**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 13 OR15(d)**

**OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

**FOR THEQUARTERLY PERIOD ENDED MARCH 31, 2005**

 

**or**

 

**o****TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d)**

**OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from              to               **

 

**Commissionfile number 0-20045**

 

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**WATSON PHARMACEUTICALS, INC.**

(Exact name ofregistrant as specified in its charter)

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

 

**311Bonnie Circle**

**Corona,CA  92880-2882**

(Address ofprincipal executive offices, including zip code)

 

**(951)493-5300**

(Registrant’s telephonenumber, including area code)

 

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

 

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

 

The number of sharesoutstanding of the Registrant’s only class of common stock as of May 6, 2005was approximately  110,168,370.

 

 

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**WATSONPHARMACEUTICALS, INC.**

**TABLE OFCONTENTS**

**FORM10-Q FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005**

 
| **Part  I. FINANCIAL INFORMATION**             | ** **                                                                                           |
|------------------------------------------------|------------------------------------------------------------------------------------------------------|
|                                           |                                                                                                 |
| Item 1.                                        | Condensed Consolidated Financial Statements  (Unaudited):                                            |   |
|                                           |                                                                                                 |   |
|                                           | Condensed  Consolidated Balance Sheets as of March 31, 2005 and December 31, 2004                    |   |
|                                           |                                                                                                 |   |
|                                           | Condensed  Consolidated Statements of Income for the Three Months Ended March 31, 2005  and 2004     |   |
|                                           |                                                                                                 |   |
|                                           | Condensed  Consolidated Statements of Cash Flows for the Three Months Ended March 31,  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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**WATSONPHARMACEUTICALS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

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

 
| ** **                                                                                                                 | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|---------------|------------|------------------|------------|
| ** **                                                                                                                 | ** ** | **2005**      | ** ** | **2004**         | ** ** |
| **ASSETS**                                                                                                                 |       |          |       |             |       |
| Current assets:                                                                                                            |       |          |       |             |       |
| Cash and cash  equivalents                                                                                                 |       | $             | 333,385    |             | $          | 298,653 |   |
| Marketable  securities                                                                                                     |       | 383,142       |       | 381,679          |       |
| Accounts  receivable, net                                                                                                  |       | 230,024       |       | 251,459          |       |
| Inventories                                                                                                                |       | 314,778       |       | 321,299          |       |
| Prepaid expenses  and other current assets                                                                                 |       | 22,229        |       | 26,894           |       |
| Deferred tax  assets                                                                                                       |       | 84,186        |       | 90,202           |       |
| Total current  assets                                                                                                      |       | 1,367,744     |       | 1,370,186        |       |
|                                                                                                                       |       |          |       |             |       |
| Property and  equipment, net                                                                                               |       | 428,084       |       | 427,377          |       |
| Investments and  other assets                                                                                              |       | 44,818        |       | 47,499           |       |
| Deferred tax  assets                                                                                                       |       | 29,902        |       | 30,280           |       |
| Product rights  and other intangibles, net                                                                                 |       | 872,133       |       | 912,746          |       |
| Goodwill                                                                                                                   |       | 455,595       |       | 455,595          |       |
| Total assets                                                                                                               |       | $             | 3,198,276  |             | $          | 3,243,683 |   |
|                                                                                                                       |       |          |       |             |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                              |       |          |       |             |       |
| Current  liabilities:                                                                                                      |       |          |       |             |       |
| Accounts payable  and accrued expenses                                                                                     |       | $             | 181,475    |             | $          | 192,701 |   |
| Income taxes  payable                                                                                                      |       | 54,984        |       | 57,851           |       |
| Deferred revenue                                                                                                           |       | 3,975         |       | 5,077            |       |
| Total current  liabilities                                                                                                 |       | 240,434       |       | 255,629          |       |
|                                                                                                                       |       |          |       |             |       |
| Long-term debt                                                                                                             |       | 587,724       |       | 587,653          |       |
| Deferred revenue                                                                                                           |       | 11,221        |       | 11,557           |       |
| Other long-term  liabilities                                                                                               |       | 4,167         |       | 4,736            |       |
| Deferred tax  liabilities                                                                                                  |       | 133,475       |       | 140,959          |       |
| Total  liabilities                                                                                                         |       | 977,021       |       | 1,000,534        |       |
|                                                                                                                       |       |          |       |             |       |
| Commitments and  contingencies                                                                                             |       |          |       |             |       |
|                                                                                                                       |       |          |       |             |       |
| Stockholders’  equity:                                                                                                |       |          |       |             |       |
| Preferred stock;  no par value per share; 2,500,000 shares authorized; none issued                                         |       | —        |       | —           |       |
| Common stock;  $0.0033 par value per share; 500,000,000 shares authorized; 110,147,400 and  109,719,900 shares outstanding |       | 363           |       | 362              |       |
| Additional  paid-in capital                                                                                                |       | 890,668       |       | 880,202          |       |
| Retained  earnings                                                                                                         |       | 1,391,958     |       | 1,353,047        |       |
| Accumulated  other comprehensive income                                                                                    |       | 7,344         |       | 9,538            |       |
| Treasury stock,  at cost: 2,242,100 shares and 0 shares, respectively                                                      |       | (69,078       | )          | —           |       |
| Total  stockholders’ equity                                                                                           |       | 2,221,255     |       | 2,243,149        |       |
| Total  liabilities and stockholders’ equity                                                                           |       | $             | 3,198,276  |             | $          | 3,243,683 |   |

 

*See accompanying Notes to Condensed ConsolidatedFinancial Statements.*

 

1

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**WATSONPHARMACEUTICALS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF INCOME**

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

 
| ** **                                                     | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                     | ** ** | **March 31,**          | ** ** |
| ** **                                                     | ** ** | **2005**               | ** ** | **2004** | ** ** |
|                                                           |       |                   |       |   |   |
| Net revenues                                                   |       | $                      | 400,828    |   | $ | 409,658 |   |
| Cost of sales                                                  |       | 206,950                |       | 196,481 |   |
| Gross profit                                                   |       | 193,878                |       | 213,177 |   |
|                                                           |       |                   |       |   |   |
| Operating  expenses:                                           |       |                   |       |   |   |
| Research and  development                                      |       | 28,838                 |       | 29,681 |   |
| Selling, general  and administrative                           |       | 63,651                 |       | 77,411 |   |
| Amortization                                                   |       | 40,638                 |       | 17,932 |   |
| Total operating  expenses                                      |       | 133,127                |       | 125,024 |   |
| Operating income                                               |       | 60,751                 |       | 88,153 |   |
|                                                           |       |                   |       |   |   |
| Other income  (expense):                                       |       |                   |       |   |   |
| Equity in  earnings (losses) of joint ventures                 |       | 420                    |       | (1,579 | ) |
| Loss on  impairment of investments and other assets            |       | —                 |       | (891 | ) |
| Gain on sales of  securities                                   |       | —                 |       | 3,938 |   |
| Loss on early  extinguishment of debt                          |       | —                 |       | (14,006 | ) |
| Interest income                                                |       | 4,106                  |       | 1,207 |   |
| Interest expense                                               |       | (3,290                 | )          | (3,743 | ) |
| Other expense                                                  |       | (224                   | )          | (164 | ) |
| Total other  income (expense), net                             |       | 1,012                  |       | (15,238 | ) |
|                                                           |       |                   |       |   |   |
| Income before  income taxes                                    |       | 61,763                 |       | 72,915 |   |
| Provision for  income taxes                                    |       | 22,852                 |       | 26,256 |   |
| Net income                                                     |       | $                      | 38,911     |   | $ | 46,659 |   |
|                                                           |       |                   |       |   |   |
| Earnings per  share (as restated per Note 1):                  |       |                   |       |   |   |
| Basic                                                          |       | $                      | 0.36       |   | $ | 0.43 |   |
| Diluted                                                        |       | $                      | 0.33       |   | $ | 0.39 |   |
|                                                           |       |                   |       |   |   |
| Weighted average  shares outstanding (as restated per Note 1): |       |                   |       |   |   |
| Basic                                                          |       | 109,136                |       | 108,580 |   |
| Diluted                                                        |       | 124,104                |       | 125,137 |   |

