**UNITEDSTATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 

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

 

**FOR THEQUARTERLY PERIOD ENDED SEPTEMBER 30, 2004**

 

**or**

** **

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

** **

**For the transition period from           to           **

 

**Commissionfile number 0-20045**

 

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**WATSONPHARMACEUTICALS, INC.**

(Exact name ofregistrant as specified in its charter)

 
| **Nevada**                                                       | ** ** | **95-3872914**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                             |       |                                  |
| **311  Bonnie Circle  Corona, CA 92880-2882**                    |
| (Address of  principal executive offices, including zip code)    |
|                                                             |
| **(951)  493-5300**                                              |
| (Registrant’s telephone  number, including area code)       |

 

Indicate by check mark 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   No o

 

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

 

The number of shares outstanding of the Registrant’s only class ofcommon stock as of November 2, 2004 was approximately 109,502,360.

 

 

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**WATSON PHARMACEUTICALS, INC.**

 

**TABLE OF CONTENTS**

 

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

 

 
| **Part I. FINANCIAL INFORMATION**                                                                    |
|------------------------------------------------------------------------------------------------------|
|                                                                                                 | ** ** |
| Item 1. Condensed  Consolidated Financial Statements (Unaudited):                                    | ** ** |
|                                                                                                 |   |   |
|                                                                                                 | Condensed  Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003 |   |
|                                                                                                 |   |   |
|                                                                                                 | Condensed  Consolidated Statements of Income for the Three and Nine Months Ended  September 30, 2004 and 2003 |   |
|                                                                                                 |   |   |
|                                                                                                 | Condensed  Consolidated Statements of Cash Flows for the Nine Months Ended September 30,  2004 and 2003 |   |
|                                                                                                 |   |   |
|                                                                                                 | Notes  to Condensed Consolidated Financial Statements |   |
|                                                                                                 |   |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations |   |
|                                                                                                 |   |
| Item 3.  Quantitative and Qualitative Disclosures about Market Risk                                  |   |
|                                                                                                 |   |
| Item 4. Controls  and Procedures                                                                     |   |
|                                                                                                 |   |
|                                                                                                 |   |
| **Part II.  OTHER INFORMATION AND SIGNATURES**                                                       |
|                                                                                                 |   |
| Item 1. Legal Proceedings                                                                            |   |
|                                                                                                 |   |
| Item 6. Exhibits                                                                                     |   |
|                                                                                                 |   |
| Signatures                                                                                           |   |

 

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**WATSON PHARMACEUTICALS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

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

 
| ** **                                                                                                                 | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| **ASSETS**                                                                                                                 |       |                    |       |                   |       |
| Current assets:                                                                                                            |       |                    |       |                   |       |
| Cash and cash  equivalents                                                                                                 |       | $                       | 595,219    |                   | $          | 553,353 |   |
| Marketable  securities                                                                                                     |       | 13,578                  |       | 20,368                 |       |
| Accounts  receivable, net                                                                                                  |       | 230,102                 |       | 211,174                |       |
| Inventories                                                                                                                |       | 340,147                 |       | 393,393                |       |
| Prepaid expenses  and other current assets                                                                                 |       | 29,294                  |       | 38,561                 |       |
| Deferred tax  assets                                                                                                       |       | 96,737                  |       | 106,640                |       |
| Total current  assets                                                                                                      |       | 1,305,077               |       | 1,323,489              |       |
|                                                                                                                       |       |                    |       |                   |       |
| Property and  equipment, net                                                                                               |       | 433,031                 |       | 424,995                |       |
| Investments and  other assets                                                                                              |       | 46,353                  |       | 50,096                 |       |
| Deferred tax  assets                                                                                                       |       | 22,042                  |       | 27,130                 |       |
| Product rights  and other intangibles, net                                                                                 |       | 908,589                 |       | 1,001,295              |       |
| Goodwill                                                                                                                   |       | 455,595                 |       | 455,595                |       |
| Total assets                                                                                                               |       | $                       | 3,170,687  |                   | $          | 3,282,600 |   |
|                                                                                                                       |       |                    |       |                   |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                              |       |                    |       |                   |       |
| Current  liabilities:                                                                                                      |       |                    |       |                   |       |
| Accounts payable  and accrued expenses                                                                                     |       | $                       | 179,705    |                   | $          | 215,388 |   |
| Income taxes  payable                                                                                                      |       | 62,490                  |       | 111,982                |       |
| Deferred revenue                                                                                                           |       | 7,029                   |       | 11,315                 |       |
| Total current  liabilities                                                                                                 |       | 249,224                 |       | 338,685                |       |
|                                                                                                                       |       |                    |       |                   |       |
| Long-term debt                                                                                                             |       | 587,583                 |       | 722,535                |       |
| Deferred revenue                                                                                                           |       | 12,060                  |       | 10,767                 |       |
| Other long-term  liabilities                                                                                               |       | 5,815                   |       | 9,641                  |       |
| Deferred tax  liabilities                                                                                                  |       | 133,765                 |       | 143,626                |       |
| Total  liabilities                                                                                                         |       | 988,447                 |       | 1,225,254              |       |
|                                                                                                                       |       |                    |       |                   |       |
| Commitments and  contingencies                                                                                             |       |                    |       |                   |       |
|                                                                                                                       |       |                    |       |                   |       |
| Stockholders’  equity:                                                                                                |       |                    |       |                   |       |
| Preferred stock;  no par value per share; 2,500,000 shares authorized; none issued                                         |       | —                  |       | —                 |       |
| Common stock;  $0.0033 par value per share; 500,000,000 shares authorized; 109,484,300 and  108,330,300 shares outstanding |       | 361                     |       | 357                    |       |
| Additional  paid-in capital                                                                                                |       | 873,283                 |       | 841,007                |       |
| Retained  earnings                                                                                                         |       | 1,297,941               |       | 1,201,714              |       |
| Accumulated  other comprehensive income                                                                                    |       | 10,655                  |       | 14,268                 |       |
| Total  stockholders’ equity                                                                                           |       | 2,182,240               |       | 2,057,346              |       |
| Total  liabilities and stockholders’ equity                                                                           |       | $                       | 3,170,687  |                   | $          | 3,282,600 |   |

 

*See accompanying Notes to Condensed Consolidated FinancialStatements.*

 

1

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**WATSON PHARMACEUTICALS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF INCOME**

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

 
| ** **                                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                     | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                           |       |                                  |       |                                 |       |   |   |   |   |
| Net revenues                                   |       | $                                     | 408,018    |                                 | $          | 358,756 |   | $ | 1,217,044 |   | $ | 1,051,558 |   |
| Cost of sales                                  |       | 202,508                               |       | 142,331                              |       | 597,843 |   | 446,308 |   |
| Gross profit                                   |       | 205,510                               |       | 216,425                              |       | 619,201 |   | 605,250 |   |
|                                           |       |                                  |       |                                 |       |   |   |   |   |
| Operating  expenses:                           |       |                                  |       |                                 |       |   |   |   |   |
| Research and  development                      |       | 34,261                                |       | 26,428                               |       | 106,471 |   | 74,613 |   |
| Selling, general  and administrative           |       | 80,578                                |       | 87,547                               |       | 237,158 |   | 227,420 |   |
| Amortization                                   |       | 18,040                                |       | 17,820                               |       | 53,955 |   | 54,040 |   |
| Total operating  expenses                      |       | 132,879                               |       | 131,795                              |       | 397,584 |   | 356,073 |   |
| Operating income                               |       | 72,631                                |       | 84,630                               |       | 221,617 |   | 249,177 |   |
|                                           |       |                                  |       |                                 |       |   |   |   |   |
| Other income  (expense):                       |       |                                  |       |                                 |       |   |   |   |   |
| Equity in  earnings (losses) of joint ventures |       | (810                                  | )          | (68                                  | )          | (4,089 | ) | 137 |   |
| Loss on  impairment of assets                  |       | (50,894                               | )          | (1,605                               | )          | (51,785 | ) | (15,865 | ) |
| Gain on sale of  securities                    |       | 1,799                                 |       | 2,496                                |       | 5,737 |   | 5,510 |   |
| Gain on sale of  subsidiary                    |       | —                                |       | —                               |       | — |   | 15,676 |   |
| Loss on early  extinguishment of debt          |       | —                                |       | —                               |       | (17,752 | ) | (2,807 | ) |
| Interest income                                |       | 1,504                                 |       | 1,603                                |       | 3,726 |   | 4,287 |   |
| Interest expense                               |       | (3,681                                | )          | (5,980                               | )          | (9,071 | ) | (18,901 | ) |
| Other income  (expense)                        |       | 2,327                                 |       | (293                                 | )          | 1,987 |   | (1,731 | ) |
| Total other  expense, net                      |       | (49,755                               | )          | (3,847                               | )          | (71,247 | ) | (13,694 | ) |
|                                           |       |                                  |       |                                 |       |   |   |   |   |
| Income before  income taxes                    |       | 22,876                                |       | 80,783                               |       | 150,370 |   | 235,483 |   |
| Provision for  income taxes                    |       | 8,235                                 |       | 29,324                               |       | 54,143 |   | 85,480 |   |
| Net income                                     |       | $                                     | 14,641     |                                 | $          | 51,459 |   | $ | 96,227 |   | $ | 150,003 |   |
|                                           |       |                                  |       |                                 |       |   |   |   |   |
| Earnings per  share:                           |       |                                  |       |                                 |       |   |   |   |   |
| Basic                                          |       | $                                     | 0.13       |                                 | $          | 0.48 |   | $ | 0.88 |   | $ | 1.40 |   |
| Diluted                                        |       | $                                     | 0.13       |                                 | $          | 0.47 |   | $ | 0.87 |   | $ | 1.38 |   |
|                                           |       |                                  |       |                                 |       |   |   |   |   |
| Weighted average  shares outstanding:          |       |                                  |       |                                 |       |   |   |   |   |
| Basic                                          |       | 109,442                               |       | 107,762                              |       | 109,041 |   | 107,282 |   |
| Diluted                                        |       | 109,739                               |       | 109,658                              |       | 110,262 |   | 108,459 |   |

 

*See accompanying Notes to Condensed ConsolidatedFinancial Statements.*

 

