**UNITED STATES****SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C.20549**

 

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**FORM 10-Q**

 

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ý  **QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d)**

**OF THESECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE QUARTERLYPERIOD ENDED JUNE 30, 2003**

 

**or**

 

o  **TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d)**

**OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from                to                **

 

**Commission filenumber 0-20045**

 

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**WATSON PHARMACEUTICALS, INC.**

(Exact name of registrant as specified in its charter)

 

| **Nevada**                                                      |   | **95-3872914**                       |
|-----------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer Identification No.) |
|                                                            |   |                                 |
| **311 Bonnie Circle****Corona,   CA  92880-2882**     |
| (Address of principal executive offices, including zip code)    |
|                                                            |   |                                 |
| **(909) 493-5300**                                              |
| (Registrant’s telephone number, including area code)       |

 

Indicate by check mark whether the Registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  Yes ý  Noo

 

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

 

The number of shares outstanding of the Registrant’s only class ofcommon stock as of August 11, 2003 was approximately 107,734,417.

 

 

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**WATSON PHARMACEUTICALS, INC.**

 

**TABLE OF CONTENTS**

 

**FORM 10-Q FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003**

 
| **Part I.**** ****FINANCIAL INFORMATION**      |
|-----------------------------------------------------|
|                                                |
| Item 1.                                             | Consolidated Financial Statements: |
|                                                |
|                                                | Consolidated Balance Sheets  as of June 30, 2003 and December 31, 2002 |
|                                                |   |
|                                                | Consolidated  Statements of Income for the Three and Six Months Ended June 30, 2003 and  2002 |
|                                                |   |
|                                                | Consolidated  Statements of Cash Flows for the Six Months Ended June 30, 2003 and 2002 |
|                                                |   |
|                                                | Notes to  Consolidated Financial Statements |
|                                                |
| Item 2.                                             | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |
|                                                |   |
| Item 3.                                             | Quantitative and Qualitative Disclosure about  Market Risk |
|                                                |   |
| Item 4.                                             | Controls and Procedures |
|                                                |   |
| **Part II.  OTHER INFORMATION AND SIGNATURES** |
|                                                |
| Item 1.                                        | Legal Proceedings |
|                                                |   |
| Item  4.                                       | Submission  of Matters to a Vote of Security Holders |
|                                                |   |
| Item 6.                                        | Exhibits and Reports on Form 8-K |
|                                                |   |
| Signatures                                          |
|                                                     |  |  |

 

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**WATSON PHARMACEUTICALS, INC.**

**CONSOLIDATEDBALANCE SHEETS**

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

 
|                                                                                                                      |   | **June 30,  2003** |       | **December 31,  2002** |       |
|---------------------------------------------------------------------------------------------------------------------------|--------|--------------------|------------|------------------------|------------|
| **ASSETS**                                                                                                                |   |               | ** ** |                   | ** ** |
| Current assets:                                                                                                           |   |               |       |                   |       |
| Cash and cash equivalents                                                                                                 |   | $                  | 535,842    |                   | $          | 230,155 |   |
| Marketable securities                                                                                                     |   | 46,746             |       | 42,649                 |       |
| Accounts receivable, net                                                                                                  |   | 130,668            |       | 178,563                |       |
| Inventories                                                                                                               |   | 375,798            |       | 348,773                |       |
| Prepaid expenses and other current assets                                                                                 |   | 21,598             |       | 35,895                 |       |
| Deferred tax assets                                                                                                       |   | 96,074             |       | 77,416                 |       |
| Total current assets                                                                                                      |   | 1,206,726          |       | 913,451                |       |
| Property and equipment, net                                                                                               |   | 340,776            |       | 304,667                |       |
| Investments and other assets                                                                                              |   | 85,181             |       | 75,435                 |       |
| Deferred tax assets                                                                                                       |   | 33,563             |       | 34,596                 |       |
| Product rights and other intangibles, net                                                                                 |   | 1,031,046          |       | 889,027                |       |
| Goodwill                                                                                                                  |   | 446,288            |       | 446,288                |       |
| Total assets                                                                                                              |   | $                  | 3,143,580  |                   | $          | 2,663,464 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                             |   |               | ** ** |                   | ** ** |
| Current liabilities:                                                                                                      |   |               |       |                   |       |
| Accounts payable and accrued expenses                                                                                     |   | $                  | 209,391    |                   | $          | 177,812 |   |
| Income taxes payable                                                                                                      |   | 119,560            |       | 111,565                |       |
| Current portion of long-term debt                                                                                         |   | —             |       | 83,360                 |       |
| Other current liabilities                                                                                                 |   | 1,718              |       | 2,728                  |       |
| Total current liabilities                                                                                                 |   | 330,669            |       | 375,465                |       |
|                                                                                                                      |   |               |       |                   |       |
| Long-term debt                                                                                                            |   | 722,320            |       | 331,877                |       |
| Other long-term liabilities                                                                                               |   | 9,881              |       | 5,948                  |       |
| Deferred tax liabilities                                                                                                  |   | 150,463            |       | 151,890                |       |
| Total liabilities                                                                                                         |   | 1,213,333          |       | 865,180                |       |
|                                                                                                                      |   |               |       |                   |       |
| Commitments and contingencies                                                                                             |   |               |       |                   |       |
|                                                                                                                      |   |               |       |                   |       |
| Stockholders’ equity:                                                                                                |   |               |       |                   |       |
| Preferred stock; no par value per share; 2,500,000 shares authorized;  none issued                                        |   | —             |       | —                 |       |
| Common stock; $0.0033 par value per share; 500,000,000 shares  authorized; 107,494,300 and 106,878,900 shares outstanding |   | 355                |       | 353                    |       |
| Additional paid-in capital                                                                                                |   | 814,307            |       | 797,097                |       |
| Retained earnings                                                                                                         |   | 1,097,394          |       | 998,850                |       |
| Accumulated other comprehensive income                                                                                    |   | 18,191             |       | 1,984                  |       |
| Total stockholders’ equity                                                                                           |   | 1,930,247          |       | 1,798,284              |       |
| Total liabilities and stockholders’ equity                                                                           |   | $                  | 3,143,580  |                   | $          | 2,663,464 |   |

 

*See accompanying Notes to Consolidated FinancialStatements.*

 

1

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**WATSON PHARMACEUTICALS, INC.**

**CONSOLIDATEDSTATEMENTS OF INCOME**

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

 
|                                          |   | **Three Months Ended  June 30,** |    | **Six Months Ended  June 30,** |   |
|-----------------------------------------------|--------|----------------------------------|---------|--------------------------------|--------|
|                                          |   | **2003**                         |    | **2002**                       |   | **2003** |   | **2002** |   |
|                                          |   |                             |    |                           |   |   |   |   |   |
| Net revenues                                  |   | $                                | 355,880 |                           | $      | 300,074 |   | $ | 692,802 |   | $ | 585,764 |   |
| Cost of sales                                 |   | 154,376                          |    | 138,085                        |   | 303,977 |   | 273,772 |   |
| Gross profit                                  |   | 201,504                          |    | 161,989                        |   | 388,825 |   | 311,992 |   |
|                                          |   |                             |    |                           |   |   |   |   |   |
| Operating expenses:                           |   |                             |    |                           |   |   |   |   |   |
| Research and development                      |   | 25,701                           |    | 19,769                         |   | 48,185 |   | 38,288 |   |
| Selling, general and administrative           |   | 72,214                           |    | 59,635                         |   | 139,873 |   | 121,898 |   |
| Amortization                                  |   | 17,785                           |    | 14,542                         |   | 36,220 |   | 27,836 |   |
| Total operating expenses                      |   | 115,700                          |    | 93,946                         |   | 224,278 |   | 188,022 |   |
| Operating income                              |   | 85,804                           |    | 68,043                         |   | 164,547 |   | 123,970 |   |
|                                          |   |                             |    |                           |   |   |   |   |   |
| Other income (expense):                       |   |                             |    |                           |   |   |   |   |   |
| Equity in earnings (losses) of joint ventures |   | 88                               |    | (755                           | )      | 205 |   | (1,814 | ) |
| Impairment of securities                      |   | (1,218                           | )       | —                         |   | (14,260 | ) | — |   |
| Gain on sale of securities                    |   | 1,925                            |    | —                         |   | 3,014 |   | — |   |
| Gain on sale of subsidiary                    |   | —                           |    | —                         |   | 15,676 |   | — |   |
| Gain from legal settlement                    |   | —                           |    | 32,000                         |   | — |   | 32,000 |   |
| Loss on early extinguishment of debt          |   | —                           |    | —                         |   | (2,807 | ) | — |   |
| Interest income                               |   | 1,442                            |    | 1,678                          |   | 2,684 |   | 3,277 |   |
| Interest expense                              |   | (7,580                           | )       | (5,783                         | )      | (12,921 | ) | (10,943 | ) |
| Other income (expense)                        |   | (844                             | )       | (14                            | )      | (1,438 | ) | 15 |   |
| Total other income (expense), net             |   | (6,187                           | )       | 27,126                         |   | (9,847 | ) | 22,535 |   |
|                                          |   |                             |    |                           |   |   |   |   |   |
| Income before income taxes                    |   | 79,617                           |    | 95,169                         |   | 154,700 |   | 146,505 |   |
| Provision for income taxes                    |   | 28,902                           |    | 35,213                         |   | 56,156 |   | 54,464 |   |
| Net income                                    |   | $                                | 50,715  |                           | $      | 59,956 |   | $ | 98,544 |   | $ | 92,041 |   |
|                                          |   |                             |    |                           |   |   |   |   |   |
| Earnings per share:                           |   |                             |    |                           |   |   |   |   |   |
| Basic                                         |   | $                                | 0.47    |                           | $      | 0.56 |   | $ | 0.92 |   | $ | 0.86 |   |
| Diluted                                       |   | $                                | 0.47    |                           | $      | 0.56 |   | $ | 0.91 |   | $ | 0.86 |   |
|                                          |   |                             |    |                           |   |   |   |   |   |
| Weighted average shares outstanding:          |   |                             |    |                           |   |   |   |   |   |
| Basic                                         |   | 107,134                          |    | 106,515                        |   | 107,038 |   | 106,491 |   |
| Diluted                                       |   | 108,334                          |    | 107,229                        |   | 107,847 |   | 107,315 |   |

 

*See accompanying Notes to Consolidated FinancialStatements.*

 

