**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM10-Q**

 

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

 

**FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004**

 

**or**

 

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

 

**For the transitionperiod from            to**

 

**Commission file****number 0-20045**

 

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**WATSONPHARMACEUTICALS, INC.**

(Exact name of registrant as specified in its charter)

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

 
| **311 Bonnie Circle**                                        |
|--------------------------------------------------------------|
| **Corona, CA 92880-2882**                                    |
| (Address of principal executive offices, including zip code) |
|                                                         |
| **(951) 493-5300**                                           |
| (Registrant’s telephone number, including area code)    |

 

Indicate by check mark whetherthe Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.   Yes ý   No o

 

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

 

The number of sharesoutstanding of the Registrant’s only class of common stock as of August 4, 2004was approximately 109,452,060.

 

 

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**WATSON PHARMACEUTICALS, INC.**

** **

**TABLE OF CONTENTS**

** **

**FORM 10-Q FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004**

 
| **Part I.  FINANCIAL INFORMATION**                                                                              | ** **                                                                                              |
|-----------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
|                                                                                                            |                                                                                                    |
| Item 1.  Condensed Consolidated Financial Statements  (Unaudited):                                    |                                                                                                    |
|                                                                                                            |                                                                                                    |   |
|                                                                                                            | Condensed  Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003                        |   |
|                                                                                                            |                                                                                                    |   |
|                                                                                                            | Condensed  Consolidated Statements of Income for the Three and Six Months Ended June 30,  2004 and 2003 |   |
|                                                                                                            |                                                                                                    |   |
|                                                                                                            | Condensed  Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2004  and 2003       |   |
|                                                                                                            |                                                                                                    |   |
|                                                                                                            | 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  4.  Submission of Matters to a Vote of  Security Holders                                             |                                                                                                    |
|                                                                                                            |                                                                                                    |
| Item 6.  Exhibits and Reports on Form 8-K                                                                  |                                                                                                    |
|                                                                                                            |                                                                                                    |
| Signatures                                                                                                      |                                                                                                    |
|                                                                                                                 |                                                                                                         |  |  |

 

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**WATSON PHARMACEUTICALS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(Unaudited; in thousands, except shareamounts)**

 
| ** **                                                                                                                | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| **ASSETS**                                                                                                                |       |               |       |                   |       |
| Current assets:                                                                                                           |       |               |       |                   |       |
| Cash and cash equivalents                                                                                                 |       | $                  | 473,399    |                   | $          | 553,353 |   |
| Marketable securities                                                                                                     |       | 19,475             |       | 20,368                 |       |
| Accounts receivable, net                                                                                                  |       | 210,619            |       | 211,174                |       |
| Inventories                                                                                                               |       | 385,119            |       | 393,393                |       |
| Prepaid expenses and other current assets                                                                                 |       | 43,916             |       | 38,561                 |       |
| Deferred tax assets                                                                                                       |       | 97,291             |       | 106,640                |       |
| Total current assets                                                                                                      |       | 1,229,819          |       | 1,323,489              |       |
|                                                                                                                      |       |               |       |                   |       |
| Property and equipment, net                                                                                               |       | 447,820            |       | 424,995                |       |
| Investments and other assets                                                                                              |       | 51,189             |       | 50,096                 |       |
| Deferred tax assets                                                                                                       |       | 26,379             |       | 27,130                 |       |
| Product rights and other intangibles, net                                                                                 |       | 971,007            |       | 1,001,295              |       |
| Goodwill                                                                                                                  |       | 455,595            |       | 455,595                |       |
| Total assets                                                                                                              |       | $                  | 3,181,809  |                   | $          | 3,282,600 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                             |       |               |       |                   |       |
| Current liabilities:                                                                                                      |       |               |       |                   |       |
| Accounts payable and accrued expenses                                                                                     |       | $                  | 210,673    |                   | $          | 215,388 |   |
| Income taxes payable                                                                                                      |       | 46,201             |       | 111,982                |       |
| Deferred revenue                                                                                                          |       | 4,399              |       | 11,315                 |       |
| Total current liabilities                                                                                                 |       | 261,273            |       | 338,685                |       |
|                                                                                                                      |       |               |       |                   |       |
| Long-term debt                                                                                                            |       | 587,511            |       | 722,535                |       |
| Deferred revenue                                                                                                          |       | 11,250             |       | 10,767                 |       |
| Other long-term liabilities                                                                                               |       | 6,487              |       | 9,641                  |       |
| Deferred tax liabilities                                                                                                  |       | 149,043            |       | 143,626                |       |
| Total liabilities                                                                                                         |       | 1,015,564          |       | 1,225,254              |       |
|                                                                                                                      |       |               |       |                   |       |
| 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; 109,305,400 and 108,330,300 shares outstanding |       | 361                |       | 357                    |       |
| Additional paid-in capital                                                                                                |       | 869,520            |       | 841,007                |       |
| Retained earnings                                                                                                         |       | 1,283,296          |       | 1,201,714              |       |
| Accumulated other comprehensive income                                                                                    |       | 13,068             |       | 14,268                 |       |
| Total stockholders’ equity                                                                                           |       | 2,166,245          |       | 2,057,346              |       |
| Total liabilities and stockholders’ equity                                                                           |       | $                  | 3,181,809  |                   | $          | 3,282,600 |   |

 

*See accompanying Notes to CondensedConsolidated Financial Statements.*

 

1

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**WATSON PHARMACEUTICALS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF INCOME**

**(Unaudited; in thousands, except per shareamounts)**

 
| ** **                                     | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                     | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                           |       |                             |       |                           |       |   |   |   |   |
| Net revenues                                   |       | $                                | 399,368    |                           | $          | 355,880 |   | $ | 809,026 |   | $ | 692,802 |   |
| Cost of sales                                  |       | 198,854                          |       | 154,376                        |       | 395,335 |   | 303,977 |   |
| Gross profit                                   |       | 200,514                          |       | 201,504                        |       | 413,691 |   | 388,825 |   |
|                                           |       |                             |       |                           |       |   |   |   |   |
| Operating expenses:                            |       |                             |       |                           |       |   |   |   |   |
| Research and development                       |       | 42,529                           |       | 25,701                         |       | 72,210 |   | 48,185 |   |
| Selling, general and administrative            |       | 79,169                           |       | 72,214                         |       | 156,580 |   | 139,873 |   |
| Amortization                                   |       | 17,983                           |       | 17,785                         |       | 35,915 |   | 36,220 |   |
| Total operating expenses                       |       | 139,681                          |       | 115,700                        |       | 264,705 |   | 224,278 |   |
| Operating income                               |       | 60,833                           |       | 85,804                         |       | 148,986 |   | 164,547 |   |
|                                           |       |                             |       |                           |       |   |   |   |   |
| Other income (expense):                        |       |                             |       |                           |       |   |   |   |   |
| Equity in earnings (losses) of joint  ventures |       | (1,700                           | )          | 88                             |       | (3,279 | ) | 205 |   |
| Loss on impairment of assets                   |       | —                           |       | (1,218                         | )          | (891 | ) | (14,260 | ) |
| Gain on sale of securities                     |       | —                           |       | 1,925                          |       | 3,938 |   | 3,014 |   |
| Gain on sale of subsidiary                     |       | —                           |       | —                         |       | — |   | 15,676 |   |
| Loss on early extinguishment of debt           |       | (3,746                           | )          | —                         |       | (17,752 | ) | (2,807 | ) |
| Interest income                                |       | 1,015                            |       | 1,442                          |       | 2,222 |   | 2,684 |   |
| Interest expense                               |       | (1,647                           | )          | (7,580                         | )          | (5,390 | ) | (12,921 | ) |
| Other income (expense)                         |       | (176                             | )          | (844                           | )          | (340 | ) | (1,438 | ) |
| Total other income (expense), net              |       | (6,254                           | )          | (6,187                         | )          | (21,492 | ) | (9,847 | ) |
|                                           |       |                             |       |                           |       |   |   |   |   |
| Income before income taxes                     |       | 54,579                           |       | 79,617                         |       | 127,494 |   | 154,700 |   |
| Provision for income taxes                     |       | 19,652                           |       | 28,902                         |       | 45,908 |   | 56,156 |   |
| Net income                                     |       | $                                | 34,927     |                           | $          | 50,715 |   | $ | 81,586 |   | $ | 98,544 |   |
|                                           |       |                             |       |                           |       |   |   |   |   |
| Earnings per share:                            |       |                             |       |                           |       |   |   |   |   |
| Basic                                          |       | $                                | 0.32       |                           | $          | 0.47 |   | $ | 0.75 |   | $ | 0.92 |   |
| Diluted                                        |       | $                                | 0.32       |                           | $          | 0.47 |   | $ | 0.74 |   | $ | 0.91 |   |
|                                           |       |                             |       |                           |       |   |   |   |   |
| Weighted average shares outstanding:           |       |                             |       |                           |       |   |   |   |   |
| Basic                                          |       | 109,049                          |       | 107,134                        |       | 108,839 |   | 107,038 |   |
| Diluted                                        |       | 110,325                          |       | 108,334                        |       | 110,616 |   | 107,847 |   |

 

*Seeaccompanying Notes to Condensed Consolidated Financial Statements.*

 

2

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**WATSONPHARMACEUTICALS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited; inthousands)

