0.32 |   | $ | 0.74 |   | $ | 0.75 |   |
| Basic - pro  forma                                                                                                                             |       | $                                     | 0.36       |                                | $          | 0.28 |   | $ | 0.69 |   | $ | 0.67 |   |
|                                                                                                                                           |       |                                  |       |                                |       |   |   |   |   |
| Diluted - as  reported                                                                                                                         |       | $                                     | 0.35       |                                | $          | 0.29 |   | $ | 0.68 |   | $ | 0.67 |   |
| Diluted - pro  forma                                                                                                                           |       | $                                     | 0.33       |                                | $          | 0.25 |   | $ | 0.63 |   | $ | 0.60 |   |

 

The weighted average fairvalues of the employee stock options and employee stock purchase plan (ESPP)have been estimated on the date of each grant using the Black-Scholes optionpricing model. Weighted averages are used because of varying assumed exercisedates.  The following weighted averageassumptions were used for stock options granted during the three and six monthsended June 30, 2005 and 2004:

 
| ** **                   | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                   | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Dividend yield               |       | None                                  |       | None                                |       | None |   | None |   |
| Expected  volatility         |       | 44                                    | %          | 49                                  | %          | 37 | % | 38 | % |
| Risk-free  interest rate     |       | 3.96                                  | %          | 3.78                                | %          | 3.98 | % | 3.78 | % |
| Expected term in  years      |       | 5.3                                   |       | 5.1                                 |       | 5.4 |   | 5.2 |   |
|                         |       |                                  |       |                                |       |   |   |   |   |
| Weighted average  fair value |       |                                  |       |                                |       |   |   |   |   |
| per share at  grant date     |       | $                                     | 13.51      |                                | $          | 14.93 |   | $ | 12.12 |   | $ | 13.65 |   |
|                              |            |                                       |            |                                     |            |  |  |  |  |  |  |  |  |

 

6

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The following weightedaverage assumptions were used for the ESPP during the three and six months endedJune 30, 2005 and 2004:

 
| ** **                                           | ** ** | **Three and Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                      | ** ** | **2004** | ** ** |
| Dividend yield                                       |       | None                                          |       | None |   |
| Expected  volatility                                 |       | 26%                                           |       | 38% |   |
| Risk-free  interest rate                             |       | 4.00%                                         |       | 3.78% |   |
| Expected term                                        |       | 6 months                                      |       | 6 months |   |
|                                                 |       |                                          |       |   |   |
| Weighted average  fair value per share at grant date |       | $                                             | 7.31       |   | $ | 11.83 |   |
|                                                      |            |                                               |            |  |  |  |  |

 

*StockAwards*

 

Weimplemented certain changes in employee stock-based compensation during thesecond quarter of 2005 to help us strengthen our ability to attract, retain andmotivate our employees, and to better align employee interests with those ofour shareholders. Generally, employees are now granted restricted stock awardsas well as stock options. The stock award program offers employees theopportunity to earn shares of our stock over time, rather than options thatgive employees the right to purchase stock at a set price. Restricted stockawards are grants that entitle the holder to shares of common stock as theaward vests.  On June 29, 2005,approximately 38,000 restricted stock awards with a weighted-average fair valueof $29.97 per share were granted to certain non-employee directors and theCompany’s Chief Executive Officer.  Theserestricted stock awards generally vest over a one to four year period.

 

*Stock Repurchases*

 

We have repurchasedapproximately 6.0 million shares of our common stock at an aggregate cost ofapproximately $182.6 million under the Company’s $300.0 million stockrepurchase program approved by the Board of Directors (Board) on February 10,2005.  As of June 30, 2005, theCompany had approximately $117.4 million available for future repurchases ofits common stock under this Board authorization.  This program provides for purchases to bemade in the open market or in privately negotiated transactions through February 10,2006.

 

*Recent accounting pronouncements*

 

In November 2004,the Financial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards (SFAS) No. 151, “Inventory Costs-an Amendment of ARB No. 43,Chapter 4” (SFAS 151).  SFAS 151 requiresthat accounting for items such as idle facility expense, freight, handlingcosts, and wasted materials (spoilage) be recognized as current period chargesregardless of whether they meet the criterion of “so abnormal.”  In addition, SFAS 151 requires that allocationof fixed production overheads to the costs of conversion be based on the normalcapacity of the production facilities. SFAS 151 is effective for inventory costs incurred during fiscal yearsbeginning after June 15, 2005.  Theprovision of SFAS 151 shall be applied prospectively.  The Company believes that the adoption ofSFAS 151 will not have a material effect on our Condensed ConsolidatedFinancial Statements.

 

In December 2004,the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS123R), which replaces SFAS 123, and supercedes APB 25. Under SFAS 123R,the Company must determine the appropriate fair value model to be used forvaluing share-based payment transactions with employees, the amortizationmethod for compensation cost and the transition method to be used at the dateof adoption. The transition methods include modified prospective and modifiedretrospective adoption options. Under the 

 

7

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modified retrospective option, prior periods may be restated either asof the beginning of the year of adoption or for all periods presented. Themodified prospective method requires that compensation expense be recorded forall unvested stock options and restricted stock at the beginning of the firstquarter of adoption of SFAS 123R, while the modified retrospective methodwould record compensation expense for all unvested stock options and restrictedstock beginning with the first period restated. The Company is evaluating therequirements of SFAS 123R. The Company has not yet determined the methodof adoption or the effect of adopting SFAS 123R, and it has not determinedwhether the adoption will result in amounts that are similar to the current proforma disclosures under SFAS 123.

 

In April 2005, theSecurities and Exchange Commission announced an amendment to Regulation S-X toamend the date for compliance with FAS 123R. The amendment requires each registrant that is not a small businessissuer to adopt FAS 123R in the first fiscal year commencing after June 15,2005.  The Company is required to adoptSFAS 123R beginning January 1, 2006. Adoption of FAS 123R will have a material impact on our consolidatedfinancial statements, as we will be required to expense the fair value of ourstock option awards and ESPP grants rather than disclose the pro forma impacton our consolidated net income within the footnotes to our consolidatedfinancial statements, as is our current practice.

 

**NOTE 2 – INVESTMENTS**

 

The Company’s equityinvestments in publicly traded companies are classified as available-for-saleand are recorded at fair value based on quoted market prices using the specificidentification method.  These investmentsare classified as current marketable securities, or investments and other assets,as appropriate, on the Company’s Condensed Consolidated Balance Sheets.

 

The Company’s debtinvestments in U.S. Treasury securities are classified as available-for-saleand are recorded at fair value based on quoted market prices using the specificidentification method.

 

The following tableprovides a summary of the fair value and unrealized holding gain (loss) relatedto Watson’s available-for-sale securities at June 30, 2005 and December 31,2004 (in thousands):

 
| **At June 30, 2005**        | ** ** | **Cost, Including  Accrued Interest** | ** ** | **Gross Unrealized  Gains** | ** ** | **Gross Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|-----------------------------|------------|------------------------------|------------|----------------|------------|
| Available-for-sale:              |       |                                  |       |                        |       |                         |       |           |       |
| U.S. Treasury  securities        |       | $                                     | 149,947    |                        | $          | —                       |       | $              | (1,232     | ) | $ | 148,715 |   |
| Equity  securities - current     |       | 1,572                                 |       | 10,762                      |       | —                       |       | 12,334         |       |
| Current                          |       | 151,519                               |       | 10,762                      |       | (1,232                       | )          | 161,049        |       |
| Equity  securities - non-current |       | 2,032                                 |       | 723                         |       | (300                         | )          | 2,455          |       |
| Total                            |       | $                                     | 153,551    |                        | $          | 11,485                       |       | $              | (1,532     | ) | $ | 163,504 |   |

 
| **At December 31, 2004**    | ** ** | **Cost, Including  Accrued Interest** | ** ** | **Gross Unrealized  Gains** | ** ** | **Gross Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|-----------------------------|------------|------------------------------|------------|----------------|------------|
| Available-for-sale:              |       |                                  |       |                        |       |                         |       |           |       |
| U.S. Treasury  securities        |       | $                                     | 198,828    |                        | $          | —                       |       | $              | (105       | ) | $ | 198,723 |   |
| Auction rate  securities         |       | 169,699                               |       | —                      |       | —                       |       | 169,699        |       |
| Equity  securities - current     |       | 1,572                                 |       | 11,685                      |       | —                       |       | 13,257         |       |
| Current                          |       | 370,099                               |       | 11,685                      |       | (105                         | )          | 381,679        |       |
| Equity  securities - non-current |       | 2,032                                 |       | 3,290                       |       | —                       |       | 5,322          |       |
| Total                            |       | $                                     | 372,131    |                        | $          | 14,975                       |       | $              | (105       | ) | $ | 387,001 |   |

 

Our investments inauction rate securities were liquidated in May 2005 and approximately $50million in U.S. Treasury securities matured in June 2005.  Proceeds were deposited in cash and cashequivalents.

 

8

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Gross unrealized gains atJune 30, 2005 and December 31, 2004 primarily relate to our holdingsin shares of Andrx Corporation (Andrx) common stock.  The gross unrealized holding loss at June 30,2005 and December 31, 2004 is attributable to adjustments, included inother comprehensive income, for the decline in fair value in the Company’sinvestment in U.S. Treasury securities.

 

Net unrealized holdinggains related to available-for-sale securities were $9.9 million and $20.4million for the six month periods ended June 30, 2005 and 2004,respectively.  Changes in the Company’snet unrealized holding gains (losses) are included in other comprehensiveincome (loss).

 

*Current investments*

 

The Company’s investmentin the common stock of Andrx, publicly traded on the Nasdaq Stock Market underthe symbol ADRX, is classified as a current investment on the Company’sCondensed Consolidated Balance Sheets at June 30, 2005 and December 31,2004.

 

The Company did not sellany of its shares of Andrx during the six month period ended June 30,2005.     During the six month periodended June 30, 2004, Watson sold 150,000 shares of its investment in thecommon stock of Andrx for proceeds of $4.3 million and recorded a pre-tax gainof $3.9 million.  Realized gains arecomputed using the specific identification method to determine the cost basisfor each investment.

 

The Company’s investmentsin U.S. Treasury securities and auction rate securities are classified as acurrent investment on the Company’s Condensed Consolidated Balance Sheet at June 30,2005 and December 31, 2004.

 

The contractualmaturities of the U.S. Treasury securities consisted of the following (inthousands):

 
| ** **               | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Mature within  one year  |       | $                       | —     |                        | $          | 49,502 |   |
| Mature within  two years |       | 148,715                 |       | 149,221                     |       |
|                     |       | $                       | 148,715    |                        | $          | 198,723 |   |

 

*Non-current investments*

 

The Company’s investmentsin the common stock of Genelabs Technologies, Inc., NovaDel Pharma Inc.and Amarin Corporation plc are classified as non-current investments and areincluded in “Investments and other assets” on the Company’s CondensedConsolidated Balance Sheets at June 30, 2005 and December 31, 2004.

 

**NOTE 3 – OPERATING SEGMENTS**

 

Watson has two operatingsegments: brand and generic.  The brandbusiness segment includes the Company’s lines of Specialty Products andNephrology products. Watson has aggregated its brand product lines in a singlesegment because of similarities in regulatory environment, methods ofdistribution and types of customer.  Thissegment includes patent-protected products and certain trademarked off-patentproducts that Watson sells and markets as brand pharmaceutical products.  The generic business segment includesoff-patent pharmaceutical products that are therapeutically equivalent toproprietary products.  The Company sellsits brand and generic products primarily to pharmaceutical wholesalers, drugdistributors and chain drug stores.

 

Prior to January 1,2005, the Company evaluated the performance of its segments based on netrevenues and gross profit.  As of January 1,2005, the Company began to evaluate segment performance based on segment grossprofit and contribution. Segment contribution represents segment gross profitless direct research and 

 

9

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development expenses and selling and marketing expenses.  Segment financial data for prior periods havebeen reclassified to reflect this change in evaluating the associated segmentresults.

 

The Company has notreported general and administrative expenses, amortization, depreciationexpense, total assets, and capital expenditures by segment as such informationis not used by management, or accounted for, at the segment level.  Net revenues, segment gross profit andsegment contribution information for the Company’s brand and generic segments,as reclassified, consisted of the following:

 

***ThreeMonths Ended June 30, 2005 Compared to the Three Months Ended June 30,2004***

 
| ** **                                 | ** ** | **Brand** | ** ** | **Generic** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|-----------|------------|-------------|------------|-----------|------------|
| **Three  months ended June 30, 2005** |       |      |       |        |       |      |       |
| Product sales                              |       | $         | 100,746    |        | $          | 312,453   |       | $ | 413,199 |   |
| Other                                      |       | 1,918     |       | 1,149       |       | 3,067     |       |
| Net revenues                               |       | 102,664   |       | 313,602     |       | 416,266   |       |
| Cost of revenue                            |       | 23,072    |       | 188,141     |       | 211,213   |       |
| Gross profit                               |       | 79,592    |       | 125,461     |       | 205,053   |       |
| Gross margin                               |       | 78        | %          | 40          | %          | 49        | %          |
|                                       |       |      |       |        |       |      |       |
| Research and  development                  |       | 9,668     |       | 21,818      |       | 31,486    |       |
| Selling and  marketing                     |       | 30,532    |       | 11,688      |       | 42,220    |       |
| Contribution                               |       | $         | 39,392     |        | $          | 91,955    |       | 131,347 |   |
| Contribution  margin                       |       | 38        | %          | 29          | %          | 32        | %          |
|                                       |       |      |       |        |       |      |       |
| General and  administrative                |       |      |       |        |       | 25,905    |       |
| Amortization                               |       |      |       |        |       | 41,101    |       |
| Operating income                           |       |      |       |        |       | $         | 64,341     |   |

 
| ** **                                 | ** ** | **Brand** | ** ** | **Generic** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|-----------|------------|-------------|------------|-----------|------------|
| **Three  months ended June 30, 2004** |       |      |       |        |       |      |       |
| Product sales                              |       | $         | 84,510     |        | $          | 305,566   |       | $ | 390,076 |   |
| Other                                      |       | 2,637     |       | 6,655       |       | 9,292     |       |
| Net revenues                               |       | 87,147    |       | 312,221     |       | 399,368   |       |
| Cost of revenue                            |       | 19,577    |       | 179,277     |       | 198,854   |       |
| Gross profit                               |       | 67,570    |       | 132,944     |       | 200,514   |       |
| Gross margin                               |       | 78        | %          | 43          | %          | 50        | %          |
|                                       |       |      |       |        |       |      |       |
| Research and  development                  |       | 25,479    |       | 17,050      |       | 42,529    |       |
| Selling and  marketing                     |       | 42,066    |       | 11,156      |       | 53,222    |       |
| Contribution                               |       | $         | 25         |        | $          | 104,738   |       | 104,763 |   |
| Contribution  margin                       |       | 0         | %          | 34          | %          | 26        | %          |
|                                       |       |      |       |        |       |      |       |
| General and  administrative                |       |      |       |        |       | 25,947    |       |
| Amortization                               |       |      |       |        |       | 17,983    |       |
| Operating income                           |       |      |       |        |       | $         | 60,833     |   |

 

