**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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**ý****QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d)**

**OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30,2005**

 

**or**

 

**o****TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d)**

**OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from                   to                   **

 

**Commission file number 0-20045**

 

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**WATSON PHARMACEUTICALS, INC.**

(Exact name of registrant as specified in its charter)

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

 

**311 Bonnie Circle**

**Corona, CA 92880-2882**

(Address of principal executive offices, including zip code)

 

**(951) 493-5300**

(Registrant’s telephone number, including area code)

 

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

 

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

 

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

 

The number of sharesoutstanding of the Registrant’s only class of common stock as of November 3,2005 was approximately 110,815,000.

 

 

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**WATSON PHARMACEUTICALS, INC.**

 

**TABLE OF CONTENTS**

 

**FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30,2005**

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

 

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**PART I. FINANCIAL INFORMATION**

 

**ITEM 1. CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

**WATSON PHARMACEUTICALS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(Unaudited; in thousands)**

 
| ** **                                      | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **ASSETS**                                      |       |                         |       |                        |       |
| Current assets:                                 |       |                         |       |                        |       |
| Cash and cash equivalents                       |       | $                            | 472,224    |                        | $          | 298,653 |   |
| Marketable securities                           |       | 162,368                      |       | 381,679                     |       |
| Accounts receivable, net                        |       | 290,648                      |       | 251,459                     |       |
| Inventories                                     |       | 271,745                      |       | 321,299                     |       |
| Prepaid expenses and other current assets       |       | 21,193                       |       | 26,894                      |       |
| Deferred tax assets                             |       | 89,602                       |       | 90,202                      |       |
| Total current assets                            |       | 1,307,780                    |       | 1,370,186                   |       |
|                                            |       |                         |       |                        |       |
| Property and  equipment, net                    |       | 443,206                      |       | 427,377                     |       |
| Investments and  other assets                   |       | 42,507                       |       | 47,499                      |       |
| Deferred tax  assets                            |       | 30,780                       |       | 30,280                      |       |
| Product rights  and other intangibles, net      |       | 790,448                      |       | 912,746                     |       |
| Goodwill                                        |       | 455,595                      |       | 455,595                     |       |
| Total assets                                    |       | $                            | 3,070,316  |                        | $          | 3,243,683 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**   |       |                         |       |                        |       |
| Current  liabilities:                           |       |                         |       |                        |       |
| Accounts payable and accrued expenses           |       | $                            | 194,407    |                        | $          | 192,701 |   |
| Income taxes payable                            |       | 46,407                       |       | 57,851                      |       |
| Deferred revenue                                |       | 5,721                        |       | 5,077                       |       |
| Total current liabilities                       |       | 246,535                      |       | 255,629                     |       |
|                                            |       |                         |       |                        |       |
| Long-term debt                                  |       | 587,864                      |       | 587,653                     |       |
| Deferred revenue                                |       | 16,636                       |       | 11,557                      |       |
| Other long-term  liabilities                    |       | 4,748                        |       | 4,736                       |       |
| Deferred tax  liabilities                       |       | 127,379                      |       | 140,959                     |       |
| Total liabilities                               |       | 983,162                      |       | 1,000,534                   |       |
|                                            |       |                         |       |                        |       |
| Commitments and  contingencies                  |       |                         |       |                        |       |
| Stockholders’  equity:                     |       |                         |       |                        |       |
| Preferred stock                                 |       | —                       |       | —                      |       |
| Common stock                                    |       | 366                          |       | 362                         |       |
| Additional  paid-in capital                     |       | 919,859                      |       | 880,202                     |       |
| Unearned  compensation                          |       | (10,009                      | )          | —                      |       |
| Retained  earnings                              |       | 1,472,438                    |       | 1,353,047                   |       |
| Accumulated  other comprehensive income         |       | 4,500                        |       | 9,538                       |       |
| Treasury stock,  at cost                        |       | (300,000                     | )          | —                      |       |
| Total stockholders’ equity                 |       | 2,087,154                    |       | 2,243,149                   |       |
| Total liabilities and stockholders’ equity |       | $                            | 3,070,316  |                        | $          | 3,243,683 |   |

 

*See accompanying Notes to Condensed ConsolidatedFinancial Statements.*

 

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,** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Net revenues                                                   |       | $                                          | 410,296    |                                      | $          | 408,018 |   | $ | 1,227,390 |   | $ | 1,217,044 |   |
| Cost of sales                                                  |       | 210,809                                    |       | 202,508                                   |       | 628,972 |   | 597,843 |   |
| Gross profit                                                   |       | 199,487                                    |       | 205,510                                   |       | 598,418 |   | 619,201 |   |
|                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Operating  expenses:                                           |       |                                       |       |                                      |       |   |   |   |   |
| Research and development                                       |       | 29,840                                     |       | 34,261                                    |       | 90,164 |   | 106,471 |   |
| Selling, general and administrative                            |       | 65,175                                     |       | 80,578                                    |       | 196,951 |   | 237,158 |   |
| Amortization                                                   |       | 41,100                                     |       | 18,040                                    |       | 122,839 |   | 53,955 |   |
| Loss on impairment of product rights                           |       | —                                     |       | 46,100                                    |       | — |   | 46,100 |   |
| Total operating expenses                                       |       | 136,115                                    |       | 178,979                                   |       | 409,954 |   | 443,684 |   |
| Operating income                                               |       | 63,372                                     |       | 26,531                                    |       | 188,464 |   | 175,517 |   |
|                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Other (expense)  income:                                       |       |                                       |       |                                      |       |   |   |   |   |
| Equity in losses of joint ventures                             |       | (284                                       | )          | (810                                      | )          | (442 | ) | (4,089 | ) |
| Loss on impairment of investments and other assets             |       | —                                     |       | (4,794                                    | )          | — |   | (5,685 | ) |
| Gain on sales of securities                                    |       | —                                     |       | 1,799                                     |       | — |   | 5,737 |   |
| Loss on early extinguishment of debt                           |       | —                                     |       | —                                    |       | — |   | (17,752 | ) |
| Interest income                                                |       | 4,928                                      |       | 1,504                                     |       | 13,580 |   | 3,726 |   |
| Interest expense                                               |       | (4,690                                     | )          | (3,681                                    | )          | (11,604 | ) | (9,071 | ) |
| Other (expense) income                                         |       | (450                                       | )          | 2,327                                     |       | (489 | ) | 1,987 |   |
| Total other (expense) income, net                              |       | (496                                       | )          | (3,655                                    | )          | 1,045 |   | (25,147 | ) |
|                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Income before  income taxes                                    |       | 62,876                                     |       | 22,876                                    |       | 189,509 |   | 150,370 |   |
| Provision for  income taxes                                    |       | 23,264                                     |       | 8,235                                     |       | 70,118 |   | 54,143 |   |
| Net income                                                     |       | $                                          | 39,612     |                                      | $          | 14,641 |   | $ | 119,391 |   | $ | 96,227 |   |
|                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Earnings per  share (as restated per Note 1):                  |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                          |       | $                                          | 0.38       |                                      | $          | 0.13 |   | $ | 1.12 |   | $ | 0.88 |   |
| Diluted                                                        |       | $                                          | 0.36       |                                      | $          | 0.13 |   | $ | 1.03 |   | $ | 0.81 |   |
|                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Weighted average shares outstanding (as restated per  Note 1): |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                          |       | 102,966                                    |       | 109,442                                   |       | 106,131 |   | 109,041 |   |
| Diluted                                                        |       | 118,158                                    |       | 124,096                                   |       | 121,156 |   | 124,619 |   |

 

*See accompanying Notes to Condensed ConsolidatedFinancial Statements.*

 

2

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**WATSON PHARMACEUTICALS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited; in thousands)**

 
| ** **                                                    | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                    |       |                                      |       |   |   |
| Net income                                                    |       | $                                         | 119,391    |   | $ | 96,227 |   |
| Reconciliation  to net cash provided by operating activities: |       |                                      |       |   |   |
| Depreciation                                                  |       | 30,857                                    |       | 24,357 |   |
| Amortization                                                  |       | 122,839                                   |       | 53,955 |   |
| Restricted stock and stock option compensation                |       | 1,175                                     |       | — |   |
| Deferred income tax (benefit) provision                       |       | (10,746                                   | )          | 7,305 |   |
| Equity in losses of joint ventures                            |       | 442                                       |       | 4,089 |   |
| Gain on sales of securities                                   |       | —                                    |       | (5,737 | ) |
| Loss on early extinguishment of debt                          |       | —                                    |       | 17,752 |   |
| Loss (gain) on sale of fixed assets                           |       | 1,607                                     |       | (2,383 | ) |
| Loss on impairment of investments and other assets            |       | —                                    |       | 51,785 |   |
| Tax benefits from employee stock plans                        |       | 3,111                                     |       | 6,070 |   |
| Mark to market on derivative                                  |       | 12                                        |       | (3,826 | ) |
| Other                                                         |       | (2,389                                    | )          | (1,296 | ) |
| Changes in assets and liabilities:                            |       |                                      |       |   |   |
| Accounts receivable, net                                      |       | (39,189                                   | )          | (18,928 | ) |
| Inventories                                                   |       | 49,554                                    |       | 53,246 |   |
| Prepaid expenses and other current assets                     |       | 5,701                                     |       | 9,267 |   |
| Accounts payable and accrued expenses                         |       | 1,706                                     |       | (35,685 | ) |
| Deferred revenue                                              |       | 5,723                                     |       | (2,993 | ) |
| Income taxes payable                                          |       | (11,444                                   | )          | (49,492 | ) |
| Other assets                                                  |       | 1,131                                     |       | 2,305 |   |
| Total adjustments                                             |       | 160,090                                   |       | 109,791 |   |
| Net cash provided by operating activities                     |       | 279,481                                   |       | 206,018 |   |
|                                                          |       |                                      |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                    |       |                                      |       |   |   |
| Additions to  property and equipment                          |       | (48,293                                   | )          | (59,033 | ) |
| Acquisitions of  product rights                               |       | (541                                      | )          | (7,349 | ) |
| Additions to  long-term investments                           |       | (1,500                                    | )          | (10,590 | ) |
| Additions to  marketable securities                           |       | (3,809                                    | )          | — |   |
| Proceeds from  sales of marketable securities                 |       | 220,083                                   |       | 28,753 |   |
| Distribution  from joint venture                              |       | 2,791                                     |       | — |   |
| Proceeds from  sale of property and equipment                 |       | —                                    |       | 23,809 |   |
| Proceeds from  sale of Halsey note receivable                 |       | —                                    |       | 5,381 |   |
| Other investing  activities, net                              |       | —                                    |       | 2,009 |   |
| Net cash provided by (used in) investing activities           |       | 168,731                                   |       | (17,020 | ) |
|                                                          |       |                                      |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                    |       |                                      |       |   |   |
| Payments to  repurchase 1998 Senior Notes                     |       | —                                    |       | (135,905 | ) |
| Premium paid on  1998 Senior Notes repurchase                 |       | —                                    |       | (17,072 | ) |
| Repurchase of common  stock                                   |       | (300,000                                  | )          | — |   |
| Principal  payments on acquisition liabilities                |       | (7                                        | )          | (7 | ) |
| Proceeds from  stock plans                                    |       | 25,366                                    |       | 26,210 |   |
| Net cash used in financing activities                         |       | (274,641                                  | )          | (126,774 | ) |
| Net increase in cash and cash equivalents                     |       | 173,571                                   |       | 62,224 |   |
| Cash and cash  equivalents at beginning of period             |       | 298,653                                   |       | 318,043 |   |
| Cash and cash  equivalents at end of period                   |       | $                                         | 472,224    |   | $ | 380,267 |   |

 

*See accompanying Notes to Condensed ConsolidatedFinancial Statements.*

 

3

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**WATSON PHARMACEUTICALS, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**(Unaudited)**

 

**NOTE 1 –GENERAL**

 

WatsonPharmaceuticals, Inc. (“Watson”, “the Company”, “we”, “us” or “our”) is primarilyengaged in the development, manufacture, marketing, sale and distribution ofbrand and off-patent (generic) pharmaceutical products.  Watson was incorporated in 1985 and beganoperations as a manufacturer and marketer of off-patent pharmaceuticals.  Through internal product development andsynergistic acquisitions of products and businesses, the Company has grown intoa diversified specialty pharmaceutical company. Watson operates manufacturing, distribution, research and developmentand administrative facilities primarily in 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 31,2004.  Certain information and footnotedisclosures normally included in annual financial statements prepared inaccordance with generally accepted accounting principles have been condensed oromitted from the accompanying Condensed Consolidated Financial Statements.  The year end balance sheet was derived fromthe audited financial statements.  Theaccompanying interim Condensed Consolidated Financial Statements are unaudited,but reflect all adjustments which are, in the opinion of management, necessaryto fairly state Watson’s consolidated financial position, results of operationsand cash flows for the periods presented. Unless otherwise noted, all such adjustments are of a normal, recurringnature. Certainreclassifications, none of which affected net income or retained earnings, havebeen made to prior period amounts to conform to current periodpresentation.  The Company’s results ofoperations and cash flows for the interim periods are not necessarilyindicative of the results of operations and cash flows that it may achieve infuture periods or for the full year.

 

*Comprehensiveincome*

 

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

 

| ** **                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                         | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income                                         |       | $                                          | 39,612     |                                      | $          | 14,641 |   | $ | 119,391 |   | $ | 96,227 |   |
| Other  comprehensive loss:                         |       |                                       |       |                                      |       |   |   |   |   |
| Unrealized holding loss on securities              |       | (2,704                                     | )          | (3,242                                    | )          | (7,997 | ) | (4,026 | ) |
| Less related income taxes                          |       | 985                                        |       | 1,167                                     |       | 2,959 |   | 1,449 |   |
| Total unrealized loss on securities, net           |       | (1,719                                     | )          | (2,075                                    | )          | (5,038 | ) | (2,577 | ) |
|                                               |       |                                       |       |                                      |       |   |   |   |   |
| Reclassification for losses included in net income |       | —                                     |       | (527                                      | )          | — |   | (1,619 | ) |
| Less related income taxes                          |       | —                                     |       | 189                                       |       | — |   | 583 |   |
| Total reclassification, net                        |       | —                                     |       | (338                                      | )          | — |   | (1,036 | ) |
| Total other  comprehensive loss                    |       | (1,719                                     | )          | (2,413                                    | )          | (5,038 | ) | (3,613 | ) |
| Total  comprehensive income                        |       | $                                          | 37,893     |                                      | $          | 12,228 |   | $ | 114,353 |   | $ | 92,614 |   |

 

4

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*Preferredand Common Stock*

 

As of September 30,2005 and December 31, 2004 there were 2,500,000 shares of preferred stockauthorized, with none issued.  As of September 30,2005 and December 31, 2004, there were 500,000,000 shares of common stockauthorized, with 111,085,400 and 109,719,900 shares issued, respectively.  Of the issued shares, 9,399,800 and 0 shareswere held as treasury shares as of September 30, 2005 and December 31,2004, respectively.

 

*Earningsper share*

 

Basicearnings per share is computed by dividing net income by the weighted averagecommon shares outstanding during a period. Diluted earnings per share is based on the treasury stock method andincludes the effect from potential issuance of common stock, such as sharesissuable upon conversion of the $575 million convertible contingent seniordebentures (“CODES”), and shares issuable pursuant to the exercise of stockoptions, assuming the exercise of all in-the-money stock options.  Other potential common share equivalents havebeen excluded where their inclusion would be antidilutive.  In accordance with Emerging Issues Task Force(“EITF”) Issue No. 04-8, “The Effect of Contingently Convertible Debt onDiluted Earnings per Share” (“EITF No. 04-8”), the Company is required toadd approximately 14.4 million shares associated with the conversion of theCODES to the number of shares outstanding for the calculation of dilutedearnings per share for all periods in which the securities wereoutstanding.  Prior period comparativeshave been restated to conform to the requirements of EITF No. 04-8. 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,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                         | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                               |       |                                       |       |                                      |       |   |   |   |   |
| **Earnings  per share - basic**                    |       |                                       |       |                                      |       |   |   |   |   |
| Net income                                         |       | $                                          | 39,612     |                                      | $          | 14,641 |   | $ | 119,391 |   | $ | 96,227 |   |
|                                               |       |                                       |       |                                      |       |   |   |   |   |
| Basic weighted average common shares outstanding   |       | 102,966                                    |       | 109,442                                   |       | 106,131 |   | 109,041 |   |
|                                               |       |                                       |       |                                      |       |   |   |   |   |
| Earnings per share - basic                         |       | $                                          | 0.38       |                                      | $          | 0.13 |   | $ | 1.12 |   | $ | 0.88 |   |
|                                               |       |                                       |       |                                      |       |   |   |   |   |
| **Earnings  per share - assuming dilution**        |       |                                       |       |                                      |       |   |   |   |   |
| Net income                                         |       | $                                          | 39,612     |                                      | $          | 14,641 |   | $ | 119,391 |   | $ | 96,227 |   |
| Add: Interest expense on CODES, net of tax         |       | 2,523                                      |       | 1,840                                     |       | 5,963 |   | 4,352 |   |
| Net income, adjusted                               |       | $                                          | 42,135     |                                      | $          | 16,481 |   | $ | 125,354 |   | $ | 100,579 |   |
|                                               |       |                                       |       |                                      |       |   |   |   |   |
| Basic weighted average common shares outstanding   |       | 102,966                                    |       | 109,442                                   |       | 106,131 |   | 109,041 |   |
| Effect of dilutive securities:                     |       |                                       |       |                                      |       |   |   |   |   |
| Conversion of CODES                                |       | 14,357                                     |       | 14,357                                    |       | 14,357 |   | 14,357 |   |
| Dilutive stock options                             |       | 835                                        |       | 297                                       |       | 668 |   | 1,221 |   |
| Diluted weighted average common shares outstanding |       | 118,158                                    |       | 124,096                                   |       | 121,156 |   | 124,619 |   |
|                                               |       |                                       |       |                                      |       |   |   |   |   |
| Earnings per share - diluted                       |       | $                                          | 0.36       |                                      | $          | 0.13 |   | $ | 1.03 |   | $ | 0.81 |   |

 

Excludedfrom the computation of diluted earnings per share are outstanding common stockoptions with an exercise price greater than the average market price of thecommon shares for the periods reported. For each of the three month periods ended September 30, 2005 and2004, stock options to purchase 6.2 million and 11.3 million common shares,respectively, were outstanding but were not included in the computation ofdiluted earnings per share because the options were antidilutive.  For the nine month periods ended September 30,2005 and 2004, stock options to purchase 6.3 million and 6.8 million commonshares, respectively, were outstanding but were not included in the computationof diluted earnings per share because they were antidilutive.