 
| ** **                                                       | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                       | ** ** | **2004**                       | ** ** | **2003** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                        |       |                           |       |   |   |
| Net income                                                       |       | $                              | 81,586     |   | $ | 98,544 |   |
| Reconciliation to net cash provided by operating activities:     |       |                           |       |   |   |
| Depreciation                                                     |       | 15,075                         |       | 13,767 |   |
| Amortization                                                     |       | 35,915                         |       | 36,220 |   |
| Deferred income tax benefit (provision)                          |       | 16,434                         |       | (19,213 | ) |
| Equity in (earnings) losses of joint ventures                    |       | 3,279                          |       | (205 | ) |
| Gain on sales of securities                                      |       | (3,938                         | )          | (3,014 | ) |
| Gain on sale of subsidiary                                       |       | —                         |       | (15,676 | ) |
| Loss on early extinguishment of debt                             |       | 17,752                         |       | 2,807 |   |
| Loss on impairment of assets                                     |       | 891                            |       | 14,260 |   |
| Tax benefits from employee stock plans                           |       | 5,854                          |       | 3,050 |   |
| Mark to market on derivative                                     |       | (3,154                         | )          | 2,000 |   |
| Other                                                            |       | 434                            |       | (1,015 | ) |
| Changes in assets and liabilities:                               |       |                           |       |   |   |
| Accounts receivable, net                                         |       | 555                            |       | 45,699 |   |
| Inventories                                                      |       | 8,274                          |       | (27,999 | ) |
| Prepaid expenses and other current assets                        |       | (5,355                         | )          | 14,260 |   |
| Accounts payable and accrued expenses                            |       | (4,715                         | )          | 31,364 |   |
| Deferred revenue                                                 |       | (6,433                         | )          | 2,200 |   |
| Income taxes payable                                             |       | (65,781                        | )          | 8,016 |   |
| Other assets                                                     |       | 933                            |       | (2,643 | ) |
| Total adjustments                                                |       | 16,020                         |       | 103,878 |   |
| Net cash provided by operating activities                        |       | 97,606                         |       | 202,422 |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                        |       |                           |       |   |   |
| Additions to property and equipment                              |       | (43,094                        | )          | (53,696 | ) |
| Acquisitions of product rights                                   |       | (5,627                         | )          | (178,468 | ) |
| Additions to long-term investments                               |       | (10,590                        | )          | — |   |
| Proceeds from sales of marketable equity securities              |       | 4,706                          |       | 7,388 |   |
| Proceeds from sale of Halsey note receivable                     |       | 5,381                          |       | — |   |
| Proceeds from sale of subsidiary                                 |       | —                         |       | 16,368 |   |
| Other investing activities, net                                  |       | 1,983                          |       | 3,838 |   |
| Net cash used in investing activities                            |       | (47,241                        | )          | (204,570 | ) |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                        |       |                           |       |   |   |
| Proceeds from issuance of debt, net of issuance costs of $14,375 |       | —                         |       | 560,625 |   |
| Proceeds from borrowings under revolving credit facility         |       | —                         |       | 60,000 |   |
| Principal payments on credit facility                            |       | —                         |       | (325,940 | ) |
| Payments to repurchase 1998 Senior Notes                         |       | (135,905                       | )          | — |   |
| Premium paid on 1998 Senior Notes repurchase                     |       | (17,072                        | )          | — |   |
| Principal payments on acquisition liabilities                    |       | (5                             | )          | (1,012 | ) |
| Proceeds from stock plans                                        |       | 22,663                         |       | 14,162 |   |
| Net cash (used in) provided by financing activities              |       | (130,319                       | )          | 307,835 |   |
| Net (decrease) increase in cash and cash equivalents             |       | (79,954                        | )          | 305,687 |   |
| Cash and cash equivalents at beginning of period                 |       | 553,353                        |       | 230,155 |   |
| Cash and cash equivalents at end of period                       |       | $                              | 473,399    |   | $ | 535,842 |   |

 

*See accompanying Notes to Condensed Consolidated FinancialStatements.*

 

3

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**WATSON PHARMACEUTICALS, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

**NOTE A –GENERAL**

 

WatsonPharmaceuticals, Inc. (Watson or the Company) is primarily engaged in thedevelopment, manufacture, marketing, sale and distribution of branded andoff-patent (generic) pharmaceutical products. The Company also developsadvanced drug delivery systems designed to enhance the therapeutic benefits ofexisting drug forms.  Watson operatesmanufacturing, distribution, research and development and administrativefacilities primarily in the United States of America (U.S.).

 

Theaccompanying condensed consolidated financial statements should be read inconjunction with the Company’s Annual Report on Form 10-K for the yearended December 31, 2003.  Certaininformation and footnote disclosures normally included in annual financialstatements prepared in accordance with generally accepted accounting principleshave been condensed or omitted from the accompanying consolidated financialstatements.  The year end balance sheetwas derived from the audited financial statements.  The accompanying interim financial statementsare unaudited, but reflect all adjustments which are, in the opinion ofmanagement, necessary to present fairly Watson’s consolidated financialposition, results of operations and cash flows for the periods presented.  Unless otherwise noted, all such adjustmentsare of a normal, recurring nature. Certain reclassifications, none of which affected net income or retainedearnings, have been 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.

 

*Comprehensiveincome*

 

Comprehensiveincome includes all changes in equity during a period except those thatresulted from investments by or distributions to the Company’sstockholders.  Other comprehensive incomerefers to revenues, expenses, gains and losses that, under generally acceptedaccounting principles, are included in comprehensive income, but excluded fromnet income as these amounts are recorded directly as an adjustment tostockholders’ equity.  Watson’s othercomprehensive income (loss) is comprised of unrealized gains (losses) on itsholdings of publicly traded equity securities, net of realized gains (losses)included in net income.  The componentsof comprehensive income and related income taxes consisted of the following (inthousands):

 

4

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| ** **                                                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                  | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                        |       |                             |       |                           |       |   |   |   |   |
| Net income                                                  |       | $                                | 34,927     |                           | $          | 50,715 |   | $ | 81,586 |   | $ | 98,544 |   |
| Other comprehensive income (loss):                          |       |                             |       |                           |       |   |   |   |   |
| Unrealized holding gain (loss) on  securities               |       | (686                             | )          | 17,704                         |       | (783 | ) | 15,072 |   |
| Less related income taxes                                   |       | 247                              |       | (7,081                         | )          | 282 |   | (6,029 | ) |
| Total unrealized gain (loss) on securities,  net            |       | (439                             | )          | 10,623                         |       | (501 | ) | 9,043 |   |
|                                                        |       |                             |       |                           |       |   |   |   |   |
| Reclassification for gains (losses)  included in net income |       | —                           |       | (707                           | )          | (1,092 | ) | 11,246 |   |
| Less related income taxes                                   |       | —                           |       | 256                            |       | 393 |   | (4,082 | ) |
| Total reclassification, net                                 |       | —                           |       | (451                           | )          | (699 | ) | 7,164 |   |
| Total other comprehensive income (loss)                     |       | (439                             | )          | 10,172                         |       | (1,200 | ) | 16,207 |   |
| Total comprehensive income                                  |       | $                                | 34,488     |                           | $          | 60,887 |   | $ | 80,386 |   | $ | 114,751 |   |

 

5

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*Earningsper share*

 

Basic earnings per share is computed bydividing net income by the weighted average common shares outstanding.  Diluted earnings per share is computed bydividing net income by the weighted average number of common shares anddilutive potential common shares outstanding based on the treasury stockmethod, assuming the exercise of all in-the-money stock options. Areconciliation of the numerators and denominators of basic and diluted earningsper share consisted of the following (in thousands, except per share amounts):

 
| ** **                                          | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                          | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Numerator:**                                      |       |                             |       |                           |       |   |   |   |   |
| Net income                                          |       | $                                | 34,927     |                           | $          | 50,715 |   | $ | 81,586 |   | $ | 98,544 |   |
| **Denominator:**                                    |       |                             |       |                           |       |   |   |   |   |
| Basic weighted average common shares  outstanding   |       | 109,049                          |       | 107,134                        |       | 108,839 |   | 107,038 |   |
| Effect of dilutive stock options                    |       | 1,276                            |       | 1,200                          |       | 1,777 |   | 809 |   |
| Diluted weighted average common shares  outstanding |       | 110,325                          |       | 108,334                        |       | 110,616 |   | 107,847 |   |
|                                                |       |                             |       |                           |       |   |   |   |   |
| **Basic earnings per share**                        |       | $                                | 0.32       |                           | $          | 0.47 |   | $ | 0.75 |   | $ | 0.92 |   |
|                                                |       |                             |       |                           |       |   |   |   |   |
| **Diluted earnings per share**                      |       | $                                | 0.32       |                           | $          | 0.47 |   | $ | 0.74 |   | $ | 0.91 |   |

 

Excluded fromthe computation of diluted earnings per share are outstanding common stockoptions with an exercise price greater than the average market price of thecommon shares for the periods reported. For the three month periods ended June 30, 2004 and 2003, excluded fromthe computation of diluted earnings per share were stock options to purchase6.5 million and 5.7 million common shares, respectively.  For the six month periods ended June 30, 2004and 2003, excluded from the computation of diluted earnings per share werestock options to purchase 6.1 million and 7.6 million common shares,respectively.

 

The effect ofapproximately 14.4 million shares which would have been issuable uponconversion of the $575 million convertible contingent debentures (as describedin Note F) has been excluded from the computation of diluted earnings per sharefor the three and six month periods ended June 30, 2004 and 2003, because theconditions that would permit conversion were not satisfied.  However, the Company expects the accountingrules to change with respect to this convertible debt.  The impact of this proposed accounting changewould require the Company’s diluted earnings per share to be computed takinginto account the shares underlying this convertible debt.

 

*Stock-basedcompensation*

 

The Companyaccounts for its stock-based employee compensation plans using the recognitionand measurement principles of Accounting Principles Board (APB) Opinion No. 25,“Accounting for Stock Issued to Employees” and related interpretations.  No stock-based employee compensation expensehas been recognized

 

6

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for the options in theaccompanying condensed consolidated statements of income, as all optionsgranted under the plans had an exercise price equal to the market value of theunderlying common stock on the date of grant.

 

The Companyhas elected to use the intrinsic value method under APB Opinion No. 25 aspermitted by Statement of Financial Accounting Standards (SFAS) No. 123, “Accountingfor Stock-Based Compensation,” subsequently amended by SFAS 148, “Accountingfor Stock-Based Compensation-Transition and Disclosure” to account for stockoptions issued to its employees.  TheCompany makes pro forma fair value disclosures required by SFAS 123 whichreflect the impact of net income and earnings per share had the Company appliedthe fair value method of accounting for its stock-based awards toemployees.  The Company estimates thefair value of its stock-based awards to employees using a Black-Scholes optionpricing model.  The pro forma effects onnet income and earnings per share are as follows (in thousands, except pershare amounts):

 

 
| ** **                                                                                                                                          | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                                          | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                                                                |       |                             |       |                           |       |   |   |   |   |
| Net income                                                                                                                                          |       | $                                | 34,927     |                           | $          | 50,715 |   | $ | 81,586 |   | $ | 98,544 |   |
| Deduct:   Total stock-based employee compensation expense determined under fair  value based method for all awards, net of related tax effects |       | 4,103                            |       | 4,397                          |       | 8,592 |   | 9,595 |   |
| Pro forma net income                                                                                                                                |       | $                                | 30,824     |                           | $          | 46,318 |   | $ | 72,994 |   | $ | 88,949 |   |
|                                                                                                                                                |       |                             |       |                           |       |   |   |   |   |
| Earnings per share:                                                                                                                                 |       |                             |       |                           |       |   |   |   |   |
| Basic - as reported                                                                                                                                 |       | $                                | 0.32       |                           | $          | 0.47 |   | $ | 0.75 |   | $ | 0.92 |   |
| Basic - pro forma                                                                                                                                   |       | $                                | 0.28       |                           | $          | 0.43 |   | $ | 0.67 |   | $ | 0.83 |   |
|                                                                                                                                                |       |                             |       |                           |       |   |   |   |   |
| Diluted - as reported                                                                                                                               |       | $                                | 0.32       |                           | $          | 0.47 |   | $ | 0.74 |   | $ | 0.91 |   |
| Diluted - pro forma                                                                                                                                 |       | $                                | 0.28       |                           | $          | 0.43 |   | $ | 0.66 |   | $ | 0.82 |   |
|                                                                                                                                                |       |                             |       |                           |       |   |   |   |   |
| Weighted average shares outstanding:                                                                                                                |       |                             |       |                           |       |   |   |   |   |
| Basic                                                                                                                                               |       | 109,049                          |       | 107,134                        |       | 108,839 |   | 107,038 |   |
| Diluted                                                                                                                                             |       | 110,325                          |       | 108,334                        |       | 110,616 |   | 107,847 |   |