10

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***SixMonths Ended June 30, 2005 Compared to the Six Months Ended June 30,2004***

 
| ** **                               | ** ** | **Brand** | ** ** | **Generic** | ** ** | **Total** | ** ** |
|------------------------------------------|------------|-----------|------------|-------------|------------|-----------|------------|
| **Six  months ended June 30, 2005** |       |      |       |        |       |      |       |
| Product sales                            |       | $         | 205,272    |        | $          | 605,616   |       | $ | 810,888 |   |
| Other                                    |       | 3,971     |       | 2,235       |       | 6,206     |       |
| Net revenues                             |       | 209,243   |       | 607,851     |       | 817,094   |       |
| Cost of revenue                          |       | 46,832    |       | 371,331     |       | 418,163   |       |
| Gross profit                             |       | 162,411   |       | 236,520     |       | 398,931   |       |
| Gross margin                             |       | 78        | %          | 39          | %          | 49        | %          |
|                                     |       |      |       |        |       |      |       |
| Research and  development                |       | 19,362    |       | 40,962      |       | 60,324    |       |
| Selling and  marketing                   |       | 58,000    |       | 22,948      |       | 80,948    |       |
| Contribution                             |       | $         | 85,049     |        | $          | 172,610   |       | 257,659 |   |
| Contribution  margin                     |       | 41        | %          | 28          | %          | 32        | %          |
|                                     |       |      |       |        |       |      |       |
| General and  administrative              |       |      |       |        |       | 50,828    |       |
| Amortization                             |       |      |       |        |       | 81,739    |       |
| Operating income                         |       |      |       |        |       | $         | 125,092    |   |

 
| ** **                               | ** ** | **Brand** | ** ** | **Generic** | ** ** | **Total** | ** ** |
|------------------------------------------|------------|-----------|------------|-------------|------------|-----------|------------|
| **Six  months ended June 30, 2004** |       |      |       |        |       |      |       |
| Product sales                            |       | $         | 172,886    |        | $          | 611,588   |       | $ | 784,474 |   |
| Other                                    |       | 8,659     |       | 15,893      |       | 24,552    |       |
| Net revenues                             |       | 181,545   |       | 627,481     |       | 809,026   |       |
| Cost of revenue                          |       | 37,228    |       | 358,107     |       | 395,335   |       |
| Gross profit                             |       | 144,317   |       | 269,374     |       | 413,691   |       |
| Gross margin                             |       | 79        | %          | 43          | %          | 51        | %          |
|                                     |       |      |       |        |       |      |       |
| Research and  development                |       | 37,250    |       | 34,960      |       | 72,210    |       |
| Selling and  marketing                   |       | 84,668    |       | 20,449      |       | 105,117   |       |
| Contribution                             |       | $         | 22,399     |        | $          | 213,965   |       | 236,364 |   |
| Contribution  margin                     |       | 12        | %          | 34          | %          | 29        | %          |
|                                     |       |      |       |        |       |      |       |
| General and  administrative              |       |      |       |        |       | 51,463    |       |
| Amortization                             |       |      |       |        |       | 35,915    |       |
| Operating income                         |       |      |       |        |       | $         | 148,986    |   |

 

**NOTE 4 – INVENTORIES**

 

Inventories consist offinished goods held for sale and distribution, raw materials andwork-in-process. Included in inventory at June 30, 2005 and December 31,2004 is approximately $6.7 million and $17.3 million, respectively, ofinventory that is pending approval by the U.S. Food and Drug Administration(FDA) or has not been launched due to contractual restrictions.  This inventory consists of genericpharmaceutical products that are capitalized only when the bioequivalence ofthe product is demonstrated or the product is already FDA approved and isawaiting a contractual triggering event to enter the marketplace.

 

11

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Inventories are stated atthe lower of cost (first-in, first-out method) or market (net realizable value)and consisted of the following (inthousands):

 
| ** **         | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------|------------|-------------------------|------------|-----------------------------|------------|
| Raw materials      |       | $                       | 107,309    |                        | $          | 109,422 |   |
| Work-in-process    |       | 61,624                  |       | 70,207                      |       |
| Finished goods     |       | 120,375                 |       | 141,670                     |       |
| Total  inventories |       | $                       | 289,308    |                        | $          | 321,299 |   |

 

**NOTE 5 – GOODWILL AND OTHERINTANGIBLE ASSETS**

 

Watson tests itsgoodwill and intangible assets with indefinite lives by comparing the fairvalue of each of the Company’s reporting units to the respective carrying valueof the reporting units.  The Companyperforms this impairment testing annually during the second quarter and whenevents occur or circumstances change that would more likely than not reduce thefair value of a reporting unit below its carrying amount.  The Company’s two reporting units are brandand generic pharmaceutical products.  Thecarrying value of each reporting unit is determined by assigning the assets andliabilities, including the existing goodwill and intangible assets, to thosereporting units.  Goodwill is consideredimpaired if the carrying amount exceeds the fair value of the asset.

 

Duringthe second quarter of 2005, Watson performed its annual test for the impairmentof goodwill and determined there was no indication of impairment.  There were no additions to goodwill recordedduring the six months ended June 30, 2005. At June 30, 2005 and December 31, 2004, goodwill for theCompany’s reporting units consisted of the following (in thousands):

 
| Brand  pharmaceutical products   |   | $      | 368,105 |   |
|----------------------------------|--------|--------|---------|--------|
| Generic  pharmaceutical products |   | 87,490 |    |
| Total goodwill                   |   | $      | 455,595 |   |

 

Otherintangible assets consist primarily of product rights.  The original cost and accumulatedamortization of these intangible assets are as follows (in thousands):

 
| ** **                                         | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Product rights  and related intangibles            |       | $                       | 1,266,938  |                        | $          | 1,266,512 |   |
| Less accumulated  amortization                     |       | (435,504                | )          | (353,766                    | )          |
| Total product  rights and related intangibles, net |       | $                       | 831,434    |                        | $          | 912,746 |   |

 

The Company’scurrent product rights and related intangibles have a weighted average usefullife of approximately twelve years. Assuming no additions, disposals or adjustments are made to the carryingvalues and/or useful lives of the assets, remaining amortization expense onproduct rights and related intangibles is

 

12

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estimated to be asfollows (in thousands):

 

**Periodending December 31,**

 
| 2005       |   | $       | 82,201  |   |
|------------|--------|---------|---------|--------|
| 2006       |   | 164,402 |    |
| 2007       |   | 164,402 |    |
| 2008       |   | 53,452  |    |
| 2009       |   | 52,491  |    |
| Thereafter |   | 314,486 |    |
| Total      |   | $       | 831,434 |   |

 

**NOTE 6 –LONG-TERM DEBT**

 

Long-term debt consistedof the following (in thousands):

 
| ** **                                                                                          | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                                                                                                |       |                    |       |                        |       |
| CODES, face  amount of $575 million, due 2003,  net of unamortized discount                         |       | $                       | 573,711    |                        | $          | 573,573 |   |
| Senior unsecured  notes, 7.125%, face amount of $14 million,  due 2008, net of unamortized discount |       | 14,045                  |       | 14,036                      |       |
| Other notes  payable                                                                                |       | 38                      |       | 44                          |       |
| Total long-term  debt                                                                               |       | $                       | 587,794    |                        | $          | 587,653 |   |

 

*CODES*

 

In March 2003, theCompany issued $575 million of CODES. The CODES, which are convertible into shares of Watson’s common stockupon the occurrence of certain events, are due in March 2023, withinterest payments due semi-annually in March and September at aneffective annual interest rate of 2.1%, excluding changes in fair value of thecontingent interest derivative. At June 30, 2005 and at December 31,2004, the unamortized discount for the CODES was $1.3 million and $1.4 million,respectively.

 

The CODES are convertibleinto Watson’s common stock at a conversion price of approximately $40.05 pershare (subject to certain adjustments upon certain events such as (i) stocksplits or dividends, (ii) material stock distributions orreclassifications, (iii) distribution of stock purchase rights at lessthan current market rates, or (iv) a distribution of assets or commonstock to our shareholders or subsidiaries). The CODES may be converted, at the option of the holders, prior tomaturity under any of the following circumstances:

 

•                  during anyquarterly conversion period (period from and including the thirtieth tradingday in a fiscal quarter to, but not including, the thirtieth trading day in theimmediately following fiscal quarter) if the closing sale price per share ofWatson’s common stock for a period of at least 20 trading days during the 30consecutive trading-day period ending on the first day of such conversionperiod is more than 125% ($50.06) of the conversion price in effect on thatthirtieth day;

 

•                  on or before March 15,2018, during the five business-day period following any 10 consecutivetrading-day period in which the daily average trading price for the CODES forsuch ten-day period was less than 105% of the average conversion value for thedebentures during that period.  Thisconversion feature represents an embedded derivative.  However, based on the de minimis valueassociated with this feature, no value has been assigned at issuance and at June 30,2005;

 

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•                  during anyperiod, following the earlier of (a) the date the CODES are rated by bothStandard & Poor’s Rating Services and Moody’s Investor Services, Inc.,and (b) April 21, 2003, when the long-term credit rating assigned tothe CODES by either Standard & Poor’s or Moody’s (or any successors tothese entities) is lower than “BB” or “Ba3”, respectively, or when either ofthese rating agencies does not have a rating then assigned to the CODES for anyreason, including any withdrawal or suspension of a rating assigned to theCODES.  This conversion featurerepresents an embedded derivative. However, based on the de minimis value associated with this feature, novalue has been assigned at issuance and at June 30, 2005;

 

•                  if the CODEShave been called for redemption; or

 

•                  upon theoccurrence of specified corporate transactions.

 

The Company may redeemsome or all of the CODES for cash, on or after March 20, 2008, for a priceequal to 100% of the principal amount of the CODES plus accrued and unpaidinterest (including contingent interest) to, but excluding, the redemptiondate.

 

The CODES contain putoptions which may require the Company to repurchase for cash all or a portionof the CODES on March 15 of 2010, 2015 and 2018 at a repurchase priceequal to 100% of the principal amount of the CODES plus any accrued and unpaidinterest (including contingent interest) to, but excluding, the date ofrepurchase.

 

In addition, the holdersof the CODES have the right to receive contingent interest payments during anysix-month period from March 15 to September 14 and from September 15to March 14, commencing on September 15, 2003, if the average tradingprice of the CODES for the five trading days ending on the second trading dayimmediately preceding the relevant six-month period equals 120% or more of theprincipal amount of the CODES.  Theinterest rate used to calculate the contingent interest is the greater of 5% ofthe Company’s then-current estimated per annum borrowing rate for seniornon-convertible fixed-rate debt with a maturity date and other terms comparableto that of the CODES or 0.33% per annum. This contingent interest payment feature is an embedded derivative andhas been bifurcated and recorded separately in the Condensed ConsolidatedBalance Sheets in other long-term liabilities. The initial fair value assigned to the embedded derivative was $1.9million, which is recorded as a discount to the CODES.  Changes to the fair value of this embeddedderivative are reflected as an adjustment to interest expense.  At June 30, 2005 and December 31,2004 the current value of the embedded derivative was $846,000 and $1,687,000,respectively.

 

*1998 Senior Notes*

 

In May 1998, Watsonissued $150 million of its senior unsecured notes (1998 Senior Notes).  The 1998 Senior Notes are due in May 2008but may be redeemed earlier under certain circumstances.  The Company is required to make interest onlypayments due semi-annually in May and November.  The effective annual interest rate is 7.2%.  At June 30, 2005 and December 31,2004, the unamortized discount for the 1998 Senior Notes was $50,000 and$59,000, respectively.

 

In February 2004,the Company initiated a tender offer to purchase all of its outstanding 1998Senior Notes and a related consent solicitation.  The Company received tenders of its 1998Senior Notes and deliveries of related consents from holders of approximately $101.6million of the $150 million aggregate principal amount of 1998 Senior Notesoutstanding.  As a result, the Companyreceived the required consents to eliminate substantially all of therestrictive covenants of the indenture governing the 1998 Senior Notes and tomake certain amendments.  The Companyexecuted and delivered a supplemental indenture setting forth the amendments.

 

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In May 2004, theCompany acquired an additional $34.3 million of its outstanding 1998 SeniorNotes in an open market transaction.  TheCompany recorded charges of $14.0 million and $3.7 million in the first andsecond quarters of 2004, respectively, related to fees, expenses, unamortized discount,and premiums paid for the bond repurchases.

 

*Credit Facility*

 

In May 2003, theCompany entered into an agreement****with asyndicate of lenders for a five-year, $300 million senior, unsecured revolvingcredit facility (the Credit Facility) for working capital and other generalcorporate purposes. Watson’s assets generally are held by, and its operationsgenerally are conducted through, its subsidiaries.  Within the meaning of Regulation S-X, Rule 3-10,the Company has no assets or operations independent of its subsidiaries.  The terms of the Credit Facility require eachsubsidiary, other than minor subsidiaries, to provide full and unconditionalguarantees on a joint and several basis. In order to provide subsidiaryguarantees in connection with this Credit Facility, the Company was also required,by the terms of the Indenture for the 1998 Senior Notes, to grant similarsubsidiary guarantees in favor of the 1998 Senior Note holders. The subsidiaryguarantees related to both the Credit Facility and the 1998 Senior Notes arefull and unconditional, on a joint and several basis, and are given by allsubsidiaries other than minor subsidiaries. Watson is subject to certain financial and operational covenants, all ofwhich, as of June 30, 2005, the Company was in compliance.  As of June 30, 2005, the Company had notdrawn any funds from the Credit Facility.

 

**NOTE 7 – FINANCIAL INSTRUMENTS**

 

*Fair value of financialinstruments*

 

The Company’s financialinstruments consist primarily of cash and cash equivalents, marketablesecurities, accounts and other receivables, investments, trade accountspayable, 1998 Senior Notes, CODES and embedded derivatives related to theissuance of the CODES.  The carryingamounts of cash and cash equivalents, marketable securities, accounts and otherreceivables and trade accounts payable are representative of their respectivefair values due to their relatively short maturities.  The fair values of investments in companiesthat are publicly traded are based on quoted market prices.  The fair value of investments in privatelyheld companies, or cost-method investments, are based on historical cost,adjusted for any write-down related to impairment.  The Company estimates the fair value of itsfixed rate long-term obligations based on quoted market rates of interest andmaturity schedules for similar issues. The carrying value of these obligations approximates their fairvalue.  The fair value of the embeddedderivatives related to the CODES is based on a present value technique usingdiscounted expected future cash flows.

 

*Derivative financial instruments*

 

The Company’s derivativefinancial instruments consist of embedded derivatives related to itsCODES.  These embedded derivativesinclude certain conversion features and a contingent interest feature.   See Note 6 for a more detailed descriptionof these features of the CODES.  Althoughthe conversion features represent embedded derivative financial instruments,based on the de minimis value of these features at the time of issuance and at June 30,2005, no value has been assigned to these instruments.  The contingent interest feature providesunique tax treatment under the Internal Revenue Service’s Contingent DebtRegulations.  In essence, interestaccrues, for tax purposes, on the basis of the instrument’s comparable yield (theyield at which the issuer would issue a fixed rate instrument with similarterms). This embedded derivative is reported on the Company’s CondensedConsolidated Balance Sheets at fair value and the changes in the fair value ofthe embedded derivative are reported as gains or losses in the Company’sCondensed Consolidated Statements of Income.

 

The carrying value of theCompany’s derivative financial instruments, which approximates fair value,decreased $841,000 from $1,687,000 at December 31, 2004 to $846,000 at June 30,2005.  The change in fair value wasrecorded as an adjustment to interest expense during the respective period.

 

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**NOTE 8 – COMMITMENTS ANDCONTINGENCIES**

 

*Facility and equipment leases*

 

The Company has enteredinto long-term operating leases for certain facilities and equipment.  The terms of the operating leases for theCompany’s facilities require the Company to pay property taxes, normalmaintenance expenses and maintain minimum insurance coverage.  Total rental expense for operating leases forthe six months ended June 30, 2005 and 2004 were $5.5 million and $6.2million, respectively.

 

Remaining future minimumlease payments under all non-cancelable operating leases are as follows (in thousands):

 

**Periodending December 31,**

 
| 2005       |   | $      | 4,586  |   |
|------------|--------|--------|--------|--------|
| 2006       |   | 7,127  |   |
| 2007       |   | 5,526  |   |
| 2008       |   | 3,355  |   |
| 2009       |   | 2,604  |   |
| Thereafter |   | 14,298 |   |
| Total      |   | $      | 37,496 |   |

 

*Employee retirement plans*

 

The Company maintainscertain defined contribution retirement plans covering substantially allemployees.  The Company contributes tothe plans based upon the employee contributions.  The Company does not sponsor any definedbenefit retirement plans or postretirement benefit plans.  Watson’s contributions to these retirementplans for the three and six months ended June 30, 2005 were $1.6 millionand $3.3 million, respectively.  Watson’scontributions to these retirement plans for the three and six months ended June 30,2004 were $2.4 million and $3.8 million, respectively.