 

*See accompanying Notes to Condensed ConsolidatedFinancial Statements.*

 

2

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* *

**WATSONPHARMACEUTICALS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited; in thousands)

 
| ** **                                                    | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                    | ** ** | **March 31,**          | ** ** |
| ** **                                                    | ** ** | **2005**               | ** ** | **2004** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                    |       |                   |       |   |   |
| Net income                                                    |       | $                      | 38,911     |   | $ | 46,659 |   |
| Reconciliation  to net cash provided by operating activities: |       |                   |       |   |   |
| Depreciation                                                  |       | 9,365                  |       | 7,026 |   |
| Amortization                                                  |       | 40,638                 |       | 17,932 |   |
| Deferred income  tax (provision) benefit                      |       | (56                    | )          | 7,842 |   |
| Equity in  (earnings) losses of joint ventures                |       | (420                   | )          | 1,579 |   |
| Gain on sales of  securities                                  |       | —                 |       | (3,938 | ) |
| Loss on early  extinguishment of debt                         |       | —                 |       | 14,006 |   |
| Loss on  impairment of investments and other assets           |       | —                 |       | 891 |   |
| Tax benefits  from employee stock plans                       |       | 1,490                  |       | 3,410 |   |
| Mark to market  on derivative                                 |       | (569                   | )          | (225 | ) |
| Other                                                         |       | (1,992                 | )          | (314 | ) |
| Changes in  assets and liabilities:                           |       |                   |       |   |   |
| Accounts  receivable, net                                     |       | 21,435                 |       | (3,002 | ) |
| Inventories                                                   |       | 6,521                  |       | (2,395 | ) |
| Prepaid expenses  and other current assets                    |       | 4,665                  |       | 1,803 |   |
| Accounts payable  and accrued expenses                        |       | (11,226                | )          | (5,813 | ) |
| Deferred revenue                                              |       | (1,438                 | )          | (4,644 | ) |
| Income taxes  payable                                         |       | (2,867                 | )          | (71,588 | ) |
| Other assets                                                  |       | 910                    |       | 796 |   |
| Total  adjustments                                            |       | 66,456                 |       | (36,634 | ) |
| Net cash  provided by operating activities                    |       | 105,367                |       | 10,025 |   |
|                                                          |       |                   |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                    |       |                   |       |   |   |
| Additions to  property and equipment                          |       | (10,294                | )          | (23,169 | ) |
| Acquisitions of  product rights                               |       | (25                    | )          | (158 | ) |
| Proceeds from  sales of marketable equity securities          |       | —                 |       | 4,706 |   |
| Proceeds from  sale of Halsey note receivable                 |       | —                 |       | 5,381 |   |
| Other investing  activities, net                              |       | —                 |       | 1,783 |   |
| Net cash used in  investing activities                        |       | (10,319                | )          | (11,457 | ) |
|                                                          |       |                   |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                    |       |                   |       |   |   |
| Payments to  repurchase 1998 Senior Notes                     |       | —                 |       | (101,615 | ) |
| Premium paid on  1998 Senior Notes repurchase                 |       | —                 |       | (14,006 | ) |
| Repurchase of  common stock                                   |       | (69,078                | )          | — |   |
| Principal payments  on acquisition liabilities                |       | (2                     | )          | (2 | ) |
| Proceeds from  stock plans                                    |       | 8,764                  |       | 13,107 |   |
| Net cash used in  financing activities                        |       | (60,316                | )          | (102,516 | ) |
| Net increase in  cash and cash equivalents                    |       | 34,732                 |       | (103,948 | ) |
| Cash and cash  equivalents at beginning of period             |       | 298,653                |       | 318,043 |   |
| Cash and cash  equivalents at end of period                   |       | $                      | 333,385    |   | $ | 214,095 |   |

 

*See accompanying Notes to Condensed ConsolidatedFinancial Statements.*

 

3

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**WATSONPHARMACEUTICALS, INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1 – GENERAL**

 

Watson Pharmaceuticals,Inc. (Watson or the Company) is primarily engaged in the development,manufacture, marketing, sale and distribution of brand and off-patent (generic)pharmaceutical products.  Watson wasincorporated in 1985 and began operations as a manufacturer and marketer ofoff-patent pharmaceuticals.  Throughinternal product development and synergistic acquisitions of products andbusinesses, the Company has grown into a diversified specialty pharmaceuticalcompany.  Watson operates manufacturing,distribution, research and development and administrative facilities primarilyin the United States of America (U.S.).

 

The accompanyingcondensed consolidated financial statements should be read in conjunction withthe Company’s Annual Report on Form 10-K for the year ended December 31,2004.  Certain information and footnotedisclosures normally included in annual financial statements prepared inaccordance with generally accepted accounting principles have been condensed oromitted from the accompanying consolidated financial statements.  The year end balance sheet was derived fromthe audited financial statements.  Theaccompanying interim financial statements are unaudited, but reflect alladjustments which are, in the opinion of management, necessary to presentfairly Watson’s consolidated financial position, results of operations and cashflows for the periods presented.  Unlessotherwise noted, all such adjustments are of a normal, recurring nature.  Certain reclassifications, none of whichaffected net income or retained earnings, have been made to prior periodamounts to conform to current period presentation.  The Company’s results of operations and cashflows for the interim periods are not necessarily indicative of the results ofoperations and cash flows that it may achieve in future periods or for the fullyear.

 

*Comprehensive income*

 

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

 
| ** **                                          | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|
| ** **                                          | ** ** | **2005**                         | ** ** | **2004** | ** ** |
|                                                |       |                             |       |   |   |
| Net income                                          |       | $                                | 38,911     |   | $ | 46,659 |   |
|                                                |       |                             |       |   |   |
| Other  comprehensive loss:                          |       |                             |       |   |   |
| Unrealized  holding loss on securities              |       | (3,499                           | )          | (97 | ) |
| Less related  income taxes                          |       | 1,305                            |       | 35 |   |
| Total unrealized  loss on securities, net           |       | (2,194                           | )          | (62 | ) |
|                                                |       |                             |       |   |   |
| Reclassification  for losses included in net income |       | —                           |       | (1,091 | ) |
| Less related  income taxes                          |       | —                           |       | 392 |   |
| Total  reclassification, net                        |       | —                           |       | (699 | ) |
| Total other  comprehensive loss                     |       | (2,194                           | )          | (761 | ) |
| Total  comprehensive income                         |       | $                                | 36,717     |   | $ | 45,898 |   |

 

4

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*Earnings per share*

 