 

*Stock-basedcompensation*

 

TheCompany accounts for its stock-based employee compensation plans using therecognition and measurement principles of Accounting Principles Board (“APB”)Opinion No. 25, “Accounting for Stock Issued

 

5

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to Employees” (“APB 25”)and related interpretations.  Nostock-based employee compensation expense has been recognized for the optionsin the accompanying condensed consolidated statements of income, as all optionsgranted under the plans had an exercise price equal to the market value of theunderlying common stock on the date of grant.

 

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

 

| ** **                                                                                                                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                                          |       |                                       |       |                                      |       |   |   |   |   |
| Net income, as  reported                                                                                                                      |       | $                                          | 39,612     |                                      | $          | 14,641 |   | $ | 119,391 |   | $ | 96,227 |   |
| Add: Stock-based employee compensation expense  included in reported net income, net of related tax effects                                   |       | 358                                        |       | —                                    |       | 358 |   | — |   |
| Deduct: Total stock-based employee compensation  expense determined under fair value based method for all awards, net of  related tax effects |       | (2,950                                     | )          | (1,229                                    | )          | (8,917 | ) | (9,820 | ) |
| Pro forma net  income                                                                                                                         |       | 37,020                                     |       | 13,412                                    |       | 110,832 |   | 86,407 |   |
| Add: Interest  expense on CODES                                                                                                               |       | 2,523                                      |       | 1,840                                     |       | 5,963 |   | 4,352 |   |
| Pro forma net  income, as adjusted                                                                                                            |       | $                                          | 39,543     |                                      | $          | 15,252 |   | $ | 116,795 |   | $ | 90,759 |   |
|                                                                                                                                          |       |                                       |       |                                      |       |   |   |   |   |
| Earnings per  share:                                                                                                                          |       |                                       |       |                                      |       |   |   |   |   |
| Basic - as reported                                                                                                                           |       | $                                          | 0.38       |                                      | $          | 0.13 |   | $ | 1.12 |   | $ | 0.88 |   |
| Basic - pro forma                                                                                                                             |       | $                                          | 0.36       |                                      | $          | 0.12 |   | $ | 1.04 |   | $ | 0.79 |   |
|                                                                                                                                          |       |                                       |       |                                      |       |   |   |   |   |
| Diluted - as reported                                                                                                                         |       | $                                          | 0.36       |                                      | $          | 0.13 |   | $ | 1.03 |   | $ | 0.81 |   |
| Diluted - pro forma                                                                                                                           |       | $                                          | 0.34       |                                      | $          | 0.12 |   | $ | 0.96 |   | $ | 0.73 |   |

 

Theweighted average fair values of the employee stock options and employee stockpurchase plan (“ESPP”) have been estimated on the date of each grant using theBlack-Scholes option pricing model. Weighted averages are used because ofvarying assumed exercise dates.  Thefollowing weighted average

 

6

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assumptions were used forstock options granted during the three and nine months ended September 30,2005 and 2004:

 

| ** **                                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                          | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                |       |                                       |       |                                      |       |   |   |   |   |
| Dividend yield                                      |       | None                                       |       | None                                      |       | None |   | None |   |
| Expected  volatility                                |       | 22                                         | %          | 35                                        | %          | 23 | % | 33 | % |
| Risk-free  interest rate                            |       | 4.18                                       | %          | 3.84                                      | %          | 4.15 | % | 3.78 | % |
| Expected term in  years                             |       | 4.8                                        |       | 5.4                                       |       | 5.0 |   | 5.4 |   |
|                                                |       |                                       |       |                                      |       |   |   |   |   |
| Weighted average fair value per share at grant date |       | $                                          | 9.56       |                                      | $          | 10.40 |   | $ | 9.25 |   | $ | 11.35 |   |
|                                                     |            |                                            |            |                                           |            |  |  |  |  |  |  |  |  |

 

Thefollowing weighted average assumptions were used for the ESPP during the threeand nine months ended September 30, 2005 and 2004:

 
| ** **                                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Dividend yield                                       |       | None                                       |       | None                                      |       | None |   | None |   |
| Expected  volatility                                 |       | 22                                         | %          | 35                                        | %          | 24 | % | 36 | % |
| Risk-free  interest rate                             |       | 3.80                                       | %          | 3.84                                      | %          | 3.90 | % | 3.82 | % |
| Expected term                                        |       | 6 months                                   |       | 6 months                                  |       | 6 months |   | 6 months |   |
|                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Weighted average fair value  per share at grant date |       | $                                          | 6.45       |                                      | $          | 6.84 |   | $ | 6.87 |   | $ | 8.69 |   |
|                                                      |            |                                            |            |                                           |            |  |  |  |  |  |  |  |  |

 

*StockAwards*

 

Weimplemented certain changes in employee and non-employee director (the “Participants”)share-based compensation during the second quarter of 2005 to help us strengthenour ability to attract, retain and motivate our Participants, and to betteralign Participant interests with those of our shareholders. Certain Participantsare now granted restricted stock awards as well as stock options. The stockaward program offers Participants the opportunity to earn shares of our common stockover time, rather than options that give Participants the right to purchasestock at a set price. Restricted stock awards are grants that entitle theholder to shares of common stock subject to certain restrictions.  On June 29, 2005, approximately 38,000restricted stock awards with a weighted-average fair value of $29.97 per sharewere granted to certain non-employee directors and the Company’s ChiefExecutive Officer.  During the threemonths ended September 30, 2005 approximately 268,000 restricted stockawards with a weighted average fair value of $35.10 per share were granted toemployees of the company.  Restrictedstock awards generally have restrictions eliminated over a one to four yearperiod.  Restrictions generally lapse fornon-employee directors after one year. Restrictions generally lapse for employees over a two to four yearperiod.

 

*StockRepurchases*

 

Wehave repurchased approximately 9.4 million shares of our common stock at anaggregate cost of approximately $300.0 million under the Company’s $300.0million stock repurchase program approved by the Board of Directors (“Board”)on February 10, 2005.  Thiscompletes our stock repurchase program under the existing Board authorization.

 

7

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*Recentaccounting pronouncements*

 

In November 2004,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 151, “InventoryCosts-an Amendment of ARB No. 43, Chapter 4” (“SFAS 151”).  SFAS 151 requires that accounting for itemssuch as idle facility expense, freight, handling costs, and wasted materials(spoilage) be recognized as current period charges regardless of whether theymeet the criterion of being abnormal.  Inaddition, SFAS 151 requires that allocation of fixed production overheads tothe costs of conversion be based on the normal capacity of the productionfacilities.  SFAS 151 is effective forinventory costs incurred during fiscal years beginning after June 15,2005.  The provision of SFAS 151 shall beapplied prospectively.  The Companybelieves that the adoption of SFAS 151 will not have a material effect on ourCondensed Consolidated Financial Statements.

 

In December 2004,the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS123R”), which replaces SFAS 123, and supercedes APB 25. Under SFAS 123R,the Company must determine the appropriate fair value model to be used forvaluing share-based payment transactions with employees, the amortization methodfor compensation cost and the transition method to be used at the date ofadoption. The transition methods include modified prospective and modifiedretrospective adoption options. Under the modified retrospective option, priorperiods may be restated either as of the beginning of the year of adoption orfor all periods presented. The modified prospective method requires thatcompensation expense be recorded for all unvested stock options and restrictedstock at the beginning of the first quarter of adoption of SFAS 123R,while the modified retrospective method would record compensation expense forall unvested stock options and restricted stock beginning with the first periodrestated. The Company is evaluating the requirements of SFAS 123R. TheCompany has not yet determined whether the adoption will result in share-basedcompensation expense amounts that are similar to the current pro formadisclosures under SFAS 123.

 

In April 2005,the Securities and Exchange Commission announced an amendment to Regulation S-Xto amend the date for compliance with SFAS 123R.  The amendment requires each registrant thatis not a small business issuer to adopt SFAS 123R in the first fiscal yearcommencing after June 15, 2005.  TheCompany is required to adopt SFAS 123R beginning January 1, 2006.  Adoption of SFAS 123R will have a materialimpact on our consolidated financial statements, as we will be required toexpense the fair value of our stock option awards and ESPP grants rather thandisclose the pro forma impact on our consolidated net income within thefootnotes, as is our current practice.

 

In May 2005,the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS154”), which replaces APB Opinion No. 20, “Accounting Changes” (“APB 20”)and SFAS No. 3, “Reporting Accounting Changes in Interim FinancialStatements” (“SFAS 3”). SFAS 154 applies to all voluntary changes in accountingprinciple and changes the requirements for the accounting for and reporting ofa change in accounting principle.  SFAS154 also requires retrospective application to prior period financialstatements involving changes in accounting principle unless it is impracticableto determine either the period-specific or cumulative effect of the change.  This statement also requires that a change inthe method of depreciation, amortization or depletion of long-lived assets beaccounted for as a change in accounting estimate that is accounted forprospectively.  SFAS 154 also retainsmany provisions of APB 20 including those related to reporting a change inaccounting estimate, a change in the reporting entity and a correction of anerror and also carries forward provisions of SFAS 3 governing the reporting ofaccounting changes in interim financial statements.  SFAS 154 is effective for accounting changesand corrections of errors made in fiscal years beginning after December 15,2005.  The Company believes that theadoption of SFAS 154 will not have a material effect on our CondensedConsolidated Financial Statements.

 

**NOTE 2 –INVESTMENTS**

 

TheCompany’s equity investments in publicly traded companies are classified asavailable-for-sale and are recorded at fair value based on quoted market pricesusing the specific identification method. These investments are classified as current marketable securities, orinvestments and other assets, as appropriate, on the Company’s CondensedConsolidated Balance Sheets.

 

8

----

 

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

 

Thefollowing table provides a summary of the fair value and unrealized holdinggain (loss) related to Watson’s available-for-sale securities at September 30,2005 and December 31, 2004 (in thousands):

 

| **At September 30, 2005**  | ** ** | **Cost, Including  Accrued Interest** | ** ** | **Gross Unrealized  Gains** | ** ** | **Gross Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|-----------------------------|------------|------------------------------|------------|----------------|------------|
|                            |       |                                  |       |                        |       |                         |       |           |       |
| Available-for-sale:             |       |                                  |       |                        |       |                         |       |           |       |
| U.S. Treasury securities        |       | $                                     | 154,878    |                        | $          | —                       |       | $              | (1,880     | ) | $ | 152,998 |   |
| Equity securities - current     |       | 1,572                                 |       | 7,798                       |       | —                       |       | 9,370          |       |
| Current                         |       | 156,450                               |       | 7,798                       |       | (1,880                       | )          | 162,368        |       |
| Equity securities - non-current |       | 2,032                                 |       | 1,161                       |       | —                       |       | 3,193          |       |
| Total                           |       | $                                     | 158,482    |                        | $          | 8,959                        |       | $              | (1,880     | ) | $ | 165,561 |   |
|                            |       |                                  |       |                        |       |                         |       |           |       |
| **At December 31,  2004**  | ** ** | **Cost, Including  Accrued Interest** | ** ** | **Gross Unrealized  Gains** | ** ** | **Gross Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|                            |       |                                  |       |                        |       |                         |       |           |       |
| Available-for-sale:             |       |                                  |       |                        |       |                         |       |           |       |
| U.S. Treasury securities        |       | $                                     | 198,828    |                        | $          | —                       |       | $              | (105       | ) | $ | 198,723 |   |
| Auction rate securities         |       | 169,699                               |       | —                      |       | —                       |       | 169,699        |       |
| Equity securities - current     |       | 1,572                                 |       | 11,685                      |       | —                       |       | 13,257         |       |
| Current                         |       | 370,099                               |       | 11,685                      |       | (105                         | )          | 381,679        |       |
| Equity securities - non-current |       | 2,032                                 |       | 3,290                       |       | —                       |       | 5,322          |       |
| Total                           |       | $                                     | 372,131    |                        | $          | 14,975                       |       | $              | (105       | ) | $ | 387,001 |   |

 

Ourinvestments in auction rate securities were liquidated in May 2005 andapproximately $50 million in U.S. Treasury securities matured in June 2005.  Proceeds were deposited in cash and cashequivalents.

 

Grossunrealized gains at September 30, 2005 and December 31, 2004primarily relate to our holdings in shares of Andrx Corporation (“Andrx”)common stock.  The gross unrealized lossesat September 30, 2005 and December 31, 2004 is attributable toadjustments, included in other comprehensive income, for the decline in fairvalue in the Company’s investment in U.S. Treasury securities.

 

TheCompany’s net unrealized losses related to its available-for-sale securitieswere $1.7 million and $5.0 million for the three and nine month periods ended September 30,2005, respectively.  During the three andnine month periods ended September 30, 2004, the Company’s net unrealizedlosses related to its available-for-sale securities were $2.4 million and $3.6million, respectively.  Changes in theCompany’s net unrealized gains (losses) related to its available-for-salesecurities are included in other comprehensive income (loss).

 

*Currentinvestments*

 

TheCompany’s investment in the common stock of Andrx, publicly traded on theNasdaq Stock Market under the symbol ADRX, is classified as a currentinvestment on the Company’s Condensed Consolidated Balance Sheets at September 30,2005 and December 31, 2004.

 

TheCompany did not sell any of its shares of Andrx during the nine month periodended September 30, 2005.  Duringthe nine month period ended September 30, 2004, Watson sold 240,000 sharesof its investment in the common stock of Andrx for gross proceeds of $6.3million and recorded a pre-tax gain of $5.7 million.  Realized gains are computed using thespecific identification method to determine the cost basis for each investment.

 

TheCompany’s investments in U.S. Treasury securities and auction rate securities,where applicable, are classified as a current investment on the Company’sCondensed Consolidated Balance Sheets at September 30, 2005 and December 31,2004.

 

9

----

 

Thecontractual maturities of the U.S. Treasury securities consisted of thefollowing (in thousands):

 

| ** **               | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Mature within  one year  |       | $                            | —     |                        | $          | 49,502 |   |
| Mature within  two years |       | 152,998                      |       | 149,221                     |       |
|                     |       | $                            | 152,998    |                        | $          | 198,723 |   |

 

*Non-currentinvestments*

 

TheCompany’s investments in the common stock of Genelabs Technologies, Inc.,NovaDel Pharma Inc. and Amarin Corporation plc are classified as non-currentinvestments and are included in “Investments and other assets” on the Company’sCondensed Consolidated Balance Sheets at September 30, 2005 and December 31,2004.

 

**NOTE 3 –OPERATING SEGMENTS**

 

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

 

Priorto January 1, 2005, the Company evaluated the performance of its segmentsbased on net revenues and gross profit. As of January 1, 2005, the Company began to evaluate segmentperformance based on segment net revenues, gross profit and contribution.Segment contribution represents segment gross profit less direct research anddevelopment expenses and selling and marketing expenses.  Segment financial data for prior periods havebeen reclassified to reflect this change in evaluating the associated segment results.