2

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**WATSON PHARMACEUTICALS, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited; in thousands)

 
|                                                        |   | **Six Months Ended  June 30,** |    |
|-------------------------------------------------------------|--------|--------------------------------|---------|
|                                                        |   | **2003**                       |    | **2002** |   |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                   |   |                           |    |   |   |
| Net income                                                  |   | $                              | 98,544  |   | $ | 92,041 |   |
| Reconciliation to net cash provided by operating activites: |   |                           |    |   |   |
| Depreciation                                                |   | 13,767                         |    | 12,399 |   |
| Amortization                                                |   | 36,220                         |    | 27,836 |   |
| Deferred income tax benefit                                 |   | (19,213                        | )       | (3,774 | ) |
| Equity in (earnings) losses of joint ventures               |   | (205                           | )       | 1,497 |   |
| Gain on sale of securities                                  |   | (3,014                         | )       | — |   |
| Gain on sale of subsidiary                                  |   | (15,676                        | )       | — |   |
| Loss on early extinguishment of debt                        |   | 2,807                          |    | — |   |
| Charge for impairment of securities                         |   | 14,260                         |    | — |   |
| Tax benefits related to exercises of stock options          |   | 3,050                          |    | 1,240 |   |
| Other                                                       |   | (1,015                         | )       | 997 |   |
| Changes in assets and liabilities:                          |   |                           |    |   |   |
| Accounts receivable                                         |   | 45,699                         |    | (4,863 | ) |
| Inventories                                                 |   | (27,999                        | )       | (26,166 | ) |
| Prepaid expenses and other current assets                   |   | 14,260                         |    | 2,912 |   |
| Accounts payable and accrued expenses                       |   | 33,564                         |    | 6,706 |   |
| Income taxes payable                                        |   | 8,016                          |    | 78,574 |   |
| Other assets                                                |   | (2,643                         | )       | 8,848 |   |
| Other liabilities                                           |   | 2,000                          |    | — |   |
| Total adjustments                                           |   | 103,878                        |    | 106,206 |   |
| Net cash provided by operating activities                   |   | 202,422                        |    | 198,247 |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                   |   |                           |    |   |   |
| Additions to property and equipment                         |   | (53,696                        | )       | (35,779 | ) |
| Acquisitions of product rights                              |   | (178,468                       | )       | (70,512 | ) |
| Proceeds from sales of securities                           |   | 7,388                          |    | — |   |
| Proceeds from sale of subsidiary                            |   | 16,368                         |    | — |   |
| Other investing activities, net                             |   | 3,838                          |    | (430 | ) |
| Net cash used in investing activities                       |   | (204,570                       | )       | (106,721 | ) |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                   |   |                           |    |   |   |
| Proceeds from issuance of debt, net of issuance costs       |   | 560,625                        |    | — |   |
| Proceeds from borrowings under revolving credit facility    |   | 60,000                         |    | — |   |
| Principal payments on credit facility                       |   | (325,940                       | )       | — |   |
| Principal payments on acquisition liabilities               |   | (1,012                         | )       | — |   |
| Proceeds from stock plans                                   |   | 14,162                         |    | 1,776 |   |
| Net cash provided by financing activities                   |   | 307,835                        |    | 1,776 |   |
| Net increase in cash and cash equivalents                   |   | 305,687                        |    | 93,302 |   |
| Cash and cash equivalents at beginning of period            |   | 230,155                        |    | 193,731 |   |
| Cash and cash equivalents at end of period                  |   | $                              | 535,842 |   | $ | 287,033 |   |

 

*See accompanying Notes to Consolidated Financial Statements.*

 

3

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**WATSONPHARMACEUTICALS, INC.**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE A – GENERAL**

 

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

 

Theaccompanying consolidated financial statements should be read in conjunctionwith the Company’s Annual Report on Form 10-K for the year ended December31, 2002.  Certain information andfootnote disclosures normally included in annual financial statements preparedin accordance with generally accepted accounting principles have been condensedor omitted from the accompanying consolidated financial statements.  The accompanying interim financialstatements are unaudited, but reflect all adjustments which are, in the opinionof management, necessary to present fairly Watson’s consolidated financial position,results of operations and cash flows for the periods presented.  Unless otherwise noted, all such adjustmentsare of a normal, recurring nature. Certain reclassifications, none of which affected net income or retainedearnings, have been made to prior period amounts to conform to current periodpresentation.  The Company’s results ofoperations and cash flows for the interim periods are not necessarilyindicative of the results of operations and cash flows that it may achieve infuture periods or for the full year.

 

*Comprehensive income*

 

Comprehensiveincome includes all changes in equity during a period except those thatresulted from investments by or distributions to the Company’sstockholders.  Other comprehensiveincome refers to revenues, expenses, gains and losses that, under generallyaccepted accounting principles, are included in comprehensive income, butexcluded from net income as these amounts are recorded directly as anadjustment to stockholders’ equity. Watson’s other comprehensive income (loss) is comprised of unrealized gains(losses) on its holdings of publicly traded equity securities, net of realizedgains included in net income.  Thecomponents of comprehensive income and related income taxes consisted of thefollowing (in thousands): 

 
|                                            |   | **Three Months Ended  June 30,** |   | **Six Months Ended  June 30,** |   |
|-------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                            |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
|                                            |   |                             |   |                           |   |   |   |   |   |
| Net income                                      |   | $                                | 50,715 |                           | $      | 59,956 |   | $ | 98,544 |   | $ | 92,041 |   |
| Other comprehensive income (loss):              |   |                             |   |                           |   |   |   |   |   |
| Unrealized holding gain (loss) on securities    |   | 17,704                           |   | (21,063                        | )      | 15,072 |   | (67,680 | ) |
| Less related income taxes                       |   | (7,081                           | )      | 8,425                          |   | (6,029 | ) | 27,072 |   |
| Total unrealized gain (loss) on securities, net |   | 10,623                           |   | (12,638                        | )      | 9,043 |   | (40,608 | ) |
|                                            |   |                             |   |                           |   |   |   |   |   |
| Reclassification for (gains) losses included    |   |                             |   |                           |   |   |   |   |   |
| in net income                                   |   | (707                             | )      | —                         |   | 11,246 |   | — |   |
| Less related income taxes                       |   | 256                              |   | —                         |   | (4,082 | ) | — |   |
| Total reclassification, net                     |   | (451                             | )      | —                         |   | 7,164 |   | — |   |
| Total other comprehensive income (loss)         |   | 10,172                           |   | (12,638                        | )      | 16,207 |   | (40,608 | ) |
| Total comprehensive income                      |   | $                                | 60,887 |                           | $      | 47,318 |   | $ | 114,751 |   | $ | 51,433 |   |

 

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*Earnings per share*

* *

Basic earningsper share is computed by dividing net income by the weighted average commonshares outstanding.  Diluted earningsper share is based on the treasury stock method and is computed by dividing netincome by the weighted average number of common shares and dilutive potentialcommon shares outstanding, assuming the exercise of all in-the-money stockoptions. A reconciliation of the numerators and denominators of basic anddiluted earnings per share consisted of the following (in thousands, except pershare amounts): 

 
|                                               |   | **Three Months Ended  June 30,** |   | **Six Months Ended  June 30** |   |
|----------------------------------------------------|--------|----------------------------------|--------|-------------------------------|--------|
|                                               |   | **2003**                         |   | **2002**                      |   | **2003** |   | **2002** |   |
| **Numerator:**                                     |   |                             |   |                          |   |   |   |   |   |
| Net income                                         |   | $                                | 50,715 |                          | $      | 59,956 |   | $ | 98,544 |   | $ | 92,041 |   |
| **Denominator:**                                   |   |                             |   |                          |   |   |   |   |   |
| Basic weighted average common shares outstanding   |   | 107,134                          |   | 106,515                       |   | 107,038 |   | 106,491 |   |
| Effect of dilutive stock options                   |   | 1,200                            |   | 714                           |   | 809 |   | 824 |   |
| Diluted weighted average common shares outstanding |   | 108,334                          |   | 107,229                       |   | 107,847 |   | 107,315 |   |
|                                               |   |                             |   |                          |   |   |   |   |   |
| **Basic earnings per share**                       |   | $                                | 0.47   |                          | $      | 0.56 |   | $ | 0.92 |   | $ | 0.86 |   |
|                                               |   |                             |   |                          |   |   |   |   |   |
| **Diluted earnings per share**                     |   | $                                | 0.47   |                          | $      | 0.56 |   | $ | 0.91 |   | $ | 0.86 |   |

 

Excluded fromthe computation of diluted earnings per share are outstanding common stockoptions with an exercise price greater than the average market price of thecommon shares for the period reported. For the three month periods ended June 30, 2003 and 2002, excluded fromthe computation of diluted earnings per share were stock options to purchase5.7 million and 10.5 million common shares, respectively. For the six monthperiods ended June 30, 2003 and 2002, excluded from the computation of dilutedearnings per share were stock options to purchase 7.6 million and 10.3 millioncommon shares, respectively.

 

The effect ofapproximately 14.4 million shares related to the assumed conversion of the $575million convertible contingent debentures (as described in Note H) has beenexcluded from the computation of diluted earnings per share for the three andsix months ended June 30, 2003 as none of the conditions that would permitconversion have been satisfied.

 

*Stock-based compensation*

 

The Companyaccounts for its stock-based employee compensation plans using the recognitionand measurement principles of Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees” and related interpretations.  No stock-based employee compensation expensehas been recognized for the options in the accompanying consolidated statementsof income, as all options granted under the plans had an exercise price equalto the market value of the underlying common stock on the date of grant.

 

5

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Had theCompany determined compensation expense for all prior periods using the fairvalue method prescribed by Statement of Financial Accounting Standards (SFAS)No. 123, “Accounting for Stock-Based Compensation”, the Company’s net incomeand earnings per share would have been as follows (in thousands, except pershare amounts): 

 
|                                                                                                     |   | **Three Months Ended  June 30,** |   | **Six Months Ended  June 30,** |   |
|----------------------------------------------------------------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                                                                                     |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
| Net income                                                                                               |   | $                                | 50,715 |                           | $      | 59,956 |   | $ | 98,544 |   | $ | 92,041 |   |
| Total stock-based employee compensation expense determined under fair  value based method for all awards |   | 6,664                            |   | 11,185                         |   | 14,640 |   | 25,093 |   |
| Tax effect of compensation expense                                                                       |   | (2,419                           | )      | (4,139                         | )      | (5,314 | ) | (9,328 | ) |
| Pro forma net income                                                                                     |   | $                                | 46,470 |                           | $      | 52,910 |   | $ | 89,218 |   | $ | 76,276 |   |
|                                                                                                     |   |                             |   |                           |   |   |   |   |   |
| Earnings per share:                                                                                      |   |                             |   |                           |   |   |   |   |   |
| Basic - as reported                                                                                      |   | $                                | 0.47   |                           | $      | 0.56 |   | $ | 0.92 |   | $ | 0.86 |   |
| Basic - pro forma                                                                                        |   | $                                | 0.43   |                           | $      | 0.50 |   | $ | 0.83 |   | $ | 0.72 |   |
|                                                                                                     |   |                             |   |                           |   |   |   |   |   |
| Diluted - as reported                                                                                    |   | $                                | 0.47   |                           | $      | 0.56 |   | $ | 0.91 |   | $ | 0.86 |   |
| Diluted - pro forma                                                                                      |   | $                                | 0.43   |                           | $      | 0.49 |   | $ | 0.83 |   | $ | 0.71 |   |
|                                                                                                     |   |                             |   |                           |   |   |   |   |   |
| Weighted average shares outstanding:                                                                     |   |                             |   |                           |   |   |   |   |   |
| Basic                                                                                                    |   | 107,134                          |   | 106,515                        |   | 107,038 |   | 106,491 |   |
| Diluted                                                                                                  |   | 108,334                          |   | 107,229                        |   | 107,847 |   | 107,315 |   |