 

*Legal matters*

 

The Company is party tocertain lawsuits and legal proceedings, which are described in “Part I,Item 3. Legal Proceedings,” of our Annual Report on Form 10-K for the yearended December 31, 2004.  Thefollowing is a description of material developments during the period coveredby this Quarterly Report and through the filing of this Quarterly Report, andshould be read in conjunction with the Annual Report referenced above.

 

*Phen-fenlitigation.*  Withrespect to the phentermine hydrochloride product liability lawsuits pendingagainst the Company, certain subsidiaries, and others, additional actionsraising similar issues have been filed, and some actions have been settled orotherwise dismissed.  As of August 8,2005, approximately 50 cases were pending against Watson and its affiliates innumerous state and federal courts.  Mostof the cases involve multiple plaintiffs, and several were filed or certifiedas class actions.  The Company believesit will be fully indemnified by Rugby’s former owner, Aventis Pharmaceuticals(Aventis, formerly known as Hoechst Marion Roussel, Inc., and now known asSanofi-Aventis) for the defense of all such cases and for any liability thatmay arise out of these cases.  Aventis iscurrently controlling the defense of all these matters as the indemnifyingparty under its agreements with the Company.

 

*Cipro®Litigation. *On May 7,2005, three groups of plaintiffs from the consolidated action (*In re: Ciprofloxacin Hydrochloride Antitrust Litigation, MDL Docket No. 001383*),including the direct purchaser plaintiffs, the indirect purchaser plaintiffs,and plaintiffs Rite Aid and CVS, filed Notices of Appeal in the United StatesCourt of Appeals for the Second Circuit, appealing, among other things, the March 31,2005 Order 

 

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by the United States District Court for the Eastern District of NewYork granting summary judgment in favor of the defendants.

 

*GovernmentalReimbursement Investigations and Drug Pricing Litigation.* With respect to the Drug Pricing Litigationpending against the Company and certain subsidiaries, additional actionsraising similar allegations were filed in June and July of 2005,including actions by six counties in New York State (*County ofColumbia v. Abbott Laboratories, Inc., et al*., United StatesDistrict Court for the Northern District of New York, Case No. 05-CV-0867-GLS/RFTl;*County of Cortland v. Abbott Laboratories, Inc.,et al.*, United States District Court for the Northern District ofNew York, Case No. 05-CV-0881-NAM/GJD; *County of Dutchess v.Abbott Laboratories, Inc., et al.,* United States District Courtfor the Southern District of New York, Case No. 05-CV-06458-ESJ/KNF; *Essex County v. Abbott Laboratories, Inc., et al.,*United States District Court for the Northern District of New York, Case No. 05-CV-0878-TJM/DRH;*County of Lewis v. Abbott Laboratories, Inc.,et al.,* United States District Court for the Northern District ofNew York, Case No. 05-CV-0839-DNH/GHL; and *County ofOrleans v. Abbott Laboratories, Inc., et al.,* United StatesDistrict Court for the Western District of New York, Case No. 05-CV-06371-MAT).  In the Consolidated Action pending in theUnited States District Court for the District of Massachusetts (*In re Pharmaceutical Industry Average Wholesale Price Litigation, MDLDocket No. 1456, Civil Action No. 01-CV-12257-PBS*), on June 15,2005, a separate consolidated complaint was filed that adds six other New Yorkcounties (County of Jefferson, County of Madison, County of Niagra, County ofPutnam, County of Steuben, and County of Suffolk) to those that had earliersued the Company and certain subsidiaries. On July 20, 2005, an action was filed against the Company and asubsidiary by the Attorney General for the State of Florida (*The State of Florida ex rel. Ven-A-Care of the Florida Keys, Inc.et al. v. Mylan Laboratories, Inc. et al.*, Civil Action No. 98-3032G,Florida Leon County Court).  As of August 8,2005, in addition to the Consolidated Action pending in the United StatesDistrict Court for the District of Massachusetts, there were approximately 45plaintiffs in 40 cases pending against the Company or its subsidiaries andother third parties, including actions by eight State Attorneys General, theCity of New York, and 36 counties in New York State. The defendants haveremoved several of these actions (originally filed in state court) to federalcourt, and are seeking eventual transfer of these cases into the ConsolidatedAction.  However, the plaintiffs havefiled motions to remand several of the cases back to state court. The Companyhas been served in several of the actions filed by New York counties. Additionalactions are anticipated.  The Companyintends to defend these actions vigorously. However, if successful, these actions could adversely affect the Companyand may have a material adverse effect on the Company’s business, results ofoperations, financial condition and cash flows.

 

*SecuritiesLitigation.*  On May 31,2005, the appellants in the action pending in the U.S. Court of Appeals for theNinth Circuit (*Pension Fund v. Watson Pharmaceuticals, Inc.,USCA Docket No. 04-56791*) filed their reply brief.  The appellate court has not yet scheduled ahearing on the appeal.

 

*HormoneReplacement Therapy Litigation.*           Withrespect to the hormone replacement therapy product liability lawsuits pendingagainst the Company, certain of its subsidiaries, and other third parties,additional actions raising similar allegations have been filed, and someactions have been dismissed.  As of August 8,2005, there were approximately 90 cases pending against the Company and itsaffiliates in various state and federal courts, representing claims byapproximately 800 plaintiffs.  Many ofthe cases seek certification as class actions. These actions, if successful, could adversely affect the Company andcould have a material adverse effect on the Company’s business, results ofoperations, financial condition and cash flows.

 

Watson and its affiliatesare involved in various other disputes, governmental and/or regulatoryinspections, inquires, investigations and proceedings, and litigation mattersthat arise from time to time in the ordinary course of business.  The process of resolving matters through litigationor other means is inherently uncertain and it is possible that an unfavorableresolution of these matters will adversely affect the Company, its results ofoperations, financial condition and cash flows.

 

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**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

The following discussionof our financial condition and the results of our operations should be read inconjunction with the condensed consolidated financial statements and notesthereto included elsewhere in this Quarterly Report.  This discussion contains forward-lookingstatements that are subject to known and unknown risks, uncertainties and otherfactors that may cause our actual results to differ materially from thoseexpressed or implied by such forward-looking statements.  These risks, uncertainties and other factorsinclude, among others, those identified under “Cautionary Note RegardingForward-Looking Statements” and elsewhere in this Quarterly Report and under “RisksRelated to our Business” in our Annual Report on Form 10-K for the yearended December 31, 2004.

 

**Overview**

 

Watson Pharmaceuticals, Inc.(Watson, the “Company” “we”, “us” or “our”) was incorporated in 1985 and isengaged in the development, manufacture, marketing, sale and distribution ofbrand and off-patent (generic) pharmaceutical products. Watson operatesmanufacturing, distribution, research and development, and administrativefacilities primarily in the United States (U.S.).

 

Prescriptionpharmaceutical products in the U.S. are generally marketed as either generic orbrand pharmaceuticals.  Genericpharmaceutical products are bioequivalents of their respective brand productsand provide a cost-efficient alternative to brand products. Brandpharmaceutical products are marketed under brand names through programs thatare designed to generate physician and consumer loyalty.  As a result of the differences between thetwo types of products, we operate and manage our business as two segments:generic and brand.

 

**Results of Operations**

 

***ThreeMonths Ended June 30, 2005 Compared to the Three Months Ended June 30,2004***

 

***NetRevenues***

 
| ** **                 | ** ** | **Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|----------------------------|------------|--------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                       |       |                                 |       |       |       |   |   |   |   |
| Generic product  sales     |       | $                                    | 312,453    |       | $          | 305,566 |   | $ | 6,887 |   | 2.3 | % |
| *% of  product net sales*  | * *   | *76*                                 | *%*        | *78*       | %          |   |   |   |   |
| Brand product  sales       |       |                                 |       |       |       |   |   |   |   |
| Specialty  Products        |       | 54,710                               |       | 43,075     |       | 11,635 |   | 27.0 | % |
| Nephrology                 |       | 46,036                               |       | 41,435     |       | 4,601 |   | 11.1 | % |
| Total brand  product sales |       | 100,746                              |       | 84,510     |       | 16,236 |   | 19.2 | % |
| *% of  product net sales*  | * *   | *24*                                 | *%*        | *22*       | *%*        | * * | * * | * * | * * |
| Total product  net sales   |       | 413,199                              |       | 390,076    |       | 23,123 |   | 5.9 | % |
| Other                      |       | 3,067                                |       | 9,292      |       | (6,225 | ) | -67.0 | % |
| Total net  revenues        |       | $                                    | 416,266    |       | $          | 399,368 |   | $ | 16,898 |   | 4.2 | % |

 

*Generic Products*

 

Our genericpharmaceutical business develops, manufactures, markets, sells and distributesgeneric products that are the therapeutic equivalent to their brand namecounterparts and are generally sold at prices significantly less than the brandproduct. As such, generic products provide an effective and cost-efficientalternative to brand products. When patents or other regulatory exclusivitiesno longer protect a brand product, opportunities exist to introduce off-patentor generic counterparts to the brand product. Our portfolio of generic productsincludes 

 

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products we have internally developed, products we have licensed fromthird parties, and products we distribute for third parties.

 

Sales from our genericsegment during the three months ended June 30, 2005 increased 2.3% oversales from the same period of the prior year.  Increased sales of oral contraceptives and bupropion sustained release werepartially offset by a decrease in sales of nicotine gum due to the entry of acompetitor in that product line in December 2004 and selective pricedeclines in certain other products.

 

Sales of oralcontraceptive products represented 25% and 22% of total generic sales for thethree months ended June 30, 2005 and 2004, respectively.  Generic oral contraceptive product sales werelower during the prior year period due to wholesaler destocking.

 

*Brand Products*

 

Our brand pharmaceuticalbusiness develops, manufactures, markets, sells and distributes products withintwo sales and marketing groups: Specialty Products and Nephrology.

 

Our Specialty Productsproduct line consists primarily of products for the treatment of urologicdisorders.  Our Specialty Product portfolioalso includes: (i) anti-hypertensive, psychiatry, pain management anddermatology products, (ii) a genital warts treatment, and (iii) avisual cervical screening device.

 

Our Nephrology productline consists of products for the treatment of iron deficiency anemia and isgenerally marketed to nephrologists and dialysis centers.  The major product of the Nephrology group isFerrlecit®, which is used to treat low iron levels in patients undergoinghemodialysis in conjunction with erythropoietin therapy.

 

The $16.2 million or 19%increase in sales from our brand segment for the three months ended June 30,2005, as compared to the same prior year period, was primarily attributable toan increase in sales within our Specialty Products group.  The increase in sales of Specialty Productsresulted primarily from the launch of our Trelstar® Depot and Trelstar® LA(collectively “Trelstar®”) products for the palliative treatment of advancedprostate cancer and higher sales of our Oxytrol® product.

 

Sales from our Nephrologybusiness increased $4.6 million or 11.1% due to an increase in sales of ourFerrlecit® product.  Ferrlecit®represented approximately 79% of sales from our Nephrology business.

 

*Other*

 

Other revenues includerevenues earned under research and development agreements, other agreements androyalties.  Revenues recognized from research,development and licensing agreements (including milestone payments) aredeferred and recognized over the entire contract performance period, startingwith the contract’s commencement, but not prior to the removal of anycontingencies for each individual milestone. We recognize this revenue based upon the pattern in which the revenue isearned or the obligation is fulfilled.

 

The decrease in otherrevenues in the three months ended June 30, 2005 was primarily related tothe absence of royalty payments from Aventis Pharmaceuticals (Aventis, formerlyknown as Hoechst Marion Roussel, Inc., and now known as Sanofi-Aventis) inconnection with Barr Laboratories, Inc.’s sales of ciprofloxacin tablets.  Several companies launched competitiveproducts into the ciprofloxacin market during the second half of 2004.

 

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***GrossProfit Margin (Gross Margin)***

 
| ** **                         | ** ** | **Three Months Ended  June 30,** | ** ** |
|------------------------------------|------------|---------------------------------------|------------|
| ** **                         | ** ** | **2005**                              | ** ** | **2004** | ** ** | **Change** | ** ** |
|                               |       |                                  |       |   |   |   |   |
| Overall  Consolidated Gross Margin |       | 49.3                                  | %          | 50.2 | % | -0.9 | % |
|                               |       |                                  |       |   |   |   |   |
| Generic product  sales             |       | 39.8                                  | %          | 41.3 | % | -1.5 | % |
| Brand product  sales               |       | 77.1                                  | %          | 76.8 | % | 0.3 | % |
| Gross margin on  product net sales |       | 48.9                                  | %          | 49.0 | % | -0.1 | % |

 

Gross profit increased by$4.6 million to $205.1 million during the three months ended June 30, 2005from $200.5 million during same period of 2004. The primary contributors to the gross profit improvement were improvedefficiencies and cost reductions. However, such improvements were offset by price erosion within certain productsin our generic segment.

 

The $6.2 million decreasein other revenues during the three months ended June 30, 2005 was asignificant factor in the reduction of our overall consolidated gross margin ascompared to the same period of the prior year.

 

***Researchand Development Expenses***

 
| ** **                                     | ** ** | **Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|------------------------------------------------|------------|--------------------------------------|------------|------------|------------|
| **($ in thousands):**                     | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                           |       |                                 |       |       |       |   |   |   |   |
| Research and  development expenses by segment: |       |                                 |       |       |       |   |   |   |   |
| Generic                                        |       | $                                    | 21,818     |       | $          | 17,050 |   | $ | 4,768 |   | 28.0 | % |
| Brand                                          |       | 9,668                                |       | 25,479     |       | (15,811 | ) | -62.1 | % |
| Total research  and development expenses       |       | $                                    | 31,486     |       | $          | 42,529 |   | $ | (11,043 | ) | -26.0 | % |
| *as % of  net revenues*                        | * *   | *7.6*                                | *%*        | *10.6*     | %          |   |   |   |   |

 

Research and developmentexpenses consist predominantly of personnel costs, contract research,development and facilities costs associated with the development of ourproducts.

 

Generic research anddevelopment expenses increased during the three months ended June 30,2005, as compared to the same period of the prior year, due to an increase inthe number of generic products being developed in conjunction with ourdevelopment partners. Our Abbreviated New Drug Application (ANDA) count at June 30,2005 was 40, which is up from the 33 ANDAs, on file as of December 31,2004.

 

Brand research anddevelopment expenses for 2004 included a $10 million milestone payment toKissei Pharmaceutical Co., Ltd., related to silodosin, Watson’s investigationaldrug to treat the signs and symptoms of Benign Prostatic Hyperplasia(BPH).   In addition, research anddevelopment expenses within our brand segment decreased due to the timing ofthe commencement of development programs and clinical studies.

 

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***Selling,General and Administrative Expenses***

 
| ** **                                          | ** ** | **Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------|------------|------------|------------|
| **($ in thousands):**                          | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                                |       |                                 |       |       |       |   |   |   |   |
| Selling and  marketing expenses by segment:         |       |                                 |       |       |       |   |   |   |   |
| Generic                                             |       | $                                    | 11,688     |       | $          | 11,156 |   | $ | 532 |   | 4.8 | % |
| Brand                                               |       | 30,532                               |       | 42,066     |       | (11,534 | ) | -27.4 | % |
| Total segment  selling and marketing expenses       |       | 42,220                               |       | 53,222     |       | (11,002 | ) | -20.7 | % |
| Corporate  general and administrative               |       | 25,905                               |       | 25,947     |       | (42 | ) | -0.2 | % |
| Total selling,  general and administrative expenses |       | $                                    | 68,125     |       | $          | 79,169 |   | $ | (11,044 | ) | -13.9 | % |
| *as % of  net revenues*                             | * *   | *16.4*                               | *%*        | *19.8*     | *%*        | * * | * * | * * | * * |

 

Selling, general andadministrative expenses consist mainly of personnel costs, facilities costs,insurance, depreciation, distribution costs and professional services costs.

 

Brand segment selling andmarketing expenses decreased during the three months ended June 30, 2005as compared to the same period of the prior year due to cost reductionsrealized from the termination of a contract sales force agreement during thethird quarter of 2004.