 

TheCompany does not report general and administrative expenses, amortization,depreciation expense, total assets, and capital expenditures by segment as suchinformation is not used by management, or accounted for, at the segmentlevel.  Segment net revenues, segmentgross profit and segment contribution information for the

 

10

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Company’s Brand and Genericsegments, as reclassified, consisted of the following:

 

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

 

**Three months ended September 30, 2005**

 
| ** **                           | ** ** | **Brand** | ** ** | **Generic** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|-----------|------------|-------------|------------|-----------|------------|
|                                 |       |      |       |        |       |      |       |
| Product sales                        |       | $         | 91,554     |        | $          | 315,234   |       | $ | 406,788 |   |
| Other                                |       | 2,371     |       | 1,137       |       | 3,508     |       |
| Net revenues                         |       | 93,925    |       | 316,371     |       | 410,296   |       |
| Cost of revenue                      |       | 23,483    |       | 187,326     |       | 210,809   |       |
| Gross profit                         |       | 70,442    |       | 129,045     |       | 199,487   |       |
| Gross margin                         |       | 75        | %          | 41          | %          | 49        | %          |
|                                 |       |      |       |        |       |      |       |
| Research and development             |       | 11,347    |       | 18,493      |       | 29,840    |       |
| Selling and marketing                |       | 28,867    |       | 12,800      |       | 41,667    |       |
| Contribution                         |       | $         | 30,228     |        | $          | 97,752    |       | 127,980 |   |
| Contribution margin                  |       | 32        | %          | 31          | %          | 31        | %          |
|                                 |       |      |       |        |       |      |       |
| General and administrative           |       |      |       |        |       | 23,508    |       |
| Amortization                         |       |      |       |        |       | 41,100    |       |
| Loss on impairment of product rights |       |      |       |        |       | —    |       |
| Operating income                     |       |      |       |        |       | $         | 63,372     |   |

 

**Threemonths ended September 30, 2004**

 
| ** **                           | ** ** | **Brand** | ** ** | **Generic** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|-----------|------------|-------------|------------|-----------|------------|
|                                 |       |      |       |        |       |      |       |
| Product sales                        |       | $         | 97,572     |        | $          | 303,337   |       | $ | 400,909 |   |
| Other                                |       | 5,913     |       | 1,196       |       | 7,109     |       |
| Net revenues                         |       | 103,485   |       | 304,533     |       | 408,018   |       |
| Cost of revenue                      |       | 20,044    |       | 182,464     |       | 202,508   |       |
| Gross profit                         |       | 83,441    |       | 122,069     |       | 205,510   |       |
| Gross margin                         |       | 81        | %          | 40          | %          | 50        | %          |
|                                 |       |      |       |        |       |      |       |
| Research and development             |       | 15,108    |       | 19,153      |       | 34,261    |       |
| Selling and marketing                |       | 36,926    |       | 11,586      |       | 48,512    |       |
| Contribution                         |       | $         | 31,407     |        | $          | 91,330    |       | 122,737 |   |
| Contribution margin                  |       | 30        | %          | 30          | %          | 30        | %          |
|                                 |       |      |       |        |       |      |       |
| General and administrative           |       |      |       |        |       | 32,066    |       |
| Amortization                         |       |      |       |        |       | 18,040    |       |
| Loss on impairment of product rights |       |      |       |        |       | 46,100    |       |
| Operating income                     |       |      |       |        |       | $         | 26,531     |   |

 

11

----

 

***NineMonths Ended September 30, 2005 Compared to the Nine Months Ended September 30,2004***

 

**Nine monthsended September 30, 2005**

 
| ** **                                    | ** ** | **Brand** | ** ** | **Generic** | ** ** | **Total** | ** ** |
|-----------------------------------------------|------------|-----------|------------|-------------|------------|-----------|------------|
|                                          |       |      |       |        |       |      |       |
| Product sales                                 |       | $         | 296,826    |        | $          | 920,850   |       | $ | 1,217,676 |   |
| Other                                         |       | 6,342     |       | 3,372       |       | 9,714     |       |
| Net revenues                                  |       | 303,168   |       | 924,222     |       | 1,227,390 |       |
| Cost of revenue                               |       | 70,315    |       | 558,657     |       | 628,972   |       |
| Gross profit                                  |       | 232,853   |       | 365,565     |       | 598,418   |       |
| Gross margin                                  |       | 77        | %          | 40          | %          | 49        | %          |
|                                          |       |      |       |        |       |      |       |
| Research and development                      |       | 30,709    |       | 59,455      |       | 90,164    |       |
| Selling and marketing                         |       | 86,867    |       | 35,748      |       | 122,615   |       |
| Contribution                                  |       | $         | 115,277    |        | $          | 270,362   |       | 385,639 |   |
| Contribution margin                           |       | 38        | %          | 29          | %          | 31        | %          |
|                                          |       |      |       |        |       |      |       |
| General and administrative                    |       |      |       |        |       | 74,336    |       |
| Amortization                                  |       |      |       |        |       | 122,839   |       |
| Loss on impairment of product rights          |       |      |       |        |       | —    |       |
| Operating income                              |       |      |       |        |       | $         | 188,464    |   |
|                                          |       |      |       |        |       |      |       |
| **Nine months ended September 30, 2004** |       |      |       |        |       |      |       |
| ** **                                    |       |      |       |        |       |      |       |
| ** **                                    | ** ** | **Brand** | ** ** | **Generic** | ** ** | **Total** | ** ** |
|                                          |       |      |       |        |       |      |       |
| Product sales                                 |       | $         | 270,458    |        | $          | 914,925   |       | $ | 1,185,383 |   |
| Other                                         |       | 14,572    |       | 17,089      |       | 31,661    |       |
| Net revenues                                  |       | 285,030   |       | 932,014     |       | 1,217,044 |       |
| Cost of revenue                               |       | 57,272    |       | 540,571     |       | 597,843   |       |
| Gross profit                                  |       | 227,758   |       | 391,443     |       | 619,201   |       |
| Gross margin                                  |       | 80        | %          | 42          | %          | 51        | %          |
|                                          |       |      |       |        |       |      |       |
| Research and development                      |       | 52,358    |       | 54,113      |       | 106,471   |       |
| Selling and marketing                         |       | 121,594   |       | 32,035      |       | 153,629   |       |
| Contribution                                  |       | $         | 53,806     |        | $          | 305,295   |       | 359,101 |   |
| Contribution margin                           |       | 19        | %          | 33          | %          | 30        | %          |
|                                          |       |      |       |        |       |      |       |
| General and administrative                    |       |      |       |        |       | 83,529    |       |
| Amortization                                  |       |      |       |        |       | 53,955    |       |
| Loss on impairment of product rights          |       |      |       |        |       | 46,100    |       |
| Operating income                              |       |      |       |        |       | $         | 175,517    |   |

 

**NOTE 4 –INVENTORIES**

 

Inventoriesconsist of finished goods held for sale and distribution, raw materials andwork-in-process. Included in inventory at September 30, 2005 and December 31,2004 is approximately $3.6 million and $17.3 million, respectively, ofinventory that is pending approval by the U.S. Food and Drug Administration (“FDA”)or has not been launched due to contractual restrictions.  This inventory consists of genericpharmaceutical products that are capitalized only when the bioequivalence ofthe product is demonstrated or the product is already FDA approved and isawaiting a contractual triggering event to enter the marketplace.

 

12

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

 
| ** **        | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------|------------|------------------------|------------|-----------------------|------------|
| ** **        | ** ** | **2005**               | ** ** | **2004**              | ** ** |
|              |       |                   |       |                  |       |
| Raw materials     |       | $                      | 104,471    |                  | $          | 109,422 |   |
| Work-in-process   |       | 58,089                 |       | 70,207                |       |
| Finished goods    |       | 109,185                |       | 141,670               |       |
| Total inventories |       | $                      | 271,745    |                  | $          | 321,299 |   |

 

**NOTE 5 –GOODWILL AND OTHER INTANGIBLE ASSETS**

 

Watson tests itsgoodwill and intangible assets with indefinite lives by comparing the fairvalue of each of the Company’s reporting units to the respective carrying valueof the reporting units.  The Companyperforms this impairment testing annually during the second quarter and whenevents occur or circumstances change that would more likely than not reduce thefair value of a reporting unit below its carrying amount.  The Company has aligned the reporting units tocorrespond with our Brand and Generic segments. The carrying value of each reporting unit is determined by assigning theassets and liabilities, including the existing goodwill and intangible assets,to those reporting units.  Goodwill isconsidered impaired if its carrying amount exceeds its implied fair value.

 

During the second quarter of 2005, Watsonperformed its annual test for the impairment of goodwill and determined therewas no indication of impairment.  Therewere no additions to goodwill recorded during the nine months ended September 30,2005.  At September 30, 2005 and December 31,2004, goodwill for the Company’s reporting units consisted of the following (inthousands):

 

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

 

Other intangible assets consist primarily of acquired productrights.  We regularly review the appropriateness ofthe useful lives assigned to our product rights taking into considerationpotential future changes in the markets for our products.  As a result of reviews performed in 2004, weaccelerated the amortization of several product rights including our Ferrlecit®product rights.  The original cost andaccumulated amortization of these intangible assets are as follows (inthousands):

 
| ** **                                       | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **2005**               | ** ** | **2004**              | ** ** |
|                                             |       |                   |       |                  |       |
| Product rights  and related intangibles, at cost |       | $                      | 1,267,053  |                  | $          | 1,266,512 |   |
| Less accumulated  amortization                   |       | (476,605               | )          | (353,766              | )          |
| Product rights and related intangibles, net      |       | $                      | 790,448    |                  | $          | 912,746 |   |

 

The Company’s current product rights and relatedintangibles have a weighted average useful life of approximately twelveyears.  Assuming no additions, disposalsor adjustments are made to the carrying values and/or useful lives of theassets, remaining amortization expense on product rights and relatedintangibles is

 

13

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estimatedto be as follows (in thousands):

 
| **Period ending December 31,** | ** ** | ** ** | ** ** |
|-------------------------------------|------------|------------|------------|
| 2005                                |       | $          | 41,101     |   |
| 2006                                |       | 164,402    |       |
| 2007                                |       | 164,402    |       |
| 2008                                |       | 53,452     |       |
| 2009                                |       | 52,491     |       |
| Thereafter                          |       | 314,600    |       |
| Total                               |       | $          | 790,448    |   |

 

**NOTE 6 – LONG-TERM DEBT**

 

Long-term debt consisted of the following (inthousands):

 
| ** **                                                                                                                         | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                         | ** ** | **2005**               | ** ** | **2004**              | ** ** |
|                                                                                                                               |       |                   |       |                  |       |
| CODES, face amount of $575 million, due 2023, net of  unamortized discount                                                         |       | $                      | 573,780    |                  | $          | 573,573 |   |
| Senior unsecured notes, 7.125%, face amount of $14  million, due 2008, net of unamortized discount (“1998 Senior Notes”) |       | 14,049                 |       | 14,036                |       |
| Other notes payable                                                                                                                |       | 35                     |       | 44                    |       |
| Total long-term debt                                                                                                               |       | $                      | 587,864    |                  | $          | 587,653 |   |

 

*CODES*

 

In March 2003,the Company issued $575 million of CODES. The CODES, which are convertible into shares of Watson’s common stockupon the occurrence of certain events, are due in March 2023, withinterest payments due semi-annually in March and September at aneffective annual interest rate of 2.1%, excluding changes in fair value of thecontingent interest derivative. At September 30, 2005 and at December 31,2004, the unamortized discount for the CODES was $1.2 million and $1.4 million,respectively.

 

TheCODES are convertible into Watson’s common stock at a conversion price ofapproximately $40.05 per share (subject to certain adjustments upon certainevents such as (i) stock splits or dividends, (ii) material stockdistributions or reclassifications, (iii) distribution of stock purchaserights at less than current market rates, or (iv) a distribution of assetsor common stock to our shareholders or subsidiaries).  The CODES may be converted, at the option ofthe holders, prior to maturity under any of the following circumstances:

 

•                  duringany quarterly conversion period (period from and including the thirtiethtrading day in a fiscal quarter to, but not including, the thirtieth tradingday in the immediately following fiscal quarter) if the closing sale price pershare of Watson’s common stock for a period of at least 20 trading days duringthe 30 consecutive trading-day period ending on the first day of suchconversion period is more than 125% ($50.06) of the conversion price in effecton that thirtieth day;

 

•                  onor before March 15, 2018, during the five business-day period followingany 10 consecutive trading-day period in which the daily average trading pricefor the CODES for such ten-day period was less than 105% of the averageconversion value for the debentures during that period.  This conversion feature represents anembedded derivative.  However, based onthe de minimis value associated with this feature, no value has been assignedat issuance or at September 30, 2005;

 

•                  duringany period, following the earlier of (a) the date the CODES are rated byboth Standard & Poor’s Rating Services and Moody’s Investor Services, Inc.,and (b) April 21, 2003, when the long-term credit

 

14

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rating assigned to theCODES by either Standard & Poor’s or Moody’s (or any successors tothese entities) is lower than “BB” or “Ba3”, respectively, or when either ofthese rating agencies does not have a rating then assigned to the CODES for anyreason, including any withdrawal or suspension of a rating assigned to theCODES.  This conversion featurerepresents an embedded derivative. However, based on the de minimis value associated with this feature, novalue has been assigned at issuance or at September 30, 2005;

 

•                  ifthe CODES have been called for redemption; or

 

•                  uponthe occurrence of specified corporate transactions.

 

TheCompany may redeem some or all of the CODES for cash, on or after March 20,2008, for a price equal to 100% of the principal amount of the CODES plusaccrued and unpaid interest (including contingent interest) to, but excluding,the redemption date.

 

TheCODES contain put options which may require the Company to repurchase for cashall or a portion of the CODES on March 15 of 2010, 2015 and 2018 at arepurchase price equal to 100% of the principal amount of the CODES plus anyaccrued and unpaid interest (including contingent interest) to, but excluding,the date of repurchase.

 

Inaddition, the holders of the CODES have the right to receive contingentinterest payments during any six-month period from March 15 to September 14and from September 15 to March 14, commencing on September 15,2003, if the average trading price of the CODES for the five trading days endingon the second trading day immediately preceding the relevant six-month periodequals 120% or more of the principal amount of the CODES.  The interest rate used to calculate thecontingent interest is the greater of 5% of the Company’s then-current estimatedper annum borrowing rate for senior non-convertible fixed-rate debt with amaturity date and other terms comparable to that of the CODES or 0.33% perannum.  This contingent interest paymentfeature is an embedded derivative and has been bifurcated and recordedseparately in the Condensed Consolidated Balance Sheets in other long-termliabilities.  The initial fair valueassigned to the embedded derivative was $1.9 million, which is recorded as adiscount to the CODES.  Changes to thefair value of this embedded derivative are reflected as an adjustment tointerest expense.  At September 30,2005 and December 31, 2004 the fair value of the embedded derivative was approximately$1.7 million.

 

*1998Senior Notes*

 

In May 1998,Watson issued $150 million of its 1998 Senior Notes.  The 1998 Senior Notes are due in May 2008but may be redeemed earlier under certain circumstances.  The Company is required to make interest onlypayments due semi-annually in May and November.  The effective annual interest rate is7.2%.  At September 30, 2005 and December 31,2004, the unamortized discount for the 1998 Senior Notes was $46,000 and$59,000, respectively.

 

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

 

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

 

15

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*CreditFacility*

 

In May 2003, the Company entered into anagreement****with a syndicate of lenders for afive-year, $300 million senior, unsecured revolving credit facility (the “CreditFacility”) for working capital and other general corporate purposes.  On September 8, 2005, we entered into aSecond Amendment to the Credit Facility on substantially the same terms andconditions except the fee structure was reduced and certain defined terms wereadded or amended.  Watson’s assetsgenerally are held by, and its operations generally are conducted through, itssubsidiaries.  Within the meaning of RegulationS-X, Rule 3-10, the Company has no assets or operations independent of itssubsidiaries.  The terms of the CreditFacility require each subsidiary, other than minor subsidiaries, to providefull and unconditional guarantees on a joint and several basis. In order toprovide subsidiary guarantees in connection with this Credit Facility, theCompany was also required, by the terms of the Indenture for the 1998 SeniorNotes, to grant similar subsidiary guarantees in favor of the 1998 Senior Noteholders. The subsidiary guarantees related to both the Credit Facility and the1998 Senior Notes are full and unconditional, on a joint and several basis, andare given by all subsidiaries other than minor subsidiaries.  Watson is subject to certain financial andoperational covenants, all of which, as of September 30, 2005 and December31, 2004, the Company was in compliance. As of September 30, 2005 and December 31, 2004, the Company had notdrawn any funds from the Credit Facility.

 

**NOTE 7 –FINANCIAL INSTRUMENTS**

 

*Fairvalue of financial instruments*

 

The Company’s financial instruments consist primarilyof cash and cash equivalents, marketable securities, accounts and otherreceivables, investments, trade accounts payable, 1998 Senior Notes, CODES andembedded derivatives related to the issuance of the CODES.  The carrying amounts of cash and cashequivalents, marketable securities, accounts and other receivables and tradeaccounts payable are representative of their respective fair values due totheir relatively short maturities.  Thefair values of investments in companies that are publicly traded are based onquoted market prices.  The fair value ofinvestments in privately held companies, or cost-method investments, are basedon historical cost, adjusted for any write-down related to impairment.  The Company estimates the fair value of itsfixed rate long-term obligations based on quoted market rates of interest andmaturity schedules for similar issues. The carrying value of these obligations approximates their fairvalue.  The fair value of the embeddedderivatives related to the CODES is based on a present value technique usingdiscounted expected future cash flows.

 

*Derivativefinancial instruments*

 

The Company’s derivative financial instruments consistof embedded derivatives related to its CODES. These embedded derivatives include certain conversion features and acontingent interest feature.   See Note 6for a more detailed description of these features of the CODES.  Although the conversion features representembedded derivative financial instruments, based on the de minimis value ofthese features at the time of issuance and at September 30, 2005, no valuehas been assigned to these instruments. The contingent interest feature provides unique tax treatment under theInternal 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) within interest expense in theCompany’s Condensed Consolidated Statements of Income.

