** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-Q**

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

**FOR THEQUARTERLY PERIOD ENDED SEPTEMBER 30, 2006**

**or**

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

**Forthe transition period from               to               **

**Commission file number 001-13305**

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**WATSON PHARMACEUTICALS, INC.**

(Exact name ofregistrant as specified in its charter)

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

 

**311Bonnie Circle**

**Corona,CA  92880-2882**

(Address ofprincipal executive offices, including zip code)

**(951)493-5300**

(Registrant’stelephone number, including area code)

Indicate by checkmark whether the 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 x   No o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act. (Check one):
| Large accelerated filer x | Accelerated filer o | Non-accelerated filer o |
|---------------------------|---------------------|-------------------------|

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).  Yes o  No x

The number of sharesoutstanding of the Registrant’s only class of common stock as of November 3,2006 was approximately 102,468,000.

 

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**WATSON PHARMACEUTICALS, INC.**

**TABLE OF CONTENTS**

**FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006**
|            | **Part I.  FINANCIAL INFORMATION**                                                                            | ** ** |
|------------|---------------------------------------------------------------------------------------------------------------|------------|
|       |                                                                                                          |       |
| Item 1.    | Condensed Consolidated Financial Statements  (Unaudited):                                                     | ** ** |
|       |                                                                                                          |       |
|       | Condensed Consolidated Balance Sheets as of September  30, 2006 and  December 31, 2005                        |       |
|       |                                                                                                          |       |
|       | Condensed Consolidated Statements of Income for the  Three and Nine Months  Ended September 30, 2006 and 2005 |       |
|       |                                                                                                          |       |
|       | Condensed Consolidated Statements of Cash Flows for  the Nine Months  Ended September 30, 2006 and 2005       |       |
|       |                                                                                                          |       |
|       | 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  1A.  | Risk  Factors                                                                                                 |       |
|       |                                                                                                          |       |
| Item 2.    | Unregistered  Sales of Equity Securities and Use of Proceeds                                                  |       |
|       |                                                                                                          |       |
| Item  6.   | Exhibits                                                                                                      |       |
|       |                                                                                                          |       |
| Signatures |                                                                                                          |

 

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**WATSON PHARMACEUTICALS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(Unaudited; in thousands)**
| ** **                                       | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| **ASSETS**                                       |       |                   |       |                  |       |
| Current assets:                                  |       |                   |       |                  |       |
| Cash and cash  equivalents                       |       | $                      | 735,222    |                  | $          | 467,451 |   |
| Marketable  securities                           |       | 171,545                |       | 162,475               |       |
| Accounts  receivable, net                        |       | 264,264                |       | 333,832               |       |
| Inventories                                      |       | 318,166                |       | 278,062               |       |
| Prepaid expenses  and other current assets       |       | 35,018                 |       | 31,014                |       |
| Deferred tax  assets                             |       | 98,242                 |       | 87,596                |       |
| Total current  assets                            |       | 1,622,457              |       | 1,360,430             |       |
|                                             |       |                   |       |                  |       |
| Property and equipment,  net                     |       | 444,043                |       | 436,149               |       |
| Investments and other  assets                    |       | 66,026                 |       | 50,318                |       |
| Deferred tax assets                              |       | 25,172                 |       | 25,733                |       |
| Product rights and  other intangibles, net       |       | 561,409                |       | 751,808               |       |
| Goodwill                                         |       | 479,926                |       | 455,595               |       |
| Total assets                                     |       | $                      | 3,199,033  |                  | $          | 3,080,033 |   |
|                                             |       |                   |       |                  |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**   |       |                   |       |                  |       |
| Current liabilities:                             |       |                   |       |                  |       |
| Accounts payable  and accrued expenses           |       | $                      | 253,864    |                  | $          | 211,160 |   |
| Income taxes  payable                            |       | 76,972                 |       | 28,789                |       |
| Current portion  of long-term debt               |       | 10,336                 |       | —                |       |
| Deferred revenue                                 |       | 8,606                  |       | 5,721                 |       |
| Total current  liabilities                       |       | 349,778                |       | 245,670               |       |
|                                             |       |                   |       |                  |       |
| Long-term debt                                   |       | 574,078                |       | 587,935               |       |
| Deferred revenue                                 |       | 18,812                 |       | 13,891                |       |
| Other long-term  liabilities                     |       | 1,853                  |       | 2,504                 |       |
| Deferred tax  liabilities                        |       | 84,095                 |       | 125,792               |       |
| Total  liabilities                               |       | 1,028,616              |       | 975,792               |       |
|                                             |       |                   |       |                  |       |
| Commitments and  contingencies                   |       |                   |       |                  |       |
|                                             |       |                   |       |                  |       |
| Stockholders’ equity:                       |       |                   |       |                  |       |
| Preferred stock                                  |       | —                 |       | —                |       |
| Common stock                                     |       | 368                    |       | 367                   |       |
| Additional paid-in  capital                      |       | 932,883                |       | 923,619               |       |
| Unearned compensation                            |       | —                 |       | (9,326                | )          |
| Retained earnings                                |       | 1,529,095              |       | 1,485,100             |       |
| Accumulated other  comprehensive income          |       | 8,071                  |       | 4,481                 |       |
| Treasury stock, at cost                          |       | (300,000               | )          | (300,000              | )          |
| Total  stockholders’ equity                 |       | 2,170,417              |       | 2,104,241             |       |
| Total liabilities and  stockholders’ equity |       | $                      | 3,199,033  |                  | $          | 3,080,033 |   |

 

*See accompanying Notes to Condensed Consolidated FinancialStatements.*

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**WATSONPHARMACEUTICALS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF INCOME**

**(Unaudited; in thousands, except per share amounts)**
| ** **                                              | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                              | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                              | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                              | ** ** | ** **                       | ** ** | **Restated**                    | ** ** | ** ** | ** ** | **Restated** | ** ** |
|                                                    |       |                             |       |                            |       |   |   |   |   |
| Net revenues                                            |       | $                                | 440,493    |                            | $          | 410,296 |   | $ | 1,358,082 |   | $ | 1,227,390 |   |
| Cost of sales  (excludes amortization, presented below) |       | 257,896                          |       | 210,809                         |       | 823,510 |   | 628,972 |   |
| Gross profit                                            |       | 182,597                          |       | 199,487                         |       | 534,572 |   | 598,418 |   |
|                                                    |       |                             |       |                            |       |   |   |   |   |
| Operating  expenses:                                    |       |                             |       |                            |       |   |   |   |   |
| Research and development                                |       | 29,447                           |       | 29,840                          |       | 90,409 |   | 90,164 |   |
| Selling, general and administrative                     |       | 64,467                           |       | 65,175                          |       | 201,991 |   | 196,951 |   |
| Amortization                                            |       | 39,392                           |       | 41,100                          |       | 121,593 |   | 122,839 |   |
| Loss on impairment                                      |       | —                           |       | —                          |       | 66,981 |   | — |   |
| Total operating expenses                                |       | 133,306                          |       | 136,115                         |       | 480,974 |   | 409,954 |   |
| Operating income                                        |       | 49,291                           |       | 63,372                          |       | 53,598 |   | 188,464 |   |
|                                                    |       |                             |       |                            |       |   |   |   |   |
| Other income  (expense):                                |       |                             |       |                            |       |   |   |   |   |
| Earnings (losses) on equity method investments          |       | 184                              |       | (810                            | )          | 1,638 |   | (1,685 | ) |
| Gain on sales of securities                             |       | —                           |       | —                          |       | 3,695 |   | — |   |
| Loss on early extinguishment of debt                    |       | —                           |       | —                          |       | (525 | ) | — |   |
| Interest income                                         |       | 9,601                            |       | 4,928                           |       | 22,766 |   | 13,580 |   |
| Interest expense                                        |       | (3,814                           | )          | (4,690                          | )          | (10,437 | ) | (11,604 | ) |
| Other expense                                           |       | (428                             | )          | (450                            | )          | (420 | ) | (489 | ) |
| Total other income, net                                 |       | 5,543                            |       | (1,022                          | )          | 16,717 |   | (198 | ) |
|                                                    |       |                             |       |                            |       |   |   |   |   |
| Income before  income taxes                             |       | 54,834                           |       | 62,350                          |       | 70,315 |   | 188,266 |   |
| Provision for  income taxes                             |       | 20,453                           |       | 23,264                          |       | 26,320 |   | 70,118 |   |
| Net income                                              |       | $                                | 34,381     |                            | $          | 39,086 |   | $ | 43,995 |   | $ | 118,148 |   |
|                                                    |       |                             |       |                            |       |   |   |   |   |
| Earnings per  share:                                    |       |                             |       |                            |       |   |   |   |   |
| Basic                                                   |       | $                                | 0.34       |                            | $          | 0.38 |   | $ | 0.43 |   | $ | 1.11 |   |
| Diluted                                                 |       | $                                | 0.31       |                            | $          | 0.35 |   | $ | 0.43 |   | $ | 1.02 |   |
|                                                    |       |                             |       |                            |       |   |   |   |   |
| Weighted average  shares outstanding:                   |       |                             |       |                            |       |   |   |   |   |
| Basic                                                   |       | 101,865                          |       | 102,966                         |       | 101,760 |   | 106,131 |   |
| Diluted                                                 |       | 116,353                          |       | 118,158                         |       | 116,356 |   | 121,156 |   |

 

*Seeaccompanying Notes to Condensed Consolidated Financial Statements.*

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** **

**WATSONPHARMACEUTICALS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited;in thousands)**
| ** **                                                           | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                           | ** ** | **September 30,**          | ** ** |
| ** **                                                           | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| ** **                                                           | ** ** | ** **                      | ** ** | **Restated** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                           |       |                            |       |   |   |
| Net income                                                           |       | $                               | 43,995     |   | $ | 118,148 |   |
| Reconciliation  to net cash provided by operating activities:        |       |                            |       |   |   |
| Depreciation                                                         |       | 37,027                          |       | 30,857 |   |
| Amortization                                                         |       | 121,593                         |       | 122,839 |   |
| Charge for asset impairment                                          |       | 66,981                          |       | — |   |
| Deferred income tax (provision) benefit                              |       | (54,111                         | )          | (10,746 | ) |
| Provision for inventory reserve                                      |       | 18,126                          |       | 36,607 |   |
| Restricted stock and stock option compensation                       |       | 9,731                           |       | 1,175 |   |
| Losses (earnings) on equity method investments                       |       | (1,638                          | )          | 1,685 |   |
| Gain on sale of securities                                           |       | (3,695                          | )          | — |   |
| Loss on early extinguishment of debt                                 |       | 525                             |       | — |   |
| Loss on sale of fixed assets                                         |       | 329                             |       | 1,607 |   |
| Tax benefits from employee stock plans                               |       | 932                             |       | 3,111 |   |
| Mark to market on derivative                                         |       | (651                            | )          | 12 |   |
| Other                                                                |       | (3,179                          | )          | (2,389 | ) |
| Changes in assets and liabilities (net of  acquisition of business): |       |                            |       |   |   |
| Accounts receivable, net                                             |       | 69,931                          |       | (39,189 | ) |
| Inventories                                                          |       | (53,712                         | )          | 12,947 |   |
| Prepaid expenses and other current assets                            |       | (2,369                          | )          | 5,701 |   |
| Accounts payable and accrued expenses                                |       | 40,445                          |       | 1,706 |   |
| Deferred revenue                                                     |       | 2,796                           |       | 5,723 |   |
| Income taxes payable                                                 |       | 48,183                          |       | (11,444 | ) |
| Other assets                                                         |       | (3,472                          | )          | 1,131 |   |
| Total adjustments                                                    |       | 293,772                         |       | 161,333 |   |
| Net cash provided by operating activities                            |       | 337,767                         |       | 279,481 |   |
|                                                                 |       |                            |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                           |       |                            |       |   |   |
| Acquisitions of property  and equipment                              |       | (25,468                         | )          | (48,293 | ) |
| Acquisition of  product rights                                       |       | (440                            | )          | (541 | ) |
| Acquisition of  business, net of cash acquired                       |       | (29,574                         | )          | — |   |
| Proceeds from  sale of marketable equity securities                  |       | 3,693                           |       | 220,083 |   |
| Proceeds from  sale of investments                                   |       | 4,695                           |       | — |   |
| Additions to  marketable securities                                  |       | (5,164                          | )          | (3,809 | ) |
| Additions to  long-term investments                                  |       | (12,682                         | )          | (1,500 | ) |
| Distribution  from joint venture                                     |       | 5,942                           |       | 2,791 |   |
| Net cash (used in) provided by investing activities                  |       | (58,998                         | )          | 168,731 |   |
|                                                                 |       |                            |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                           |       |                            |       |   |   |
| Payments to  repurchase 1998 Senior Notes                            |       | (14,585                         | )          | — |   |
| Repurchase of  common stock                                          |       | —                          |       | (300,000 | ) |
| Payments on term  loan, current debt and other long-term liabilities |       | (4,341                          | )          | (7 | ) |
| Proceeds from  stock plans                                           |       | 7,928                           |       | 25,366 |   |
| Net cash used in financing activities                                |       | (10,998                         | )          | (274,641 | ) |
| Net increase in cash and cash equivalents                            |       | 267,771                         |       | 173,571 |   |
| Cash and cash  equivalents at beginning of period                    |       | 467,451                         |       | 298,653 |   |
| Cash and cash  equivalents at end of period                          |       | $                               | 735,222    |   | $ | 472,224 |   |

 

*See accompanying Notes to CondensedConsolidated Financial Statements.*

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**WATSON PHARMACEUTICALS, INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

**NOTE 1 –GENERAL**

WatsonPharmaceuticals, Inc. (“Watson” or the “Company”) is primarily engaged in thedevelopment, manufacture, marketing, sale and distribution of brand andoff-patent (generic) pharmaceutical products. Watson was incorporated in 1985 and began operations as a manufacturerand marketer of off-patent pharmaceuticals. Through internal product development and synergistic acquisitions ofproducts and businesses, the Company has grown into a diversified specialtypharmaceutical company.  Watson operatesmanufacturing, distribution, research and development and administrativefacilities primarily in the United States of America (“U.S.”).

The accompanyingCondensed Consolidated Financial Statements should be read in conjunction withthe Company’s Annual Report on Form 10-K for the year ended December 31,2005.  Certain information and footnotedisclosures normally included in annual financial statements prepared inaccordance with generally accepted accounting principles have been condensed oromitted from the accompanying Condensed Consolidated Financial Statements.  The year end balance sheet was derived fromthe audited financial statements.  Theaccompanying interim financial statements are unaudited, but reflect alladjustments which are, in the opinion of management, necessary to fairly state Watson’sconsolidated financial position, results of operations and cash flows for theperiods presented.  Unless otherwisenoted, all such adjustments are of a normal, recurring nature.  Certain reclassifications, none of whichaffected net income or retained earnings, have been made to prior periodamounts to conform to current period presentation.  The Company’s results of operations and cashflows for the interim periods are not necessarily indicative of the results ofoperations and cash flows that it may achieve in future periods or for the fullyear.

In the year ended December 31, 2005 the Company acquired additionalcommon shares in Scinopharm Taiwan, Ltd. (“Scinopharm”), previously accountedfor under the cost method, to an ownership level in excess of 20%. Accordingly,as required by Accounting Principles Board (“APB”) Opinion No. 18, “The EquityMethod of Accounting for Investments in Common Stock” (“APB 18”), results ofoperations, earnings per share and cash flows from operating and investingactivities have been restated for the three and nine months ended September 30,2005 to conform to current period presentation.

*Acquisition of Andrx Corporation*

On November 3, 2006, the Company acquired all theoutstanding shares of common stock of Andrx Corporation (“Andrx”) in anall-cash transaction for $25 per share, or total consideration of approximately$1.9 billion (the “Andrx Acquisition”). Andrx distributes pharmaceutical products primarily to independent andchain pharmacies and physicians’ offices and is considered a leader informulating and commercializing difficult-to-replicate controlled-release pharmaceuticalproducts and selective immediate-release products.  For additional information on the AndrxAcquisition, refer to NOTE 12 – SUBSEQUENT EVENTS.

*ComprehensiveIncome*

Comprehensiveincome includes all changes in equity during a period except those thatresulted from investments by or distributions to the Company’sstockholders.  Other comprehensive income(loss) refers to revenues, expenses, gains and losses that, under generallyaccepted accounting principles, are included in comprehensive income (loss),but excluded from net income as these amounts are recorded directly as anadjustment to stockholders’ equity. Watson’s other comprehensive income (loss) is comprised of unrealizedgains (losses) on its holdings of publicly traded debt and equity securities,net of realized gains (losses) included in net income and foreign currencytranslation adjustments.  Othercomprehensive income includes unrealized 

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gains on our holdings inshares of Andrx common stock.  For additional information onthe impact of the Andrx Acquisition on our accounting for unrealized gainsrelated to Andrx, refer to NOTE 12 – SUBSEQUENT EVENTS.  The components of comprehensive incomeincluding attributable income taxes consisted of the following (in thousands):
| ** **                                      | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                      | ** ** | ** **                                               | ** ** | **Restated**                                            | ** ** | ** ** | ** ** | **Restated** | ** ** |
| Net income                                      |       | $                                                        | 34,381     |                                                    | $          | 39,086 |   | $ | 43,995 |   | $ | 118,148 |   |
|                                            |       |                                                     |       |                                                    |       |   |   |   |   |
| Other  comprehensive income (loss):             |       |                                                     |       |                                                    |       |   |   |   |   |
| Unrealized gain (loss) on securities            |       | 1,676                                                    |       | (2,704                                                  | )          | 6,739 |   | (7,997 | ) |
| Less related income taxes                       |       | (601                                                     | )          | 985                                                     |       | (2,520 | ) | 2,959 |   |
| Total unrealized gain (loss) on securities, net |       | 1,075                                                    |       | (1,719                                                  | )          | 4,219 |   | (5,038 | ) |
|                                            |       |                                                     |       |                                                    |       |   |   |   |   |
| Translation loss                                |       | (199                                                     | )          | —                                                  |       | (629 | ) | — |   |
| Total other  comprehensive income (loss)        |       | 876                                                      |       | (1,719                                                  | )          | 3,590 |   | (5,038 | ) |
| Total comprehensive  income                     |       | $                                                        | 35,257     |                                                    | $          | 37,367 |   | $ | 47,585 |   | $ | 113,110 |   |

 

*Preferred and Common Stock*

As of September 30, 2006 and December 31, 2005 therewere 2,500,000 shares of no par value per share preferred stock authorized,with none issued.  As of September 30,2006 and December 31, 2005, there were 500,000,000 shares of $0.0033 par valueper share common stock authorized, with 111,865,000 and 110,205,000 sharesissued, and 102,465,000 and 100,805,000 outstanding, respectively.  Approximately 9,399,800 shares were held astreasury shares as of September 30, 2006 and December 31, 2005, respectively.

*Stock Repurchases*

During 2005, we repurchasedapproximately 9.4 million shares of our common stock at an aggregate cost of$300.0 million under the Company’s $300.0 million stock repurchase programapproved by the Company’s Board of Directors (“Board”) on February 10, 2005(the “2005 Repurchase Program”).  Thiscompleted our stock repurchase program under the 2005 Repurchase Program.

On February 15, 2006, theBoard authorized the expenditure of an additional $300.0 million to repurchaseshares of the Company’s outstanding common stock (the “2006 Repurchase Program”).  Repurchases are authorized to be made in openmarket or privately negotiated transactions from time to time in compliancewith the SEC Rule 10b-18, subject to market conditions, applicable legalrequirements and other factors. Additionally, the Board has authorized thatpurchases may be made under Rule 10b5-1 promulgated under the Securities andExchange Act of 1934, as amended.  A Rule10b5-1 plan allows Watson to repurchase its shares during periods when it wouldnormally not be active in the market due to its internal trading blackoutperiods. All such purchases must be made in accordance with a pre-defined planthat is established when the plan administrator is not aware of any materialnon-public information.  At this time,the Company has no current plans to repurchase common stock under the 2006Repurchase Program.

*Provisionsfor Sales Returns and Allowances*

As customary in the pharmaceutical industry, the Company’s grossproduct sales are subject to a variety of deductions in arriving at reportednet product sales.  When the Companyrecognizes revenue from the sale of its products, an estimate of sales returnsand allowances (“SRA”) is recorded which reduces product sales and accountsreceivable. These adjustments include estimates for chargebacks, rebates, cashdiscounts and returns and other allowances. These provisions are estimated basedon historical payment experience, historical relationship to revenues,estimated customer inventory levels and current contract sales terms withdirect and 

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indirect customers. The estimation process used to determine our SRA provision has beenapplied on a consistent basis and no material adjustments have been necessaryto increase or decrease our reserves for SRA as a result of a significantchange in underlying estimates.  The Company uses a variety of methods to assess the adequacy of our SRAreserves to ensure that our financial statements are fairly stated.  This includes periodic reviews of customerinventory data, customer contract programs and product pricing trends to analyzeand validate the SRA reserves.