 

The weightedaverage fair value of the options has been estimated on the date of grant usingthe Black-Scholes option-pricing model. Weighted averages are used because of varying assumed exercisedates.  The following weighted averageassumptions were used for options granted during the three and six months endedJune 30, 2003 and 2002: 

 
|                    |   | **2003**   |   | **2002**   |   |
|-------------------------|--------|------------|--------|------------|--------|
| Dividend yield          |   | None       |   | None       |   |
| Expected volatility     |   | 40         | %      | 38         | %      |
| Risk-free interest rate |   | 3.26       | %      | 4.21       | %      |
| Expected term           |   | 5.2  years |   | 5.1  years |   |

* *

*Recent accountingpronouncements*

 

In July 2002, the Financial Accounting Standards Board (FASB) issuedSFAS No. 146, “Accounting for Costs Associated with Exit or DisposalActivities.”  SFAS No. 146 requiresrecognition of a liability for a cost associated with an exit or disposalactivity when the liability is incurred, as opposed to when the entity commitsto an exit plan as provided under previous guidance. This statement iseffective for exit or disposal activities initiated after December 31, 2002.The Company adopted SFAS No. 146 on January 1, 2003, which had no materialimpact on the Company’s consolidated financial statements.  

 

In December 2002, the FASB issued SFAS No. 148, “Accounting forStock-Based Compensation – Transition and Disclosure.”  SFAS No. 148 amends SFAS No. 123,“Accounting for Stock-Based

 

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Compensation,” to provide alternative methods of transition for avoluntary change to the fair value based method of accounting for stock-basedemployee compensation.  In addition,SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to requireprominent disclosures in both annual and interim financial statements about themethod of accounting for stock-based employee compensation and the effect ofthe method used on reported results. The Company adopted SFAS No. 148 on January 1, 2003, which had nomaterial impact on the Company’s consolidated financial statements.  

 

In January 2003, the FASB issued Interpretation No. (FIN) 46,“Consolidation of Variable Interest Entities.” FIN 46 requires reporting entities to perform an evaluation in order todetermine whether the reporting entity has a controlling financial interest ina variable interest entity, and if that interest requires consolidation and/ordisclosure by the reporting entity.  FIN46 is effective immediately for all new variable interest entities created oracquired after January 31, 2003.  Forvariable interest entities created or acquired prior to February 1, 2003, theprovisions of FIN 46 must be applied for the first interim or annual periodbeginning after June 15, 2003.  TheCompany does not expect the provisions of FIN 46 to have a material impact onits consolidated financial statements.  

 

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends andclarifies accounting for derivative instruments, including certain derivativeinstruments embedded in other contracts, and for hedging activities under SFASNo. 133. SFAS No. 149 is generally effective for contracts entered into ormodified after June 30, 2003 (with a few exceptions) and for hedgingrelationships designated after June 30, 2003. The guidance is to be appliedprospectively. The Company does not expect the provisions of SFAS No. 149 tohave a material impact on its consolidated financial statements.  

 

In May 2003, the FASB issued SFAS No. 150, “Accounting for CertainFinancial Instruments with Characteristics of Both Liabilities and Equity.”SFAS No. 150 improves the accounting for certain financial instruments that,under previous guidance, issuers could account for as equity.  SFAS No. 150 requires that those instrumentsbe classified as liabilities in statements of financial position.  SFAS No. 150 is effective for financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective at the beginning of the first interim period beginning after June 15,2003.  The Company does not expect theprovisions of SFAS No. 150 to have a material impact on its consolidated financialstatements.

 

**NOTE B - ACQUISITIONSOF PRODUCT RIGHTS**

 

In February 2003, Watson acquired the U.S. rights to the Fioricetâand Fiorinalâ product lines from Novartis PharmaceuticalsCorporation (Novartis).  These productsare indicated for the treatment of tension headaches.  The Company paid approximately $178 million in cash for therights to these products.

 

7

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**NOTE C – EQUITYINVESTMENTS**

 

Watson’s equity investments in publicly traded companies are classifiedas available-for-sale and are recorded at fair value based on quoted marketprices using the specific identification method.  These investments are classified as either current ornon-current, as appropriate, on the Company’s Consolidated Balance Sheets.

 

*Current investments*

 

The Company’s current investments are comprised of the common stock ofAndrx Corporation — Andrx Group (Andrx) and Dr. Reddy’s Laboratories, Limited(Dr. Reddy), and are included in “Marketable securities” on the Company’sConsolidated Balance Sheets at June 30, 2003 and December 31, 2002.

 

During the three and six month periods ended June 30, 2003, Watson soldshares of its Andrx and Dr. Reddy common stock investments.  The Company did not sell any of its sharesof Andrx and Dr. Reddy during the six month period ended June 30, 2002.  The following table provides a summary ofthe Company’s sales of its Andrx and Dr. Reddy holdings during the periodsreported.  Realized gains are computed usingthe specific identification method to determine the cost basis for each investment(in thousands except share amounts): 

 
|                |   | **Three Months  Ended  June 30, 2003** |   | **Six Months  Ended  June 30, 2003** |   |
|---------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
| *Andrx:*            |   |                                   |   |                                 |   |
| Shares sold         |   | 70,000                                 |   | 70,000                               |   |
| Proceeds from sale  |   | $                                      | 1,372  |                                 | $      | 1,372 |   |
| Gross realized gain |   | $                                      | 1,179  |                                 | $      | 1,179 |   |
|                |   |                                   |   |                                 |   |
| *Dr. Reddy:*        |   |                                   |   |                                 |   |
| Shares sold         |   | 100,000                                |   | 290,000                              |   |
| Proceeds from sale  |   | $                                      | 2,188  |                                 | $      | 6,017 |   |
| Gross realized gain |   | $                                      | 746    |                                 | $      | 1,835 |   |

 

*Non-currentinvestments*  

 

The Company’s non-current investments include its investment in thecommon stock of Genelabs Technologies, Inc. (Genelabs), NovaDel Pharma Inc.,and Amarin Corporation plc (Amarin), and warrants to purchase shares of commonstock of Halsey Drug Co., Inc. (Halsey). These investments are included in “Investments and other assets” on theCompany’s Consolidated Balance Sheets at June 30, 2003 and December 31, 2002.

 

The following table provides a summary of the fair value and unrealizedholding gain (loss) related to Watson’s available-for-sale securities (inthousands): 

 
|                          |   | **June 30,  2003** |   | **December 31,  2002** |   |
|-------------------------------|--------|--------------------|--------|------------------------|--------|
| Equity securities:            |   |               |   |                   |   |
| Cost basis                    |   | $                  | 31,033 |                   | $      | 49,669 |   |
| Gross unrealized holding gain |   | 33,394             |   | 24,530                 |   |
| Gross unrealized holding loss |   | (4,558             | )      | (13,625                | )      |
| Fair value of securities      |   | $                  | 59,869 |                   | $      | 60,574 |   |

 

The gross unrealized holding loss at June 30,2003 is attributable to adjustments, included in other comprehensive income,for the decline in fair value in the Company’s investment in the warrants topurchase

 

8

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common stock of Halsey.  At June 30, 2003 the fair value of theCompany’s investment in Halsey had been less than its recorded cost forapproximately six months.  The grossunrealized holding loss at December 31, 2002 is primarily attributable to theCompany’s investment in Genelabs.

 

The Company’s net unrealized holding gain related to itsavailable-for-sale securities, increased $10.2 million and $16.2 million forthe three and six month periods ended June 30, 2003, respectively.  During the three and six month periods endedJune 30, 2002, the Company’s net unrealized holding gain decreased $12.6million and $40.6 million, respectively. These changes in the Company’s net unrealized holding gain are includedin other comprehensive income.

 

**NOTED – OPERATING SEGMENTS**

 

Watson has two reportable operating segments: branded and genericpharmaceutical products.  The brandedproducts segment includes the Company’s lines of Women’s Health,Urology/General Products and Nephrology products. Watson has aggregated itsbranded product lines in a single segment because of similarities in regulatoryenvironment, manufacturing processes, methods of distribution and types ofcustomer.  This segment includespatent-protected products and trademarked generic products that Watson promotesdirectly to healthcare professionals as branded pharmaceutical products.  The generic products segment includesoff-patent pharmaceutical products that are therapeutically equivalent toproprietary products.  The Company sellsits branded and generic products primarily to pharmaceutical wholesalers, drugdistributors and chain drug stores.

 

The accounting policies of the segments are described in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2002.  Watson primarily evaluates the performanceof its segments based on net revenues and gross profit.  The “other” classification consistsprimarily of contingent payments received from the settlement of a legaldispute and revenues from research, development and licensing fees.  The Company does not report depreciationexpense, total assets, and capital expenditures by segment as such informationis not used by management, nor accounted for at the segment level.  Net revenues and gross profit informationfor the Company’s segments consisted of the following (in thousands): 

 
|                            |   | **Three Months Ended  June 30,** |    | **Six Months Ended  June 30,** |   |
|---------------------------------|--------|----------------------------------|---------|--------------------------------|--------|
|                            |   | **2003**                         |    | **2002**                       |   | **2003** |   | **2002** |   |
|                            |   |                             |    |                           |   |   |   |   |   |
| **Net revenues:**               |   |                             |    |                           |   |   |   |   |   |
| Branded pharmaceutical products |   | $                                | 185,901 |                           | $      | 156,027 |   | $ | 369,662 |   | $ | 317,554 |   |
| Generic pharmaceutical products |   | 161,267                          |    | 135,009                        |   | 304,466 |   | 251,092 |   |
| Other                           |   | 8,712                            |    | 9,038                          |   | 18,674 |   | 17,118 |   |
| Total net revenues              |   | $                                | 355,880 |                           | $      | 300,074 |   | $ | 692,802 |   | $ | 585,764 |   |
| **Gross profit:**               |   |                             |    |                           |   |   |   |   |   |
| Branded pharmaceutical products |   | $                                | 144,040 |                           | $      | 120,647 |   | $ | 284,737 |   | $ | 241,228 |   |
| Generic pharmaceutical products |   | 48,752                           |    | 32,304                         |   | 85,414 |   | 53,646 |   |
| Other                           |   | 8,712                            |    | 9,038                          |   | 18,674 |   | 17,118 |   |
| Total gross profit              |   | $                                | 201,504 |                           | $      | 161,989 |   | $ | 388,825 |   | $ | 311,992 |   |

 

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**NOTE E – INVENTORIES**

 

Inventoriesconsist of finished goods held for distribution, raw materials andwork-in-process. At June 30, 2003, inventories included approximately $31.6million of inventory, net of reserve, relating to products that are pendingapproval by the FDA or have not been launched due to contractual restrictions.During the second quarter of 2003, the Company established an inventory reserveof $3.1 million related to product approaching expiration that had not beenlaunched due to contractual restrictions.