 

The carrying value of the Company’s derivativefinancial instruments, which approximates fair value, was approximately $1.7million at December 31, 2004 and at September 30, 2005.  Changes in fair value are recognized as anadjustment to interest expense during the respective period.

 

16

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**NOTE 8 –COMMITMENTS AND CONTINGENCIES**

 

*Facility and equipment leases*

 

The Company has entered intolong-term operating leases for certain facilities and equipment.  The terms of the operating leases for theCompany’s facilities require the Company to pay property taxes, normalmaintenance expenses and maintain minimum insurance coverage.  Total rental expense for operating leases forthe nine months ended September 30, 2005 and 2004 were $7.8 million and $8.7 million, respectively.

 

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

 
| **Period ending December 31,** | ** ** | ** ** | ** ** |
|-------------------------------------|------------|------------|------------|
| ** **                          | ** ** | ** ** | ** ** |
| 2005                                |       | $          | 1,842      |   |
| 2006                                |       | 7,127      |       |
| 2007                                |       | 5,526      |       |
| 2008                                |       | 3,355      |       |
| 2009                                |       | 2,604      |       |
| Thereafter                          |       | 14,298     |       |
| Total                               |       | $          | 34,752     |   |

 

*Employee retirement plans*

 

The Company maintainscertain defined contribution retirement plans covering substantially allemployees.  The Company contributes tothe plans based upon the employee contributions.  The Company does not sponsor any definedbenefit retirement plans or postretirement benefit plans.  Watson’s contributions to these retirementplans for the three and nine months ended September 30, 2005 were $1.4 million and $4.8 million,respectively.  Watson’s contributions tothese retirement plans for the three and nine months ended September 30,2004 were $1.6 million and $5.5million, respectively.

 

*Legal matters*

 

The Company is party to certain lawsuits and legalproceedings, which are described in “Part I, Item 3. Legal Proceedings,”of our Annual Report on Form 10-K for the year ended December 31,2004.  The following is a description ofmaterial developments during the period covered by this Quarterly Report andthrough the filing of this Quarterly Report, and should be read in conjunctionwith the Annual Report referenced above.

 

*Phen-fen litigation.*  With respect to the phenterminehydrochloride product liability lawsuits pending against the Company, certainsubsidiaries, and others, additional actions raising similar issues have beenfiled, and some actions have been settled or otherwise dismissed.  As of November 4,2005, approximately 35 cases were pending against Watson and its affiliates innumerous state and federal courts.  Most of the cases involve multipleplaintiffs, and several were filed or certified as class actions.  TheCompany believes it will be fully indemnified by Rugby’s former owner, AventisPharmaceuticals (“Aventis”, formerly known as Hoechst Marion Roussel, Inc.,and now known as Sanofi-Aventis) for the defense of all such cases and for anyliability that may arise out of these cases.  Aventis is currentlycontrolling the defense of all these matters as the indemnifying party underits agreements with the Company.

 

*Cipro® Litigation.** * On August 25, 2005, defendants filed amotion to transfer the appeals of the judgment in defendants’ favor in theconsolidated action from the United States Court of Appeals for the SecondCircuit to the United States Court of Appeals for the Federal Circuit.  Appellants filed their briefs in oppositionto the motion to transfer on or about September 26, 2005.  Defendants filed their reply in support ofthe motion to transfer on October 21, 2005.  All parties have requested oral argument onthe motion.

 

17

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In the New York State court Cipro® action, which thecourt dismissed in 2004, and in which the plaintiffs filed a Notice of Appeal inOctober 2004, the appellants filed their appellate brief on July 27,2005.  The defendants/appellees filedtheir joint response brief on September 7, 2005.  The court has scheduled oral argument of theappeal on November 22, 2005.

 

*Governmental ReimbursementInvestigations and Drug Pricing Litigation.* With respect to the Drug PricingLitigation pending against the Company and certain subsidiaries, an additionalaction raising similar allegations was filed by the Attorney General of theState of Mississippi on October 20, 2005, in the Chancery Court of HindsCounty, Mississippi *(State of Mississippi v.Abbott Laboratories, Inc. et al, Civil Action No. G2005-2021 S/2)*.  With respect to the actions filed bygovernmental subdivisions of New York State, 27 of the 36 New York State countyactions and the action filed by the City of New York have been consolidatedinto the Consolidated Action pending in the United States District Court forthe District of Massachusetts *(In re PharmaceuticalIndustry Average Wholesale Price Litigation, MDL Docket No. 1456, CivilAction No. 01-CV-12257-PBS)*. Several federal district courts have remanded cases to state court thatthe defendants had removed to federal court. Additional actions are anticipated. The Company intends to defend these actions vigorously.  However, if successful, these actions couldadversely affect the Company and may have a material adverse effect on theCompany’s business, results of operations, financial condition and cash flows.

 

*Hormone Replacement TherapyLitigation**.*  With respect to the hormone replacementtherapy product liability lawsuits pending against the Company, certain of itssubsidiaries, and other third parties, additional actions raising similarallegations have been filed, and some actions have been dismissed.  As of November 4,2005, there were approximately 85 cases pending against the Company and itsaffiliates in various state and federal courts, representing claims byapproximately 750 plaintiffs.  Many of the cases seek certification asclass actions.  These actions, if successful, could adversely affect theCompany and could have a material adverse effect on the Company’s business,results of operations, financial condition and cash flows.

 

Watson and its affiliates are involved in variousother disputes, governmental and/or regulatory inspections, inquires,investigations and proceedings, and litigation matters that arise from time totime in the ordinary course of business.  The process of resolving mattersthrough litigation or other means is inherently uncertain and it is possiblethat an unfavorable resolution of these matters will adversely affect theCompany, its results of operations, financial condition and cash flows.

 

**NOTE 9 –SUBSEQUENT EVENT**

 

On October 11,2005 the Company initiated a plan to consolidate certain manufacturingfacilities as part of an ongoing effort to optimize the capacity utilization ofthe Company’s manufacturing operations. As a result, we plan to transfer existing product manufacturing from ourHumacao, Puerto Rico site to our facilities located in Carmel, New York andCorona, California over the next 18 to 24 months.  In conjunction with the closure of our PuertoRico facility, we may record a non-cash asset impairment charge in the fourthquarter of 2005.  A current estimate ofcharges, if any, relating to this restructuring has not been determined.  The net book value of property and equipmentlocated in Puerto Rico as at September 30, 2005 is approximately $41million.  Under SFAS No. 146,“Accounting for Costs Associated with Exit or Disposal Activities,” costsassociated with exit or disposal activities are recognized when the liabilityis incurred rather than at the date of a commitment to an exit or disposalplan.  Accordingly, additional cash costswill be recognized in future periods as we transition production to other sitesand we incur product transfer, severance and decommissioning costs.

 

18

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

 

Thefollowing discussion of our financial condition and the results of ouroperations should be read in conjunction with the Condensed ConsolidatedFinancial Statements and notes thereto included elsewhere in this QuarterlyReport on Form 10-Q (“Quarterly Report”). This discussion contains forward-looking statements that are subject toknown and unknown risks, uncertainties and other factors that may cause ouractual results to differ materially from those expressed or implied by suchforward-looking statements.  These risks,uncertainties and other factors include, among others, those identified under “CautionaryNote Regarding Forward-Looking Statements” and elsewhere in this QuarterlyReport and under “Risks Related to our Business” in our Annual Report on Form 10-Kfor the year ended December 31, 2004.

 

**Overview**

 

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

 

Prescription pharmaceutical products in the U.S. aregenerally marketed as either generic or brand pharmaceuticals.  Generic pharmaceutical products arebioequivalents of their respective brand products and provide a cost-efficientalternative to brand products. Brand pharmaceutical products are marketed underbrand names through programs that are designed to generate physician andconsumer loyalty.  As a result of thedifferences between the two types of products, we operate and manage ourbusiness as two segments: Generic and Brand.

 

**Resultsof Operations**

 

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

 

***NetRevenues***

 
| ** **                 | ** ** | **Three Months Ended September 30,** | ** ** | **Change** | ** ** |
|----------------------------|------------|-------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2005**                                  | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                       |       |                                      |       |       |       |   |   |   |   |
| Generic product sales      |       | $                                         | 315,234    |       | $          | 303,337 |   | $ | 11,897 |   | 3.9 | % |
| *% of product net sales*   | * *   | *77*                                      | *%*        | *76*       | %          |   |   |   |   |
| Brand product sales        |       |                                      |       |       |       |   |   |   |   |
| Specialty Products         |       | 46,385                                    |       | 54,086     |       | (7,701 | ) | -14.2 | % |
| Nephrology                 |       | 45,169                                    |       | 43,486     |       | 1,683 |   | 3.9 | % |
| Total brand product sales  |       | 91,554                                    |       | 97,572     |       | (6,018 | ) | -6.2 | % |
| *% of product net sales*   | * *   | *23*                                      | *%*        | *24*       | *%*        | * * | * * | * * | * * |
| * *                   | * *   | * *                                  | * *   | * *   | * *   | * * | * * | * * | * * |
| Total product net sales    |       | 406,788                                   |       | 400,909    |       | 5,879 |   | 1.5 | % |
| Other                      |       | 3,508                                     |       | 7,109      |       | (3,601 | ) | -50.7 | % |
| Total net revenues         |       | $                                         | 410,296    |       | $          | 408,018 |   | $ | 2,278 |   | 0.6 | % |

 

*GenericSegment*

 

Our Generic segment develops, manufactures, markets,sells and distributes generic products that are the therapeutic equivalent totheir brand name counterparts and are generally sold at prices significantlyless than the brand product. As such, generic products provide an effective andcost-efficient alternative to brand products. When patents or other regulatoryexclusivities no longer protect a brand product, opportunities exist tointroduce off-patent or generic counterparts to the brand product. Ourportfolio of generic products includes products we have internally developed,products we have licensed from third parties, and products we distribute forthird parties.

 

19

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Salesfrom our Generic segment during the three months ended September 30, 2005increased $11.9 million or 3.9% over sales from the same period of the prioryear.  Increased sales of certain oralcontraceptives and several products launched since the third quarter of 2004 werepartially offset by a decrease in sales of nicotine gum related to the entry ofa competitor in that product line in December 2004.

 

Sales of our generic oral contraceptive productsrepresented 26% and 25% of total generic sales for the three months ended September 30,2005 and 2004, respectively.

 

*BrandSegment*

 

OurBrand segment develops, manufactures, markets, sells and distributes productswithin two sales and marketing groups: Specialty Products and Nephrology.

 

OurSpecialty Products product line includes products for the treatment of urologicdisorders, including palliative cancer treatment, and also includes: (i) hormonereplacement therapy products and (ii) a genital warts treatment.

 

OurNephrology product line consists of products for the treatment of irondeficiency anemia and is generally marketed to nephrologists and dialysiscenters.  The major product within theNephrology product line is Ferrlecit®, which is used to treat low iron levelsin patients undergoing hemodialysis in conjunction with erythropoietin therapy.

 

The$6.0 million or 6.2% decrease in sales from our Brand segment for the threemonths ended September 30, 2005, as compared to the same prior yearperiod, was attributable to a decrease in sales within our Specialty Products group.  The decrease in sales within SpecialtyProducts resulted primarily from a decline in prescription volumes which wasoffset in part by sales ofour Trelstar® Depot and Trelstar® LA (collectively “Trelstar®”) productslaunched earlier this year for the palliative treatment of advanced prostatecancer.

 

Salesfrom our Nephrology product line increased $1.7 million or 3.9% due to anincrease in unit sales of our Ferrlecit® product.  For the three months ended September 30, 2005and 2004, Ferrlecit® represented approximately 81% and 80% of sales, respectively,from our Nephrology product line.

 

*Other*

 

Other revenues include revenues earned underresearch and development agreements, other agreements and royalties.  Revenues recognized from research, developmentand licensing agreements (including milestone payments) are deferred andrecognized over the entire contract performance period, starting with thecontract’s commencement, but not prior to the removal of any contingencies foreach individual milestone.  We recognizethis revenue based upon the pattern in which the revenue is earned or theobligation is fulfilled.

 

Thedecrease in other revenues in the three months ended September 30, 2005was primarily related to a decline in the amount of deferred revenue recognizedin the quarter.

 

20

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

 
| ** **                        | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------|------------|------------------------|------------|
| ** **                        | ** ** | **September 30,** | ** ** |
| ** **                        | ** ** | **2005**               | ** ** | **2004** | ** ** | **Change** | ** ** |
|                              |       |                   |       |   |   |   |   |
| Overall Consolidated Gross Margin |       | 48.6                   | %          | 50.4 | % | -1.8 | % |
|                              |       |                   |       |   |   |   |   |
| Generic product sales             |       | 40.6                   | %          | 39.8 | % | 0.8 | % |
| Brand product sales               |       | 74.4                   | %          | 79.5 | % | -5.1 | % |
| Gross margin on product net sales |       | 48.2                   | %          | 49.5 | % | -1.3 | % |

 

Grossprofit decreased by $6.0 million to $199.5 million during the three monthsended September 30, 2005 from $205.5 million during same period of2004.  The primary contributors to the $6.0million gross profit decline from the prior year period were changes to theproduct mix with lower margin generic product sales increasing and highermargin brand product sales at lower levels and a reduction in other revenues.

 

The decrease in our consolidated gross marginduring the three months ended September 30, 2005 compared to the sameperiod of the prior year was a result of the reduction in other revenues and margindeclines within our Specialty Products product line due to reduced productionlevels at certain manufacturing facilities resulting in higher unit overheadabsorption for these products.  Grossmargins in our Generic segment and our Nephrology product line increasedslightly compared to the prior year period.

 

***Researchand Development Expenses***

 
| ** **                                    | ** ** | **Three Months Ended September 30,** | ** ** | **Change** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------|------------|------------|------------|
| **($ in thousands):**                    | ** ** | **2005**                                  | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                          |       |                                      |       |       |       |   |   |   |   |
| Research and development expenses by segment: |       |                                      |       |       |       |   |   |   |   |
| Generic                                       |       | $                                         | 18,493     |       | $          | 19,153 |   | $ | (660 | ) | -3.4 | % |
| Brand                                         |       | 11,347                                    |       | 15,108     |       | (3,761 | ) | -24.9 | % |
| Total research and development expenses       |       | $                                         | 29,840     |       | $          | 34,261 |   | $ | (4,421 | ) | -12.9 | % |
| *as % of net revenues*                        | * *   | *7.3*                                     | *%*        | *8.4*      | %          |   |   |   |   |

 

Researchand development expenses consist predominantly of personnel costs, contractresearch, development and facilities costs associated with the development ofour products.

 

Brand research and development expenses decreasedfrom the prior year period due mainly to a $2.2 million restructuringcharge recorded in the third quarter of 2004.

 

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

 
| ** **                                         | ** ** | **Three Months Ended September 30,** | ** ** | **Change** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------|------------|------------|------------|
| **($ in thousands):**                         | ** ** | **2005**                                  | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                               |       |                                      |       |       |       |   |   |   |   |
| Selling and marketing expenses by segment:         |       |                                      |       |       |       |   |   |   |   |
| Generic                                            |       | $                                         | 12,800     |       | $          | 11,586 |   | $ | 1,214 |   | 10.5 | % |
| Brand                                              |       | 28,867                                    |       | 36,926     |       | (8,059 | ) | -21.8 | % |
| Total segment selling and marketing expenses       |       | 41,667                                    |       | 48,512     |       | (6,845 | ) | -14.1 | % |
|                                               |       |                                      |       |       |       |   |   |   |   |
| Corporate general and administrative               |       | 23,508                                    |       | 32,066     |       | (8,558 | ) | -26.7 | % |
| Total selling, general and administrative expenses |       | $                                         | 65,175     |       | $          | 80,578 |   | $ | (15,403 | ) | -19.1 | % |
| *as % of net revenues*                             | * *   | *15.9*                                    | *%*        | *19.7*     | *%*        | * * | * * | * * | * * |

 

Selling,general and administrative expenses consist mainly of personnel costs,facilities costs, insurance, depreciation, distribution costs and professionalservices costs.

 

Brand segment selling and marketing expenses decreasedduring the three months ended September 30, 2005 as compared to the same period of theprior year due mainly to cost savings from the termination of a contract salesforce agreement and a restructuring charge taken during the third quarter of2004.  Corporate general andadministrative expenses decreased compared to the prior year period due tohigher severance and legal services costs in the prior period quarter. Corporategeneral and administrative expenses were also higher in the prior year perioddue to costs related to our Enterprise Resource Planning (“ERP”) systemimplementation. Selling, general and administrative expenses in the thirdquarter of 2004 included a $6.3 million restructuring charge.