 

***Amortization***

 
| ** **                 | ** ** | **Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|----------------------------|------------|--------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                       |       |                                 |       |       |       |   |   |   |   |
| Amortization               |       | $                                    | 41,101     |       | $          | 17,983 |   | $ | 23,118 |   | 128.6 | % |
| *as % of  net revenues*    | * *   | *9.9*                                | *%*        | *4.5*      | *%*        | * * | * * | * * | * * |
|                            |            |                                      |            |            |            |  |  |  |  |  |  |  |

 

The Company’s amortizableassets consist primarily of acquired product rights.  The increase in amortization during the threemonths ended June 30, 2005 as compared to the same period of the prioryear is primarily due to the acceleration of the amortization of the Ferrlecit®product rights.

 

***Equityin Losses of Joint Ventures***

 
| ** **                          | ** ** | **Three Months Ended June 30,** | ** ** | **Change** | ** ** | ** **  | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|------------|------------|-------------|------------|
| **($ in thousands):**          | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                |       |                                 |       |       |       |        |       |   |   |
| Equity in losses  of joint ventures |       | $                                    | (578       | )          | $          | (1,700      | )          | $ | 1,122 |   | -66.0 | % |
| *as % of  net revenues*             | * *   | *-0.1*                               | *%*        | *-0.4*     | *%*        | * *    | * *   | * * | * * |
|                                     |            |                                      |            |            |            |             |            |  |  |  |  |  |

 

The Company’s equityinvestments are accounted for under the equity-method when the Company’sownership does not exceed 50% and when the Company can exert significantinfluence over the management of the investee. The loss recorded during the three months ended June 30, 2005 and 2004represents our equity in losses incurred by Somerset Pharmaceuticals, Inc.(Somerset), our joint venture with Mylan Laboratories, Inc., due toexpenses associated with ongoing trials, operational costs and the remainingU.S. Food and Drug Administration (FDA) requirements relating to EmsamTM, aselegeline patch for the treatment of depression.

 

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***Losson Early Extinguishment of Debt***

 
| ** **                            | ** ** | **Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|---------------------------------------|------------|--------------------------------------|------------|------------|------------|
| **($ in thousands):**            | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                  |       |                                 |       |       |       |   |   |   |   |
| Loss on early  extinguishment of debt |       | $                                    | —     |       | $          | 3,746 |   | $ | (3,746 | ) | -100.0 | % |
| *as % of  net revenues*               | * *   | *0.0*                                | *%*        | *0.9*      | *%*        | * * | * * | * * | * * |
|                                       |            |                                      |            |            |            |  |  |  |  |  |  |  |

 

In May 2004, weacquired $34.3 million of our 1998 Senior Notes in an open markettransaction.  As a result of the repurchase,we incurred charges of $3.7 million related to fees, expenses, and the premiumpaid.

 

***InterestExpense***

 
| ** **                                                                             | ** ** | **Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|----------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------|------------|
| **($ in thousands):**                                                             | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                                                                   |       |                                 |       |       |       |   |   |   |   |
| Interest expense  - convertible contingent senior debentures due 2003 (CODES)          |       | $                                    | 3,151      |       | $          | 3,928 |   | $ | (777 | ) | (19.8 | )% |
| Interest expense  - Senior unsecured notes issued in May 1998 (1998 Senior Notes) |       | 255                                  |       | 586        |       | (331 | ) | (56.5 | )% |
| Interest and  fees on credit facility                                                  |       | 125                                  |       | 425        |       | (300 | ) | (70.6 | )% |
| Change in  derivative value                                                            |       | (272                                 | )          | (2,929     | )          | 2,657 |   | (90.7 | )% |
| Interest expense  - other                                                              |       | 365                                  |       | 22         |       | 343 |   | 1559.1 | % |
| Total interest  expense before capitalized interest                                    |       | 3,624                                |       | 2,032      |       | 1,592 |   | 78.3 | % |
| Capitalized  interest                                                                  |       | —                               |       | (385       | )          | 385 |   | (100.0 | )% |
| Interest expense                                                                       |       | $                                    | 3,624      |       | $          | 1,647 |   | $ | 1,977 |   | 120.0 | % |
| *as % of  net revenues*                                                                | * *   | *0.9*                                | *%*        | *0.4*      | %          |   |   |   |   |

 

Interest expenseincreased for the three month period ended June 30, 2005 over the threemonth period ended June 30, 2004 due to a lower downward adjustment to thefair value of the derivative in the period (as described in Note 7 in theaccompanying Notes to Condensed Consolidated Financial Statements in thisQuarterly Report).

 

22

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***SixMonths Ended June 30, 2005 Compared to the Six Months Ended June 30,2004***

 

***NetRevenues***

 
| ** **                 | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|----------------------------|------------|------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2005**                           | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                       |       |                               |       |       |       |   |   |   |   |
| Generic products           |       | $                                  | 605,616    |       | $          | 611,588 |   | $ | (5,972 | ) | -1.0 | % |
| *% of  product net sales*  | * *   | *75*                               | *%*        | *78*       | %          |   |   |   |   |
| Brand products             |       |                               |       |       |       |   |   |   |   |
| Specialty  Products        |       | 118,173                            |       | 87,500     |       | 30,673 |   | 35.1 | % |
| Nephrology                 |       | 87,099                             |       | 85,386     |       | 1,713 |   | 2.0 | % |
| Total brand  products      |       | 205,272                            |       | 172,886    |       | 32,386 |   | 18.7 | % |
| *% of  product net sales*  | * *   | *25*                               | *%*        | *22*       | *%*        | * * | * * | * * | * * |
| * *                   | * *   | * *                           | * *   | * *   | * *   | * * | * * | * * | * * |
| Total product net  sales   |       | 810,888                            |       | 784,474    |       | 26,414 |   | 3.4 | % |
| Other                      |       | 6,206                              |       | 24,552     |       | (18,346 | ) | -74.7 | % |
| Total net  revenues        |       | $                                  | 817,094    |       | $          | 809,026 |   | $ | 8,068 |   | 1.0 | % |

 

*Generic Products*

 

The $6.0 million or 1.0%decrease in sales from our generic segment for the six months ended June 30,2005 was primarily due to price reductions on select generic products,particularly nicotine gum as a competitor launched a nicotine gum product in December 2004.  The effect of price reductions was partiallyoffset by higher sales of our oral contraceptive products.  Sales of oral contraceptive productsrepresented 26% and 23% of total generic sales for the six months ended June 30,2005 and 2004, respectively.

 

For the remainder of2005, sales of generic pharmaceutical products are expected to increaseslightly.

 

*Brand Products*

 

The $32.4 million or 19%increase in sales from our brand segment for the six months ended June 30,2005, as compared to the same prior year period, was primarily attributable toan increase in sales within our Specialty Products group.  The change in sales of Specialty Productsresulted primarily from the following:

 

1.              Thelaunch of our Trelstar® products in the current year period; and

 

2.              Lowerprior year period sales levels for Oxytrol® and Androderm® due to wholesalerdestocking.

 

Sales from our Nephrologybusiness increased $1.7 million or 2% due to an increase in sales of ourFerrlecit® product.  Ferrlecit®represented approximately 81% of sales from our Nephrology business for the sixmonths ended June 30, 2005.

 

Sales of brandpharmaceutical products are expected to total approximately $400 million for theyear ended December 31, 2005.

 

*Other*

 

The decrease in otherrevenues in the six months ended June 30, 2005 was primarily related tothe absence of royalty payments from Aventis in connection with BarrLaboratories, Inc.’s sales of ciprofloxacin tablets.  Several companies launched competitiveproducts into the ciprofloxacin market during the second half of 2004.

 

23

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***GrossProfit Margin (Gross Margin)***

 
| ** **                         | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------|------------|-------------------------------------|------------|
| ** **                         | ** ** | **2005**                            | ** ** | **2004** | ** ** | **Change** | ** ** |
|                               |       |                                |       |   |   |   |   |
| Overall  Consolidated Gross Margin |       | 48.8                                | %          | 51.1 | % | -2.3 | % |
|                               |       |                                |       |   |   |   |   |
| Generic product  sales             |       | 38.7                                | %          | 41.4 | % | -2.7 | % |
| Brand product  sales               |       | 77.2                                | %          | 78.5 | % | -1.3 | % |
| Gross margin on  product net sales |       | 48.4                                | %          | 49.6 | % | -1.2 | % |

 

The decrease in grossmargin from our generic segment for the six months ended June 30, 2005 wasprimarily due to price reductions on certain generic products (particularlynicotine gum).

 

Gross margin from ourbrand segment decreased as we reduced production levels at certainmanufacturing facilities resulting in higher unit overhead costs during thefirst six months of 2005 as compared to the same period of the prior year.

 

The $18.3 milliondecrease in other revenues during the six months ended June 30, 2005 was asignificant factor in the reduction of our overall consolidated gross margin ascompared to the same period of the prior year.

 

Overall gross margins areexpected to be between 48.5% and 50% for the remainder of 2005.

 

***Researchand Development Expenses***

 
| ** **                                     | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|------------------------------------------------|------------|------------------------------------|------------|------------|------------|
| **($ in thousands):**                     | ** ** | **2005**                           | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                           |       |                               |       |       |       |   |   |   |   |
| Research and  development expenses by segment: |       |                               |       |       |       |   |   |   |   |
| Generic                                        |       | $                                  | 40,962     |       | $          | 34,960 |   | $ | 6,002 |   | 17.2 | % |
| Brand                                          |       | 19,362                             |       | 37,250     |       | (17,888 | ) | -48.0 | % |
| Total research  and development expenses       |       | $                                  | 60,324     |       | $          | 72,210 |   | $ | (11,886 | ) | -16.5 | % |
| *as % of  net revenues*                        | * *   | *7.4*                              | *%*        | *8.9*      | *%*        | * * | * * | * * | * * |

 

Research and developmentexpenses within our generic segment increased during the six months ended June 30,2005, as compared to the same period of the prior year, due to an increase inthe number of generic products being developed in conjunction with ourdevelopment partners.

 

During the six monthsended June 30, 2004, research and development expenses within our brandsegment included a $10 million milestone payment to Kissei Pharmaceutical Co.,Ltd., related to silodosin.   Inaddition, research and development expenses within our brand segment decreaseddue to the timing of the commencement of development programs and clinicalstudies.

 

We expect research anddevelopment spending to be in the range of 7.5% to 8% of revenues for 2005 duein part to costs associated with the Phase III studies currently underway onthe silodosin product for BPH in the current year period.

 

24

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***Selling,General and Administrative Expenses***

 
| ** **                                          | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|-----------------------------------------------------|------------|------------------------------------|------------|------------|------------|
| **($ in thousands):**                          | ** ** | **2005**                           | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                                |       |                               |       |       |       |   |   |   |   |
| Selling and  marketing expenses by segment:         |       |                               |       |       |       |   |   |   |   |
| Generic                                             |       | $                                  | 22,948     |       | $          | 20,449 |   | $ | 2,499 |   | 12.2 | % |
| Brand                                               |       | 58,000                             |       | 84,668     |       | (26,668 | ) | -31.5 | % |
| Total segment  selling and marketing expenses       |       | 80,948                             |       | 105,117    |       | (24,169 | ) | -23.0 | % |
| Corporate  general and administrative               |       | 50,828                             |       | 51,463     |       | (635 | ) | -1.2 | % |
| Total selling,  general and administrative expenses |       | $                                  | 131,776    |       | $          | 156,580 |   | $ | (24,804 | ) | -15.8 | % |
| *as % of  net revenues*                             | * *   | *16.1*                             | *%*        | *19.4*     | *%*        | * * | * * | * * | * * |

 

Brand segment selling andmarketing expenses decreased during the six months ended June 30, 2005 ascompared to the same period of the prior year due to cost reductions realized fromthe termination of a contract sales force agreement during the third quarter of2004.

 

We expect our selling,general and administrative expenses to range from 16.5% to 17% of net revenues for2005.

 

***Amortization***

 
| ** **                 | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|----------------------------|------------|------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2005**                           | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                       |       |                               |       |       |       |   |   |   |   |
| Amortization               |       | $                                  | 81,739     |       | $          | 35,915 |   | $ | 45,824 |   | 127.6 | % |
| *as % of  net revenues*    | * *   | *10.0*                             | *%*        | *4.4*      | *%*        | * * | * * | * * | * * |
|                            |            |                                    |            |            |            |  |  |  |  |  |  |  |

 

The increase inamortization in the first half of 2005 was primarily due to the acceleration ofthe amortization of our product rights associated with Ferrlecit®.

 

***Equityin Losses of Joint Ventures***

 
| ** **                          | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|-------------------------------------|------------|------------------------------------|------------|------------|------------|
| **($ in thousands):**          | ** ** | **2005**                           | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                |       |                               |       |       |       |   |   |   |   |
| Equity in losses  of joint ventures |       | $                                  | (158       | )          | $          | (3,279 | ) | $ | 3,121 |   | -95.2 | % |
| *as % of  net revenues*             | * *   | *0.0*                              | *%*        | *-0.4*     | *%*        | * * | * * | * * | * * |
|                                     |            |                                    |            |            |            |  |  |  |  |  |  |  |

 

The loss recorded duringthe six months ended June 30, 2005 and 2004 represents our equity inlosses incurred by Somerset, our joint venture with Mylan Laboratories, Inc.,due to expenses associated with ongoing trials, operational costs and theremaining FDA requirements relating to EmsamTM, a selegeline patch for thetreatment of depression.

 

25

----

 

***Gainon Sale of Securities***

 
| ** **                  | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|-----------------------------|------------|------------------------------------|------------|------------|------------|
| **($ in thousands):**  | ** ** | **2005**                           | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                        |       |                               |       |       |       |   |   |   |   |
| Gain on sale of  securities |       | $                                  | —     |       | $          | 3,938 |   | $ | (3,938 | ) | -100.0 | % |
| *as % of  net revenues*     | * *   | *0.0*                              | *%*        | *1.0*      | *%*        | * * | * * | * * | * * |
|                             |            |                                    |            |            |            |  |  |  |  |  |  |  |

 

The 2004 gain on sale ofsecurities resulted from the sale of a portion of our investment in the commonstock of Andrx Corporation (Andrx).  Forthe six months ended June 30, 2004, we sold a total of 150,000 shares ofAndrx common stock for proceeds of $4.3 million.  We did not sell any securities during the sixmonths ended June 30, 2005.  At June 30,2005, we held approximately 607,000 shares of Andrx common stock at a fairvalue of $12.3 million with a gross unrealized holding gain of $10.8 million.

 

***Losson Early Extinguishment of Debt***

 
| ** **                            | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|---------------------------------------|------------|------------------------------------|------------|------------|------------|
| **($ in thousands):**            | ** ** | **2005**                           | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                  |       |                               |       |       |       |   |   |   |   |
| Loss on early  extinguishment of debt |       | $                                  | —     |       | $          | 17,752 |   | $ | (17,752 | ) | -100.0 | % |
| *as % of  net revenues*               | * *   | *0.0*                              | *%*        | *2.2*      | *%*        | * * | * * | * * | * * |
|                                       |            |                                    |            |            |            |  |  |  |  |  |  |  |

 

During the first half of2004, we repurchased $135.9 million of our 1998 Senior Notes for totalconsideration of $152.5 million, representing a 12% premium over each note’sface value.  As a result of therepurchase, we incurred $14.0 million and $3.7 million in charges related tofees, expenses, unamortized discount, and the premiums paid in the first andsecond quarters of 2004, respectively (as described in Note 7).