 

The weightedaverage fair value of the stock options and Employee Stock Purchase Plan(“ESPP”) has been estimated on the date of grant using the Black-Scholes optionpricing model. Weighted averages are used because of varying assumed exercisedates.  The weighted average fair valueof stock options granted for the six months ended June 30, 2004 and 2003 was$13.65 per share and $13.17 per share, respectively.  The weighted average fair value of ESPPgranted for the six months ended June 30, 2004 and 2003 was $11.83 per shareand $7.63 per share, respectively.  Thefollowing weighted average assumptions were used for stock options grantedduring the three and six months ended June 30, 2004 and 2003:

 

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| ** **              | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** |
|-------------------------|------------|----------------------------------|------------|--------------------------------|
| ** **              | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** |
| Dividend yield          |       | None                             |       | None                           |   | None |   | None |
| Expected volatility     |       | 49%                              |       | 35%                            |   | 38% |   | 40% |
| Risk-free interest rate |       | 3.78%                            |       | 3.26%                          |   | 3.78% |   | 3.26% |
| Expected term           |       | 5.1 years                        |       | 5.1 years                      |   | 5.2 years |   | 5.2 years |

 

The following weighted averageassumptions were used for ESPP during the three and six months ended June 30,2004 and 2003:

 

| ** **              | ** ** | **Three and Six Months Ended  June 30,** |
|-------------------------|------------|------------------------------------------|
| ** **              | ** ** | **2004**                                 | ** ** | **2003** |
| Dividend yield          |       | None                                     |   | None |
| Expected volatility     |       | 38%                                      |   | 40% |
| Risk-free interest rate |       | 3.78%                                    |   | 3.26% |
| Expected term           |       | 6 months                                 |   | 6 months |

 

*Recentaccounting pronouncements*

 

In January2003, the FASB issued Interpretation No. (FIN) 46, “Consolidation of VariableInterest Entities” an interpretation of Accounting Research Bulletin No. 51,“Consolidated Financial Statements.”  Theprimary objectives of FIN 46 are to provide guidance on the identification ofentities which the Company may control through means other than through votingrights (“variable interest entities”) and to determine when and which businessenterprise (“primary beneficiary”) should consolidate the variable interestentity.  FIN 46 requires existingunconsolidated variable interest entities to be consolidated by their primarybeneficiaries if the entities do not effectively disperse risks among theparties involved.  Variable interestentities that effectively disperse risks will not be consolidated unless asingle party holds an interest or combination of interests that effectivelyrecombines risks that were previously dispersed.  In addition, FIN 46 requires that the primarybeneficiary, as well as all other enterprises with a significant variableinterest in a variable interest entity, make additional disclosures.  Certain disclosure requirements of FIN 46 wereeffective for financial statements issued after January 31, 2003.  In December 2003, the FASB revised FIN 46(FIN 46R) to address certain FIN 46 implementation issues.  The revised provisions are applicable nolater than the first reporting period ending after March 15, 2004.  The Company adopted FIN 46 and FIN 46R and,based upon the evaluation performed of all interests, have determined theCompany does not have any variable interest entities that require consolidation.

 

In April 2004,the FASB issued FASB Staff Position No. 129-1 (FSP 129-1), “DisclosureRequirements under FASB Statement No. 129, Disclosure of Information aboutCapital Structure, Relating to Contingently Convertible Securities.”  This FSP requires the disclosure provisionsof Statement 129 to apply to all existing and newly created contingentlyconvertible securities and to their potentially dilutive effects on earningsper share.  The Company has adopted thedisclosure requirements of FSP 129-1 in its Condensed Consolidated Financial Statements.

 

**NOTE B –EQUITY INVESTMENTS**

 

Watson’sequity investments in publicly traded companies are classified asavailable-for-sale and are recorded at fair value based on quoted market pricesusing the specific identification method. These investments are classified as either current or non-current, asappropriate, on the Company’s Condensed Consolidated Balance Sheets.

 

8

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*Currentinvestments*

 

The Company’sinvestment in the common stock of Andrx Corporation – Andrx Group (Andrx),publicly traded on the Nasdaq Stock Market under the symbol ADRX, is classifiedas a current investment and is included in “Marketable securities” on theCompany’s Condensed Consolidated Balance Sheets at June 30, 2004 and December31, 2003.

 

During the sixmonth period ended June 30, 2004, Watson sold 150,000 shares of its investmentin the common stock of Andrx for proceeds of $4.3 million and recorded apre-tax gain of $3.9 million.  Realizedgains are computed using the specific identification method to determine thecost basis for each investment.  Duringthe three month and six month periods ended June 30, 2003, Watson sold 70,000shares of its investment in the common stock of Andrx for proceeds of $1.4million and recorded a pre-tax gain of $1.2 million.

 

During thethree month period ended June 30, 2003, Watson sold 100,000 shares of itsinvestment in the common stock of Dr. Reddy’s Laboratories, Limited (Dr. Reddy)for proceeds of $2.2 million and recorded a pre-tax gain of $0.7 million.

 

During the sixmonth period ended June 30, 2003, Watson sold 290,000 shares of its investmentin the common stock of Dr. Reddy’s Laboratories, Limited (Dr. Reddy) forproceeds of $6.0 million and recorded a pre-tax gain of $1.8 million.  At December 31, 2003 and June 30, 2004, theCompany held no shares of Dr. Reddy common stock.

 

*Non-currentinvestments*

 

The Company’s investmentsin the common stock of Genelabs Technologies, Inc. (Genelabs), NovaDel PharmaInc., Amarin Corporation plc (Amarin), and warrants to purchase shares ofcommon stock of Halsey Drug Co., Inc. (Halsey) are classified as non-currentinvestments and are included in “Investments and other assets” on the Company’sCondensed Consolidated Balance Sheets at June 30, 2004 and December 31,2003.  During the six month period endedJune 30, 2004, the Company wrote off its remaining investment in the Halseywarrants, net of proceeds from the sale of its note receivable.

 

The followingtable provides a summary of the fair value and unrealized holding gain (loss)related to Watson’s available-for-sale securities (in thousands):

 

| ** **                    | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------------------|------------|--------------------|------------|------------------------|------------|
|                          |       |               |       |                   |       |
| Equity securities:            |       |               |       |                   |       |
| Cost basis                    |       | $                  | 7,297      |                   | $          | 10,556 |   |
| Gross unrealized holding gain |       | 21,474             |       | 23,336                 |       |
| Gross unrealized holding loss |       | (1,139             | )          | (716                   | )          |
| Fair value of securities      |       | $                  | 27,632     |                   | $          | 33,176 |   |

 

Grossunrealized gains primarily relate to our holdings in shares of Andrx commonstock.  The gross unrealized holding lossat June 30, 2004 and December 31, 2003 is attributable to adjustments, includedin other comprehensive income, for the decline in fair value in the Company’sinvestment in Amarin.

 

The Company’snet unrealized holding gain related to its available-for-sale securitiesdecreased $439,000 and $1.2 million for the three and six month periods endedJune 30, 2004, respectively.  During thethree and six month periods ended June 30, 2003, the Company’s net unrealizedholding gain increased $10.2 million and

 

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$16.2 million,respectively. These changes in the Company’s net unrealized holding gain are includedin other comprehensive income.

 

 **NOTE C – OPERATINGSEGMENTS**

 

Watson has tworeportable operating segments: branded and generic pharmaceuticalproducts.  The branded products segmentincludes the Company’s lines of Women’s Health, Urology/General Products andNephrology products. Watson has aggregated its branded product lines in asingle segment because of similarities in regulatory environment, manufacturingprocesses, methods of distribution and types of customer.  This segment includes patent-protectedproducts and trademarked generic products that Watson sells and promotesdirectly to healthcare professionals as branded pharmaceutical products.  The generic products segment includesoff-patent pharmaceutical products that are therapeutically equivalent toproprietary products.  The Company sellsits branded and generic products primarily to pharmaceutical wholesalers, drugdistributors and chain drug stores.

 

Thesignificant accounting policies of the segments are described in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2003.  Watson primarily evaluates the performance ofits segments based on net revenues and gross profit.  The “other” classification for the three andsix month periods ended June 30, 2004 consisted primarily of royalties andrevenues from research, development and licensing fees.  The “other” classification for the three andsix month periods ended June 30, 2003 consisted primarily of contingentpayments received from the settlement of a legal dispute and revenues fromresearch, development and licensing fees. The Company does not report depreciation expense, total assets, andcapital expenditures by segment as such information is not used by management,or accounted for at the segment level. Net revenues and gross profit information for the Company’s segmentsconsisted of the following (in thousands):

 

| ** **                      | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                      | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                            |       |                             |       |                           |       |   |   |   |   |
| **Net revenues:**               |       |                             |       |                           |       |   |   |   |   |
| Branded pharmaceutical products |       | $                                | 165,763    |                           | $          | 185,901 |   | $ | 335,144 |   | $ | 369,662 |   |
| Generic pharmaceutical products |       | 224,313                          |       | 161,267                        |       | 449,330 |   | 304,466 |   |
| Other                           |       | 9,292                            |       | 8,712                          |       | 24,552 |   | 18,674 |   |
| Total net revenues              |       | $                                | 399,368    |                           | $          | 355,880 |   | $ | 809,026 |   | $ | 692,802 |   |
| **Gross profit:**               |       |                             |       |                           |       |   |   |   |   |
| Branded pharmaceutical products |       | $                                | 118,093    |                           | $          | 144,040 |   | $ | 241,827 |   | $ | 284,737 |   |
| Generic pharmaceutical products |       | 73,129                           |       | 48,752                         |       | 147,312 |   | 85,414 |   |
| Other                           |       | 9,292                            |       | 8,712                          |       | 24,552 |   | 18,674 |   |
| Total gross profit              |       | $                                | 200,514    |                           | $          | 201,504 |   | $ | 413,691 |   | $ | 388,825 |   |

 

As a result ofa recent change in the way we manage certain products and product lines, we arein the process of changing how we report the results of our businesssegments.  This change will result in asignificant shift of product revenues from our branded segment to our genericsegment.  In future periods, we expect toclassify the bulk of our oral contraceptive products, and certain otherproducts, within our generic segment.  Weexpect to finalize this change in the third quarter of 2004 and provide priorperiods’ segment information based on our new segment reporting structure forcomparative purposes.  Management believesthis change will better reflect the performance of each segment and helpmanagement make more informed decisions about the Company as a whole.

 

**NOTE D –INVENTORIES**

 

Inventoriesconsist of finished goods held for distribution, raw materials and work-in-process.Included in inventory at June 30, 2004 is approximately $12.3 million ofinventory that is pending approval by the Food and

 

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Drug Administration (FDA) orhas 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 awaitinga contractual triggering event to enter the marketplace.