Basic earnings per shareis computed by dividing net income by the weighted average common sharesoutstanding during a period.  Dilutedearnings per share is based on the treasury stock method and includes theeffect from potential issuance of common stock, such as shares issuable uponconversion of the $575 million convertible contingent senior debentures(CODES), and shares issuable pursuant to the exercise of stock options,assuming the exercise of all in-the-money stock options.  Common share equivalents have been excludedwhere their inclusion would be anti-dilutive. In accordance with Emerging Issues Task Force (EITF) Issue No. 04-8, “TheEffect of Contingently Convertible Debt on Diluted Earnings per Share,” theCompany is required to add approximately 14.4 million shares associated withthe conversion of the CODES to the number of shares outstanding for thecalculation of diluted earnings per share for all periods in which thesecurities were outstanding.  A reconciliationof the numerators and denominators of basic and diluted earnings per shareconsisted of the following (in thousands, except per share amounts):

 
| ** **                                          | ** ** | **Three months ended** | ** ** |
|-----------------------------------------------------|------------|------------------------|------------|
| ** **                                          | ** ** | **March 31,**          | ** ** |
| ** **                                          | ** ** | **2005**               | ** ** | **2004** | ** ** |
| ** **                                          | ** ** | ** **             | ** ** | ** ** | ** ** |
| **Earnings  per share - basic**                     |       |                   |       |   |   |
| Net income                                          |       | $                      | 38,911     |   | $ | 46,659 |   |
|                                                |       |                   |       |   |   |
| Basic weighted  average common shares outstanding   |       | 109,136                |       | 108,580 |   |
|                                                |       |                   |       |   |   |
| Earnings per  share - basic                         |       | $                      | 0.36       |   | $ | 0.43 |   |
|                                                |       |                   |       |   |   |
| **Earnings  per share - assuming dilution**         |       |                   |       |   |   |
| Net income                                          |       | $                      | 38,911     |   | $ | 46,659 |   |
| Add: Interest  expense on CODES, net of tax         |       | 1,627                  |       | 1,873 |   |
| Net income,  adjusted                               |       | $                      | 40,538     |   | $ | 48,532 |   |
|                                                |       |                   |       |   |   |
| Basic weighted  average common shares outstanding   |       | 109,136                |       | 108,580 |   |
| Effect of  dilutive securities:                     |       |                   |       |   |   |
| Conversion of  CODES                                |       | 14,357                 |       | 14,357 |   |
| Dilutive stock  options                             |       | 611                    |       | 2,200 |   |
| Diluted weighted  average common shares outstanding |       | 124,104                |       | 125,137 |   |
|                                                |       |                   |       |   |   |
| Earnings per  share - diluted                       |       | $                      | 0.33       |   | $ | 0.39 |   |

 

Stock options to purchase6.6 million and 5.5 million common shares for the three month periods endedMarch 31, 2005 and 2004, respectively, were outstanding but were not included in the computation of dilutedearnings per share because the options were antidilutive.

 

*Stock-based compensation*

 

The Companyaccounts for its stock-based employee compensation plans using the recognitionand measurement principles of Accounting Principles Board (APB) Opinion No. 25,“Accounting for Stock Issued to Employees” (APB 25) and relatedinterpretations.  No stock-based employeecompensation expense has been recognized for the options in the accompanyingcondensed consolidated statements of income, as all options granted under theplans had an exercise price equal to the market value of the underlying commonstock on the date of grant.

 

5

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The Company haselected to use the intrinsic value method under APB 25 as permitted byStatement of Financial Accounting Standards (SFAS) No. 123, “Accounting forStock-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 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 awards to employees. The Company estimates the fair value of its stock-based awards toemployees using the Black-Scholes option pricing model.  The pro forma effects on net income andearnings per share are as follows (in thousands, except per share amounts):

 
| ** **                                                                                                                                    | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                                                    | ** ** | **March 31,**          | ** ** |
| ** **                                                                                                                                    | ** ** | **2005**               | ** ** | **2004** | ** ** |
|                                                                                                                                          |       |                   |       |   |   |
| Net income, as  reported                                                                                                                      |       | $                      | 38,911     |   | $ | 46,659 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | 3,099                  |       | 4,461 |   |
| Pro forma net  income                                                                                                                         |       | 35,812                 |       | 42,198 |   |
| Add: Interest  expense on CODES                                                                                                               |       | 1,627                  |       | 1,873 |   |
| Pro forma net  income, adjusted                                                                                                               |       | $                      | 37,439     |   | $ | 44,071 |   |
|                                                                                                                                          |       |                   |       |   |   |
| Earnings per  share:                                                                                                                          |       |                   |       |   |   |
| Basic - as  reported                                                                                                                          |       | $                      | 0.36       |   | $ | 0.43 |   |
| Basic - pro  forma                                                                                                                            |       | $                      | 0.33       |   | $ | 0.39 |   |
|                                                                                                                                          |       |                   |       |   |   |
| Diluted - as  reported                                                                                                                        |       | $                      | 0.33       |   | $ | 0.39 |   |
| Diluted - pro  forma                                                                                                                          |       | $                      | 0.30       |   | $ | 0.35 |   |

 

The weightedaverage fair values of the employee stock options and employee stock purchaseplan (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 assumptions were used for stock options grantedduring the three months ended March 31, 2005 and 2004:

 
| ** **                                           | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|
| ** **                                           | ** ** | **March 31,**          | ** ** |
| ** **                                           | ** ** | **2005**               | ** ** | **2004** | ** ** |
|                                                 |       |                   |       |   |   |
| Dividend yield                                       |       | None                   |       | None |   |
| Expected  volatility                                 |       | 26                     | %          | 21 | % |
| Risk-free  interest rate                             |       | 4.00                   | %          | 3.51 | % |
| Expected term                                        |       | 5.5 years              |       | 5.3 years |   |
|                                                 |       |                   |       |   |   |
| Weighted average  fair value per share at grant date |       | $                      | 9.87       |   | $ | 12.59 |   |
|                                                      |            |                        |            |  |  |  |  |

 

6

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The followingweighted average assumptions were used for the ESPP during the three months endedMarch 31, 2005 and 2004:

 

| ** **                                           | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|
| ** **                                           | ** ** | **March 31,**          | ** ** |
| ** **                                           | ** ** | **2005**               | ** ** | **2004** | ** ** |
|                                                 |       |                   |       |   |   |
| Dividend yield                                       |       | None                   |       | None |   |
| Expected  volatility                                 |       | 26                     | %          | 21 | % |
| Risk-free  interest rate                             |       | 4.00                   | %          | 3.51 | % |
| Expected term                                        |       | 6 months               |       | 6 months |   |
|                                                 |       |                   |       |   |   |
| Weighted average  fair value per share at grant date |       | $                      | 7.31       |   | $ | 9.73 |   |
|                                                      |            |                        |            |  |  |  |  |

 

*Stock Repurchases*

 

Under the Company’s$300.0 million stock repurchase program approved by the Board of Directors(Board) on February 10, 2005, we repurchased approximately 2.2 million sharesof our common stock during the first quarter of 2005 at an aggregate cost ofapproximately $69.1 million.  As of March31, 2005, the Company had approximately $230.9 million available for futurerepurchases of its common stock under this Board authorization.  This program provides for purchases to bemade in the open market or in privately negotiated transactions throughFebruary 2006.

 

*Recent accounting 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 “so 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 this Statementshall be applied prospectively.  TheCompany believes that the adoption of SFAS 151 will not have a material effecton our Condensed Consolidated Financial Statements.