2

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**WATSON PHARMACEUTICALS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited;in thousands)

 
| ** **                                                        | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                        | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                        |       |                                 |       |   |   |
| Net income                                                        |       | $                                    | 96,227     |   | $ | 150,003 |   |
| Reconciliation  to net cash provided by operating activities:     |       |                                 |       |   |   |
| Depreciation                                                      |       | 24,357                               |       | 20,683 |   |
| Amortization                                                      |       | 53,955                               |       | 54,040 |   |
| Deferred income  tax benefit (provision)                          |       | 7,305                                |       | (15,460 | ) |
| Equity in  (earnings) losses of joint ventures                    |       | 4,089                                |       | (137 | ) |
| Gain on sales of  securities                                      |       | (5,737                               | )          | (5,510 | ) |
| Gain on sale of  property and equipment                           |       | (2,383                               | )          | — |   |
| Gain on sale of  subsidiary                                       |       | —                               |       | (15,676 | ) |
| Loss on early  extinguishment of debt                             |       | 17,752                               |       | 2,807 |   |
| Loss on  impairment of assets                                     |       | 51,785                               |       | 15,865 |   |
| Tax benefits  from employee stock plans                           |       | 6,070                                |       | 4,750 |   |
| Mark to market  on derivative                                     |       | (3,826                               | )          | 2,057 |   |
| Other                                                             |       | 346                                  |       | (826 | ) |
| Changes in  assets and liabilities:                               |       |                                 |       |   |   |
| Accounts receivable,  net                                         |       | (18,928                              | )          | 54,112 |   |
| Inventories                                                       |       | 53,246                               |       | (51,789 | ) |
| Prepaid expenses  and other current assets                        |       | 9,267                                |       | 5,891 |   |
| Accounts payable  and accrued expenses                            |       | (35,685                              | )          | 40,332 |   |
| Deferred revenue                                                  |       | (2,993                               | )          | 18,005 |   |
| Income taxes  payable                                             |       | (49,492                              | )          | 19,713 |   |
| Other assets                                                      |       | 2,305                                |       | (933 | ) |
| Total  adjustments                                                |       | 111,433                              |       | 147,924 |   |
| Net cash  provided by operating activities                        |       | 207,660                              |       | 297,927 |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                        |       |                                 |       |   |   |
| Additions to  property and equipment                              |       | (59,033                              | )          | (104,542 | ) |
| Acquisitions of  product rights                                   |       | (7,349                               | )          | (179,303 | ) |
| Additions to  long-term investments                               |       | (10,590                              | )          | — |   |
| Proceeds from  sale of property and equipment                     |       | 23,809                               |       | — |   |
| Proceeds from  sales of marketable equity securities              |       | 6,753                                |       | 12,122 |   |
| Proceeds from  sale of Halsey note receivable                     |       | 5,381                                |       | — |   |
| Proceeds from  sale of subsidiary                                 |       | —                               |       | 16,368 |   |
| Distribution  from equity investments                             |       | —                               |       | 13,500 |   |
| Other investing  activities, net                                  |       | 2,009                                |       | 3,944 |   |
| Net cash used in  investing activities                            |       | (39,020                              | )          | (237,911 | ) |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                        |       |                                 |       |   |   |
| Proceeds from  issuance of debt, net of issuance costs of $14,375 |       | —                               |       | 560,625 |   |
| Proceeds from  borrowings under revolving credit facility         |       | —                               |       | 60,000 |   |
| Principal  payments on credit facility                            |       | —                               |       | (325,940 | ) |
| Payments to repurchase  1998 Senior Notes                         |       | (135,905                             | )          | — |   |
| Premium paid on  1998 Senior Notes repurchase                     |       | (17,072                              | )          | — |   |
| Principal  payments on acquisition liabilities                    |       | (7                                   | )          | (1,012 | ) |
| Proceeds from  stock plans                                        |       | 26,210                               |       | 26,174 |   |
| Net cash (used  in) provided by financing activities              |       | (126,774                             | )          | 319,847 |   |
| Net increase in  cash and cash equivalents                        |       | 41,866                               |       | 379,863 |   |
| Cash and cash  equivalents at beginning of period                 |       | 553,353                              |       | 230,155 |   |
| Cash and cash  equivalents at end of period                       |       | $                                    | 595,219    |   | $ | 610,018 |   |

 

*See accompanying Notes to Condensed Consolidated FinancialStatements.*

 

3

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**WATSON PHARMACEUTICALS, INC.**

**NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

**NOTE A – GENERAL**

 

Watson Pharmaceuticals,Inc. (Watson or the Company) is primarily engaged in the development,manufacture, marketing, sale and distribution of branded and off-patent(generic) pharmaceutical products. The Company also develops advanced drugdelivery systems designed to enhance the therapeutic benefits of existing drugforms.  Watson operates manufacturing,distribution, research and development and administrative facilities primarilyin the United States of America (U.S.).

 

The accompanying condensedconsolidated financial statements should be read in conjunction with theCompany’s Annual Report on Form 10-K for the year ended December 31, 2003.  Certain information and footnote disclosuresnormally included in annual financial statements prepared in accordance withgenerally accepted accounting principles have been condensed or omitted fromthe accompanying consolidated financial statements.  The year end balance sheet was derived fromthe audited financial statements.  Theaccompanying interim financial statements are unaudited, but reflect all adjustmentswhich are, in the opinion of management, necessary to present fairly Watson’sconsolidated financial position, results of operations and cash flows for theperiods presented.  Unless otherwisenoted, all such adjustments are of a normal, recurring nature.  Certain reclassifications, none of whichaffected net income or retained earnings, have been made to prior periodamounts to conform to current period presentation.  The Company’s results of operations and cashflows for the interim periods are not necessarily indicative of the results ofoperations and cash flows that it may achieve in future periods or for the fullyear.

 

*Comprehensive income*

 

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

 

4

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| ** **                                                  | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                  | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                        |       |                                  |       |                                 |       |   |   |   |   |
| Net income                                                  |       | $                                     | 14,641     |                                 | $          | 51,459 |   | $ | 96,227 |   | $ | 150,003 |   |
|                                                        |       |                                  |       |                                 |       |   |   |   |   |
| Other  comprehensive income (loss):                         |       |                                  |       |                                 |       |   |   |   |   |
| Unrealized  holding gain (loss) on securities               |       | (3,242                                | )          | 1,598                                |       | (4,026 | ) | 16,670 |   |
| Less related income  taxes                                  |       | 1,167                                 |       | (641                                 | )          | 1,449 |   | (6,670 | ) |
| Total unrealized  gain (loss) on securities, net            |       | (2,075                                | )          | 957                                  |       | (2,577 | ) | 10,000 |   |
|                                                        |       |                                  |       |                                 |       |   |   |   |   |
| Reclassification  for gains (losses) included in net income |       | (527                                  | )          | (891                                 | )          | (1,619 | ) | 10,355 |   |
| Less related  income taxes                                  |       | 189                                   |       | 323                                  |       | 583 |   | (3,759 | ) |
| Total  reclassification, net                                |       | (338                                  | )          | (568                                 | )          | (1,036 | ) | 6,596 |   |
| Total other  comprehensive income (loss)                    |       | (2,413                                | )          | 389                                  |       | (3,613 | ) | 16,596 |   |
| Total  comprehensive income                                 |       | $                                     | 12,228     |                                 | $          | 51,848 |   | $ | 92,614 |   | $ | 166,599 |   |

 

*Earnings per share*

 

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

 
| ** **                                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                          | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                |       |                                  |       |                                 |       |   |   |   |   |
| **Numerator:**                                      |       |                                  |       |                                 |       |   |   |   |   |
| Net income                                          |       | $                                     | 14,641     |                                 | $          | 51,459 |   | $ | 96,227 |   | $ | 150,003 |   |
| **Denominator:**                                    |       |                                  |       |                                 |       |   |   |   |   |
| Basic weighted  average common shares outstanding   |       | 109,442                               |       | 107,762                              |       | 109,041 |   | 107,282 |   |
| Effect of  dilutive stock options                   |       | 297                                   |       | 1,896                                |       | 1,221 |   | 1,177 |   |
| Diluted weighted  average common shares outstanding |       | 109,739                               |       | 109,658                              |       | 110,262 |   | 108,459 |   |
|                                                |       |                                  |       |                                 |       |   |   |   |   |
| **Basic  earnings per share**                       |       | $                                     | 0.13       |                                 | $          | 0.48 |   | $ | 0.88 |   | $ | 1.40 |   |
|                                                |       |                                  |       |                                 |       |   |   |   |   |
| **Diluted  earnings per share**                     |       | $                                     | 0.13       |                                 | $          | 0.47 |   | $ | 0.87 |   | $ | 1.38 |   |

 

Excluded from thecomputation of diluted earnings per share are outstanding common stock optionswith an exercise price greater than the average market price of the commonshares for the periods reported.  For thethree month periods ended September 30, 2004 and 2003, excluded from thecomputation of diluted earnings per share were stock options to purchase 11.3million and 4.4 million common shares, respectively.  For the nine month periods ended September30, 2004 and 2003, excluded from the computation of diluted earnings per sharewere stock options to purchase 6.8 million and 6.3 million common shares,respectively.

 

The effect ofapproximately 14.4 million shares which would have been issuable upon conversionof the $575 million convertible contingent debentures (as described in Note F)has been excluded from the computation of diluted earnings per share for the threeand nine month periods ended September 30, 2004 and

 

5

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2003, because theconditions that would permit conversion were not satisfied.  However, the accounting rules will changewith respect to this convertible debt beginning in the fourth quarter of 2004for all reported periods.  Absent anymodifications to the terms of the convertible contingent debentures, thisaccounting change will require the Company’s diluted earnings per share to becomputed taking into account the shares issuable upon conversion of thisconvertible debt.

 

*Stock-based compensation*

 

The Company accounts forits stock-based employee compensation plans using the recognition andmeasurement principles of Accounting Principles Board (APB) Opinion No. 25, “Accountingfor Stock Issued to Employees” and related interpretations.  No stock-based employee compensation expensehas been recognized for the options in the accompanying condensed consolidatedstatements of income, as all options granted under the plans had an exerciseprice equal to the market value of the underlying common stock on the date ofgrant.

 

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

 
| ** **                                                                                                                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                                                          |       |                                  |       |                                 |       |   |   |   |   |
| Net income                                                                                                                                    |       | $                                     | 14,641     |                                 | $          | 51,459 |   | $ | 96,227 |   | $ | 150,003 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | 1,229                                 |       | 5,591                                |       | 9,820 |   | 15,044 |   |
| Pro forma net  income                                                                                                                         |       | $                                     | 13,412     |                                 | $          | 45,868 |   | $ | 86,407 |   | $ | 134,959 |   |
|                                                                                                                                          |       |                                  |       |                                 |       |   |   |   |   |
| Earnings per  share:                                                                                                                          |       |                                  |       |                                 |       |   |   |   |   |
| Basic - as  reported                                                                                                                          |       | $                                     | 0.13       |                                 | $          | 0.48 |   | $ | 0.88 |   | $ | 1.40 |   |
| Basic - pro  forma                                                                                                                            |       | $                                     | 0.12       |                                 | $          | 0.43 |   | $ | 0.79 |   | $ | 1.26 |   |
|                                                                                                                                          |       |                                  |       |                                 |       |   |   |   |   |
| Diluted - as  reported                                                                                                                        |       | $                                     | 0.13       |                                 | $          | 0.47 |   | $ | 0.87 |   | $ | 1.38 |   |
| Diluted - pro  forma                                                                                                                          |       | $                                     | 0.12       |                                 | $          | 0.42 |   | $ | 0.78 |   | $ | 1.24 |   |
|                                                                                                                                          |       |                                  |       |                                 |       |   |   |   |   |
| Weighted average  shares outstanding:                                                                                                         |       |                                  |       |                                 |       |   |   |   |   |
| Basic                                                                                                                                         |       | 109,442                               |       | 107,762                              |       | 109,041 |   | 107,282 |   |
| Diluted                                                                                                                                       |       | 109,739                               |       | 109,658                              |       | 110,262 |   | 108,459 |   |

 

The weighted average fairvalue of the stock options and Employee Stock Purchase Plan (ESPP) has beenestimated on the date of grant using the Black-Scholes option pricing model.Weighted averages are used because of varying assumed exercise dates.  The weighted average fair value of stockoptions granted for the nine months ended September 30, 2004 and 2003 was $11.35per share and $14.25 per share, respectively. The weighted average fair value of ESPP granted for the nine monthsended September 30, 

 