The provision for chargebacks is our most significant salesallowance.  A chargeback represents anamount payable in the future to a wholesaler for the difference between theinvoice price paid to the Company by our wholesale customer for a particularproduct and the negotiated contract price that the wholesaler’s customer paysfor that product.  The Company’schargeback provision and related reserve vary with changes in product mix,changes in customer pricing and changes to estimated wholesaler inventory.  The provision for chargebacks also takes intoaccount an estimate of the expected wholesaler sell-through levels to indirectcustomers at contract prices.  TheCompany validates the chargeback accrual quarterly through a review of theinventory reports obtained from our largest wholesale customers.  This customer inventory information is usedto verify the estimated liability for future chargeback claims based onhistorical chargeback and contract rates. These large wholesalers represent 85% - 90% of the Company’s chargebackpayments.  The Company continuallymonitors current pricing trends and wholesaler inventory levels to ensure theliability for future chargebacks is fairly stated.  The following table summarizesthe activity in the Company’s major categories of SRA (in thousands):
| ** **                                                          | ** ** | **Chargebacks** | ** ** | **Rebates** | ** ** | **Returns and  Other  Allowances** | ** ** | **Cash  Discounts** | ** ** | **Total**  | ** ** |
|---------------------------------------------------------------------|------------|-----------------|------------|-------------|------------|-----------------------------------------|------------|---------------------|------------|------------|------------|
|                                                                |       |            |       |        |       |                                    |       |                |       |       |       |
| Balance at  December 31, 2004                                       |       | $               | 129,551    |        | $          | 148,948                                 |       | $                   | 44,483     |       | $          | 10,614 |   | $ | 333,596 |   |
| Provision related to sales in nine months ended  September 30, 2005 |       | 668,145         |       | 253,964     |       | 84,154                                  |       | 43,647              |       | 1,049,910  |       |
| Credits and payments                                                |       | (692,243        | )          | (269,903    | )          | (91,317                                 | )          | (43,672             | )          | (1,097,135 | )          |
| Balance at  September 30, 2005                                      |       | 105,453         |       | 133,009     |       | 37,320                                  |       | 10,589              |       | 286,371    |       |
| Provision related to sales in three months ended  December 31, 2005 |       | 267,679         |       | 91,906      |       | 35,719                                  |       | 15,853              |       | 411,157    |       |
| Credits and payments                                                |       | (233,527        | )          | (96,622     | )          | (27,746                                 | )          | (14,348             | )          | (372,243   | )          |
| Balance at  December 31, 2005                                       |       | 139,605         |       | 128,293     |       | 45,293                                  |       | 12,094              |       | 325,285    |       |
| Provision related to sales in nine months ended  September 30, 2006 |       | 876,450         |       | 306,016     |       | 141,136                                 |       | 52,224              |       | 1,375,826  |       |
| Credits and payments                                                |       | (852,695        | )          | (294,088    | )          | (132,733                                | )          | (51,762             | )          | (1,331,278 | )          |
| Balance at September  30, 2006                                      |       | $               | 163,360    |        | $          | 140,221                                 |       | $                   | 53,696     |       | $          | 12,556 |   | $ | 369,833 |   |

 

*Earnings Per Share*

Basic earnings pershare is computed by dividing net income by the weighted average common sharesoutstanding during a period.  Dilutedearnings per share is based on the treasury stock method and includes theeffect from potential issuance of common stock, such as shares issuable uponconversion of the $575 million convertible contingent senior debentures (“CODES”),and the dilutive effect of stock options and restricted stock awardsoutstanding during the period.  Commonshare equivalents have been excluded where their inclusion would beanti-dilutive.  In accordance withEmerging Issues Task Force (“EITF”) Issue No. 04-8, “The Effect of ContingentlyConvertible Debt on Diluted Earnings per Share,” the Company is required to addapproximately 14.4 million shares associated with the conversion of the CODESto the number of shares outstanding for the calculation of diluted earnings pershare for all periods in which the securities were outstanding.  A reconciliation of the numerators anddenominators of basic and diluted earnings per share

6

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consisted of thefollowing (in thousands, except per share amounts):
| ** **                                         | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                         | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                         | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                         | ** ** | ** **                       | ** ** | **Restated**                    | ** ** | ** ** | ** ** | **Restated** | ** ** |
|                                               |       |                             |       |                            |       |   |   |   |   |
| **Earnings  per share - basic**                    |       |                             |       |                            |       |   |   |   |   |
| Net income                                         |       | $                                | 34,381     |                            | $          | 39,086 |   | $ | 43,995 |   | $ | 118,148 |   |
|                                               |       |                             |       |                            |       |   |   |   |   |
| Basic weighted average common shares outstanding   |       | 101,865                          |       | 102,966                         |       | 101,760 |   | 106,131 |   |
|                                               |       |                             |       |                            |       |   |   |   |   |
| Earnings per share - basic                         |       | $                                | 0.34       |                            | $          | 0.38 |   | $ | 0.43 |   | $ | 1.11 |   |
|                                               |       |                             |       |                            |       |   |   |   |   |
| **Earnings  per share - assuming dilution**        |       |                             |       |                            |       |   |   |   |   |
| Net income                                         |       | $                                | 34,381     |                            | $          | 39,086 |   | $ | 43,995 |   | $ | 118,148 |   |
| Add: Interest expense on CODES, net of tax         |       | 2,023                            |       | 2,511                           |       | 5,482 |   | 5,940 |   |
| Net income, adjusted                               |       | $                                | 36,404     |                            | $          | 41,597 |   | $ | 49,477 |   | $ | 124,088 |   |
|                                               |       |                             |       |                            |       |   |   |   |   |
| Basic weighted average common shares outstanding   |       | 101,865                          |       | 102,966                         |       | 101,760 |   | 106,131 |   |
| Effect of dilutive securities:                     |       |                             |       |                            |       |   |   |   |   |
| Conversion of CODES                                |       | 14,357                           |       | 14,357                          |       | 14,357 |   | 14,357 |   |
| Dilutive stock options                             |       | 131                              |       | 835                             |       | 239 |   | 668 |   |
| Diluted weighted average common shares outstanding |       | 116,353                          |       | 118,158                         |       | 116,356 |   | 121,156 |   |
|                                               |       |                             |       |                            |       |   |   |   |   |
| Earnings per  share - diluted                      |       | $                                | 0.31       |                            | $          | 0.35 |   | $ | 0.43 |   | $ | 1.02 |   |

 

Stock awards topurchase 10.8 million and 6.2 million common shares for the three month periodsended September 30, 2006 and 2005, respectively, were outstanding but were notincluded in the computation of diluted earnings per share because the optionswere antidilutive.  Stock awards topurchase 10.1 million and 6.3 million common shares for the nine month periodsended September 30, 2006 and 2005, respectively, were outstanding but were notincluded in the computation of diluted earnings per share because the optionswere antidilutive.

*Recent Accounting Pronouncements*

In November 2004, the Financial Accounting StandardsBoard (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No.151, “Inventory Costs-an Amendment of ARB No. 43, Chapter 4” (“SFAS 151”).  SFAS 151 clarifies that items such asabnormal freight, handling costs, and wasted materials (spoilage) be recognizedas current period charges rather than as a portion of the inventory cost.  Unallocated overheads are to be recognized asan expense in the period in which they are incurred.  In addition, this Statement requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities.  This Statement is effective for inventorycosts incurred during fiscal years beginning after June 15, 2005.  The provision of this Statement shall be appliedprospectively.  The adoption of SFAS 151on January 1, 2006, did not have a material effect on our CondensedConsolidated Financial Statements.

InDecember 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-BasedPayment” (“SFAS 123R”), which replaces SFAS No. 123, “Accounting forStock-Based Compensation” (“SFAS 123”) as well as SFAS No. 148, “Accountingfor Stock-Based Compensation-Transition and Disclosure” (“SFAS 148”),supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB25”) and amends SFAS No. 95, “Statement of Cash Flows” (“SFAS 95”). SFAS 123R requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the financial statements based on their fair values. Theintrinsic value method as permitted under APB 25 together with the 

7

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proforma disclosures previously permitted under SFAS 123 no longer will be analternative to financial statement recognition. Under SFAS 123R, the Companymust determine the appropriate fair value model to be used for valuingshare-based payments, the amortization method for attributing compensation costto reporting periods and the transition method to be used at date ofadoption.  The transition methods includemodified prospective and modified retrospective adoption options. Under themodified retrospective option, prior periods may be restated either as of thebeginning of the year of adoption or for all periods presented. The modifiedprospective method requires that compensation expense be recorded for allunvested stock options at the beginning of the first quarter of adoption ofSFAS 123R, while the modified retrospective method would recordcompensation expense for all unvested stock options beginning with the firstperiod restated.  SFAS 123R also requiresany previously recorded unearned or deferred compensation accounts (i.e.contra-equity accounts) within stockholders’ equity be recorded as a reductionto additional paid-in capital balances rather than shown as contra equity accountsas was permitted prior to January 1, 2006.  SFAS 95 is amended to require excess taxbenefits be reported as a financing cash flow rather than as a reduction intaxes paid within the Consolidated Statement of Cash Flows.  On January 1, 2006, the Company adoptedSFAS 123R using the modified prospective method option.

In March 2005, the SEC issued SEC Staff Bulletin No.107 (“SAB 107”) which describes the SEC staff position as well as supplementalimplementation guidance on the application and adoption of SFAS 123R.  TheCompany has applied the provisions of SAB 107 and its guidance in our adoptionof SFAS 123R on January 1, 2006 (Refer to NOTE 2 – SHARE-BASED COMPENSATION).

In May 2005, the FASB issued SFAS No. 154,“Accounting Changes and Error Corrections” (“SFAS 154”), which replaces APBOpinion No. 20, “Accounting Changes” (“APB 20”) and SFAS No. 3, “ReportingAccounting Changes in Interim Financial Statements” (“SFAS 3”). SFAS 154applies to all voluntary changes in accounting principle and changes therequirements for the accounting for and reporting of a change in accountingprinciple.  SFAS 154 also requiresretrospective application to prior period financial statements involvingchanges in accounting principle unless it is impracticable to determine eitherthe period-specific or cumulative effect of the change.  This statement also requires that a change inthe method of depreciation, amortization or depletion of long-lived assets beaccounted for as a change in accounting estimate that is accounted forprospectively.  SFAS 154 also retainsmany provisions of APB 20 including those related to reporting a change inaccounting estimate, a change in the reporting entity and a correction of anerror and also carries forward provisions of SFAS 3 governing the reporting ofaccounting changes in interim financial statements.  SFAS 154 is effective for accounting changesand corrections of errors made in fiscal years beginning after December 15,2005.  The adoption of SFAS 154 onJanuary 1, 2006, did not have a material effect on our Consolidated FinancialStatements.

In July 2006, the FASB issued InterpretationNo. 48, “Accounting for Uncertainty in Income Taxes – An Interpretation ofFASB Statement No. 109” (“FIN 48”).  FIN48 clarifies the accounting for the uncertainty in recognizing income taxes inan organization in accordance with FASB Statement No. 109 by providing detailedguidance for financial statement recognition, measurement and disclosureinvolving uncertain tax positions.  FIN48 requires an uncertain tax position to meet a more-likely-than-notrecognition threshold at the effective date to be recognized both upon theadoption of FIN 48 and in subsequent periods. FIN 48 is effective for fiscal years beginning after December 15,2006.  As the provisions of FIN 48 willbe applied to all tax positions upon initial adoption, the cumulative effect ofapplying the provisions of FIN 48 will be reported as an adjustment to theopening balance of retained earnings for that fiscal year.  The Company is currently evaluating FIN 48and the effect, if any, on our Condensed Consolidated Financial Statements.

8

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**NOTE 2 –SHARE-BASED COMPENSATION**

As indicated above, effective January 1, 2006, theCompany adopted the modified prospective method of SFAS 123R which requires themeasurement and recognition of compensation expense for all share-basedcompensation awards made to employees and directors based on estimated fairvalues.  SFAS 123R eliminates previouslyavailable alternatives to account for share-based compensation transactions, asthe Company formerly did, using the recognition and measurement principles ofAPB 25 and related interpretations. Under the intrinsic value method of APB 25, no stock-based employee compensationexpense had been recognized for employee options in the Company’s CondensedConsolidated Statements of Income, as all employee options granted under theCompany’s stock option plans or employee stock purchase plan (“ESPP”) eitherhad an exercise price equal to the market value of the underlying common stockon the date of grant or were deemed non-compensatory under APB 25 for commonstock issued under our ESPP.  Inaccordance with the modified prospective method, the consolidated financialstatements for prior periods have not been restated to reflect, and do notinclude, the share-based compensation impact of FAS 123R.

*Stock Option Plans*

The Company has adoptedseveral stock option plans, all of which have been approved by the Company’sshareholders, that authorize the granting of options to purchase the Company’scommon shares subject to certain conditions. At September 30, 2006, the Company had reserved 14.6 million of itscommon shares for issuance of share-based compensation awards under the Company’sstock option and restricted stock plans. Options are granted at the fair value of the shares underlying theoptions at the date of the grant and generally become exercisable over periodsranging from three to five years and expire in ten years.  In conjunction with certain of the Company’sacquisitions, Watson assumed stock option and warrant plans from the acquiredcompanies.  The options and warrants inthese plans were adjusted by the individual exchange ratios specified in eachtransaction.  No additional options orwarrants have been granted under any of the assumed plans.  In connection with the Andrx Acquisition, theCompany assumed the Andrx Corporation 2000 Stock Option Plan, as amended andrestated (the "Andrx Plan"), and converted the shares remainingavailable for future grants thereunder into shares available for future grantsunder the Amendment and Restatement of the 2001 Incentive Award Plan of WatsonPharmaceuticals, Inc. (the "Watson Plan").  The shares availablefor future awards under the Watson Plan will not be used for grants toindividuals who, as of immediately prior to the effective time of the AndrxAcquisition, were providing services (whether as an employee, director orconsultant) to the Company or any entity that was a subsidiary of the Companyimmediately prior to the effective time of the Andrx Acquisition.  As of September 30, 2006, approximately 6.1million shares of common stock remain available for future grants under theAndrx Plan, of which no more than approximately 0.3 million shares areavailable for award grants other than stock options.

TheCompany estimates the fair value of its stock option plans and the ESPP usingthe Black-Scholes option pricing model (the “Option Model”).  The Option Model requires the use ofsubjective and complex assumptions, including the option’s expected term andthe estimated future price volatility of the underlying stock, which determinethe fair value of the share-based awards. The Company’s estimate of expected term in 2006 was determined based onthe weighted average period of time that options granted are expected to beoutstanding considering current vesting schedules and the historical exercisepatterns of existing option plans. Beginning in 2005, the expected volatility assumption used in the OptionModel changed from being based on historical volatility to implied volatilitybased on traded options on the Company’s stock in accordance with guidanceprovided in SFAS 123R and SAB 107.  Priorto 2005, the Company’s measurement of expected volatility was based on thehistorical volatility of its stock.  Therisk-free interest rate used in the Option Model is based on the yield of U.S.Treasuries with a maturity closest to the expected term of the Company’s stockoptions.

9

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The following weighted average assumptions were usedfor stock options granted during the three and nine months ended September 30,2006 and 2005:
|                                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                           | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                           | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| Dividend yield                                       |       | None                             |       | None                            |       | None |   | None |   |
| Expected  volatility                                 |       | 26                               | %          | 22                              | %          | 26 | % | 23 | % |
| Risk-free  interest rate                             |       | 4.70                             | %          | 4.18                            | %          | 4.78 | % | 4.15 | % |
| Expected term                                        |       | 5.4                              |       | 4.8                             |       | 5.4 |   | 5.0 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| Weighted average fair  value per share at grant date |       | $                                | 8.67       |                            | $          | 9.56 |   | $ | 8.87 |   | $ | 9.25 |   |
|                                                      |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

Effective January 1, 2006, in accordance with the provisions of SFAS123R, share-based compensation expense recognized during a period is based onthe value of the portion of share-based awards that are expected to vest withemployees.  Accordingly, the recognitionof share-based compensation expense beginning January 1, 2006 has been reducedfor estimated future forfeitures.  SFAS123R requires forfeitures to be estimated at the time of grant with adjustmentsrecorded in subsequent period compensation expense if actual forfeitures differfrom those estimates.  Prior to 2006, weaccounted for forfeitures as they occurred for the disclosure of pro formainformation presented in our Notes to Condensed Consolidated FinancialStatements for prior periods. Share-based compensation expense recognized under SFAS 123R includesshare-based awards granted subsequent to December 31, 2005, based on the grantdate fair value estimated in accordance with the provisions of SFAS 123R aswell as share-based awards granted prior to, but not yet vested as of December31, 2005, based on the grant date fair value estimated in accordance with theprovisions of SFAS 123.  In conjunctionwith the adoption of SFAS 123R, we changed the method of recognizingshare-based compensation expense from the accelerated multiple-option approachto the ratable single-option approach.

As a result of adopting SFAS 123R on January 1, 2006, the Company’soperating income and net income before income tax was reduced by $1.6 millionand $6.1 million, and net income was reduced by $1.0 million ($0.01 per basicand diluted share) and $3.8 million ($0.04 per basic and $0.03 per dilutedshare) for the three and nine months ended September 30, 2006, related to theCompany’s employee stock option plans, respectively.  There was no employee stock optioncompensation related expense recognized in the three and nine months endedSeptember 30, 2005.  Total stock optioncost capitalized as part of inventory was $0.2 million and $0.9 million forthree and nine months ended September 30, 2006, respectively. There was nostock option cost capitalized as part of inventory in the three and nine monthsended September 30, 2005.

On December 15, 2005 the Compensation Committee of the Board approvedthe accelerated vesting of certain unvested, out-of-the-money stock optionshaving an exercise price of $38.00 or greater. The acceleration of vesting was effective December 15, 2005, for stockoptions previously awarded to the Company’s employees, including its executiveofficers under the Company’s equity compensation plans.  In connection with the acceleration ofvesting terms of these options, the Company recognized an additional $6.9million, pre-tax non-cash compensation expense on a pro forma basis inaccordance with SFAS 123 in the three months ended December 31, 2005.  The acceleration action was taken in order toreduce the impact on future compensation expense of recognizing share basedpayment transactions within future periods’ consolidated statements of incomeupon adoption of SFAS 123R on January 1, 2006.

10

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A summary of the changes in the Company’s stock option plans during thenine months ended September 30, 2006 is presented below (in thousands, exceptper share amounts):
|                                                    | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted**          | ** ** | ** **    | ** ** |
|----------------------------------------------------|------------|------------|------------|--------------|------------|-----------------------|------------|---------------|------------|
| ** **                                         | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Average**           | ** ** | ** **    | ** ** |
| ** **                                         | ** ** | ** ** | ** ** | **Average**  | ** ** | **Remaining**         | ** ** | **Aggregate** | ** ** |
| ** **                                         | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual**       | ** ** | **Intrinsic** | ** ** |
| ** **                                         | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Term (Years)** | ** ** | **Value**     | ** ** |
|                                               |       |       |       |         |       |                  |       |          |       |
| Outstanding at  December 31, 2005                  |       | 11,194     |       | $            | 36.76      |                  |       |          |       |   |
| Granted                                            |       | 840        |       | 26.46        |       |                  |       |          |       |
| Exercised                                          |       | (303       | )          | 18.67        |       |                  |       |          |       |
| Cancelled                                          |       | (503       | )          | 39.42        |       |                  |       |          |       |
| Outstanding at  September 30, 2006                 |       | 11,228     |       | $            | 36.36      |                  | 6.0        |          | $          | 1,551 |   |
|                                               |       |       |       |         |       |                  |       |          |       |
| Vested and  expected to vest at September 30, 2006 |       | 10,598     |       | $            | 36.82      |                  | 6.0        |          | $          | 1,438 |   |
|                                               |       |       |       |         |       |                  |       |          |       |
| Options exercisable at  September 30, 2006         |       | 8,290      |       | $            | 39.07      |                  | 5.1        |          | $          | 1,023 |   |

 

As of September 30, 2006, the Company had $11.7 million of totalunrecognized compensation expense, net of estimated forfeitures, related tostock option grants, which will be recognized over the remaining weightedaverage period of 1.8 years.

*RestrictedStock*

During 2005, the Compensation Committee of the Board authorized andissued restricted stock to the Company’s employees, including its executiveofficers and certain non-employee directors (the “Participants”) under theCompany’s equity compensation plans.  Therestricted stock award program offers Participants the opportunity to earnshares of our common stock over time, rather than options that giveParticipants the right to purchase stock at a set price. Restricted stockawards are grants that entitle the holder to shares of common stock subject tocertain terms. Restricted stock awards generally have restrictions eliminatedover a one to four year period. Restrictions generally lapse for non-employee directors after oneyear.  Restrictions generally lapse foremployees over a two to four year period. The fair value of restricted stock grants is based on the fair marketvalue of our common stock on the respective grant dates.  Restricted stock compensation is beingamortized and charged to operations over the same period as the restrictionsare eliminated for the Participants.

The Company’s operating income and net income before income taxprovision was reduced by $1.4 and $2.6 million and net income was reduced by$0.9 million ($0.01 per basic and diluted share) and $1.6 million ($0.02 perbasic and $0.01 per diluted share) for the three and nine months endedSeptember 30, 2006, related to the Company’s restricted stock plans,respectively.  For the three and ninemonths ended September 30, 2005 the Company’s operating income and net incomebefore income tax provision was reduced by $0.4 million and net income wasreduced by $0.2 million ($0.00 per basic and diluted share) related to theCompany’s restricted stock plans, respectively. Total restricted stock cost capitalized as part of inventory was $0.4million and $0.8 for the three and nine months ended September 30, 2006,respectively. Restricted stock cost capitalized as part of inventory in thethree and nine months ended September 30, 2005 was $0.2 million.

11

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A summary of the changes in restricted stock grants during the ninemonths ended September 30, 2006 is presented below (in thousands, except pershare amounts):
|                                                                       | ** ** | ** ** | ** ** | ** **          | ** ** | **Weighted**          | ** ** | ** **    | ** ** |
|-----------------------------------------------------------------------|------------|------------|------------|---------------------|------------|-----------------------|------------|---------------|------------|
| ** **                                                            | ** ** | ** ** | ** ** | **Weighted**        | ** ** | **Average**           | ** ** | ** **    | ** ** |
| ** **                                                            | ** ** | ** ** | ** ** | **Average**         | ** ** | **Remaining**         | ** ** | **Aggregate** | ** ** |
| ** **                                                            | ** ** | ** ** | ** ** | **Grant Date** | ** ** | **Contractual**       | ** ** | **Intrinsic** | ** ** |
| ** **                                                            | ** ** | **Shares** | ** ** | **Fair Value** | ** ** | **Term (Years)** | ** ** | **Value**     | ** ** |
|                                                                  |       |       |       |                |       |                  |       |          |       |
| Restricted  shares outstanding at December 31, 2005                   |       | 315.5      |       | $                   | 34.43      |                  | 2.3        |          | $          | 10,863 |   |
| Granted                                                               |       | 296.3      |       | 26.62               |       |                  |       | 7,894         |       |
| Vested                                                                |       | (5.0       | )          | 30.04               |       |                  |       | (150          | )          |
| Cancelled                                                             |       | (30.4      | )          | 35.00               |       |                  |       | (1,063        | )          |
| Restricted  shares outstanding at September 30, 2006                  |       | 576.4      |       | $                   | 30.44      |                  | 2.2        |          | $          | 17,544 |   |
|                                                                  |       |       |       |                |       |                  |       |          |       |
| Restricted shares net  of estimated forfeitures at September 30, 2006 |       | 410.5      |       | $                   | 31.09      |                  | 2.2        |          | $          | 12,760 |   |

 

As of September 30, 2006, the Company had $8.5 million of totalunrecognized compensation expense, net of estimated forfeitures, related torestricted stock grants, which will be recognized over the remaining weightedaverage period of 2.2 years.

*ESPP*

An ESPP was established foreligible employees to purchase shares of the Company’s common stock at 85% ofthe lower of the fair market value of Watson common stock on the effective dateof subscription or the date of purchase. Under the ESPP, employees could authorize the Company to withhold up to15% of their compensation during any offering period for common stockpurchases, subject to certain limitations. The ESPP was implemented on January 1, 2002 and was qualified underSection 423 of the Internal Revenue Code. The Board authorized an aggregate of 700,000 shares of the Company’scommon stock for issuance under the ESPP. As of December 31, 2005, a total of 471,307 shares were issued under theESPP.  On June 29, 2005 the CompensationCommittee of the Board terminated the ESPP effective January 1, 2006.