 

InDecember 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-BasedPayment” (SFAS 123R), which replaces SFAS 123, and supercedes APB 25.Under SFAS 123R, the Company must determine the appropriate fair value model tobe used for valuing share-based payment transactions with employees, theamortization method for compensation cost and the transition method to be usedat date of adoption. The transition methods include modified prospective andmodified retrospective adoption options. Under the modified retrospectiveoption, prior periods may be restated either as of the beginning of the year ofadoption or for all periods presented. The modified prospective method requiresthat compensation 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 the method of adoption or the effect of adoptingSFAS 123R, and it has not determined whether the adoption will result inamounts that are similar to the current pro forma disclosures underSFAS 123.

 

In April 2005, theSecurities and Exchange Commission announced an amendment to Regulation S-X toamend the date for compliance with FAS 123R. The amendment requires each registrant that is not a small business issuerto adopt FAS 123R in the first fiscal year commencing after June 15, 2005.  The Company is required to adopt SFAS 123Rbeginning January 1, 2006.  Adoption ofFAS 123R will have a significant impact

 

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on our consolidatedfinancial statements, as we will be required to expense the fair value of ouremployee stock option and ESPP grants rather than disclose the pro forma impacton our consolidated net income within the footnotes to our consolidatedfinancial statements, as is our current practice.

 

**NOTE 2 –INVESTMENTS**

 

The Company’s equityinvestments in publicly traded companies are classified as available-for-saleand are recorded at fair value based on quoted market prices using the specificidentification method.  These investmentsare classified as current marketable securities, or investment and otherassets, as appropriate, on the Company’s Condensed Consolidated Balance Sheets.

 

The Company’s debtinvestments in U.S. Treasury securities and auction rate securities areclassified as available-for-sale and are recorded at fair value based on quotedmarket prices using the specific identification method.

 

The followingtable provides a summary of the fair value and unrealized holding gain (loss)related to Watson’s available-for-sale securities at March 31, 2005 andDecember 31, 2004 (in thousands):

 
| **At March 31, 2005**     | ** ** | **Cost, Including  Accrued Interest** | ** ** | **Gross Unrealized  Gains** | ** ** | **Gross Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|---------------------------|------------|---------------------------------------|------------|-----------------------------|------------|------------------------------|------------|----------------|------------|
|                      |       |                                  |       |                        |       |                         |       |           |       |
| Available-for-sale:       |       |                                  |       |                        |       |                         |       |           |       |
| U.S. Treasury  securities |       | $                                     | 200,688    |                        | $          | —                       |       | $              | (1,709     | ) | $ | 198,979 |   |
| Auction rate  securities  |       | 170,396                               |       | —                      |       | —                       |       | 170,396        |       |
| Equity  securities        |       | 3,604                                 |       | 13,294                      |       | —                       |       | 16,898         |       |
| Total                     |       | $                                     | 374,688    |                        | $          | 13,294                       |       | $              | (1,709     | ) | $ | 386,273 |   |

 
| **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        |       | 3,604                                  |       | 14,975                       |       | —                        |       | 18,579          |       |
| Total                     |       | $                                      | 372,131    |                         | $          | 14,975                        |       | $               | (105       | ) | $ | 387,001 |   |

 

Gross unrealizedgains at March 31, 2005 and December 31, 2004 primarily relate to our holdingsin shares of Andrx Corporation (Andrx) common stock.  The gross unrealized holding loss at March31, 2005 and December 31, 2004 is attributable to adjustments, included inother comprehensive income, for the decline in fair value in the Company’sinvestment in U.S. Treasury securities.

 

The Company’s netunrealized holding gain related to its available-for-sale securities decreased$2.2 million for the three month period ended March 31, 2005.  During the three month period ended March 31,2004, the Company’s net unrealized holding gain decreased $0.8 million.  These changes in the Company’s net unrealizedholding gain are included in other comprehensive loss.

 

*Current investments*

 

The Company’s investmentin the common stock of Andrx, publicly traded on the Nasdaq Stock Market underthe symbol ADRX, is classified as a current investment on the Company’sCondensed Consolidated Balance Sheets at March 31, 2005 and December 31, 2004.

 

The Company didnot sell any of its shares of Andrx during the three month period ended March31, 2005.     During the three monthperiod ended March 31, 2004, Watson sold 150,000 shares of its investment inthe common stock of Andrx for proceeds of $4.3 million and recorded a pre-taxgain of $3.9 million.  Realized gains arecomputed using the specific identification method to determine the cost basisfor each investment.

 

8

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The Company’sinvestments in U.S. Treasury securities and auction rate securities areclassified as a current investment on the Company’s Condensed ConsolidatedBalance Sheet at March 31, 2005 and December 31, 2004.

 

The contractualmaturities of the U.S. Treasury securities at March 31, 2005 are as follows (inthousands):

 
| ** **               | ** ** | **Fair value** | ** ** |
|--------------------------|------------|----------------|------------|
|                     |       |           |       |
| Mature within  one year  |       | $              | 49,773     |   |
| Mature within  two years |       | 149,206        |       |
|                     |       | $              | 198,979    |   |

 

*Non-current investments*

 

The Company’sinvestments in the common stock of Genelabs Technologies, Inc. (Genelabs),NovaDel Pharma Inc. and Amarin Corporation plc (Amarin) are classified asnon-current investments and are included in “Investments and other assets” onthe Company’s Condensed Consolidated Balance Sheets at March 31, 2005 andDecember 31, 2004.

 

**NOTE 3 –OPERATING SEGMENTS**

 

Watson has twooperating segments: brand and generic. The brand business segment includes the Company’s lines of SpecialtyProducts and Nephrology products. Watson has aggregated its brand product linesin a single segment because of similarities in regulatory environment,manufacturing processes, methods of distribution and types of customer.  This segment includes patent-protectedproducts and certain trademarked off-patent products that Watson sells andmarkets as brand pharmaceutical products. The generic business segment includes off-patent pharmaceutical productsthat are therapeutically equivalent to proprietary products.  The Company sells its brand and genericproducts primarily to pharmaceutical wholesalers, drug distributors and chaindrug stores.

 

Prior to January1, 2005, the Company evaluated the performance of its segments based on netrevenues and gross profit.  As of January1, 2005, the Company began to evaluate segment performance based on netrevenues and segment contribution. Segment contribution represents segmentgross profit less direct research and development expenses and selling andmarketing expenses.  Segment financialdata for prior periods have been reclassified to reflect this change inevaluating the associated segment results.