6

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2004 and 2003 was $8.69 pershare and $8.93 per share, respectively.  The following weighted averageassumptions were used for stock options granted during the three and nine monthsended September 30, 2004 and 2003:

 

| ** **               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **               | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                     |       |                                  |       |                                 |       |   |   |   |   |
| Dividend yield           |       | None                                  |       | None                                 |       | None |   | None |   |
| Expected  volatility     |       | 35%                                   |       | 36%                                  |       | 33% |   | 38% |   |
| Risk-free  interest rate |       | 3.84%                                 |       | 3.40%                                |       | 3.78% |   | 3.38% |   |
| Expected term            |       | 5.4 years                             |       | 5.3 years                            |       | 5.4 years |   | 5.3 years |   |

 

The following weightedaverage assumptions were used for ESPP during the three and nine months ended September30, 2004 and 2003:

 

| ** **               | ** ** | **Three Months Ended  September** | ** ** | **Nine Months Ended  September** | ** ** |
|--------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **               | ** ** | **2004**                          | ** ** | **2003**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|                     |       |                              |       |                             |       |   |   |   |   |
| Dividend yield           |       | None                              |       | None                             |       | None |   | None |   |
| Expected  volatility     |       | 35%                               |       | 35%                              |       | 36% |   | 37% |   |
| Risk-free  interest rate |       | 3.84%                             |       | 3.49%                            |       | 3.81% |   | 3.38% |   |
| Expected term            |       | 6 months                          |       | 6 months                         |       | 6 months |   | 6 months |   |

 

*Recent accounting pronouncements*

 

In January 2003, the FinancialAccounting Standards Board (FASB) issued Interpretation No. (FIN) 46, “Consolidationof Variable Interest Entities” an interpretation of Accounting ResearchBulletin No. 51, “Consolidated Financial Statements.”  The primary objectives of FIN 46 are toprovide guidance on the identification of entities which the Company maycontrol through means other than through voting rights (“variable interestentities”) and to determine when and which business enterprise (“primarybeneficiary”) should consolidate the variable interest entity.  FIN 46 requires existing unconsolidatedvariable interest entities to be consolidated by their primary beneficiaries ifthe entities do not effectively disperse risks among the parties involved.  Variable interest entities that effectivelydisperse risks will not be consolidated unless a single party holds an interestor combination of interests that effectively recombines risks that werepreviously dispersed.  In addition, FIN46 requires that the primary beneficiary, as well as all other enterprises witha significant variable interest in a variable interest entity, make additionaldisclosures.  Certain disclosurerequirements of FIN 46 were effective for financial statements issued afterJanuary 31, 2003.  In December 2003, theFASB revised FIN 46 (FIN 46R) to address certain FIN 46 implementationissues.  The revised provisions areapplicable no later than the first reporting period ending after March 15,2004.  The Company adopted FIN 46 and FIN46R and determined the Company does not have any variable interest entitiesthat require consolidation nor any material entities that require disclosure.

 

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

 

7

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In September 2004, the EmergingIssues Task Force (EITF) reached a final consensus on EITF Issue No. 04-8, “TheEffect of Contingently Convertible Debt on Diluted Earnings per Share.” Under EITFIssue No. 04-8, contingently convertible debt instruments (Co-Cos) should beincluded in diluted earnings per share computations (if dilutive) regardless ofwhether the market price trigger (or other contingent feature) has beenmet.  Additionally, prior period earningsper share amounts presented for comparative purposes should be restated toconform to this consensus, which is effective for reporting periods endingafter December 15, 2004.  Absent anymodifications to the terms of the Co-Cos, the Company will be required to addapproximately 14.4 million shares associated with the conversion of our $575million convertible contingent debentures to the number of shares outstandingfor the calculation of diluted earnings per share for all reported periods.

 

In September 2004, EITFreached a final consensus on EITF Issue No. 04-10, “Applying Paragraph 19 ofFASB Statement No. 131, Disclosures about Segments of an Enterprise andRelated Information, in Determining Whether to Aggregate Operating Segments ThatDo Not Meet the Quantitative Thresholds.” Under EITF Issue No. 04-10, operating segments that do not meet thequantitative thresholds can be aggregated into a reportable segment ifaggregation is consistent with the objective and basic principles of FASBStatement No. 131, the segments have similar economic characteristics, and thesegments share a majority of the other aggregation criteria as defined by FASBStatement No. 131, paragraph 17.  EITFIssue No. 04-10 is effective for fiscal years ending after October 13,2004.  The corresponding information forearlier periods, including interim periods, shall be restated unless it isimpractical to do so.  Restatement ofpreviously issued financial statements is required.  The Company is currently assessing the impactof EITF Issue No. 04-10.

 

**NOTE B – EQUITY INVESTMENTS**

 

Watson’s equityinvestments in publicly traded companies are classified as available-for-saleand are recorded at fair value based on quoted market prices using the specificidentification method.  These investmentsare classified as either current or non-current, as appropriate, on the Company’sCondensed Consolidated Balance Sheets.

 

*Current investments*

 

The Company’s investment inthe common stock of Andrx Corporation (Andrx), publicly traded on the NasdaqStock Market under the symbol ADRX, is classified as a current investment andis included in “Marketable securities” on the Company’s Condensed ConsolidatedBalance Sheets at September 30, 2004 and December 31, 2003.

 

During the three monthperiod ended September 30, 2004, Watson sold 90,000 shares of its investment inthe common stock of Andrx for proceeds of $2.0 million and recorded a pre-taxgain of $1.8 million.  During the nine monthperiod ended September 30, 2004, Watson sold 240,000 shares of its investmentin the common stock of Andrx for proceeds of $6.3 million and recorded apre-tax gain of $5.7 million.  Realizedgains are computed using the specific identification method to determine thecost basis for each investment.  Duringthe three month period ended September 30, 2003, Watson sold 47,000 shares ofits investment in the common stock of Andrx for proceeds of $1.0 million andrecorded a pre-tax gain of $0.9 million. During the nine month period ended September 30, 2003, Watson sold117,000 shares of its investment in the common stock of Andrx for proceeds of$2.4 million and recorded a pre-tax gain of $2.0 million.

 

During the three monthperiod ended September 30, 2003, Watson sold 146,228 shares of its investmentin the common stock of Dr. Reddy’s Laboratories, Limited (Dr. Reddy) forproceeds of $3.7 million and recorded a pre-tax gain of $1.6 million.

 

During the nine monthperiod ended September 30, 2003, Watson sold 436,228 shares of its investmentin the common stock of Dr. Reddy for proceeds of $9.7 million and recorded apre-tax gain of $3.5 million.  AtDecember 31, 2003 and September 30, 2004, the Company held no shares of Dr.Reddy common stock.

 

8

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*Non-current investments*

 

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

 

The following tableprovides a summary of the fair value and unrealized holding gain (loss) relatedto Watson’s available-for-sale securities (in thousands):

 

| ** **                     | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------|------------|-------------------------|------------|------------------------|------------|
|                           |       |                    |       |                   |       |
| Equity  securities:            |       |                    |       |                   |       |
| Cost basis                     |       | $                       | 5,777      |                   | $          | 10,556 |   |
| Gross unrealized  holding gain |       | 16,833                  |       | 23,336                 |       |
| Gross unrealized  holding loss |       | —                  |       | (716                   | )          |
| Fair value of  securities      |       | $                       | 22,610     |                   | $          | 33,176 |   |

 

Gross unrealized gainsprimarily relate to our holdings in shares of Andrx common stock.  The gross unrealized holding loss at December31, 2003 is attributable to adjustments, included in other comprehensiveincome, for the decline in fair value in the Company’s investment in Amarin.  The Company wrote down its investment inAmarin during the third quarter of 2004 (as described in Note H).

 

The Company’s netunrealized holding gain related to its available-for-sale securities decreased$2.4 million and $3.6 million for the three and nine month periods ended September30, 2004, respectively.  During the threeand nine month periods ended September 30, 2003, the Company’s net unrealizedholding gain increased $0.4 million and $16.6 million, respectively.  These changes in the Company’s net unrealizedholding gain are included in other comprehensive income.

 

**NOTE C – OPERATING SEGMENTS**

 

Watson has two reportableoperating segments: branded and generic pharmaceutical products.  The branded products segment includes theCompany’s lines of Specialty Products and Nephrology products. Watson hasaggregated its branded product lines in a single segment because ofsimilarities in regulatory environment, manufacturing processes, methods ofdistribution and types of customer.  Thissegment includes patent-protected products and certain trademarked off-patent productsthat Watson sells and markets 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.

 

Beginning July 1, 2004,as a result of a change in the way the Company manages certain products andproduct lines, the Company reclassified the product revenues from the bulk ofits oral contraceptive products in Women’s Health and certain other products inGeneral Products from the branded segment to the generic segment.  Prior to July 1, 2004, the branded productssegment included the Company’s lines of Women’s Health, General Products andNephrology products.  Effective July 1,2004, we no longer report the results of Women’s Health and General Products asseparate groups and have included these results in our Specialty Productsgroup.  Details on this change inreporting, including a reclassification of prior periods, were disclosed in theCompany’s Form 8-K dated October 20, 2004. All historical results provided in this Quarterly Report reflect thisreclassification.

 

9

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The significant accountingpolicies of the segments are described in the Company’s Annual Report on Form10-K for the year ended December 31, 2003. Watson primarily evaluates the performance of its segments based on netrevenues and gross profit.  The “other”classification for the three and nine month periods ended September 30, 2004 consistedprimarily of royalties and revenues from research, development and licensingfees.  The “other” classification for thethree and nine month periods ended September 30, 2003 consisted primarily ofcontingent payments received from the settlement of a legal dispute andrevenues 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, or accounted for at the segment level.  Net revenues and gross profit information forthe Company’s segments, as restated, consisted of the following (in thousands):

 
| ** **                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                       | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                             |       |                                  |       |                                 |       |   |   |   |   |
| **Net  revenues:**               |       |                                  |       |                                 |       |   |   |   |   |
| Branded  pharmaceutical products |       | $                                     | 97,572     |                                 | $          | 102,091 |   | $ | 270,458 |   | $ | 300,660 |   |
| Generic  pharmaceutical products |       | 303,337                               |       | 236,757                              |       | 914,925 |   | 712,316 |   |
| Other                            |       | 7,109                                 |       | 19,908                               |       | 31,661 |   | 38,582 |   |
| Total net  revenues              |       | $                                     | 408,018    |                                 | $          | 358,756 |   | $ | 1,217,044 |   | $ | 1,051,558 |   |
| **Gross  profit:**               |       |                                  |       |                                 |       |   |   |   |   |
| Branded  pharmaceutical products |       | $                                     | 77,528     |                                 | $          | 80,548 |   | $ | 213,186 |   | $ | 230,908 |   |
| Generic  pharmaceutical products |       | 120,873                               |       | 115,969                              |       | 374,354 |   | 335,760 |   |
| Other                            |       | 7,109                                 |       | 19,908                               |       | 31,661 |   | 38,582 |   |
| Total gross  profit              |       | $                                     | 205,510    |                                 | $          | 216,425 |   | $ | 619,201 |   | $ | 605,250 |   |

 

**NOTE D – INVENTORIES**

 

Inventories consist offinished goods held for distribution, raw materials and work-in-process. Includedin inventory at September 30, 2004 is approximately $11.3 million of inventorythat is pending approval by the Food and Drug Administration (FDA) or has notbeen launched due to contractual restrictions.  This inventory consists of genericpharmaceutical products that are capitalized only when the bioequivalence ofthe product is demonstrated or the product is already FDA approved and is awaitinga contractual triggering event to enter the marketplace.