 

***InterestExpense***

 
| ** **                                          | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|-----------------------------------------------------|------------|------------------------------------|------------|------------|------------|
| **($ in thousands):**                          | ** ** | **2005**                           | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                                |       |                               |       |       |       |   |   |   |   |
| Interest expense  - CODES                           |       | $                                  | 6,302      |       | $          | 7,080 |   | $ | (778 | ) | (11.0 | )% |
| Interest expense  - 1998 Senior Notes               |       | 511                                |       | 2,495      |       | (1,984 | ) | (79.5 | )% |
| Interest and  fees on credit facility               |       | 541                                |       | 843        |       | (302 | ) | (35.8 | )% |
| Change in  derivative value                         |       | (841                               | )          | (3,154     | )          | 2,313 |   | (73.3 | )% |
| Interest expense  - other                           |       | 401                                |       | 30         |       | 371 |   | 1236.7 | % |
| Total interest  expense before capitalized interest |       | 6,914                              |       | 7,294      |       | (380 | ) | (5.2 | )% |
| Capitalized  interest                               |       | —                             |       | (1,904     | )          | 1,904 |   | (100.0 | )% |
| Total interest  expense                             |       | $                                  | 6,914      |       | $          | 5,390 |   | $ | 1,524 |   | 28.3 | % |
| *as % of  net revenues*                             | * *   | *0.8*                              | *%*        | *0.7*      | %          |   |   |   |   |

 

Interest expenseincreased as a result of a lower downward adjustment to the fair value of thederivative (as described in Note 7 in the accompanying Notes to CondensedConsolidated Financial Statements in this Quarterly Report) and because therewas no capitalization of interest expense during the six months ended June 30,2005.   These factors were partiallyoffset by a reduction in interest on our 1998 Senior Notes.  We repurchased a portion of our 1998 Senior Notesin February and in May of 2004.

 

26

----

 

***SegmentContribution***

 
| ** **                 | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|----------------------------|------------|------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2005**                           | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
| Segment  contribution      |       |                               |       |       |       |   |   |   |   |
| Generic                    |       | $                                  | 172,610    |       | $          | 213,965 |   | $ | (41,355 | ) | -19.3 | % |
| Brand                      |       | 85,049                             |       | 22,399     |       | 62,650 |   | 279.7 | % |
|                       |       | $                                  | 257,659    |       | $          | 236,364 |   | $ | 21,295 |   | 9.0 | % |
| *as % of  net revenues*    | * *   | *31.5*                             | *%*        | *29.2*     | *%*        | * * | * * | * * | * * |

 

 

Genericsegment contribution decreased for the six months ended June 30, 2005, ascompared to the same period of the prior year, primarily due to:

 

1.              Reducedlevels of other revenue;

 

2.              Areduction in gross margins due to price reductions on certain generic products;and

 

3.              Anincrease in research and development expenses due to an increase in the numberof generic products being developed in the period.

 

Brandsegment contribution increased during the six months ended June 30, 2005,as compared to the same period of the prior year, primarily due to:

 

1.              Anincrease in sales of certain Specialty Products including Trelstar®, Oxytrol® and Androderm®;

 

2.              Areduction in research and development expenses as the prior year periodincluded a $10 million milestone payment related to silodosin; and

 

3.              Areduction in sales and marketing expenses due to the termination of a contractsales force agreement in the third quarter of 2004.

 

For more information on segment contribution, refer toabove Management’s Discussion and Analysis of Financial Condition and Resultsof Operations and Note 3 in the accompanying Notes to Condensed ConsolidatedFinancial Statements in this Quarterly Report.

 

**Liquidity and Capital Resources**

 

***Cashfrom Operations***

 

Watson’s primary sourceof liquidity is cash from operations. Net working capital at June 30, 2005 was $1.08 billion compared to$1.11 billion at December 31, 2004 and $968.5 million at June 30,2004.

 

We expect that 2005 cashflows from operating activities will continue to exceed net income.  In addition, management expects that 2005cash flows from operating activities and available cash balances will besufficient to fund our operating liquidity needs.

 

Summarized cash flowinformation is as follows:

 
| ** **                                 | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------|------------|------------------------------------|------------|
| **($ in thousands):**                 | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| ** **                                 | ** ** | ** **                         | ** ** | ** ** | ** ** |
| Net cash  provided by operating activities |       | $                                  | 178,944    |   | $ | 96,546 |   |
|                                            |            |                                    |            |  |  |  |  |

# ** **

Net cash provided byoperating activities increased during the six month period ended June 30,2005, as compared to the same period of the prior year, due primarily to a largerdecrease in inventory balances in 2005 and the timing of tax payments in 2004.

 

 Net cash provided by operating activities isexpected to exceed $320 million in 2005.

 

27

----

 

***Changesin Working Capital***

 

Working capital at June 30,2005 and December 31, 2004 is summarized as follows:

 
| **($ in thousands):**              | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** | **Increase  (Decrease)** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **                              | ** ** | ** **              | ** ** | ** **                  | ** ** | ** **               | ** ** |
| Current Assets:                         |       |                    |       |                        |       |                     |       |
| Cash and cash  equivalents              |       | $                       | 488,735    |                        | $          | 298,653                  |       | $ | 190,082 |   |
| Marketable  securities                  |       | 161,049                 |       | 381,679                     |       | (220,630                 | )          |
| Accounts  receivable, net of allowances |       | 271,258                 |       | 251,459                     |       | 19,799                   |       |
| Inventories                             |       | 289,308                 |       | 321,299                     |       | (31,991                  | )          |
| Other                                   |       | 110,723                 |       | 117,096                     |       | (6,373                   | )          |
| Total current  assets                   |       | 1,321,073               |       | 1,370,186                   |       | (49,113                  | )          |
| Current  liabilities:                   |       |                    |       |                        |       |                     |       |
| Accounts payable  and accrued expenses  |       | 186,808                 |       | 192,701                     |       | (5,893                   | )          |
| Other                                   |       | 53,334                  |       | 62,928                      |       | (9,594                   | )          |
| Total current  liabilities              |       | 240,142                 |       | 255,629                     |       | (15,487                  | )          |
|                                    |       |                    |       |                        |       |                     |       |
| Working Capital                         |       | $                       | 1,080,931  |                        | $          | 1,114,557                |       | $ | (33,626 | ) |
|                                    |       |                    |       |                        |       |                     |       |
| Current Ratio                           |       | 5.50                    |       | 5.36                        |       |                     |       |

 

Our investments inauction rate securities were liquidated in May 2005 and approximately $50million in U.S. Treasury securities matured in June 2005.  Proceeds were deposited in cash and cashequivalents.

 

***CapitalExpenditures***

 

Our capital expendituresare summarized as follows:

 
| ** **                           | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------|------------|------------------------------------|------------|
| **($ in thousands):**           | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| ** **                           | ** ** | ** **                         | ** ** | ** ** | ** ** |
| Additions to  property and equipment |       | $                                  | 38,103     |   | $ | 43,094 |   |
|                                      |            |                                    |            |  |  |  |  |

 

A significant portion ofWatson’s capital expenditures for the first half of 2005 were incurred to constructour distribution facility in Gurnee, Illinois. The facility was constructed to enhance our distribution capabilitiesand was placed in service in the third quarter of this year. Other capitalexpenditures included costs to support the manufacture of transdermal productsin Salt Lake City, and various additions to machinery and equipment at various Watsonlocations.  The approximate total forcapital expenditures for 2005 are estimated to be between $75 and $100 million.

 

***Debtand Borrowing Capacity***

 

Our debt at June 30,2005 and December 31, 2004 is summarized as follows:

 
| **($ in thousands):** | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** | **Increase  (Decrease)** | ** ** |
|----------------------------|------------|-------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **                 | ** ** | ** **              | ** ** | ** **                  | ** ** | ** **               | ** ** |
| Long-term debt             |       | $                       | 587,794    |                        | $          | 587,653                  |       | $ | 141 |   |
| Debt to capital  ratio     |       | 21.5                    | %          | 20.8                        | %          |                     |       |
|                            |            |                         |            |                             |            |                          |            |  |  |  |

 

28

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In March 2003, weissued $575 million of convertible contingent senior debentures due in 2023(CODES).  As of June 30, 2005, theentire amount of the CODES remained outstanding at an effective annual interestrate of approximately 2.1%, excluding changes in the related derivative.

 

Between February andMay 2004, we repurchased $135.9 million of our 1998 Senior Notes for totalconsideration of $152.5 million, or a 12% premium over each note’s facevalue.  We recorded charges of $17.8million in 2004, related to fees, expenses, unamortized discount, and premiumspaid.

 

In May 2003, weentered into an agreement with a syndicate of lenders for a five-year, $300million senior, unsecured revolving credit facility (the Credit Facility) forworking capital and other general corporate purposes.  As of June 30, 2005, the total $300million under the Credit Facility was available to us. Under the terms of theCredit Facility, each of our subsidiaries, other than minor subsidiaries,entered into a full and unconditional guarantee on a joint and severalbasis.  In order to provide subsidiaryguarantees in connection with the Credit Facility, we were required to issuesimilar guarantees to the 1998 Senior Note holders.  We are subject to, and, as of June 30,2005, were in full compliance with financial and operation covenants under theterms of the Credit Facility.  Theagreement includes the following financial covenants:

 

•                  maintenanceof a minimum net worth, as defined in the Credit Facility, of at least $1.66billion at June 30, 2005 (the sum of $1.44 billion plus an amount equal tothe sum of 50% of net income for each fiscal quarter after December 31,2002);

•                  maintenanceof a maximum leverage ratio not greater than 2.25 to 1.0; and

•                  maintenanceof a minimum interest coverage ratio of at least 7.0 to 1.0.

 

At June 30, 2005,our net worth was $2.2 billion and our leverage ratio was 1.33 to 1.0.   Our interest coverage ratio for the threemonths ended June 30, 2005 was 30 to 1.0.

 

Under the CreditFacility, interest coverage ratio, with respect to any financial covenantperiod, is defined as the ratio of EBITDA for such period to interest expensefor such period.  EBITDA under the CreditFacility, for any covenant period, is defined as net income plus (1) depreciationand amortization, (2) interest expense, (3) provision for incometaxes, (4) extraordinary or unusual losses, (5) non-cash portion ofnonrecurring losses and charges, (6) other non-operating, non-cash lossesand (7) minority interest expense in respect of equity holdings inaffiliates; minus (1) extraordinary gains, (2) interest income and (3) othernon-operating, non-cash income.  Theleverage ratio, for any financial covenant period, is defined as the ratio ofthe outstanding principal amount of funded debt for the borrower and itssubsidiaries at the end of such period, to EBITDA for such period.

 

***Long-termObligations***

 

The following table listsour enforceable and legally binding obligations as of June 30, 2005.  Some of the amounts included herein are basedon management’s estimates and assumptions about these obligations, includingtheir duration, the possibility of renewal, anticipated actions by thirdparties, and other factors.  Becausethese estimates and assumptions are necessarily subjective, the enforceable andlegally binding

 

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obligation we willactually pay in future periods may vary from those reflected in this table (inthousands):

 
| ** **                                                        | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                        | ** ** | **Total**                  | ** ** | **Less than 1  year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **After 5 years** | ** ** |
|                                                              |       |                       |       |   |   |   |   |   |   |   |   |
| Long-term and  other debt                                         |       | $589,149                   |       | $6 |   | $14,132 |   | $11 |   | $575,000 |   |
| Liabilities  incurred for acquisitions of products and businesses |       | 4,148                      |       | 2,074 |   | 2,074 |   | — |   | — |   |
| Operating lease  obligations                                      |       | 37,496                     |       | 8,149 |   | 13,746 |   | 3,465 |   | 12,136 |   |
| Total  contractual cash obligations                               |       | $630,793                   |       | $10,229 |   | $29,952 |   | $3,476 |   | $587,136 |   |

 

The Company is involvedin certain minor joint venture arrangements that are intended to complement theCompany’s core business and markets.  TheCompany has the discretion to provide funding on occasion for working capitalor capital expenditures.  The Companymakes an evaluation of additional funding based on an assessment of the venture’sbusiness opportunities.  The Companybelieves that any possible commitments arising from the current arrangementswill not be significant to the Company’s financial condition or results ofoperations.

 

The Company does not haveany material off-balance sheet arrangements that have, or are reasonably likelyto have, a current or future effect on our financial condition, changes infinancial conditions, revenues or expenses, results of operations, liquidity,capital expenditures or capital resources.

 

We have repurchasedapproximately 6.0 million shares of our common stock at an aggregate cost ofapproximately $182.6 million under the Company’s $300.0 million stockrepurchase program approved by the Board of Directors (Board) on February 10,2005.  As of June 30, 2005, theCompany had approximately $117.4 million available for future repurchases ofits common stock under this Board authorization.  This program provides for purchases to bemade in the open market or in privately negotiated transactions through February 2006.  The stock repurchase program is not expectedto affect our compliance with our debt covenants.  Based on current stock prices, completion ofthe stock repurchase plan would not materially impact the Company’s liquidity.

 

*Recent accounting pronouncements*

 

In November 2004,the Financial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards (SFAS) No. 151, “Inventory Costs-an Amendment of ARB No. 43,Chapter 4” (SFAS 151).  SFAS 151 requiresthat accounting for items such as idle facility expense, freight, handlingcosts, and wasted materials (spoilage) be recognized as current period chargesregardless of whether they meet the criterion of “so abnormal.”  In addition, SFAS 151 requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities.  SFAS 151 is effective for inventory costsincurred during fiscal years beginning after June 15, 2005.  The provision of SFAS 151 shall be appliedprospectively.  The Company believes thatthe adoption of SFAS 151 will not have a material effect on our CondensedConsolidated Financial Statements.

 

In December 2004,the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS123R), which replaces SFAS No. 123, “Accounting for Stock-BasedCompensation,” (SFAS 123) and supercedes Accounting Principles Board (APB)Opinion No. 25, “Accounting for Stock Issued to Employees”. SFAS 123Rrequires all share-based payments to employees, including grants of employeestock options, to be recognized in the financial statements based on their fairvalues. The pro forma disclosures previously permitted under SFAS 123 nolonger will be an alternative to financial statement recognition. Under SFAS123R, the Company must determine the appropriate fair value model to be usedfor valuing share-based payments, the amortization 

 

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method for compensation cost and the transition method to be used atdate of adoption. The transition methods include modified prospective andmodified retrospective adoption options. Under the modified retrospectiveoption, prior periods may be restated either as of the beginning of the year ofadoption or for all periods presented. The modified prospective method requiresthat compensation expense be recorded for all unvested stock options andrestricted stock at the beginning of the first quarter of adoption ofSFAS 123R, while the modified retrospective method would recordcompensation expense for all unvested stock options and restricted stockbeginning with the first period restated. The Company is evaluating therequirements of SFAS 123R. The Company has not yet determined the methodof adoption or the effect of adopting SFAS 123R, and it has not determinedwhether the adoption will result in amounts that are similar to the current proforma disclosures under SFAS 123.

 

In April 2005, theSecurities and Exchange Commission (SEC) announced an amendment to RegulationS-X to amend the date for compliance with FAS 123R.  The amendment requires each registrant thatis not a small business issuer to adopt FAS 123R in the first fiscal yearcommencing after June 15, 2005.  TheCompany is required to adopt SFAS 123R beginning January 1, 2006.  Adoption of FAS 123R will have a significantimpact on our consolidated financial statements, as we will be required toexpense the fair value of our employee stock option and employee stock purchaseplan (ESPP) grants rather than disclose the pro forma impact on ourconsolidated net income within the footnotes to our consolidated financialstatements, as is our current practice.

 

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**CAUTIONARYNOTE REGARDING FORWARD-LOOKING STATEMENTS**

 

Any statements made inthis report that are not statements of historical fact or that refer toestimated or anticipated future events are forward-looking statements.  We have based our forward-looking statementson our management’s beliefs and assumptions based on information available toour management at the time these statements are made.  Such forward-looking statements reflect ourcurrent perspective of our business, future performance, existing trends andinformation as of the date of this filing. These include, but are not limited to, our beliefs about future revenueand expense levels and growth rates, prospects related to our strategicinitiatives and business strategies, express or implied assumptions aboutgovernment regulatory action or inaction, anticipated product approvals andlaunches, business initiatives and product development activities, assessmentsrelated to clinical trial results, product performance and competitiveenvironment, and anticipated financial performance. Without limiting thegenerality of the foregoing, words such as *“may,” “will,” “expect,” “believe,”“anticipate,” “intend,” “could,” “would,” “estimate,” “continue,” or “pursue,”*or the negative other variations thereof or comparable terminology, areintended to identify forward-looking statements.  The statements are not guarantees of futureperformance and involve certain risks, uncertainties and assumptions that aredifficult to predict.