 

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

 
|              |   | **June 30,  2003** |    | **December 31,  2002** |   |
|-------------------|--------|--------------------|---------|------------------------|--------|
| Raw materials     |   | $                  | 119,670 |                   | $      | 116,806 |   |
| Work-in-process   |   | 85,466             |    | 80,062                 |   |
| Finished goods    |   | 170,662            |    | 151,905                |   |
| Total inventories |   | $                  | 375,798 |                   | $      | 348,773 |   |

 

**NOTE F – ASSETS HELD FORDISPOSITION**

 

Inconnection with the acquisition of Schein Pharmaceutical, Inc. (Schein), Watsonacquired two injectable pharmaceutical manufacturing facilities, SterisLaboratories, Inc. (Steris), located in Phoenix, Arizona and MarsamPharmaceuticals, Inc. (Marsam), located in Cherry Hill, New Jersey.  Upon acquisition, Watson’s intent was todispose of these facilities and, therefore, these assets were reported asassets held for disposition in the Company’s Consolidated Balance Sheets.  Watson recorded these assets held fordisposition at estimated fair value. The operating expenses associated with the facilities were recorded separatelyin the Company’s Consolidated Statements of Income as loss on assets held fordisposition.

 

AtDecember 31, 2002, the Company had approximately $6 million of property relatedto Marsam and approximately $22 million of inventories and approximately $1million of fixed assets related to Steris.

 

OnJanuary 1, 2003 Watson reclassified its assets held for disposition as held andused.  This reclassification was made asa result of the absence of a completed sale transaction or binding offer foreither of the facilities, in accordance with SFAS No. 144.  The related assets were reclassified asinventories and property and equipment, as appropriate, in the Company’sConsolidated Balance Sheets.  For thethree and six months ended June 30, 2002, $6.8 million and $13.7 million ofoperating expenses related to the Steris facility were reclassified to cost ofsales, research and development expenses and selling, general andadministrative expenses, as appropriate.

 

Althoughthe assets were reclassified as held and used, the Company continues itsefforts to dispose of the Marsam property and continues to evaluate divestitureor other alternatives related to the Steris facility.

 

**NOTE G – GOODWILL AND OTHERINTANGIBLE ASSETS**

 

Watsontests its goodwill and intangible assets with indefinite lives by comparing thefair value of each of the Company’s reporting units to the respective carryingvalue of the reporting units.  TheCompany performs this impairment testing annually during the secondquarter.  The Company’s reporting unitshave been identified by Watson as branded and generic pharmaceuticalproducts.  The carrying value of eachreporting unit is determined by assigning the assets and liabilities, includingthe existing goodwill and intangible assets, to those reporting units.  Goodwill is considered impaired if thecarrying amount exceeds the fair value of the asset.

 

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Duringthe second quarter of 2003, Watson performed its annual test for the impairmentof goodwill and determined there was no indication of impairment.  There were no additions to goodwill recordedduring the six months ended June 30, 2003. At June 30, 2003, goodwill for the Company’s reporting units consistedof the following (in thousands): 

 
| Branded pharmaceutical products |   | $      | 358,798 |   |
|---------------------------------|--------|--------|---------|--------|
| Generic pharmaceutical products |   | 87,490 |    |
| Total goodwill                  |   | $      | 446,288 |   |

 

Other intangible assets consistprimarily of product rights.  Theoriginal cost and accumulated amortization of these intangible assets are asfollows (in thousands):

 
|                                              |   | **June 30,  2003** |      | **December 31,  2002** |   |
|---------------------------------------------------|--------|--------------------|-----------|------------------------|--------|
|                                              |   |               |      |                   |   |
| Product rights and related intangibles            |   | $                  | 1,285,408 |                   | $      | 1,107,200 |   |
| Less accumulated amortization                     |   | (254,362           | )         | (218,173               | )      |
| Total product rights and related intangibles, net |   | $                  | 1,031,046 |                   | $      | 889,027 |   |

 

Assuming no additions,disposals or adjustments are made to the carrying values and/or useful lives ofthe assets, annual amortization expense on product rights and relatedintangibles is estimated to be approximately $71.7 million in 2003, $71.4million in 2004 and $71.7 million in each of 2005, 2006 and 2007.  The Company’s current product rights andrelated intangibles have a weighted average useful life of approximately 19years.

 

**NOTE H– LONG-TERM DEBT**

 

Long-termdebt consisted of the following (in thousands):

 
|                                                                                                         |   | **June 30,  2003** |    | **December 31,  2002** |   |
|--------------------------------------------------------------------------------------------------------------|--------|--------------------|---------|------------------------|--------|
|                                                                                                         |   |               |    |                   |   |   |   |
| Senior unsecured notes, 7.125%, face amount of $150 million, due 2008                                        |   | $                  | 149,101 |                   | $      | 149,023 |   |
| Term loan facility, due 2005                                                                                 |   | —             |    | 265,928                |   |
| Convertible contingent debentures, face amount of $575 million due  2023, net of $1,841 unamortized discount |   | 573,159            |    | —                 |   |
| Other notes payable                                                                                          |   | 60                 |    | 286                    |   |
| Total debt                                                                                                   |   | $                  | 722,320 |                   | $      | 415,237 |   |
| Less current portion                                                                                         |   | —             |    | (83,360                | )      |
| Total long-term debt                                                                                         |   | $                  | 722,320 |                   | $      | 331,877 |   |

 

In May 1998, Watson issued $150million of its senior unsecured notes (1998 Senior Notes).  These notes are due in May 2008 but maybe redeemed earlier under certain circumstances.  The Company is required to make interest only payments duesemi-annually in May and November at an effective annual rate of 7.2%.

 

The 1998 Senior Notes wereissued pursuant to a shelf registration statement authorizing up to $300million in debt securities, preferred stock or common stock.  On April 2, 2003, the Company determinedthat it did not intend to offer any additional debt securities, preferred stockor common stock under the registration statement, and filed an amendment withthe Securities and Exchange Commission deregistering the remaining unsold $150million aggregate amount of debt securities, preferred stock and common stockcovered by the registration statement.

 

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In March 2003, the Companyissued $575 million of convertible contingent senior debentures (CODES).  The CODES, which are convertible into sharesof Watson’s common stock upon the occurrence of certain events, are due inMarch 2023, with interest payments due semi-annually in March and September atan effective annual interest rate of 2.1%.

 

The CODES are convertible intoWatson’s common stock at a conversion price of approximately $40.05 per share(subject to certain adjustments).  TheCODES may be converted, at the option of the holders, prior to maturity underany of the following circumstances:

 

•                                          duringany quarterly conversion period (period from and including the thirtiethtrading day in a fiscal quarter to, but not including, the thirtieth tradingday in the immediately following fiscal quarter) if the closing sale price pershare of Watson’s common stock for a period of at least 20 trading days duringthe 30 consecutive trading-day period ending on the first day of suchconversion period is more than 125% of the conversion price in effect on thatthirtieth day;

 

•                                          onor before March 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 atJune 30, 2003;

 

•                                          duringany period, following the earlier of (a) the date the CODES are rated by bothStandard & Poor’s Rating Services and Moody’s Investor Services, Inc., and(b) April 21, 2003, when the long-term credit rating assigned to the CODES byeither Standard & Poor’s or Moody’s (or any successors to these entities)is lower than “BB” or “Ba3”, respectively, or when either of these ratingagencies does not have a rating then assigned to the CODES for any reason,including any withdrawal or suspension of a rating assigned to the CODES.  This conversion feature represents anembedded derivative.  However, based onthe de minimis value associated with this feature, no value has been assignedat issuance and at June 30, 2003;

 

•                                          ifthe CODES have been called for redemption; or

 

•                                          uponthe occurrence of specified corporate transactions.

 

The Company may redeem some orall of the CODES for cash, on or after March 20, 2008, for a price equal to100% of the principal amount of the CODES plus accrued and unpaid interest(including contingent interest) to, but excluding, the redemption date.

 

The CODES contain put optionswhich may require the Company to repurchase for cash all or a portion of theCODES on March 15 of 2010, 2015 and 2018 at a repurchase price equal to 100% ofthe principal amount of the CODES plus any accrued and unpaid interest (includingcontingent interest) to, but excluding, the date of repurchase.

 

In addition, the holders of theCODES have the right to receive contingent interest payments during anysix-month period from March 15 to September 14 and from September 15 to March 14,commencing on September 15, 2003, if the average trading price of the CODES forthe five trading days ending on the second trading day immediately precedingthe relevant six-month period equals 120% or more of the principal amount ofthe CODES.  The interest rate used tocalculate the contingent interest is the greater of 5% of the Company’sthen-current estimated per annum borrowing rate for senior non-convertiblefixed-rate debt with a maturity date and other terms comparable to that of theCODES or 0.33% per annum.  Thiscontingent interest payment feature is an embedded derivative and has beenbifurcated and recorded separately in the Consolidated Balance Sheets in

 

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other long-termliabilities.  The initial fair valueassigned to the embedded derivative was $1.9 million, which is recorded as adiscount to the CODES.

 

The Company used a portion ofthe proceeds from the issuance of the CODES to retire the outstanding balanceof the Company’s term loan and revolving credit facility it entered into inJuly 2000 (2000 Facility).  The totaloutstanding balance of the 2000 Facility consisted of a $246 million term loanbalance and a $60 million revolving credit balance. The Company terminated the2000 Facility in March 2003 upon repayment of the outstanding balance.  As a result of the early retirement of the2000 Facility, the Company incurred a charge in the amount of $2.8 million forthe unamortized bank fees associated with this debt.  This charge is reported separately in the Consolidated Statementsof Income.

 

In May 2003, the Companyentered into an agreement****with a syndicate of lenders for afive-year, $300 million senior, unsecured revolving credit facility for workingcapital and other general corporate purposes. Watson's assets generally areheld by, and its operations generally are conducted through, itssubsidiaries.  Within the meaning ofRegulation S-X, Rule 3-10, the Company has no assets or operations independentof its subsidiaries. The terms of the new credit facility require eachsubsidiary, other than minor subsidiaries, to provide full and unconditionalguarantees on a joint and several basis. In order to provide subsidiaryguarantees in connection with this credit facility, the Company was alsorequired, by the terms of the Indenture for the 1998 Senior Notes, to grantsimilar subsidiary guarantees in favor of the 1998 Senior Note holders. Thesubsidiary guarantees related to both the new credit facility and the 1998Senior Notes are full and unconditional, on a joint and several basis, and aregiven by all subsidiaries other than minor subsidiaries.  As of June 30, 2003, the Company had notdrawn any funds from the revolving credit facility.