 

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

 

| ** **         | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------|------------|-------------------------|------------|------------------------|------------|
|               |       |                    |       |                   |       |
| Raw materials      |       | $                       | 105,501    |                   | $          | 123,239 |   |
| Work-in-process    |       | 70,569                  |       | 70,436                 |       |
| Finished goods     |       | 164,077                 |       | 199,718                |       |
| Total  inventories |       | $                       | 340,147    |                   | $          | 393,393 |   |

 

10

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**NOTE E – GOODWILL AND OTHERINTANGIBLE ASSETS**

 

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

 

Duringthe second quarter of 2004, the Company performed its annual test for theimpairment of goodwill and determined there was no indication ofimpairment.  There were no additions togoodwill recorded during the nine months ended September 30, 2004.  At September 30, 2004, and December 31, 2003,goodwill for the Company’s reporting units consisted of the following (inthousands):

 

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

 

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

 

| ** **                                         | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
|                                               |       |                    |       |                   |       |
| Product rights  and related intangibles            |       | $                       | 1,243,996  |                   | $          | 1,291,311 |   |
| Less accumulated  amortization                     |       | (335,407                | )          | (290,016               | )          |
| Total product  rights and related intangibles, net |       | $                       | 908,589    |                   | $          | 1,001,295 |   |

 

Atthe end of third quarter 2004, the Company recognized a $46.1 millionimpairment charge relating to its Tri-Norinyl® product rights as a result of acompetitor’s introduction to the market of a generic version of the Tri-Norinyl®oral contraceptive tablets.  Inaccordance with SFAS No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets,” the Company evaluated the recoverability of its Tri-Norinyl®product rights and determined that future estimated undiscounted cash flowswere below the carrying amount of the underlying product rights.  As a result of this evaluation, the Companyadjusted the carrying value of the product rights to its estimated fair valueof $13.8 million.  The Company estimatedthe fair value of its Tri-Norinyl® product rights based on forecasted cashflows, discounted by an interest rate used for evaluating product rightacquisitions.

 

Product rights andrelated intangibles include the intangible asset related to our Ferrlecit®product.  Regulatory exclusivity on ourFerrlecit® product expired in August, 2004. During the third quarter of 2004, we submitted a second Citizen’sPetition to the FDA requesting that the FDA refuse to accept for review any AbbreviatedNew Drug Application (ANDA) referencing Ferrlecit® until the FDA establishesguidelines for determining whether the generic product is the same complex asFerrlecit®.  This petition follows thefirst petition we submitted in February, 2004, requesting the FDA refuse toapprove any ANDA referencing Ferrlecit®, unless a generic applicant can establishthat the process used to produce the product is same as the process used forproducing Ferrlecit®, and that the physiochemical characteristics are the sameas Ferrlecit®.

 

Assumingno additions, disposals or adjustments are made to the carrying values and/oruseful lives of the assets, annual amortization expense on product rights andrelated intangibles is estimated to be approximately

 

11

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$71 million in 2004 and $69 million in each of thenext four years.  The Company’s currentproduct rights and related intangibles have a weighted average useful life ofapproximately nineteen years.

 

**NOTE F –LONG-TERM DEBT**

 

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

 
| ** **                                                                                                                                                                         | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
|                                                                                                                                                                               |       |                    |       |                   |       |
| Senior unsecured  notes, 7.125%, face amount of $14 million and $150 million as of September  30, 2004 and December 31, 2003, respectively, due 2008, net of unamortized  discount |       | $                       | 14,033     |                   | $          | 149,183 |   |
| Convertible  contingent debentures, face amount of $575 million due 2023, net of  unamortized discount                                                                             |       | 573,504                 |       | 573,297                |       |
| Other notes  payable                                                                                                                                                               |       | 46                      |       | 55                     |       |
| Total debt                                                                                                                                                                         |       | $                       | 587,583    |                   | $          | 722,535 |   |
| Less current  portion                                                                                                                                                              |       | —                  |       | —                 |       |
| Total long-term  debt                                                                                                                                                              |       | $                       | 587,583    |                   | $          | 722,535 |   |

 

*1998 Senior Notes*

 

In May 1998, Watsonissued $150 million of its senior unsecured notes (1998 Senior Notes).  The 1998 Senior Notes are due inMay 2008 but may be redeemed earlier under certain circumstances.  The Company is required to make interest onlypayments due semi-annually in May and November at an effective annual rate of 8.2%.

 

In February 2004, theCompany initiated a tender offer to purchase all of its outstanding 1998 SeniorNotes and a related consent solicitation. The Company received tenders of its 1998 Senior Notes and deliveries ofrelated consents from holders of approximately $101.6 million of the $150million aggregate principal amount of 1998 Senior Notes outstanding.  As a result, the Company received therequired consents to eliminate substantially all of the restrictive covenantsof the indenture governing the 1998 Senior Notes and to make certainamendments.  The Company executed anddelivered a supplemental indenture setting forth the amendments.

 

In May 2004, the Companyacquired an additional $34.3 million of its outstanding 1998 Senior Notes in anopen market transaction.  The Company recordedcharges of $14.0 million and $3.7 million in the first and second quarters of2004, respectively, related to fees, expenses, unamortized discount, and premiumspaid for the bond repurchases.

 

*Convertible Contingent SeniorDebentures*

 

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

 

The CODES are convertibleinto Watson’s common stock at a conversion price of approximately $40.05 pershare (subject to certain adjustments). The CODES may be converted, at the option of the holders, prior tomaturity under any of the following circumstances:

 

12

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

 

•                  on or beforeMarch 15, 2018, during the five business-day period following any 10consecutive trading-day period in which the daily average trading price for theCODES for such ten-day period was less than 105% of the average conversionvalue for the debentures during that period. This conversion feature represents an embedded derivative.  However, based on the de minimis valueassociated with this feature, no value has been assigned at issuance and at September30, 2004;

 

•                  during any period,following the earlier of (a) the date the CODES are rated by both Standard& Poor’s Rating Services and Moody’s Investor Services, Inc., and (b) April21, 2003, when the long-term credit rating assigned to the CODES by eitherStandard & Poor’s or Moody’s (or any successors to these entities) is lowerthan “BB” or “Ba3”, respectively, or when either of these rating agencies doesnot have a rating then assigned to the CODES for any reason, including anywithdrawal or suspension of a rating assigned to the CODES.  This conversion feature represents anembedded derivative.  However, based onthe de minimis value associated with this feature, no value has been assignedat issuance and at September 30, 2004;

 

•                  if the CODEShave been called for redemption; or

 

•                  upon theoccurrence of specified corporate transactions.

 

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

 

The CODES contain putoptions which may require the Company to repurchase for cash all or a portionof the CODES on March 15 of 2010, 2015 and 2018 at a repurchase price equal to100% of the principal amount of the CODES plus any accrued and unpaid interest(including contingent interest) to, but excluding, the date of repurchase.

 

In addition, the holdersof the CODES have the right to receive contingent interest payments during anysix-month period from March 15 to September 14 and from September 15 to March14, commencing on September 15, 2003, if the average trading price of the CODESfor the five trading days ending on the second trading day immediatelypreceding the relevant six-month period equals 120% or more of the principalamount of the CODES.  The interest rateused to calculate 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 Condensed Consolidated Balance Sheetsin other long-term liabilities.  Theinitial fair value assigned to the embedded derivative was $1.9 million, whichis recorded as a discount to the CODES. Changes to the fair value of this embedded derivative are reflected asan adjustment to interest expense.  Thecurrent value of this embedded derivative is $1.3 million.

 

*Credit Facility*

 

In May 2003, the Companyentered into an agreement****with asyndicate of lenders for a five-year, $300 million senior, unsecured revolvingcredit facility for working capital and other general corporate purposes.Watson’s assets generally are held by, and its operations generally areconducted through, its subsidiaries.

 

13

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Within the meaning of Regulation S-X, Rule 3-10, the Company has noassets or operations independent of its subsidiaries.  The terms of the credit facility require eachsubsidiary, other than minor subsidiaries, to provide full and unconditionalguarantees on a joint and several basis. In order to provide subsidiaryguarantees in connection with this credit facility, the Company was 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 credit facility and the 1998 SeniorNotes are full and unconditional, on a joint and several basis, and are givenby all subsidiaries other than minor subsidiaries.  Watson is subject to certain financial andoperational covenants, all of which, as of September 30, 2004, the Company wasin compliance.  As of September 30, 2004,the Company had not drawn any funds from the revolving credit facility.

 

**NOTE G – FINANCIAL INSTRUMENTS**

 

*Fair value of financialinstruments*

 

The Company’s financialinstruments consist primarily of cash and cash equivalents, marketablesecurities, accounts and other receivables, investments, trade accountspayable, 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 companiesthat are publicly traded are based on quoted market prices.  The fair value of investments in privatelyheld companies, or cost-method investments, are based on historical cost,adjusted for any write-down related to impairment.  The Company estimates the fair value of itsfixed rate long-term obligations based on quoted market rates of interest andmaturity schedules for similar issues. The carrying value of these obligations approximates their fair value.  The fair value of the embedded derivatives relatedto the CODES is based on a present value technique using discounted expectedfuture 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 F for a more detailed description ofthese features of the CODES.  Althoughthe conversion features represent embedded derivative financial instruments,based on the de minimis value of these features at the time of issuance and at September30, 2004, no value has been assigned to these instruments.  The contingent interest feature providesunique tax treatment under the Internal Revenue Service’s Contingent Debt Regulations.  In essence, interest accrues, for taxpurposes, on the basis of the instrument’s comparable yield (the yield at whichthe issuer would issue a fixed rate instrument with similar terms). Thisembedded derivative is reported on the Company’s Condensed Consolidated BalanceSheets at fair value and the changes in the fair value of the embeddedderivative are reported as gains or losses in the Company’s Condensed ConsolidatedStatements of Income.

 

At September 30, 2004 andDecember 31, 2003, the carrying amount of $1.3 million and $5.1 million, respectively,approximated the estimated fair value of the Company’s derivative financialinstruments.

 

During the three and ninemonth periods ended September 30, 2004, the fair value of the Company’sderivative financial instruments decreased $0.7 million and $3.8 million,respectively.  The change in fair valuewas recorded as a reduction of interest expense during the respective periods.

 

**NOTE H – IMPAIRMENT OF SECURITIES**

 

At September 30, 2004,investments and other assets included an investment in 400,000 AmericanDepository Receipts of Amarin, classified as an available-for-sale security,with a fair market value of $348,000. During the third quarter of 2004, management determined that an other-than-temporarydecline in the fair value

 

14

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of its Amarin investment existed. As a result, the Company recognized a $1.1 million impairment charge inearnings during the third quarter of 2004.

 

During the third quarterof 2004, management determined that an other-than-temporary decline in the fairvalue of its cost method investments in Trylon Corporation (Trylon) and MithraBioindustry Co., Ltd. (Mithra) existed. As a result, asset impairment charges of $1.3 million for Trylon and$2.3 million for Mithra were recorded and recognized in earnings. Additionally,during the first quarter of 2004, the Company wrote off its remaining investmentin the Halsey warrants, net of proceeds from the sale of its note receivable.