 

The “other”classification for the three month period ended March 31, 2005 and 2004consists primarily of royalties and revenues from research, development andlicensing fees.  The Company has notreported general and administrative expenses, amortization, depreciationexpense, total assets, and capital expenditures by segment as such informationis not used by management, or accounted for at the segment level.  Net revenues

 

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and segmentcontribution information for the Company’s brand and generic segments, as reclassified,consisted of the following:

 
| **Three months ended March 31,  2005** | ** ** | **Brand** | ** ** | **Generic** | ** ** | **Other** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|-----------|------------|-------------|------------|-----------|------------|-----------|------------|
| Net revenues                           |       | $         | 104,526    |        | $          | 293,163   |       | $         | 3,139      |   | $ | 400,828 |   |
| Cost of revenue                        |       | 23,760    |       | 183,190     |       | —    |       | 206,950   |       |
| Gross profit                           |       | 80,766    |       | 109,973     |       | 3,139     |       | 193,878   |       |
| Gross margin                           |       | 77%       |       | 38%         |       |      |       | 48%       |       |
| Operating expenses                     |       |      |       |        |       |      |       |      |       |
| Research and  development              |       | 9,694     |       | 19,144      |       |      |       | 28,838    |       |
| Selling and  marketing                 |       | 27,468    |       | 11,260      |       |      |       | 38,728    |       |
| Contribution                           |       | $         | 43,604     |        | $          | 79,569    |       | $         | 3,139      |   | 126,312 |   |
| Contribution  margin                   |       | 42%       |       | 27%         |       |      |       | 32%       |       |
| General and  administrative            |       |      |       |        |       |      |       | 24,923    |       |
| Amortization                           |       |      |       |        |       |      |       | 40,638    |       |
| Operating income                       |       |      |       |        |       |      |       | $         | 60,751     |   |

 
| **Three months ended  March 31, 2004** | ** ** | **Brand** | ** ** | **Generic** | ** ** | **Other** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|-----------|------------|-------------|------------|-----------|------------|-----------|------------|
| Net revenues                                |       | $         | 88,376     |        | $          | 306,022   |       | $         | 15,260     |   | $ | 409,658 |   |
| Cost of revenue                             |       | 17,651    |       | 178,830     |       | —    |       | 196,481   |       |
| Gross profit                                |       | 70,725    |       | 127,192     |       | 15,260    |       | 213,177   |       |
| Gross margin                                |       | 80%       |       | 42%         |       |      |       | 52%       |       |
| Operating  expenses                         |       |      |       |        |       |      |       |      |       |
| Research and  development                   |       | 11,771    |       | 17,910      |       |      |       | 29,681    |       |
| Selling and  marketing                      |       | 42,602    |       | 9,293       |       |      |       | 51,895    |       |
| Contribution                                |       | $         | 16,352     |        | $          | 99,989    |       | $         | 15,260     |   | 131,601 |   |
| Contribution  margin                        |       | 19%       |       | 33%         |       |      |       | 32%       |       |
| General and  administrative                 |       |      |       |        |       |      |       | 25,516    |       |
| Amortization                                |       |      |       |        |       |      |       | 17,932    |       |
| Operating income                            |       |      |       |        |       |      |       | $         | 88,153     |   |

 

**NOTE 4 – INVENTORIES**

 

Inventories consist offinished goods held for sale and distribution, raw materials andwork-in-process. Included in inventory at March 31, 2005 is approximately $9.2million of inventory that is pending approval by the U.S. Food and DrugAdministration (FDA) or has not been launched due to contractualrestrictions.  This inventory consists ofgeneric pharmaceutical products that are capitalized only when thebioequivalence of the product is demonstrated or the product is already FDAapproved and is awaiting a contractual triggering event to enter themarketplace.

 

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

 
| ** **         | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|--------------------|------------|---------------|------------|------------------|------------|
| ** **         | ** ** | **2005**      | ** ** | **2004**         | ** ** |
|               |       |          |       |             |       |
| Raw materials      |       | $             | 113,862    |             | $          | 109,422 |   |
| Work-in-process    |       | 67,585        |       | 70,207           |       |
| Finished goods     |       | 133,331       |       | 141,670          |       |
| Total  inventories |       | $             | 314,778    |             | $          | 321,299 |   |

 

**NOTE 5 – GOODWILL AND OTHERINTANGIBLE ASSETS**

 

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

 

During the second quarter of 2004, Watsonperformed its annual test for the impairment of goodwill and determined therewas no indication of impairment.  Therewere no additions to goodwill recorded during the three months ended March 31,2005.  At March 31, 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 product rights.  The original cost and accumulatedamortization of these intangible assets are as follows (in thousands):

 
| ** **                                         | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|---------------|------------|------------------|------------|
| ** **                                         | ** ** | **2005**      | ** ** | **2004**         | ** ** |
|                                               |       |          |       |             |       |
| Product rights  and related intangibles            |       | $             | 1,266,537  |             | $          | 1,266,512 |   |
| Less accumulated  amortization                     |       | (394,404      | )          | (353,766         | )          |
| Total product  rights and related intangibles, net |       | $             | 872,133    |             | $          | 912,746 |   |

 

Assuming no additions, disposals or adjustments are made to thecarrying values and/or useful lives of the assets, annual amortization expenseon product rights and related intangibles is estimated to be approximately $165.0million in 2005, 2006 and 2007 and $53.0 million in 2008 and 2009.  The Company’s current product rights andrelated intangibles have a weighted average useful life of approximatelythirteen years.

 

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**NOTE 6 – LONG-TERM DEBT**

 

Long-term debt consisted of the following (in thousands):

 
| ** **                                                                                                      | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|---------------|------------|------------------|------------|
| ** **                                                                                                      | ** ** | **2005**      | ** ** | **2004**         | ** ** |
| ** **                                                                                                      | ** ** | ** **    | ** ** | ** **       | ** ** |
| Senior unsecured  notes, 7.125%, face amount of $14 million, due 2008, net of unamortized  discount             |       | $             | 14,041     |             | $          | 14,036 |   |
| Convertible  contingent debentures (CODES), face amount of $575 million, due 2023, net of  unamortized discount |       | 573,642       |       | 573,573          |       |
| Other notes  payable                                                                                            |       | 41            |       | 44               |       |
| Total long-term  debt                                                                                           |       | $             | 587,724    |             | $          | 587,653 |   |
|                                                                                                                 |            |               |            |                  |            |  |  |  |

 

*1998Senior Notes*

 

In May 1998,Watson issued $150 million of its senior unsecured notes (1998 SeniorNotes).  The 1998 Senior Notes are due inMay 2008 but may be redeemed earlier under certain circumstances.  The Company is required to make interest onlypayments due semi-annually in May and November at an effective annual rate of7.2%.  At March 31, 2005 and December 31,2004, the unamortized discount for the 1998 Senior Notes was $54,000 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, theCompany 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.

 

*CODES*

 

In March 2003, theCompany issued $575 million of CODES. The CODES, which are convertible into shares of Watson’s common stockupon the occurrence of certain events, are due in March 2023, with interestpayments due semi-annually in March and September at an effective annualinterest rate of  2.1%, excluding changesin fair value of the contingent interest derivative. At March 31, 2005 andDecember 31, 2004, the unamortized discount for the CODES for both periods was$1.4 million.

 

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

 

•                  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

 

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closing sale priceper share of Watson’s common stock for a period of at least 20 trading daysduring the 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 following any 10consecutive trading-day period in which the daily average trading price for theCODES for such ten-day period was less than 105% of the average conversionvalue for the debentures during that period. This conversion feature represents an embedded derivative.  However, based on the de minimis valueassociated with this feature, no value has been assigned at issuance and atMarch 31, 2005;

 

•                  duringany period, following the earlier of (a) the date the CODES are rated by bothStandard & Poor’s Rating Services and Moody’s Investor Services, Inc., and(b) April 21, 2003, when the long-term credit rating assigned to the CODES byeither Standard & Poor’s or Moody’s (or any successors to these entities)is lower than “BB” or “Ba3”, respectively, or when either of these ratingagencies does not have a rating then assigned to the CODES for any reason,including any withdrawal or suspension of a rating assigned to the CODES.  This conversion feature represents anembedded derivative.  However, based onthe de minimis value associated with this feature, no value has been assignedat issuance and at March 31, 2005;

 

•                  ifthe CODES have been called for redemption; or

 

•                  uponthe occurrence of specified corporate transactions.