 

**NOTE I – FINANCIAL INSTRUMENTS**

 

*Fair value of financial instruments*

 

The Company’s financialinstruments consist primarily of cash and cash equivalents, marketablesecurities, accounts and other receivables, investments, trade accountspayable, senior subordinated notes, CODES and embedded derivatives related tothe issuance of the CODES.  The carryingamounts of cash and cash equivalents, marketable securities, accounts and otherreceivables and trade accounts payable are representative of their respectivefair values due to their relatively short maturities.  The fair values of investments in companies that are publiclytraded are based on quoted market prices. The fair value of investments in privately held companies, or cost-methodinvestments, are based on historical cost, adjusted for any write-down relatedto impairment.  The Company estimatesthe fair value of its fixed rate long-term obligations based on quoted marketrates of interest and maturity schedules for similar issues.  The carrying value of these obligationsapproximates their fair value.  The fairvalue of the embedded derivatives related to the CODES is based on a presentvalue technique using discounted expected future cash flows.

 

*Derivative financial instruments*

 

The Company’s derivativefinancial instruments consist of embedded derivatives related to itsCODES.  These embedded derivativesinclude certain conversion features and a contingent interest feature.   See Note H for a more detailed descriptionof these features of the CODES. Although the conversion features represent embedded derivative financialinstruments, based on the de minimis value of these features at the time ofissuance and at June 30, 2003, no value has been assigned to theseinstruments.  The contingent interestfeature provides unique tax treatment under the Internal Revenue Service’sContingent Debt Regulations.  Inessence, interest accrues, for tax purposes, on the basis of the instrument’scomparable yield (the yield at which the issuer would issue a fixed rate instrumentwith similar terms). This embedded derivative is reported on the Company’sconsolidated balance sheets at fair value and the changes in the fair value ofthe embedded derivative are reported as gains or losses in the Company’sConsolidated Statements of Income.  

 

At June 30, 2003, the carryingamount of $3.9 million approximates the estimated fair value of the Company’sderivative financial instruments.  Suchfinancial instruments were not in place at June 30, 2002.

 

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During the three month periodended June 30, 2003, the fair value of the Company’s derivative financialinstruments increased $2 million.  Thischange in fair value was recorded as a charge to interest expense for theperiod.

 

**NOTE J – IMPAIRMENT OF SECURITIES**  

 

At March31, 2003, investments and other assets included an investment in three millionshares of the common stock of Genelabs Technologies, Inc. (Genelabs), apublicly traded company, with an adjusted cost basis of $3.9 million.  This investment has been classified asavailable-for-sale, pursuant to SFAS No. 115, “Accounting for CertainInvestments in Debt and Equity Securities.” Available-for-sale securities are carried at fair value, based on quotedmarket prices, with unrealized gains and losses reported as a separatecomponent of stockholders’ equity. During the first quarter of 2003, management determined that an otherthan temporary decline in the fair value of Genelabs’ common stock existed and,as a result, wrote-down the initial cost basis of the investment to its fairvalue at March 31, 2003 of $3.9 million. In connection with this write-down, an asset impairment charge of $13.0million was recorded and recognized in earnings.  This impairment should have been recognized in the first quarterof 2002, as the investment had been in an unrealized loss position for anextended period.  Recognition of theimpairment in the first quarter of 2003 was an error.  However, this charge would not have been material to theCompany’s 2002 financial statements, and is not expected to be material to theCompany’s 2003 earnings or trend of earnings.

 

At June30, 2003, investments and other assets included an investment in 400,000American Depository Receipts of Amarin, classified as an available-for-salesecurity, with a cost basis of $2.5 million and a fair value of $1.3 million. During the second quarter of 2003, management determined that another-than-temporary decline in fair value of its Amarin investmentexisted.  As a result, the Company wrotedown the initial cost basis of the investment to its fair value at June 30,2003.  In connection with thiswrite-down, an asset impairment charge of $1.2 million was recorded andrecognized in earnings.

 

**NOTE K – SALE OF SUBSIDIARY**

 

During the first quarter of2003, the Company completed the sale of its subsidiary located in the UnitedKingdom (UK).  The Company receivedproceeds from this sale of approximately $16.4 million and recorded a pre-taxgain of approximately $15.7 million. During 2002, the subsidiary had net revenues, gross profit and netincome of $10.8 million, $6.3 million and $3.2 million, respectively.

 

In connection with the sale,the Company has provided certain warranties and indemnifications to the buyerincluding an indemnification relating to website content. The buyer must givewritten notice to the Company within 18 months of the completion of the saletransaction of any claim arising out of these indemnifications.  The Company does not expect any liabilityarising out of a claim, if any, to have a material adverse impact on itsresults of operations, financial position or cash flows.  No liability has been recorded in relationto these indemnifications at June 30, 2003.

 

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**ITEM2****.  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

The following discussion of ourfinancial condition and the results of our operations should be read inconjunction with the consolidated financial statements and notes theretoincluded elsewhere in this Quarterly Report. This discussion contains forward-looking statements that are subject toknown and unknown risks, uncertainties and other factors that may cause ouractual results to differ materially from those expressed or implied by suchforward-looking statements.  Theserisks, uncertainties and other factors include, among others, those identifiedunder “Cautionary Note Regarding Forward-Looking Statements” and elsewhere inthis Quarterly Report and under “Risk Factors” in our Annual Report on Form10-K for the year ended December 31, 2002.

 

**Results of Operations**

 

***NetRevenues***

 
|                              | **Three  Months Ended  June 30,** |     | **Six Months  Ended  June 30,** |     |
|-----------------------------------|-----------------------------------|----------|---------------------------------|----------|
| **($ in  thousands):**            |                              | **2003** |                            | **2002** |   | **%  Change** |   | **2003** |   | **2002** |   | **%****Change** |   |
|                              |                              |     |                            |     |   |   |   |   |   |   |   |   |   |
| Net Revenues by Segment:          |                              |     |                            |     |   |   |   |   |   |   |   |   |   |
| Branded pharmaceutical products   |                              | $        | 185,901                         |     | $ | 156,027 |   | 19.1 | % | $ | 369,662 |   | $ | 317,554 |   | 16.4 | % |
| *% of total product net revenues* |                              | *53.5*   | *%*                             | *53.6*   | *%* |   |   | *54.8* | *%* | *55.8* | % |   |   |
| Generic pharmaceutical products   |                              | 161,267  |                            | 135,009  |   | 19.4 | % | 304,466 |   | 251,092 |   | 21.3 | % |
| *% of total product net revenues* |                              | *46.5*   | *%*                             | *46.4*   | *%* |   |   | *45.2* | *%* | *44.2* | % |   |   |
| Other                             |                              | 8,712    |                            | 9,038    |   | (3.6 | )% | 18,674 |   | 17,118 |   | 9.1 | % |
| Total net revenues                |                              | $        | 355,880                         |     | $ | 300,074 |   | 18.6 | % | $ | 692,802 |   | $ | 585,764 |   | 18.3 | % |

 

Total net revenues for thethree and six months ended June 30, 2003 increased compared to thecorresponding 2002 periods due to increases in net revenues in both our brandedand generic segments.  The changes inother net revenues were due to timing of recognition of previously deferred revenuefrom research and development agreements.

 

*Branded Pharmaceutical Products*

 

The increase in net revenuesfrom our branded pharmaceutical products segment for the three and six monthperiods was primarily attributable to increases in product sales within ourUrology/General Products division, offset in part by a decrease in ourNephrology division.  OurUrology/General Products division has been positively impacted by theacquisition of the Fioricet® and Fiorinal® product lines during the first quarterof 2003, and the launch of our OxytrolTM product during the secondquarter of 2003. OxytrolTM, which received FDA approval in February2003, is the first FDA approved transdermal therapy for overactivebladder.  In addition to the newproducts within our Urology/General Products division, higher unit sales of ourAndroderm® testosterone patch, resulting from focused product promotions andprescription growth, also contributed to the overall increase within thedivision.

 

We expect net revenues from ourbranded segment to continue to increase during 2003 based on the continuedpromotion and increased awareness of our Oxytroläproduct, and the planned introduction of new products during the second half of2003.  Compared to prior year periods,we expect the increases for the third and fourth quarters of 2003 to beconsistent with the year over year increases experienced in the second quarterof 2003.

 

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*Generic Pharmaceutical Products*

 

The increase in net revenuesfrom our generic segment was primarily related to price increases on certainproducts, as well as new products launched and products reintroduced during, orsubsequent to, the corresponding 2002 periods.

 

We expect net revenues from ourgeneric segment to increase during the remaining 2003 periods as a result ofprice increases and additional anticipated product launches.

 

*Other Revenues*

 

Otherrevenues consist primarily of contingent payments resulting from a legalsettlement in 2001. We expect to receive our final contingent payment from the2001 settlement in the third quarter of 2003. The changes in other revenues are primarily due to the timing ofrecognition of previously deferred revenue from research and developmentagreements.  These revenues (typicallymilestone payments) are recorded under the “contingency-adjusted performancemodel,” which requires deferral of revenue until such time as contractmilestone requirements, as specified in the individual agreements, have beenmet and cash has been received.

 

Duringthe second quarter of 2003, we amended one of our existing agreements for thedevelopment of certain hormonal therapies. In July 2003, we received $10 million related to the amended agreement,which was recorded as deferredrevenue.  In addition, under the amendedagreement, we are eligible for additional milestone payments in the thirdquarter of 2003 based on the positive results of a clinical study.  Under certain circumstances, the other partyto the agreement has the option to discontinue the development program.  Were that to occur, all of the revenuepreviously deferred under this agreement would be recognized.

 

Assumingthe development program continues, we expect other revenues to be approximately$35 million to $40 million for the full year 2003.

 

*Net Revenue Mix*

 

Netrevenue mix is an important consideration in evaluating the profitability ofour business.  Our branded productsgenerally realize higher gross profit margins than our generic products.  Any significant change in our net revenue mix could substantially impact our gross profit,gross margin and the overall profitability of our business.

 

For thethree and six month periods ended June 30, 2003, our net revenue mix remained consistent with the corresponding 2002 periods. We expectthe net revenue mix for the remaining 2003 quarterly periods to be consistentwith that of the second quarter of 2003.

 

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

 
|                                 |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|--------------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
|                                 |   | **2003**                          |   | **2002**                        |   | **Change** |   | **2003** |   | **2002** |   | **Change** |   |
|                                 |   |                              |   |                            |   |   |   |   |   |   |   |   |   |
| Gross Margin by Segment:             |   |                              |   |                            |   |   |   |   |   |   |   |   |   |
| Branded pharmaceutical products      |   | 77.5                              | %      | 80.4                            | %      | -2.9 | % | 77.0 | % | 79.0 | % | -2.0 | % |
| Generic pharmaceutical products      |   | 30.2                              | %      | 24.8                            | %      | 5.4 | % | 28.1 | % | 22.3 | % | 5.8 | % |
| Gross margin on product net revenues |   | 55.5                              | %      | 54.6                            | %      | 0.9 | % | 54.9 | % | 54.0 | % | 0.9 | % |

 

Our overall gross margin onproduct net revenues for the three and six months ended June 30, 2003, remainedrelatively consistent with that of the corresponding prior year periods.