 

Inventoriesare stated at the lower of cost (first-in, first-out method) or market (netrealizable value) and consisted of the following (in thousands):

 

| ** **        | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------|------------|--------------------|------------|------------------------|------------|
|              |       |               |       |                   |       |
| Raw materials     |       | $                  | 114,130    |                   | $          | 123,239 |   |
| Work-in-process   |       | 73,573             |       | 70,436                 |       |
| Finished goods    |       | 197,416            |       | 199,718                |       |
| Total inventories |       | $                  | 385,119    |                   | $          | 393,393 |   |

 

**NOTE E –GOODWILL AND OTHER INTANGIBLE ASSETS**

 

The Company 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 brandedand 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.

 

During the second quarterof 2004, the Company performed its annual test for the impairment of goodwilland determined there was no indication of impairment.  There were no additions to goodwill recordedduring the six months ended June 30, 2004. At June 30, 2004, and December 31, 2003, goodwill for the Company’sreporting units consisted of the following (in thousands):

 

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

 

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

 

| ** **                                         | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------|------------|--------------------|------------|------------------------|------------|
|                                               |       |               |       |                   |       |
| Product rights and related intangibles             |       | $                  | 1,288,374  |                   | $          | 1,291,311 |   |
| Less accumulated amortization                      |       | (317,367           | )          | (290,016               | )          |
| Total product rights and related  intangibles, net |       | $                  | 971,007    |                   | $          | 1,001,295 |   |

 

Assuming no additions, disposals or adjustments are made to thecarrying values and/or useful lives of the assets, annual amortization expenseon product rights and related intangibles is estimated to be approximately $72million in each of the next five years. The Company’s current product rights and related intangibles have aweighted average useful life of approximately nineteen years.

 

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**NOTE F – LONG-TERM DEBT**

 

Long-term debtconsisted of the following (in thousands):

 
| ** **                                                                                                   | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
|                                                                                                         |       |               |       |                   |       |
| Senior unsecured notes, 7.125%, face amount  of $150 million, due 2008, net of $66 unamortized discount      |       | $                  | 14,029     |                   | $          | 149,183 |   |
| Convertible contingent debentures, face  amount of $575 million due 2023, net of $1,565 unamortized discount |       | 573,435            |       | 573,297                |       |
| Other notes payable                                                                                          |       | 47                 |       | 55                     |       |
| Total debt                                                                                                   |       | $                  | 587,511    |                   | $          | 722,535 |   |
| Less current portion                                                                                         |       | —             |       | —                 |       |
| Total long-term debt                                                                                         |       | $                  | 587,511    |                   | $          | 722,535 |   |

 

*1998 SeniorNotes*

 

In May 1998,Watson issued $150 million of its senior unsecured notes (1998 SeniorNotes).  These notes are due inMay 2008 but may be redeemed earlier under certain circumstances.  The Company is required to make interest onlypayments due semi-annually in May and November at an effective annual rate of7.3%.

 

In February2004, the Company initiated a tender offer to purchase all of its outstanding1998 Senior Notes and a related consent solicitation.  The Company received tenders of its 1998Senior Notes and deliveries of related consents from holders of approximately$101.6 million of the $150 million aggregate principal amount of 1998 SeniorNotes outstanding.  As a result, theCompany received 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.

 

In May 2004,the Company acquired an additional $34.3 million of its outstanding 1998 SeniorNotes in an open market transaction.  Werecorded charges of $14.0 million and $3.7 million in the first and secondquarters of 2004, respectively, related to fees, expenses, unamortizeddiscount, and premiums paid for the bond repurchases.

 

*ConvertibleContingent Senior Debentures*

 

In March 2003,the Company issued $575 million of convertible contingent senior debentures(CODES).  The CODES, which areconvertible into shares of Watson’s common stock upon the occurrence of certainevents, are due in March 2023, with interest payments due semi-annually inMarch and September at an effective annual interest rate of 2.2%, excludingchanges in fair value of the contingent interest derivative.

 

The CODES areconvertible into Watson’s common stock at a conversion price of approximately$40.05 per share (subject to certain adjustments).  The CODES may be converted, at the option ofthe holders, prior to maturity 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;

 

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•                  on or beforeMarch 15, 2018, during the five business-day period following any 10consecutive trading-day period in which the daily average trading price for theCODES for such ten-day period was less than 105% of the average conversionvalue for the debentures during that period. This conversion feature represents an embedded derivative.  However, based on the de minimis value associatedwith this feature, no value has been assigned at issuance and at June 30, 2004;

 

•                  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 to the CODES byeither Standard & Poor’s or Moody’s (or any successors to these entities)is lower than “BB” or “Ba3”, respectively, or when either of these ratingagencies does not have a rating then assigned to the CODES for any reason,including any withdrawal or suspension of a rating assigned to the CODES.  This conversion feature represents anembedded derivative.  However, based onthe de minimis value associated with this feature, no value has been assignedat issuance and at June 30, 2004;

 

•                  if the CODES have been called for redemption; or

 

•                  upon the occurrence of specified corporate transactions.

 

The Companymay redeem some or all of the CODES for cash, on or after March 20, 2008, for aprice equal to 100% of the principal amount of the CODES plus accrued andunpaid interest (including contingent interest) to, but excluding, theredemption date.

 

The CODEScontain put options which may require the Company to repurchase for cash all ora portion of 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 holders of the CODES have the right to receive contingent interest paymentsduring any six-month period from March 15 to September 14 and from September 15to March 14, commencing on September 15, 2003, if the average trading price ofthe 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% of the Company’s then-current estimated perannum borrowing rate for senior non-convertible fixed-rate debt with a maturitydate and other terms comparable to that of the CODES or 0.33% per annum.  This contingent interest payment feature isan embedded derivative and has been bifurcated and recorded separately in theCondensed Consolidated Balance Sheets in other long-term liabilities.  The initial fair value assigned to theembedded derivative was $1.9 million, which is recorded as a discount to theCODES.  Changes to the fair value of thisembedded derivative are reflected as an adjustment to interest expense.  The current value of this embedded derivativeis $2.0 million.

 

*CreditFacility*

 

In May 2003,the Company entered into an agreement****with asyndicate of lenders for a five-year, $300 million senior, unsecured revolvingcredit facility for working capital and other general corporate purposes.Watson’s assets generally are held by, and its operations generally areconducted through, its subsidiaries. Within the meaning of Regulation S-X, Rule 3-10, the Company has noassets or operations independent of its subsidiaries.  The terms of the new credit facility requireeach subsidiary, other than minor subsidiaries, to provide full andunconditional guarantees on a joint and several basis.In order to provide subsidiary guarantees in connection with this creditfacility, the Company was also required, by the terms of the Indenture for the1998 Senior Notes, to grant similar subsidiary guarantees in favor of the 1998Senior Note holders. The subsidiary guarantees related to both the new creditfacility and the 1998 Senior Notes are full and unconditional, on a joint

 

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andseveral basis, and are given by all subsidiaries other than minorsubsidiaries.  Watson is subject tocertain financial and operational covenants, all of which, as of June 30, 2004,the Company was in compliance.  As ofJune 30, 2004, the Company had not drawn any funds from the revolving creditfacility.

 

**NOTE G –FINANCIAL INSTRUMENTS**

 

*Fair valueof financial instruments*

 

The Company’sfinancial instruments consist primarily of cash and cash equivalents,marketable securities, accounts and other receivables, investments, tradeaccounts payable, senior subordinated notes, CODES and embedded derivativesrelated to the issuance of the CODES. The carrying amounts of cash and cash equivalents, marketablesecurities, accounts and other receivables and trade accounts payable arerepresentative of their respective fair values due to their relatively shortmaturities.  The fair values of investmentsin companies that 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.

 

*Derivativefinancial instruments*

 

The Company’sderivative financial instruments consist of embedded derivatives related to itsCODES.  These embedded derivativesinclude certain conversion features and a contingent interest feature.  See Note F for a more detailed description ofthese 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 atJune 30, 2004, 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(the yield 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.

 

At June 30,2004 and 2003, the carrying amount of $2.0 million and $3.9 million,respectively, approximated the estimated fair value of the Company’s derivativefinancial instruments.

 

During thethree and six month periods ended June 30, 2004, the fair value of theCompany’s derivative financial instruments decreased $2.9 million and $3.2million, respectively.  The change infair value was recorded as a reduction of interest expense during therespective periods.

 

**NOTE H –COMMITMENTS AND CONTINGENCIES**

 

*Facility and equipment leases*

 

The Company has entered intooperating 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 three months ended June 30, 2004 and 2003 were $3.4 million and $3.2million, respectively.  Total rentalexpense for operating leases for the six months ended June 30, 2004 and 2003were $6.2 million and $6.2 million, respectively.

 

Future minimum leasepayments under all non-cancelable operating leases consist of approximately$8.6 million in 2004, $6.7 million in 2005, $5.4 million in 2006, $4.8 millionin 2007, and $21.4 million thereafter.

 

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*Employee retirement plans*

 

The Company maintainscertain defined contribution retirement plans covering substantially allemployees.  The Company contributes tothe plans based upon the employee contributions.  From time to time, the Company conductsself-audits of the Employees’ 401(k) Profit Sharing Plan (the Plan) to ensurethe contributions under the Plan are made in accordance with its terms.  In the first half of 2004, the Company contributedan additional $1.1 million for the year ended December 31, 2003 and hasestimated that an additional contribution of $800,000 will be made to fundprior year periods.

 

Watson’s contributions tothese retirement plans for the three and six months ended June 30, 2004 were$2.4 million and $3.8 million, respectively. Watson’s contributions to these retirement plans for the three and sixmonths ended June 30, 2003 were $1.3 million and $2.8 million,respectively.  The Company does notsponsor any defined benefit retirement plans or postretirement benefit plans.

 

*Legal matters*

 

The Company isparty to certain lawsuits and legal proceedings, which are described in “PartI, Item 3. Legal Proceedings,” of our Annual Report on Form 10-K for the yearended December 31, 2003.  The followingis a description of material developments during the period covered by thisQuarterly Report and through the filing of this Quarterly Report, and should beread in conjunction with the Annual Report referenced above.

 

*Phen-fenLitigation.* With respect to the phentermine hydrochloride product liability lawsuitspending against the Company, certain of its subsidiaries, and others,additional actions raising similar issues have been filed, and some actionshave been settled or otherwise dismissed. As of August 1, 2004, approximately 585 actions were pending against theCompany and other Company entities in a number of state and federalcourts.  The Company believes that itwill be fully indemnified by The Rugby Group’s former owner, AventisPharmaceuticals (Aventis, formerly known as Hoechst Marion Roussel, Inc.) forthe defense of all such cases and for any liability that may arise out of thesecases.  Aventis is currently controllingthe defense of all these cases as the indemnifying party under its agreementswith the Company.