 

We caution the readerthat certain important factors may affect our actual operating results andcould cause such results to differ materially from those expressed or impliedby forward-looking statements.  Webelieve the risks and uncertainties discussed under the Section entitled “RisksRelated to Our Business,” and other risks and uncertainties detailed herein andfrom time to time in our SEC filings, may affect our actual results.

 

We disclaim anyobligation to publicly update any forward-looking statements, whether as aresult of new information, future events or otherwise, except as required bylaw.  This discussion is provided aspermitted by the Private Securities Litigation Reform Act of 1995.

 

# **RisksRelated to Our Business**

# ** **

We operate in a rapidlychanging environment that involves a number of risks, some of which are beyondour control.  The following discussionhighlights some of these risks and others are discussed elsewhere in thisQuarterly report.  These and other riskscould materially and adversely affect our business, financial condition,operating results or cash flows.

 

*Risks Associated With InvestingIn the Business Of Watson*

 

**If we are unable to successfullydevelop or commercialize new products, our operating results will suffer.**

 

Our future results ofoperations will depend to a significant extent upon our ability to successfullycommercialize new brand and generic products in a timely manner.  There are numerous difficulties in developingand commercializing new products, including:

 

•                  developing,testing and manufacturing products in compliance with regulatory standards in atimely manner;

 

•                  receivingrequisite regulatory approvals for such products in a timely manner;

 

•                  theavailability, on commercially reasonable terms, of raw materials, includingactive pharmaceutical ingredients and other key ingredients;

 

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•                  developingand commercializing a new product is time consuming, costly and subject tonumerous factors that may delay or prevent the development andcommercialization of new products, including legal actions brought by ourcompetitors;

 

•                  experiencingdelays or unanticipated costs; and

 

•                  commercializinggeneric products may be substantially delayed by the listing with the FDA ofpatents that have the effect of potentially delaying approval of the off-patentproduct by up to 30 months, and in some cases, such patents have issued andbeen listed with the FDA after the key chemical patent on the brand drugproduct has expired or been litigated, causing additional delays in obtainingapproval.

 

As a result of these andother difficulties, products currently in development by Watson may or may notreceive timely regulatory approvals, or approvals at all,  necessary for marketing by Watson or otherthird-party partners.  This riskparticularly exists with respect to the development of proprietary productsbecause of the uncertainties, higher costs and lengthy time frames associatedwith research and development of such products and the inherent unproven marketacceptance of such products. If any of our products, when acquired or developedand approved, cannot be successfully or timely commercialized, our operatingresults could be adversely affected.  Wecannot guarantee that any investment we make in developing products will berecouped, even if we are successful in commercializing those products.

 

**Our brand pharmaceuticalexpenditures may not result in commercially successful products.**

 

During 2004, we increasedour planned expenditures for the development and marketing of our brandbusiness.  During 2005 and thereafter, wemay further increase the amounts we expend for our brand business segment.  For example, we plan to initiate Phase IIIclinical studies in the second half of 2005 on our next generation Oxytrol®product and initiated clinical trials on our silodosin product for treatment ofBPH in late May of 2005.  We cannotbe sure these business expenditures will result in the successful discovery,development or launch of brand products that will prove to be commerciallysuccessful or will improve the long-term profitability of our business.

 

**Our gross profit may fluctuate from period toperiod depending upon our product sales mix, our product pricing, and our coststo manufacture or purchase products.**

 

Our future results of operations, financial conditionand cash flows depend to a significant extent upon our brand and generic productsales mix.  Our sales of brand productstend to create higher gross margins than our sales of generic products.  As a result, our sales mix (the proportion oftotal sales between brand products and generic products) will significantlyimpact our gross profit from period to period. During the three months ended June 30, 2005, sales of our brandproducts and generic products accounted for approximately 24% and 76%,respectively, of our net product sales. During that same period, brand products and generic products contributedapproximately 38% and 62%, respectively, to our gross profits.  Factors that may cause our sales mix to varyinclude:

 

•                  the amount of new productintroductions;

 

•                  marketing exclusivity, if any, whichmay be obtained on certain new products;

 

•                  the level of competition in themarketplace for certain products;

 

•                  the availability of raw materialsand finished products from our suppliers;

 

•                  the scope and outcome ofgovernmental regulatory action that may involve us; and

 

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•                  periodic dependence on a smallnumber of products for a significant portion of net revenue or income.

 

The profitability of ourproduct sales is also dependent upon the prices we are able to charge for ourproducts, the costs to purchase products from third parties, and our ability tomanufacture our products in a cost effective manner.

 

**Loss of revenues from Ferrlecit®, a significantproduct, could have a material adverse effect on our results of operations, financialcondition and cash flows.**

 

During 2004 we lostregulatory exclusivity on our Ferrlecit® product, which will allow genericapplicants to submit ANDAs for Ferrlecit®. In 2004, Ferrlecit® accounted for approximately 8% of our net revenuesand 15% of our gross profit.  In February 2004,we submitted a Citizen’s Petition to the FDA requesting that the FDA notapprove any ANDA for a generic version of Ferrlecit® until certainmanufacturing, physiochemical and safety and efficacy criteria aresatisfied.  During the third quarter of2004, we submitted a second Citizen’s Petition to the FDA requesting that theFDA refuse to accept for substantive review any ANDA referencing Ferrlecit®until the FDA establishes guidelines for determining whether the generic productis the same complex as Ferrlecit®.  Wecannot predict whether the FDA will grant or deny our Citizen’s Petitions orwhen it may take such action.  We believeit will be difficult for a competitor to demonstrate to the FDA that itsproduct is the same as Ferrlecit® and that, in the absence of such a showing,the FDA should require the applicant to submit a New Drug Application (NDA)supported by clinical studies, independently demonstrating safety andefficacy.  However, if a generic versionof Ferrlecit® or other competitive product is approved by the FDA and entersthe market, our net revenues could significantly decline, which could have amaterial adverse effect on our results of operations, financial condition andcash flows.

 

**If we are unsuccessful in ourjoint ventures and other collaborations, our operating results could suffer.**

 

We have made substantialinvestments in joint ventures and other collaborations and may use these andother methods to develop or commercialize products in the future.  These arrangements typically involve otherpharmaceutical companies as partners that may be competitors of ours in certainmarkets.  In many instances, we will notcontrol these joint ventures or collaborations or the commercial exploitationof the licensed products, and cannot assure you that these ventures will beprofitable.  Although restrictionscontained in certain of these programs have not had a material adverse impacton the marketing of our own products to date, any such marketing restrictionscould affect future revenues and have a material adverse effect on ouroperations. Our results of operations may suffer if existing joint ventures orcollaboration partners withdraw, or if these products are not timely developed,approved or successfully commercialized.

 

**If we are unable to adequatelyprotect our technology or enforce our patents, our business could suffer.**

 

Our success with the brand products that we develop will depend, in part, on our ability to obtain patent protection for these products.  We currently have a number of U.S. and foreign patents issued and pending.  We cannot be sure that we will receive patents for any of our pending patent applications or any patent applications we may file in the future.  If our current and future patent applications are not approved or, if approved, if such patents are not upheld in a court of law if challenged, it may reduce our ability to competitively exploit our patented products.  Also, such patents may or may not provide competitive advantages for their respective products or they may be challenged or circumvented by our competitors, in which case our ability to commercially exploit these products may be diminished.

 

We also rely on tradesecrets and proprietary know-how that we seek to protect, in part, throughconfidentiality agreements with our partners, customers, employees andconsultants.  It is possible that theseagreements will be breached or that they will not be enforceable in everyinstance, and that we will not have adequate remedies for any such breach.  It is also possible that our trade secretswill become known or independently developed by our competitors.

 

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If we are unable toadequately protect our technology, trade secrets or propriety know-how, orenforce our patents, our results of operations, financial condition and cashflows could suffer.

 

**If brand pharmaceutical companies are successfulin limiting the use of generics through their legislative and regulatoryefforts, our sales of generic products may suffer.**

 

Many brand pharmaceuticalcompanies increasingly have used state and federal legislative and regulatorymeans to delay generic competition. These efforts have included:

 

•                  pursuingnew patents for existing products which may be granted just before theexpiration of one patent, which could extend patent protection for additionalyears or otherwise delay the launch of generics;

 

•                  usingthe Citizen Petition process to request amendments to FDA standards;

 

•                  seekingchanges to U.S. Pharmacopeia, an organization which publishes industryrecognized compendia of drug standards;

 

•                  attachingpatent extension amendments to non-related federal legislation; and

 

•                  engagingin state-by-state initiatives to enact legislation that restricts thesubstitution of some generic drugs, which could have an impact on products thatwe are developing.

 

If brand pharmaceuticalcompanies are successful in limiting the use of generic products through theseor other means, our sales of generic products may decline.  If we experience a material decline ingeneric product sales, our results of operations, financial condition and cashflows will suffer.

 

**If competitors are successful in limitingcompetition for certain generic products through their legislative, regulatoryand litigation efforts, our sales of certain generic products may suffer.**

 

Certain of ourcompetitors have recently challenged our ability to distribute genericalternatives of certain brand products (sometimes called “Authorized Generics”)during the competitors’ 180 day period of ANDA exclusivity under theHatch-Waxman Act.  Under the challengedarrangements, we have obtained rights to market and distribute under a brandmanufacturer’s NDA a generic alternative of the brand product.  Some of our competitors have challenged thepropriety of these arrangements by filing Citizen’s Petitions with the FDA,initiating lawsuits alleging violation of the antitrust and consumer protectionlaws, and seeking legislative intervention. To date, these efforts have been unsuccessful, but remainunresolved.  The FDA and courts that haveconsidered the subject to date have ruled that there is no prohibition in theFederal Food, Drug and Cosmetic Act against distributing authorized genericversions of a brand drug.  However, ifour competitors’ attempts to restrict such arrangements are successful, or ifdistribution of authorized generic versions of brand drugs is otherwiserestricted or found unlawful, it could have a material adverse effect on ourresults of operations, financial condition and cash flows.

 

**From time to time we may need torely on licenses to proprietary technologies, which may be difficult orexpensive to obtain.**

 

We may need to obtainlicenses to patents and other proprietary rights held by third parties todevelop, manufacture and market products. If we are unable to timely obtain these licenses on commerciallyreasonable terms, our ability to commercially exploit our products may beinhibited or prevented.

 

**Third parties may claim that weinfringe their proprietary rights and may prevent us from manufacturing andselling some of our products**.

 

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The manufacture, use andsale of new products that are the subject of conflicting patent rights havebeen the subject of substantial litigation in the pharmaceutical industry.  These lawsuits relate to the validity andinfringement of patents or proprietary rights of third parties.  We may have to defend against charges that weviolated patents or proprietary rights of third parties.  This is especially true in the case ofgeneric products on which the patent covering the brand product is expiring, anarea where infringement litigation is prevalent, and in the case of new brandproducts where a competitor has obtained patents for similar products.  Litigation may be costly and time-consuming,and could divert the attention of our management and technical personnel.  In addition, if we infringe on the rights ofothers, we could lose our right to develop or manufacture products or could berequired to pay monetary damages or royalties to license proprietary rightsfrom third parties.  Although the partiesto patent and intellectual property disputes in the pharmaceutical industryhave often settled their disputes through licensing or similar arrangements,the costs associated with these arrangements may be substantial and couldinclude ongoing royalties.  Furthermore,we cannot be certain that the necessary licenses would be available to us oncommercially reasonable terms.  As aresult, an adverse determination in a judicial or administrative proceeding orfailure to obtain necessary licenses could prevent us from manufacturing andselling a number of our products, which could harm our business, financialcondition, results of operations and cash flows.

 

**As a part of our businessstrategy, we plan to consider and, as appropriate, make acquisitions oftechnologies, products and businesses, which may result in us experiencingdifficulties in integrating the technologies, products and businesses that weacquire and/or experiencing significant charges to earnings that may adverselyaffect our stock price and financial condition.**

 

We regularly review potential acquisitions oftechnologies, products and businesses complementary to our business.  Acquisitions typically entail many risks andcould result in difficulties in integrating operations, personnel, technologiesand products.  If we are not able tosuccessfully integrate our acquisitions, we may not obtain the advantages thatthe acquisitions were intended to create, which may adversely affect ourbusiness, results of operations, financial condition and cash flows, ourability to develop and introduce new products and the market price of ourstock.  In addition, in connection withacquisitions, we could experience disruption in our business or employeebase.  There is also a risk that keyemployees of companies that we acquire or key employees necessary tosuccessfully commercialize technologies and products that we acquire may seekemployment elsewhere, including with our competitors.  Furthermore, there may be overlap between theproducts or customers of Watson and the companies that we acquire that maycreate conflicts in relationships or other commitments detrimental to theintegrated businesses.

 

In addition, as a resultof acquiring businesses or products, or entering into other significanttransactions, we have experienced, and will likely continue to experience,significant charges to earnings for merger and related expenses that mayinclude transaction costs, closure costs or acquired in-process research anddevelopment charges.  These costs mayinclude substantial fees for investment bankers, attorneys, accountants andfinancial printing costs and severance and other closure costs associated withthe elimination of duplicate or discontinued products, operations andfacilities.  Charges that we may incur inconnection with acquisitions could adversely affect our results of operationsfor particular quarterly or annual periods.

 

**If we are unable to obtainsufficient supplies from key suppliers that in some cases may be the onlysource of finished products or raw materials, our ability to deliver ourproducts to the market may be impeded.**

 

We are required toidentify the supplier(s) of all the raw materials for our products in ourapplications with the FDA.  To the extentpracticable, we attempt to identify more than one supplier in each drugapplication.  However, some products andraw materials are available only from a single source and, in some of our drugapplications, only one supplier of products and raw materials has beenidentified, even in instances where multiple sources exist.  Among others, this includes products thathave historically accounted for a significant portion of our revenues, such asFerrlecit® and a significant number of our oral contraceptive products.  From time to time, certain of our outsidesuppliers have experienced regulatory or supply-related difficulties that haveinhibited their ability to deliver products and raw materials to us, causingsupply delays or interruptions.  To the 

 

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extent any difficulties experienced by our suppliers cannot be resolvedwithin a reasonable time, and at reasonable cost, or if raw materials for aparticular product become unavailable from an approved supplier and we arerequired to qualify a new supplier with the FDA, our profit margins and marketshare for the affected product could decrease, as well as delay our developmentand sales and marketing efforts.

 

Our arrangements withforeign suppliers are subject to certain additional risks, including theavailability of government clearances, export duties, political instability,war, acts of terrorism, currency fluctuations and restrictions on the transferof funds.  For example, we obtain asignificant portion of our raw materials from foreign suppliers.  Arrangements with international raw materialsuppliers are subject to, among other things, FDA regulation, customsclearances, various import duties and other government clearances.  Acts of governments outside the U.S. mayaffect the price or availability of raw materials needed for the development ormanufacture of our products. In addition, recent changes in patent laws injurisdictions outside the U.S. may make it increasingly difficult to obtain rawmaterials for research and development prior to the expiration of theapplicable U.S. or foreign patents.

 

**Our policies regarding returns,allowances and chargebacks, and marketing programs adopted by wholesalers, mayreduce our revenues in future fiscal periods**.

 

Based on industrypractice, generic product manufacturers, including us, have liberal returnpolicies and have been willing to give customers post-sale inventoryallowances.  Under these arrangements,from time to time, we give our customers credits on our generic products thatour customers hold in inventory after we have decreased the market prices ofthe same generic products.  Therefore, ifnew competitors enter the marketplace and significantly lower the prices of anyof their competing products, we would likely reduce the price of ourproduct.  As a result, we would beobligated to provide significant credits to our customers who are then holdinginventories of such products, which could reduce sales revenue and gross marginfor the period the credit is provided. Like our competitors, we also give credits for chargebacks to wholesalecustomers that have contracts with us for their sales to hospitals, grouppurchasing organizations, pharmacies or other retail customers.  A chargeback represents an amount payablein the future to a wholesaler for the difference between the invoice price paidto us by our wholesale customer for a particular product and the negotiatedcontract price that the wholesaler’s customer pays for that product.  Although we establish reserves basedon our prior experience and our best estimates of the impact that thesepolicies may have in subsequent periods, we cannot ensure that our reserves areadequate or that actual product returns, allowances and chargebacks will notexceed our estimates, which could adversely affect our financial condition,cash flows and market price of our stock.