 

**NOTE I – COMMITMENTS ANDCONTINGENCIES**

 

*Facilityand equipment leases*

 

TheCompany has entered into operating leases for certain facilities andequipment.  The terms of the operatingleases for the Company’s facilities require the Company to pay property taxes,normal maintenance expenses and maintain minimum insurance coverage.  Total rental expense for operating leases forthe three months ended September 30, 2004 and 2003 were $2.5 million and $3.2million, respectively.  Total rentalexpense for operating leases for the nine months ended September 30, 2004 and2003 were $8.7 million and $9.3 million, respectively.

 

Futureminimum lease payments under all non-cancelable operating leases consist ofapproximately $2.9 million for the remainder of 2004, $7.2 million in 2005, $5.5million in 2006, $4.8 million in 2007, and $21.4 million thereafter.

 

*Employeeretirement plans*

 

TheCompany maintains certain defined contribution retirement plans coveringsubstantially all employees.  The Companycontributes to the plans based upon the employee contributions.  From time to time, the Company conductsself-audits of the Employees’ 401(k) Profit Sharing Plan (the Plan) to ensurethe contributions under the Plan are made in accordance with its terms.  In the first half of 2004, the Companycontributed an additional $1.1 million for the year ended December 31, 2003 andhas estimated that an additional contribution of $0.6 million will be made tofund prior year periods.

 

Watson’scontributions to these retirement plans for the three and nine months ended September30, 2004 were $1.6 million and $5.5 million, respectively.  Watson’s contributions to these retirementplans for the three and nine months ended September 30, 2003 were $1.4 millionand $4.2 million, respectively.  TheCompany does not sponsor any defined benefit retirement plans or postretirementbenefit plans.

 

*Legalmatters*

 

The Company is party tocertain lawsuits and legal proceedings, which are described in “Part I, Item 3.Legal Proceedings,” of our Annual Report on Form 10-K for the year endedDecember 31, 2003.  The following is adescription of material developments during the period covered by thisQuarterly Report and through the filing of this Quarterly Report, and should beread in conjunction with the Annual Report referenced above.

 

*Phen-fen Litigation.*  With respect to the phentermine hydrochlorideproduct liability lawsuits pending against the Company, certain of itssubsidiaries, and others, additional actions raising similar issues have beenfiled, and some actions have been settled or otherwise dismissed.  As of November 1, 2004, approximately 500actions were pending against the Company and other Company entities in a numberof state and federal courts.  The Companybelieves that it will be fully indemnified by The Rugby Group’s former owner,Aventis Pharmaceuticals (Aventis, formerly known as Hoechst Marion Roussel,Inc.) for the defense of all such cases

 

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and for any liabilitythat may arise out of these cases. Aventis is currently controlling the defense of all these cases as theindemnifying party under its agreements with the Company.

 

*Cipro® Litigation.*  On September 27, 2004, the defendants,including the Company and certain of its affiliates, filed motions for summaryjudgment in the action pending in the California Superior Court for the Countyof San Diego *(In re: Cipro**Cases I & II, JCCP Proceeding Nos. 4154 & 4220)*,seeking dismissal of all the claims asserted by the plaintiffs.  The plaintiffs’ opposition briefs are due onNovember 15, 2004.  Defendants’ replybriefs are due on December 3, 2004, and a hearing on the defendants’ motions isset for December 17, 2004.  Aventis iscontinuing to defend and indemnify the Company and its affiliates in connectionwith these claims.

 

*Governmental Reimbursement Investigations andProceedings.*  On July 26, 2004, the Attorney General of theState of Wisconsin filed a motion to remand the Wisconsin case from the UnitedStates District Court back to the Wisconsin Superior Court.  On October 5, 2004, the United StatesDistrict Court for the District of Wisconsin granted the motion, and orderedthe case remanded to the Wisconsin Superior Court.  (*State of Wisconsin v.Abbott Laboratories, et al.*, *Case No. 04-cv-1709,Wisconsin Circuit Court for Dane County*)  Pursuant to the parties’ agreement, thedefendants are not required to respond to the complaint until at least November10, 2004.

 

On August 16, 2004, theCompany produced certain documents to the State of Florida Office of theAttorney General in response to a civil investigative subpoena seeking theproduction of documents regarding the pricing, distribution, marketing andsales of four drugs.  The Company is indiscussions with the Office of the Attorney General regarding production ofadditional responsive documents on mutually agreeable terms.

 

On August 17, 2004, theCompany and numerous other pharmaceutical companies received a letter from the Departmentof Audit and Control for Albany County, New York, inviting the parties to meetwith representatives of Albany County to discuss drug pricing reimbursementissues in connection with Albany County’s consideration of whether to file alawsuit alleging claims similar to the pending actions.  To date no meeting with representatives ofAlbany County has been scheduled.

 

*FDA Matters.*  With respectto the May 2002 consent decree entered against Watson Laboratories, Inc. inconnection with the Company’s Corona, California facility, in September, 2004,the FDA replied to the Company’s June, 2004, response to the FDA’sinvestigational observations, and the corrective actions outlined during theCompany’s June 30, 2004 meeting with the FDA. In its reply, the FDA requested additional information concerning theCompany’s responses to certain of the investigational observations made inconnection with the inspection conducted by FDA from March 31, 2004 until May6, 2004, and the corrective actions the Company has taken and intends to take.  The FDA also advised the Company that itintends to conduct a follow-up inspection in the near future.  The Company responded to the FDA’s September,2004, correspondence in October, 2004.  TheCompany believes that its responses, and the corrective actions it has takenand intends to take, address the FDA’s observations.  However, theFDA is not required to accept or agree with the Company’s responses and/orcommitments.  If, in the future, the FDAdetermines that, with respect to its Corona facility, Watson has failed to complywith the consent decree or FDA regulations, including cGMPs, or has failed toadequately address the observations in the Form 483, the consent decree allowsthe FDA to order Watson to take a variety of actions to remedy thedeficiencies. These actions could include ceasing manufacturing and relatedoperations at the Corona facility, and recalling affected products.  Such actions, if taken by the FDA, couldadversely affect the Company, its results of operations, financial positionand/or cash flows.

 

*Securities Litigation**. *On August 30, 2004,the lead plaintiff in the consolidated action pending in the United StatesDistrict Court for the Central District of California *(In re:  Watson Pharmaceuticals, Inc. SecuritiesLitigation, Case No. CV-03-8236 AHM)*, notified the court that it didnot intend to file an amended complaint in response to the court’s ordergranting the defendants’ motion to dismiss the plaintiff’s previouscomplaint.  On September 2, 2004, theDistrict Court entered a judgment of dismissal in favor of the defendants.  On October 1,

 

16

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2004, one of the non-leadplaintiffs in the consolidated action filed a Notice of Appeal of the dismissalof the action with the United States Court of Appeals for the NinthCircuit.  *(PensionFund v. Watson Pharmaceuticals, Inc., USCA Docket No. 04-56791)*  The defendants have not yet responded to theNotice of Appeal.

 

*Hormone Replacement Therapy Litigation.*  With respect to the hormone replacementtherapy product liability lawsuits pending against the Company, certain of itssubsidiaries, and others, additional actions raising similar issues have beenfiled.  As of November 1, 2004,approximately 50 cases were pending against Watson and/or its affiliates in stateand federal courts.  Many of the casesinvolve multiple plaintiffs.  The Companymaintains products liability insurance against such claims.  However, these actions, if successful, or ifinsurance does not provide sufficient coverage against the claims, couldadversely affect the Company and may have a material adverse effect on theCompany’s business, results of operations, financial condition and cash flows.

 

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

 

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

 

The following discussionof our financial condition and the results of our operations should be read inconjunction with the condensed consolidated financial statements and notesthereto included elsewhere in this Quarterly Report.  This discussion contains forward-lookingstatements that are subject to known and unknown risks, uncertainties and otherfactors that may cause our actual results to differ materially from thoseexpressed or implied by such forward-looking statements.  These risks, uncertainties and other factorsinclude, among others, those identified under “Cautionary Note RegardingForward-Looking Statements” and elsewhere in this Quarterly Report and under “RisksRelated to our Business” in our Annual Report on Form 10-K for the year endedDecember 31, 2003.

 

**Results of Operations**

 

Beginning July 1, 2004,as a result of a change in the way we manage certain products and productlines, we reclassified the product revenues from the bulk of our oralcontraceptive products in Women’s Health and certain other products in GeneralProducts from the branded segment to the generic segment.  Prior to July 1, 2004, our branded productssegment included the Company’s lines of Women’s Health, General Products andNephrology products.  Effective July 1,2004, we no longer report the results of Women’s Health and General Products asseparate groups and have included these results in our Specialty Products group**. **Details on this change in reporting,including a reclassification of prior periods, were disclosed in our Form 8-Kdated October 20, 2004.  All historicalresults provided in this Quarterly Report reflect this reclassification.

 

During the third quarterof 2004, we experienced strong growth in our generic pharmaceutical products segmentas compared to the prior year due to sales of products launched subsequent to thethird quarter of 2003.  Brand revenues experienceda slight decline from the prior year period. Our research and development expenses increased 30% in the third quarterof 2004 compared to the corresponding prior period as we continue to invest inour generic pipeline.

 

Expenses in thethird quarter of 2004 included a $46.1 million asset impairment charge relatedto our Tri-Norinyl® product rights, as disclosed in our Form 8-K dated October20, 2004, and an $8.5 million restructuring charge associated with theorganizational changes announced on June 28, 2004.  Of this $8.5 million restructuring charge, researchand development incurred a $2.2 million charge, and selling, general andadministrative incurred a $6.3 million charge.

 

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***NetRevenues***

 
| ** **                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| **($ in thousands):**         | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **%  Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **%  Change** | ** ** |
| ** **                         | ** ** | ** **                            | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net Revenues by  Segment:          |       |                                  |       |                                 |       |   |   |   |   |   |   |   |   |
| Branded  pharmaceutical products   |       | $                                     | 97,572     |                                 | $          | 102,091 |   | (4.4 | )% | $ | 270,458 |   | $ | 300,660 |   | (10.0 | )% |
| *% of  total product net revenues* | * *   | *24.3*                                | *%*        | *30.1*                               | *%*        | * * | * * | *22.8* | *%* | *29.7* | % |   |   |
| Generic  pharmaceutical products   |       | 303,337                               |       | 236,757                              |       | 28.1 | % | 914,925 |   | 712,316 |   | 28.4 | % |
| *% of  total product net revenues* | * *   | *75.7*                                | *%*        | *69.9*                               | *%*        | * * | * * | *77.2* | *%* | *70.3* | % |   |   |
| Other                              |       | 7,109                                 |       | 19,908                               |       | (64.3 | )% | 31,661 |   | 38,582 |   | (17.9 | )% |
| Total net  revenues                |       | $                                     | 408,018    |                                 | $          | 358,756 |   | 13.7 | % | $ | 1,217,044 |   | $ | 1,051,558 |   | 15.7 | % |

 

*Branded Pharmaceutical Products*

 

The decrease in netrevenues for the three and nine month periods of 2004 from 2003 periods wasprimarily due to lower sales of certain products within our Specialty Productsgroup including our branded oral contraceptive products.  We expect sales during the fourth quarter withinour branded segment to remain consistent with third quarter levels.