 

*Cipro®Litigation.* On May 28, 2004, the defendants, including the Company and certain ofits affiliates, filed motions for summary judgment in the consolidated actionpending in the U.S. District Court for the Eastern District of New York *(In re: Ciprofloxacin Hydrochloride Litigation, MDL Docket No. 001383)*,seeking dismissal of several of the claims asserted by the plaintiffs,including claims alleging violation of the antitrust laws.  On July 9, 2004, the plaintiffs filedoppositions to the defendants’ summary judgment motions, and the directpurchasers filed a cross-motion for partial summary judgment on theirclaims.  The court has not yet set ahearing date to consider these motions and cross-motion.  On July 21, 2004, the California Court ofAppeal granted in part and denied in part the defendants’ petition for a writof mandate seeking to reverse the trial court’s order granting the plaintiffs’motion for class certification.  Pursuantto the ruling, the majority of the plaintiffs will be permitted to pursue theirclaims as a class.  The trial court inthe case pending in the California Superior Court has continued the trial dateuntil January 24, 2005.  Aventis iscontinuing to defend and indemnify the Company and its affiliates in connectionwith these claims.

 

*GovernmentalReimbursement Investigations and Proceedings.*  OnJune 10, 2004, the court in the consolidated action pending in the UnitedStates District Court for the District of Massachusetts (*In re:Pharmaceutical Industry Average Wholesale Price Litigation, MDL Docket No.1456)* dismissed the State of Nevada’s state RICO claim, the State ofMontana’s False Claims Act “Best Price” claims, Montana’s Medicaid Fraud Act“Best Price” claims, and Nevada’s “Best Price” Medicaid claims.  On June 3, 2004, the Attorney Generalof the State of Wisconsin filed an action in the Wisconsin Superior Courtagainst the Company and numerous other pharmaceutical defendants.  On August 4, 2004, the City of New York filedan action in the United States District Court for the Southern District of NewYork against the Company and numerous other pharmaceutical defendants.  The Wisconsin and City of New York complaintsgenerally allege claims similar to the other actions pending against thedefendants, alleging improper or fraudulent reporting practices related to thereporting of average wholesale

 

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prices of certainproducts, and that defendants committed other improper acts in order toincrease prices and market shares.  OnJuly 14, 2004, the defendants filed a notice of removal of the Wisconsin actionto the United States District Court for the District of Wisconsin, and a noticeseeking to have the Wisconsin case transferred to the consolidated actionpending in the United States District Court for the District ofMassachusetts.  The defendants arerequired to respond to the Wisconsin complaint by September 15, 2004.

 

On July 19, 2004, the Company received a civil investigative subpoenafrom the State of Florida’s Office of the Attorney General, seeking theproduction of documents regarding the pricing, distribution, marketing andsales of four drugs.  The subpoena seeksproduction by August 16, 2004.

 

*FDA Matters.*  On April 8,2004, the United States District Court for the District of Arizona entered anorder vacating the Consent Decree of Condemnation and Permanent Injunctionpreviously entered against Steris Laboratories, Inc. (Steris) and otherdefendants on October 21, 1998.  Thecourt entered the order upon Steris’ request, which the FDA agreed not tooppose.  On June 28, 2004, the Companyannounced that it has elected to retain the Steris facility as part of itscontinuing operations.

 

With respect to the May 2002 consent decree enteredagainst Watson Laboratories, Inc. in connection with the Company’s Corona,California facility, in June 2004 the Company submitted its response to theFDA’s inspectional observations, and met with FDA Officials on June 30, 2004 todiscuss the Company’s response to the FDA’s inspectional observations made inconnection with the inspection conducted by FDA from March 31, 2004 until May6, 2004.  During the meeting, the Companyand FDA discussed the corrective actions the Company has taken, and intends totake, to address the inspectional observations. The Company believes that its responses, and the commitments made duringthe June 30, 2004, meeting, address the FDA’s observations.  However, theFDA is not required to accept or agree with the Company’s responses and,or commitments.  If,in the future, the FDA determines that, with respect to its Corona facility,Watson has failed to comply with the consent decree or FDA regulations,including cGMPs, or has failed to adequately address the observations in theForm 483, the consent decree allows the FDA to order Watson to take a varietyof actions to remedy the deficiencies. These actions could include ceasingmanufacturing and related operations at the Corona facility, and recallingaffected products.  Such actions, iftaken by the FDA, could adversely affect the Company, its results ofoperations, financial position and/or cash flows.

 

*Securities Litigation**.** *On May 24, 2004, thedefendants in the shareholders derivative action pending in the CaliforniaSuperior Court for the County of Riverside *(Charles Zimmerman v.Allen Chao, etal., Lead Case No. 403715)*, filed a demurrer to theconsolidated complaint, seeking to have the case dismissed.  On July 7, 2004, the Superior Court entered astay of all proceedings until January 5, 2005, at which time the court willconsider whether to lift the stay of proceedings.  The court deferred ruling on the defendants’demurrer to the consolidated complaint until after the stay is lifted.  In the action pending in the United States DistrictCourt for the Central District of California *(In re:  Watson Pharmaceuticals, Inc. SecuritiesLitigation, Case No. CV-03-8236 AHM)*, on May 24, 2004, thedefendants moved to dismiss the amended complaint.  On August 2, 2004, the court granted the defendants’motion to dismiss, and allowed plaintiffs until August 30, 2004 to file anamended complaint.

 

*HormoneReplacement Therapy Litigation.*  Beginning in early 2004, a number of productliability suits were filed against the Company and certain Company affiliates,for personal injuries allegedly arising out of the use of hormone replacementtherapy products, including but not limited to estropipate and estradiol.  These complaints also name numerous otherpharmaceutical companies as defendants, and allege various injuries, includingovarian cancer, breast cancer and blood clots. As of August 1, 2004, approximately twenty-one cases were pendingagainst Watson and/or its affiliates in state and federal courts.  Many of the cases involve multiple plaintiffs.  Several of the cases have been transferred toand consolidated in the United States District Court for the Eastern Districtof Arkansas (*In re: Prempro Products Liability Litigation, MDL Docket No. 1507*).  The Company maintains products liability insuranceagainst such claims.  However, theseactions, if successful, or if insurance does not provide sufficient coverageagainst the claims, could adversely affect the Company and

 

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may have amaterial adverse effect on the Company’s business, results of operations,financial condition and cash flows.

 

The Company and its affiliates are involvedin various other disputes, governmental and/or regulatory inspections,investigations and proceedings, and litigation matters that arise from time totime in the ordinary course of business, including, but not limited to, productliability lawsuits.  The process ofresolving matters through litigation or other means is inherently uncertain andit is possible that the resolution of these matters will adversely affect theCompany, its results of operations, financial position and/or cash flows.

 

17

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**ITEM 2.****  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

The followingdiscussion of our financial condition and the results of our operations shouldbe read in conjunction with the condensed consolidated financial statements andnotes thereto 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“Risk Factors” in our Annual Report on Form 10-K for the year ended December31, 2003.

 

**Results ofOperations**

 

During the second quarter of 2004, we experiencedstrong growth in our generic pharmaceutical products segment due to sales ofproducts launched in the fourth quarter of 2003 and in the first quarter of2004.  These generic product sale gainswere offset in part by lower branded segment sales due to lower wholesalerpurchases and the impact of customer mix on pricing for certain oralcontraceptive products.  Also, weexperienced declining sales in our mature pain products within our GeneralProducts group.  During the quarter, ourinvestment in research and development increased significantly from prior yearlevels due to a $10 million milestone payment related to a transaction withKissei Pharmaceuticals Co., Ltd. to acquire certain rights to a productcurrently under development to treat benign prostatic hyperplasia, andcontinuing investment in our product pipeline focusing heavily on our genericsegment.

 

***Net Revenues***

 
| ** **                        | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                        | ** ** | ** **                       | ** ** | ** **                     | ** ** | **%** | ** ** | ** ** | ** ** | ** ** | ** ** | **%** | ** ** |
| **($ in thousands):**        | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
|                              |       |                             |       |                           |       |   |   |   |   |   |   |   |   |
| Net Revenues by Segment:          |       |                             |       |                           |       |   |   |   |   |   |   |   |   |
| Branded pharmaceutical products   |       | $                                | 165,763    |                           | $          | 185,901 |   | (10.8 | )% | $ | 335,144 |   | $ | 369,662 |   | (9.3 | )% |
| *% of total product net revenues* | * *   | *42.5*                           | *%*        | *53.5*                         | *%*        | * * | * * | *42.7* | *%* | *54.8* | % |   |   |
| Generic pharmaceutical products   |       | 224,313                          |       | 161,267                        |       | 39.1 | % | 449,330 |   | 304,466 |   | 47.6 | % |
| *% of total product net revenues* | * *   | *57.5*                           | *%*        | *46.5*                         | *%*        | * * | * * | *57.3* | *%* | *45.2* | % |   |   |
| Other                             |       | 9,292                            |       | 8,712                          |       | 6.7 | % | 24,552 |   | 18,674 |   | 31.5 | % |
| Total net revenues                |       | $                                | 399,368    |                           | $          | 355,880 |   | 12.2 | % | $ | 809,026 |   | $ | 692,802 |   | 16.8 | % |

 

*BrandedPharmaceutical Products*

 

The decreasein net revenues from our branded pharmaceutical products segment for the threeand six months period was primarily attributable to lower oral contraceptivesales within our Women’s Health group as well as lower sales of certain painproducts within our General Products group. We expect sales within our branded segment to increase slightly duringthe second half of 2004 due to higher projected sales of our Oxytrol® productbased upon expected script trends and the launch of a new branded oralcontraceptive product.

 

*GenericPharmaceutical Products*

 

The increasein net revenues from our generic segment was the result of new product launchessubsequent to second quarter 2003, including bupropion hydrochloridesustained-release tablets during the first and second quarters of 2004 andglipizide extended-release tablets and oxycodone with acetaminophen tablets duringthe fourth quarter of 2003.

 

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We expect ourrecent product launches and future product launches to continue to contributeto improvements year over year in net revenues from our generic segment.  However, we expect our generic segmentrevenues in the second half of 2004 to have a modest decline from first halfsales levels due to competitive pricing pressures on certain products.

 

*Otherrevenues*

 

Other revenues inthe second quarter of 2004 remained relatively the same year over year.  Other revenues for the six month periodincreased primarily due to timing of revenue recognition from research anddevelopment agreements.  Revenuesrecognized from research, development and licensing agreements (includingmilestone payments) are deferred and recognized over the entire contractperformance period, starting with the contract’s commencement, but not prior tothe removal of any contingencies for each individual milestone.  We recognize this revenue based upon thepattern in which the revenue is earned or the obligation is fulfilled.

 

During the firsthalf of 2004, we received revenue from Aventis Pharmaceuticals (Aventis) inconnection with Barr Laboratories, Inc.’s sales of ciprofloxacin tablets.  We expect our revenues associated with thesale of ciprofloxacin to decline significantly by the fourth quarter of thisyear as several additional companies launch competitive products into theciprofloxacin market.  During the firstquarter of 2003, other net revenues included contingent payments received from Aventisrelating to a litigation settlement.  Thefinal payment relating to this settlement was received from Aventis in thethird quarter of 2003.

 

*Net Revenue Mix*

 

Net revenue mix is an importantconsideration in evaluating the profitability of our business.  Our branded products generally realize highergross profit margins than our generic products. Any significant change in our net revenue mix could substantially impactour gross profit, gross margin and the overall profitability of our business.