 

The decrease in the grossmargin from our branded segment for the three and six months ended June 30,2003, was attributable to decreased margins in our Women’s Health divisionprimarily due to lower margins realized on our Necon® 7/7/7 and MononessaTMproducts.  These lower margins were aresult of a profit sharing arrangement with the manufacturer.

 

The decrease from our Women’sHealth division was partially offset by an increase in the gross margin of ourUrology/General Products division.  Thisincrease resulted from higher gross margins realizedon the products that we introduced during 2003.

 

We expect our gross margins forthe remaining 2003 quarterly periods to improve as a result of recent priceincreases for certain products within our generic segment and the impact ofanticipated higher gross marginsfrom product introductions within our branded segment.

 

***Research andDevelopment (R&D) Expenses***

 
|                     |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|--------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
| **($ in thousands):**    |   | **2003**                          |   | **2002**                        |   | **%****Change** |   | **2003** |   | **2002** |   | **%****Change** |   |
|                     |   |                              |   |                            |   |   |   |   |   |   |   |   |   |
| R&D expenses         |   | $                                 | 25,701 |                            | $      | 19,769 |   | 30.0 | % | $ | 48,185 |   | $ | 38,288 |   | 25.8 | % |
| *as**%**of net revenues* |   | *7.2*                             | *%*    | *6.6*                           | *%*    |   |   | *7.0* | *%* | *6.5* | *%* |   | * * |
|                          |        |                                   |        |                                 |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

Research and development expensesincreased from the corresponding prior year periods due to increased spendingon clinical studies and expanded generic development programs.  The clinical studies relate to ouranti-fungal nail patch and additional Ferrlecit® indications.  Expenses also increased due to biostudiesand other expenses related to various generic products under different stages of development.  We expect research and development expenses for the remainder of2003 to continue to increase slightly due to our efforts in both branded andgeneric product development.

 

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***Selling, General andAdministrative (SG&A) Expenses***

 
|                   |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
| **($ in thousands):**  |   | **2003**                          |   | **2002**                        |   | **%****Change** |   | **2003** |   | **2002** |   | **%****Change** |   |
|                   |   |                              |   |                            |   |   |   |   |   |   |   |   |   |
| SG&A expenses      |   | $                                 | 72,214 |                            | $      | 59,635 |   | 21.1 | % | $ | 139,873 |   | $ | 121,898 |   | 14.7 | % |
| *as % of net revenues* |   | *20.3*                            | *%*    | *19.9*                          | *%*    |   |   | *20.2* | *%* | *20.8* | *%* |   | * * |
|                        |        |                                   |        |                                 |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

SG&A expenses remained relativelyconsistent as a percentage of net revenues. The increase from prior year periods was primarily related to increasedspending during the second quarter of 2003 on the Oxytroläproduct launch.  In addition, increasedcorporate insurance premiums on policy renewals and expenses associated withthe implementation of our Enterprise Resource Planning (ERP) system contributedto the increase over prior year periods.

 

***Amortization Expense***

 
|                  |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|-----------------------|--------|-----------------------------------|--------|---------------------------------|--------|
| **($ in  thousands)** |   | **2003**                          |   | **2002**                        |   | **%  Change** |   | **2003** |   | **2002** |   | **%****Change** |   |
|                  |   |                              |   |                            |   |   |   |   |   |   |   |   |   |
| Amortization expense  |   | $                                 | 17,785 |                            | $      | 14,542 |   | 22.3 | % | $ | 36,220 |   | $ | 27,836 |   | 30.1 | % |
|                       |        |                                   |        |                                 |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in amortization expense wasprimarily due to amortization associated with the nifedipine ER product rightsacquired in August 2002 and the Fiorinalâand Fioricetâ product lines acquired in February 2003.  See Note B in the accompanying Notes toConsolidated Financial Statements in this Quarterly Report. Assuming noadditions, disposals or adjustments are made to the carrying values and/oruseful lives of our product rights and other intangible assets, we expectamortization expense for the remaining 2003 quarterly periods to remainconsistent with that of the second quarter of 2003.

 

***Equity in Earnings(Losses) of Joint Ventures***

 
|                                          |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|-----------------------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
| **($ in  thousands):**                        |   | **2003**                          |   | **2002**                        |   | **%  Change** |   | **2003** |   | **2002** |   | **%****Change** |   |
|                                          |   |                              |   |                            |   |   |   |   |   |   |   |   |   |
| Equity in earnings (losses) of joint ventures |   | $                                 | 88     |                            | $      | (755 | ) | -111.7 | % | $ | 205 |   | $ | (1,814 | ) | -111.3 | % |
|                                               |        |                                   |        |                                 |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our earnings from joint ventures for thethree and six months ended June 30, 2003 were primarily the result of incomefrom our interest in ANCIRC Pharmaceuticals (ANCIRC), a joint venture withAndrx Corporation.  The income fromANCIRC was substantially offset by losses from our interest in SomersetPharmaceuticals, Inc. (Somerset), a joint venture with Mylan Laboratories,Inc.  Our loss on joint ventures for the2002 period was primarily related to losses from our interest in Somerset.  We expect our ANCIRC earnings to continue tooffset Somerset losses.

 

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***Impairment ofSecurities***

 
|                     |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|--------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
| **($ in  thousands):**   |   | **2003**                          |   | **2002**                        |   | **%  Change** |   | **2003** |   | **2002** |   | **%****Change** |   |
|                     |   |                              |   |                            |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Impairment of securities |   | $                                 | 1,218  |                            | $      | — |   | n/a |   | $ | 14,260 |   | $ | — |   | n/a |   |

 

During the second quarter of 2003, werecorded a $1.2 million impairment charge related to our investment in Amarin.Additionally, we recorded a $13.0 million impairment charge during the firstquarter of 2003, related to our investment in Genelabs.  See Note J in the accompanying Notes toConsolidated Financial Statements in this Quarterly Report.

 

At June 30, 2003, we had atotal gross unrealized holding loss of approximately $4.6 million related toone investment, which had a fair value less than its recorded cost forapproximately six months.  Investmentsare considered to be impaired when a decline in fair value is judged to beother-than-temporary.  If a decline infair value is determined to be other-than-temporary, an impairment charge isrecorded and a new cost basis in the investment is established.  We employ a systematic methodology thatconsiders all available evidence in evaluating potential impairment of ourinvestments.  In the event that the costof an investment exceeds its fair value, we evaluate, among other factors,general market conditions, the duration and extent to which the fair value isless than cost, as well as our intent and ability to hold the investment.  We also consider specific adverse conditionsrelated to the financial health of and business outlook for the investee,including industry and sector performance, changes in technology, operationaland financing cash flow factors, and rating agency actions.  However, when the carrying value of aninvestment is greater than the realizable value for an extended period, unlesssufficient positive, objective evidence exists to support such an extendedperiod, the decline will be considered other-than-temporary.  Any decline in the market prices of ourequity investments that are deemed to be other-than-temporary may require us toincur additional impairment charges.

 

***Gain on Sale ofSecurities***

 
|                       |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|----------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
| **($ in  thousands):**     |   | **2003**                          |   | **2002**                        |   | **%  Change** |   | **2003** |   | **2002** |   | **%****Change** |   |
|                       |   |                              |   |                            |   |   |   |   |   |   |   |   |   |
| Gain on sale of securities |   | $                                 | 1,925  |                            | $      | — |   | n/a |   | $ | 3,014 |   | $ | — |   | n/a |   |
|                            |        |                                   |        |                                 |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our gain on sale of securities resulted fromthe sale of shares of Dr. Reddy and Andrx common stock.  See Note C in the accompanying Notes toConsolidated Financial Statements in this Quarterly Report.

 

***Gain on Sale ofSubsidiary***

*** ***
|                       |   | **Three  Months Ended  March 31,** |   | **Six Months  Ended  March 31,** |   |
|----------------------------|--------|------------------------------------|--------|----------------------------------|--------|
| **($ in  thousands):**     |   | **2003**                           |   | **2002**                         |   | **%  Change** |   | **2003** |   | **2002** |   | **%****Change** |   |
|                       |   |                               |   |                             |   |   |   |   |   |   |   |   |   |
| Gain on sale of subsidiary |   | $                                  | — |                             | $      | — |   | n/a |   | $ | 15,676 |   | $ | — |   | n/a |   |
|                            |        |                                    |        |                                  |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

During the first quarter of 2003, we sold oursubsidiary located in the United Kingdom. As a result of the sale, we recorded a pre-tax gain of $15.7million.   During 2002, the subsidiaryhad net revenues, gross profit

 

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and net income of $10.8 million, $6.3 millionand $3.2 million, respectively.  SeeNote K in the accompanying Notes to Consolidated Financial Statements in thisQuarterly Report.

 

***Gain from LegalSettlement***

*** ***
|                       |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|----------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
| **($ in  thousands):**     |   | **2003**                          |   | **2002**                        |   | **%****Change** |   | **2003** |   | **2002** |   | **%****Change** |   |
|                       |   |                              |   |                            |   |   |   |   |   |   |   |   |   |
| Gain from legal settlement |   | $                                 | — |                            | $      | 32,000 |   | -100 | % | $ | — |   | $ | 32,000 |   | -100 | % |
|                            |        |                                   |        |                                 |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

During the second quarter of 2002, werecorded a $32 million gain as a result of the settlement reached withBristol-Myers Squibb (BMS) resolving all outstanding disputes between thecompanies related to buspirone.

 

***Loss on EarlyExtinguishment of Debt***

 
|                                 |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|--------------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
| **($ in thousands):**                |   | **2003**                          |   | **2002**                        |   | **%****Change** |   | **2003** |   | **2002** |   | **%****Change** |   |
|                                 |   |                              |   |                            |   |   |   |   |   |   |   |   |   |
| Loss on early extinguishment of debt |   | $                                 | — |                            | $      | — |   | n/a |   | $ | 2,807 |   | $ | — |   | n/a |   |
|                                      |        |                                   |        |                                 |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

During the first quarter of 2003, as a resultof the retirement of our previous credit facility, we incurred a charge for theunamortized bank fees associated with the facility.  See Note H in the accompanying Notes to Consolidated FinancialStatements in this Quarterly Report.

 

***Interest Expense***

 
|                  |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|-----------------------|--------|-----------------------------------|--------|---------------------------------|--------|
| **($ in thousands):** |   | **2003**                          |   | **2002**                        |   | **%****Change** |   | **2003** |   | **2002** |   | **%****Change** |   |
|                  |   |                              |   |                            |   |   |   |   |   |   |   |   |   |
| Interest expense      |   | $                                 | 7,580  |                            | $      | 5,783 |   | 31.1 | % | $ | 12,921 |   | $ | 10,943 |   | 18.1 | % |
|                       |        |                                   |        |                                 |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in interest expense was a resultof the $2 million adjustment to the fair value of our derivative financialinstruments during the second quarter of 2003. The change in the fair value was recorded as a charge to interestexpense during the three months ended June 30, 2003.  See Note I in the accompanying Notes to Consolidated FinancialStatements in this Quarterly Report.