 

*Generic Pharmaceutical Products*

 

The increase in netrevenues from our generic segment for the three and nine month periods of 2004over 2003 periods was the result of new product launches subsequent to the thirdquarter of 2003, including mint nicotine gum during the third quarter of 2004, bupropionhydrochloride sustained-release tablets during the first and second quarters of2004, and glipizide extended-release tablets, additional strengths of oxycodonewith acetaminophen tablets, and TrinessaTM during the fourth quarter of 2003.

 

We expect sales duringthe fourth quarter within our generic segment to be up slightly from thirdquarter levels.

 

*Other revenues*

 

Other revenues decreasedin the third quarter of 2004 as compared to the prior year period because we receivedno royalties in the third quarter of 2004 from Aventis Pharmaceuticals(Aventis) in connection with Barr Laboratories, Inc.’s sales of ciprofloxacintablets.  Other revenues for the ninemonth period of 2004 decreased from the prior year period due to the absence ofquarterly contingent payments during 2004 from a litigation settlement withAventis.  The final payment relating tothis settlement was received from Aventis in the third quarter of 2003.

 

Other revenues for the threeand nine month periods of both years include revenue recognized from researchand development agreements.  Revenuesrecognized from research, development and licensing agreements (includingmilestone payments) are deferred and recognized over the entire contractperformance period, starting with the contract’s commencement, but not prior tothe removal of any contingencies for each individual milestone.  We recognize this revenue based upon thepattern in which the revenue is earned or the obligation is fulfilled.

 

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*Net RevenueMix*

 

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 mixcould substantially impact our gross profit, gross margin and the overallprofitability of our business.

 

Forthe three month period ended September 30, 2004, our net revenue mix was 24%brand and 76% generic, compared to 30% brand and 70% generic for the sameperiod ended September 30, 2003.  For thenine month period ended September 30, 2004, our net revenue mix was 23% brandand 77% generic, compared to 30% brand and 70% generic for the same periodended September 30, 2003.  We expect ourrevenue mix for the fourth quarter of 2004 to be consistent with the thirdquarter of 2004.

 

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

 
| ** **                            | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                            | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
|                                  |       |                                  |       |                                 |       |   |   |   |   |   |   |   |   |
| Overall  Consolidated Gross Margin    |       | 50.4                                  | %          | 60.3                                 | %          | (9.9 | )% | 50.9 | % | 57.6 | % | (6.7 | )% |
|                                  |       |                                  |       |                                 |       |   |   |   |   |   |   |   |   |
| Gross Margin by  Segment:             |       |                                  |       |                                 |       |   |   |   |   |   |   |   |   |
| Branded  pharmaceutical products      |       | 79.5                                  | %          | 78.9                                 | %          | 0.6 | % | 78.8 | % | 76.8 | % | 2.0 | % |
| Generic  pharmaceutical products      |       | 39.8                                  | %          | 49.0                                 | %          | (9.2 | )% | 40.9 | % | 47.1 | % | (6.2 | )% |
| Gross margin on  product net revenues |       | 49.5                                  | %          | 58.0                                 | %          | (8.5 | )% | 49.6 | % | 55.9 | % | (6.3 | )% |

 

Overall consolidatedgross margin for the three and nine months ended September 30, 2004 decreasedcompared to the same periods in 2003 partially due to the decrease of Otherrevenues in the third quarter of 2004.

 

Gross margin on productnet revenues for the three and nine months ended September 30, 2004 decreasedcompared to the same periods in 2003 primarily due to a decline in grossmargins in our generic pharmaceutical products. Our generic segment margin declined due to higher sales of in-licenseddistributed products which generally have lower gross margins.  Additionally, increased competition resultedin lower pricing on certain generic products.

 

We expect our grossmargins for the fourth quarter to remain consistent with the third quarter of2004.

 

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

 
| ** **                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| **($ in thousands):** | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **%  Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **%  Change** | ** ** |
|                       |       |                                  |       |                                 |       |   |   |   |   |   |   |   |   |
| R&D expenses           |       | $                                     | 34,261     |                                 | $          | 26,428 |   | 29.6 | % | $ | 106,471 |   | $ | 74,613 |   | 42.7 | % |
| *as% of  net revenues*     | * *   | *8.4*                                 | *%*        | *7.4*                                | *%*        | * * | * * | *8.7* | *%* | *7.1* | *%* | * * | * * |
|                            |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

R&D expenses for thethree and nine months ended September 30, 2004 increased from the correspondingprior year periods due to expanded generic development programs.  We have an increased number of genericproducts under different stages of development, which account for a significantportion of the increase over the

 

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prior year period.  Additionally,R&D expenses included a $2.2 million restructuring charge recorded in thethird quarter of 2004.

 

Included in R&Dexpenses for the nine month period ended September 30, 2004 was a $10 millionmilestone payment to Kissei Pharmaceutical Co., Ltd.  for the acquisition of certain rights to itsproduct for the treatment of the signs and symptoms of benign prostatichyperplasia (BPH).

 

We expect research anddevelopment expense for the fourth quarter to remain consistent with thirdquarter levels.

 

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

 
| ** **                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| **($ in thousands):** | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **%  Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **%  Change** | ** ** |
|                       |       |                                  |       |                                 |       |   |   |   |   |   |   |   |   |
| SG&A  expenses         |       | $                                     | 80,578     |                                 | $          | 87,547 |   | (8.0 | )% | $ | 237,158 |   | $ | 227,420 |   | 4.3 | % |
| *as% of  net revenues*     | * *   | *19.7*                                | *%*        | *24.4*                               | *%*        | * * | * * | *19.5* | *%* | *21.6* | *%* | * * | * * |
|                            |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

SG&A expenses decreasedin the third quarter of 2004 as compared to the corresponding prior year perioddue to cost reduction realized by the termination of our contract sales forceagreement with Ventiv Health, Inc. during the third quarter of 2004 and a workforcereduction in our sales and marketing area as a result of our decision to focusour brand specialty business on urology and nephrology therapeutic areas.  The restructuring charge of $6.3 million recordedin the third quarter of 2004 partially offset the decrease in SG&Aexpenses.

 

We expect SG&Aexpense in the fourth quarter 2004 to decrease from the corresponding prior yearperiod as we realize the full savings from the termination of our contract withVentiv Health, Inc.  We expect selling,general and administrative expenses for the full year of 2004 to beapproximately 19% of revenues.

 

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

 

| ** **                                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| **($ in thousands):**                     | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                           |       |                                  |       |                                 |       |   |   |   |   |
| Equity in  earnings (losses) of joint ventures |       | $                                     | (810       | )                                    | $          | (68 | ) | $ | (4,089 | ) | $ | 137 |   |
|                                                |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |

 

The increase in ourequity losses of joint ventures for the three and nine month periods endedSeptember 30, 2004 is the result of increased losses from our interest inSomerset Pharmaceuticals, Inc. (Somerset), our joint venture with MylanLaboratories, Inc.  Somerset obtained anapprovable letter in February 2004 for its New Drug Application (NDA) forEmSamTM, a selegeline patch for the treatment of depression.  Somerset continues to incur expensesassociated with on-going trials, operational costs and the remaining Food andDrug Administration (FDA) requirements.  Somersetis in negotiation with a potential licensee to grant rights to market and sell EmSamTMupon final FDA approval.

 

The income from ourinterest in ANCIRC Pharmaceuticals, a joint venture with Andrx Corporation(Andrx), partially offset the losses from our joint venture in Somerset.

 

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***Losson Impairment of Assets***

 

| ** **                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| **($  in thousands):** | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                             |       |                                  |       |                                 |       |   |   |   |   |
| Loss on  impairment of assets    |       | $                                     | 50,894     |                                 | $          | 1,605 |   | $ | 51,785 |   | $ | 15,865 |   |
|                                  |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |

 

We recognized a $46.1million impairment charge relating to our Tri-Norinyl® product rights as aresult of the announcement of an Abbreviated New Drug Application (ANDA)approval and introduction of a generic version of the Tri-Norinyl® oral contraceptivetablets by a competitor in the market at the end of the third quarter of 2004.

 

Also during the thirdquarter of 2004, we recorded investment impairment related charges of $4.8million related to the write-down of our investments in various securities.  During the first quarter of 2004, we wroteoff the remaining investment in the warrants to purchase shares of common stockof Halsey Drug Co., Inc., net of proceeds from the sale of its note receivable.

 

In 2003, we wrote down ourinvestments and recorded impairment charges of $13.0 million in our GenelabsTechnologies, Inc. investment in the first quarter, $1.2 million related to ourAmarin Corporation plc (Amarin) investment in the second quarter, and $1.6million in Halsey warrants in the third quarter.

 

***Gainon Sale of Securities***

 

| ** **                  | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| **($ in thousands):**  | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                        |       |                                  |       |                                 |       |   |   |   |   |
| Gain on sale of  securities |       | $                                     | 1,799      |                                 | $          | 2,496 |   | $ | 5,737 |   | $ | 5,510 |   |
|                             |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |

 

For the three and ninemonth periods ended September 30, 2004, the gain on sale of securities primarilyresulted from the sale of the Company’s investment in the common stock of Andrx.  For the three and nine month periods ended September30, 2003, the gain on sale of securities resulted from the sale of shares ofAndrx and the Company’s investment in the common stock of Dr. Reddy’sLaboratories, Limited (Dr. Reddy) (see Note B in the accompanying Notes toCondensed Consolidated Financial Statements in this Quarterly Report).

 

At September 30, 2004, weheld approximately 607,000 shares of Andrx common stock at a fair value of $13.6million with a gross unrealized holding gain of $12.0 million.  We no longer hold shares of common stock ofDr. Reddy.

 

***Losson Early Extinguishment of Debt***

 

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

 

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During the first half of 2004,we repurchased $135.9 million of our senior unsecured notes issued in May 1998(1998 Senior Notes) for total consideration of $152.5 million, or a 12% premiumover each note’s face value.  As a resultof the repurchase, we incurred charges of $14.0 million and $3.7 millionrelated to fees, expenses, unamortized discount, and the premiums paid in thefirst and second quarters of 2004, respectively (as described in Note F in theaccompanying Notes to Condensed Consolidated Financial Statements in thisQuarterly Report).

 

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

 

***InterestExpense***

 
| ** **                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| **($ in thousands):** | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **%  Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **%  Change** | ** ** |
|                       |       |                                  |       |                                 |       |   |   |   |   |   |   |   |   |
| Interest expense           |       | $                                     | 3,681      |                                 | $          | 5,980 |   | (38.4 | )% | $ | 9,071 |   | $ | 18,901 |   | (52.0 | )% |
|                            |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Interest expense decreasedfor the three and nine month periods ended September 30, 2004 as a result ofthe repurchase of a portion of our 1998 Senior Notes in February and May 2004, adecrease in the fair value of the derivative (as described in Note G in theaccompanying Notes to Condensed Consolidated Financial Statements in thisQuarterly Report), and an increase in capitalized interest related to higherbalances of capital projects in process during the first quarter of 2004.  Interest expense relating to the 1998 SeniorNotes decreased $2.4 million and $5.5 million, respectively, for the three andnine month periods ended September 30, 2004 compared to the corresponding prioryear periods.

 

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**Liquidity and Capital Resources**

 

We assess liquidity by our ability to generate cash tofund our operations.  Significant factorsthat affect the management of our liquidity include: current balances of cash,cash equivalents and the fair value of marketable securities; expected cashflows provided by operations; current levels of our accounts receivable,inventory and accounts payable balances; our expected investment in capital;access to financing sources, including credit and equity arrangements; and thefinancial flexibility to attract long-term capital on satisfactory terms.