 

For the three month period endedJune 30, 2004, our net revenue mix was 42% brand and 58% generic, compared to54% brand and 46% generic for the same period ended June 30, 2003.  For the six month period ended June 30, 2004,our net revenue mix was 43% brand and 57% generic, compared to 55% brand and45% generic for the same period ended June 30, 2003.  Our decline in brand revenues as a percentageof total revenues contributed to the overall decline in gross margin, as notedbelow.  We expect our revenue mix duringthe second half of 2004 to be approximately even with the revenue mix duringthe first half, disregarding for this comparison any change in how we reportthe results of our business segments.  Infuture periods, we expect to classify the bulk of our oral contraceptiveproducts, and certain other products, within our generic segment.  Upon implementing this change, we expect ournet revenue mix during second half of 2004 to be weighted more heavily towardthe generic division.

 

***Gross Profit Margin on Product Net Revenues (Gross Margin)***

 
| ** **                            | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                            | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
|                                  |       |                             |       |                           |       |   |   |   |   |   |   |   |   |
| Gross Margin by  Segment:             |       |                             |       |                           |       |   |   |   |   |   |   |   |   |
| Branded  pharmaceutical products      |       | 71.2                             | %          | 77.5                           | %          | -6.3 | % | 72.2 | % | 77.0 | % | (4.8 | )% |
| Generic pharmaceutical  products      |       | 32.6                             | %          | 30.2                           | %          | 2.4 | % | 32.8 | % | 28.1 | % | 4.7 | % |
| Gross margin on  product net revenues |       | 49.0                             | %          | 55.5                           | %          | -6.5 | % | 49.6 | % | 54.9 | % | (5.3 | )% |

 

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The decrease ingross margin from our branded segment for the three and six months ended June30, 2004 was primarily due to increases in branded sales from certainin-licensed oral contraceptive products which have lower gross margins thanproducts we own.  Branded margins alsowere impacted by lower sales of certain high margin pain products.

 

The increase inthe gross margin from our generic pharmaceutical products for the three and sixmonths ended June 30, 2004 is due to the launch of higher margin products,including oxycodone acetaminophen and glipizide extended release tablets, aswell as price increases on certain products subsequent to the second quarter of2003.

 

For the secondhalf of 2004, we expect gross margins from product net revenues to improveslightly from first half levels due to increased sales of certain higher marginbrand and generic products.  Margins inthe second half of the year will also improve from first half levels due tolower expected inventory write-offs as compared to the first half of 2004.

 

***Researchand Development (R&D) Expenses***

 
| ** **                 | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **($ in thousands):** | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **%  Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **%  Change** | ** ** |
|                       |       |                             |       |                           |       |   |   |   |   |   |   |   |   |
| R&D expenses           |       | $                                | 42,529     |                           | $          | 25,701 |   | 65.5 | % | $ | 72,210 |   | $ | 48,185 |   | 49.9 | % |
| *as  % of net revenues*    | * *   | *10.6*                           | *%*        | *7.2*                          | *%*        | * * | * * | *8.9* | *%* | *7.0* | *%* | * * | * * |
|                            |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Research anddevelopment expenses increased from the corresponding prior year periods due toexpanded generic development programs and a $10 million milestone payment to KisseiPharmaceutical Co., Ltd.  We have anincreased number of generic products under different stages of development,which account for a significant portion of the increase over the prior yearperiod.

 

The $10 million milestonepayment to Kissei Pharmaceutical Co., Ltd. relates to our acquisition ofcertain rights to its product for the treatment of the signs and symptoms ofbenign prostatic hyperplasia (BPH).

 

We expect researchand development expense to increase approximately 35% for the full year of2004, as compared to the full year of 2003.

 

***Selling,General and Administrative (SG&A) Expenses***

 
| ** **                 | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **($ in thousands):** | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **%  Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **%  Change** | ** ** |
|                       |       |                             |       |                           |       |   |   |   |   |   |   |   |   |
| SG&A  expenses         |       | $                                | 79,169     |                           | $          | 72,214 |   | 9.6 | % | $ | 156,580 |   | $ | 139,873 |   | 11.9 | % |
| *as  % of net revenues*    | * *   | *19.8*                           | *%*        | *20.3*                         | *%*        | * * | * * | *19.4* | *%* | *20.2* | *%* | * * | * * |
|                            |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Selling, generaland administrative expenses increased from the corresponding prior year periodsdue to higher spending associated with the Oxytrol® product launch and marketingexpenses.

 

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During the thirdquarter of 2004, as a result of our decision to focus our brand specialtybusiness on the urology and nephrology therapeutic areas, we terminated ourcontract with Ventiv Health, Inc., the contract sales organization we have usedto promote Oxytrol® inthe primary care area.  As a result ofthe termination of this agreement and other operating expense reductionsconsummated in connection with our decision to focus our brand business on theurology and nephrology therapeutic areas, SG&A spending during the secondhalf of 2004 is expected to be lower than first half spending levels.  In connection with this restructuring, weexpect to incur a charge during the third quarter of approximately $10 millionfor severance and other restructuring related expenses.  Including this restructuring charge, weexpect selling, general and administrative expenses for the full year of 2004to be approximately 19% of revenues.

 

***Equityin Earnings (Losses) of Joint Ventures***

 
| ** **                                     | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **($ in thousands):**                     | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                           |       |                             |       |                           |       |   |   |   |   |
| Equity in  earnings (losses) of joint ventures |       | $                                | (1,700     | )                              | $          | 88 |   | $ | (3,279 | ) | $ | 205 |   |
|                                                |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |

 

The change fromthe prior year earnings is the result of increased losses from our interest inSomerset Pharmaceuticals, Inc. (Somerset), our jointventure with Mylan Laboratories, Inc. Somerset obtained an approvable letter in February 2004 for its NDA forEmSamTM, a selegeline patch for the treatment of depression.  Somerset continues to incur expensesassociated with on-going trials, operational costs and the remaining FDArequirements.

 

***Gainon Sale of Securities***

 
| ** **                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **($ in thousands):**  | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                        |       |                             |       |                           |       |   |   |   |   |
| Gain on sale of  securities |       | $                                | —     |                           | $          | 1,925 |   | $ | 3,938 |   | $ | 3,014 |   |
|                             |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |

 

For the six monthperiod ended June 30, 2004, the gain on sale of securities resulted from thesale of 150,000 shares of Andrx common stock in the first quarter of 2004.  For the three month period ended June 30,2003, the gain resulted from the sale of 100,000 shares of Dr. Reddy commonstock and 70,000 shares of Andrx common stock. For the six month period ended June 30, 2003, the gain resulted from thesale of 290,000 shares of Dr. Reddy common stock and 70,000 shares of Andrxcommon stock.

 

At June 30, 2004,we held approximately 697,000 shares of Andrx common stock at a fair value of$19.5 million with a gross unrealized holding gain of $17.7 million.  We no longer hold shares of common stock ofDr. Reddy. See Note B in the accompanying Notes to Condensed ConsolidatedFinancial Statements in this Quarterly Report.

 

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***Losson Early Extinguishment of Debt***

 
| ** **                            | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **($ in thousands):**            | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                  |       |                             |       |                           |       |   |   |   |   |
| Loss on early  extinguishment of debt |       | $                                | 3,746      |                           | $          | — |   | $ | 17,752 |   | $ | 2,807 |   |
|                                       |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |

 

During the firsthalf of 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.  As a result of the repurchase, weincurred $14.0 million and $3.7 million charges related to fees, expenses,unamortized discount, and the premiums paid in the first and second quarters of2004, respectively (as described in Note F).

 

During the firstquarter of 2003, as a result of the retirement of our previous credit facility,we incurred a $2.8 million charge for the unamortized bank fees associated withthe credit facility.

 

***InterestExpense***

 
| ** **                 | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **($ in thousands):** | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **%  Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **%  Change** | ** ** |
|                       |       |                             |       |                           |       |   |   |   |   |   |   |   |   |
| Interest expense           |       | $                                | 1,647      |                           | $          | 7,580 |   | -78.3 | % | $ | 5,390 |   | $ | 12,921 |   | -58.3 | % |
|                            |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Interest expensedecreased for the three and six month periods ended June 30, 2004 as a resultof the repurchase of a portion of our 1998 Senior Notes in February and May2004, a decrease in the fair value of the derivative, and increased capitalizedinterest related to higher balances of capital projects in process.

 

**Liquidityand Capital Resources**

 

We assess liquidity by our ability togenerate cash to fund our operations. Significant factors that affect the management of our liquidity include:current balances of cash, cash equivalents and value of marketable securities;expected cash flows provided by operations; current levels of our accountsreceivable, inventory and accounts payable balances; our expected investment incapital; access to financing sources, including credit and equity arrangements;and the financial flexibility to attract long-term capital on satisfactoryterms.

 

We generated cash inexcess of our working capital requirements for the six months ended June 30,2004.  Our cash flows provided byoperations were $97.6 million.  Cash flowfrom operations was positively impacted primarily by net income.  Cash flow from operations was negativelyimpacted primarily by the change in balances from December 31, 2003 of incometax payable due to a tax payment of $80 million made in the first quarter of2004.

 

Other significant uses ofcash for the six months ended June 30, 2004, included the additions to propertyand equipment ($43.1 million) and the repurchase of $135.9 million of our 1998Senior Notes (as discussed above and in Note F).  We currently expect to spend between $110million to $120 million for property and equipment additions for the fullyear of 2004, of which we expect approximately $21 million to be related to theinstallation and implementation of our new Enterprise Resource Planning system,approximately $20 million to be related to the construction of a newdistribution facility, and the remaining expenditures to be related to plantimprovements and expansion.

 

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In March 2003, we issued$575 million of convertible contingent senior debentures (CODES) due in2023.  As of June 30, 2004, the entireamount of the CODES remained outstanding at an effective annual interest rateof approximately 2.2%.

 

In February and May 2004, we repurchased $135.9 million ofour 1998 Senior Notes for total consideration of $152.5 million, or a 12%premium over each note’s face value.  We recorded$14.0 million and $3.7 million charges in the first quarter and second quarterof 2004 related to fees, expenses, unamortized discount, and premiumspaid.  Interest expense in 2004 willdecline as a result of the repurchase.

 

In May 2003, we entered into an agreement****witha syndicate of lenders for a five-year, $300 million senior, unsecuredrevolving credit facility for working capital and other general corporatepurposes.  As of June 30, 2004, the total$300 million under the revolving credit facility was available to us. Under theterms of the revolving credit facility, each of our subsidiaries, other thanminor subsidiaries, entered into a full and unconditional guarantee on a jointand several basis. In order to provide subsidiary guarantees in connection with the newcredit facility, we were required to issue similar guarantees to the 1998Senior Note holders.  We are subject to,and, as of June 30, 2004, were in compliance with certain financial and operationcovenants under the terms of the credit facility.