The following weightedaverage assumptions were used for the ESPP during the three and nine monthsended September 30, 2005:
|                                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                           | ** ** | **September 30, 2005** | ** ** | **September 30, 2005** | ** ** |
|                                                 |       |                             |       |                             |       |
| Dividend yield                                       |       | None                             |       | None                             |       |
| Expected  volatility                                 |       | 22                               | %          | 24                               | %          |
| Risk-free  interest rate                             |       | 3.80                             | %          | 3.90                             | %          |
| Expected term                                        |       | 6 months                         |       | 6 months                         |       |
|                                                 |       |                             |       |                             |       |
| Weighted average fair  value per share at grant date |       | $                                | 6.45       |                             | $          | 6.87 |   |
|                                                      |            |                                  |            |                                  |            |  |  |

 

*Pro Forma Information forPeriods Prior to the Adoption of FAS 123R*

Prior to 2006, the Company determined stock-based compensation expenseusing the intrinsic value method of APB 25 and we provided the disclosuresrequired by SFAS 123, as amended by SFAS 148.  The following table provides the pro formaeffects on net income and earnings per share for the three and nine monthsended September 30, 2005 as if the fair value recognition provisions of SFAS123R had been applied to options and ESPP

12

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grants under theCompany’s employee compensation plans (in thousands, except per share amounts):
| ** **                                                                                                                                    | ** ** | **Three Months**            | ** ** | **Nine Months**             | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **Ended**                        | ** ** | **Ended**                        | ** ** |
| ** **                                                                                                                                    | ** ** | **September 30, 2005** | ** ** | **September 30, 2005** | ** ** |
| ** **                                                                                                                                    | ** ** | **Restated**                     | ** ** | **Restated**                     | ** ** |
| Net income, as  reported                                                                                                                      |       | $                                | 39,086     |                             | $          | 118,148 |   |
| Add: Stock-based  employee compensation expense included in reported net income, net of related  tax effects                                  |       | 356                              |       | 356                              |       |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (2,935                           | )          | (8,881                           | )          |
| Pro forma net  income                                                                                                                         |       | 36,507                           |       | 109,623                          |       |
| Add: Interest  expense on CODES, net of related tax effects                                                                                   |       | 2,510                            |       | 5,940                            |       |
| Pro forma net  income, adjusted                                                                                                               |       | $                                | 39,017     |                             | $          | 115,563 |   |
| Earnings per  share:                                                                                                                          |       |                             |       |                             |       |
| Basic - as reported                                                                                                                           |       | $                                | 0.38       |                             | $          | 1.11 |   |
| Basic - pro forma                                                                                                                             |       | $                                | 0.35       |                             | $          | 1.03 |   |
|                                                                                                                                          |       |                             |       |                             |       |
| Diluted - as reported                                                                                                                         |       | $                                | 0.35       |                             | $          | 1.02 |   |
| Diluted - pro  forma                                                                                                                          |       | $                                | 0.33       |                             | $          | 0.95 |   |

 

**NOTE 3 –ACQUISITIONS**

*Acquisition of Andrx Corporation*

On November 3, 2006, the Company completed the AndrxAcquisition.  Accordingly, the Company’sCondensed Consolidated Financial Statements for the nine months ended September30, 2006 do not include the results of operations, cash flows or financialposition of Andrx.  For additionalinformation on the Andrx Acquisition, refer to NOTE 12 – SUBSEQUENT EVENTS.

*Acquisitionof Sekhsaria Chemicals Ltd.*

On March 16, 2006, theCompany acquired Sekhsaria Chemicals Ltd. (“Sekhsaria”), a private companylocated in Mumbai, India that provides active pharmaceutical ingredient andfinished dosage formulation expertise to the global pharmaceuticalindustry.  The Company acquired all theoutstanding shares of Sekhsaria for approximately $29.5 million plusacquisition costs.  The transaction wasaccounted for as a purchase in accordance with SFAS No. 141, “BusinessCombinations” “SFAS 141” and accordingly, the tangible assets acquired wererecorded at fair value on acquisition date based on reasonable assumptions.

The results of operations ofSekhsaria have been included in the Company’s Condensed Consolidated FinancialStatements subsequent to the date of acquisition.  Pro forma results of operations have not beenpresented because the effect of the acquisition was not material. 

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*Additional Investment inScinopharm*

The Company holds an equityinterest in Scinopharm.  In January 2006,we made an additional investment in Scinopharm of approximately $12.0 millionwhich increased our ownership share to approximately 31%.  Additionally, we have an option to acquire anadditional 44% interest in Scinopharm at a cost of approximately $80 millionwhich expires in October 2007.

*Acquisitionof Manufacturing Facility in Goa, India*

In October 2005, the Company entered into an asset purchase agreementto purchase a manufacturing facility located in Goa, India from Dr. Reddy’sLaboratories, Ltd. for total cash consideration of approximately $16.4 millionplus acquisition costs.  The transactionincluded a manufacturing facility, machinery and equipment.

**NOTE 4 –INVESTMENTS**

The Company’sequity investments in publicly traded securities 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 current marketable securities, orinvestment and other assets, as appropriate, on the Company’s CondensedConsolidated Balance Sheets.

The Company’s debtinvestments in U.S. Treasury and agency securities are classified asavailable-for-sale and are recorded at fair value based on quoted market pricesusing the specific identification method.

Thefollowing table provides a summary of the fair value and unrealized holdinggain (loss) related to Watson’s available-for-sale securities (in thousands):
| ** **                               | ** ** | **Cost, Including**  | ** ** | **Gross Unrealized** | ** ** | **Gross Unrealized** | ** ** | ** **          | ** ** |
|------------------------------------------|------------|---------------------------|------------|---------------------------|------------|---------------------------|------------|---------------------|------------|
| **At September 30, 2006** | ** ** | **Accrued Interest** | ** ** | **Gains**                 | ** ** | **Losses**                | ** ** | **Fair Value** | ** ** |
| Available-for-sale:                      |       |                      |       |                      |       |                      |       |                |       |
| U.S. Treasury and agency securities      |       | $                         | 157,100    |                      | $          | —                    |       | $                   | (393       | ) | $ | 156,707 |   |
| Equity securities - current              |       | 1,575                     |       | 13,263                    |       | —                    |       | 14,838              |       |
| Current                                  |       | 158,675                   |       | 13,263                    |       | (393                      | )          | 171,545             |       |
| Equity securities - non-current          |       | 232                       |       | 832                       |       | —                    |       | 1,064               |       |
| Total                                    |       | $                         | 158,907    |                      | $          | 14,095                    |       | $                   | (393       | ) | $ | 172,609 |   |

 
| ** **                              | ** ** | **Cost, Including**  | ** ** | **Gross Unrealized** | ** ** | **Gross Unrealized** | ** ** | ** **          | ** ** |
|-----------------------------------------|------------|---------------------------|------------|---------------------------|------------|---------------------------|------------|---------------------|------------|
| **At December 31, 2005** | ** ** | **Accrued Interest** | ** ** | **Gains**                 | ** ** | **Losses**                | ** ** | **Fair Value** | ** ** |
| Available-for-sale:                     |       |                      |       |                      |       |                      |       |                |       |
| U.S. Treasury and agency securities     |       | $                         | 154,302    |                      | $          | —                    |       | $                   | (1,835     | ) | $ | 152,467 |   |
| Equity securities - current             |       | 1,572                     |       | 8,436                     |       | —                    |       | 10,008              |       |
| Current                                 |       | 155,874                   |       | 8,436                     |       | (1,835                    | )          | 162,475             |       |
| Equity securities - non-current         |       | 232                       |       | 707                       |       | —                    |       | 939                 |       |
| Total                                   |       | $                         | 156,106    |                      | $          | 9,143                     |       | $                   | (1,835     | ) | $ | 163,414 |   |

 

Grossunrealized gains at September 30, 2006 and December 31, 2005 primarily relateto our holdings in shares of Andrx common stock.  The gross unrealized holding loss atSeptember 30, 2006 and December 31, 2005 is attributable to adjustments,included in other comprehensive income, for the decline in fair value in theCompany’s investment in U.S. Treasury and agency securities.  For additional information on the impact of the Andrx Acquisition onour accounting for unrealized gains related to Andrx, refer to NOTE 12 –SUBSEQUENT EVENTS.

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TheCompany’s net unrealized gain related to its available-for-sale securitiesincreased $4.2 million for the nine month period ended September 30, 2006.  During the nine month period ended September30, 2005, the Company’s net unrealized holding gain decreased $5.0million.  These changes in the Company’snet unrealized holding gain are included in other comprehensive income.

*Current Investments*

The Company’sinvestment in the common stock of Andrx is classified as a current investmenton the Company’s Condensed Consolidated Balance Sheets at September 30, 2006and December 31, 2005.  The Company didnot sell any of its shares of Andrx during the nine month periods endedSeptember 30, 2005 and 2006.  (Refer toNOTE 1 – GENERAL.)

TheCompany’s investments in U.S. Treasury and agency securities are classified asa current investment on the Company’s Condensed Consolidated Balance Sheet atSeptember 30, 2006 and December 31, 2005.

Thecontractual maturities of the U.S. Treasury and agency securities at September30, 2006 are as follows (in thousands):

|                         | ** ** | **Fair value** | ** ** |
|-------------------------|------------|---------------------|------------|
|                    |       |                |       |
| Mature within one year  |       | $                   | 154,247    |   |
| Mature within two years |       | 2,460               |       |
|                    |       | $                   | 156,707    |   |

 

For additional information on the impact of the Andrx Acquisition onour accounting for current marketable securities, refer to NOTE 12 – SUBSEQUENTEVENTS.

*Non-current Investments*

The Company’sinvestments in the common stock of NovaDel Pharma Inc. and Amarin Corporationplc (“Amarin”) are classified as non-current investments and are included ininvestments and other assets on the Company’s Condensed Consolidated BalanceSheets at September 30, 2006 and December 31, 2005.

**NOTE 5 –SEGMENTS**

Watson has two reportable operating segments: Brandand Generic.  The Brand business segmentincludes the Company’s lines of Specialty Products and Nephrology products.Watson has aggregated its Brand product lines in a single reportable segmentbecause of similarities in regulatory environment, methods of distribution andtypes of customer.  This segment includespatent-protected products and certain trademarked off-patent products thatWatson sells and markets as Brand pharmaceutical products.  The Generic business segment includesoff-patent pharmaceutical products that are therapeutically equivalent toproprietary products.  The Company sellsits Brand and Generic products primarily to pharmaceutical wholesalers, drugdistributors and chain drug stores.

The Company evaluates segment performance based onsegment net revenues, gross profit and contribution. Segment contributionrepresents segment gross profit less direct research and development expensesand selling and marketing expenses.  The Company does not report depreciationexpense, total assets, and capital expenditures by segment as such informationis not used by management, or has not been accounted for at the segment level.

The “other” revenue classification for the three monthperiod ended September 30, 2006 and 2005 consists primarily of royalties andrevenues from research, development and licensing fees and, beginning in 2006, 

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commission revenue earned as a sales agent of Cephalon, Inc. from thelaunch of Fentanyl Citrate.  Netrevenues and segment contribution information for the Company’s Brand andGeneric segments, consisted of the following:

|                                                           | ** ** | **Three Months Ended September 30, 2006** | ** ** | **Three Months Ended September 30, 2005** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                | ** ** | **Generic**                                                        | ** ** | **Brand**                                                          | ** ** | **Total** | ** ** | **Generic** | ** ** | **Brand** | ** ** | **Total** | ** ** |
|                                                      |       |                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Product sales                                             |       | $                                                                  | 347,635    |                                                               | $          | 85,543 |   | $ | 433,178 |   | $ | 315,234 |   | $ | 91,554 |   | $ | 406,788 |   |
| Other                                                     |       | 5,436                                                              |       | 1,879                                                              |       | 7,315 |   | 1,137 |   | 2,371 |   | 3,508 |   |
|                                                      |       |                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Net  revenues                                             |       | 353,071                                                            |       | 87,422                                                             |       | 440,493 |   | 316,371 |   | 93,925 |   | 410,296 |   |
| Cost of revenue  (excludes amortization, presented below) |       | 234,973                                                            |       | 22,923                                                             |       | 257,896 |   | 187,326 |   | 23,483 |   | 210,809 |   |
| Gross  profit                                             |       | 118,098                                                            |       | 64,499                                                             |       | 182,597 |   | 129,045 |   | 70,442 |   | 199,487 |   |
| Gross  margin                                             |       | 33                                                                 | %          | 74                                                                 | %          | 41 | % | 41 | % | 75 | % | 49 | % |
|                                                      |       |                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Research and  development                                 |       | 18,339                                                             |       | 11,108                                                             |       | 29,447 |   | 18,493 |   | 11,347 |   | 29,840 |   |
| Selling and marketing                                     |       | 12,656                                                             |       | 26,447                                                             |       | 39,103 |   | 12,800 |   | 28,867 |   | 41,667 |   |
| Contribution                                              |       | $                                                                  | 87,103     |                                                               | $          | 26,944 |   | 114,047 |   | $ | 97,752 |   | $ | 30,228 |   | 127,980 |   |
| Contibution  margin                                       |       | 25                                                                 | %          | 31                                                                 | %          | 26 | % | 31 | % | 32 | % | 31 | % |
|                                                      |       |                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| General and  administrative                               |       |                                                               |       |                                                               |       | 25,364 |   |   |   |   |   | 23,508 |   |
| Amortization                                              |       |                                                               |       |                                                               |       | 39,392 |   |   |   |   |   | 41,100 |   |
| Loss on impairment                                        |       |                                                               |       |                                                               |       | — |   |   |   |   |   | — |   |
| Operating  income                                         |       |                                                               |       |                                                               |       | $ | 49,291 |   |   |   |   |   | $ | 63,372 |   |
| Operating margin                                          |       |                                                               |       |                                                               |       | 11 | % |   |   |   |   | 15 | % |

 
| ** **                                                | ** ** | **Nine Months Ended September 30, 2006** | ** ** | **Nine Months Ended September 30, 2005** | ** ** |
|-----------------------------------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                | ** ** | **Generic**                                                       | ** ** | **Brand**                                                         | ** ** | **Total** | ** ** | **Generic** | ** ** | **Brand** | ** ** | **Total** | ** ** |
|                                                      |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Product sales                                             |       | $                                                                 | 1,088,491  |                                                              | $          | 256,831 |   | $ | 1,345,322 |   | $ | 920,850 |   | $ | 296,826 |   | $ | 1,217,676 |   |
| Other                                                     |       | 7,101                                                             |       | 5,659                                                             |       | 12,760 |   | 3,372 |   | 6,342 |   | 9,714 |   |
|                                                      |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Net revenues                                              |       | 1,095,592                                                         |       | 262,490                                                           |       | 1,358,082 |   | 924,222 |   | 303,168 |   | 1,227,390 |   |
| Cost of revenue  (excludes amortization, presented below) |       | 758,921                                                           |       | 64,589                                                            |       | 823,510 |   | 558,657 |   | 70,315 |   | 628,972 |   |
| Gross profit                                              |       | 336,671                                                           |       | 197,901                                                           |       | 534,572 |   | 365,565 |   | 232,853 |   | 598,418 |   |
| Gross margin                                              |       | 31                                                                | %          | 75                                                                | %          | 39 | % | 40 | % | 77 | % | 49 | % |
|                                                      |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Research and  development                                 |       | 56,958                                                            |       | 33,451                                                            |       | 90,409 |   | 59,455 |   | 30,709 |   | 90,164 |   |
| Selling and marketing                                     |       | 39,120                                                            |       | 85,187                                                            |       | 124,307 |   | 35,748 |   | 86,867 |   | 122,615 |   |
| Contribution                                              |       | $                                                                 | 240,593    |                                                              | $          | 79,263 |   | 319,856 |   | $ | 270,362 |   | $ | 115,277 |   | 385,639 |   |
| Contibution  margin                                       |       | 22                                                                | %          | 30                                                                | %          | 24 | % | 29 | % | 38 | % | 31 | % |
|                                                      |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| General and administrative                                |       |                                                              |       |                                                              |       | 77,684 |   |   |   |   |   | 74,336 |   |
| Amortization                                              |       |                                                              |       |                                                              |       | 121,593 |   |   |   |   |   | 122,839 |   |
| Loss on impairment                                        |       |                                                              |       |                                                              |       | 66,981 |   |   |   |   |   | — |   |
| Operating income                                          |       |                                                              |       |                                                              |       | $ | 53,598 |   |   |   |   |   | $ | 188,464 |   |
| Operating margin                                          |       |                                                              |       |                                                              |       | 4 | % |   |   |   |   | 15 | % |

 

For additional information on the impact of theAndrx Acquisition on our operating segments related to Andrx, refer to NOTE 12 –SUBSEQUENT EVENTS.

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**NOTE 6 –INVENTORIES**

Inventoriesconsist of finished goods held for sale and distribution, raw materials andwork-in-process. Included in inventory at September 30, 2006 and December 31,2005 is approximately $11.3 and $6.0 million, respectively, of inventory thatis pending approval by the U.S. Food and Drug Administration (“FDA”) or has notbeen launched due to contractual restrictions. This inventory consists of generic pharmaceutical products that arecapitalized only when the bioequivalence of the product is demonstrated or theproduct is already FDA approved and is awaiting a contractual triggering eventto 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):
|                   | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------|------------|------------------------|------------|-----------------------|------------|
| ** **        | ** ** | **2006**               | ** ** | **2005**              | ** ** |
|              |       |                   |       |                  |       |
| Raw materials     |       | $                      | 94,673     |                  | $          | 85,983 |   |
| Work-in-process   |       | 57,121                 |       | 67,173                |       |
| Finished goods    |       | 166,372                |       | 124,906               |       |
| Total inventories |       | $                      | 318,166    |                  | $          | 278,062 |   |

 

**NOTE 7 – ASSET IMPAIRMENT CHARGES**

In Accordance with SFASNo. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS144”), Watson reevaluates the carrying value of identifiable intangible andlong-lived assets for impairment whenever events or changes in circumstancesindicate that the carrying value may not be recoverable.  SFAS 144 defines impairment as the conditionthat exists when the carrying amount of a long-lived asset exceeds its fairvalue.  An impairment loss is recognizedonly if the carrying amount of a long-lived asset is not recoverable andexceeds its fair value.

In the quarter endedJune 30, 2006, revisions to the Company’s long range product sales forecastwere deemed necessary as a result of a detailed analysis of prescription trendsand a review of sales and inventory data provided by our largestcustomers.  As a result of these downwardrevisions to our long range product sales forecast, the Company conducted aproduct right impairment review.  Resultsof our impairment review indicated future undiscounted cash flows for fourproduct rights were less than their respective carrying values.  An analysis was undertaken to determine thefair values for the four product rights and an impairment of approximately$67.0 million was recognized predominantly relating to Alora®(purchased in 1999) and Actigall®(purchased in 2002).

**NOTE 8 – GOODWILL AND OTHERINTANGIBLE ASSETS**

Watson tests itsgoodwill and intangible assets with indefinite lives by comparing the fairvalue of each of the Company’s reporting units to the respective carrying valueof the reporting units.  The Companyperforms this impairment testing annually during the second quarter and whenevents occur or circumstances change that would more likely than not reduce thefair value of a reporting unit below its carrying amount.  The Company’s two reporting units are Brandand Generic pharmaceutical products.  Thecarrying value of each reporting unit is determined by assigning the assetsemployed in, and liabilities relating to, to those reporting units, includingthe existing goodwill and intangible assets. Goodwill is considered impaired if the carrying amount exceeds the fairvalue of the reporting unit.  During thesecond quarter of 2006, Watson performed its annual assessment for theimpairment of goodwill and determined there was no indication of impairment.

During the nine months ended September30, 2006, in conjunction with the acquisition of Sekhsaria, the total purchaseprice in excess of the fair value of net assets acquired amounted to $24.3million (See Note 3 –

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ACQUISITIONS). This entire amount was recorded as an addition to goodwill under theGeneric pharmaceutical product segment. Goodwill for the Company’s reporting units consisted of the following(in thousands):
|                                  | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| ** **                       | ** ** | ** **             | ** ** | ** **            | ** ** |
| Brand pharmaceutical  products   |       | $                      | 368,105    |                  | $          | 368,105 |   |
| Generic pharmaceutical  products |       | 111,821                |       | 87,490                |       |
| Total goodwill                   |       | $                      | 479,926    |                  | $          | 455,595 |   |

 

Other intangibleassets consist primarily of product rights. The original cost and accumulated amortization of these intangibleassets are as follows (in thousands):
|                                                    | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2006**               | ** ** | **2005**              | ** ** |
|                                               |       |                   |       |                  |       |
| Product rights and  related intangibles            |       | $                      | 1,200,708  |                  | $          | 1,269,513 |   |
| Less accumulated  amortization                     |       | (639,299               | )          | (517,705              | )          |
| Total product rights  and related intangibles, net |       | $                      | 561,409    |                  | $          | 751,808 |   |

 

Based on theCompany’s current intangible assets at September 30, 2006 and assuming nodisposals or additional adjustments are made to the carrying values and/oruseful lives of the assets, annual amortization expense on product rights andrelated intangibles is estimated to be approximately $160.3 million in 2006,$157.7 in 2007, $46.7 million in 2008, $45.7 in 2009 and $38.6 million in2010.  The Company’s current productrights and related intangibles as at September 30, 2006 have a weighted averageuseful life of approximately fourteen years.

For information onthe impact of the Andrx Acquisition on goodwill and other intangible assets,see NOTE 12 – SUBSEQUENTEVENTS.

**NOTE 9 – LONG-TERM DEBT**

Long-term debt consisted of the following (in thousands):
|                                                                                                                           | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                | ** ** | **2006**               | ** ** | **2005**              | ** ** |
|                                                                                                                      |       |                   |       |                  |       |
| CODES, face amount of  $575 million, due 2023, net of unamortized discount                                                |       | $                      | 574,056    |                  | $          | 573,849 |   |
| Senior unsecured notes,  7.125% (“1998 Senior Notes”), face amount of $14 million, net of unamortized  discount |       | —                 |       | 14,054                |       |
| Other notes payable                                                                                                       |       | 10,358                 |       | 32                    |       |
|                                                                                                                      |       | 584,414                |       | 587,935               |       |
| Less: Current portion  of long-term debt                                                                                  |       | 10,336                 |       | —                |       |
| Total long-term debt                                                                                                      |       | $                      | 574,078    |                  | $          | 587,935 |   |

 

*CODES*

In March 2003, theCompany issued $575 million of CODES. The CODES, which are convertible into shares of Watson’s common stockupon the occurrence of certain events, are due in March 2023, with interestpayments due semi-annually in March and September at an effective annualinterest rate of 2.1%, excluding 

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changes in fairvalue of the contingent interest derivative. At September 30, 2006 and December31, 2005, the unamortized discount for the CODES for both periods was $0.9 and1.2 million, respectively.

The CODES areconvertible into Watson’s common stock at a conversion price of approximately$40.05 per share (subject to certain adjustments upon certain events such as(i) stock splits or dividends, (ii) material stock distributions orreclassifications, (iii) distribution of stock purchase rights at less thancurrent market rates or (iv) a distribution of assets or common stock to ourshareholders or subsidiaries).  The CODESmay be converted, at the option of the holders, prior to maturity under any ofthe following circumstances:

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

·                  on or 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 valueassociated with this feature, no value has been assigned at issuance and atSeptember 30, 2006;

·                  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 September 30, 2006;

·                  if the CODEShave been called for redemption; or

·                  upon the occurrenceof specified corporate transactions.

The Company mayredeem 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 CODES containput options which may require the Company to repurchase for cash all or aportion 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, theholders 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% ofthe Company’s then-current estimated per annum borrowing rate for seniornon-convertible fixed-rate debt with a maturity date and other terms comparableto that of the CODES or 0.33% per annum. This contingent interest payment feature is an embedded derivative andhas been bifurcated and recorded separately in the Condensed Consolidated 

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Balance Sheets in otherlong-term liabilities.  The initial fairvalue assigned to the embedded derivative was $1.9 million, which is recordedas a discount to the CODES.  Changes tothe fair value of this embedded derivative are reflected as an adjustment tointerest expense.  The current value ofthe embedded derivative was $ 0.3 and $0.9 million at September 30, 2006 andDecember 31, 2005, respectively.