 

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**Liquidityand Capital Resources**

 

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

 

We generated cash in excess of our workingcapital requirements for the six months ended June 30, 2003.  Our cash flows provided by operations were$202 million, an increase of approximately $4 million from the previous year’speriod.  This increase was primarilyrelated to the change, year over year, in net income and balances of accountsreceivable and accounts payable and accrued expenses.  These increases were substantially offset by the changes, yearover year, in balances of inventories and income taxes payable.

 

The increase in inventories isthe result of supply chain initiatives to improve customer service levels andto support new or recently launched products. Of the $376 million of inventories at June 30, 2003, $31.6 millionsupport expected new product launches and marketing initiatives.  During the second quarter of 2003, wereserved $3.1 million of this inventory related to potential expiration of aportion of such inventory prior to launch. In the event we are unable to launch certain products during the secondhalf of 2003, we may be required to incur additional reserves of approximately$2 million and $10 million for the third and fourth quarters of 2003,respectively.

 

In addition to the increase in inventories,other significant uses of cash for the six months ended June 30, 2003, includedthe acquisition of product rights ($178.5 million), additions to property andequipment ($53.7 million) and principal payments on our credit facility ($325.9million, of which $306.1 million was paid from the proceeds of the issuance ofour convertible contingent debentures as discussed below).  We currently expect to spend between $125million to $135 million for property and equipment additions in 2003, ofwhich we expect approximately $30 million to be related to the installation andimplementation of our new ERP system.

 

In May 1998, we issued $150 million of seniorunsecured notes due May 2008 (1998 Senior Notes), with interest payablesemi-annually in May and November at an effective rate of 7.2%, pursuant to ashelf registration statement authorizing up to $300 million in debt securities,preferred stock or common stock.  OnApril 2, 2003, we determined that we did not intend to offer any additionaldebt securities, preferred stock or common stock under the registrationstatement, and filed an amendment with the Securities and Exchange Commissionderegistering the remaining unsold $150 million aggregate amount of debtsecurities, preferred stock and common stock covered by the registrationstatement.  In March 2003, we issued$575 million of convertible contingent senior debentures (CODES) due in2023.  As of June 30, 2003, the entireamount of the CODES remained outstanding at an effective annual interest rateof approximately 2.1%.

 

We used a portion of the proceeds from theissuance of the CODES to repay the $306.1 million balance on our term loan andrevolving credit facility we entered into in July 2000 (2000 Facility).  We terminated the 2000 Facility in March2003 upon our repayment of this balance.

 

In May 2003, we entered into an agreement****witha syndicate of lenders for a five-year, $300 million senior, unsecuredrevolving credit facility for working capital and other general corporatepurposes.  As of June 30, 2003, thetotal $300 million under the revolving credit facility was available to us.Under the terms of the revolving credit facility, each of our subsidiaries,other than minor subsidiaries, entered into a full and unconditional guaranteeon a joint and several basis.  In orderto provide subsidiary guarantees in connection with the new credit facility, wewere required to issue similar guarantees to the 1998 Senior Note holders.

 

Our cash and current marketable securitiestotaled $582.6 million at June 30, 2003. The fair value of our current marketable securities may fluctuatesignificantly due to volatility of the stock market and changes in generaleconomic conditions.  See Item 3. inthis Quarterly Report on Form 10-Q.  Webelieve that our cash and marketable securities balance and our expected cash flowsfrom operations will be sufficient to meet our normal

 

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operating requirements during the next twelvemonths.  However, we continue to reviewopportunities to acquire or invest in companies, technologies, product rightsand other investments that are compatible with our existing business.  We could use cash and financing sourcesdiscussed herein, or financing sources that subsequently become available, tofund additional acquisitions or investments. In addition, we may consider issuing additional debt or equitysecurities in the future to fund potential acquisitions or investment, torefinance existing debt, or for general corporate purposes.  If a material acquisition or investment iscompleted, our operating results and financial condition could changematerially in future periods.  However,no assurance can be given that additional funds will be available onsatisfactory terms, or at all, to fund such activities.

 

**CAUTIONARYNOTE REGARDING FORWARD-LOOKING STATEMENTS**

 

Any statements made in this report that arenot statements of historical fact or that refer to estimated or anticipatedfuture events are forward-looking statements. We have based our forward-looking statements on our management’s beliefsand assumptions based on information available to our management at the timethese statements are made.  Suchforward-looking statements reflect our current perspective of our business,future performance, existing trends and information as of the date of thisfiling.  These include, but are notlimited to, prospects related to our strategic initiatives and businessstrategies, express or implied assumptions about government regulatory actionor inaction, anticipated product approvals and launches, business initiativesand product development activities, assessments related to clinical trialresults, product performance and competitive environment, and anticipatedfinancial performance. Without limiting the generality of the foregoing, wordssuch 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 thatcertain important factors may affect our actual operating results and couldcause such results to differ materially from those expressed or implied byforward-looking statements.  We believethe following important risks, uncertainties and other factors, among others,may affect our actual results:

 

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

 

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

 

• the outcome of ourlitigation (including, without limitation, patent, trademark and copyrightlitigation), and the costs, expenses and possible diversion of management’stime and attention arising from such litigation;

 

• our ability to retain key personnel

 

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

 

• our ability to obtain and maintain a sufficientsupply of products to meet market demand in a timely manner;

 

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

 

• the scope, outcome and timeliness of anygovernmental, court or other regulatory action that may involve us (including,without limitation, the scope, outcome or timeliness of any inspection or otheraction of the FDA);

 

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

 

• the increasing costs of insurance, andlimitations on obtaining insurance coverage;

 

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• the scope, outcomeand effect of investigations, actions or legislation related to our productpricing and ability to retain key personnel;

 

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

 

• our exposure toproduct liability and other lawsuits and contingencies;

 

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

 

• our dependence onrevenues from significant products, in particular, Ferrlecit®, for which 2003net revenues are expected to be approximately 10% of our total net revenues;

 

• our dependence onrevenues from significant customers;

 

• the ability of thirdparties to assert patents or other intellectual property rights against uswhich, among other things, could cause a delay or disruption in themanufacture, marketing or sale of our products;

 

• our ability tolicense patents or other intellectual property rights from third parties oncommercially reasonable terms;

 

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

 

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

 

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

 

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

 

- seizure or recall of products;

 

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

 

- manufacturing or distributionproblems;

 

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

 

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

 

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

 

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

 

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

 

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We disclaim any obligation to publicly updateany forward-looking statements, whether as a result of new information, futureevents or otherwise.  We also may makeadditional disclosures in our Annual Report on Form 10-K, Quarterly Reports onForm 10-Q and Current Reports on Form 8-K that we may file from time to timewith the Securities and Exchange Commission (SEC).  Please also note that we provided a cautionary discussion ofrisks and uncertainties under the section entitled “Risk Factors” in our AnnualReport on Form 10-K for the year ended December 31, 2002.  The factors identified above and those setforth in our SEC filings are the factors that we think could cause our actualresults to differ materially from expected results.  Other factors besides those listed here could also adverselyaffect us.  This discussion is providedas permitted by the Private Securities Litigation Reform Act of 1995.

 

**ITEM 3.****  QUANTITATIVE AND QUALITATIVE DISCLOSUREABOUT MARKET RISK**

 

We are exposed to market risk for changes inthe market values of our investments (Investment Risk) and the impact ofinterest rate changes (Interest Rate Risk). We have not used derivative financial instruments in our investmentportfolio.  The quantitative andqualitative disclosures about market risk are set forth below.

 

**InvestmentRisk**

 

As of June 30, 2003, our total investment inequity securities of other companies was $97.4 million.  Of this amount, we had equity-methodinvestments of $37.5 million and publicly traded equity securities(available-for-sale securities) at fair value totaling $59.9 million ($46.7million that was included in “Marketable securities” and $13.2 million that wasincluded in “Investments and other assets”). The fair values of these investments are subject to significantfluctuations due to volatility of the stock market and changes in general economicconditions.  Based on the fair value ofthe publicly traded equity securities we held at June 30, 2003, an assumed25%, 40% and 50% adverse change in the market prices of these securities wouldresult in a corresponding decline in total fair value of approximately $15million, $24 million and $30 million, respectively.

 

At June 30, 2003, our investment in Andrxconsisted of approximately 1.5 million shares of Andrx common stock with a fairmarket value of $29.2 million.  BecauseAndrx is a publicly traded equity security, our holdings of Andrx have exposureto investment risk.   The market priceof Andrx common shares has been, and may continue to be, volatile as reflectedin the table below.  On August 11, 2003,before completing this Form 10-Q, the closing price of Andrx common stock was$18.30.

 

The following table sets forth the Andrx highand low market price per share information, based on published financialsources, for 2003 and 2002:

 
|                 |   | **High** |   | **Low** |   |
|----------------------|--------|----------|--------|---------|--------|
| **2003, by quarter** |   |     |   |    |   |
| First                |   | $        | 16.83  |    | $      | 7.68 |   |
| Second               |   | $        | 24.20  |    | $      | 11.10 |   |
|                 |   |     |   |    |   |
| **2002, by quarter** |   |     |   |    |   |
| First                |   | $        | 71.27  |    | $      | 31.13 |   |
| Second               |   | $        | 48.20  |    | $      | 25.80 |   |
| Third                |   | $        | 27.89  |    | $      | 16.61 |   |
| Fourth               |   | $        | 23.19  |    | $      | 10.75 |   |

 

In addition, our marketable securitiesinclude shares of common stock of Dr. Reddy’s Laboratories, Limited (Dr. Reddy).  As of June 30, 2003, Watson owned 750,000common shares of Dr. Reddy with a market value of approximately $17.5million.  Dr. Reddy’s shares trade onthe Bombay Stock Exchange (BSE) and on the New York Stock Exchange in the formof American depositary shares.  However,the shares of Dr. Reddy common stock that we hold are currently tradable onlyon the BSE, since our shares are not presently in the form of

 

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American depositary shares.  The liquidity of our Dr. Reddy investmentmay be limited due to the current Dr. Reddy daily trading volume on the BSE,among other factors.  The followingtable sets forth the Dr. Reddy high and low market price per share information,based on published financial sources, for 2003 and 2002: 

 
|                 |   | **High** |   | **Low** |   |
|----------------------|--------|----------|--------|---------|--------|
| **2003, by quarter** |   |     |   |    |   |
| First                |   | $        | 21.00  |    | $      | 18.03 |   |
| Second               |   | $        | 23.53  |    | $      | 17.58 |   |
|                 |   |     |   |    |   |
| **2002, by quarter** |   |     |   |    |   |
| First                |   | $        | 23.76  |    | $      | 18.91 |   |
| Second               |   | $        | 24.00  |    | $      | 18.40 |   |
| Third                |   | $        | 21.64  |    | $      | 16.00 |   |
| Fourth               |   | $        | 19.47  |    | $      | 14.26 |   |

 

We regularly review the carryingvalue of our investments and identify and recognize losses, for incomestatement purposes, when events and circumstances indicate that any declines inthe fair values of such investments, below our accounting basis, areother-than-temporary.  During 2003, wemade such a determination with respect to our investments in Genelabs and Amarin, resulting in impairmentcharges of $13.0 million and $1.2 million, respectively (see Note J in theaccompanying Notes to Consolidated Financial Statements in this QuarterlyReport).