 

***Amortization***

 
| ** **                 | ** ** | **Three Months Ended September 30,** | ** ** | **Change** | ** ** |
|----------------------------|------------|-------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2005**                                  | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                       |       |                                      |       |       |       |   |   |   |   |
| Amortization               |       | $                                         | 41,100     |       | $          | 18,040 |   | $ | 23,060 |   | 127.8 | % |
| *as % of net revenues*     | * *   | *10.0*                                    | *%*        | *4.4*      | *%*        | * * | * * | * * | * * |
|                            |            |                                           |            |            |            |  |  |  |  |  |  |  |

 

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

 

***Losson Impairment of Product Rights***

 
| ** **                           | ** ** | **Three Months Ended September 30,** | ** ** | **Change** | ** ** |
|--------------------------------------|------------|-------------------------------------------|------------|------------|------------|
| **($ in thousands):**           | ** ** | **2005**                                  | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                 |       |                                      |       |       |       |   |   |   |   |
| Loss on impairment of product rights |       | $                                         | —     |       | $          | 46,100 |   | $ | (46,100 | ) | -100.0 | % |
| *as % of net revenues*               | * *   | *0.0*                                     | *%*        | *11.3*     | *%*        | * * | * * | * * | * * |
|                                      |            |                                           |            |            |            |  |  |  |  |  |  |  |

 

In thethree months ended September 30, 2004, we recognized a $46.1 millionimpairment charge relating to our Tri-Norinyl® product rights as a result of theannouncement of an Abbreviated New Drug Application (“ANDA”) approval andintroduction of a generic version of the Tri-Norinyl® oral contraceptive tablets by a competitor in the market.

 

22

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***Equityin Losses of Joint Ventures***

 
| ** **                         | ** ** | **Three Months Ended September 30,** | ** ** | **Change** | ** ** |
|------------------------------------|------------|-------------------------------------------|------------|------------|------------|
| **($ in thousands):**         | ** ** | **2005**                                  | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                               |       |                                      |       |       |       |   |   |   |   |
| Equity in losses of joint ventures |       | $                                         | (284       | )          | $          | (810 | ) | $ | 526 |   | -64.9 | % |
| *as % of net revenues*             | * *   | *-0.1*                                    | *%*        | *-0.2*     | *%*        | * * | * * | * * | * * |
|                                    |            |                                           |            |            |            |  |  |  |  |  |  |  |

 

TheCompany’s equity investments are accounted for under the equity-method when theCompany’s ownership does not exceed 50% and when the Company can exertsignificant influence over the management of the investee.  The loss recorded during the three monthsended September 30, 2005 and 2004 represents our equity in losses incurredby Somerset Pharmaceuticals, Inc. (“Somerset”), our joint venture withMylan Laboratories, Inc., due to expenses associated with ongoing trials,operational costs and the remaining U.S. Food and Drug Administration (“FDA”)requirements relating to Emsam®, a selegiline patch for the treatment ofdepression.

 

***Gainon Sale of Securities***

 
| ** **                  | ** ** | **Three Months Ended September 30,** | ** ** | **Change** | ** ** |
|-----------------------------|------------|-------------------------------------------|------------|------------|------------|
| **($ in thousands):**  | ** ** | **2005**                                  | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
| ** **                  | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Gain on sale of  securities |       | $                                         | —     |       | $          | 1,799 |   | $ | (1,799 | ) | -100.0 | % |
| *as % of net revenues*      | * *   | *0.0*                                     | *%*        | *0.4*      | *%*        | * * | * * | * * | * * |
|                             |            |                                           |            |            |            |  |  |  |  |  |  |  |

 

The2004 gain on sale of securities resulted from the sale of a portion of ourinvestment in the common stock of Andrx Corporation (“Andrx”).  For the three months ended September 30,2004, we sold a total of 90,000 shares of Andrx common stock for proceeds of$2.0 million.  We did not sell anysecurities during the three months ended September 30, 2005.  At September 30, 2005, we heldapproximately 607,000 shares of Andrx common stock at a fair value of $9.4million with a gross unrealized holding gain of $7.8 million.

 

***InterestExpense***

 
| ** **                                                                                         | ** ** | **Three Months Ended September 30,** | ** ** | **Change** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------|------------|
| **($ in thousands):**                                                                         | ** ** | **2005**                                  | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
| ** **                                                                                         | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest expense - convertible contingent senior  debentures due 2023 (“CODES”)          |       | $                                         | 3,151      |       | $          | 3,547 |   | $ | (396 | ) | -11.2 | % |
| Interest expense - senior unsecured notes issued in May 1998  (“1998 Senior Notes”) |       | 255                                       |       | 356        |       | (101 | ) | -28.4 | % |
| Interest and fees on credit facility                                                               |       | 387                                       |       | 429        |       | (42 | ) | -9.8 | % |
| Change in derivative value                                                                         |       | 853                                       |       | (672       | )          | 1,525 |   | -226.9 | % |
| Interest expense - other                                                                           |       | 44                                        |       | 21         |       | 23 |   | 109.5 | % |
| Total interest expense before capitalized interest                                                 |       | 4,690                                     |       | 3,681      |       | 1,009 |   | 27.4 | % |
| Capitalized interest                                                                               |       | —                                    |       | —     |       | — |   | 0.0 | % |
| Interest expense                                                                                   |       | $                                         | 4,690      |       | $          | 3,681 |   | $ | 1,009 |   | 27.4 | % |
| *as % of net revenues*                                                                             | * *   | *1.1*                                     | *%*        | *0.9*      | %          |   |   |   |   |

 

Interestexpense increased for the three month period ended September 30, 2005 overthe same period in the prior year due to an increase in the fair value of thederivative in the current period (as described in Notes 6 and 7 in theaccompanying Notes to Condensed Consolidated Financial Statements in thisQuarterly Report).

 

***Segment Contribution***

 
| ** ** | ** **                 | ** ** | **Three Months Ended September 30,** | ** ** | **Change** | ** ** |
|------------|----------------------------|------------|-------------------------------------------|------------|------------|------------|
| ** ** | **($ in thousands):** | ** ** | **2005**                                  | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|       |                       |       |                                      |       |       |       |   |   |   |   |
|       | Segment  contribution      |       |                                      |       |       |       |   |   |   |   |
|       | Generic                    |       | $                                         | 97,751     |       | $          | 91,330 |   | $ | 6,421 |   | 7.0 | % |
|       | Brand                      |       | 30,229                                    |       | 31,407     |       | (1,178 | ) | -3.8 | % |
|       |                       |       | $                                         | 127,980    |       | $          | 122,737 |   | $ | 5,243 |   | 4.3 | % |
| * *   | *as % of  net revenues*    | * *   | *31.2*                                    | *%*        | *29.9*     | *%*        | * * | * * | * * | * * |

 

Generic segment contribution increased for the threemonths ended September 30, 2005, as compared to the same period of theprior year, due to an increase in sales of certain oral contraceptives andsales of certain generic products launched since the third quarter of 2004.

 

Brand segment contribution decreased during the threemonths ended September 30, 2005, as compared to the same period of theprior year, primarily due to a decrease in sales of certain Specialty Products which were impacted by a decline inprescription volumes.

 

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

 

23

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***NineMonths Ended September 30, 2005 Compared to the Nine Months Ended September 30,2004***

 

***NetRevenues***

 
| ** **                 | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|----------------------------|------------|------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2005**                                 | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                       |       |                                     |       |       |       |   |   |   |   |
| Generic product sales      |       | $                                        | 920,850    |       | $          | 914,925 |   | $ | 5,925 |   | 0.6 | % |
| *% of product net sales*   | * *   | *76*                                     | *%*        | *77*       | %          |   |   |   |   |
| Brand product sales        |       |                                     |       |       |       |   |   |   |   |
| Specialty Products         |       | 164,557                                  |       | 141,586    |       | 22,971 |   | 16.2 | % |
| Nephrology                 |       | 132,269                                  |       | 128,872    |       | 3,397 |   | 2.6 | % |
| Total brand product sales  |       | 296,826                                  |       | 270,458    |       | 26,368 |   | 9.7 | % |
| *% of product net sales*   | * *   | *24*                                     | *%*        | *23*       | *%*        | * * | * * | * * | * * |
| * *                   | * *   | * *                                 | * *   | * *   | * *   | * * | * * | * * | * * |
| Total product net sales    |       | 1,217,676                                |       | 1,185,383  |       | 32,293 |   | 2.7 | % |
| Other                      |       | 9,714                                    |       | 31,661     |       | (21,947 | ) | -69.3 | % |
| Total net revenues         |       | $                                        | 1,227,390  |       | $          | 1,217,044 |   | $ | 10,346 |   | 0.9 | % |

 

*Generic Segment*

 

The $5.9 million or 0.6% increase in sales from our Generic segment forthe nine months ended September 30, 2005 was primarily due to increasedsales of oral contraceptive products and several products launched since thethird quarter of 2004.  These increased unit sales in the above Genericsegment were offset in part by lower sales of nicotine gum as a competitorlaunched a nicotine gum product in December 2004.  Sales of oral contraceptive productsrepresented 26% and 23% of total Generic segment sales for the nine monthsended September 30, 2005 and 2004, respectively.

 

Sales within the Generic segment are expected to total approximately $1.24billion for the year ended December 31, 2005.

 

*Brand Segment*

 

The $26.4 millionor 9.7% increase in sales from our Brand segment for the nine months ended September 30,2005, as compared to the same prior year period, was primarily attributable toan increase in sales within our Specialty Products product line.  The increase in net sales of SpecialtyProducts resulted primarily from the launch of our Trelstar® products earlier this year and lower comparableprior year period sales levels for Oxytrol® and Androderm® due to wholesaler inventoryreductions.

 

Sales from ourNephrology product line increased $3.4 million or 2.6% due to an increase insales of our Ferrlecit® product.  For thenine months ended September 30, 2005 and 2004, Ferrlecit® representedapproximately 81% of sales from our Nephrology product line.

 

Sales within the Brand segment are expected to total approximately $385million for the year ended December 31, 2005.

 

*Other*

 

The decrease inother revenues in the nine months ended September 30, 2005 was primarilyrelated to the absence of royalty payments from Aventis Pharmaceuticals (“Aventis”, formerly known asHoechst Marion Roussel, Inc., and now known as Sanofi Aventis) inconnection with Barr Laboratories, Inc.’s sales of ciprofloxacintablets.  Several companies launchedcompetitive products into the ciprofloxacin market during the second half of2004.

 

24

----

 

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

 

| ** **                        | ** ** | **Nine Months Ended**  | ** ** |
|-----------------------------------|------------|------------------------|------------|
| ** **                        | ** ** | **September 30,** | ** ** |
| ** **                        | ** ** | **2005**               | ** ** | **2004** | ** ** | **Change** | ** ** |
|                              |       |                   |       |   |   |   |   |
| Overall Consolidated Gross Margin |       | 48.8                   | %          | 50.9 | % | -2.1 | % |
|                              |       |                   |       |   |   |   |   |
| Generic product sales             |       | 39.3                   | %          | 40.9 | % | -1.6 | % |
| Brand product sales               |       | 76.3                   | %          | 78.8 | % | -2.5 | % |
| Gross margin on product net sales |       | 48.3                   | %          | 49.6 | % | -1.3 | % |

 

The decrease ingross margin from our Generic segment for the nine months ended September 30,2005 was primarily due to price reductions on certain generic products(particularly nicotine gum).

 

Gross margin fromour Brand segment decreased due to reduced production levels at certainmanufacturing facilities resulting in higher unit overhead costs during thefirst nine months of 2005 as compared to the same period of the prior year.

 

The $21.9 million decrease in other revenues during the ninemonths ended September 30, 2005 was also a factor in the reduction of ouroverall consolidated gross margin as compared to the same period of the prioryear.

 

Overall grossmargins are expected to be between 48.5% and 49% for 2005.

 

***Researchand Development Expenses***

 
| ** **                                    | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|-----------------------------------------------|------------|------------------------------------------|------------|------------|------------|
| **($ in thousands):**                    | ** ** | **2005**                                 | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                          |       |                                     |       |       |       |   |   |   |   |
| Research and development expenses by segment: |       |                                     |       |       |       |   |   |   |   |
| Generic                                       |       | $                                        | 59,455     |       | $          | 54,113 |   | $ | 5,342 |   | 9.9 | % |
| Brand                                         |       | 30,709                                   |       | 52,358     |       | (21,649 | ) | -41.3 | % |
| Total research and development expenses       |       | $                                        | 90,164     |       | $          | 106,471 |   | $ | (16,307 | ) | -15.3 | % |
| *as % of net revenues*                        | * *   | *7.3*                                    | *%*        | *8.7*      | *%*        | * * | * * | * * | * * |

 

Research anddevelopment expenses within our Generic segment increased $5.3 million or 9.9% duringthe nine months ended September 30, 2005, as compared to the same periodof the prior year, due to an increase in the number of generic products beingdeveloped.

 

During the ninemonths ended September 30, 2004, research and development expenses within our Brand segment included a$10 million milestone payment to Kissei Pharmaceutical Co., Ltd., related tosilodosin.   In addition, Brand researchand development expenses included a $2.2 million restructuring chargerecorded in the third quarter of 2004. Cost savings resulting from the refocusing of Brand product development,announced during the second quarter of 2004, also contributed to the reductionin Brand segment research and development expenses.

 

We expect researchand development spending to be approximately 7.5% of revenues for 2005 due inpart to costs associated with the Phase 3 studies currently underway on thesilodosin product for benignprostatic hyperplasia (“BPH”) in the current year period.

 

25

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

 
| ** **                                         | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|----------------------------------------------------|------------|------------------------------------------|------------|------------|------------|
| **($ in thousands):**                         | ** ** | **2005**                                 | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                               |       |                                     |       |       |       |   |   |   |   |
| Selling and marketing expenses by segment:         |       |                                     |       |       |       |   |   |   |   |
| Generic                                            |       | $                                        | 35,748     |       | $          | 32,035 |   | $ | 3,713 |   | 11.6 | % |
| Brand                                              |       | 86,867                                   |       | 121,594    |       | (34,727 | ) | -28.6 | % |
| Total segment selling and marketing expenses       |       | 122,615                                  |       | 153,629    |       | (31,014 | ) | -20.2 | % |
|                                               |       |                                     |       |       |       |   |   |   |   |
| Corporate general and administrative               |       | 74,336                                   |       | 83,529     |       | (9,193 | ) | -11.0 | % |
| Total selling, general and administrative expenses |       | $                                        | 196,951    |       | $          | 237,158 |   | $ | (40,207 | ) | -17.0 | % |
| *as % of net revenues*                             | * *   | *16.0*                                   | *%*        | *19.5*     | *%*        | * * | * * | * * | * * |

 

Brand segment selling and marketing expenses decreased $34.7 million or28.6% during the nine months ended September 30, 2005 as compared to the same period of theprior year due to cost reductions realized from the termination of a contractsales force agreement and a restructuring charge taken during the third quarterof 2004. Corporate general and administrative expenses decreased during thisperiod due to higher severance, higher costs related to the Company aircraft andhigher costs related to our ERP system implementation in the prior year period.Selling, general and administrative expenses in the third quarter of 2004 includeda $6.3 million restructuring charge.

 

We expect ourselling, general and administrative expenses to represent 16.0% of net revenuesfor 2005.

 

***Amortization***

 
| ** **                 | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|----------------------------|------------|------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2005**                                 | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                       |       |                                     |       |       |       |   |   |   |   |
| Amortization               |       | $                                        | 122,839    |       | $          | 53,955 |   | $ | 68,884 |   | 127.7 | % |
| *as % of net revenues*     | * *   | *10.0*                                   | *%*        | *4.4*      | *%*        | * * | * * | * * | * * |
|                            |            |                                          |            |            |            |  |  |  |  |  |  |  |

 

The increase inamortization in the nine months ended September 30, 2005 was primarily dueto the acceleration of amortization associated with our Ferrlecit® productrights.

 

***Losson Impairment of Product Rights***

 
| ** **                           | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|------------|------------|
| **($ in thousands):**           | ** ** | **2005**                                 | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                 |       |                                     |       |       |       |   |   |   |   |
| Loss on impairment of product rights |       | $                                        | —     |       | $          | 46,100 |   | $ | (46,100 | ) | -100.0 | % |
| *as % of net revenues*               | * *   | *0.0*                                    | *%*        | *3.8*      | *%*        | * * | * * | * * | * * |
|                                      |            |                                          |            |            |            |  |  |  |  |  |  |  |

 

In thenine months ended September 30, 2004, we recognized a $46.1 millionimpairment charge relating to our Tri-Norinyl® product rights as a result of theannouncement of an ANDA approval and introduction of a generic version of theTri-Norinyl® oral contraceptivetablets by a competitor in the market.

 

26

----

 

***Equityin Losses of Joint Ventures***

 
| ** **                         | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|------------------------------------|------------|------------------------------------------|------------|------------|------------|
| **($ in thousands):**         | ** ** | **2005**                                 | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                               |       |                                     |       |       |       |   |   |   |   |
| Equity in losses of joint ventures |       | $                                        | (442       | )          | $          | (4,089 | ) | $ | 3,647 |   | -89.2 | % |
| *as % of net revenues*             | * *   | *0.0*                                    | *%*        | *-0.3*     | *%*        | * * | * * | * * | * * |
|                                    |            |                                          |            |            |            |  |  |  |  |  |  |  |

 

Theloss recorded during the nine months ended September 30, 2005 and 2004represents our equity in losses incurred by Somerset, our joint venture withMylan Laboratories, Inc., due to expenses associated with ongoing trials,operational costs and the remaining FDA requirements relating to Emsam®, aselegiline patch for the treatment of depression.