 

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

 

The CODES containput options which may require the Company to repurchase for cash all or aportion of the CODES on March 15 of 2010, 2015 and 2018 at a repurchase priceequal to 100% of the principal amount of the CODES plus any accrued and unpaidinterest (including contingent interest) to, but excluding, the date ofrepurchase.

 

In addition, theholders of the CODES have the right to receive contingent interest paymentsduring any six-month period from March 15 to September 14 and from September 15to March 14, commencing on September 15, 2003, if the average trading price ofthe CODES for the five trading days ending on the second trading dayimmediately preceding the relevant six-month period equals 120% or more of theprincipal amount of the CODES.  Theinterest rate used to calculate the contingent interest is the greater of 5% ofthe Company’s then-current estimated per annum borrowing rate for seniornon-convertible fixed-rate debt with a maturity date and other terms comparableto that of the CODES or 0.33% per annum. This contingent interest payment feature is an embedded derivative andhas been bifurcated and recorded separately in the Condensed ConsolidatedBalance Sheets in other long-term liabilities. The initial fair value assigned to the embedded derivative was $1.9million, which is recorded as a discount to the CODES.  Changes to the fair value of this embeddedderivative are reflected as an adjustment to interest expense.  The current value of the embedded derivativewas $1.1 million at March 31, 2005.

 

*CreditFacility*

 

In May 2003, theCompany 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. Watson’s assets generally are held by, and its operationsgenerally are conducted through, its subsidiaries.  Within the meaning of Regulation S-X, Rule3-10, the Company has no assets or operations independent of itssubsidiaries.  The terms of the Credit Facilityrequire each subsidiary, other than minor

 

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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 March 31, 2005, the Company was incompliance.  As of March 31, 2005, theCompany had not drawn any funds from the Credit Facility.

 

**NOTE 7 –FINANCIAL INSTRUMENTS**

 

*Fairvalue of financial instruments*

 

The Company’sfinancial instruments consist primarily of cash and cash equivalents,marketable securities, accounts and other receivables, investments, tradeaccounts payable, senior subordinated notes, CODES and embedded derivativesrelated to the issuance of the CODES. The carrying amounts of cash and cash equivalents, marketablesecurities, accounts and other receivables and trade accounts payable arerepresentative of their respective fair values due to their relatively shortmaturities.  The fair values ofinvestments in companies that are publicly traded are based on quoted marketprices.  The fair value of investments inprivately held companies, or cost-method investments, are based on historicalcost, adjusted for any write-down related to impairment.  The Company estimates the fair value of itsfixed rate long-term obligations based on quoted market rates of interest andmaturity schedules for similar issues. The carrying value of these obligations approximates their fairvalue.  The fair value of the embeddedderivatives related to the CODES is based on a present value technique usingdiscounted expected future cash flows.

 

*Derivativefinancial instruments*

 

The Company’sderivative financial instruments consist of embedded derivatives related to itsCODES.  These embedded derivativesinclude certain conversion features and a contingent interest feature.   See Note 6 for a more detailed descriptionof these features of the CODES.  Althoughthe conversion features represent embedded derivative financial instruments,based on the de minimis value of these features at the time of issuance and atMarch 31, 2005, no value has been assigned to these instruments.  The contingent interest feature providesunique tax treatment under the Internal Revenue Service’s Contingent DebtRegulations.  In essence, interestaccrues, for tax purposes, on the basis of the instrument’s comparable yield(the yield at which the issuer would issue a fixed rate instrument with similarterms). This embedded derivative is reported on the Company’s CondensedConsolidated Balance Sheets at fair value and the changes in the fair value ofthe embedded derivative are reported as gains or losses in the Company’sCondensed Consolidated Statements of Income.

 

The carrying valueof the Company’s derivative financial instruments, which approximates fairvalue, decreased $0.6 million from $1.7 million at December 31, 2004 to $1.1million at March 31, 2005.  The change infair value was recorded as a reduction of interest expense during the respectiveperiod.

 

**NOTE 8 –COMMITMENTS AND CONTINGENCIES**

 

*Facilityand equipment leases*

 

The Company hasentered into long-term operating leases for certain facilities andequipment.  The terms of the operatingleases for the Company’s facilities require the Company to pay property taxes,normal maintenance expenses and maintain minimum insurance coverage.  Total rental expense for operating leases forthe three months ended March 31, 2005 and 2004 were $2.9 million and $2.8million, respectively.

 

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Future minimumlease payments under all non-cancelable operating leases consist ofapproximately $6.1 million remaining in 2005, $7.0 million in 2006, $5.5million in 2007, $3.4 million in 2008, $2.6 million in 2009 and $14.4 millionthereafter.

 

*Employeeretirement plans*

 

The Companymaintains certain defined contribution retirement plans covering substantiallyall employees.  The Company contributesto the plans based upon the employee contributions.  Watson’s contributions to these retirementplans for the three months ended March 31, 2005 and 2004 were $1.8 million and$1.4 million, respectively.  The Companydoes not sponsor any defined benefit retirement plans or postretirement benefitplans.

 

*Legal matters*

 

The Company isparty to certain lawsuits and legal proceedings, which are described in “PartI, Item 3. Legal Proceedings,” of our Annual Report on Form 10-K for the yearended December 31, 2004.  The followingis a description of material developments during the period covered by thisQuarterly Report and through the filing of this Quarterly Report, and should beread in conjunction with the Annual Report referenced above.

 

*Phen-fenlitigation.*  Withrespect to the phentermine hydrochloride product liability lawsuits pendingagainst the Company, certain subsidiaries, and others, additional actionsraising similar issues have been filed, and some actions have been settled orotherwise dismissed.  As of May 6, 2005,approximately 370 cases were pending against Watson and its affiliates innumerous state and federal courts.  Mostof the cases involve multiple plaintiffs, and several were filed or certifiedas class actions.  The Company believesit will be fully indemnified by Rugby’s former owner, Aventis Pharmaceuticals(Aventis, formerly known as Hoechst Marion Roussel, Inc., and now known asSanofi-Aventis) for the defense of all such cases and for any liability thatmay arise out of these cases.  Aventis iscurrently controlling the defense of all these matters as the indemnifyingparty under its agreements with the Company.

 

*Cipro®Litigation. *OnMarch 31, 2005, the U.S. District Court for the Eastern District of New Yorkgranted summary judgment in the consolidated action (*In re:Ciprofloxacin Hydrochloride Antitrust Litigation, MDL Docket No. 001383*)in favor of the defendants on all of plaintiffs’ claims, denied the plaintiffs’motions for class certification, and directed the clerk of the court to closethe case.  The clerk entered judgment onApril 5, 2005.  Plaintiffs are expectedto appeal.  In the action pending in theCalifornia Superior Court for the County of San Diego (*In re: CiproCases I & II, JCCP Proceeding Nos. 4154 & 4220*), on April14, 2005, the court granted the parties’ joint request for a stay of allproceedings, vacated all previously set dates and deadlines in the case, andset a further status conference for October 14, 2005, at which time the partiesare to report on the status of the appeal of the consolidated action.  In the action pending in the Kansas StateCourt (*Sandhaus v. Bayer, et al., Johnson County Dist.Court Case No. 00CV06193*), on April 22, 2005, the court granted theparties’ joint motion to stay all proceedings pending the outcome of the appealin the consolidated action, vacated all pending dates and settings, and set astatus conference for October 7, 2005, at which time the parties are to reporton the status of the appeal in the consolidated action.