 

We generated cash inexcess of our working capital requirements for the nine months ended September30, 2004.  Our cash flows provided byoperations were $207.7 million.  Cash flowfrom operations was positively impacted primarily by net income and a reductionin the prior year balance of inventories. Cash flow from operations was negatively impacted primarily by thechange in balances from December 31, 2003 of income taxes payable due to a taxpayment of $80 million made in the first quarter of 2004.

 

Other significant uses ofcash for the nine months ended September 30, 2004, included the additions toproperty and equipment ($59.0 million) and the repurchase of $135.9 million ofour 1998 Senior Notes (as discussed above and in Note F in the accompanyingNotes to Condensed Consolidated Financial Statements in this Quarterly Report).  We currently expect to spend between $90 millionand $100 million for property and equipment additions for the full year of2004, of which we expect approximately $21 million to be related to theinstallation and implementation of our new Enterprise Resource Planning system,approximately $20 million to be related to the construction of a new distributionfacility, and the remaining expenditures to be related to plant improvementsand expansion.

 

In the fourth quarter of2004, we expect to spend approximately $19 million for an upfront payment toDebiopharm S.A. relating to an exclusive license agreement pursuant to which weacquired rights to market and sell Trelstar®, a product for treatment ofprostate cancer.  Also, we are expectedto pay an additional $14 million in milestone payments to Debiopharm S.A. upon theattainment of specified future milestones.

 

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

 

In Februaryand May 2004, we repurchased $135.9 million of our 1998 Senior Notes for totalconsideration of $152.5 million, or a 12% premium over each note’s facevalue.  We recorded charges of $14.0million and $3.7 million in the first quarter and second quarter of 2004,respectively, related to fees, expenses, unamortized discount, and premiumspaid.  Interest expense in 2004 will declineas a result of the repurchase.

 

In May2003, we entered into an agreement****with asyndicate of lenders for a five-year, $300 million senior, unsecured revolvingcredit facility for working capital and other general corporate purposes.  As of September 30, 2004, the total $300million under the revolving credit facility was available to us. Under theterms of the revolving credit facility, each of our subsidiaries, other thanminor subsidiaries, entered into a full and unconditional guarantee on a jointand several basis.  In order to providesubsidiary guarantees in connection with the new credit facility, we wererequired to issue similar guarantees to the 1998 Senior Note holders.  We are subject to, and, as of September 30,2004, were in compliance with financial and operation covenants under the termsof the credit facility.

 

Our cash and currentmarketable securities totaled $608.8 million at September 30, 2004.  The fair value of our current marketablesecurities may fluctuate significantly due to the volatility of the stockmarket and changes in general economic conditions.  See Item 3 of Part I in this Quarterly Reporton Form 10-Q.  We believe that our cashand marketable securities balance and our expected cash flows from operationswill be sufficient to meet our normal operating requirements during the nexttwelve months.  However, we continue toreview opportunities to acquire or invest in companies, technologies, productrights and other investments that

 

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

 

*Recent accounting pronouncements*

 

In January 2003, the FinancialAccounting Standards Board (FASB) issued Interpretation No. (FIN) 46, “Consolidationof Variable Interest Entities” an interpretation of Accounting ResearchBulletin No. 51, “Consolidated Financial Statements.”  The primary objectives of FIN 46 are toprovide guidance on the identification of entities which the Company maycontrol through means other than through voting rights (“variable interestentities”) and to determine when and which business enterprise (“primarybeneficiary”) should consolidate the variable interest entity.  FIN 46 requires existing unconsolidatedvariable interest entities to be consolidated by their primary beneficiaries ifthe entities do not effectively disperse risks among the parties involved.  Variable interest entities that effectivelydisperse risks will not be consolidated unless a single party holds an interestor combination of interests that effectively recombines risks that werepreviously dispersed.  In addition, FIN46 requires that the primary beneficiary, as well as all other enterprises witha significant variable interest in a variable interest entity, make additionaldisclosures.  Certain disclosurerequirements of FIN 46 were effective for financial statements issued afterJanuary 31, 2003.  In December 2003, theFASB revised FIN 46 (FIN 46R) to address certain FIN 46 implementation issues.  The revised provisions are applicable nolater than the first reporting period ending after March 15, 2004.  We adopted FIN 46 and FIN 46R and determined thatwe do not have any variable interest entities that require consolidation norany material entities that require disclosure.

 

In April 2004, the FASB issuedFASB Staff Position No. 129-1 (FSP 129-1), “Disclosure Requirements under FASBStatement No. 129, Disclosure of Information about Capital Structure, Relatingto Contingently Convertible Securities.” FSP 129-1 requires the disclosure provisions of Statement 129 to applyto all existing and newly created contingently convertible securities and totheir potentially dilutive effects on earnings per share.  We have adopted the disclosure requirementsof FSP 129-1 in our Condensed Consolidated Financial Statements.

 

In September 2004, the EmergingIssues Task Force (EITF) reached a final consensus on EITF Issue No. 04-8, “TheEffect of Contingently Convertible Debt on Diluted Earnings per Share.”  Under EITF Issue No. 04-8, contingentlyconvertible debt instruments (Co-Cos) should be included in diluted earningsper share computations (if dilutive) regardless of whether the market pricetrigger (or other contingent feature) has been met.  Additionally, prior period earnings per shareamounts presented for comparative purposes should be restated to conform tothis consensus, which is effective for reporting periods ending after December15, 2004.  Absent any modifications tothe terms of the Co-Cos, we will be required to add approximately 14.4 millionshares associated with the conversion of our CODES to the number of sharesoutstanding for the calculation of diluted earnings per share for all reportedperiods.

 

In September 2004, EITFreached a final consensus on EITF Issue No. 04-10, “Applying Paragraph 19 ofFASB Statement No. 131, Disclosures about Segments of an Enterprise and RelatedInformation, in Determining Whether to Aggregate Operating Segments That Do NotMeet the Quantitative Thresholds.”  UnderEITF Issue No. 04-10, operating segments that do not meet the quantitativethresholds can be aggregated into a reportable segment if aggregation isconsistent with the objective and basic principles of FASB Statement No. 131,the segments have similar economic characteristics, and the segments share amajority of the other aggregation criteria as defined by FASB Statement No.131, paragraph 17.  EITF Issue No. 04-10is effective for fiscal years ending after October 13, 2004.  The corresponding information for earlierperiods, including interim periods,

 

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shall be restated unless it is impractical to do so.  Restatement of previously issued financialstatements is required.  The Company iscurrently assessing the impact of EITF Issue No. 04-10.

 

**CAUTIONARYNOTE REGARDING FORWARD-LOOKING STATEMENTS**

 

Any statements made inthis report that are not statements of historical fact or that refer toestimated or anticipated future events are forward-looking statements.  We have based our forward-looking statementson management’s beliefs and assumptions based on information available to ourmanagement at the time these statements are made.  Such forward-looking statements reflect ourcurrent perspective of our business, future performance, existing trends andinformation as of the date of this filing. These include, but are not limited to:

 

•        our beliefs about future revenue and expenselevels and growth rates,

•        prospects related to our strategic initiativesand business strategies,

•        express or implied assumptions about governmentregulatory action or inaction,

•        anticipated product approvals and launches,

•        business initiatives and product developmentactivities,

•        assessments related to clinical trial results,

•        product performance and competitiveenvironment, and

•        anticipated financial performance.

 

Without limiting thegenerality of the foregoing, words such as *“may,” “will,” “expect,” “believe,”“anticipate,” “intend,” “could,” “would,” “estimate,” “continue,” or “pursue,”*or the negative other variations thereof or comparable terminology, areintended to identify forward-looking statements.  The statements are not guarantees of futureperformance and involve certain risks, uncertainties and assumptions that aredifficult to predict.

 

**Wecaution the reader that certain important factors may affect our actualoperating results and could cause such results to differ materially from thoseexpressed or implied by forward-looking statements.  We believe the following important risks,uncertainties and other factors, among others, may affect our actual results:**

 

• thesuccess of our product development activities and uncertainties related to thetiming or outcome of these activities;

 

• thetiming and unpredictability of regulatory authorizations and product launches,which is particularly sensitive in our generic business;

 

• theoutcome of our litigation and other dispute resolution procedures, and thecosts, expenses and possible diversion of management’s time and attentionarising from such litigation and other dispute resolution procedures;

 

• ourability to attract and retain key personnel;

 

• ourability to adequately protect our technology and enforce our intellectualproperty rights;

 

• ourability to obtain and maintain a sufficient supply of raw materials or productsto meet market demand in a timely manner;

 

• ourability to obtain sufficient supplies of raw materials or finished productsfrom key suppliers that may be the only source of such finished products or rawmaterials;

 

• ourdependence on sole source suppliers and the risks associated with productioninterruptions or supply delays at such third party suppliers or at our ownmanufacturing facilities;

 

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• thescope, outcome and timeliness of any governmental, court or other regulatoryaction that may involve us (including, without limitation, the scope, outcomeor timeliness of any inspection or other action of the FDA);

 

• oursuccess in divesting assets or facilities we intend to dispose of;

 

• theincreasing costs of insurance, and limitations on obtaining insurance coverage;

 

• thescope, outcome and effect of investigations, actions or legislation related toour product pricing;

 

• theavailability to us, on commercially reasonable terms, of raw materials andother third party sourced products;

 

• our exposure to product liability and other lawsuitsand contingencies;

 

• our mix of product sales between brandedproducts, which typically have higher margins, and generic products;

 

• ourdependence on revenues and gross profit from significant products, inparticular, Ferrlecit®, for which 2004 net revenues are expected to beapproximately 9% of our total net revenues, and 16% of our gross profit.  Our regulatory exclusivity on our Ferrlecit®product expired in August, 2004.  If ageneric version or therapeutic equivalent of Ferrlecit® is approved by the FDA,or if our revenues on Ferrlecit® significantly decline for other reasons, itcould have a material adverse impact on our results of operations, financialcondition and cash flows;

 

• ourdependence on revenues from significant customers;

 

• theability of third parties to assert patents or other intellectual propertyrights against us which, among other things, could cause a delay or disruptionin the manufacture, marketing or sale of our products;

 

• our ability to license patents or other intellectualproperty rights from third parties on commercially reasonable terms;

 

• theexpiration of patent and regulatory exclusivity on certain of our products thatwill result in competitive and pricing pressures;

 

•difficulties and delays inherent in product development, manufacturing andsale, such as:

 

•products that may appear promising in the development stage may fail to reachmarket for numerous reasons, including efficacy or safety concerns;

 

• theinability to obtain necessary regulatory approvals and the difficulty orexcessive cost to manufacture;

 

•seizure or recall of products;

 

• thefailure to obtain, the imposition of limitations on the use of, or loss ofpatent and other intellectual property rights; and

 

•manufacturing or distribution problems;

 

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• oursuccessful compliance with extensive, costly, complex and evolving governmentalregulations and restrictions;

 

•market acceptance of and continued demand for our products and the impact ofcompetitive products and pricing;

 

• ourability to successfully compete in both the branded and generic pharmaceuticalproduct sectors;

 

• our timely and successful implementation of strategicinitiatives, including integrating companies and products we acquire and newenterprise resource planning systems; and

 

•other risks and uncertainties detailed herein and from time to time in ourSecurities and Exchange Commission filings.