 

***Gainon Sale of Securities***

 
| ** **                 | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|----------------------------|------------|------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2005**                                 | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                       |       |                                     |       |       |       |   |   |   |   |
| Gain on sale of securities |       | $                                        | —     |       | $          | 5,737 |   | $ | (5,737 | ) | -100.0 | % |
| *as % of net revenues*     | * *   | *0.0*                                    | *%*        | *0.5*      | *%*        | * * | * * | * * | * * |
|                            |            |                                          |            |            |            |  |  |  |  |  |  |  |

 

The2004 gain on sale of securities resulted from the sale of a portion of ourinvestment in the common stock of Andrx. For the nine months ended September 30, 2004, we sold a total of240,000 shares of Andrx common stock for proceeds of $6.3 million.  We did not sell any of our investment securitiesduring the nine months ended September 30, 2005.  At September 30, 2005, we heldapproximately 607,000 shares of Andrx common stock at a fair value of $9.4million with a gross unrealized holding gain of $7.8 million.

 

***Losson Early Extinguishment of Debt***

 
| ** **                           | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|------------|------------|
| **($ in thousands):**           | ** ** | **2005**                                 | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                 |       |                                     |       |       |       |   |   |   |   |
| Loss on early extinguishment of debt |       | $                                        | —     |       | $          | 17,752 |   | $ | (17,752 | ) | -100.0 | % |
| *as % of net revenues*               | * *   | *0.0*                                    | *%*        | *1.5*      | *%*        | * * | * * | * * | * * |
|                                      |            |                                          |            |            |            |  |  |  |  |  |  |  |

 

Duringthe first half of 2004, we repurchased $135.9 million of our 1998 Senior Notesfor total consideration of $152.5 million, representing a 12% premium over eachnote’s face value.  As a result of therepurchase, we incurred $14.0 million and $3.7 million in charges related tofees, expenses, unamortized discount, and the premiums paid in the first andsecond quarters of 2004, respectively (as described in Notes 6 and 7 in theaccompanying Notes to Condensed Consolidated Financial Statements in thisQuarterly Report).

 

27

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***InterestExpense***

 
| ** **                                         | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|----------------------------------------------------|------------|------------------------------------------|------------|------------|------------|
| **($ in thousands):**                         | ** ** | **2005**                                 | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                               |       |                                     |       |       |       |   |   |   |   |
| Interest expense - CODES                           |       | $                                        | 9,453      |       | $          | 10,627 |   | $ | (1,174 | ) | -11.0 | % |
| Interest expense - 1998 Senior Notes               |       | 766                                      |       | 2,851      |       | (2,085 | ) | -73.1 | % |
| Interest and fees on credit facility               |       | 1,230                                    |       | 1,272      |       | (42 | ) | -3.3 | % |
| Change in derivative value                         |       | 12                                       |       | (3,826     | )          | 3,838 |   | -100.3 | % |
| Interest expense - other                           |       | 143                                      |       | 51         |       | 92 |   | 180.4 | % |
| Total interest expense before capitalized interest |       | 11,604                                   |       | 10,975     |       | 629 |   | 5.7 | % |
| Capitalized interest                               |       | —                                   |       | (1,904     | )          | 1,904 |   | -100.0 | % |
| Total interest expense                             |       | $                                        | 11,604     |       | $          | 9,071 |   | $ | 2,533 |   | 27.9 | % |
| *as % of net revenues*                             | * *   | *0.9*                                    | *%*        | *0.7*      | %          |   |   |   |   |

 

Interestexpense increased as a result of an increase in the fair value of thederivative (as described in Notes 6 and 7 in the accompanying Notes toCondensed Consolidated Financial Statements in this Quarterly Report) andbecause there was no capitalized interest expense during the nine months ended September 30,2005.   These factors were partiallyoffset by a reduction in interest on our 1998 Senior Notes.  We repurchased a portion of our 1998 SeniorNotes in February and May of 2004.

 

***SegmentContribution***

 
| ** **                 | ** ** | **Nine Months Ended September 30,** | ** ** | **Change** | ** ** |
|----------------------------|------------|------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2005**                                 | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                       |       |                                     |       |       |       |   |   |   |   |
| Segment contribution       |       |                                     |       |       |       |   |   |   |   |
| Generic                    |       | $                                        | 270,362    |       | $          | 305,295 |   | $ | (34,933 | ) | -11.4 | % |
| Brand                      |       | 115,277                                  |       | 53,806     |       | 61,471 |   | 114.2 | % |
|                       |       | $                                        | 385,639    |       | $          | 359,101 |   | $ | 26,538 |   | 7.4 | % |
| *as % of net revenues*     | * *   | *31.4*                                   | *%*        | *29.5*     | *%*        | * * | * * | * * | * * |

 

Generic segmentcontribution decreased for the nine months ended September 30, 2005, ascompared to the same period of the prior year, primarily due to:

 

1.               Reduced levels ofother revenue related to the absence of royalty payments from Aventis inconnection with Barr Laboratories, Inc.’s sales of ciprofloxacin tablets;

 

2.               A reduction ingross margins due to price reductions on certain generic products; and

 

3.               An increase inresearch and development expenses due to an increase in the number of genericproducts being developed in the period.

 

Brand segmentcontribution increased during the nine months ended September 30, 2005, ascompared to the same period of the prior year, primarily due to:

 

1.               An increase insales of certain Specialty Products including Oxytrol® and Androderm® which were impacted by wholesaler inventoryreductions in the prior year period;

 

2.               The launch of Trelstar® in the current year period;

 

3.               A reduction inresearch and development expenses as the prior year period included a $10million milestone payment related to silodosin as well as $2.2 million inrestructuring charges; and

 

28

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4.               A reduction insales and marketing expenses due to the termination of a contract sales forceagreement in the third quarter of 2004.

 

For moreinformation on segment contribution, refer to above Management’s Discussion andAnalysis of Financial Condition and Results of Operations and Note 3 in theaccompanying Notes to Condensed Consolidated Financial Statements in thisQuarterly Report.

 

**Liquidityand Capital Resources**

 

***Cashfrom Operations***

 

Watson’s primary source of liquidity is cash fromoperations.  Net working capital at September 30,2005 was $1.06 billion compared to $1.11 billion at December 31, 2004 and$1.06 billion at September 30, 2004.

 

Weexpect that 2005 cash flows from operating activities will exceed $350 million.  Management expects that 2005 cash flows fromoperating activities and available cash balances will be sufficient to fund ouroperating liquidity needs.

 

Summarized cash flow information is as follows:

 
| ** **                                 | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------------------------------|------------|------------------------------------------|------------|
| **($ in thousands):**                 | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| ** **                                 | ** ** | ** **                               | ** ** | ** ** | ** ** |
| Net cash provided  by operating activities |       | $                                        | 279,481    |   | $ | 206,018 |   |
|                                            |            |                                          |            |  |  |  |  |

 

Netcash provided by operating activities increased during the nine month periodended September 30, 2005, as compared to the same period of the prioryear, due primarily to higher operating and net income in the 2005 period, adecrease in accounts payable and accrued expenses in 2004 and the timing of taxpayments in 2004.

 

***Changesin Working Capital***

 

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

 
| ** **                             | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** |
|----------------------------------------|------------|------------------------|------------|-----------------------|------------|----------------|------------|
| **($ in thousands):**             | ** ** | **2005**               | ** ** | **2004**              | ** ** | **(Decrease)** | ** ** |
| Current Assets:                        | ** ** | ** **             | ** ** | ** **            | ** ** | ** **     | ** ** |
| Cash and cash equivalents              |       | $                      | 472,224    |                  | $          | 298,653        |       | $ | 173,571 |   |
| Marketable securities                  |       | 162,368                |       | 381,679               |       | (219,311       | )          |
| Accounts receivable, net of allowances |       | 290,648                |       | 251,459               |       | 39,189         |       |
| Inventories                            |       | 271,745                |       | 321,299               |       | (49,554        | )          |
| Other                                  |       | 110,795                |       | 117,096               |       | (6,301         | )          |
| Total current assets                   |       | 1,307,780              |       | 1,370,186             |       | (62,406        | )          |
| Current  liabilities:                  |       |                   |       |                  |       |           |       |
| Accounts payable and accrued expenses  |       | 194,407                |       | 192,701               |       | 1,706          |       |
| Other                                  |       | 52,128                 |       | 62,928                |       | (10,800        | )          |
| Total current liabilities              |       | 246,535                |       | 255,629               |       | (9,094         | )          |
|                                   |       |                   |       |                  |       |           |       |
| Working Capital                        |       | $                      | 1,061,245  |                  | $          | 1,114,557      |       | $ | (53,312 | ) |
|                                   |       |                   |       |                  |       |           |       |
| Current Ratio                          |       | 5.30                   |       | 5.36                  |       |           |       |

 

Our investments in auction rate securities wereliquidated in May 2005 and approximately $50 million in U.S. Treasurysecurities matured in June 2005. Proceeds were deposited in cash and cash equivalents.

 

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***CapitalExpenditures***

 

Our capital expenditures are summarized as follows:

 
| ** **                          | ** ** | **Nine months ended September 30,** | ** ** |
|-------------------------------------|------------|------------------------------------------|------------|
| **($ in thousands):**          | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| ** **                          | ** ** | ** **                               | ** ** | ** ** | ** ** |
| Additions to property and equipment |       | $                                        | 48,293     |   | $ | 59,033 |   |
|                                     |            |                                          |            |  |  |  |  |

 

Asignificant portion of Watson’s capital expenditures for the first nine months of2005 were incurred to construct our distribution facility in Gurnee,Illinois.  The facility was constructedto enhance our distribution capabilities and was placed in service in the thirdquarter of this year. Other capital expenditures included costs to support themanufacture of transdermal products in Salt Lake City, and additions tomachinery and equipment at various Watson locations.  The approximate total for capitalexpenditures for 2005 is estimated to be $75 million.

 

***Repurchaseof Common Stock***

 

We have repurchasedapproximately 9.4 million shares of our common stock at an aggregate cost ofapproximately $300.0 million under the Company’s $300.0 million stockrepurchase program approved by the Board of Directors (“Board”) on February 10,2005.  This completes our stockrepurchase program under the existing Board authorization.  This program provided for purchases to bemade in the open market or in privately negotiated transactions through February 2006.  The stock repurchase program did not affectour compliance with our debt covenants and did not materially impact theCompany’s liquidity.

 

***Debtand Borrowing Capacity***

 

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

 
| ** **                 | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | ** **   | ** ** |
|----------------------------|------------|------------------------|------------|-----------------------|------------|--------------|------------|
| **($ in thousands):** | ** ** | **2005**               | ** ** | **2004**              | ** ** | **Increase** | ** ** |
| ** **                 | ** ** | ** **             | ** ** | ** **            | ** ** | ** **   | ** ** |
| Long-term debt             |       | $                      | 587,864    |                  | $          | 587,653      |       | $ | 211 |   |
| Debt to capital ratio      |       | 22.0                   | %          | 20.8                  | %          |         |       |
|                            |            |                        |            |                       |            |              |            |  |  |  |

 

In March 2003, we issued $575 million ofCODES.  As of September 30, 2005,the entire amount of the CODES remained outstanding at an effective annualinterest rate of approximately 2.1%, excluding changes in the relatedderivative.

 

Between February and May 2004, werepurchased $135.9 million of our 1998 Senior Notes for total consideration of$152.5 million, or a 12% premium over each note’s face value.  We recorded charges of $17.8 million in 2004,related to fees, expenses, unamortized discount, and premiums paid.

 

In May 2003, we entered into an agreement with asyndicate of lenders for a five-year, $300 million senior, unsecured revolvingcredit facility (the “Credit Facility”) for working capital and other generalcorporate purposes.  On September 8,2005, we entered into a Second Amendment to the Credit Facility onsubstantially the same terms and conditions except the fee structure wasreduced and certain defined terms were added or amended.  As of September 30, 2005, the total $300million under the Credit Facility was available to us. Under the terms of theCredit Facility, each of our subsidiaries, other than minor subsidiaries,entered into a full and unconditional guarantee on a joint and severalbasis.  In order to provide subsidiaryguarantees in connection with the Credit Facility, we were required to issuesimilar guarantees to the 1998 Senior Note holders.  We are subject to, and, as of September 30,2005, were in full compliance with financial and operation covenants under

 

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theterms of the Credit Facility.  Theagreement includes the following financial covenants:

 

•                  maintenance of aminimum net worth, as defined in the Credit Facility, of at least $1.68 billionat September 30, 2005 (the sum of $1.44 billion plus an amount equal tothe sum of 50% of net income for each fiscal quarter after December 31,2002);

•                  maintenance of amaximum leverage ratio not greater than 2.25 to 1.0; and

•                  maintenance of aminimum interest coverage ratio of at least 7.0 to 1.0.

 

At September 30,2005, our net worth was $2.09 billion and our leverage ratio was 1.29 to1.0.   Our interest coverage ratio for the threemonths ended September 30, 2005 was 29.0 to 1.0.

 

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

 

***Long-termObligations***

 

Thefollowing table lists our enforceable and legally binding obligations as of September 30,2005.  Some of the amounts includedherein are based on management’s estimates and assumptions about theseobligations, including their duration, the possibility of renewal, anticipatedactions by third parties, and other factors. Because these estimates and assumptions are necessarily subjective, theenforceable and legally binding obligation we will actually pay in futureperiods may vary from those reflected in this table (in thousands):

 
| ** **                                                        | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                        | ** ** | **Total**                  | ** ** | **Less than 1  year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **After 5 years** | ** ** |
| ** **                                                        | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Long-term and other debt                                          |       | $                          | 589,147    |   | $ | 17 |   | $ | 14,130 |   | $ | — |   | $ | 575,000 |   |
| Liabilities incurred for acquisitions of products and  businesses |       | 4,148                      |       | 2,074 |   | 2,074 |   | — |   | — |   |
| Operating lease obligations                                       |       | 34,752                     |       | 7,188 |   | 12,615 |   | 3,070 |   | 11,879 |   |
| Total contractual cash obligations                                |       | $                          | 628,047    |   | $ | 9,279 |   | $ | 28,819 |   | $ | 3,070 |   | $ | 586,879 |   |

 

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

 

TheCompany does not have any material off-balance sheet arrangements that have, orare reasonably likely to have, a current or future effect on our financialcondition, changes in financial conditions, revenues or expenses, results ofoperations, liquidity, capital expenditures or capital resources.

 

*Recentaccounting pronouncements*

 

In November 2004,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 151, “Inventory Costs-an Amendment ofARB No. 43, Chapter 4” (“SFAS 151”). SFAS 151 requires that accounting for items such as idle facilityexpense, freight, handling costs, and

 

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wasted materials(spoilage) be recognized as current period charges regardless of whether theymeet the criterion of being abnormal.  Inaddition, SFAS 151 requires that allocation of fixed production overheads tothe costs of conversion be based on the normal capacity of the productionfacilities.  SFAS 151 is effective forinventory costs incurred during fiscal years beginning after June 15,2005.  The provision of SFAS 151 shall beapplied prospectively.  The Companybelieves that the adoption of SFAS 151 will not have a material effect on ourCondensed Consolidated Financial Statements.

 

In December 2004,the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS123R”), which replaces SFAS No. 123, “Accounting for Stock-BasedCompensation,” (“SFAS 123”) and supercedes Accounting Principles Board (“APB”)Opinion No. 25, “Accounting for Stock Issued to Employees”. SFAS 123Rrequires all share-based payments to employees, including grants of employeestock options, to be recognized in the financial statements based on their fairvalues. The pro forma disclosures previously permitted under SFAS 123 nolonger will be an alternative to financial statement recognition. Under SFAS123R, the Company must determine the appropriate fair value model to be usedfor valuing share-based payments, the amortization method for compensation costand the transition method to be used at date of adoption. The transitionmethods include modified prospective and modified retrospective adoptionoptions. Under the modified retrospective option, prior periods may be restatedeither as of the beginning of the year of adoption or for all periodspresented. The modified prospective method requires that compensation expensebe recorded for all unvested stock options and restricted stock at thebeginning of the first quarter of adoption of SFAS 123R, while themodified retrospective method would record compensation expense for allunvested stock options and restricted stock beginning with the first periodrestated. The Company is evaluating the requirements of SFAS 123R. TheCompany has not yet determined whether the adoption will result in share-basedcompensation expense amounts that are similar to the current pro formadisclosures under SFAS 123.

 

In April 2005, the Securities and ExchangeCommission (“SEC”) announced an amendment to Regulation S-X to amend the datefor compliance with SFAS 123R.  Theamendment requires each registrant that is not a small business issuer to adoptSFAS 123R in the first fiscal year commencing after June 15, 2005.  The Company is required to adopt SFAS 123Rbeginning January 1, 2006.  Adoptionof SFAS 123R will have a significant impact on our consolidated financialstatements, as we will be required to expense the fair value of our employeestock option and employee stock purchase plan grants rather than disclose thepro forma impact on our consolidated net income within the footnotes, as is ourcurrent practice.