 

*GovernmentalReimbursement Investigations and Drug Pricing Litigation.*  With respect to the Drug Pricing Litigationpending against the Company and certain subsidiaries, additional actionsraising similar allegations were filed in April and May 2005.  As of May 6, 2005, in addition to theconsolidated action pending in the United States District Court for theDistrict of Massachusetts (*In re: PharmaceuticalIndustry Average Wholesale Price Litigation, MDL Docket No.*1456),there were approximately 33 cases pending against the Company or itssubsidiaries and other third parties, including actions by seven StateAttorneys General, the City of New York, and numerous counties in New YorkState.  Additional actions areanticipated.

 

15

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These actions, ifsuccessful, could adversely affect the Company and may have a material adverseeffect on the Company’s business, results of operations, financial conditionand cash flows.

 

*FDAMatters.*   In May2002, Watson reached an agreement with the FDA on the terms of a consent decreewith respect to its Corona, California manufacturing facility.  The court approved the consent decree on May13, 2002 (*United States of America v. Watson Laboratories,Inc., and Allen Y. Chao*, United States District Court for theCentral District of California, EDCV-02-412-VAP).  From April 5, 2005 through April 13, 2005,the FDA conducted an inspection of the Company’s Corona, Californiafacility.  At the conclusion of theinspection no formal observations were made and no FDA Form 483 was issued.However, if, in the future, the FDA determines that, with respect to its Coronafacility, Watson has failed to comply with the consent decree or FDAregulations, including current Good Manufacturing Practices (cGMPs), theconsent decree allows the FDA to order Watson to take a variety of actions toremedy the deficiencies. These actions could include ceasing manufacturing andrelated operations at the Corona facility, and recalling affectedproducts.  Such actions, if taken by the FDA,could adversely affect the Company, its results of operations, financialposition and/or cash flows.

 

*SecuritiesLitigation.*  OnMarch 14, 2005, the appellants in the action pending in the U.S. Court ofAppeals for the Ninth Circuit (*Pension Fund v. WatsonPharmaceuticals, Inc., USCA Docket No. 04-56791*) filed their openingbrief.  The defendants filed theiranswering brief on April 27, 2005, and the appellants are required to filetheir reply brief, if any, on or before May 11, 2005.

 

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

 

16

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

 

The followingdiscussion of our financial condition and the results of our operations shouldbe read in conjunction with the condensed consolidated financial statements andnotes thereto included elsewhere in this Quarterly Report.  This discussion contains forward-lookingstatements that are subject to known and unknown risks, uncertainties and otherfactors that may cause our actual results to differ materially from thoseexpressed or implied by such forward-looking statements.  These risks, uncertainties and other factorsinclude, among others, those identified under “Cautionary Note RegardingForward-Looking Statements” and elsewhere in this Quarterly Report and under “RisksRelated to our Business” in our Annual Report on Form 10-K for the year endedDecember 31, 2004.

 

**Overview**

 

Watson Pharmaceuticals,Inc. (Watson, the “Company” “we”, “us” or “our”) was incorporated in 1985 andis engaged in the development, manufacture, marketing, sale and distribution ofbrand and off-patent (generic) pharmaceutical products. Watson operatesmanufacturing, distribution, research and development, and administrativefacilities primarily in the United States (U.S.).

 

Prescriptionpharmaceutical products in the U.S. are generally marketed as either generic orbrand pharmaceuticals.  Genericpharmaceutical products are bioequivalents of their respective brand productsand provide a cost-efficient alternative to brand products. Brandpharmaceutical products are marketed under brand names through programs thatare designed to generate physician and consumer loyalty.  As a result of the differences between thetwo types of products, we operate and manage our business as two segments:generic and brand.  As of March 31, 2005,we marketed more than 130 generic pharmaceutical products and more than 20 brandpharmaceutical products.

 

**Resultsof Operations**

 

***NetRevenues***

*** ***
| ** **                   | ** ** | **Three Months Ended March 31,** | ** ** | **Change** | ** ** |
|------------------------------|------------|----------------------------------|------------|------------|------------|
| **($ in thousands):**   | ** ** | **2005**                         | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                         |       |                             |       |       |       |   |   |   |   |
| Generic products             |       | $                                | 293,163    |       | $          | 306,022 |   | $ | (12,859 | ) | -4.2% |   |
| *% of  product net revenues* | * *   | *74%*                            | * *   | *78%*      | * *   |   |   |   |   |
| Brand products               |       |                             |       |       |       |   |   |   |   |
| Specialty  Products          |       | 63,463                           |       | 44,425     |       | 19,038 |   | 42.9% |   |
| Nephrology                   |       | 41,063                           |       | 43,951     |       | (2,888 | ) | -6.6% |   |
| Total brand  products        |       | 104,526                          |       | 88,376     |       | 16,150 |   | 18.3% |   |
| *% of  product net revenues* | * *   | *26%*                            | * *   | *22%*      | * *   | * * | * * | * * | * * |
| * *                     | * *   | * *                         | * *   | * *   | * *   | * * | * * | * * | * * |
| Total product  net sales     |       | 397,689                          |       | 394,398    |       | 3,291 |   | 0.8% |   |
| Other                        |       | 3,139                            |       | 15,260     |       | (12,121 | ) | -79.4% |   |
| Total net  revenues          |       | $                                | 400,828    |       | $          | 409,658 |   | $ | (8,830 | ) | -2.2% |   |

 

*GenericProducts*

 

Our genericpharmaceutical business develops, manufactures, markets, sells and distributesgeneric products that are the therapeutic equivalent to their brand namecounterparts and are generally sold at prices significantly less than the brandproduct. As such, generic products provide an effective and cost-efficientalternative to brand products. When patents or other regulatory exclusivity nolonger protect a brand product, opportunities exist to introduce off-patent orgeneric counterparts to the brand product. Our portfolio of generic productsincludes products we have internally developed, products we have licensed fromthird parties, and products we distribute for third parties.

 

17

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The $12.9 millionor 4% decrease in sales from our generic segment for the first quarter of 2005was primarily due to the following:

 

1.               A decrease in salesof bupropion hydrochloride sustained-release tablets.  Bupropion hydrochloride sustained-releasetablets are a distributed product and was launched during the first quarter of2004.

 

2.               Price reductions onselect generic products, particularly nicotine gum, as a competitor entered thenicotine gum business in December 2004.

 

The decrease in salesfrom the aforementioned products was partially offset by higher sales of ouroral contraceptive products.  Sales oforal contraceptive products represented 28% and 23% of total generic sales forthe three months ended March 31, 2005 and 2004, respectively.  Sales of oral contraceptive products for thethree months ended March 31, 2005 increased approximately $11.0 million to$81.3 million, compared to $70.3 million in the prior year period.

 

We expect sales ofgeneric pharmaceutical products to increase slightly in 2005 as a result of newproduct launches and a full year of sales for the products launched in thethird and fourth quarters of 2004.

 

*BrandProducts*

 

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

 

Our SpecialtyProducts product line consists primarily of products for the treatment ofurologic disorders.  Our portfolio alsoincludes: (i) anti-hypertensive, psychiatry, pain management and dermatologyproducts, (ii) genital warts treatment, and (iii) a visual cervical screeningdevice.