*1998Senior Notes*

In May 1998,Watson issued $150 million of its 1998 Senior Notes.  The Company was required to make interestonly payments due semi-annually in May and November at an effective annual rateof 7.2%.  In February 2004, the Company initiated atender offer to purchase all of its outstanding 1998 Senior Notes and a relatedconsent solicitation.  The Companyreceived tenders of its 1998 Senior Notes and deliveries of related consentsfrom holders of approximately $101.6 million of the $150 million aggregateprincipal amount of 1998 Senior Notes outstanding.  In May 2004, the Company acquired an additional$34.3 million of its outstanding 1998 Senior Notes in an open markettransaction.  On March 31, 2006,the Company initiated a redemption notice to the holders of all of itsoutstanding 1998 Senior Notes.  As aresult, the remaining 1998 Senior Notes were redeemed on May 23, 2006.

*CreditFacility*

In May 2003, we entered into an agreement with a syndicate of lendersfor a five-year, $300 million senior, unsecured revolving credit facility (the “CreditFacility”) for working capital and other general corporate purposes.  On September 8, 2005, we entered into aSecond Amendment to the Credit Facility on substantially the same terms andconditions except the fee structure was reduced and certain defined terms wereadded or amended.  On March 6, 2006, weentered into a Third Amendment to the Credit Facility which, among otherthings, permits the Company to repurchase up to $300.0 million of its commonstock.  As of September 30, 2006, thetotal $300 million under the Credit Facility was available to us. Watson’sassets generally are held by, and its operations generally are conductedthrough its subsidiaries.  Within themeaning of Regulation S-X, Rule 3-10, the Company has no assets or operationsindependent of its subsidiaries.  Underthe terms of the Credit Facility, each of our subsidiaries, other than minorsubsidiaries, entered into a full and unconditional guarantee on a joint andseveral basis.  In order to providesubsidiary guarantees in connection with the Credit Facility, we were requiredto issue similar guarantees to the 1998 Senior Note holders.  The subsidiary guarantees related to both theCredit Facility and the 1998 Senior Notes are full and unconditional, on ajoint and several basis, and are given by all subsidiaries other than minorsubsidiaries.  As of September 30, 2006and December 31, 2005, the Company had not drawn any funds from the CreditFacility.  Watson is subject to certainfinancial and operational covenants, all of which, as of September 30, 2006, the Company was in compliance.  On November 3, 2006, in conjunction with theAndrx Acquisition and the entering into a new credit agreement, we terminatedour existing Credit Facility.  Foradditional information on the impact of the Andrx Acquisition on long-term debtand our existing Credit Facility related to the Andrx Acquisition, refer toNOTE 12 – SUBSEQUENT EVENTS.

**NOTE 10 –FINANCIAL INSTRUMENTS**

*Fairvalue of 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 ofinvestments in companies that are publicly traded are based on quoted marketprices.  The fair value of investments inprivately held companies, or cost-method investments, are based on historicalcost, adjusted for any write-down related to impairment.  The Company estimates the fair value of itsfixed rate long-term obligations based on quoted 

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market rates of interestand maturity 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 9 for a more detailed descriptionof these features of the CODES.  Althoughthe conversion features represent embedded derivative financial instruments,based on the de minimis value of these features at the time of issuance and atSeptember 30, 2006, 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.

The carrying valueof the Company’s derivative financial instruments, which approximates fairvalue, decreased $0.6 million from $0.9 million at December 31, 2005 to $0.3million at September 30, 2006.  Thechange in fair value was recorded as an adjustment to interest expense duringthe respective period.

**NOTE 11 –COMMITMENTS AND CONTINGENCIES**

*Facility and Equipment Leases*

The Company has entered into long-termoperating 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 nine months ended September 30, 2006 and 2005 were $6.2 million and $7.8 million, respectively.

Future minimum lease payments under allnon-cancelable operating leases as at September 30, 2006 consist ofapproximately $2.1 million remaining in 2006, $7.4 million in 2007, $5.4million in 2008, $4.4 million in 2009, $2.4 million in 2010 and $13.8 millionthereafter.

*Employee Retirement Plans*

The Company maintains certain definedcontribution retirement plans covering substantially all employees.  The Company contributes to the plans basedupon the employee contributions.  Watson’scontributions to these retirement plans for the three and nine months ended September30, 2006 were $1.4 million and$5.0 million, respectively. Watson’s contributions to these retirement plansfor the three and nine months ended September 30, 2005 were $1.4 million and $4.8 million,respectively.  The Company does notsponsor any defined benefit retirement plans or postretirement benefit plans.

*Legal Matters*

TheCompany is party to certain lawsuits and legal proceedings, which are describedin “PART I, ITEM 3. LEGAL PROCEEDINGS,” of our Annual Report on Form 10-K forthe year ended December 31, 2005.  Thefollowing is a description of material developments during the period coveredby this Quarterly Report and through the filing of this Quarterly Report, andshould be read in conjunction with the Annual Report referenced above.

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*Governmental ReimbursementInvestigations And Drug Pricing Litigation.* With respect to the Drug Pricing Litigationpending against the Company and certain subsidiaries, an additional action hasbeen filed by the Attorney General of the State of Alaska naming the Company and other drugmanufacturers as defendants and raising similar allegations to those filed bythe Attorneys General of several other states.  *(State ofAlaska v. Abbott Laboratories, Inc., et al.* in the Superior Courtfor the Third Judicial Circuit, Civil Action No. 3AN-06-12026 CI).  Additional actions in other states are anticipated.  Additionally, Andrx Corporation and itssubsidiaries, which the Company recently acquired, are named as defendants inseveral cases in which the Company and its subsidiaries already were named as adefendant, including cases filed by the Counties of Erie, Schenectady, andOswego, New York, and the Attorneys General of the States of Alabama andMississippi.   These actions, ifsuccessful, could adversely affect the Company and may have a material adverseeffect on the Company’s business, results of operations, financial conditionand cash flows.

*Naproxen Sodium (Naprelan).* InOctober 1998, Elan Corporation Plc sued Andrx in the United States DistrictCourt for the Southern District of Florida, alleging that Andrx’s pending ANDAfor a generic version of Elan’s Naprelan® infringed Elan’s patent No.5,637,320.  (*Elan Corporation PLC v. Andrx Pharmaceuticals, Inc.,* CaseNo. 98-7164).  In March 2002, theDistrict Court issued an order that Elan’s patent was invalid, and in September2002, Andrx commenced selling the 500mg strength of naproxen sodium, itsgeneric version of Naprelan®.  In March2003, the District Court issued an order denying, among other things, (i) Elan’smotion for consideration of the March 2002 order invalidating its patent, and(ii) Andrx’s motion asking the District Court for a ruling on itsnon-infringement defenses.  Both partiesappealed that March 2003 decision.  (*Elan Corporation PLC v. Andrx Pharmaceuticals, Inc.,*Case No. 03-1354).  On May 5, 2004, theFederal Circuit Court of Appeals reversed the District Court’s determinationthat the Elan patent was invalid, and remanded the case back to the DistrictCourt for a determination as to whether Andrx’s product infringes the Elanpatent.  On July 12, 2005, the FederalCircuit Court of Appeals issued a decision, in an unrelated case, on how acourt should address issues of claim construction, and the District Courtinstructed the parties to file briefs on how the District Court should proceedin this matter in light of the Federal Circuit Court of Appeals decision.  The parties filed their briefs and areawaiting the court’s decision.

In January 2005, Elan filed a complaint in the U.S.District Court for the Southern District of Florida seeking willful damages asa result of Andrx’s sale of its generic version of Naprelan®.  (*ElanCorporation PLC v. Andrx Pharmaceuticals, Inc.,* Case No. 058-60158).  In February 2005, Andrx filed its answer toElan’s January 2005 complaint and filed a counterclaim for declaratory relieffor unenforceability due to inequitable conduct and for non-infringement andinvalidity of the applicable patent. This matter has been stayed pending resolution of the infringementaction.  Andrx has sold and is continuingto sell its generic version of the 500mg strength of Naprelan®.  Therefore, an adverse determination couldhave a material adverse effect on the Company’s business, results ofoperations, financial condition and cash flows.

*Mallinckrodt Claim.* OnFebruary 17, 2006, Andrx filed a complaint against Mallinckrodt in the U.S.District Court for the Southern District of Florida.  (*AndrxTherapeutics, Inc v. Mallinckrodt, Inc..,* Case No. 06-60210). Thecomplaint results from a dispute over certain agreements, including a supplyand marketing agreement entered into between Andrx and Mallinckrodt.  The complaint seeks to establish the parties’rights under the agreements, a judgment declaring that the agreements are stillin force and that Andrx has not defaulted in its obligations.  In the alternative, Andrx seeks a judgmentfor either breach of contract for anticipatory repudiation or for breach ofduty of good faith.  On March 10, 2006,Mallinckrodt filed suit against Andrx in state court in Missouri, arising fromthe same dispute referenced above.  (*Mallinckrodt, Inc. v. Andrx Laboratories, Inc., etal.,* Case No. 06-1000).  Inits suit, Mallinckrodt alleges breach of contract, breach of implied covanentof good faith and fair dealing and seeks damages of $3.8 million, along with adeclaratory judgment and injunctive relief. This matter is set for trial on March 5, 2007.

*Securities Litigation Against Andrx Corporation.*  OnOctober 11, 2005, Jerry Lowry filed a class action complaint on behalf ofpurchasers of the Andrx’s common stock during the class period (March 9,2005 through 

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September 5,2005) in the U.S. District Court for the Southern District of Florida againstAndrx Corporation and its Chief Executive Officer. (*Jerry Lowryv. Andrx Corporation, et al.,* Case No. 05-61640).  The complaint seeks damages under theSecurities Exchange Act of 1934, as amended, and alleges that during the classperiod, it failed to properly disclose the status of its compliance with cGMPestablished by the FDA. The complaint also alleges that the plaintiffs suffereddamages as a result of its disclosure on September 6, 2005 that FDA placedthe Company in Official Action Indicated status and a subsequent decline in thetrading price of its common stock from $17.94 on September 5, 2005 to aclosing price of $14.89 on September 6, 2005.   On December 14, 2005, a shareholders’derivative action was filed in the U.S. District Court for the SouthernDistrict of Florida by Greg Umeda on behalf of Andrx, against Andrx’s ChiefExecutive Officer, former Chief Financial Officer, the Board of Directors andAndrx (as a nominal defendant in the U.S. District Court for the SouthernDistrict of Florida) for alleged breach of fiduciary duties, abuse of control,gross mismanagement, waste of corporate assets and unjust enrichment betweenMarch 2005 and December 2005.  (*Greg Umeda v. Thomas Rice, et al.,* Case No. 05-61796).  The complaint alleges that the individualdefendants breached their fiduciary duties by allowing Andrx to issuestatements that claimed Andrx was in compliance with FDA regulations and alsofrom withholding from the public during the relevent period material non-publicinformation relating to Andrx’s cGMP violations at its manufacturingfacilities.  The plaintiff furtheralleges that as a result of the wrongdoing, Andrx’s stock dropped from $17.94on September 2, 2005 to a closing price of $14.89 on September 6, 2005.  On January 6, 2006, a second shareholders’derivative action was filed by Joseph Michael on behalf of Andrx, against Andrx’sChief Executive Officer and the members of the Board of Directors in the U.S.District Court for the Southern District of Florida.  (*Joseph Michael v. ThomasRice, et al.,* Case No. 05-60019). The complaint alleges violations of state law, including breaches offiduciary duties, abuse of control, gross mismanagement, waste of corporateassets, unjust enrichment and negligence that occurred from March 9, 2005through January 6, 2006, and that have allegedly caused substantial losses toAndrx.  On March 13, 2006, these twoderivative cases were consolidated under *Greg Umeda v. Thomas Rice,et al.,* Case No. 05-61796.  OnAugust 16, 2006, the court entered an order administratively closing the caseand ordering the parties to file a joint status report once a ruling is issuedon Andrx’s motion to dismiss in the pending *Lowry v. AndrxCorporation, et al.,* Case No. 05-61640.  Though we are not in a position to determinethe ultimate outcome of these matters, an adverse determination of any of theseactions could have a material adverse effect on the Company’s business, resultsof operations, financial condition and cash flows.

*Securities Litigation Against Watson. *In the actionpending in the U.S. Court of Appeals for the Ninth Circuit (*Pension Fund v. Watson Pharmaceuticals, Inc*., USCA DocketNo. 04-56791), the Court has set a hearing on the pending appeal for November17, 2006.

Watson and itsaffiliates are involved in various other disputes, governmental and/orregulatory inspections, inquires, investigations and proceedings, andlitigation matters that arise from time to time in the ordinary course ofbusiness.  The process of resolvingmatters through litigation or other means is inherently uncertain and it ispossible that an unfavorable resolution of these matters will adversely affectthe Company, its results of operations, financial condition and cash flows.

**NOTE 12 –SUBSEQUENTEVENTS**

*Acquisitionof Andrx Corporation*

On November 3, 2006, pursuant to the definitivemerger agreement (the “Merger Agreement”), dated March 13, 2006, as amended, byand among Watson, Andrx and Water Delaware, Inc., a wholly owned subsidiary ofWatson, we completed our acquisition of Andrx, for total consideration ofapproximately $1.9 billion, in an all-cash transaction for $25 per share.  Andrx distributes pharmaceutical productsprimarily to independent and chain pharmacies and physicians’ offices and isconsidered a leader in formulating and commercializing difficult-to-replicatecontrolled-release pharmaceutical products and selective immediate-releaseproducts.

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The Andrx Acquisition will be accounted for as abusiness purchase combination using the purchase method of accounting under theprovisions of Statement of Financial Accounting Standards No. 141, “BusinessCombinations” (“SFAS 141”).  Theallocation of consideration for acquisitions requires extensive use ofaccounting estimates and management judgment to allocate the purchase price oftangible and identifiable intangible assets acquired and liabilities assumedbased on their respective fair values. The purchase price for the Andrx Acquisition will be allocated totangible and identifiable intangible assets acquired and liabilities assumedbased on their estimated fair values at the acquisition date, with any excessbeing allocated to goodwill.

As a result of the Andrx Acquisition, Watson willhave three operating segments: Generic, Brand and Distribution.  Distribution will include results from Andrx’sformer operating segment Distributed Products. Andrx’s former Generic Products operating segment results will beincluded in Watson’s Generic segment results. With certain exceptions, Andrx’s former Contract Services operatingsegment results will be included in Watson’s Brand segment results.

Grossunrealized gains at September 30, 2006 and December 31, 2005 primarily relateto our holdings in shares of Andrx common stock.  The Company’s net unrealized gain related toour holdings in shares of Andrx common stock of $8.2 million at September 30,2006 will be reversed effective November 3, 2006 in our Statement ofComprehensive Income as a result of the Andrx Acquisition.

*Financingof Andrx Acquisition*

The Andrx Acquisition was funded using existing Andrx and Watson cash andcash equivalents, the proceeds from the sale of marketable securities and certainAndrx long term investments and $650 million in borrowings from a new seniorcredit facility.

On November 3, 2006, Watson entered into a Senior Credit Facility (the “NewCredit Agreement”) with Canadian Imperial Bank of Commerce, acting through its NewYork agency, as Administrative Agent, Wachovia Capital Markets, LLC, asSyndication Agent, and a syndicate of banks (collectively, the “Lenders”).  The Credit Agreement provides an aggregate of$1.15 billion of senior financing to Watson, consisting of a $500 millionrevolving credit facility (“Revolving Facility”) and a $650 million senior termloan facility (“Term Facility”).

The New Credit Agreement has a five year term and will bear interestequal to LIBOR plus 0.75% (subject to certain adjustments).  The indebtedness under the New CreditAgreement is guaranteed by Watson’s material domestic subsidiaries.  The Revolving Facility is available forworking capital and other general corporate requirements subject to thesatisfaction of certain conditions.  Theterms of the New Credit Agreement required that the entire amount under theTerm Facility be drawn on the closing date of the Acquisition.  With certain exceptions, quarterly principlepayments of $25 million will be required on the Term Facility, under the termsof the New Credit Agreement, beginning March 31, 2007 with the remainder due onmaturity.  Indebtedness under the NewCredit Agreement may be pre-payable, and commitments reduced at the election ofWatson without premium (subject to certain conditions).

The New Credit Agreement replaces the Company’sexisting Credit Facility which was terminated on November 3, 2006.  As of November 3, 2006 and September 30,2006, the Company had not drawn any funds from the existing Credit Facility.

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Foradditional information on the Andrx Acquisition, refer to our Current Report onForm 8-K filed on November 6, 2006.

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

The following discussion of our financial conditionand the results of operations should be read in conjunction with the CondensedConsolidated Financial Statements and notes thereto included elsewhere in thisQuarterly Report on Form 10-Q (“Quarterly Report”).  This discussion contains forward-lookingstatements that are subject to known and unknown risks, uncertainties and otherfactors that may cause our actual results to differ materially from thoseexpressed or implied by such forward-looking statements.  These risks, uncertainties and other factorsinclude, among others, those identified under “Cautionary Note RegardingForward-Looking Statements” and elsewhere in this Quarterly Report and under “RisksRelated to our Business” in our Annual Report on Form 10-K for the year endedDecember 31, 2005.

**Overview**

Watson Pharmaceuticals, Inc. (“Watson”, the “Company” “we”, “us” or “our”)was incorporated in 1985 and is engaged in the development, manufacture,marketing, sale and distribution of brand and off-patent (generic)pharmaceutical products. Watson operates manufacturing, distribution, researchand development, and administrative facilities primarily in the United States (“U.S.”).

Prescription pharmaceutical products in the U.S. are generally marketedas either generic or brand pharmaceuticals. Generic pharmaceutical products are bioequivalents of their respectivebrand products and provide a cost-efficient alternative to brand products.Brand pharmaceutical products are marketed under brand names through programsthat are designed to generate physician and consumer loyalty.  As a result of the differences between thetwo types of products, we currently operate and manage our business as twosegments: Generic and Brand.

The Company has announced several recent cost reduction initiativesthat will take place by early 2007 including the closure of our Puerto Ricomanufacturing facility and the planned divestiture of our Phoenix, Arizonainjectable facility.  The Company is alsoestablishing a foreign operating infrastructure to supply the U.S. market whichincludes a recently acquired solid dose manufacturing facility in Goa, India;an increased investment in a Chinese/Taiwanese company specializing in thedevelopment and manufacture of active pharmaceutical ingredients (“API”); andthe acquisition of Mumbai, India-based Sekhsaria Chemicals, Ltd. (“Sekhsaria”) thatprovides API and finished dosage formulation expertise to the globalpharmaceutical industry.

On November 3, 2006, the Company acquired all theoutstanding shares of common stock of Andrx Corporation (“Andrx”) in anall-cash transaction for $25 per share, or total consideration of approximately$1.9 billion (the “Andrx Acquisition”). Andrx distributes pharmaceutical products primarily to independent andchain pharmacies and physicians’ offices and is considered a leader informulating and commercializing difficult-to-replicate controlled-releasepharmaceutical products and selective immediate-release products.  As a result of the Andrx Acquisition, Watsonwill have three operating segments: Generic, Brand and Distribution.  For additional information on the AndrxAcquisition, refer to NOTE 12 – SUBSEQUENT EVENTS in the accompanying Notes toCondensed Consolidated Financial Statements in this Quarterly Report and to ourCurrent Report on Form 8-K filed on November 6, 2006.

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**Resultsof Operations**

***Three Months Ended September 30,2006 Compared to the Three Months Ended September 30, 2005***

***NetRevenues***
|                                     | ** ** | **Three Months Ended September 30,** | ** ** | **Change** | ** ** |
|-------------------------------------|------------|----------------------------------------------------------|------------|------------|------------|
| **($ in thousands):**     | ** ** | **2006**                                                 | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                |       |                                                     |       |       |       |   |   |   |   |
| Generic segment                     |       |                                                     |       |       |       |   |   |   |   |
| Generics                            |       | $                                                        | 263,748    |       | $          | 234,122 |   | $ | 29,626 |   | 12.7 | % |
| Generic oral contraceptives         |       | 83,887                                                   |       | 81,112     |       | 2,775 |   | 3.4 | % |
| Total generic  product sales        |       | 347,635                                                  |       | 315,234    |       | 32,401 |   | 10.3 | % |
| Other                               |       | 5,436                                                    |       | 1,137      |       | 4,299 |   | 378.1 | % |
| Total generic  segment net revenues |       | 353,071                                                  |       | 316,371    |       | 36,700 |   | 11.6 | % |
|                                |       |                                                     |       |       |       |   |   |   |   |
| Brand segment                       |       |                                                     |       |       |       |   |   |   |   |
| Specialty Products                  |       | 43,910                                                   |       | 46,385     |       | (2,475 | ) | (5.3 | )% |
| Nephrology                          |       | 41,633                                                   |       | 45,169     |       | (3,536 | ) | (7.8 | )% |
| Total brand  product sales          |       | 85,543                                                   |       | 91,554     |       | (6,011 | ) | (6.6 | )% |
| Other                               |       | 1,879                                                    |       | 2,371      |       | (492 | ) | (20.8 | )% |
| Total brand  segment net revenues   |       | 87,422                                                   |       | 93,925     |       | (6,503 | ) | (6.9 | )% |
| * *                            | * *   | * *                                                 | * *   | * *   | * *   | * * | * * | * * | * * |
| Total net  revenues                 |       | $                                                        | 440,493    |       | $          | 410,296 |   | $ | 30,197 |   | 7.4 | % |

 

*Generic Segment*

Our generic pharmaceutical business develops, manufactures, markets,sells and distributes generic products that are the therapeutic equivalent totheir brand name counterparts and are generally sold at prices significantlyless than the brand product. As such, generic products provide an effective andcost-efficient alternative to brand products. When patents or other regulatoryexclusivity no longer protect a brand product, opportunities exist to introduceoff-patent or generic counterparts to the brand product. Our portfolio ofgeneric products includes products we have internally developed, products wehave licensed from third parties, and products we distribute for third parties.

Other revenues include royalties and, beginning in 2006, commissionrevenue earned as a sales agent of Cephalon, Inc., from the launch of FentanylCitrate.

Our Generic segment develops, manufactures, markets, sells anddistributes products within two product lines: Generics and Generic OralContraceptives (“Generic OC’s”).

Our Generics product line includes oral dosage, transdermal, injectableand transmucosal products used for a variety of indications including painmanagement, depression, hypertension and smoking cessation.

For the three months ended September 30, 2006, revenues from ourGeneric segment increased $36.7 million or 12% over sales from the prior yearperiod.  Sales increased due to certainrecently launched authorized generic products including oxycodone HClcontrolled-release tablets that were launched during the fourth quarter of 2005and pravastatin sodium tablets that were launched during the second quarter of2006.  Sales from these authorizedgeneric products were $75.1 million during the third quarter of 2006.  Excluding these recently launched authorizedgeneric products, revenues in our Generic segment declined by $38.4 million or12%.  This decline was primarily due tolower pricing in the current year period and a decline in unit sales due tofluctuations in customer buying patterns offset, in part, by higher sales ofGeneric OC’s and other 

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revenue as a result of the launch of Quasense and Fentanyl Citrateduring the three months ended September 30, 2006.