 

**Investigations of the calculationof average wholesale prices may adversely affect our business.**

 

Many government and third-party payors, includingMedicare, Medicaid, Health Maintenance Organizations (HMOs) and Managed CareOrganizations (MCOs), reimburse doctors and others for the purchase of certainprescription drugs based on a drug’s average wholesale price, or AWP.  In the past several years, state and federalgovernment agencies have conducted ongoing investigations of manufacturers’reporting practices with respect to AWP, in which they have suggested thatreporting of inflated AWP’s have led to excessive payments for prescriptiondrugs.  For example, beginning in July 2002,we and certain of our subsidiaries, as well as numerous other pharmaceuticalcompanies, were named as defendants in various state and federal court actionsalleging improper or fraudulent practices related to the reporting of AWP ofcertain products, and other improper acts, in order to increase prices andmarket shares. We have also received notices or subpoenas from the attorneysgeneral of various states, including Florida, Nevada, New York, California andTexas, indicating investigations, claims and/or possible lawsuits relating topharmaceutical pricing issues and whether allegedly improper actions by pharmaceuticalmanufacturers led to excessive payments by Medicare and/or Medicaid.  These actions, if successful, could adverselyaffect us and may have a material adverse effect on our business, results ofoperations, financial condition and cash flows.

 

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**The design, development,manufacture and sale of our products involves the risk of product liabilityclaims by consumers and other third parties, and insurance against suchpotential claims is expensive and may be difficult to obtain.**

 

The design, development,manufacture and sale of our products involve an inherent risk of productliability claims and the associated adverse publicity.  Insurance coverage is expensive and may bedifficult to obtain, and may not be available in the future on acceptableterms, or at all.  Although we currentlymaintain product liability insurance for our products in amounts we believe tobe commercially reasonable, if the coverage limits of these insurance policiesare not adequate, a claim brought against Watson, whether covered by insuranceor not, could have a material adverse effect on our business, results ofoperations, financial condition and cash flows.

 

**The loss of our key personnelcould cause our business to suffer.**

 

The success of ourpresent and future operations will depend, to a significant extent, upon theexperience, abilities and continued services of key personnel.  For example, although we have other seniormanagement personnel, a significant loss of the services of Allen Chao, Ph.D.,our Chairman, President and Chief Executive Officer, or other senior executiveofficers, could cause our business to suffer. We cannot assure you that we will be able to attract and retain keypersonnel.  We have entered into employmentagreements with all of our senior executive officers, including Dr. Chao.  We do not carry key-man life insurance on anyof our officers.

 

**Rising insurancecosts could negatively impact profitability.**

 

The costof insurance, including workers compensation, product liability and generalliability insurance, have risen significantly in recent years and mayincrease.  In response, we may increasedeductibles and/or decrease certain coverages to mitigate these costs.  These increases, and our increased risk dueto increased deductibles and reduced coverages, could have a negative impact onour results of operations, financial condition and cash flows.

 

**Implementationof enterprise resource planning systems could cause business interruptions andnegatively affect our profitability and cash flows.**

 

During2004, we implemented an enterprise resource planning (ERP) system to improvecustomer service, enhance operating efficiencies, and provide more effectivemanagement of business operations.  Fromtime to time, we may implement new ERP systems and software, or upgrades toexisting systems and software, to further enhance our operations.  Implementation of ERP systems and softwarecarry risks such as cost overruns, project delays and business interruptionsand delays.  If we experience a materialbusiness interruption as a result of such implementations, it could adverselyaffect us, and could have a material adverse effect on our business, results ofoperations, financial condition and cash flows.

 

**Significant balances ofintangible assets, including product rights and goodwill acquired, are subjectto impairment testing and may result in impairment charges, which willadversely affect our results of operations and financial condition.**

 

A significant amount of ourtotal assets is related to acquired product rights and goodwill.  As of June 30, 2005, the carrying valueof our product rights and other intangible assets was approximately $830 millionand the carrying value of our goodwill was approximately $460 million.

 

Our product rights arestated at cost, less accumulated amortization. We determine original fair value and amortization periods for productrights based on our assessment of various factors impacting estimated usefullives and cash flows of the acquired products. Such factors include the product’s position in its life cycle, theexistence or absence of like products in the market, various other competitiveand regulatory issues and contractual terms. Significant changes to any of these factors would require us to performan impairment test on 

 

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the affected asset and, if evidence of impairment exists, we would berequired to take an impairment charge with respect to the asset.  Such a charge would adversely affect ourresults of operations and financial condition.

 

Goodwill is tested forimpairment annually and when events occur or circumstances change that couldpotentially reduce the fair value of the reporting unit.  Impairment testing compares the fair value ofthe reporting unit to its carrying amount. An impairment, if any, would be recorded in operating income and couldhave a significant adverse affect on our results of operations and financialcondition.

 

**Issuance of debtor equity securities could materially change our operating results andfinancial condition.**

 

We may consider issuingadditional debt or equity securities in the future to fund potentialacquisitions or investment, to refinance existing debt, or for generalcorporate purposes.  If a materialacquisition or investment is completed, our operating results and financialcondition could change materially in future periods.  However, no assurance can be given thatadditional funds will be available on satisfactory terms, or at all, to fundsuch activities.

 

*Risks Relating To Investing Inthe Pharmaceutical Industry*

 

**Extensive industry regulation hashad, and will continue to have, a significant impact on our business,especially our product development, manufacturing and distributioncapabilities.**

 

All pharmaceuticalcompanies, including Watson, are subject to extensive, complex, costly andevolving regulation by the federal government, principally the FDA and to alesser extent by the U.S. Drug Enforcement Agency (DEA) and state governmentagencies.  The Federal Food, Drug andCosmetic Act, the Controlled Substances Act and other federal statutes andregulations govern or influence the testing, manufacturing, packing, labeling,storing, record keeping, safety, approval, advertising, promotion, sale anddistribution of our products.

 

Under these regulations,we are subject to periodic inspection of our facilities, procedures andoperations and/or the testing of our products by the FDA, the DEA and otherauthorities, which conduct periodic inspections to confirm that we are incompliance with all applicable regulations. In addition, the FDA conducts pre-approval and post-approval reviews andplant inspections to determine whether our systems and processes are incompliance with current Good Manufacturing Practice, or cGMP, and other FDAregulations.  Following such inspections,the FDA may issue notices on Form 483 and warning letters that could causeus to modify certain activities identified during the inspection.  A Form 483 notice is generally issued atthe conclusion of a FDA inspection and lists conditions the FDA inspectorsbelieve may violate cGMP or other FDA regulations.  FDA guidelines specify that a warning letteris issued only for violations of “regulatory significance” for which thefailure to adequately and promptly achieve correction may be expected to resultin an enforcement action.

 

Our principalmanufacturing facility in Corona, California is currently subject to a consentdecree of permanent injunction.  Wecannot assure you that the FDA will determine that we have adequately correcteddeficiencies at our manufacturing sites (including the one referenced above),that subsequent FDA inspections will not result in additional inspectionalobservations at such sites, that approval of any of the pending or subsequentlysubmitted NDAs, ANDAs or supplements to such applications by Watson or itssubsidiaries will be granted or that the FDA will not seek to impose additionalsanctions against Watson or any of its subsidiaries.  The range of possible sanctions includes,among others, FDA issuance of adverse publicity, product recalls or seizures,fines, total or partial suspension of production and/or distribution,suspension of the FDA’s review of product applications, enforcement actions,injunctions, and civil or criminal prosecution. Any such sanctions, if imposed, could materially harm our operatingresults and financial condition.  Undercertain circumstances, the FDA also has the authority to revoke previouslygranted drug approvals.  Similarsanctions as detailed above may be available to the FDA under a consent decree,depending upon the actual terms of such 

 

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decree.  Although we haveinstituted internal compliance programs, if these programs do not meetregulatory agency standards or if compliance is deemed deficient in anysignificant way, it could materially harm our business.  Certain of our vendors are subject to similarregulation and periodic inspections.

 

The process for obtaininggovernmental approval to manufacture and market pharmaceutical products isrigorous, time-consuming and costly, and we cannot predict the extent to whichwe may be affected by legislative and regulatory developments.  We are dependent on receiving FDA and othergovernmental or third-party approvals prior to manufacturing, marketing andshipping our products.  Consequently,there is always the chance that we will not obtain FDA or other necessary approvals,or that the rate, timing and cost of such approvals, will adversely affect ourproduct introduction plans or results of operations.  We carry inventories of certain product(s) inanticipation of launch, and if such product(s) are not subsequently launched,we may be required to write-off the related inventory.

 

**Federal regulation ofarrangements between manufacturers of brand and generic products couldadversely affect our business.**

 

As part of the MedicarePrescription Drug, Improvement, and Modernization Act of 2003, companies arenow required to file with the Federal Trade Commission (FTC) and the Departmentof Justice certain types of agreements entered into between brand and genericpharmaceutical companies related to the manufacture, marketing and sale ofgeneric versions of brand drugs.  Thisrequirement could affect the manner in which generic drug manufacturers resolveintellectual property litigation and other disputes with brand pharmaceuticalcompanies and could result generally in an increase in private-party litigationagainst pharmaceutical companies or additional investigations or proceedings bythe FTC or other governmental authorities. The impact of this requirement, and the potential private-party lawsuitsassociated with arrangements between brand name and generic drug manufacturers,is uncertain and could adversely affect our business.

 

**Healthcare reform and a reduction in thereimbursement levels by governmental authorities, HMOs, MCOs or otherthird-party payors may****adversely affect ourbusiness.**

 

In order to assist us incommercializing products, we have obtained from government authorities andprivate health insurers and other organizations, such as HMOs and MCOs,authorization to receive reimbursement at varying levels for the cost ofcertain products and related treatments. Third party payors increasingly challenge pricing of pharmaceuticalproducts.  The trend toward managedhealthcare in the U.S., the growth of organizations such as HMOs and MCOs andlegislative proposals to reform healthcare and government insurance programscould significantly influence the purchase of pharmaceutical products,resulting in lower prices and a reduction in product demand.  Such cost containment measures and healthcarereform could affect our ability to sell our products and may have a materialadverse effect on our business, results of operations and financialcondition.  Additionally, there isuncertainty surrounding the implementation of the provisions of the Medicare Part DPrescription Drug Benefit as authorized by the Medicare Prescription,Improvement, and Modernization Act of 2003. Depending on how such provisions are implemented, reimbursement may notbe available for some of Watson’s products. Additionally, any reimbursement granted may not be maintained or limitson reimbursement available from third-party payors may reduce the demand for,or negatively affect the price of, those products and could harm significantlyour business, results of operations, financial condition and cash flows.  We may also be subject to lawsuits relatingto reimbursement programs that could be costly to defend, divert management’sattention and adversely affect our operating results.

 

 **The pharmaceuticalindustry is highly competitive.**

 

We face strong competition in both our generic andbrand product businesses.  The intenselycompetitive environment requires an ongoing, extensive search for technologicalinnovations and the ability to market products effectively, including theability to communicate the effectiveness, safety and value of brand products tohealthcare professionals in private practice, group practices and managed careorganizations. Our competitors vary depending upon product categories, andwithin each product category, upon dosage strengths and drug-delivery 

 

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systems. Based ontotal assets, annual revenues, and market capitalization, we are smaller thancertain of our national and international competitors in the brand productarena.  Most of our competitors have beenin business for a longer period of time than Watson, have a greater number ofproducts on the market and have greater financial and other resources than wedo.  If we directly compete with them forthe same markets and/or products, their financial strength could prevent usfrom capturing a profitable share of those markets. It is possible thatdevelopments by our competitors will make our products or technologiesnoncompetitive or obsolete.

 

Revenues and gross profitderived from the sales of generic pharmaceutical products tend to follow apattern based on certain regulatory and competitive factors.  As patents for brand name products andrelated exclusivity periods expire, the first generic manufacturer to receiveregulatory approval for generic equivalents of such products is generally ableto achieve significant market penetration. As competing off-patent manufacturers receive regulatory approvals onsimilar products or as brand manufacturers launch generic versions of such products(for which no separate regulatory approval is required), market share, revenuesand gross profit typically decline, in some cases dramatically.  Accordingly, the level of market share,revenue and gross profit attributable to a particular generic product normallyis related to the number of competitors in that product’s market and the timingof that product’s regulatory approval and launch, in relation to competingapprovals and launches.  Consequently, wemust continue to develop and introduce new products in a timely andcost-effective manner to maintain our revenues and gross margins.  Additionally, as new competitors enter themarket, there may be increased pricing pressure on certain products, whichwould result in lower gross margins. This is particularly true in the case of certain overseas competitors,who may be able to produce products at costs lower than the costs of domesticmanufacturers.  If we experiencesubstantial competition from overseas competitors with lower production costs,our profit margins will suffer.

 

**Sales of our products maycontinue to be adversely affected by the continuing consolidation of ourdistribution network and the concentration of our customer base.**

 

Our principal customersare wholesale drug distributors and major retail drug store chains.  These customers comprise a significant partof the distribution network for pharmaceutical products in the U.S.  This distribution network is continuing toundergo significant consolidation marked by mergers and acquisitions amongwholesale distributors and the growth of large retail drug store chains.  As a result, a small number of largewholesale distributors and large chain drug stores control a significant shareof the market.  We expect thatconsolidation of drug wholesalers and retailers will increase pricing and othercompetitive pressures on drug manufacturers, including Watson.

 

For the year ended December 31, 2004, our fourlargest customers accounted for 15%, 14%, 11% and 11% respectively, of our netrevenues.  The loss of any of thesecustomers could materially adversely affect our business, results ofoperations, financial condition and our cash flows.  In addition, none of our customers are partyto any long-term supply agreements with us which would enable them to changesuppliers freely should they wish to do so.

 

**ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUTMARKET RISK**

 

We are exposed to marketrisk for changes in the market values of our investments (Investment Risk) andthe impact of interest rate changes (Interest Rate Risk).  We have not used derivative financialinstruments in our investment portfolio. The quantitative and qualitative disclosures about market risk are setforth below.

 

**Investment Risk**

 

As of June 30, 2005,our total holdings in equity securities of other companies, includingequity-method investments and available-for-sale securities, were$39.8 million.  Of this amount, wehad equity-method investments of $3.4 million and publicly traded equitysecurities (available-for-sale securities) at fair value totaling $14.8 million($12.3 million that was included in “Marketable securities” and $2.5 millionthat was 

 

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included in “Investments and other assets”).  The fair values of these investments aresubject to significant fluctuations due to volatility of the stock market andchanges in general economic conditions. Based on the fair value of the publicly traded equity securities we heldat June 30, 2005, an assumed 25%, 40% and 50% adverse change in themarket prices of these securities would result in a corresponding decline intotal fair value of approximately $3.7 million, $5.9 million and$7.4 million, respectively.

 

At June 30, 2005,our investment in Andrx consisted of approximately 607,000 shares of Andrxcommon stock with a fair market value of $12.3 million.  Because Andrx is a publicly traded equitysecurity, our holdings of Andrx have exposure to investment risk.   The market price of Andrx common shares hasbeen, and may continue to be volatile.

 

The following table setsforth the Andrx high and low market price per share information, based onpublished financial sources, for 2005 and 2004 and further reflects thevolatility of the stock price:

 
| ** **            | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------------|------------|----------|------------|---------|------------|
| **2005,  by quarter** |       |     |       |    |       |
| First                 |       | $        | 24.47      |    | $          | 20.55 |   |
| Second                |       | $        | 23.38      |    | $          | 19.15 |   |
|                  |       |     |       |    |       |
| **2004,  by quarter** |       |     |       |    |       |
| First                 |       | $        | 30.87      |    | $          | 23.55 |   |
| Second                |       | $        | 29.35      |    | $          | 22.24 |   |
| Third                 |       | $        | 28.10      |    | $          | 16.95 |   |
| Fourth                |       | $        | 23.63      |    | $          | 14.09 |   |

 

**We regularly review the carrying value of our investmentsand identify and recognize losses, for income statement purposes, when eventsand circumstances indicate that any declines in the fair values of suchinvestments, below our accounting basis, are other than temporary.**

** **

**Interest Rate Risk**

** **

Our exposure to interestrate risk relates primarily to our non-equity investment portfolio.  Our cash is invested in A-rated money marketmutual funds and short-term securities. Consequently, our interest rate andprincipal risk are minimal.