 

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections” (“SFAS 154”), which replaces APB Opinion No. 20,“Accounting Changes” (“APB 20”) and SFAS No. 3, “Reporting AccountingChanges in Interim Financial Statements” (“SFAS 3”). SFAS 154 applies to allvoluntary changes in accounting principle and changes the requirements for theaccounting for and reporting of a change in accounting principle.  SFAS 154 also requires retrospectiveapplication to prior period financial statements involving changes inaccounting principle unless it is impracticable to determine either theperiod-specific or cumulative effect of the change.  This statement also requires that a change inthe method of depreciation, amortization or depletion of long-lived assets beaccounted for as a change in accounting estimate that is accounted forprospectively.  SFAS 154 also retainsmany provisions of APB 20 including those related to reporting a change inaccounting estimate, a change in the reporting entity and a correction of anerror and also carries forward provisions of SFAS 3 governing the reporting ofaccounting changes in interim financial statements.  SFAS 154 is effective for accounting changesand corrections of errors made in fiscal years beginning after December 15,2005.  The Company believes that theadoption of SFAS 154 will not have a material effect on our CondensedConsolidated Financial Statements.

 

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**CAUTIONARY NOTE REGARDINGFORWARD-LOOKING STATEMENTS**

 

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

 

We caution the reader that certain important factorsmay affect our actual operating results and could cause such results to differmaterially from those expressed or implied by forward-looking statements.  We believe the risks and uncertaintiesdiscussed under the Section entitled “Risks Related to Our Business,” andother risks and uncertainties detailed herein and from time to time in our SECfilings, may affect our actual results.

 

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

 

**RisksRelated to Our Business**

 

We operate in a rapidly changing environment thatinvolves a number of risks, some of which are beyond our control.  The following discussion highlights some ofthese risks and others are discussed elsewhere in this Quarterly Report.  These and other risks could materially andadversely affect our business, financial condition, operating results or cashflows.

 

*Risks Associated With Investing In the Business of Watson*

 

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

 

Our future results of operations will depend to asignificant extent upon our ability to successfully commercialize new brand andgeneric products in a timely manner. There are numerous difficulties in developing and commercializing new products,including:

 

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

 

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

 

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

 

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

 

•                  experiencingdelays or unanticipated costs; and

 

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

 

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

 

**Our brand pharmaceutical expenditures may not result in commerciallysuccessful products.**

 

During 2004, we increased our planned expendituresfor the development and marketing of our Brand business segment.  During 2005 and thereafter, we may furtherincrease the amounts we expend for our Brand business segment.  For example, we plan to initiate Phase IIIclinical studies in early 2006 on our next generation Oxytrol® product andinitiated clinical trials on our silodosin product for treatment of BPH in lateMay of 2005.  We cannot be surethese business expenditures will result in the successful discovery,development or launch of brand products that will prove to be commerciallysuccessful or will improve the long-term profitability of our business.

 

**Our gross profit may fluctuatefrom period to period depending upon our product sales mix, our productpricing, and our costs to manufacture or purchase products.**

 

Our futureresults of operations, financial condition and cash flows depend to asignificant extent upon our brand and generic product sales mix.  Our sales of brand products tend to createhigher gross margins than our sales of generic products.  As a result, our sales mix (the proportion oftotal sales between brand products and generic products) will significantlyimpact our gross profit from period to period. During the three months ended September 30, 2005, sales of ourbrand products and generic products accounted for approximately 23% and 77%,respectively, of our net product sales. During that same period, brand products and generic products contributedapproximately 35% and 65%, respectively, to our gross profits.  Factors that may cause our sales mix to varyinclude:

 

•                  the amountof new product introductions;

 

•                  marketingexclusivity, if any, which may be obtained on certain new products;

 

•                  the levelof competition in the marketplace for certain products;

 

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

 

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

 

•                  periodicdependence on a small number of products for a significant portion of netrevenue or income; and

 

•      our customers’implementation of inventory management programs, which may cause our customersto reduce their inventory carrying levels, resulting temporarily in lower salesvolumes of certain products.

 

The profitability of our product sales is alsodependent upon the prices we are able to charge for our products, the costs topurchase products from third parties, and our ability to manufacture ourproducts in a cost effective manner.

 

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**Loss of revenues from Ferrlecit®,a significant product, could have a material adverse effect on our results ofoperations, financial condition and cash flows.**

 

                        During 2004, we lost regulatory exclusivityon our Ferrlecit® product, which will allow generic applicants to submit ANDAsfor Ferrlecit®.  In 2004, Ferrlecit®accounted for approximately 8% of our net revenues and 15% of our gross profit.  In the nine months ended September 30, 2005, Ferrlecit®accounted for approximately 9% of our net revenues and 16% of our gross profit.  In February 2004, we submitted a Citizen’sPetition to the FDA requesting that the FDA not approve any ANDA for a genericversion of Ferrlecit® until certain manufacturing, physiochemical and safetyand efficacy criteria are satisfied. During the third quarter of 2004, we submitted a second Citizen’sPetition to the FDA requesting that the FDA refuse to accept for substantivereview any ANDA referencing Ferrlecit® until the FDA establishes guidelines fordetermining whether the generic product is the same complex as Ferrlecit®.  We cannot predict whether the FDA will grantor deny our Citizen’s Petitions or when it may take such action.  We believe it will be difficult for acompetitor to demonstrate to the FDA that its product is the same as Ferrlecit®and that, in the absence of such a showing, the FDA should require theapplicant to submit a New Drug Application (“NDA”) supported by clinicalstudies, independently demonstrating safety and efficacy.  However, if a generic version of Ferrlecit®or other competitive product is approved by the FDA and enters the market, ournet revenues could significantly decline, which could have a material adverseeffect on our results of operations, financial condition and cash flows.

 

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

 

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

 

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

 

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

 

We also rely on trade secrets and proprietaryknow-how that we seek to protect, in part, through confidentiality agreementswith our partners, customers, employees and consultants.  It is possible that these agreements will bebreached or that they will not be enforceable in every instance, and that wewill not have adequate remedies for any such breach.  It is also possible that our trade secretswill become known or independently developed by our competitors.

 

If we are unable to adequately protect ourtechnology, trade secrets or propriety know-how, or enforce our patents, our resultsof operations, financial condition and cash flows could suffer.

 

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**If brand pharmaceutical companiesare successful in limiting the use of generics through their legislative andregulatory efforts, our sales of generic products may suffer.**

 

Many brand pharmaceutical companies increasinglyhave used state and federal legislative and regulatory means to delay genericcompetition.  These efforts haveincluded:

 

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

 

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

 

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

 

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

 

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

 

                        If brand pharmaceutical companies aresuccessful in limiting the use of generic products through these or othermeans, our sales of generic products may decline.  If we experience a material decline ingeneric product sales, our results of operations, financial condition and cashflows will suffer.

 

**If competitors are successful inlimiting competition for certain generic products through their legislative,regulatory and litigation efforts, our sales of certain generic products maysuffer.**

 

                        Certain of our competitors have recentlychallenged our ability to distribute generic alternatives of certain brandproducts (sometimes called “Authorized Generics”) during the competitors’ 180day period of ANDA exclusivity under the Hatch-Waxman Act.  Under the challenged arrangements, we haveobtained rights to market and distribute under a brand manufacturer’s NDA ageneric alternative of the brand product. Some of our competitors have challenged the propriety of thesearrangements by filing Citizen’s Petitions with the FDA, initiating lawsuitsalleging violation of the antitrust and consumer protection laws, and seekinglegislative intervention.  To date, theseefforts have been unsuccessful, but remain unresolved.  The FDA and courts that have considered thesubject to date have ruled that there is no prohibition in the Federal Food,Drug and Cosmetic Act against distributing authorized generic versions of abrand drug.  However, if our competitors’attempts to restrict such arrangements are successful, or if distribution ofauthorized generic versions of brand drugs is otherwise restricted or foundunlawful, it could have a material adverse effect on our results of operations,financial condition and cash flows.

 

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

 

We may need to obtain licenses to patents and otherproprietary rights held by third parties to develop, manufacture and marketproducts.  If we are unable to timelyobtain these licenses on commercially reasonable terms, our ability tocommercially exploit our products may be inhibited or prevented.

 

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**Third parties may claim that we infringe their proprietary rights andmay prevent us from manufacturing and selling some of our products**.

 

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

 

**As a part of our business strategy, we plan to consider and, asappropriate, make acquisitions of technologies, products and businesses, whichmay result in us experiencing difficulties in integrating the technologies,products and businesses that we acquire and/or experiencing significant chargesto earnings that may adversely affect our stock price and financial condition.**

 

We regularly reviewpotential acquisitions of technologies, products and businesses complementaryto our business.  Acquisitions typicallyentail many risks and could result in difficulties in integrating operations,personnel, technologies and products.  Ifwe are not able to successfully integrate our acquisitions, we may not obtainthe advantages that the acquisitions were intended to create, which mayadversely affect our business, results of operations, financial condition andcash flows, our ability to develop and introduce new products and the marketprice of our stock.  In addition, inconnection with acquisitions, we could experience disruption in our business oremployee base.  There is also a risk thatkey employees of companies that we acquire or key employees necessary tosuccessfully commercialize technologies and products that we acquire may seekemployment elsewhere, including with our competitors.  Furthermore, there may be overlap between theproducts or customers of Watson and the companies that we acquire that may createconflicts in relationships or other commitments detrimental to the integratedbusinesses.

 

In addition, as a result of acquiring businesses orproducts, or entering into other significant transactions, we have experienced,and will likely continue to experience, significant charges to earnings formerger and related expenses that may include transaction costs, closure costsor acquired in-process research and development charges.  These costs may include substantial fees forinvestment bankers, attorneys, accountants and financial printing costs andseverance and other closure costs associated with the elimination of duplicateor discontinued products, operations and facilities.  Charges that we may incur in connection withacquisitions could adversely affect our results of operations for particularquarterly or annual periods.

 

**If we are unable to obtain sufficient supplies from key suppliers thatin some cases may be the only source of finished products or raw materials, ourability to deliver our products to the market may be impeded.**

 

We are required to identify the supplier(s) of allthe raw materials for our products in our applications with the FDA.  To the extent practicable, we attempt toidentify more than one supplier in each drug application.  However, some products and raw materials areavailable only from a single source and, in some of our drug applications, onlyone supplier of products and raw materials has been identified, even ininstances where multiple sources exist. Among others, this includes products that have historically accountedfor a significant portion of our revenues, such as Ferrlecit® and a significantnumber of our oral contraceptive products. From time to time, certain of our outside suppliers have experiencedregulatory or supply-related difficulties that have inhibited their ability todeliver products and raw materials to us, causing supply delays orinterruptions.  To the extent anydifficulties experienced by our suppliers cannot be resolved within areasonable time, and at

 

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reasonablecost, or if raw materials for a particular product become unavailable from anapproved supplier and we are required to qualify a new supplier with the FDA,our profit margins and market share for the affected product could decrease, aswell as delay our development and sales and marketing efforts.

 

Our arrangements with foreign suppliers are subjectto certain additional risks, including the availability of governmentclearances, export duties, political instability, war, acts of terrorism,currency fluctuations and restrictions on the transfer of funds.  For example, we obtain a significant portionof our raw materials from foreign suppliers. Arrangements with international raw material suppliers are subject to,among other things, FDA regulation, customs clearances, various import dutiesand other government clearances.  Acts ofgovernments outside the U.S. may affect the price or availability of rawmaterials needed for the development or manufacture of our products. In addition,recent changes in patent laws in jurisdictions outside the U.S. may make itincreasingly difficult to obtain raw materials for research and developmentprior to the expiration of the applicable U.S. or foreign patents.

 

**Our policies regarding returns, allowances and chargebacks, andmarketing programs adopted by wholesalers, may reduce our revenues in futurefiscal periods**.

 

Based on industry practice, generic productmanufacturers, including us, have liberal return policies and have been willingto give customers post-sale inventory allowances.  Under these arrangements, from time to time,we give our customers credits on our generic products that our customers holdin inventory after we have decreased the market prices of the same genericproducts.  Therefore, if new competitorsenter the marketplace and significantly lower the prices of any of theircompeting products, we would likely reduce the price of our product.  As a result, we would be obligated to providesignificant credits to our customers who are then holding inventories of suchproducts, which could reduce sales revenue and gross margin for the period thecredit is provided.  Like ourcompetitors, we also give credits for chargebacks to wholesale customers thathave contracts with us for their sales to hospitals, group purchasingorganizations, pharmacies or other retail customers.  Achargeback represents an amount payable in the future to a wholesaler for thedifference between the invoice price paid to us by our wholesale customer for aparticular product and the negotiated contract price that the wholesaler’scustomer pays for that product.  Although we establish reserves based on ourprior experience and our best estimates of the impact that these policies mayhave in subsequent periods, we cannot ensure that our reserves are adequate orthat actual product returns, allowances and chargebacks will not exceed ourestimates, which could adversely affect our financial condition, cash flows andmarket price of our stock.

 

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

 

Manygovernment and third-party payors, including Medicare, Medicaid, HealthMaintenance Organizations (“HMOs”) and Managed Care Organizations (“MCOs”),reimburse doctors and others for the purchase of certain prescription drugsbased on a drug’s average wholesale price (“AWP”).  In the past several years, state and federalgovernment agencies have conducted ongoing investigations of manufacturers’reporting practices with respect to AWP, in which they have suggested thatreporting of inflated AWP’s have led to excessive payments for prescriptiondrugs.  For example, beginning in July 2002,we and certain of our subsidiaries, as well as numerous other pharmaceuticalcompanies, were named as defendants in various state and federal court actionsalleging improper or fraudulent practices related to the reporting of AWP ofcertain products, and other improper acts, in order to increase prices andmarket shares. We have also been named as a defendant in similar actions bynine State Attorneys General, 36 counties in New York State and the City of NewYork. We have also received notices or subpoenas from the Attorneys General ofvarious states, including California and Texas, indicating investigations,claims and/or possible lawsuits relating to pharmaceutical pricing issues andwhether allegedly improper actions by pharmaceutical manufacturers led toexcessive payments by Medicare and/or Medicaid. These actions, if successful, could adversely affect us and may have amaterial adverse effect on our business, results of operations, financialcondition and cash flows.

 

**The design, development, manufacture and sale of our products involvesthe risk of product liability claims by consumers and other third parties, andinsurance against such potential claims is expensive and may be difficult toobtain.**

 

The design, development, manufacture and sale of ourproducts involve an inherent risk of product liability claims and theassociated adverse publicity.  Insurancecoverage is expensive and may be difficult to obtain, and may not be availablein the future on acceptable terms, or at all. Although we currently maintain product

 

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liabilityinsurance for our products in amounts we believe to be commercially reasonable,if the coverage limits of these insurance policies are not adequate, a claimbrought against Watson, whether covered by insurance or not, could have amaterial adverse effect on our business, results of operations, financialcondition and cash flows.

 

**The loss of our key personnel could cause our business to suffer.**

 

The success of our present and future operationswill depend, to a significant extent, upon the experience, abilities and continuedservices of key personnel.  For example,although we have other senior management personnel, a significant loss of theservices of Allen Chao, Ph.D., our Chairman, President and Chief ExecutiveOfficer, or other senior executive officers, could cause our business tosuffer.  We cannot assure you that wewill be able to attract and retain key personnel.  We have entered into employment agreementswith all of our senior executive officers, including Dr. Chao.  We do not carry key-man life insurance on anyof our officers.

 

**Rising insurance costs could negatively impactprofitability.**

 

The cost of insurance, includingworkers compensation, product liability and general liability insurance, haverisen significantly in recent years and may increase.  In response, we may increase deductiblesand/or decrease certain coverages to mitigate these costs.  These increases, and our increased risk dueto increased deductibles and reduced coverages, could have a negative impact onour results ofoperations, financial condition and cash flows.

 

**Implementation of enterprise resource planning systemscould cause business interruptions and negatively affect our profitability andcash flows.**

 

During 2004, we implemented an ERPsystem to improve customer service, enhance operating efficiencies, and providemore effective management of business operations.  From time to time, we may implement new ERPsystems and software, or upgrades to existing systems and software, to furtherenhance our operations.  Implementationof ERP systems and software carry risks such as cost overruns, project delaysand business interruptions and delays. If we experience a material business interruption as a result of suchimplementations, it could adversely affect us, and could have a material adverseeffect on our business, results of operations, financial condition and cashflows.

 

**Significant balances of intangible assets, including product rights andgoodwill acquired, are subject to impairment testing and may result inimpairment charges, which will adversely affect our results of operations andfinancial condition.**

 

A significant amount of our total assets is relatedto acquired product rights and goodwill. As of September 30, 2005, the carrying value of our product rightsand other intangible assets was approximately $790 million and the carryingvalue of our goodwill was approximately $460 million.

 

Our product rights are stated at cost, lessaccumulated amortization.  We determineoriginal fair value and amortization periods for product rights based on ourassessment of various factors impacting estimated useful lives and cash flowsof the acquired products.  Such factorsinclude the product’s position in its life cycle, the existence or absence oflike products in the market, various other competitive and regulatory issuesand contractual terms.  Significantchanges to any of these factors would require us to perform an impairment teston the affected asset and, if evidence of impairment exists, we would berequired to take an impairment charge with respect to the asset.  Such a charge would adversely affect ourresults of operations and financial condition.

 

Goodwill is tested for impairment annually and whenevents occur or circumstances change that could potentially reduce the fairvalue of the reporting unit.  Impairmenttesting compares the fair value of the reporting unit to its carryingamount.  An impairment, if any, would berecorded in operating income and could have a significant adverse affect on ourresults of operations and financial condition.