*Brand Segment*

Our brandpharmaceutical business develops, manufactures, markets, sells and distributesproducts within two sales and marketing groups: Specialty Products andNephrology.

Our Specialty Products product line includes urology and a number ofother non-promoted products.

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

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

For the three months ended September 30, 2006,revenues from our Specialty Products group declined approximately $2.5million or 5%.  The decrease in salesfrom our Specialty Products group forthe three months ended September 30,2006, as compared to the prior year period was primarily attributable to adecrease in pricing on Trelstar® Depotand Trelstar® LA, products for the palliative treatment of advanced prostatecancer, which were launched in the second quarter of 2005.

For the three months ended September 30, 2006,revenues from our Nephrology group declined approximately $3.5 millionor 8%.  The decrease in sales from our Specialty Products group for the threemonths ended September 30, 2006,as compared to the prior year period was primarily attributable to a decreasein sales of Ferrlecit® as a result of a loss of a customer.

***GrossProfit (Gross Margin)***
|                                       | ** ** | **Three Months Ended September 30,** | ** ** |
|---------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                                 | ** ** | **2005** | ** ** | **Change** | ** ** |
|                                  |       |                                                     |       |   |   |   |   |
| Overall  Consolidated Gross Margin    |       | 41.5                                                     | %          | 48.6 | % | (7.1 | )% |
|                                  |       |                                                     |       |   |   |   |   |
| Generic pharmaceutical products       |       | 32.4                                                     | %          | 40.6 | % | (8.2 | )% |
| Brand pharmaceutical products         |       | 73.2                                                     | %          | 74.4 | % | (1.2 | )% |
| Gross margin on  product net revenues |       | 40.5                                                     | %          | 48.2 | % | (7.7 | )% |

 

Gross profitrepresents net revenues less cost of sales. Cost of sales includes the cost of manufacturing and packaging for theproducts we manufacture, the cost of products we purchase from third parties,our profit-sharing or royalty payments made to third parties, changes to ourinventory reserves and excess capacity utilization charges, whereapplicable.  Amortization of acquiredproduct rights is not included in our cost of sales.

Gross margins forour Generic product sales declined to 32.4% from 40.6% in the year agoperiod.  The decrease in gross marginfrom our Generic product sales for the three months ended September 30, 2006 was primarily dueto sales of oxycodone HClcontrolled-release tablets and pravastatin sodium tablets during the 

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third quarter of 2006.  Salesfrom these authorized generic products generated $11.7 million of gross profiton $75.1 million of revenues.  Excludingthese newly launched products, the gross margin for our Generic segment was37.1%.  Margins in our Generic segmentwere also adversely impacted by plant rationalization costs of $3.8 million inthe third quarter of 2006 and price declines over the past year on existingproducts.

During the thirdquarter of 2006, gross margins from our Brand segment declined to 73.2% from74.4% due to sales mix and plant rationalization costs incurred in connectionwith the planned divestiture of our Phoenix, Arizona sterile manufacturingfacility.

***Researchand Development Expenses***
|                                                | ** ** | **Three Months Ended September 30,** | ** ** | **Change** | ** ** |
|------------------------------------------------|------------|----------------------------------------------------------|------------|------------|------------|
| **($ in thousands):**                | ** ** | **2006**                                                 | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                           |       |                                                     |       |       |       |   |   |   |   |
| Research and  development expenses by segment: |       |                                                     |       |       |       |   |   |   |   |
| Generic                                        |       | $                                                        | 18,339     |       | $          | 18,493 |   | $ | (154 | ) | (0.8 | )% |
| Brand                                          |       | 11,108                                                   |       | 11,347     |       | (239 | ) | (2.1 | )% |
| Total research  and development expenses       |       | $                                                        | 29,447     |       | $          | 29,840 |   | $ | (393 | ) | (1.3 | )% |
| *as a %  of net revenues*                      | * *   | *6.7*                                                    | *%*        | *7.3*      | *%*        | * * | * * | * * | * * |

 

Research anddevelopment expenses consist predominantly of personnel costs, contractresearch, development and facilities costs associated with the development ofour products.   The level ofresearch and development expenses are influenced greatly by the commencementand termination of development programs and clinical studies during eachquarter.

Research anddevelopment expenses during the three months ended September 30, 2006 remained at similarlevels compared to the same period of the prior year.

***Selling,General and Administrative Expenses***
|                                                     | ** ** | **Three Months Ended September 30,** | ** ** | **Change** | ** ** |
|-----------------------------------------------------|------------|----------------------------------------------------------|------------|------------|------------|
| **($ in thousands):**                     | ** ** | **2006**                                                 | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                                |       |                                                     |       |       |       |   |   |   |   |
| Selling and  marketing expenses by segment:         |       |                                                     |       |       |       |   |   |   |   |
| Generic                                             |       | $                                                        | 12,656     |       | $          | 12,800 |   | $ | (144 | ) | (1.1 | )% |
| Brand                                               |       | 26,447                                                   |       | 28,867     |       | (2,420 | ) | (8.4 | )% |
| Total segment  selling and marketing expenses       |       | 39,103                                                   |       | 41,667     |       | (2,564 | ) | (6.2 | )% |
| Corporate general and administrative                |       | 25,364                                                   |       | 23,508     |       | 1,856 |   | 7.9 | % |
| Total selling,  general and administrative expenses |       | $                                                        | 64,467     |       | $          | 65,175 |   | $ | (708 | ) | (1.1 | )% |
| *as a %  of net revenues*                           | * *   | *14.6*                                                   | *%*        | *15.9*     | *%*        |   |   |   |   |

 

Selling, generaland administrative expenses consist mainly of personnel costs, facilitiescosts, insurance and professional services costs, which support our sales,marketing, human resources, finance and administration functions.

Brand segment selling and marketing expenses decreased during the threemonths ended September 30, 2006 as compared to the same period of the prioryear due to lower product spending for Oxytrol® during the current quarter.

Corporate general and administrative expenses increased during three months ended September30, 2006 as compared to the same period of the prior year due to highercorporate insurance costs and administrative costs 

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associated with our recently acquired operations in India offset inpart by lower legal costs as a result of amounts received in settlement of alitigation matter.

***Amortization***
|                                 | ** ** | **Three Months Ended September 30,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                                                 | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                            |       |                                                     |       |       |       |   |   |   |   |
| Amortization                    |       | $                                                        | 39,392     |       | $          | 41,100 |   | $ | (1,708 | ) | (4.2 | )% |
| *as a %  of net revenues*       | * *   | *8.9*                                                    | *%*        | *10.0*     | *%*        | * * | * * | * * | * * |
|                                 |            |                                                          |            |            |            |  |  |  |  |  |  |  |

 

The Company’samortizable assets consist primarily of acquired product rights.  Amortization expense decreased during the three months ended September 30,2006 as compared to the same period of the prior year due to the product rightimpairment recognized in the second quarter of 2006.

***Earnings(Losses) on Equity Method Investments***
|                                                 | ** ** | **Three Months Ended September 30,** | ** ** | **Change**   | ** ** |
|-------------------------------------------------|------------|----------------------------------------------------------|------------|--------------|------------|
| **($ in thousands):**                 | ** ** | **2006**                                                 | ** ** | **2005**     | ** ** | **Dollars** | ** ** | **%** | ** ** |
| ** **                                      | ** ** | ** **                                               | ** ** | **Restated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Earnings  (losses) on equity method investments |       | $                                                        | 184        |         | $          | (810 | ) | $ | 994 |   | (122.7 | )% |
| *as a %  of net revenues*                       | * *   | *0.0*                                                    | *%*        | *-0.2*       | *%*        | * * | * * | * * | * * |
|                                                 |            |                                                          |            |              |            |  |  |  |  |  |  |  |

 

The Company’sequity investments are accounted for under the equity-method when the Company’sownership does not exceed 50% and when the Company can exert significantinfluence over the management of the investee.  Inthe year ended December 31, 2005 the Company acquired additional common sharesin Scinopharm Taiwan, Ltd. (“Scinopharm”), previously accounted for under thecost method, to an ownership level of approximately 24%. Accordingly, asrequired by Accounting Principles Board (“APB”) Opinion No. 18, “The EquityMethod of Accounting for Investments in Common Stock” (“APB 18”), loss onequity method investments has been restated for all periods presented toconform to current period presentation. In January 2006, we made an additional $12.0 million investment inScinopharm which increased our ownership share to approximately 31%.

The earningsrecorded during the three months ended September 30, 2006 consists primarily of our equity in earningsby Scinopharm.  The change to earnings on equity methodinvestments for the three months endedSeptember 30, 2006 as compared to losses during the same period of the prioryear was primarily due to an improvement in results at Scinopharm fromnet losses to net earnings.

***InterestIncome***
|                                 | ** ** | **Three Months Ended September 30,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                                                 | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                            |       |                                                     |       |       |       |   |   |   |   |
| Interest income                 |       | $                                                        | 9,601      |       | $          | 4,928 |   | $ | 4,673 |   | 94.8 | % |
| *as a %  of net revenues*       | * *   | *2.2*                                                    | *%*        | *1.2*      | *%*        | * * | * * | * * | * * |
|                                 |            |                                                          |            |            |            |  |  |  |  |  |  |  |

 

30

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Interest incomeincreased during thethree months ended September 30, 2006 as compared to the same period of theprior year due to higher balances of cash and marketable securities and higherinterest rates on invested balances in the current quarter.

***InterestExpense***
|                                                                                           | ** ** | **Three Months Ended September 30,** | ** ** | **Change** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|------------|------------|
| **($ in thousands):**                                                           | ** ** | **2006**                                                 | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                                                                      |       |                                                     |       |       |       |   |   |   |   |
| Interest expense  - convertible contingent senior debentures due 2023 (“CODES”) |       | $                                                        | 3,151      |       | $          | 3,151 |   | $ | — |   | 0.0 | % |
| Interest expense  - 1998 Senior Notes                                                     |       | —                                                   |       | 255        |       | (255 | ) | (100.0 | )% |
| Interest and  fees on credit facility                                                     |       | 248                                                      |       | 387        |       | (139 | ) | (35.9 | )% |
| Change in  derivative value                                                               |       | 81                                                       |       | 853        |       | (772 | ) | (90.5 | )% |
| Interest expense  - other                                                                 |       | 334                                                      |       | 44         |       | 290 |   | 659.1 | % |
| Interest expense                                                                          |       | $                                                        | 3,814      |       | $          | 4,690 |   | $ | (876 | ) | (18.7 | )% |
| *as a %  of net revenues*                                                                 | * *   | *0.9*                                                    | *%*        | *1.1*      | *%*        |   |   |   |   |

 

Interest expensedecreased for the three month period ended September 30, 2006 primarily due to amore favorable change in the value of the embedded derivative related to theCODES as compared with the prior year period.

***Provisionfor Income Taxes***
|                                 | ** ** | **Three Months Ended September 30,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                                                 | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                            |       |                                                     |       |       |       |   |   |   |   |
| Provision for  income taxes     |       | $                                                        | 20,453     |       | $          | 23,264 |   | $ | (2,811 | ) | (12.1 | )% |
| *as a % of net revenues*        | * *   | *4.6*                                                    | *%*        | *5.7*      | *%*        | * * | * * | * * | * * |
| *Effective  tax rate*           | * *   | *37.3*                                                   | *%*        | *37.3*     | *%*        | * * | * * | * * | * * |
|                                 |            |                                                          |            |            |            |  |  |  |  |  |  |  |

 

The provision forincome taxes differs from the amount computed by applying the statutory U.S.federal income tax rate primarily due to state taxes and other factors which,combined, increases the effective tax rate.

The Companyrecorded a reduction in provision for income taxes in the three months ended September 30, 2006, compared to the same period of the prioryear, due to lower net income before income tax in the current period.

***SegmentContribution***
|                                 | ** ** | **Three Months Ended September 30,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                                                 | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                            |       |                                                     |       |       |       |   |   |   |   |
| Segment  contribution           |       |                                                     |       |       |       |   |   |   |   |
| Generic                         |       | $                                                        | 87,103     |       | $          | 97,752 |   | $ | (10,649 | ) | (10.9 | )% |
| Brand                           |       | 26,944                                                   |       | 30,228     |       | (3,284 | ) | (10.9 | )% |
|                            |       | $                                                        | 114,047    |       | $          | 127,980 |   | $ | (13,933 | ) | (10.9 | )% |
| *as % of  net revenues*         | * *   | *25.9*                                                   | *%*        | *31.2*     | *%*        | * * | * * | * * | * * |

 

Generic segmentcontribution decreased for the three months ended September 30, 2006, as compared to thesame period of the prior year, primarily due to lower gross profit during thecurrent quarter.

31

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Brand segmentcontribution decreased for the three months ended September 30, 2006, as compared to thesame period of the prior year, primarily due to lower net sales and resultinglower gross profit offset, in part, by lower selling and marketing expenses.

For moreinformation on segment contribution, refer to above Management’s Discussion andAnalysis of Financial Condition and Results of Operations and Note 5 in theaccompanying Notes to Condensed Consolidated Financial Statements in this QuarterlyReport.

**Results of Operations**

***Nine Months Ended September 30,2006 Compared to the Nine Months Ended September 30, 2005***

***NetRevenues***
|                                     | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|-------------------------------------|------------|---------------------------------------------------------|------------|------------|------------|
| **($ in thousands):**     | ** ** | **2006**                                                | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                |       |                                                    |       |       |       |   |   |   |   |
| Generic segment                     |       |                                                    |       |       |       |   |   |   |   |
| Generics                            |       | $                                                       | 850,039    |       | $          | 680,126 |   | $ | 169,913 |   | 25.0 | % |
| Generic OC’s                   |       | 238,452                                                 |       | 240,724    |       | (2,272 | ) | (0.9 | )% |
| Total generic  product sales        |       | 1,088,491                                               |       | 920,850    |       | 167,641 |   | 18.2 | % |
| Other                               |       | 7,101                                                   |       | 3,372      |       | 3,729 |   | 110.6 | % |
| Total generic  segment net revenues |       | 1,095,592                                               |       | 924,222    |       | 171,370 |   | 18.5 | % |
|                                |       |                                                    |       |       |       |   |   |   |   |
| Brand segment                       |       |                                                    |       |       |       |   |   |   |   |
| Specialty Products                  |       | 127,414                                                 |       | 164,557    |       | (37,143 | ) | (22.6 | )% |
| Nephrology                          |       | 129,417                                                 |       | 132,269    |       | (2,852 | ) | (2.2 | )% |
| Total brand  product sales          |       | 256,831                                                 |       | 296,826    |       | (39,995 | ) | (13.5 | )% |
| Other                               |       | 5,659                                                   |       | 6,342      |       | (683 | ) | (10.8 | )% |
| Total brand  segment net revenues   |       | 262,490                                                 |       | 303,168    |       | (40,678 | ) | (13.4 | )% |
| * *                            | * *   | * *                                                | * *   | * *   | * *   | * * | * * | * * | * * |
| Total net  revenues                 |       | $                                                       | 1,358,082  |       | $          | 1,227,390 |   | $ | 130,692 |   | 10.6 | % |

 

*Generic Segment*

For the nine months ended September 30, 2006, revenues from our Genericsegment increased $171.4 million or 19% over sales from the prior yearperiod.  Sales increased due to recentlylaunched authorized generic products including oxycodone HCl controlled-releasetablets, launched during the fourth quarter of 2005, and pravastatin sodiumtablets, launched during the second quarter of 2006.  Sales from these authorized generic productswere $221.2 million during the nine months ended September 30, 2006.  Excluding these recently launched authorizedgeneric products, revenues in our Generic segment declined by $49.8 million or5%.  This decline was due to lowerpricing on the Company’s existing products.

*Brand Segment*

The $37.1 millionor 23% decrease in sales from our Specialty Products group for the nine months ended September 30,2006, as compared to the same prior year period, was primarily attributable toa decrease in prescription volumes for our non-promoted specialty products anda reduction in wholesaler inventory levels resulting from our entry intoinventory management agreements with some of our larger customers during 2005.

32

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The reduction insales for the period was partiallyoffset by sales of our Trelstar®Depot and Trelstar® LA products for the palliative treatment of advancedprostate cancer launched in the second quarter of 2005.

***GrossProfit (Gross Margin)***
|                                       | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                                | ** ** | **2005** | ** ** | **Change** | ** ** |
|                                  |       |                                                    |       |   |   |   |   |
| Overall  Consolidated Gross Margin    |       | 39.4                                                    | %          | 48.8 | % | (9.4 | )% |
|                                  |       |                                                    |       |   |   |   |   |
| Generic pharmaceutical products       |       | 30.3                                                    | %          | 39.3 | % | (9.0 | )% |
| Brand pharmaceutical products         |       | 74.9                                                    | %          | 76.3 | % | (1.4 | )% |
| Gross margin on  product net revenues |       | 38.8                                                    | %          | 48.3 | % | (9.5 | )% |

 

Gross margins fromGeneric product sales declined to 30.3% from 39.3% in the year ago period.  The decrease in gross margin from our Genericsegment was primarily due to sales of oxycodone HCl controlled-release tablets for the nine monthsended September 30, 2006 and pravastatin sodium tablets during thesecond and third quarters of 2006, each of which are lower margin products.

***Researchand Development Expenses***
|                                                | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------------|------------|------------|------------|
| **($ in thousands):**                | ** ** | **2006**                                                | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                           |       |                                                    |       |       |       |   |   |   |   |
| Research and  development expenses by segment: |       |                                                    |       |       |       |   |   |   |   |
| Generic                                        |       | $                                                       | 56,958     |       | $          | 59,455 |   | $ | (2,497 | ) | (4.2 | )% |
| Brand                                          |       | 33,451                                                  |       | 30,709     |       | 2,742 |   | 8.9 | % |
| Total research  and development expenses       |       | $                                                       | 90,409     |       | $          | 90,164 |   | $ | 245 |   | 0.3 | % |
| *as a %  of net revenues*                      | * *   | *6.7*                                                   | *%*        | *7.3*      | *%*        | * * | * * | * * | * * |

 

Research anddevelopment expenses within our Generic segment decreased during the ninemonths ended September 30,2006, as compared to the same period of the prior year, due to lower biostudycosts particularly in the second quarter of 2006.

Research anddevelopment expenses within our Brand segment increased during the nine monthsended September 30, 2006, as compared to the same period of the prior year,primarily due to the commencement of Phase III studies on the gel formulationof oxybutynin for overactive bladder.

33

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***Selling,General and Administrative Expenses***
|                                                     | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------------------|------------|------------|------------|
| **($ in thousands):**                     | ** ** | **2006**                                                | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                                |       |                                                    |       |       |       |   |   |   |   |
| Selling and  marketing expenses by segment:         |       |                                                    |       |       |       |   |   |   |   |
| Generic                                             |       | $                                                       | 39,120     |       | $          | 35,748 |   | $ | 3,372 |   | 9.4 | % |
| Brand                                               |       | 85,187                                                  |       | 86,867     |       | (1,680 | ) | (1.9 | )% |
| Total segment selling  and marketing expenses       |       | 124,307                                                 |       | 122,615    |       | 1,692 |   | 1.4 | % |
| Corporate general and administrative                |       | 77,684                                                  |       | 74,336     |       | 3,348 |   | 4.5 | % |
| Total selling,  general and administrative expenses |       | $                                                       | 201,991    |       | $          | 196,951 |   | $ | 5,040 |   | 2.6 | % |
| *as a %  of net revenues*                           | * *   | *14.9*                                                  | *%*        | *16.0*     | *%*        |   |   |   |   |

 

Generic and segment selling and marketing expenses increased during thenine months ended September 30, 2006 as compared to the same period of theprior year primarily due to higher distribution costs related to higher unitsales.

Brand segment selling and marketing expenses decreased during the ninemonths ended September 30, 2006 as compared to the same period of the prioryear due to lower product spending for Oxytrol®.

***Amortization***
|                                 | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|---------------------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                                                | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                            |       |                                                    |       |       |       |   |   |   |   |
| Amortization                    |       | $                                                       | 121,593    |       | $          | 122,839 |   | $ | (1,246 | ) | (1.0 | )% |
| *as a %  of net revenues*       | * *   | *9.0*                                                   | *%*        | *10.0*     | *%*        | * * | * * | * * | * * |
|                                 |            |                                                         |            |            |            |  |  |  |  |  |  |  |

 

The Company’samortizable assets consist primarily of acquired product rights.

***Losson Impairment***
|                                       | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|---------------------------------------|------------|---------------------------------------------------------|------------|------------|------------|
| **($ in thousands):**       | ** ** | **2006**                                                | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                  |       |                                                    |       |       |       |   |   |   |   |
| Loss on  impairment of product rights |       | $                                                       | 66,981     |       | $          | — |   | $ | 66,981 |   | 100.0 | % |
| *as a %  of net revenues*             | * *   | *4.9*                                                   | *%*        | *0.0*      | *%*        | * * | * * | * * | * * |
|                                       |            |                                                         |            |            |            |  |  |  |  |  |  |  |

 

During the secondquarter of 2006, the Company recognized a $67.0 million loss on impairment ofproduct rights resulting from a downward revision of long range product salespredominantly relating to Alora® and Actigall®(refer to Note 7 in the accompanying Notes to Condensed Consolidated FinancialStatements in this Quarterly Report).

34

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***Earnings(Losses) on Equity Method Investments***
|                                                 | ** ** | **Nine Months Ended September 30,** | ** ** | **Change**   | ** ** |
|-------------------------------------------------|------------|---------------------------------------------------------|------------|--------------|------------|
| **($ in thousands):**                 | ** ** | **2006**                                                | ** ** | **2005**     | ** ** | **Dollars** | ** ** | **%** | ** ** |
| ** **                                      | ** ** | ** **                                              | ** ** | **Restated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Earnings (losses)  on equity method investments |       | $                                                       | 1,638      |         | $          | (1,685 | ) | $ | 3,323 |   | (197.2 | )% |
| *as a %  of net revenues*                       | * *   | *0.1*                                                   | *%*        | *-0.1*       | *%*        | * * | * * | * * | * * |
|                                                 |            |                                                         |            |              |            |  |  |  |  |  |  |  |

 

The earnings onequity method investments recorded during the nine months ended September 30,2006 consists of our share of earnings generated by our various joint ventureinvestments.  Improved year-to-dateresults at both Scinopharm and Somerset contributed primarily to the changefrom a net loss to net earnings on equity method investments.  Results at Somerset improved as a result ofthe U.S. Food and Drug Administration (“FDA”) granting Somerset final approvalfor Emsam®, aselegeline patch for the treatment of depression on February 28, 2006.

***Gainon Sale of Securities***

The 2006 gain onsale of securities resulted from the sale of our investment in Adheris,Inc.  We received cash proceeds of $4.7million from our sale of our entire investment in Adheris, Inc. and may receiveadditional proceeds upon the achievement of certain earn-out milestones.  We did not sell any securities during thenine months ended September 30, 2005.