 

During 2004, we acquireda significant amount of U.S. Treasury securities classified asavailable-for-sale securities, with no security having a maturity in excess oftwo years.  These securities are exposedto interest rate fluctuations.  Becauseof the short-term nature of these investments, we are subject to minimalinterest rate risk and do not believe that an increase in market rates wouldhave a significant negative impact on the realized value of our portfolio.  Our investments in auction rate securitieswere liquidated during the second quarter of 2005.

 

Basedon quoted market rates of interest and maturity schedules for similar debtissues, we estimate that the fair values of our CODES and our 1998 Senior Notesapproximated their carrying values on June 30, 2005.  While changes in market interest rates mayaffect the fair value of our fixed-rate debt, we believe the effect, if any, ofreasonably possible near-term changes in the fair value of such debt on ourfinancial condition, results of operations or cash flows will not be material.

 

At this time, we are notparty to any interest rate or derivative hedging contracts and have no materialforeign exchange or commodity price risks.

 

We do not believe thatinflation has had a significant impact on our revenues or operations.

 

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**ITEM 4.  CONTROLS AND PROCEDURES**

 

The Company maintainsdisclosure controls and procedures that are designed to ensure that informationrequired to be disclosed in the Company’s Exchange Act reports is recorded,processed, summarized and reported within the time periods specified in the SEC’srules and forms, and that such information is accumulated and communicatedto the Company’s management, including its Principal Executive Officer andPrincipal Financial Officer, as appropriate, to allow timely decisionsregarding required disclosure.  Indesigning and evaluating the disclosure controls and procedures, managementrecognized that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and management necessarily was required to apply itsjudgment in evaluating the cost-benefit relationship of possible controls andprocedures.  Also, the Company hasinvestments in certain unconsolidated entities. As the Company does not control or manage these entities, its disclosurecontrols and procedures with respect to such entities are necessarilysubstantially more limited than those it maintains with respect to itsconsolidated subsidiaries.

 

As required by SEC Rule 13a-15(b),the Company carried out an evaluation, under the supervision and with theparticipation of the Company’s management, including the Company’s PrincipalExecutive Officer and Principal Financial Officer, of the effectiveness of thedesign and operation of the Company’s disclosure controls and procedures as ofthe end of the quarter covered by this Report. Based on the foregoing, theCompany’s Principal Executive Officer and Principal Financial Officer concludedthat the Company’s disclosure controls and procedures were effective.

 

There have been nochanges in the Company’s internal control over financial reporting, during thethree months ended June 30, 2005, that has materially affected, or isreasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

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**PART II.  OTHER INFORMATION AND SIGNATURES**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

The Company is party tocertain lawsuits and legal proceedings, which are described in “Part I,Item 3. Legal Proceedings,” of our Annual Report on Form 10-K for the yearended December 31, 2004.  Thefollowing is a description of material developments during the period coveredby this Quarterly Report and through the filing of this Quarterly Report, andshould be read in conjunction with the Annual Report referenced above.

 

*Phen-fenlitigation.*  Withrespect to the phentermine hydrochloride product liability lawsuits pendingagainst the Company, certain subsidiaries, and others, additional actionsraising similar issues have been filed, and some actions have been settled orotherwise dismissed.  As of August 8,2005, approximately 50 cases were pending against Watson and its affiliates innumerous state and federal courts.  Mostof the cases involve multiple plaintiffs, and several were filed or certifiedas class actions.  The Company believesit will be fully indemnified by Rugby’s former owner, Aventis Pharmaceuticals(Aventis, formerly known as Hoechst Marion Roussel, Inc., and now known asSanofi-Aventis) for the defense of all such cases and for any liability thatmay arise out of these cases.  Aventis iscurrently controlling the defense of all these matters as the indemnifying partyunder its agreements with the Company.

 

*Cipro®Litigation. *On May 7,2005, three groups of plaintiffs from the consolidated action (*In re: Ciprofloxacin Hydrochloride Antitrust Litigation, MDL Docket No. 001383*),including the direct purchaser plaintiffs, the indirect purchaser plaintiffs,and plaintiffs Rite Aid and CVS, filed Notices of Appeal in the United StatesCourt of Appeals for the Second Circuit, appealing, among other things, the March 31,2005 Order by the United States District Court for the Eastern District of NewYork granting summary judgment in favor of the defendants.

 

*GovernmentalReimbursement Investigations and Drug Pricing Litigation.*  With respect to the Drug Pricing Litigationpending against the Company and certain subsidiaries, additional actionsraising similar allegations were filed in June and July of 2005,including actions by six counties in New York State (*County ofColumbia v. Abbott Laboratories, Inc., et al*., United StatesDistrict Court for the Northern District of New York, Case No. 05-CV-0867-GLS/RFTl;*County of Cortland v. Abbott Laboratories, Inc.,et al.*, United States District Court for the Northern District ofNew York, Case No. 05-CV-0881-NAM/GJD; *County of Dutchess v.Abbott Laboratories, Inc., et al.,* United States District Courtfor the Southern District of New York, Case No. 05-CV-06458-ESJ/KNF; *Essex County v. Abbott Laboratories, Inc., et al.,*United States District Court for the Northern District of New York, Case No. 05-CV-0878-TJM/DRH;*County of Lewis v. Abbott Laboratories, Inc.,et al.,* United States District Court for the Northern District ofNew York, Case No. 05-CV-0839-DNH/GHL; and *County ofOrleans v. Abbott Laboratories, Inc., et al.,* United StatesDistrict Court for the Western District of New York, Case No. 05-CV-06371-MAT).  In the Consolidated Action pending in theUnited States District Court for the District of Massachusetts (*In re Pharmaceutical Industry Average Wholesale Price Litigation, MDLDocket No. 1456, Civil Action No. 01-CV-12257-PBS*), on June 15,2005, a separate consolidated complaint was filed that adds six other New Yorkcounties (County of Jefferson, County of Madison, County of Niagra, County ofPutnam, County of Steuben, and County of Suffolk) to those that had earliersued the Company and certain subsidiaries.  On July 20, 2005, an action was filedagainst the Company and a subsidiary by the Attorney General for the State ofFlorida (*The State of Florida ex rel. Ven-A-Care of theFlorida Keys, Inc. et al. v. Mylan Laboratories, Inc. et al.*,Civil Action No. 98-3032G, Florida Leon County Court).  As of August 8, 2005, in addition to theConsolidated Action pending in the United States District Court for theDistrict of Massachusetts, there were approximately 45 plaintiffs in 40 casespending against the Company or its subsidiaries and other third parties,including actions by eight State Attorneys General, the City of New York, and36 counties in New York State. The defendants have removed several of theseactions (originally filed in state court) to federal court, and are seekingeventual transfer of these cases into the Consolidated Action.  However, the plaintiffs have filed motions toremand several of the cases back to state court. The Company has been served inseveral of the actions filed by New York counties. Additional actions areanticipated.  The Company 

 

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intends to defend these actions vigorously.  However, if successful, these actions couldadversely affect the Company and may have a material adverse effect on theCompany’s business, results of operations, financial condition and cash flows.

 

*SecuritiesLitigation.*  On May 31,2005, the appellants in the action pending in the U.S. Court of Appeals for theNinth Circuit (*Pension Fund v. Watson Pharmaceuticals, Inc.,USCA Docket No. 04-56791*) filed their reply brief.  The appellate court has not yet scheduled ahearing on the appeal.

 

*HormoneReplacement Therapy Litigation. *With respect to the hormone replacementtherapy product liability lawsuits pending against the Company, certain of itssubsidiaries, and other third parties, additional actions raising similarallegations have been filed, and some actions have been dismissed.  As of August 8, 2005, there wereapproximately 90 cases pending against the Company and its affiliates invarious state and federal courts, representing claims by approximately 800 plaintiffs.  Many of the cases seek certification as classactions.  These actions, if successful,could adversely affect the Company and could have a material adverse effect onthe Company’s business, results of operations, financial condition and cashflows.

 

Watson and its affiliatesare involved in various other disputes, governmental and/or regulatoryinspections, inquires, investigations and proceedings, and litigation mattersthat arise from time to time in the ordinary course of business.  The process of resolving matters throughlitigation or other means is inherently uncertain and it is possible that anunfavorable resolution of these matters will adversely affect the Company, itsresults of operations, financial condition and cash flows.

 

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**ITEM2.  UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS**

 

There were nounregistered sales of equity securities.

 

**Issuer Purchases of Equity Securities**

 

The following tablesummarizes the Company’s purchases of common stock during the second quarter of2005:

 
| **Period**                                       | ** ** | **Total Number of  Shares  Purchased**                  | ** ** | **Average Price  Paid Per  Share** | ** ** | **Total Number of  Shares Purchased  as Part of  Publicly Announced  Plans or Programs** | ** ** | **Approximate  Dollar Value of  Shares that May Yet Be  Purchased Under the  Plans or Programs** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------------------|------------|------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|
|                                             |       | **(In thousands, except average price paid per share)** |       |                               |       |
|                                             |       |                                                    |       |                               |       |                                                                                          |       |                                                                                                  |       |
| April 1, 2005  through  April 30, 2005 |       | —                                                  |       | N/A                                |       | —                                                                                        |       | $                                                                                                     | 230,922    |   |
|                                             |       |                                                    |       |                               |       |                                                                                          |       |                                                                                                  |       |
| May 1, 2005  through  May 31, 2005     |       | 2,769                                                   |       | $                                  | 29.97      |                                                                                          | 2,769      |                                                                                                  | $          | 147,958 |   |
|                                             |       |                                                    |       |                               |       |                                                                                          |       |                                                                                                  |       |
| June 1, 2005  through  June 30, 2005   |       | 1,000                                                   |       | $                                  | 30.54      |                                                                                          | 1,000      |                                                                                                  | $          | 117,415 |   |
| **Total**                                        |       | 3,769                                                   |       |                               |       | 3,769                                                                                         |       |                                                                                                  |       |

 

In February 2005, the Board authorized a programto repurchase shares of Watson’s common stock. The Board approved the repurchase of up to $300.0 million of shares overa period of one year.  This programprovides for purchases to be made in the open market or in privately negotiatedtransactions.  Additionally, the Boardresolved that purchases may be made under Rule 10b5-1 promulgated underthe Securities and Exchange Act of 1934, as amended.  The repurchase of shares will be made usingour cash resources.  The repurchaseprogram may be suspended or discontinued at any time without prior notice.

 

As of June 30, 2005, the Company hadapproximately $117.4 million available for future repurchases of its commonstock under this $300.0 million Board authorization.

 

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**ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

 

At our Annual Meeting ofStockholders held on May 13, 2005, the following proposals were set beforethe stockholders for their vote:

 

Proposal1.            To elect three personsas Class I Directors to a three-year term and until their successors areduly elected and qualified.

 
| ** **                                 | ** ** | **Michael J.  Fedida** | ** ** | **Albert F.  Hummel** | ** ** | **Catherine M.  Klema** | ** ** |
|--------------------------------------------|------------|------------------------|------------|-----------------------|------------|-------------------------|------------|
| *Votes “For”*                    |       | 93,215,298             |       | 94,032,747            |       | 94,440,221              |       |
| *Votes  to “Withhold Authority”* |       | 4,180,451              |       | 3,363,002             |       | 2,955,528               |       |

 

The terms of thefollowing directors continued after the annual meeting:

 
| **Class II** | ** ** | **Expiration  of Term** | ** ** |
|-------------------|------------|-------------------------|------------|
| Ronald R. Taylor  |       | 2006                    |       |
| Andrew L. Turner  |       | 2006                    |       |
| Jack Michaelson   |       | 2006                    |       |

 
| **Class III** | ** ** | ** ** | ** ** |
|--------------------|------------|------------|------------|
| Allen Chao, Ph.D   |       | 2007       |       |
| Michel J.  Feldman |       | 2007       |       |
| Fred G. Weiss      |       | 2007       |       |

 

Proposal2.            To approve anAmendment and Restatement of the 2001 Incentive Award Plan of WatsonPharmaceuticals, Inc., which provides for the grant of certain additionaltypes of awards to eligible employees, consultants and directors.

 

Votes *“For”*— 61,779,184 shares

Votes *“Against”*— 16,423,037 shares

Votes *“Abstained”*— 701,566 shares

 

Proposal3.            To ratify of theappointment of PricewaterhouseCoopers LLP as the Company’s independent auditorfor the year ending December 31, 2005:

 

Votes *“For”*— 95,439,088 shares

Votes *“Against”*— 1,333,294 shares

Votes *“Abstained”*— 619,768 shares

Broker “Non-Vote*”*— 7,200 shares

 

**ITEM 6.  EXHIBITS**

 

(a) Exhibits:

 

Reference is hereby made to the Exhibit Indexon page 49.

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 

 
| ** ** | **WATSON  PHARMACEUTICALS, INC**.  (Registrant) |
|------------|-------------------------------------------------|
| ** ** | ** **                                      |
|       | By:                                             | **/s/  Charles P. Slacik** | ** ** |
|       |                                            | Charles P.  Slacik |   |
|       | ** **                                      | Executive Vice  President – Chief Financial Officer | ** ** |
|       | ** **                                      | (Principal  Financial Officer) | ** ** |
|       |                                            |   |   |
|       |                                            |   |   |
|       | By:                                             | **/s/ R.  Todd Joyce** | ** ** |
|       | ** **                                      | R. Todd Joyce | ** ** |
|       | ** **                                      | Vice President –  Corporate Controller and | ** ** |
|       | ** **                                      | Treasurer | ** ** |
|       | ** **                                      | (Principal  Accounting Officer) | ** ** |
|       |                                            |

 

Date:  August 9, 2005

 

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**WATSONPHARMACEUTICALS, INC.**

 

**EXHIBIT INDEXTO FORM 10-Q**

**For theQuarterly Period Ended June 30, 2005**

 

 
| **Exhibit   No.** | ** ** | **Description**                                                                                                                                                       |
|-------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **        | ** ** | ** **                                                                                                                                                            |
| 10.1              |       | Amendment and  Restatement of the 2001 Incentive Award Plan of Watson  Pharmaceuticals, Inc.                                                                     |
|              |       |                                                                                                                                                                  |
| 10.2              |       | Form of Amendment  and Restatement of the 2001 Incentive Award Plan Notice of Grant and  Signature Page for a Non-Employee Director Restricted Stock Award. |
|              |       |                                                                                                                                                                  |
| 10.3              |       | Form of Amendment  and Restatement of the 2001 Incentive Award Plan Notice of Grant and  Signature Page for a Non-Employee Director Option Grant.           |
|              |       |                                                                                                                                                                  |
| 10.4              |       | Form of Amendment  and Restatement of the 2001 Incentive Award Plan Notice of Grant and  Signature page for an Employee Restricted Stock Award.             |
|              |       |                                                                                                                                                                  |
| 10.5              |       | Form of Amendment  and Restatement of the 2001 Incentive Award Plan Notice of Grant and  Signature Page for an Employee Stock Option Award.                 |
|              |       |                                                                                                                                                                  |
| 10.6              |       | Form of Amendment  and Restatement of the 2001 Incentive Award Plan Notice of Grant and  Signature Page for a Vice President and Above Stock Option Award.  |
|              |       |                                                                                                                                                                  |
| 31.1              |       | Certification of  Chairman and Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                               |
|              |       |                                                                                                                                                                  |
| 31.2              |       | Certification of  Executive Vice President and Chief Financial Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                               |
|              |       |                                                                                                                                                                  |
| 32.1              |       | Certification of  Chairman and Chief Executive Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                               |
|              |       |                                                                                                                                                                  |
| 32.2              |       | Certification of  Executive Vice President and Chief Financial Officer pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                               |

 

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