 

We disclaim anyobligation to publicly update any forward-looking statements, whether as aresult of new information, future events or otherwise.  We also may make additional disclosures inour Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and CurrentReports on Form 8-K that we may file from time to time with the Securities andExchange Commission (SEC).  Please alsonote that we provided a cautionary discussion of risks and uncertainties underthe section entitled “Risks Related to our Business” in our Annual Report onForm 10-K for the year ended December 31, 2003. The factors identified above and those set forth in our SEC filings arethe factors that we think could cause our actual results to differ materiallyfrom expected results.  Other factorsbesides those listed here could also adversely affect us.  This discussion is provided as permitted bythe Private Securities Litigation Reform Act of 1995.

 

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

 

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

 

**Investment Risk**

 

As of September 30, 2004,our total holdings in equity securities of other companies, includingequity-method investments and available-for-sale securities, were $43.4 million.  Of this amount, we had equity-methodinvestments of $4.0 million and publicly traded equity securities(available-for-sale securities) at fair value totaling $22.6 million ($13.6million that was included in “Marketable securities” and $9.0 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 generaleconomic conditions.  Based on the fairvalue of the publicly traded equity securities we held at September 30, 2004,an assumed 25%, 40% and 50% adverse change in the market prices of thesesecurities would result in a corresponding decline in total fair value ofapproximately $5.7 million, $9.0 million and $11.3 million,respectively.

 

At September 30, 2004,our investment in Andrx consisted of approximately 607,000 shares of Andrxcommon stock with a fair market value of $13.6 million.  Because Andrx is a publicly traded equitysecurity, our holdings of Andrx have exposure to investment risk.  The market price of Andrx common shares hasbeen, and may continue to be, volatile.  Forexample, on September 30, 2004, the final trading day of the quarter, theclosing price of Andrx was $22.36.  On November4, 2004, before the filing of this Form 10-Q, the closing price of Andrx commonstock was $16.59.

 

The following table setsforth the Andrx high and low market price per share information, based onpublished financial sources, for 2004 and 2003 and further reflects thevolatility of the stock price:

 

| ** **            | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------------|------------|----------|------------|---------|------------|
| **2004,  by quarter** |       |     |       |    |       |
| First                 |       | $        | 30.87      |    | $          | 23.55 |   |
| Second                |       | $        | 29.35      |    | $          | 22.24 |   |
| Third                 |       | $        | 28.10      |    | $          | 16.95 |   |
|                  |       |     |       |    |       |
| **2003,  by quarter** |       |     |       |    |       |
| First                 |       | $        | 16.83      |    | $          | 7.68 |   |
| Second                |       | $        | 24.20      |    | $          | 11.10 |   |
| Third                 |       | $        | 25.90      |    | $          | 16.32 |   |
| Fourth                |       | $        | 24.05      |    | $          | 17.00 |   |

 

We regularly review thecarrying value 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 are other thantemporary.

 

**Interest Rate Risk**

 

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

 

Basedon quoted market rates of interest and maturity schedules for similar debtissues, we estimate that the fair values of our CODES and our 1998 Senior Notesapproximated their carrying values on September 30, 2004.  While changes in market interest rates mayaffect the fair value of our fixed-rate debt, we believe the

 

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effect, if any, of reasonably possible near-term changes in the fairvalue of such debt on our financial condition, results of operations or cashflows will not be material.

 

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

 

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

 

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

 

As required by SEC Rule13a-15(b), the Company carried out an evaluation, under the supervision andwith the participation of the Company’s management, including the Company’sPrincipal Executive Officer and Principal Financial Officer, of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures as of the end of the quarter covered by this Report. Based onthe foregoing, the Company’s Principal Executive Officer and PrincipalFinancial Officer concluded that the Company’s disclosure controls andprocedures were effective at the reasonable assurance level.

 

There have been nochanges in the Company’s internal control over financial reporting, during thethree months ended September 30, 2004, that have materially affected, or arereasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

Section 404 of theSarbanes Oxley Act of 2002 requires that our management evaluate and certify,and our independent auditors attest to, our internal control systems beginningwith our Annual Report filed on form 10-K for the year ending December 31,2004. We are in the process of documenting and testing our internal controlsystems to provide the basis for the management certification and auditorattestation.  We believe that we haveadequate internal control systems in place to support the managementcertification and independent auditor attestation required by Section 404. However,we cannot be certain about our level of compliance with Section 404 at thistime, since there is no precedent against which to measure the adequacy of oursystems.  If we are not able to timely complywith the internal control requirements of Section 404, it could result inreportable conditions that we would be required to disclose in our AnnualReport on Form 10-K.  Such reportableconditions could adversely affect investor perceptions about our business,and/or otherwise adversely affect our business.

 

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**PARTII.  OTHER INFORMATION AND SIGNATURES**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

The Company is party tocertain lawsuits and legal proceedings, which are described in “Part I, Item 3.Legal Proceedings,” of our Annual Report on Form 10-K for the year endedDecember 31, 2003.  The following is adescription of material developments during the period covered by thisQuarterly Report and through the filing of this Quarterly Report, and should beread in conjunction with the Annual Report referenced above.

 

*Phen-fen Litigation.*  With respect to the phentermine hydrochlorideproduct liability lawsuits pending against the Company, certain of itssubsidiaries, and others, additional actions raising similar issues have beenfiled, and some actions have been settled or otherwise dismissed.  As of November 1, 2004, approximately 500actions were pending against the Company and other Company entities in a numberof state and federal courts.  The Companybelieves that it will be fully indemnified by The Rugby Group’s former owner,Aventis Pharmaceuticals (Aventis, formerly known as Hoechst Marion Roussel,Inc.) for the defense of all such cases and for any liability that may ariseout of these cases.  Aventis is currentlycontrolling the defense of all these cases as the indemnifying party under itsagreements with the Company.

 

*Cipro® Litigation.*  On September 27, 2004, the defendants,including the Company and certain of its affiliates, filed motions for summaryjudgment in the action pending in the California Superior Court for the Countyof San Diego *(In re: Cipro Cases I & II, JCCPProceeding Nos. 4154 & 4220)*, seeking dismissal of all theclaims asserted by the plaintiffs.  Theplaintiffs’ opposition briefs are due on November 15, 2004.  Defendants’ reply briefs are due on December3, 2004, and a hearing on the defendants’ motions is set for December 17,2004.  Aventis is continuing to defendand indemnify the Company and its affiliates in connection with these claims.

 

*Governmental Reimbursement Investigations andProceedings.*  On July 26, 2004, the Attorney General of theState of Wisconsin filed a motion to remand the Wisconsin case from the UnitedStates District Court back to the Wisconsin Superior Court.  On October 5, 2004, the United StatesDistrict Court for the District of Wisconsin granted the motion, and orderedthe case remanded to the Wisconsin Superior Court.  (*State of Wisconsin v.Abbott Laboratories, et al.*, *Case No. 04-cv-1709,Wisconsin Circuit Court for Dane County*)  Pursuant to the parties’ agreement, thedefendants are not required to respond to the complaint until at least November10, 2004.

 

On August 16, 2004, theCompany produced certain documents to the State of Florida Office of theAttorney General in response to a civil investigative subpoena seeking theproduction of documents regarding the pricing, distribution, marketing andsales of four drugs.  The Company is indiscussions with the Office of the Attorney General regarding production ofadditional responsive documents on mutually agreeable terms.

 

On August 17, 2004, theCompany and numerous other pharmaceutical companies received a letter from the Departmentof Audit and Control for Albany County, New York, inviting the parties to meetwith representatives of Albany County to discuss drug pricing reimbursementissues in connection with Albany County’s consideration of whether to file alawsuit alleging claims similar to the pending actions.  To date no meeting with representatives ofAlbany County has been scheduled.

 

*FDA Matters.*  With respectto the May 2002 consent decree entered against Watson Laboratories, Inc. inconnection with the Company’s Corona, California facility, in September, 2004,the FDA replied to the Company’s June, 2004, response to the FDA’sinvestigational observations, and the corrective actions outlined during theCompany’s June 30, 2004 meeting with the FDA. In its reply, the FDA requested additional information concerning theCompany’s responses to certain of the investigational observations made inconnection with the inspection conducted by FDA from March 31, 2004 until May6, 2004, and the corrective actions the Company has taken and intends totake.  The FDA also advised the Companythat it intends to conduct a follow-up inspection in the near future.  The Company responded to the FDA’s September,2004,

 

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correspondence in October, 2004.  The Company believes that its responses, andthe corrective actions it has taken and intends to take, address the FDA’s observations.  However, the FDA is not required to accept oragree with the Company’s responses and/or commitments.  If, in the future, the FDA determines that,with respect to its Corona facility, Watson has failed to comply with theconsent decree or FDA regulations, including cGMPs, or has failed to adequatelyaddress the observations in the Form 483, the consent decree allows the FDA toorder Watson to take a variety of actions to remedy the deficiencies. Theseactions could include ceasing manufacturing and related operations at theCorona facility, and recalling affected products.  Such actions, if taken by the FDA, couldadversely affect the Company, its results of operations, financial positionand/or cash flows.

 

*Securities Litigation**. *On August 30, 2004,the lead plaintiff in the consolidated action pending in the United StatesDistrict Court for the Central District of California *(In re:  Watson Pharmaceuticals, Inc. SecuritiesLitigation, Case No. CV-03-8236 AHM)*, notified the court that it didnot intend to file an amended complaint in response to the court’s ordergranting the defendants’ motion to dismiss the plaintiff’s previouscomplaint.  On September 2, 2004, theDistrict Court entered a judgment of dismissal in favor of the defendants.  On October 1, 2004, one of the non-leadplaintiffs in the consolidated action filed a Notice of Appeal of the dismissalof the action with the United States Court of Appeals for the NinthCircuit.  *(PensionFund v. Watson Pharmaceuticals, Inc., USCA Docket No. 04-56791)*  The defendants have not yet responded to theNotice of Appeal.

 

*Hormone Replacement Therapy Litigation.*  With respect to the hormone replacementtherapy product liability lawsuits pending against the Company, certain of itssubsidiaries, and others, additional actions raising similar issues have beenfiled.  As of November 1, 2004,approximately 50 cases were pending against Watson and/or its affiliates instate and federal courts.  Many of thecases involve multiple plaintiffs.  TheCompany maintains products liability insurance against such claims.  However, these actions, if successful, or ifinsurance does not provide sufficient coverage against the claims, couldadversely affect the Company and may have a material adverse effect on theCompany’s business, results of operations, financial condition and cash flows.

 

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

 

**ITEM 6.  EXHIBITS**

 

(a) Exhibits:

 

Reference is hereby made to the Exhibit Index on page 34.

 

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**SIGNATURES**

 

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

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

 

Date:  November 5, 2004

 

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**WATSONPHARMACEUTICALS, INC.**

 

**EXHIBITINDEX TO FORM 10-QFor the Quarterly Period Ended September 30, 2004**

 
| **Exhibit  No.** | ** ** | **Description**                                                                                                                    |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------|
| ** **       | ** ** | ** **                                                                                                                         |
| *10.1            |       | Key Employment  Agreement entered into as of August 16, 2004 by and between James Nash and  the Company.                           |
|             |       |                                                                                                                               |
| *10.2            |       | Amendment to Key  Employment Agreement entered as of September 7, 2004 by and between Maria Chow  Yee 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 orAgreement

 

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