***InterestIncome***
|                                 | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|---------------------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                                                | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                            |       |                                                    |       |       |       |   |   |   |   |
| Interest income                 |       | $                                                       | 22,766     |       | $          | 13,580 |   | $ | 9,186 |   | 67.6 | % |
| *as a %  of net revenues*       | * *   | *1.7*                                                   | *%*        | *1.1*      | *%*        | * * | * * | * * | * * |
|                                 |            |                                                         |            |            |            |  |  |  |  |  |  |  |

 

Interest incomeincreased during the ninemonths ended September 30, 2006 as compared to the same period of the prioryear due to higher balances of cash and marketable securities and higher ratesof return on invested balances in the current period.  Foradditional information on the impact of the Andrx Acquisition on interestincome related to the Andrx Acquisition, refer to NOTE 12 – SUBSEQUENT EVENTSin the accompanying Notes to Condensed Consolidated Financial Statements inthis Quarterly Report.

***InterestExpense***
|                                       | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|---------------------------------------|------------|---------------------------------------------------------|------------|------------|------------|
| **($ in thousands):**       | ** ** | **2006**                                                | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                  |       |                                                    |       |       |       |   |   |   |   |
| Interest expense  - CODES             |       | $                                                       | 9,453      |       | $          | 9,453 |   | $ | — |   | 0.0 | % |
| Interest expense  - 1998 Senior Notes |       | 406                                                     |       | 766        |       | (360 | ) | (47.0 | )% |
| Interest and  fees on credit facility |       | 744                                                     |       | 1,230      |       | (486 | ) | (39.5 | )% |
| Change in  derivative value           |       | (651                                                    | )          | 12         |       | (663 | ) | (5525.0 | )% |
| Interest expense  - other             |       | 485                                                     |       | 143        |       | 342 |   | 239.2 | % |
| Interest expense                      |       | $                                                       | 10,437     |       | $          | 11,604 |   | $ | (1,167 | ) | (10.1 | )% |
| *as a %  of net revenues*             | * *   | *0.8*                                                   | *%*        | *0.9*      | *%*        |   |   |   |   |

 

35

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Interest expensedecreased for the nine month period ended September 30, 2006 due to a reductionin the value of the embedded derivative related to the CODES, the redemption ofthe 1998 Senior Notes in the second quarter of 2006 and due to reduced fees onthe credit facility.  For additional information on the impact ofthe Andrx Acquisition on interest expense related to the Andrx Acquisition,refer to NOTE 12 – SUBSEQUENT EVENTS in the accompanying Notes to CondensedConsolidated Financial Statements in this Quarterly Report.

***Provisionfor Income Taxes***
|                                 | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|---------------------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                                                | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                            |       |                                                    |       |       |       |   |   |   |   |
| Provision for  income taxes     |       | $                                                       | 26,320     |       | $          | 70,118 |   | $ | (43,798 | ) | (62.5 | )% |
| *as a % of net revenues*        | * *   | *1.9*                                                   | *%*        | *5.7*      | *%*        | * * | * * | * * | * * |
| *Effective  tax rate*           | * *   | *37.4*                                                  | *%*        | *37.2*     | *%*        | * * | * * | * * | * * |
|                                 |            |                                                         |            |            |            |  |  |  |  |  |  |  |

 

The provision forincome taxes decreased in the nine months ended September 30, 2006 due toreduced levels of income before income taxes.

***SegmentContribution***
|                                 | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|---------------------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                                                | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                            |       |                                                    |       |       |       |   |   |   |   |
| Segment  contribution           |       |                                                    |       |       |       |   |   |   |   |
| Generic                         |       | $                                                       | 240,593    |       | $          | 270,362 |   | $ | (29,769 | ) | (11.0 | )% |
| Brand                           |       | 79,263                                                  |       | 115,277    |       | (36,014 | ) | (31.2 | )% |
|                            |       | $                                                       | 319,856    |       | $          | 385,639 |   | $ | (65,783 | ) | (17.1 | )% |
| *as % of  net revenues*         | * *   | *23.6*                                                  | *%*        | *31.4*     | *%*        | * * | * * | * * | * * |

 

Generic segmentcontribution decreased for the nine months ended September 30, 2006, ascompared to the same period of the prior year, primarily due to lower grossprofit.

Brand segmentcontribution decreased for the nine months ended September 30, 2006, ascompared to the same period of the prior year, primarily due to lower net salesand resulting lower gross profit and due to higher research and development expenses.

For moreinformation on segment contribution, refer to above Management’s Discussion andAnalysis of Financial Condition and Results of Operations and Note 5 in theaccompanying Notes to Condensed Consolidated Financial Statements in thisQuarterly Report.  For additional information on the impact ofthe Andrx Acquisition on reportable segments as a result of the AndrxAcquisition, refer to NOTE 12 – SUBSEQUENT EVENTS in the accompanying Notes toCondensed Consolidated Financial Statements in this Quarterly Report.

36

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**Liquidityand Capital Resources**

***Cashfrom Operations***

Watson’sprimary source of liquidity is cash from operations.  Net working capital at September 30, 2006 was$1.27 billion compared to $1.11 billion at December 31, 2005 and $1.06 billionat September 30, 2005.

We expect that2006 cash flows from operating activities will continue to exceed netincome.  In addition, management expectsthat 2006 cash flows from operating activities, available cash balances andavailable credit facilities will be sufficient to fund our operating liquidityneeds.

Summarized cashflow information is as follows:
|                                           | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------|------------|---------------------------------------------------------|------------|
| **($ in thousands):**           | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
|                                      |       |                                                    |       |   |   |
| Net cash provided by operating activities |       | $                                                       | 337,767    |   | $ | 279,481 |   |
|                                           |            |                                                         |            |  |  |  |  |

#  

Net cash provided by operating activities increased during the ninemonth period ended September 30, 2006, as compared to the same period of theprior year, due primarily to relative decreases in accounts receivable,increases in accounts payable (refer to discussion under “Changes in WorkingCapital”)and income taxes payable offset by an increase in inventories.

***Changesin Working Capital***

Working capital atSeptember 30, 2006 and December 31, 2005 is summarized as follows:

|                                         | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** |
|-----------------------------------------|------------|------------------------|------------|-----------------------|------------|----------------|------------|
| **($ in thousands):**              | ** ** | **2006**               | ** ** | **2005**              | ** ** | **(Decrease)** | ** ** |
|                                    |       |                   |       |                  |       |           |       |
| Current Assets:                         |       |                   |       |                  |       |           |       |
| Cash and cash  equivalents              |       | $                      | 735,222    |                  | $          | 467,451        |       | $ | 267,771 |   |
| Marketable securities                   |       | 171,545                |       | 162,475               |       | 9,070          |       |
| Accounts receivable,  net of allowances |       | 264,264                |       | 333,832               |       | (69,568        | )          |
| Inventories                             |       | 318,166                |       | 278,062               |       | 40,104         |       |
| Other                                   |       | 133,260                |       | 118,610               |       | 14,650         |       |
| Total current assets                    |       | 1,622,457              |       | 1,360,430             |       | 262,027        |       |
| Current liabilities:                    |       |                   |       |                  |       |           |       |
| Accounts payable and  accrued expenses  |       | 253,864                |       | 211,160               |       | 42,704         |       |
| Current portion of  long-term debt      |       | 10,336                 |       | —                |       | 10,336         |       |
| Other                                   |       | 85,578                 |       | 34,510                |       | 51,068         |       |
| Total current  liabilities              |       | 349,778                |       | 245,670               |       | 104,108        |       |
|                                    |       |                   |       |                  |       |           |       |
| Working Capital                         |       | $                      | 1,272,679  |                  | $          | 1,114,760      |       | $ | 157,919 |   |
|                                    |       |                   |       |                  |       |           |       |
| Current Ratio                           |       | 4.64                   |       | 5.54                  |       |           |       |

The increase in inventoryat September 30, 2006 was partly due to launches of new products during thenine months ended September 30, 2006. Accounts payable increased at September 30, 2006 primarily due to higherroyalties payable on sales of oxycodone extended-release and pravastatin sodium tablets.  Current portion of long-term debtincreased at September 30, 2006 as we assumed debt in our acquisition ofSekhsaria which, pending government and other approvals, we plan to repay priorto the end of 2006.

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***CapitalExpenditures***

Our capitalexpenditures are summarized as follows:

 
|                                        | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------|------------|---------------------------------------------------------|------------|
| **($ in thousands):**        | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
|                                   |       |                                                    |       |   |   |
| Acquisitions of property and equipment |       | $                                                       | 25,468     |   | $ | 48,293 |   |
|                                        |            |                                                         |            |  |  |  |  |

 

Capitalexpenditures for the nine months ended September 30, 2006 included additions tomachinery and equipment at various Watson locations.

***Debt and Borrowing Capacity***

Ourdebt and borrowing capacity at September 30, 2006 and December 31, 2005 issummarized as follows:
|                                    | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** |
|------------------------------------|------------|------------------------|------------|-----------------------|------------|----------------|------------|
| **($ in thousands):**    | ** ** | **2006**               | ** ** | **2005**              | ** ** | **(Decrease)** | ** ** |
|                               |       |                   |       |                  |       |           |       |
| Current portion of long-term  debt |       | $                      | 10,336     |                  | $          | —         |       | $ | 10,336 |   |
| Long-term debt                     |       | 574,078                |       | 587,935               |       | (13,857        | )          |
| Total debt                         |       | $                      | 584,414    |                  | $          | 587,935        |       | $ | (3,521 | ) |
| Debt to capital ratio              |       | 21.2                   | %          | 21.8                  | %          |           |       |

 

InMarch 2003, we issued $575 million of our CODES.  As of September 30, 2006, the entire amountof the CODES remained outstanding at an effective annual interest rate ofapproximately 2.1%.

In May 1998, weissued $150 million of our 1998 Senior Notes. On March 31, 2006, the Company initiated a redemption notice to theholders of all of its outstanding 1998 Senior Notes.  As a result, the remaining 1998 Senior Noteswere redeemed on May 23, 2006.

In May 2003, we entered into an agreement with asyndicate of lenders for a five-year, $300 million senior, unsecured revolvingcredit facility (the “Credit Facility”) for working capital and other generalcorporate purposes.  On September 8,2005, we entered into a Second Amendment to the Credit Facility onsubstantially the same terms and conditions except the fee structure wasreduced and certain defined terms were added or amended.  On March 6, 2006, we entered into a ThirdAmendment to the Credit Facility which, among other things, permits the Companyto repurchase up to $300.0 million of its common stock.  As of September 30, 2006, the total $300million under the Credit Facility was available to us.  Watson’s assets generally are held by, andits operations generally are conducted through its subsidiaries.  Within the meaning of Regulation S-X, Rule3-10, the Company has no assets or operations independent of its subsidiaries.  Under the terms of the Credit Facility, eachof our subsidiaries, other than minor subsidiaries, entered into a full andunconditional guarantee on a joint and several basis.  In order to provide subsidiary guarantees inconnection with the Credit Facility, we were required to issue similarguarantees to the 1998 Senior Note holders. The subsidiary guarantees related to both the Credit Facility and the1998 Senior Notes are full and unconditional, on a joint and several basis, andare given by all subsidiaries other than minor subsidiaries.  As of September 30, 2006 and December 31,2005, the Company had not drawn any funds from the Credit Facility.  Watson is subject to certain financial andoperational covenants, all of which, as of September 30, 2006, the Company wasin compliance.  The Credit Facility currently contains thefollowing financial covenants:

·                  maintenanceof a minimum net worth of at least $1.7 billion at September 30, 2006;

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

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

At September 30, 2006, our net worth was $2.2 billion and our leverageratio was 1.50 to 1.0.   Our interestcoverage ratio for the nine months ended September 30, 2006 was 29.3 to 1.0.

Under the Credit Facility, interest coverage ratio, with respect to anyfinancial covenant period, is defined as the ratio of EBITDA for such period tointerest expense for such period.  Theleverage ratio, for any financial covenant period, is defined as the ratio ofthe outstanding principal amount of funded debt for the borrower and itssubsidiaries at the end of such period, to EBITDA for such period.  EBITDA under the Credit Facility, for anycovenant period, is defined as net income plus (1) depreciation andamortization, (2) interest expense, (3) provision for income taxes, (4)extraordinary or unusual losses, (5) non-cash portion of nonrecurring lossesand charges, (6) other non-operating, non-cash losses and (7) minority interestexpense in respect of equity holdings in affiliates; minus (1) extraordinarygains, (2) interest income and (3) other non-operating, non-cash income.

OnNovember 3, 2006, in conjunction with the Andrx Acquisition and entering into anew credit agreement, we terminated our existing Credit Facility.  For additional information on the impact ofthe Andrx Acquisition on long-term debt and our existing Credit Facilityrelated to the Andrx Acquisition, refer to NOTE 12 — SUBSEQUENT EVENTS in theaccompanying Notes to Condensed Consolidated Financial Statements in thisQuarterly Report.

***Long-termObligations***

The following table lists our enforceable and legally bindingobligations as of September 30, 2006. Some of the amounts included herein are based on management’s estimatesand assumptions about these obligations, including their duration, thepossibility of renewal, anticipated actions by third parties, and otherfactors.  Because these estimates andassumptions are necessarily subjective, the enforceable and legally bindingobligation we will actually pay in future periods may vary from those reflectedin the table:
|                                                                   | ** ** | **Payments Due by Period (Including Interest)** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| **(in thousands):**                                          | ** ** | **Total**                                                                | ** ** | **Less than   1 year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **After 5   years** | ** ** |
|                                                              |       |                                                                     |       |   |   |   |   |   |   |   |   |
| Long-term and other  debt                                         |       | $                                                                        | 758,189    |   | $ | 17,974 |   | $ | 30,210 |   | $ | 20,125 |   | $ | 689,880 |   |
| Liabilities incurred  for acquisitions of products and businesses |       | 2,953                                                                    |       | 1,100 |   | 1,572 |   | — |   | 281 |   |
| Operating lease  obligations                                      |       | 35,505                                                                   |       | 7,596 |   | 13,503 |   | 2,490 |   | 11,916 |   |
| Total contractual cash obligations                                |       | $                                                                        | 796,647    |   | $ | 26,670 |   | $ | 45,285 |   | $ | 22,615 |   | $ | 702,077 |   |

The Company isinvolved in certain minor joint venture arrangements that are intended tocomplement the Company’s core business and markets.  The Company has the discretion to providefunding on occasion for working capital or capital expenditures.  The Company makes an evaluation of additionalfunding based on an assessment of the venture’s business opportunities.  The Company believes that any possiblecommitments arising from the current arrangements will not be significant tothe Company’s financial condition or results of operations.

The Company does not have any material off-balance sheet arrangementsthat have, or are reasonably likely to have, a current or future effect on ourfinancial condition, changes in financial conditions, revenues or expenses,results of operations, liquidity, capital expenditures or capital resources.

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*Stock Repurchases*

During 2005, we repurchasedapproximately 9.4 million shares of our common stock at an aggregate cost ofapproximately $300.0 million under the Company’s $300.0 million stockrepurchase program approved by the Board on February 10, 2005 (the “2005Repurchase Program”).  This completes ourstock repurchases under the 2005 Repurchase Program.  The 2005 Repurchase Program did not affectour compliance with our debt covenants and did not materially impact theCompany’s liquidity.

On February 15, 2006, theCompany’s Board of Directors authorized the expenditure of an additional $300.0million to repurchase shares of the Company’s outstanding common stock (the “2006Repurchase Program”).  Repurchases areauthorized to be made in open market or privately negotiated transactions fromtime to time in compliance with the Securities and Exchange Commission’s (“SEC”)Rule 10b-18, subject to market conditions, applicable legal requirements andother factors. Additionally, the Board has authorized that purchases may bemade under Rule 10b5-1 promulgated under the Securities and Exchange Act of1934, as amended. A Rule 10b5-1 plan allows Watson to repurchase its sharesduring periods when it would normally not be active in the market due to itsinternal trading blackout periods. All such purchases must be made inaccordance with a pre-defined plan that is established when the planadministrator is not aware of any material non-public information.  At this time, the Company has no currentplans to repurchase common stock under the 2006 Repurchase Program.

*Acquisition of Andrx Corporation*

On November 3, 2006, the Company acquired all theoutstanding shares of common stock of Andrx in an all-cash transaction for $25per share, or total consideration of approximately $1.9 billion.  Andrx is considered a leader in formulatingand commercializing difficult-to-replicate controlled-release pharmaceuticalproducts and selective immediate-release products.  For additional information on the AndrxAcquisition, refer to NOTE 12 – SUBSEQUENT EVENTS in the accompanying Notes toCondensed Consolidated Financial Statements in this Quarterly Report.

*Recent accounting pronouncements*

In November 2004, the Financial Accounting StandardsBoard (“FASB”) issued SFAS No. 151, “Inventory Costs-an Amendment of ARB No.43, Chapter 4” (“SFAS 151”).  SFAS 151clarifies that items such as abnormal freight, handling costs, and wastedmaterials (spoilage) be recognized as current period charges rather than as aportion of the inventory cost. Unallocated overheads are to be recognized as an expense in the periodin which they are incurred.  In addition,this Statement requires that allocation of fixed production overheads to thecosts of conversion be based on the normal capacity of the productionfacilities.  This Statement is effectivefor inventory costs incurred during fiscal years beginning after June 15,2005.  The provision of this Statementshall be applied prospectively.  Theadoption of SFAS 151 on January 1, 2006, did not have a material effect on ourCondensed Consolidated Financial Statements.

InDecember 2004, the FASB issued SFAS 123R, which replaces SFAS No. 123, “Accountingfor Stock-Based Compensation” (“SFAS 123”) as well as SFAS No. 148, “Accountingfor Stock-Based Compensation-Transition and Disclosure” (“SFAS 148”),supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB25”) and amends SFAS No. 95, “Statement of Cash Flows” (“SFAS 95”). SFAS 123R requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the financial statements based on their fair values. Theintrinsic value method as permitted under APB 25 together with the pro formadisclosures previously permitted under SFAS 123 no longer will be analternative to financial statement recognition. Under SFAS 123R, the Companymust determine the appropriate fair value model to be used for valuingshare-based payments, the amortization method for attributing compensation costto reporting periods and the transition method to be used at date ofadoption.  The transition methods includemodified prospective and modified retrospective adoption options. Under themodified retrospective option, prior periods may be restated either as of thebeginning of the year of adoption or for all periods presented. The modifiedprospective method requires that compensation expense be recorded for allunvested stock options at 

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the beginning of thefirst quarter of adoption of SFAS 123R, while the modified retrospectivemethod would record compensation expense for all unvested stock optionsbeginning with the first period restated. SFAS 123R also requires any unearned or deferred compensation accounts(i.e. contra-equity accounts) within stockholders’ equity be recorded asreductions to additional paid-in capital balances rather than shown as contraequity accounts as was required prior to January 1, 2006.  SFAS95 is amended to require excess tax benefits be reported as a financing cashflow rather than as a reduction in taxes paid within the Consolidated Statementof Cash Flows.  On January 1,2006, the Company adopted SFAS 123R using the modified prospective methodoption.

In March 2005, the SEC issued SEC Staff Bulletin No.107 (“SAB 107”) which describes the SEC staff position as well as supplementalimplementation guidance on the application and adoption of SFAS 123R.  TheCompany has applied the provisions of SAB 107 and its guidance in our adoptionof SFAS 123R on January 1, 2006.

In May 2005, the FASB issued SFAS No. 154,“Accounting Changes and Error Corrections” (“SFAS 154”), which replaces APBOpinion No. 20, “Accounting Changes” (“APB 20”) and SFAS No. 3, “ReportingAccounting Changes in Interim Financial Statements” (“SFAS 3”). SFAS 154applies to all voluntary changes in accounting principle and changes therequirements for the accounting for and reporting of a change in accountingprinciple.  SFAS 154 also requiresretrospective application to prior period financial statements involvingchanges in accounting principle unless it is impracticable to determine eitherthe period-specific or cumulative effect of the change.  This statement also requires that a change inthe method of depreciation, amortization or depletion of long-lived assets beaccounted for as a change in accounting estimate that is accounted for prospectively.  SFAS 154 also retains many provisions of APB20 including those related to reporting a change in accounting estimate, achange in the reporting entity and a correction of an error and also carriesforward provisions of SFAS 3 governing the reporting of accounting changes ininterim financial statements.  SFAS 154is effective for accounting changes and corrections of errors made in fiscalyears beginning after December 15, 2005. The adoption of SFAS 154 on January 1, 2006, did not have a materialeffect on our Consolidated Financial Statements.

In July 2006, the FASB issued InterpretationNo. 48, “Accounting for Uncertainty in Income Taxes — An Interpretation ofFASB Statement No. 109” (“FIN 48”).  FIN48 clarifies the accounting for the uncertainty in recognizing income taxes inan organization in accordance with FASB Statement No. 109 by providing detailedguidance for financial statement recognition, measurement and disclosureinvolving uncertain tax positions.  FIN48 requires an uncertain tax position to meet a more-likely-than-not recognitionthreshold at the effective date to be recognized both upon the adoption of FIN48 and in subsequent periods.  FIN 48 iseffective for fiscal years beginning after December 15, 2006.  As the provisions of FIN 48 will be appliedto all tax positions upon initial adoption, the cumulative effect of applyingthe provisions of FIN 48 will be reported as an adjustment to the openingbalance of retained earnings for that fiscal year.  The Company is currently evaluating FIN 48and the effect, if any, on our Condensed Consolidated Financial Statements.

**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET 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 September 30, 2006, our total holdings in equitysecurities of other companies, including equity-method investments andavailable-for-sale securities, were $64.7 million.  Of this amount, we had equity-methodinvestments of $48.3 million and publicly traded equity securities(available-for-sale securities) at fair value totaling $16.4 million ($14.8million that was included in “Marketable securities” and $1.6 million that wasincluded in “Investments and other assets”). The fair values of these investments are subject to significant 

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fluctuations dueto volatility of the stock market and changes in general economicconditions.  Based on the fair value ofthe publicly traded equity securities we held at September 30, 2006, anassumed 25%, 40% and 50% adverse change in the market prices of these securitieswould result in a corresponding decline in total fair value of approximately$4.1 million, $6.5 million and $8.2 million, respectively.

At September 30,2006, our investment in Andrx consisted of approximately 607,000 shares ofAndrx common stock with a cost of approximately $1.6 million and a fair marketvalue of $14.8 million.  On November 3, 2006, the Company acquired theremaining outstanding shares of common stock of Andrx.  Accordingly, our reported financial positionand results of operations after November 3, 2006 will include Andrx.

**Weregularly review the carrying value of our investments and identify andrecognize losses, for income statement purposes, when events and circumstancesindicate that any declines in the fair values of such investments, below ouraccounting basis, are other than temporary.**

**Interest Rate Risk**

Our exposure tointerest rate risk relates primarily to our non-equity investmentportfolio.  Our cash is invested inA-rated money market mutual funds, short-term securities and commercial paper.Consequently, our interest rate and principal risk are minimal.

During 2004, weacquired a significant amount of U.S. Treasury securities classified asavailable-for-sale securities, with no security having a maturity in excess oftwo years.  These securities are exposedto interest rate fluctuations.  Becauseof the short-term nature of these investments, we are subject to minimal interestrate risk and do not believe that an increase in market rates would have asignificant negative impact on the realized value of our portfolio.