 

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**Issuance of debt or equity securities could materiallychange our operating results and financial condition.**

 

We may consider issuing additional debt or equitysecurities in the future to fund potential acquisitions or investment, torefinance existing debt, or for general corporate purposes.  If a material acquisition or investment iscompleted, our operating results and financial condition could changematerially in future periods.  However,no assurance can be given that additional funds will be available onsatisfactory terms, or at all, to fund such activities.

 

*Risks Relating To Investing In the Pharmaceutical Industry*

 

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

 

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

 

Under these regulations, we are subject to periodicinspection of our facilities, procedures and operations and/or the testing ofour products by the FDA, the DEA and other authorities, which conduct periodicinspections to confirm that we are in compliance with all applicableregulations.  In addition, the FDAconducts pre-approval and post-approval reviews and plant inspections todetermine whether our systems and processes are in compliance with current GoodManufacturing Practice (“cGMP”) and other FDA regulations.  Following such inspections, the FDA may issuenotices on Form 483 and warning letters that could cause us to modifycertain activities identified during the inspection.  A Form 483 notice is generally issued atthe conclusion of a FDA inspection and lists conditions the FDA inspectorsbelieve may violate cGMP or other FDA regulations.  FDA guidelines specify that a warning letteris issued only for violations of “regulatory significance” for which thefailure to adequately and promptly achieve correction may be expected to resultin an enforcement action.

 

Our principal manufacturing facility in Corona,California is currently subject to a consent decree of permanentinjunction.  We cannot assure you thatthe FDA will determine that we have adequately corrected deficiencies at ourmanufacturing sites (including the one referenced above), that subsequent FDAinspections will not result in additional inspectional observations at suchsites, that approval of any of the pending or subsequently submitted NDAs,ANDAs or supplements to such applications by Watson or its subsidiaries will begranted or that the FDA will not seek to impose additional sanctions againstWatson or any of its subsidiaries.  Therange of possible sanctions includes, among others, FDA issuance of adversepublicity, product recalls or seizures, fines, total or partial suspension ofproduction and/or distribution, suspension of the FDA’s review of productapplications, enforcement actions, injunctions, and civil or criminalprosecution.  Any such sanctions, ifimposed, could materially harm our operating results and financialcondition.  Under certain circumstances,the FDA also has the authority to revoke previously granted drugapprovals.  Similar sanctions as detailedabove may be available to the FDA under a consent decree, depending upon theactual terms of such decree.  Although wehave instituted internal compliance programs, if these programs do not meetregulatory agency standards or if compliance is deemed deficient in anysignificant way, it could materially harm our business.  Certain of our vendors are subject to similarregulation and periodic inspections.

 

The process for obtaining governmental approval tomanufacture and market pharmaceutical products is rigorous, time-consuming andcostly, and we cannot predict the extent to which we may be affected bylegislative and regulatory developments. We are dependent on receiving FDA and other governmental or third-partyapprovals prior to manufacturing, marketing and shipping our products.  Consequently, there is always the chance thatwe will not obtain FDA or other necessary approvals, or that the rate, timingand cost of such approvals, will adversely affect our product introductionplans or results of operations.  We carryinventories of

 

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certainproduct(s) in anticipation of launch, and if such product(s) are notsubsequently launched, we may be required to write-off the related inventory.

 

**Federal regulation of arrangements between manufacturers of brand andgeneric products could adversely affect our business.**

 

As part of the Medicare Prescription Drug,Improvement, and Modernization Act of 2003, companies are now required to filewith the Federal Trade Commission (“FTC”) and the Department of Justice certaintypes of agreements entered into between brand and generic pharmaceuticalcompanies related to the manufacture, marketing and sale of generic versions ofbrand drugs.  This requirement couldaffect the manner in which generic drug manufacturers resolve intellectual propertylitigation and other disputes with brand pharmaceutical companies and couldresult generally in an increase in private-party litigation againstpharmaceutical companies or additional investigations or proceedings by the FTCor other governmental authorities.  Theimpact of this requirement, and the potential private-party lawsuits associatedwith arrangements between brand name and generic drug manufacturers, isuncertain and could adversely affect our business.

 

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

 

In order to assist us in commercializing products,we have obtained from government authorities and private health insurers andother organizations, such as HMOs and MCOs, authorization to receivereimbursement at varying levels for the cost of certain products and relatedtreatments.  Third party payorsincreasingly challenge pricing of pharmaceutical products.  The trend toward managed healthcare in theU.S., the growth of organizations such as HMOs and MCOs and legislativeproposals to reform healthcare and government insurance programs couldsignificantly influence the purchase of pharmaceutical products, resulting inlower prices and a reduction in product demand. Such cost containment measures and healthcare reform could affect ourability to sell our products and may have a material adverse effect on ourbusiness, results of operations and financial condition.  Additionally, there is uncertaintysurrounding the implementation of the provisions of the Medicare Part DPrescription Drug Benefit as authorized by the Medicare Prescription,Improvement, and Modernization Act of 2003. Depending on how such provisions are implemented, reimbursement may notbe available for some of Watson’s products. Additionally, any reimbursement granted may not be maintained or limitson reimbursement available from third-party payors may reduce the demand for,or negatively affect the price of, those products and could harm significantlyour business, results of operations, financial condition and cash flows.  We may also be subject to lawsuits relatingto reimbursement programs that could be costly to defend, divert management’sattention and adversely affect our operating results.

# ** **

**The pharmaceutical industry is highly competitive.**

 

We face strong competitionin both our generic and brand product businesses.  The intensely competitive environmentrequires an ongoing, extensive search for technological innovations and theability to market products effectively, including the ability to communicatethe effectiveness, safety and value of brand products to healthcareprofessionals in private practice, group practices and managed careorganizations. Our competitors vary depending upon product categories, andwithin each product category, upon dosage strengths and drug-delivery systems.Based on total assets, annual revenues, and market capitalization, we aresmaller than certain of our national and international competitors in the brandproduct arena.  Most of our competitorshave been in business for a longer period of time than Watson, have a greaternumber of products on the market and have greater financial and other resourcesthan we do.  If we directly compete withthem for the same markets and/or products, their financial strength couldprevent us from capturing a profitable share of those markets. It is possiblethat developments by our competitors will make our products or technologiesnoncompetitive or obsolete.

 

Revenues and gross profit derived from the sales ofgeneric pharmaceutical products tend to follow a pattern based on certainregulatory and competitive factors.  Aspatents for brand name products and related exclusivity periods expire, thefirst generic manufacturer to receive regulatory approval for genericequivalents of such products is generally able to achieve significant marketpenetration.  As competing off-patentmanufacturers receive regulatory approvals on similar products or as brandmanufacturers launch generic versions of such

 

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

 

**Sales of our products may continue to be adversely affected by thecontinuing consolidation of our distribution network and the concentration ofour customer base.**

 

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

 

                        For theyear ended December 31, 2004, our four largest customers accounted for15%, 14%, 11% and 11% respectively, of our net revenues.  The loss of any of these customers couldmaterially adversely affect our business, results of operations, financialcondition and our cash flows.  Inaddition, none of our customers are party to any long-term supply agreementswith us which would enable them to change suppliers freely should they wish todo so.

 

**ITEM3.  QUANTITATIVE AND QUALITATIVEDISCLOSURE ABOUT MARKET RISK**

 

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

 

**InvestmentRisk**

 

As of September 30, 2005, our total holdings inequity securities of other companies, including equity-method investments andavailable-for-sale securities, were $37.5 million.  Of this amount, we had equity-methodinvestments of $3.4 million and publicly traded equity securities(available-for-sale securities) at fair value totaling $12.6 million ($9.4million that was included in “Marketable securities” and $3.2 million that wasincluded in “Investments and other assets”). The fair values of these investments are subject to significantfluctuations due to volatility of the stock market and changes in generaleconomic conditions.  Based on the fairvalue of the publicly traded equity securities we held at September 30, 2005,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 $3.1 million, $5.0 million and $6.3 million, respectively.

 

At September 30,2005, our investment in Andrx consisted of approximately 607,000 shares ofAndrx common stock with a fair market value of $9.4 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.

 

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The followingtable sets forth the Andrx high and low market price per share information,based on published financial sources, for 2005 and 2004 and further reflectsthe volatility of the stock price:

 

| ** **           | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------------|------------|----------|------------|---------|------------|
| **2005, by quarter** |       |     |       |    |       |
| First                |       | $        | 24.47      |    | $          | 20.55 |   |
| Second               |       | $        | 23.38      |    | $          | 19.15 |   |
| Third                |       | $        | 22.50      |    | $          | 12.74 |   |
|                 |       |     |       |    |       |
| **2004, by quarter** |       |     |       |    |       |
| First                |       | $        | 30.87      |    | $          | 23.55 |   |
| Second               |       | $        | 29.35      |    | $          | 22.24 |   |
| Third                |       | $        | 28.10      |    | $          | 16.95 |   |
| Fourth               |       | $        | 23.63      |    | $          | 14.09 |   |

 

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

 

**Interest Rate Risk**

 

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

 

During2004, we acquired a significant amount of U.S. Treasury securities classifiedas available-for-sale securities, with no security having a maturity in excessof two years.  These securities areexposed to interest rate fluctuations. Because of the short-term nature of these investments, we are subject tominimal interest rate risk and do not believe that an increase in market rateswould have a significant negative impact on the realized value of ourportfolio.  Our investments in auctionrate securities were liquidated during the second quarter of 2005.

 

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

 

At this time, weare not party to any interest rate or derivative hedging contracts and have nomaterial foreign exchange or commodity price risks.

 

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

 

**ITEM 4.  CONTROLS AND PROCEDURES**

 

TheCompany maintains disclosure controls and procedures that are designed toensure that information required to be disclosed in the Company’s Exchange Actreports is recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and forms, and that such information isaccumulated and communicated to the Company’s management, including itsPrincipal Executive Officer and Principal Financial Officer, as appropriate, toallow timely decisions regarding required disclosure.  In designing and evaluating the disclosurecontrols and procedures, management recognized that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement necessarily was required to apply its judgment in evaluating thecost-benefit relationship of possible controls and procedures.  Also, the Company has investments in certainunconsolidated entities.  As the Companydoes not control or manage these entities, its disclosure controls andprocedures with

 

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respect to such entitiesare necessarily substantially more limited than those it maintains with respectto its consolidated subsidiaries.

 

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

 

Therehave been no changes in the Company’s internal control over financialreporting, during the three months ended September 30, 2005, that hasmaterially affected, or is reasonably likely to materially affect, the Company’sinternal control over financial reporting.

 

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**PART II.  OTHER INFORMATION AND SIGNATURES**

 

**ITEM 1.  LEGAL PROCEEDINGS**

 

The Company is party to certain lawsuits and legalproceedings, which are described in “Part I, Item 3. Legal Proceedings,”of our Annual Report on Form 10-K for the year ended December 31,2004.  The following is a description ofmaterial developments during the period covered by this Quarterly Report andthrough the filing of this Quarterly Report, and should be read in conjunctionwith the Annual Report referenced above.

 

*Phen-fen litigation.*  With respect to the phenterminehydrochloride product liability lawsuits pending against the Company, certainsubsidiaries, and others, additional actions raising similar issues have beenfiled, and some actions have been settled or otherwise dismissed.  As of November 4,2005, approximately 35 cases were pending against Watson and its affiliates innumerous state and federal courts.  Most of the cases involve multipleplaintiffs, and several were filed or certified as class actions.  TheCompany believes it will be fully indemnified by Rugby’s former owner, Aventisfor the defense of all such cases and for any liability that may arise out ofthese cases.  Aventis is currently controlling the defense of all thesematters as the indemnifying party under its agreements with the Company.

 

*Cipro® Litigation.** * On August 25, 2005, defendants filed amotion to transfer the appeals of the judgment in defendants’ favor in theconsolidated action from the United States Court of Appeals for the SecondCircuit to the United States Court of Appeals for the Federal Circuit.  Appellants filed their briefs in oppositionto the motion to transfer on or about September 26, 2005.  Defendants filed their reply in support ofthe motion to transfer on October 21, 2005.  All parties have requested oral argument onthe motion.

 

In the New York State Cipro® court action, which the court dismissed in 2004, and inwhich the plaintiffs filed a Notice of Appeal in October 2004, theappellants filed their appellate brief on July 27, 2005.  The defendants/appellees filed their jointresponse brief on September 7, 2005. The court has scheduled oral argument of the appeal on November 22,2005.

 

*Governmental ReimbursementInvestigations and Drug Pricing Litigation.* With respect to the Drug PricingLitigation pending against the Company and certain subsidiaries, an additionalaction raising similar allegations was filed by the Attorney General of theState of Mississippi on October 20, 2005, in the Chancery Court of HindsCounty, Mississippi *(State of Mississippi v.Abbott Laboratories, Inc. et al, Civil Action No. G2005-2021 S/2)*.  With respect to the actions filed bygovernmental subdivisions of New York State, 27 of the 36 New York State countyactions and the action filed by the City of New York have been consolidatedinto the Consolidated Action pending in the United States District Court forthe District of Massachusetts *(In re PharmaceuticalIndustry Average Wholesale Price Litigation, MDL Docket No. 1456, CivilAction No. 01-CV-12257-PBS)*. Several federal district courts have remanded cases to state court thatthe defendants had removed to federal court. Additional actions are anticipated. The Company intends to defend these actions vigorously.  However, if successful, these actions couldadversely affect the Company and may have a material adverse effect on theCompany’s business, results of operations, financial condition and cash flows.

 

*Hormone Replacement TherapyLitigation**.*  With respect to the hormone replacementtherapy product liability lawsuits pending against the Company, certain of itssubsidiaries, and other third parties, additional actions raising similarallegations have been filed, and some actions have been dismissed.  As of November 4,2005, there were approximately 85 cases pending against the Company and itsaffiliates in various state and federal courts, representing claims byapproximately 750 plaintiffs.  Many of the cases seek certification asclass actions.  These actions, if successful, could adversely affect theCompany and could have a material adverse effect on the Company’s business,results of operations, financial condition and cash flows.

 

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

 

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

 

Therewere no unregistered sales of equity securities.

 

**(c) Issuer Purchases of Equity Securities**

 

Thefollowing table summarizes the Company’s purchases of common stock during thethird quarter of 2005:

 
| ** **                                              | ** ** | ** **                                               | ** ** | ** **        | ** ** | **Total Number of**    | ** ** | **Approximate**            | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------------------|------------|-------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                              | ** ** | ** **                                               | ** ** | ** **        | ** ** | **Shares Purchased**   | ** ** | **Dollar Value of**        | ** ** |
| ** **                                              | ** ** | **Total Number of**                                      | ** ** | **Average Price** | ** ** | **as Part of**    | ** ** | **Shares that May Yet Be** | ** ** |
| ** **                                              | ** ** | **Shares**                                               | ** ** | **Paid Per**      | ** ** | **Publicly Announced** | ** ** | **Purchased Under the**    | ** ** |
| **Period**                                              | ** ** | **Purchased**                                            | ** ** | **Share**         | ** ** | **Plans or Programs**  | ** ** | **Plans or Programs**      | ** ** |
|                                                    |       | **(In thousands, except average  price paid per share)** |       |              |       |
|                                                    |       |                                                     |       |              |       |                   |       |                       |       |
| July 1, 2005 through July 31, 2005            |       | —                                                   |       |              |       | —                 |       | $                          | 117,415    |   |
|                                                    |       |                                                     |       |              |       |                   |       |                       |       |
| August 1, 2005 through August 31, 2005        |       | 3,009                                                    |       | $                 | 34.69      |                   | 3,009      |                       | $          | 13,028 |   |
|                                                    |       |                                                     |       |              |       |                   |       |                       |       |
| September 1, 2005 through September 30,  2005 |       | 380                                                      |       | $                 | 34.25      |                   | 380        |                       | $          | — |   |
| **Total**                                               |       | 3,389                                                    |       |              |       | 3,389                  |       |                       |       |

 

In February 2005, the Board authorized a programto repurchase up to $300.0 of shares of Watson’s common stock over a period ofone year.

 

**ITEM 6. EXHIBITS**

 

(a) Exhibits:

 

Referenceis hereby made to the Exhibit Index on page 48.

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 

 
| ** **                   | ** ** | **WATSON PHARMACEUTICALS, INC**.  (Registrant)          |
|------------------------------|------------|---------------------------------------------------------|
| ** **                   | ** ** | ** **                                              |
| ** **                   | ** ** | ** **                                              |
|                         | By:        | **/s/ 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 7,  2005 |       |                                                    |

 

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**WATSON PHARMACEUTICALS, INC.**

 

**EXHIBIT INDEX TO FORM 10-Q**

**For the Quarterly Period Ended September 30,2005**

 

 
| **Exhibit** | ** ** | ** **                                                                                                                              |
|-------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|
| **No.**     | ** ** | **Description**                                                                                                                         |
| ** **  | ** ** | ** **                                                                                                                              |
| 31.1        |       | Certification of Chairman and Chief Executive Officer pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002.                  |
|        |       |                                                                                                                                    |
| 31.2        |       | Certification of  Executive Vice President and Chief Financial Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002. |
|        |       |                                                                                                                                    |
| 32.1        |       | Certification of  Chairman and Chief Executive Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                 |
|        |       |                                                                                                                                    |
| 32.2        |       | Certification of  Executive Vice President and Chief Financial Officer pursuant to Section 906  of the Sarbanes-Oxley Act of 2002. |

 

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