 

Our cash and current marketable securities totaled$492.9 million at June 30, 2004.  Thefair value of our current marketable securities may fluctuate significantly dueto volatility of the stock market and changes in general economic conditions.  See Item 3 in this Quarterly Report on Form10-Q.  We believe that our cash andmarketable securities balance and our expected cash flows from operations willbe sufficient to meet our normal operating requirements during the next twelvemonths.  However, we continue to reviewopportunities to acquire or invest in companies, technologies, product rightsand other investments that are compatible with our existing business.  We could use cash and financing sourcesdiscussed herein, or financing sources that subsequently become available, tofund additional acquisitions or investments. In addition, we may consider issuing additional debt or equitysecurities in the future to fund potential acquisitions or investments, torefinance existing debt, or for general corporate purposes.  If a material acquisition or investment iscompleted, our operating results and financial condition could changematerially in future periods.  However,no assurance can be given that additional funds will be available on satisfactoryterms, or at all, to fund such activities.

 

*Recent accounting pronouncements*

 

In January 2003, the FASBissued Interpretation No. (FIN) 46, “Consolidation of Variable InterestEntities” an interpretation of Accounting Research Bulletin No. 51, “ConsolidatedFinancial Statements.”  The primaryobjectives of FIN 46 are to provide guidance on the identification of entitieswhich the Company may control through means other than through voting rights(“variable interest entities”) and to determine when and which businessenterprise (“primary beneficiary”) should consolidate the variable interestentity.  FIN 46 requires existingunconsolidated variable interest entities to be consolidated by their primarybeneficiaries if the entities do not effectively disperse risks among theparties involved.  Variable interestentities that effectively disperse risks will not be consolidated unless asingle party holds an interest or combination of interests that effectively recombinesrisks that were previously dispersed.  Inaddition, FIN 46 requires that the primary beneficiary, as well as all otherenterprises with a significant variable interest in a variable interest entity,make additional disclosures.  Certaindisclosure requirements of FIN 46 were effective for financial statementsissued after January 31, 2003.  InDecember 2003, the FASB revised FIN 46 (FIN 46R) to address certain FIN 46implementation issues.  The revisedprovisions are applicable no later than the first reporting period ending afterMarch 15, 2004.    The Company adoptedFIN 46 and FIN 46R and, based upon the evaluation performed of all interests,have determined the Company does not have any variable interest entities thatrequire consolidation.

 

In April 2004, the FASBissued FASB Staff Position No. 129-1 (FSP 129-1), “Disclosure Requirementsunder FASB Statement No. 129, Disclosure of Information about CapitalStructure, Relating to Contingently Convertible Securities.”  This FSP requires the disclosure provisionsof Statement 129 to apply to all existing

 

23

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andnewly created contingently convertible securities and to their potentiallydilutive effects on earnings per share. The Company has adopted the disclosure requirements of FSP 129-1 in itsCondensed Consolidated Financial Statements.

 

Under Emerging Issues Task Force (EITF) Issue No.04-8, “The Effect of Contingently Convertible Debt on Diluted Earnings perShare,” the EITF has reached a tentative conclusion that contingently convertibledebt instruments (Co-Cos) should be included in diluted earnings per sharecomputations (if dilutive) regardless of whether the market price trigger (orother contingent feature) has been met. Additionally, prior period earnings per share amounts presented forcomparative purposes should be restated to conform to this consensus, which maybe effective for reporting periods ending after December 15, 2004.  If the tentative conclusion is adopted by theEITF, it will require the addition of approximately 14.4 million sharesassociated with the conversion of our $575 million convertible contingentdebentures to the number of shares outstanding for the calculation of dilutedearnings per share for all reported periods.

 

**CAUTIONARYNOTE REGARDING FORWARD-LOOKING STATEMENTS**

 

Any statementsmade in this 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 management’s beliefs and assumptions based on information available to ourmanagement 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 revenue and expense levels andgrowth rates,

•        prospects related to our strategic initiatives and businessstrategies,

•        express or implied assumptions about government regulatoryaction or inaction,

•        anticipatedproduct approvals and launches,

•        business initiatives and product development activities,

•        assessments related to clinical trial results,

•        product performance and competitive environment, and

•        anticipatedfinancial performance.

 

Without limitingthe generality of the foregoing, words such as *“may,”“will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “would,”“estimate,” “continue,” or “pursue,”* or the negative othervariations thereof or comparable terminology, are intended to identifyforward-looking statements.  Thestatements are not guarantees of future performance and involve certain risks,uncertainties and assumptions that are difficult to predict.

 

**We caution the reader that certain important factors mayaffect our actual operating results and could cause such results to differmaterially from those expressed or implied by forward-looking statements.  We believe the following important risks,uncertainties and other factors, among others, may affect our actual results:**

 

•  the success of ourproduct development activities and uncertainties related to the timing oroutcome of these activities;

 

•  the timing andunpredictability of regulatory authorizations and product launches, which isparticularly sensitive in our generic business;

 

•  the outcome of ourlitigation, and the costs, expenses and possible diversion of management’s timeand attention arising from such litigation;

 

•  our ability to retainkey personnel;

 

•  our ability toadequately protect our technology and enforce our intellectual property rights;

 

•  our ability to obtainand maintain a sufficient supply of products to meet market demand in a timelymanner;

 

• our dependence on sole source suppliers and therisks associated with production interruptions or supply delays at such thirdparty suppliers or at our own manufacturing facilities;

 

•  the scope, outcome andtimeliness of any governmental, court or other regulatory action that mayinvolve us (including, without limitation, the scope, outcome or timeliness ofany inspection or other action of the FDA);

 

•  our success indivesting assets or facilities we intend to dispose of;

 

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•  the increasing costs ofinsurance, and limitations on obtaining insurance coverage;

 

•  the scope, outcome andeffect of investigations, actions or legislation related to our productpricing;

 

•  the availability to us,on commercially reasonable terms, of raw materials and other third partysourced products;

 

•  our exposure to productliability and other lawsuits and contingencies;

 

•  our mix of productsales between branded products, which typically have higher margins, andgeneric products;

 

• our dependence on revenues and gross profit fromsignificant products, in particular, Ferrlecit®, for which 2004 net revenuesare expected to be approximately 9% of our total net revenues, and 16% of ourgross profit.  Our regulatory exclusivityon our Ferrlecit® product will expire in August 2004.  If a generic version of Ferrlecit® isapproved by the FDA, or if our revenues on Ferrlecit® significantly decline forother reasons, it could have a material adverse impact on our results ofoperations, financial conditions and cash flows;

 

•  our dependence onrevenues from significant customers;

 

• the ability of third parties to assert patentsor other intellectual property rights against us which, among other things,could cause a delay or disruption in the manufacture, marketing or sale of ourproducts;

 

•  ourability to license patents or other intellectual property rights from thirdparties on commercially reasonable terms;

 

•  the expiration ofpatent and regulatory exclusivity on certain of our products that will resultin competitive and pricing pressures;

 

•  difficulties and delaysinherent in product development, manufacturing and sale, such as:

 

•  products that mayappear promising in the development stage may fail to reach market for numerousreasons, including efficacy or safety concerns;

 

•  the inability to obtainnecessary regulatory approvals and the difficulty or excessive cost tomanufacture;

 

•  seizure or recall ofproducts;

 

•  the failure to obtain,the imposition of limitations on the use of, or loss of patent and otherintellectual property rights; and

 

•  manufacturing ordistribution problems;

 

•  our successfulcompliance with extensive, costly, complex and evolving governmentalregulations and restrictions;

 

•  market acceptance ofand continued demand for our products and the impact of competitive productsand pricing;

 

•  our ability tosuccessfully compete in both the branded and generic pharmaceutical productsectors;

 

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•  our timely andsuccessful implementation of strategic initiatives, including integrating companiesand products we acquire and new enterprise resource planning systems; and

 

•  other risks anduncertainties detailed herein and from time to time in our Securities andExchange Commission filings.

 

We disclaim anyobligation to publicly update any forward-looking statements, whether as aresult of new information, future events or otherwise.  We also may make additional disclosures inour Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reportson Form 8-K that we may file from time to time with the Securities and ExchangeCommission (SEC).  Please also note thatwe provided a cautionary discussion of risks and uncertainties under thesection entitled “Risk Factors” in our Annual Report on Form 10-K for the yearended December 31, 2003.  The factorsidentified above and those set forth in our SEC filings are the factors that wethink could cause our actual results to differ materially from expectedresults.  Other factors besides thoselisted here could also adversely affect us.  This discussion is provided as permitted bythe Private Securities Litigation Reform Act of 1995.

 

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

 

We are exposed tomarket risk for changes in the market values of our investments (InvestmentRisk) and the 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.

 

**InvestmentRisk**

 

As of June 30,2004, our total holdings in equity securities of other companies, includingequity-method investments and available-for-sale securities, were$52.8 million.  Of this amount, wehad equity-method investments of $4.8 million and publicly traded equitysecurities (available-for-sale securities) at fair value totaling $27.6 million($19.5 million that was included in “Marketable securities” and $8.1 millionthat was 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, 2004, an assumed 25%, 40% and 50% adverse change in the marketprices of these securities would result in a corresponding decline in totalfair value of approximately $6.9 million, $11.1 million and$13.8 million, respectively.

 

At June 30, 2004,our investment in Andrx consisted of approximately 697,000 shares of Andrxcommon stock with a fair market value of $19.5 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. For example, on June 30, 2004, the final trading day of the quarter, theclosing price of Andrx was $27.93.  OnAugust 4, 2004, before the filing of this Form 10-Q, the closing price of Andrxcommon stock was $23.85.

 

The followingtable sets forth the Andrx high and low market price per share information,based on published financial sources, for 2004 and 2003 and further reflectsthe volatility of the stock price:

 

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| ** **            | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------------|------------|----------|------------|---------|------------|
| **2004,  by quarter** |       |     |       |    |       |
| First                 |       | $        | 30.87      |    | $          | 23.55 |   |
| Second                |       | $        | 29.35      |    | $          | 22.24 |   |
|                  |       |     |       |    |       |
| **2003,  by quarter** |       |     |       |    |       |
| First                 |       | $        | 16.83      |    | $          | 7.68 |   |
| Second                |       | $        | 24.20      |    | $          | 11.10 |   |
| Third                 |       | $        | 25.90      |    | $          | 16.32 |   |
| Fourth                |       | $        | 24.05      |    | $          | 17.00 |   |

 

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

 

**Interest Rate Risk**

 

Our exposure to interest rate risk relates primarilyto our non-equity investment portfolio. Our cash is invested in A-rated money market mutual funds and short-termsecurities. Consequently, our interest rate and principal risk are minimal.

 

Based on quotedmarket rates of interest and maturity schedules for similar debt issues, weestimate that the fair values of our CODES and our fixed-rate senior unsecurednotes approximated their carrying values on June 30, 2004.  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, weare not party to any interest rate or derivative hedging contracts and have nomaterial foreign exchange or commodity price risks.

 

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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 theSEC’s rules and forms, and that such information is accumulated andcommunicated to the Company’s management, including its Principal ExecutiveOfficer and Principal Financial Officer, as appropriate, to allow timelydecisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures,management recognized that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving thedesired control objectives, and management necessarily was required to applyits judgment in evaluating the cost-benefit relationship of possible controlsand procedures.  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 Rule13a-15(b), the Company carried out an evaluation, under the supervision andwith the participation of the Company’s management, including the Company’sPrincipal Executive Officer and Principal Financial Officer, of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures as of the end of the quarter covered by this Report. Based onthe foregoing, the Company’s Principal Executive Officer and PrincipalFinancial Officer concluded that the Company’s disclosure controls andprocedures were effective at the reasonable assurance level.