Based on quotedmarket rates of interest and maturity schedules for similar debt issues, weestimate that the fair values of our CODES and our other notes payable approximatedtheir carrying values on September 30, 2006. While changes in market interest rates may affect the fair value of ourfixed-rate debt, we believe the effect, if any, of reasonably possiblenear-term changes in the fair value of such debt on our financial 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.

We do not believethat inflation has had a significant impact on our revenues or operations.

As a result of theAndrx Acquisition, we will be subject to variable interest rate risk on our newSenior Credit Facility (refer to NOTE 12 – SUBSEQUENT EVENTS in theaccompanying Notes to Condensed Consolidated Financial Statements in thisQuarterly Report).

**ITEM4.  CONTROLS AND PROCEDURES**

TheCompany maintains disclosure controls and procedures that are designed toensure that information required to be disclosed in the Company’s Exchange Act reportsis recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and forms, and that such information isaccumulated and communicated to the Company’s management, including itsPrincipal Executive Officer and Principal Financial Officer, as appropriate, toallow timely decisions regarding required disclosure.  In designing and evaluating the disclosurecontrols and procedures, management recognized that any controls and procedures,no matter how well designed and operated, can provide only reasonable assuranceof achieving the desired control objectives, and management necessarily wasrequired to apply its judgment in evaluating the cost-benefit relationship ofpossible controls and procedures.  Also,the Company has investments in certain unconsolidated entities.  As the Company does not control or managethese entities, its disclosure controls and procedures with respect to suchentities are necessarily substantially more limited than those it maintainswith respect to its consolidated subsidiaries.

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Asrequired by SEC Rule 13a-15(b), the Company carried out an evaluation, underthe supervision and with the participation of the Company’s management,including the Company’s Principal Executive Officer and Principal FinancialOfficer, of the effectiveness of the design and operation of the Company’sdisclosure controls and procedures as of the end of the quarter covered by thisReport. Based on the foregoing, the Company’s Principal Executive Officer andPrincipal Financial Officer concluded that the Company’s disclosure controlsand procedures were effective.

Therehave been no changes in the Company’s internal control over financialreporting, during the three months ended September 30, 2006, that hasmaterially affected, or is reasonably likely to materially affect, the Company’sinternal control over financial reporting.

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**PARTII.  OTHER INFORMATION AND SIGNATURES**

**ITEM 1. LEGAL PROCEEDINGS**

TheCompany is party to certain lawsuits and legal proceedings, which are describedin “PART I, ITEM 3. LEGAL PROCEEDINGS,” of our Annual Report on Form 10-K forthe year ended December 31, 2005.  Thefollowing is a description of material developments during the period coveredby this Quarterly Report and through the filing of this Quarterly Report, andshould be read in conjunction with the Annual Report referenced above.

*Governmental Reimbursement Investigations And DrugPricing Litigation.*With respect to the Drug Pricing Litigation pending against the Company andcertain subsidiaries, an additional action has been filed by the AttorneyGeneral of the State of Alaska namingthe Company and other drug manufacturers as defendants and raising similarallegations to those filed by the Attorneys General of several other states.  *(State ofAlaska v. Abbott Laboratories, Inc., et al.* in the Superior Courtfor the Third Judicial Circuit, Civil Action No. 3AN-06-12026 CI).  Additional actions in other states areanticipated.  Additionally, AndrxCorporation and its subsidiaries, which the Company recently acquired, arenamed as defendants in several cases in which the Company and its subsidiariesalready were named as a defendant, including cases filed by the Counties ofErie, Schenectady, and Oswego, New York, and the Attorneys General of theStates of Alabama and Mississippi.  These actions, if successful, could adversely affect the Company and mayhave a material adverse effect on the Company’s business, results ofoperations, financial condition and cash flows.

*Naproxen Sodium (Naprelan).* InOctober  1998, Elan Corporation Plc suedAndrx in the United States District Court for the Southern District of Florida,alleging that Andrx’s pending ANDA for a generic version of Elan’s Naprelan®infringed Elan’s patent No. 5,637,320.  (*Elan Corporation PLC v. Andrx Pharmaceuticals, Inc.,*Case No. 98-7164).  In March 2002, theDistrict Court issued an order that Elan’s patent was invalid, and in September2002, Andrx commenced selling the 500mg strength of naproxen sodium, itsgeneric version of Naprelan®.  In March2003, the District Court issued an order denying, among other things, (i) Elan’smotion for consideration of the March 2002 order invalidating its patent, and(ii) Andrx’s motion asking the District Court for a ruling on its non-infringementdefenses.  Both parties appealed thatMarch 2003 decision.  (*Elan Corporation PLC v. Andrx Pharmaceuticals, Inc.,*Case No. 03-1354).  On May 5, 2004, theFederal Circuit Court of Appeals reversed the District Court’s determinationthat the Elan patent was invalid, and remanded the case back to the DistrictCourt for a determination as to whether Andrx’s product infringes the Elanpatent.  On July 12, 2005, the FederalCircuit Court of Appeals issued a decision, in an unrelated case, on how acourt should address issues of claim construction, and the District Courtinstructed the parties to file briefs on how the District Court should proceedin this matter in light of the Federal Circuit Court of Appeals decision.  The parties filed their briefs and areawaiting the court’s decision.

In January 2005, Elan filed a complaint in the U.S.District Court for the Southern District of Florida seeking willful damages asa result of Andrx’s sale of its generic version of Naprelan®.  (*ElanCorporation PLC v. Andrx Pharmaceuticals, Inc.,* Case No. 058-60158).  In February 2005, Andrx filed its answer toElan’s January 2005 complaint and filed a counterclaim for declaratory relieffor unenforceability due to inequitable conduct and for non-infringement andinvalidity of the applicable patent. This matter has been stayed pending resolution of the infringementaction.  Andrx has sold and is continuingto sell its generic version of the 500mg strength of Naprelan®.  Therefore, an adverse determination couldhave a material adverse effect on the Company’s business, results ofoperations, financial condition and cash flows.

*Mallinckrodt Claim.* OnFebruary 17, 2006, Andrx filed a complaint against Mallinckrodt in the U.S.District Court for the Southern District of Florida.  (*AndrxTherapeutics, Inc v. Mallinckrodt, Inc..,* Case No. 06-60210). Thecomplaint results from a dispute over certain agreements, including a supplyand marketing agreement entered into between Andrx and Mallinckrodt.  The complaint seeks to establish the parties’rights under the agreements, a judgment declaring that the agreements are stillin force and that Andrx has not 

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defaulted in its obligations.  Inthe alternative, Andrx seeks a judgment for either breach of contract foranticipatory repudiation or for breach of duty of good faith.  On March 10, 2006, Mallinckrodt filed suitagainst Andrx in state court in Missouri, arising from the same disputereferenced above.  (*Mallinckrodt, Inc. v. Andrx Laboratories, Inc., etal.,* Case No. 06-1000).  In itssuit, Mallinckrodt alleges breach of contract, breach of implied covanent ofgood faith and fair dealing and seeks damages of $3.8 million, along with adeclaratory judgment and injunctive relief. This matter is set for trial on March 5, 2007.

*Securities LitigationAgainst Andrx Corporation.*  On October 11, 2005, JerryLowry filed a class action complaint on behalf of purchasers of the Andrx’scommon stock during the class period (March 9, 2005 throughSeptember 5, 2005) in the U.S. District Court for the Southern District ofFlorida against Andrx Corporation and its Chief Executive Officer. (*Jerry Lowry v. Andrx Corporation, et al.,* Case No. 05-61640).  The complaint seeks damages under theSecurities Exchange Act of 1934, as amended, and alleges that during the classperiod, it failed to properly disclose the status of its compliance with cGMPestablished by the FDA. The complaint also alleges that the plaintiffs suffereddamages as a result of its disclosure on September 6, 2005 that FDA placedthe Company in Official Action Indicated status and a subsequent decline in thetrading price of its common stock from $17.94 on September 5, 2005 to aclosing price of $14.89 on September 6, 2005.   On December 14, 2005, a shareholders’derivative action was filed in the U.S. District Court for the SouthernDistrict of Florida by Greg Umeda on behalf of Andrx, against Andrx’s ChiefExecutive Officer, former Chief Financial Officer, the Board of Directors andAndrx (as a nominal defendant in the U.S. District Court for the SouthernDistrict of Florida) for alleged breach of fiduciary duties, abuse of control,gross mismanagement, waste of corporate assets and unjust enrichment betweenMarch 2005 and December 2005.  (*Greg Umeda v. Thomas Rice, et al.,* Case No. 05-61796).  The complaint alleges that the individualdefendants breached their fiduciary duties by allowing Andrx to issuestatements that claimed Andrx was in compliance with FDA regulations and alsofrom withholding from the public during the relevent period material non-publicinformation relating to Andrx’s cGMP violations at its manufacturingfacilities.  The plaintiff furtheralleges that as a result of the wrongdoing, Andrx’s stock dropped from $17.94on September 2, 2005 to a closing price of $14.89 on September 6, 2005.  On January 6, 2006, a second shareholders’derivative action was filed by Joseph Michael on behalf of Andrx, against Andrx’sChief Executive Officer and the members of the Board of Directors in the U.S.District Court for the Southern District of Florida.  (*Joseph Michael v. ThomasRice, et al.,* Case No. 05-60019). The complaint alleges violations of state law, including breaches offiduciary duties, abuse of control, gross mismanagement, waste of corporateassets, unjust enrichment and negligence that occurred from March 9, 2005through January 6, 2006, and that have allegedly caused substantial losses toAndrx.  On March 13, 2006, these twoderivative cases were consolidated under *Greg Umeda v. Thomas Rice,et al.,* Case No. 05-61796.  OnAugust 16, 2006, the court entered an order administratively closing the caseand ordering the parties to file a joint status report once a ruling is issuedon Andrx’s motion to dismiss in the pending *Lowry v. AndrxCorporation, et al.,* Case No. 05-61640.  Though we are not in a position to determinethe ultimate outcome of these matters, an adverse determination of any of theseactions could have a material adverse effect on the Company’s business, resultsof operations, financial condition and cash flows.

*Securities Litigation Against Watson. *In the actionpending in the U.S. Court of Appeals for the Ninth Circuit (*Pension Fund v. Watson Pharmaceuticals, Inc.,* USCA DocketNo. 04-56791), the Court has set a hearing on the pending appeal for November17, 2006.

**ITEM 1A. RISK FACTORS**

**CAUTIONARYNOTE REGARDING FORWARD-LOOKING STATEMENTS**

Any statements made in this QuarterlyReport that are not statements of historical fact or that refer to estimated oranticipated future events are forward-looking statements.  We have based our forward-looking statementson our management’s beliefs and assumptions based on information available toour management at the time these statements are made.  Such forward-looking statements reflect ourcurrent perspective of our business, future 

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performance, existing trends and information as of the date of thisfiling.  These include, but are notlimited to, our beliefs about future revenue and expense levels and growthrates, prospects related to our strategic initiatives and business strategies,express or implied assumptions about government regulatory action or inaction,anticipated product approvals and launches, business initiatives and productdevelopment activities, assessments related to clinical trial results, productperformance and competitive environment, and anticipated financial performance.Without limiting the 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 these statements are based on certainassumptions, risks and uncertainties, many of which are beyond ourcontrol.  In addition, certain importantfactors may affect our actual operating results and could cause such results todiffer materially from those expressed or implied by forward-lookingstatements.  We believe the risks anduncertainties discussed under the Section entitled “Risks Related to OurBusiness,” and other risks and uncertainties detailed herein and from time totime in our SEC filings, may affect our actual results.

We disclaim any obligation to publicly update any forward-lookingstatements, whether as a result of new information, future events or otherwise,except as required by law.  Thisdiscussion is provided as permitted by the Private Securities Litigation ReformAct of 1995.

# **Risks Related to Our Business**

We operate in a rapidly changing environment that involves a number ofrisks, some of which are beyond our control. The following discussion highlights some of these risks and others arediscussed elsewhere in this Quarterly Report. These and other risks could materially and adversely affect ourbusiness, financial condition, operating results or cash flows.

*Risks Associated With InvestingIn the Business of Watson*

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

Our future results of operations will depend to a significant extentupon our ability to successfully commercialize new brand and generic productsin a timely manner.  There are numerousdifficulties in developing and commercializing new products, including:

·                  developing, testing and manufacturingproducts in compliance with regulatory standards in a timely manner;

·                  receiving requisite regulatory approvals forsuch products in a timely manner;

·                  the availability, on commercially reasonableterms, of raw materials, including active pharmaceutical ingredients and otherkey ingredients;

·                  developing and commercializing a new productis time consuming, costly and subject to numerous factors, including legalactions brought by our competitors, that may delay or prevent the developmentand commercialization of new products;

·                  experiencing delays or unanticipated costs;and

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·                  commercializing generic products may besubstantially delayed by the listing with the FDA of patents that have theeffect of potentially delaying approval of the off-patent product by up to 30months.

As a result ofthese and other difficulties, products currently in development by Watson orAndrx may or may not receive timely regulatory approvals, or approvals at all,necessary for marketing by Watson or other third-party partners.  This risk particularly exists with respect tothe development of proprietary products because of the uncertainties, highercosts and lengthy time frames associated with research and development of suchproducts and the inherent unproven market acceptance of such products. If anyof our products, when acquired or developed and approved, cannot besuccessfully or timely commercialized, our operating results could be adverselyaffected.  We cannot guarantee that anyinvestment we make in developing products will be recouped, even if we aresuccessful in commercializing those products.

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

Developing and commercializing brand pharmaceutical products is morecostly than generic products.  During2005, we increased our planned expenditures for the development and marketingof our brand business.  During 2006 andthereafter, we may further increase the amounts we expend for our brandbusiness segment.  For example, weinitiated Phase III clinical studies during the second quarter of 2006 on ournext generation Oxytrol® product and will incur ongoing expenditures for thePhase III clinical studies on our silodosin product for treatment of benignprostatic hyperplasia.  We cannot be surethese business expenditures will result in the successful discovery,development or launch of brand products that will prove to be commerciallysuccessful or will improve the long-term profitability of our business, whichwould adversely affect our results of operations and financial condition.

**Ourgross profit may fluctuate from period to period depending upon our productsales mix, our product pricing, and our costs to manufacture or purchaseproducts.**

Our future results of operations, financial condition andcash flows depend to a significant extent upon our brand and generic productsales mix.  Our sales of brand productstend to create higher gross margins than our sales of generic products.  As a result, our sales mix (the proportion oftotal sales between brand products and generic products) will significantlyimpact our gross profit from period to period. During 2005, sales of our brand products and generic products accountedfor approximately 24% and 76%, respectively, of our net product sales.  During that same period, brand products andgeneric products contributed approximately 38% and 62%, respectively, to ourgross profits.  Factors that may causeour sales mix to vary include:

·                  the amountof new product introductions;

·                  marketingexclusivity, if any, which may be obtained on certain brand products;

·                  the levelof competition in the marketplace for certain products;

·                  theavailability of raw materials and finished products from our suppliers;

·                  the scopeand outcome of governmental regulatory action that may involve us; and

·                  periodicdependence on a small number of products for a significant portion of netrevenue or income.

The profitabilityof our product sales is also dependent upon the prices we are able to chargefor our products, the costs to purchase products from third parties, and ourability to manufacture our products in a cost effective manner.  Our gross profits are expected to changesignificantly after the consumption of our transaction with Andrx, due in partto the significant amounts of revenue generated by Andrx’s distributionbusiness, which typically generates lower gross margins than our Genericsbusiness.

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**Loss of revenues from Ferrlecit®, a significant product, could have amaterial adverse effect on our results of operations, financial condition andcash flows.**

During 2004 we lost regulatory exclusivity on our Ferrlecit® product,which will allow generic applicants to submit Abbreviated New Drug Applications(“ANDAs”) for Ferrlecit®.  In 2005,Ferrlecit® accounted for approximately 9% of our net revenues and 16% of ourgross profit.  In February 2004, wesubmitted a Citizen’s Petition to the FDA requesting that the FDA not approveany ANDA for a generic version of Ferrlecit® until certain manufacturing,physiochemical and safety and efficacy criteria are satisfied.  During the third quarter of 2004, wesubmitted a second Citizen’s Petition to the FDA requesting that the FDA refuseto accept for substantive review any ANDA referencing Ferrlecit® until the FDAestablishes guidelines for determining whether the generic product is the samecomplex as Ferrlecit®.  In October 2006the Company submitted a supplement to its Citizen’s Petition, reiterating ourrequest for the FDA to establish guidelines for determining what data areneeded to prove that generic formulations of Ferrlecit® contain the same activecomplex as Ferrlecit®.  We cannot predictwhether the FDA will grant or deny our Citizen’s Petitions or when it may takesuch action.  We believe it will bedifficult for a competitor to demonstrate to the FDA that its product is thesame as Ferrlecit® and that, in the absence of such a showing, the FDA shouldrequire the applicant to submit a New Drug Application (“NDA”) supported byclinical studies, independently demonstrating safety and efficacy.  However, if a generic version of Ferrlecit®or other competitive product is approved by the FDA and enters the market, ournet revenues could significantly decline, which could have a material adverseeffect on our results of operations, financial condition and cash flows.

**If weare unsuccessful in our joint ventures and other collaborations, our operatingresults could suffer.**

We have made substantial investments in joint ventures and othercollaborations and may use these and other methods to develop or commercializeproducts in the future.  Thesearrangements typically involve other pharmaceutical companies as partners thatmay be competitors of ours in certain markets. In many instances, we will not control these joint ventures orcollaborations or the commercial exploitation of the licensed products, andcannot assure you that these ventures will be profitable.  Although restrictions contained in certain ofthese programs have not had a material adverse impact on the marketing of ourown products to date, any such marketing restrictions could affect futurerevenues and have a material adverse effect on our operations. Our results ofoperations may suffer if existing joint venture or collaboration partnerswithdraw, or if these products are not timely developed, approved orsuccessfully commercialized.

**If we are unable to adequately protect our technology or enforce ourpatents, our business could suffer.**

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

We also rely on trade secrets and proprietary know-how that we seek toprotect, in part, through confidentiality agreements with our partners,customers, employees and consultants.  Itis possible that these agreements will be breached or that they will not beenforceable in every instance, and that we will not have adequate remedies forany such breach.  It is also possiblethat our trade secrets will become known or independently developed by ourcompetitors.

If we are unable to adequately protect our technology, trade secrets orpropriety know-how, or enforce our patents, our results of operations,financial condition and cash flows could suffer.

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**If brand pharmaceutical companies are successful in limiting the use ofgenerics through their legislative and regulatory efforts, our sales of genericproducts may suffer.**

Many brand pharmaceutical companies increasingly have used state andfederal legislative and regulatory means to delay generic competition.  These efforts have included:

·                  pursuing new patents for existing productswhich may be granted just before the expiration of one patent, which couldextend patent protection for additional years or otherwise delay the launch ofgenerics;

·                  using the Citizen’s Petition process to requestamendments to FDA standards;

·                  seeking changes to U.S. Pharmacopeia, anorganization which publishes industry recognized compendia of drug standards;

·                  attaching patent extension amendments tonon-related federal legislation; and

·                  engaging in state-by-state initiatives toenact legislation that restricts the substitution of some generic drugs, whichcould have an impact on products that we are developing.

If brand pharmaceutical companies are successful in limiting the use ofgeneric products through these or other means, our sales of generic productsmay decline.  If we experience a materialdecline in generic product sales, our results of operations, financialcondition and cash flows will suffer.

**If competitors are successful in limiting competition for certaingeneric products through their legislative, regulatory and litigation efforts,our sales of certain generic products may suffer.**

Certain of our competitors have recently challenged our ability todistribute authorized generics during the competitors’ 180 day period of ANDAexclusivity under the Hatch-Waxman Act. Under the challenged arrangements, we have obtained rights to market anddistribute under a brand manufacturer’s NDA a generic alternative of the brandproduct.  Some of our competitors havechallenged the propriety of these arrangements by filing Citizen’s Petitionswith the FDA, initiating lawsuits alleging violation of the antitrust andconsumer protection laws, and seeking legislative intervention.  The FDA and courts that have considered thesubject to date have ruled that there is no prohibition in the Federal Food,Drug, and Cosmetic Act against distributing authorized generic versions of abrand drug.  However, on July 19, 2006,legislation was introduced in the U.S. Senate, and on July 28, 2006, similarlegislation was introduced in the U.S. House of Representatives, that wouldprohibit the marketing of authorized generics during the 180 day period of ANDAexclusivity under the Hatch-Waxman Act. Further, the Deficit Reduction Act of 2005 added provisions to theMedicaid Rebate Program that, effective January 1, 2007, may have the effect ofincreasing an NDA holder’s Medicaid Rebate liability if it permits anothermanufacturer to market an authorized generic version of its brand product.  This may affect the willingness of brandmanufacturers to continue arrangements, or enter into future arrangements,permitting us to market authorized generic versions of their brand products.  If so, or if distribution of authorizedgeneric versions of brand products is otherwise restricted or found unlawful,it could have a material adverse effect on our results of operations, financialcondition and cash flows.

**From time to time we may need to rely on licenses to proprietarytechnologies, which may be difficult or expensive to obtain.**

We may need to obtain licenses to patents and other proprietary rightsheld by third parties to develop, manufacture and market products.  If we are unable to timely obtain theselicenses on commercially reasonable terms, our ability to commercially marketour products may be inhibited or prevented.

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**Thirdparties may claim that we infringe their proprietary rights and may prevent usfrom manufacturing and selling some of our products**.

The manufacture, use and sale of new products that are the subject ofconflicting patent rights have been the subject of substantial litigation inthe pharmaceutical industry.  Theselawsuits relate to the validity and infringement of patents or proprietaryrights of third parties.  We may have todefend against charges that we violated patents or proprietary rights of thirdparties.  This is especially true in thecase of generic products on which the patent covering the brand product isexpiring, an area where infringement litigation is prevalent, and in the caseof new brand products where a competitor has obtained patents for similarproducts.  Litigation may be costly andtime-consuming, and could divert the attention of our management and technicalpersonnel.  In addition, if we infringeon the rights of others, we could lose our right to develop or manufactureproducts or could be required to pay monetary damages or royalties to licenseproprietary rights from third parties. Although the parties to patent and intellectual property disputes in thepharmaceutical industry have often settled their disputes through licensing orsimilar arrangements, the costs associated with these arrangements may besubstantial and could include ongoing royalties.  Furthermore, we cannot be certain that thenecessary licenses would be available to us on commercially reasonableterms.  As a result, an adversedetermination in a judicial or administrative proceeding or failure to obtainnecessary licenses could prevent us from manufacturing and selling a number ofour products, which could harm our business, financial condition, results ofoperations and cash flows.