 

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**Interest Rate Risk**

 

Our exposure to interest rate risk relatesprimarily to our non-equity investment portfolio.  Our cash is invested in A-rated money market mutual funds andshort-term securities. Consequently, our interest rate and principal risk areminimal.

 

Based on quoted market rates of interest andmaturity schedules for similar debt issues, we estimate that the fair values ofour CODES and our fixed-rate senior unsecured notes approximated their carryingvalues June 30, 2003.  While changes inmarket interest rates may affect the fair value of our fixed-rate debt, webelieve the effect, if any, of reasonably possible near-term changes in thefair value of such debt on our financial condition, results of operations orcash flows will not be material.

 

At this time, we are not party to anyinterest rate or derivative hedging contracts and have no material foreignexchange or commodity price risks.

 

**ITEM 4.****  CONTROLS AND PROCEDURES**

 

The Company maintains disclosure controls andprocedures that are designed to ensure that information required to bedisclosed in the Company’s Exchange Act reports is recorded, processed,summarized and reported within the time periods specified in the SEC’s rulesand forms, and that such information is accumulated and communicated to theCompany’s management, including its Principal Executive Officer and PrincipalFinancial Officer, as appropriate, to allow timely decisions regarding requireddisclosure.  In designing and evaluatingthe disclosure controls and procedures, management recognized that any controlsand procedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement necessarily was required to apply its judgment in evaluating thecost-benefit relationship of possible controls and procedures.  Also, the Company has investments in certainunconsolidated entities.  As the Companydoes not control or manage these entities, its disclosure controls andprocedures with respect to such entities are necessarily substantially morelimited than those it maintains with respect to its consolidated subsidiaries.

 

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

 

There have been no changes in the Company’sinternal control over financial reporting, during the three months ended June30, 2003, that has materially affected, or is reasonably likely to materiallyaffect, the Company’s internal control over financial reporting 

 

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**PART II.****  OTHER INFORMATION AND SIGNATURES**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

The Company is party to certain lawsuits andlegal proceedings, which are described in “Part I, Item 3. Legal Proceedings,”of our Annual Report on Form 10-K for the year ended December 31, 2002.  The following is a description of materialdevelopments during the period covered by this Quarterly Report and should beread in conjunction with the Annual Report referenced above.

 

*Phen-fen Litigation.*  With respect to the phenterminehydrochloride product liability lawsuits pending against the Company, certainof its subsidiaries, and others, additional actions raising similar issues havebeen filed, and some actions have been settled or otherwise dismissed.  As of July 15, 2003, approximately 215actions were pending against the Company and other Company entities in a numberof state and federal courts.  TheCompany believes that it will be fully indemnified by The Rugby Group’s formerowner, Aventis Pharmaceuticals (Aventis, formerly known as Hoechst MarionRoussel, Inc.) for the defense of all such cases and for any liability that mayarise out of these cases.  Aventis iscurrently controlling the defense of all these cases as the indemnifying partyunder its agreements with the Company.

 

*Cipro Litigation.*  With respect to the Cipro litigation, on May20, 2003, the court in the consolidated action pending in the United StatesDistrict Court for the Eastern District of New York (*In re: Ciprofloxacin HydrochlorideAntitrust Litigation, MDL Docket No. 001383*) granted WatsonPharmaceuticals, Inc.’s motion to dismiss, and denied the motions to dismissfiled by the other defendants, including the Company’s subsidiary, The RugbyGroup, Inc.  The court also denied theplaintiffs’ motion for partial summary judgment seeking a determination thatthe settlement agreements entered into by certain defendants constituted a perse violation of the antitrust laws. Discovery is ongoing.  Aventis iscurrently controlling the defense of these matters as the indemnifying partyunder its agreements with the Company.

 

*Government Reimbursement Investigations andProceedings.* With regard to theconsolidated actions alleging improper or fraudulent reporting practicesrelated to the reporting of average wholesale prices of certain products (*In re:Pharmaceutical Industry Average Wholesale Price Litigation, MDL Docket No. 1456*),on May 13, 2003, the court granted in part and denied in part the defendants’motion to dismiss the Master Consolidated Class Action Complaint filed by manyof the private plaintiffs, and permitted plaintiffs leave to file an amendedcomplaint.  On June 12, 2003, plaintiffsserved an Amended Master Consolidated Complaint (AMCC).  The AMCC includes various federal, state andcommon law claims against the Company and other defendants concerning allegedlyimproper or fraudulent practices in connection with reporting of averagewholesale prices of certain products, and other allegedly improper acts, inorder to increase prices and market shares. The AMCC alleges such acts improperly inflated the reimbursement amountspaid by various public and private plans and programs.  The AMCC alleges claims on behalf of apurported class of plaintiffs that paid any portion of the price of certaindrugs, which price was calculated based on its average wholesale price, orcontracted with a pharmacy benefit manager to provide others with suchdrugs.  On August 1, 2003, the Companyand other defendants filed motions to dismiss the AMCC.  The court has scheduled a hearing on themotions to dismiss on November 12, 2003. On August 4, 2003, the states of Montana and Nevada sought leave to fileamended complaints against the Company and other defendants alleging state lawclaims similar to the claims in the AMCC, as well as claims for violation oftheir respective state Medicaid fraud laws. The Company has not yet responded to these complaints.  With respect to other reimbursementinquiries, on June 26, 2003, the Company and numerous other pharmaceuticalcompanies received a request for records and information from the HouseCommittee on Energy and Commerce in connection with that Committee’sinvestigation into pharmaceutical reimbursements and rebates underMedicaid.    

 

 

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**ITEM4.  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

At our Annual Meeting of Stockholders held onMay 19, 2003, the following proposals were set before the stockholders fortheir vote:

 

**PROPOSALONE:** Election of three directors to hold office untilthe 2006 Annual Meeting: 

 
| **DIRECTORS  - CLASS II** |   | **Votes For** |   | **Votes  Withheld** |   |
|---------------------------|--------|---------------|--------|---------------------|--------|
|                      |   |          |   |                |   |
| Jack Michelson            |   | 88,272,615    |   | 3,263,775           |   |
| Ronald R. Taylor          |   | 89,622,581    |   | 1,913,809           |   |
| Andrew L. Turner          |   | 89,562,332    |   | 1,974,058           |   |

 

**PROPOSALTWO: **Approveamendment to the Company’s 2001 Incentive Award Plan, as amended, to increasethe number of shares of the Company’s common stock that may be issuedthereunder by 6,500,000 shares, from 7,500,000 shares to 14,000,000 shares:

 
| For              |   | 58,432,495 |   |
|------------------|--------|------------|--------|
| Against          |   | 15,851,469 |   |
| Abstain          |   | 665,587    |   |
| Broker non-votes |   | 16,586,839 |   |

 

**PROPOSALTHREE:**Ratification of the appointment of PricewaterhouseCoopersLLP as the Company’s independent auditor for the year ending December 31, 2003:

 
| For              |   | 86,614,283 |   |
|------------------|--------|------------|--------|
| Against          |   | 3,391,639  |   |
| Abstain          |   | 530,468    |   |
| Broker non-votes |   | 1,000,000  |   |

 

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**ITEM6.****  EXHIBITS ANDREPORTS ON FORM 8-K**

 

(a) Exhibits:

 

Reference ishereby made to the Exhibit Index on page 31.

 

(b) Reports onForm 8-K filed during the quarter ended June 30, 2003:

 

On May 6,2003, the Company filed a Current Report on Form 8-K with the Securities andExchange Commission reporting, under Item 9 (in lieu of furnishing under Item12), that it had issued a news release announcing its financial results for thequarter ended March 31, 2003.

 

On June 2,2003, the Company filed a Current Report on Form 8-K with the Securities andExchange Commission reporting, under Item 5, its agreement with a syndicate oflenders for a five-year, $300 million, unsecured revolving credit facility.

 

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**SIGNATURES**

 

Pursuant tothe 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/  CHARLES P. SLACIK** |
|                    | Charles P. Slacik                                         |
|                    | Executive Vice President – Chief Financial Officer   |
|                    | (Principal Financial Officer)                             |
|                    |                                                      |
|                    |                                                      |
|                    | By:                                                       | **/s/  R. TODD JOYCE** |
|                    | R. Todd Joyce                                             |
|                    | Vice President – Corporate Controller and  Treasurer |
|                    | (Principal Accounting Officer)                            |
|                    |                                                      |
|                    |                                                      |
| Dated: August  14, 2003 |                                                      |
|                         |                                                           |  |  |

 

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**WATSONPHARMACEUTICALS, INC.**

 

**EXHIBITINDEX TO FORM 10-Q****For theQuarterly Period Ended June 30, 2003**

 
| **Exhibit    No.** |   | **Description**                                                                                                                                                                                                                                                           |
|--------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|               |   |                                                                                                                                                                                                                                                                      |
| 4.1                |   | Form of  Guaranty, dated as of May 30, 2003, by each of the subsidiaries of the  Company, other than minor subsidiaries, in favor of Wachovia Bank National  Association, a national banking association, as trustee for the holders of  the Company's 1998 Senior Notes. |
|               |   |                                                                                                                                                                                                                                                                      |
| *10.1              |   | Key  Employment Agreement entered into as of May 5, 2003 by and between Charles  Slacik and the Company.                                                                                                                                                                  |
|               |   |                                                                                                                                                                                                                                                                      |
| *10.2              |   | Key  Employment Agreement entered into as of June 16, 2003 by and between Ian  McInnes and the Company.                                                                                                                                                                   |
|               |   |                                                                                                                                                                                                                                                                      |
| 31.1               |   | Certification  of Chairman and Chief Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                        |
|               |   |                                                                                                                                                                                                                                                                      |
| 31.2               |   | Certification  of Executive Vice President and Chief Financial Officer pursuant to Section  302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                        |
|               |   |                                                                                                                                                                                                                                                                      |
| 32.1               |   | Certification  of Chairman and Chief Executive Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                        |
|               |   |                                                                                                                                                                                                                                                                      |
| 32.2               |   | Certification  of Executive Vice President and Chief Financial Officer pursuant to Section  906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                        |

 

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*Compensation Plan or Agreement

 

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