 

There have been nochanges in the Company’s internal control over financial reporting, during thethree months ended June 30, 2004, that have materially affected, or arereasonably 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 to certain lawsuits and legal proceedings, whichare described in “Part I, Item 3. Legal Proceedings,” of our Annual Report onForm 10-K for the year ended December 31, 2003. The following is a description of material developments during theperiod covered by this Quarterly Report and through the filing of thisQuarterly Report and should be read in conjunction with the Annual Reportreferenced above.

 

*Phen-fen Litigation.*  With respect to the phentermine hydrochlorideproduct liability lawsuits pending against the Company, certain of itssubsidiaries, and others, additional actions raising similar issues have beenfiled, and some actions have been settled or otherwise dismissed.  As of August 1, 2004, approximately 585actions were pending against the Company and other Company entities in a numberof state and federal courts.  The Companybelieves that it will be fully indemnified by The Rugby Group’s former owner,Aventis Pharmaceuticals (Aventis, formerly known as Hoechst Marion Roussel,Inc.) for the defense of all such cases and for any liability that may ariseout of these cases.  Aventis is currentlycontrolling the defense of all these cases as the indemnifying party under itsagreements with the Company.

 

*Cipro® Litigation.*  On May 28, 2004, the defendants, includingthe Company and certain of its affiliates, filed motions for summary judgmentin the consolidated action pending in the U.S. District Court for the EasternDistrict of New York *(In re: CiprofloxacinHydrochloride Litigation, MDL Docket No. 001383)*, seeking dismissalof several of the claims asserted by the plaintiffs, including claims allegingviolation of the antitrust laws.  On July9, 2004, the plaintiffs filed oppositions to the defendants’ summary judgmentmotions, and the direct purchasers filed a cross-motion for partial summaryjudgment on their claims.  The court hasnot yet set a hearing date to consider these motions and cross-motion.  On July 21, 2004, the California Court ofAppeal granted in part and denied in part the defendants’ petition for a writof mandate seeking to reverse the trial court’s order granting the plaintiffs’motion for class certification.  Pursuantto the ruling, the majority of the plaintiffs will be permitted to pursue theirclaims as a class.  The trial court inthe case pending in the California Superior Court has continued the trial dateuntil January 24, 2005.  Aventis iscontinuing to defend and indemnify the Company and its affiliates in connectionwith these claims.

 

*Governmental Reimbursement Investigations andProceedings.* On June 10, 2004, the court inthe consolidated action pending in the United States District Court for theDistrict of Massachusetts (*In re: PharmaceuticalIndustry Average Wholesale Price Litigation, MDL Docket No. 1456)*dismissed the State of Nevada’s state RICO claim, the State of Montana’s FalseClaims Act “Best Price” claims, Montana’s Medicaid Fraud Act “Best Price”claims, and Nevada’s “Best Price” Medicaid claims.  On June 3, 2004, the Attorney Generalof the State of Wisconsin filed an action in the Wisconsin Superior Courtagainst the Company and numerous other pharmaceutical defendants.  On August 4, 2004, the City of New York filedan action in the United States District Court for the Southern District of NewYork against the Company and numerous other pharmaceutical defendants.  The Wisconsin and City of New York complaintsgenerally allege claims similar to the other actions pending against thedefendants, alleging improper or fraudulent reporting practices related to thereporting of average wholesale prices of certain products, and that defendantscommitted other improper acts in order to increase prices and marketshares.  On July 14, 2004, the defendantsfiled a notice of removal of the Wisconsin action to the United States DistrictCourt for the District of Wisconsin, and a notice seeking to have the Wisconsincase transferred to the consolidated action pending in the United StatesDistrict Court for the District of Massachusetts.  The defendants are required to respond to theWisconsin complaint by September 15, 2004.

 

On July 19, 2004, the Company received a civil investigative subpoenafrom the State of Florida’s Office of the Attorney General, seeking theproduction of documents regarding the pricing, distribution, marketing andsales of four drugs.  The subpoena seeksproduction by August 16, 2004.

 

*FDA Matters.*    On April 8,2004, the United States District Court for the District of Arizona entered anorder vacating the Consent Decree of Condemnation and Permanent Injunctionpreviously entered against Steris Laboratories, Inc. (Steris) and other defendantson October 21, 1998.  The court enteredthe order upon Steris’ request,

 

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which the FDA agreednot to oppose.  On June 28, 2004, theCompany announced that it has elected to retain the Steris facility as part ofits continuing operations.

 

With respect to the May 2002 consent decree enteredagainst Watson Laboratories, Inc. in connection with the Company’s Corona,California facility, in June 2004 the Company submitted its response to theFDA’s inspectional observations, and met with FDA Officials on June 30, 2004 todiscuss the Company’s response to the FDA’s inspectional observations made inconnection with the inspection conducted by FDA from March 31, 2004 until May6, 2004.  During the meeting, the Companyand FDA discussed the corrective actions the Company has taken, and intends totake, to address the inspectional observations. The Company believes that its responses, and the commitments made duringthe June 30, 2004, meeting, address the FDA’s observations.  However, the FDA is not required to accept oragree with the Company’s responses and/or commitments.  If, in the future, the FDA determines that,with respect to its Corona facility, Watson has failed to comply with theconsent decree or FDA regulations, including cGMPs, or has failed to adequatelyaddress the observations in the Form 483, the consent decree allows the FDA toorder Watson to take a variety of actions to remedy the deficiencies. Theseactions could include ceasing manufacturing and related operations at theCorona facility, and recalling affected products.  Such actions, if taken by the FDA, couldadversely affect the Company, its results of operations, financial positionand/or cash flows.

 

*Securities Litigation**.** *On May 24, 2004, thedefendants in the shareholders derivative action pending in the CaliforniaSuperior Court for the County of Riverside *(Charles Zimmerman v.Allen Chao, etal., Lead Case No. 403715)*, filed a demurrer to theconsolidated complaint, seeking to have the case dismissed.  On July 7, 2004, the Superior Court entered astay of all proceedings until January 5, 2005, at which time the court willconsider whether to lift the stay of proceedings. The Court deferred ruling onthe defendants’ demurrer to the consolidated complaint until the stay islifted.  In the action pending in theUnited States District Court for the Central District of California *(In re:   Watson Pharmaceuticals, Inc. SecuritiesLitigation, Case No. CV-03-8236 AHM)*, on May 24, 2004, the defendantsmoved to dismiss the amended complaint. On August 2, 2004, the court granted the defendants’ motion to dismiss,and allowed plaintiffs until August 30, 2004 to file an amended complaint.

 

*Hormone Replacement Therapy Litigation.*  Beginning in early 2004, a number of productliability suits were filed against the Company and certain Company affiliates,for personal injuries allegedly arising out of the use of hormone replacementtherapy products, including but not limited to estropipate and estradiol.  These complaints also name numerous otherpharmaceutical companies as defendants, and allege various injuries, includingovarian cancer, breast cancer and blood clots. As of August 1, 2004, approximately twenty one cases were pendingagainst Watson and/or its affiliates in state and federal courts.  Many of the cases involve multipleplaintiffs.  Several of the cases havebeen transferred to and consolidated in the United States District Court forthe Eastern District of Arkansas (*In re:  Prempro Products Liability Litigation, MDLDocket No. 1507*).  The Companymaintains products liability insurance against such claims.  However, these actions, if successful, or ifinsurance does not provide sufficient coverage against the claims, couldadversely affect the Company and may have a material adverse effect on theCompany’s business, results of operations, financial condition and cash flows.

 

The Company andits affiliates are involved in various other disputes, governmental and/orregulatory inspections, investigations and proceedings, and litigation mattersthat arise from time to time in the ordinary course of business, including, butnot limited to, product liability lawsuits. The process of resolving matters through litigation or other means isinherently uncertain and it is possible that the resolution of these matterswill adversely affect the Company, its results of operations, financialposition and/or cash flows.

 

**ITEM 4.****  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

At our Annual Meeting of Stockholders held on May 17, 2004, thefollowing proposals were set before the stockholders for their vote:

 

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**PROPOSAL ONE:** Election of threedirectors to hold office until the 2007 Annual Meeting:

 
| **DIRECTORS - CLASS III** | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** |
|---------------------------|------------|---------------|------------|--------------------|------------|
|                      |       |          |       |               |       |
| Allen Chao,  Ph.D.        |       | 89,426,920    |       | 2,347,840          |       |
| Michel J.  Feldman        |       | 89,684,123    |       | 2,090,637          |       |
| Fred G. Weiss             |       | 89,781,999    |       | 1,992,761          |       |

 

The remaining members of the Board of Directors whowill continue in office and the year in which their terms expire are thefollowing:

 

Term expiring in 2005: Class I directors are Michael J. Fedida, Albert F. Hummel, and CatherineKlema.

 

Term expiring in 2006: Class II directors are Ronald R. Taylor, Andrew L. Turner, and JackMichelson.

 

**PROPOSAL TWO:**Ratification ofthe appointment of PricewaterhouseCoopers LLP as the Company’s independentauditor for the year ending December 31, 2004:

 
| For              |   | 85,747,817 |   |
|------------------|--------|------------|--------|
| Against          |   | 5,277,393  |   |
| Abstain          |   | 749,550    |   |
| Broker non-votes |   | —     |   |

 

**PROPOSAL THREE:**Stockholderproposal regarding maximum compensation and changing equity compensation fromstock options to restricted stock for senior executives.

 
| For              |   | 5,346,042  |   |
|------------------|--------|------------|--------|
| Against          |   | 68,877,425 |   |
| Abstain          |   | 1,152,829  |   |
| Broker non-votes |   | 16,398,464 |   |

 

**ITEM 6.****  EXHIBITSAND REPORTS ON FORM 8-K**

 

(a) Exhibits:

 

Reference is hereby made to theExhibit Index on page 34.

 

(b) Reports on Form 8-K filed during the quarter endedJune 30, 2004:

 

On April 28, 2004, the Company filed a Current Reporton Form 8-K with the Securities and Exchange Commission reporting, under Item12, that it had issued a news release announcing its financial results for thequarter ended March 31, 2004.

 

On June 28, 2004, the Company filed a Current Reporton Form 8-K with the Securities and Exchange Commission reporting, under Items5 and 12, that it had issued a news release

 

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announcingseveral initiatives as a result of an extensive strategic and operationalreview of its business, and had issued a news release providing an update toits financial estimates for the second quarter and full year 2004.

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly 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 6,2004

 

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**WATSONPHARMACEUTICALS, INC.**

 

**EXHIBIT INDEX TO FORM 10-Q**

**For the Quarterly Period EndedJune 30, 2004**

 
| **Exhibit  No.** | ** ** | **Description**                                                                                                                   |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------|
| 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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