**As apart of our business strategy, we plan to consider and, as appropriate, makeacquisitions of technologies, products and businesses, which may result in usexperiencing difficulties in integrating the technologies, products andbusinesses that we acquire and/or experiencing significant charges to earningsthat may adversely affect our stock price and financial condition. These risksare particularly relevant with respect to our acquisition of Andrx.**

We regularly review potential acquisitions oftechnologies, products and businesses complementary to our business.  Acquisitions typically entail many risks andcould result in difficulties in integrating operations, personnel, technologiesand products.  For example, in March2006, we acquired all the outstanding shares of Sekhsaria and in November 2006,we acquired all the outstanding shares of Andrx Corporation.  If we are not able to successfully integrateour acquisitions, we may not obtain the advantages and synergies that theacquisitions were intended to create, which may adversely affect our business,results of operations, financial condition and cash flows, our ability todevelop and introduce new products and the market price of our stock.  Integrating two geographically distantcompanies can be a time consuming and expensive process.  Watson’s headquarters are in California.  Andrx’s headquarters are in Florida.  Sekhsaria’s headquarters are in India.  In addition, in connection with acquisitions,we could experience disruption in our business, customer or employee base,including diversion of management’s attention from our continuingoperations.  There is also a risk thatkey employees of companies that we acquire or key employees necessary tosuccessfully commercialize technologies and products that we acquire may seekemployment elsewhere, including with our competitors.  Furthermore, there may be overlap between theproducts or customers of Watson and the companies that we acquire that maycreate conflicts in relationships or other commitments detrimental to theintegrated businesses.  The impact of ouracquisition of Andrx may result in any or all of the following risks: thebusinesses will not be integrated successfully; the anticipated synergies fromthe acquisition may not be fully realized or may take longer to realize thanexpected; and the disruption of our business, which could harm relationshipswith our current customers, employees or suppliers, and could adversely affectour expenses, pricing, third-party relationships and revenues.

In addition, as a result of acquiring businesses or products, orentering into other significant transactions, we have experienced, and will likelycontinue to experience, significant charges to earnings for merger and relatedexpenses that may include transaction costs, closure costs or acquiredin-process research and development charges. These costs may include substantial fees for investment bankers,attorneys, accountants and financial printing costs and severance and otherclosure costs associated with the elimination of duplicate or discontinued 

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products,operations and facilities.  Charges thatwe may incur in connection with acquisitions could adversely affect our resultsof operations for particular quarterly or annual periods.

**Our newly acquired Distribution segment is highly dependent upon aprimary courier service.**

Product deliveries within our newly acquired Distribution segment arehighly dependent on overnight delivery services to deliver our products in atimely and reliable manner, typically by overnight service.  Since 2004, our newly acquired Distributionsegment shipped a substantial portion of products via one courier’s air andground delivery service.  Our contractwith this courier expires in January 2008. Additionally, our Groveport, Ohio facility is strategically located nextto one of the courier’s air hubs.  If wecannot renew the courier’s contract on favorable terms, or enter into acontract with an equally reliable overnight courier to perform, and offer thesame service level at similar or more favorable rates, our business, results ofoperations, financial condition and cash flows could be adversely affected.

**Our newly acquired Distribution segment concentrates on genericproducts and is therefore subject to the risks of the generic industry.**

The ability of our newly acquired Distribution segment to provideconsistent, sequential quarterly growth is affected, in large part, by ourparticipation in the launch of new products by us and other genericmanufacturers and the subsequent advent and extent of competition encounteredby these products.  This competition canresult in significant and rapid declines in pricing with a correspondingdecrease in net sales of our Distribution segment.  Our margins can also be affected by the risksinherent to the generic industry.

**If weare unable to obtain sufficient supplies from key suppliers that in some casesmay be the only source of finished products or raw materials, our ability todeliver our products to the market may be impeded.**

We are required to identify the supplier(s) of all the raw materialsfor our products in our applications with the FDA.  To the extent practicable, we attempt toidentify more than one supplier in each drug application.  However, some products and raw materials areavailable only from a single source and, in some of our drug applications, onlyone supplier of products and raw materials has been identified, even ininstances where multiple sources exist. Among others, this includes products that have historically accountedfor a significant portion of our revenues, such as Ferrlecit®, bupropionsustained release tablets and a significant number of our oral contraceptiveproducts.  From time to time, certain ofour outside suppliers have experienced regulatory or supply-relateddifficulties that have inhibited their ability to deliver products and rawmaterials to us, causing supply delays or interruptions.  To the extent any difficulties experienced byour suppliers cannot be resolved within a reasonable time, and at reasonablecost, or if raw materials for a particular product become unavailable from anapproved supplier and we are required to qualify a new supplier with the FDA,our profit margins and market share for the affected product could decrease, aswell as delay our development and sales and marketing efforts.

Our arrangements with foreign suppliers are subject to certainadditional risks, including the availability of government clearances, exportduties, political instability, war, acts of terrorism, currency fluctuationsand restrictions on the transfer of funds. For example, we obtain a significant portion of our raw materials fromforeign suppliers.  Arrangements withinternational raw material suppliers are subject to, among other things, FDAregulation, customs clearances, various import duties and other governmentclearances.  Acts of governments outsidethe U.S. may affect the price or availability of raw materials needed for thedevelopment or manufacture of our products. In addition, recent changes inpatent laws in jurisdictions outside the U.S. may make it increasinglydifficult to obtain raw materials for research and development prior to theexpiration of the applicable U.S. or foreign patents.

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**Ourpolicies regarding returns, allowances and chargebacks, and marketing programsadopted by wholesalers, may reduce our revenues in future fiscal periods**.

Based on industry practice, generic product manufacturers, includingWatson, have liberal return policies and have been willing to give customerspost-sale inventory allowances.  Underthese arrangements, from time to time, we give our customers credits on ourgeneric products that our customers hold in inventory after we have decreasedthe market prices of the same generic products. Therefore, if new competitors enter the marketplace and significantlylower the prices of any of their competing products, we would likely reduce theprice of our product.  As a result, wewould be obligated to provide significant credits to our customers who are thenholding inventories of such products, which could reduce sales revenue andgross margin for the period the credit is provided.  Like our competitors, we also give creditsfor chargebacks to wholesale customers that have contracts with us for theirsales to hospitals, group purchasing organizations, pharmacies or other retailcustomers.  A chargeback represents an amount payable in thefuture to a wholesaler for the difference between the invoice price paid to usby our wholesale customer for a particular product and the negotiated contractprice that the wholesaler’s customer pays for that product.  Althoughwe establish reserves based on our prior experience and our best estimates ofthe impact that these policies may have in subsequent periods, we cannot ensurethat our reserves are adequate or that actual product returns, allowances andchargebacks will not exceed our estimates, which could adversely affect ourfinancial condition, cash flows and market price of our stock.

**Investigations of the calculation of average wholesale prices mayadversely affect our business.**

Manygovernment and third-party payors, including Medicare, Medicaid, Health MaintenanceOrganizations (“HMOs”) and Managed Care Organizations (“MCOs”), reimbursedoctors and others for the purchase of certain prescription drugs based on adrug’s average wholesale price (“AWP”). In the past several years, state and federal government agencies haveconducted ongoing investigations of manufacturers’ reporting practices withrespect to AWP, in which they have suggested that reporting of inflated AWP’shave led to excessive payments for prescription drugs.  For example, beginning in July 2002, we andcertain of our subsidiaries, as well as numerous other pharmaceuticalcompanies, were named as defendants in various state and federal court actionsalleging improper or fraudulent practices related to the reporting of AWP ofcertain products, and other improper acts, in order to increase prices andmarket shares.  Additional actions areanticipated.  These actions, ifsuccessful, could adversely affect us and may have a material adverse effect onour business, results of operations, financial condition and cash flows.

**Thedesign, development, manufacture and sale of our products involves the risk ofproduct liability claims by consumers and other third parties, and insuranceagainst such potential claims is expensive and may be difficult to obtain.**

The design, development, manufacture and sale of our products involvean inherent risk of product liability claims and the associated adversepublicity.  Insurance coverage isexpensive and may be difficult to obtain, and may not be available in the futureon acceptable terms, or at all.  Althoughwe currently maintain product liability insurance for our products in amountswe believe to be commercially reasonable, if the coverage limits of theseinsurance policies are not adequate, a claim brought against Watson, whethercovered by insurance or not, could have a material adverse effect on ourbusiness, results of operations, financial condition and cash flows.

**Theloss of our key personnel could cause our business to suffer.**

The success of our present and future operations will depend, to asignificant extent, upon the experience, abilities and continued services ofkey personnel.  For example, although wehave other senior management personnel, a significant loss of the services ofAllen Chao, Ph.D., our Chairman and Chief Executive Officer, or other seniorexecutive officers, could cause our business to suffer.  We cannot assure you that we will be able toattract and retain key personnel.  Wehave entered into employment agreements with all of our senior executiveofficers, including Dr. Chao.  We do notcarry key-man life insurance on any of our officers.

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**Rising insurance costs could negatively impact profitability.**

The cost of insurance, including workers compensation, productliability and general liability insurance, have risen significantly in recentyears and may increase in 2006.  Inresponse, we may increase deductibles and/or decrease certain coverages tomitigate these costs.  These increases,and our increased risk due to increased deductibles and reduced coverages,could have a negative impact on our results of operations, financial conditionand cash flows.

**Implementation of enterprise resource planning systems could causebusiness interruptions and negatively affect our profitability and cash flows.**

From time to time, we may implement new enterprise resource planning (“ERP”)systems and software, or upgrades to existing systems and software, to furtherenhance our operations.  Implementationof ERP systems and software carry risks such as cost overruns, project delaysand business interruptions and delays. If we experience a material business interruption as a result of suchimplementations, it could have a material adverse effect on our business, resultsof operations, financial condition and cash flows.

**Significantbalances of intangible assets, including product rights and goodwill acquired,are subject to impairment testing and may result in impairment charges, whichwill adversely affect our results of operations and financial condition.**

A significant amount of our total assets is related to acquired productrights and goodwill.  As of December 31,2005, the carrying value of our product rights and other intangible assets wasapproximately $750 million and the carrying value of our goodwill wasapproximately $460 million.  Theseamounts will increase significantly as a result of our acquisition of AndrxCorporation.

Our product rights are stated at cost, less accumulatedamortization.  We determine original fairvalue and amortization periods for product rights based on our assessment ofvarious factors impacting estimated useful lives and cash flows of the acquiredproducts.  Such factors include theproduct’s position in its life cycle, the existence or absence of like productsin the market, various other competitive and regulatory issues and contractualterms.  Significant changes to any ofthese factors would require us to perform an impairment test on the affectedasset and, if evidence of impairment exists, we would be required to take animpairment charge with respect to the asset. Such a charge would adversely affect our results of operations andfinancial condition.

Goodwillis tested for impairment annually and when events occur or circumstances changethat could potentially reduce the fair value of the reporting unit. Impairmenttesting compares the fair value of the reporting unit to its carrying amount.An impairment, if any, would be recorded in operating income and could have asignificant adverse effect on our results of operations and financialcondition.

**Issuance of debt or equity securities could materially change ouroperating results and financial condition.**

Wemay consider issuing additional debt or equity securities in the future to fundpotential acquisitions or investments, to refinance existing debt, or forgeneral corporate purposes.  If amaterial acquisition or investment is completed, our operating results andfinancial condition could change materially in future periods.  However, no assurance can be given that additionalfunds will be available on satisfactory terms, or at all, to fund suchactivities.

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*RisksRelating To Investing In the Pharmaceutical Industry*

**Extensive industry regulation has had, and will continue to have, asignificant impact on our business, especially our product development,manufacturing and distribution capabilities.**

All pharmaceutical companies, including Watson, are subject toextensive, complex, costly and evolving regulation by the federal government,principally the FDA and to a lesser extent by the U.S. Drug EnforcementAdministration (“DEA”) and state government agencies.  The Federal Food, Drug and Cosmetic Act, theControlled Substances Act and other federal statutes and regulations govern orinfluence the testing, manufacturing, packing, labeling, storing, recordkeeping, safety, approval, advertising, promotion, sale and distribution of ourproducts.

Under these regulations, we are subject to periodic inspection of ourfacilities, procedures and operations and/or the testing of our products by theFDA, the DEA and other authorities, which conduct periodic inspections toconfirm that we are in compliance with all applicable regulations.  In addition, the FDA conducts pre-approvaland post-approval reviews and plant inspections to determine whether oursystems and processes are in compliance with current Good ManufacturingPractices (“cGMP”) and other FDA regulations. Following such inspections, the FDA may issue notices on Form 483 andwarning letters that could cause us to modify certain activities identifiedduring the inspection.  A Form 483 noticeis generally issued at the conclusion of a FDA inspection and lists conditionsthe FDA inspectors believe may violate cGMP or other FDA regulations.  FDA guidelines specify that a warning letteris issued only for violations of “regulatory significance” for which thefailure to adequately and promptly achieve correction may be expected to resultin an enforcement action.

Our principal manufacturing facility in Corona, California (whichmanufactured products representing approximately 17% of our total product netrevenues for 2005) is currently subject to a consent decree of permanentinjunction.  Similarly, Andrx’s principlemanufacturing facility in Davie, Florida, is currently under Official ActionIndicated (“OAI”) status by the FDA. While on OAI status, Andrx is not eligible to obtain approvals forproducts manufactured at its Davie, Florida facility.  We cannot assure you that the FDA willdetermine that we or Andrx have adequately corrected deficiencies at ourrespective manufacturing sites (including the ones referenced above), thatsubsequent FDA inspections will not result in additional inspectionalobservations at such sites, that approval of any of the pending or subsequentlysubmitted NDAs, ANDAs or supplements to such applications by Watson, Andrx ortheir subsidiaries will be granted or that the FDA will not seek to imposeadditional sanctions against Watson, Andrx or any of their subsidiaries.  The range of possible sanctions includes,among others, FDA issuance of adverse publicity, product recalls or seizures,fines, total or partial suspension of production and/or distribution,suspension of the FDA’s review of product applications, enforcement actions,injunctions, and civil or criminal prosecution. Any such sanctions, if imposed, could materially harm our operatingresults and financial condition.  Undercertain circumstances, the FDA also has the authority to revoke previouslygranted drug approvals.  Similarsanctions as detailed above may be available to the FDA under a consent decree,depending upon the actual terms of such decree. Although we and Andrx have instituted internal compliance programs, ifthese programs do not meet regulatory agency standards or if compliance isdeemed deficient in any significant way, it could materially harm ourbusiness.  Certain of our vendors aresubject to similar regulation and periodic inspections.

The process for obtaining governmental approval to manufacture andmarket pharmaceutical products is rigorous, time-consuming and costly, and wecannot predict the extent to which we may be affected by legislative andregulatory developments.  We aredependent on receiving FDA and other governmental or third-party approvalsprior to manufacturing, marketing and shipping our products.  Consequently, there is always the chance thatwe will not obtain FDA or other necessary approvals, or that the rate, timingand cost of such approvals, will adversely affect our product introductionplans or results of operations.  We carryinventories of certain product(s) in anticipation of launch, and if suchproduct(s) are not subsequently launched, we may be required to write-off therelated inventory.

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**Federalregulation of arrangements between manufacturers of brand and generic productscould adversely affect our business.**

As part of the Medicare Prescription Drug, Improvement, andModernization Act of 2003 (the “MMA”), companies are required to file with theFederal Trade Commission (“FTC”) and the Department of Justice certain types ofagreements entered into between brand and generic pharmaceutical companiesrelated to the manufacture, marketing and sale of generic versions of branddrugs.  This requirement could affect themanner in which generic drug manufacturers resolve intellectual propertylitigation and other disputes with brand pharmaceutical companies and couldresult generally in an increase in private-party litigation againstpharmaceutical companies or additional investigations or proceedings by the FTCor other governmental authorities.  Theimpact of this requirement, and the potential private-party lawsuits associatedwith arrangements between brand name and generic drug manufacturers, isuncertain and could adversely affect our business.

**Healthcare reform and a reductionin the reimbursement levels by governmental authorities, HMOs, MCOs or otherthird-party payors may****adversely affect our business.**

In order to assist us in commercializing products, we have obtainedfrom government authorities and private health insurers and otherorganizations, such as HMOs and MCOs, authorization to receive reimbursement atvarying levels for the cost of certain products and related treatments.  Third party payors increasingly challengepricing of pharmaceutical products.  Thetrend toward managed healthcare in the U.S., the growth of organizations suchas HMOs and MCOs and legislative proposals to reform healthcare and governmentinsurance programs could significantly influence the purchase of pharmaceuticalproducts, resulting in lower prices and a reduction in product demand.  Such cost containment measures and healthcarereform could affect our ability to sell our products and may have a materialadverse effect on our business, results of operations and financialcondition.  Additionally, there isuncertainty surrounding the implementation of the provisions of Part D of theMMA.  Depending on how such provisionsare implemented, reimbursement may not be available for some of Watson’sproducts.  Additionally, anyreimbursement granted may not be maintained or limits on reimbursementavailable from third-party payors may reduce the demand for, or negativelyaffect the price of, those products and could harm significantly our business,results of operations, financial condition and cash flows.  We may also be subject to lawsuits relatingto reimbursement programs that could be costly to defend, divert management’sattention and adversely affect our operating results.

**Thepharmaceutical industry is highly competitive.**

We face strong competition in both ourgeneric and brand product businesses. The intensely competitive environment requires an ongoing, extensivesearch for technological innovations and the ability to market productseffectively, including the ability to communicate the effectiveness, safety andvalue of brand products to healthcare professionals in private practice, grouppractices and MCOs. Our competitors vary depending upon product categories, andwithin each product category, upon dosage strengths and drug-delivery systems.Based on total assets, annual revenues, and market capitalization, we aresmaller than certain of our national and international competitors in the brandproduct arena.  Most of our competitorshave been in business for a longer period of time than Watson, have a greaternumber of products on the market and have greater financial and other resourcesthan we do.  If we directly compete withthem for the same markets and/or products, their financial strength couldprevent us from capturing a profitable share of those markets. It is possiblethat developments by our competitors will make our products or technologiesnoncompetitive or obsolete.

Revenues and gross profit derived from the sales of genericpharmaceutical products tend to follow a pattern based on certain regulatoryand competitive factors.  As patents forbrand name products and related exclusivity periods expire, the first genericmanufacturer to receive regulatory approval for generic equivalents of suchproducts is generally able to achieve significant market penetration.  As competing off-patent manufacturers receiveregulatory approvals on similar products or as brand manufacturers launchgeneric versions of such 

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products(for which no separate regulatory approval is required), market share, revenuesand gross profit typically decline, in some cases dramatically.  Accordingly, the level of market share,revenue and gross profit attributable to a particular generic product normallyis related to the number of competitors in that product’s market and the timingof that product’s regulatory approval and launch, in relation to competingapprovals and launches.  Consequently, wemust continue to develop and introduce new products in a timely andcost-effective manner to maintain our revenues and gross margins.  Additionally, as new competitors enter themarket, there may be increased pricing pressure on certain products, whichwould result in lower gross margins. This is particularly true in the case of certain Asian and otheroverseas competitors, who may be able to produce products at costs lower thanthe costs of domestic manufacturers.  Ifwe experience substantial competition from Asian or other overseas competitorswith lower production costs, our profit margins will suffer.

**Salesof our products may continue to be adversely affected by the continuingconsolidation of our distribution network and the concentration of our customerbase.**

Our principal customers are wholesale drug distributors and majorretail drug store chains.  Thesecustomers comprise a significant part of the distribution network forpharmaceutical products in the U.S.  Thisdistribution network is continuing to undergo significant consolidation markedby mergers and acquisitions among wholesale distributors and the growth oflarge retail drug store chains.  As aresult, a small number of large wholesale distributors and large chain drugstores control a significant share of the market.  We expect that consolidation of drugwholesalers and retailers will increase pricing and other competitive pressureson drug manufacturers, including Watson.

For the year ended December 31, 2005, our four largestcustomers accounted for 16%, 13%, 10% and 9% respectively, of our netrevenues.  The loss of any of thesecustomers could materially adversely affect our business, results ofoperations, financial condition and our cash flows.  In addition, none of our customers are partyto any long-term supply agreements with us, and thus are able to changesuppliers freely should they wish to do so.

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**ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES ANDUSE OF PROCEEDS**

**(a) Recent Sales of UnregisteredSecurities**

There were nounregistered sales of equity securities.

**(b) Use of Proceeds**

N/A.

**(c) Issuer Purchases ofEquity Securities**

On February 10, 2005, the Board authorized a program to repurchase upto $300.0 million common shares of Watson’s common stock over a period of oneyear (the “2005Repurchase Program”).  During2005, under the 2005 Repurchase Program, werepurchased approximately 9.4 million shares of our common stock at anaggregate cost of approximately $300.0 million.

On February 15, 2006, theBoard authorized the expenditure of an additional $300.0 million to repurchaseshares of the Company’s outstanding common stock (the “2006 Repurchase Program”).  Under the 2006 Repurchase Program, therepurchases can be made in open market or privately negotiated transactionsfrom time to time in compliance with the Securities and Exchange Commission’sRule 10b-18, subject to market conditions, applicable legal requirements andother factors. Additionally, the Board has authorized that purchases under the2006 Repurchase Program may be made under Rule 10b5-1 promulgated under theSecurities and Exchange Act of 1934, as amended.  A Rule 10b5-1 plan allows Watson torepurchase its shares during periods when it would normally not be active inthe market due to its internal trading blackout periods. All such purchasesmust be made in accordance with a pre-defined plan that is established when theplan administrator is not aware of any material non-public information.

No common stock has been repurchased under the 2006 Repurchase Programduring the third quarter of 2006.

**ITEM 6.  EXHIBITS**

(a)Exhibits:

Reference is hereby made to the Exhibit Index on page 59.

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.
|                         | ** ** | **WATSON  PHARMACEUTICALS, INC.**                               |
|-------------------------|------------|-----------------------------------------------------------------|
| ** **              | ** ** | (Registrant)                                                    |
| ** **              | ** ** | ** **                                                      |
| ** **              | ** ** | ** **                                                      |
|                    | By:        | **/s/ R.  Todd Joyce**                                          |
|                    |       | R. Todd Joyce                                                   |
|                    |       | Vice President –  Corporate Controller and  Treasurer      |
|                    |       |                                                            |
|                    |       | (Principal Financial  Officer and Principal Accounting Officer) |
|                    |       |                                                            |
|                    |       |                                                            |
| Date: November  7, 2006 |       |                                                            |

 

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**WATSON PHARMACEUTICALS, INC.**

**EXHIBITINDEX TO FORM 10-Q**

**For the Quarterly Period Ended September 30, 2006**
| Exhibit  No. | ** ** | **Description**                                                                                                           |
|--------------|------------|---------------------------------------------------------------------------------------------------------------------------|
|         |       |                                                                                                                      |
| 31.1         |       | Certification of Chairman and Chief Executive  Officer pursuant to Rule 13a-14a of the Securities Exchange Act of 1934.   |
|         |       |                                                                                                                      |
| 31.2         |       | Certification of Principal Financial Officer  pursuant to Rule 13a-14a of the Securities Exchange Act of 1934.            |
|         |       |                                                                                                                      |
| 32.1         |       | Certification of Chairman and Chief Executive  Officer pursuant to Rule 13a-14(d) of the Securities Exchange Act of 1934. |
|         |       |                                                                                                                      |
| 32.2         |       | Certification of Principal Financial Officer  pursuant to Rule 13a-14(d) of the Securities Exchange Act of 1934.          |

 

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