 

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

 

The $16.2 millionor 18% increase in sales from our brand segment for the three months endedMarch 31, 2005, as compared to the same prior year period, was primarilyattributable to an increase in sales within our Specialty Products group.  During the first quarter of 2004, weexperienced a decline in sales of our Androderm® product due tocustomer stocking in the fourth quarter of 2003 in advance of a priceincrease.  The increase in sales ofAndroderm® in 2005 represents a return to normal levels.  We also experienced higher sales for Oxytrol®in the first quarter of 2005 compared to the same prior year period, due to anincrease in total prescription volume which occurred as a result of the impactof physician detailing and managed care accessibility.

 

Sales from ourNephrology business declined $2.9 million or 7% due to slight reductions insales of our Ferrlecit® product.

 

We expect ourSpecialty Products group sales to increase during 2005 as a result of thelaunch of our Trelstar® Depot and Trelstar® LA (collectively “Trelstar”)products for the palliative treatment of advanced prostate cancer in the firsthalf of 2005 and price increases in certain products.  Product sales from our Nephrology group areexpected to remain at 2004 levels.

 

18

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*Other*

 

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

 

The decrease inother revenues in the three months ended March 31, 2005 was primarily relatedto the absence of royalty payments from Aventis Pharmaceuticals (Aventis) inconnection with Barr Laboratories, Inc.’s sales of ciprofloxacin tablets.

 

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

 
| ** **                         | ** ** | **Three Months Ended** | ** ** |
|------------------------------------|------------|------------------------|------------|
| ** **                         | ** ** | **March 31,**          | ** ** |
| ** **                         | ** ** | **2005**               | ** ** | **2004** | ** ** | **Change** | ** ** |
|                               |       |                   |       |   |   |   |   |
| Overall  consolidated gross margin |       | 48.4%                  |       | 52.0% |   | -3.6% |   |
|                               |       |                   |       |   |   |   |   |
| Generic products                   |       | 37.5%                  |       | 41.6% |   | -4.1% |   |
| Brand products                     |       | 77.3%                  |       | 80.0% |   | -2.7% |   |
| Gross margin on  product net sales |       | 48.0%                  |       | 50.2% |   | -2.2% |   |

 

The decrease ingross margin from our generic segment for the three months ended March 31, 2005was primarily due to price reductions on select generic products (particularlynicotine gum, as a competitor entered the nicotine gum business in December2004).

 

Gross margin fromour brand segment decreased as we decreased production levels at certainmanufacturing facilities resulting in higher unit overhead absorption duringthe three months ended March 31, 2005 as compared to the same period of theprior year.

 

The $12.1 milliondecrease in other revenues during the three months ended March 31, 2005 was asignificant factor in the reduction of our overall consolidated gross margin ascompared to prior periods.

 

Overall gross marginsare expected to be between 48.5% and 50% for the full year of 2005.

 

***Researchand Development Expenses***

*** ***
| ** **                                     | ** ** | **Three Months Ended March 31,** | ** ** | **Change** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| **($ in thousands):**                     | ** ** | **2005**                         | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                           |       |                             |       |       |       |   |   |   |   |
| Research and  development expenses by segment: |       |                             |       |       |       |   |   |   |   |
| Generic                                        |       | $                                | 19,144     |       | $          | 17,910 |   | $ | 1,234 |   | 6.9% |   |
| Brand                                          |       | 9,694                            |       | 11,771     |       | (2,077 | ) | -17.6% |   |
| Total research  and development expenses       |       | $                                | 28,838     |       | $          | 29,681 |   | $ | (843 | ) | -2.8% |   |
| *as % of  net revenues*                        | * *   | *7.2%*                           | * *   | *7.2%*     | * *   | * * | * * | * * | * * |

 

19

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

 

Research anddevelopment expenses within our generic segment increased during the threemonths ended March 31, 2005, as compared to the same period of the prior year,due to an increase in the number of generic products being developed inconjunction with our development partners.

 

Research anddevelopment expenses within our brand segment decreased during the three monthsended March 31, 2005, as compared to the same period of the prior year,primarily due to the timing of the commencement of development programs andclinical studies between the two periods.

 

We expect researchand development expenses to increase slightly in the second quarter of2005.  Research and development spendingwill continue to fluctuate during the remaining quarters of 2005 in tandem withthe timing of clinical study costs associated with (i) the Company’s genericproduct pipeline, (ii) the initiation of Phase III studies on the silodosinproduct for benign prostatic hyperplasia, as well as (iii) studies on the nextgeneration formulation of oxybutynin for overactive bladder.

 

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

 
| ** **                                          | ** ** | **Three Months Ended March 31,** | ** ** | **Change** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| **($ in thousands):**                          | ** ** | **2005**                         | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                                |       |                             |       |       |       |   |   |   |   |
| Selling and  marketing expenses by segment:         |       |                             |       |       |       |   |   |   |   |
| Generic                                             |       | $                                | 11,260     |       | $          | 9,293 |   | $ | 1,967 |   | 21.2% |   |
| Brand                                               |       | 27,468                           |       | 42,602     |       | (15,134 | ) | -35.5% |   |
| Total segment  selling and marketing expenses       |       | 38,728                           |       | 51,895     |       | (13,167 | ) | -25.4% |   |
|                                                |       |                             |       |       |       |   |   |   |   |
| Corporate  general and administrative               |       | 24,923                           |       | 25,516     |       | (593 | ) | -2.3% |   |
| Total selling,  general and administrative expenses |       | $                                | 63,651     |       | $          | 77,411 |   | $ | (13,760 | ) | -17.8% |   |
| *as % of  net revenues*                             | * *   | *15.9%*                          | * *   | *18.9%*    | * *   | * * | * * | * * | * * |

 

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

 

Brand segmentselling and marketing expenses decreased during the three months ended March31, 2005 as compared to the same period of the prior year due to costreductions realized from the termination of a long-term contract sales forceagreement during the third quarter of 2004 and the workforce reductionresulting from the realignment of our business strategy announced in June 2004.

 

We expect ourbrand segment selling and marketing and selling, general and administrativeexpenses overall to increase during the second quarter of 2005 due to productlaunch costs associated with the April 2005 launch of our Trelstar products.

 

20

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***Amortization***

 
| ** **                 | ** ** | **Three Months Ended March 31,** | ** ** | **Change** | ** ** |
|----------------------------|------------|----------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2005**                         | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                       |       |                             |       |       |       |   |   |   |   |
| Amortization               |       | $                                | 40,638     |       | $          | 17,932 |   | $ | 22,706 |   | 126.6% |   |
| *as % of  net revenues*    | * *   | *10.1%*                          | * *   | *4.4%*     | * *   | * * | * * | * * | * * |
|                            |            |                                  |            |            |            |  |  |  |  |  |  |  |

 

The Company’samortizable assets consist primarily of acquired product rights.  We regularly review the appropriateness ofthe useful lives assigned to our product rights taking into considerationpotential changes in the markets for our products.  As a result of our review, we accelerated theamortization of several product rights including the Ferrlecit® productrights.  The increase in amortizationexpense in the first quarter of 2005 was primarily due to higher amortizationassociated with the Ferrlecit® product rights.

 

We expectamortization expense in 2005 to increase over 2004 amounts due to theaccelerated amortization of the Ferrlecit® product rights and amortizationrelated to the Trelstar product rights.

 

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

*** ***
| ** **                                     | ** ** | **Three Months Ended March 31,** | ** ** | **Change** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| **($ in thousands):**                     | ** ** | **2005**                         | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                           |       |                             |       |       |       |   |   |   |   |
| Equity in  earnings (losses) of joint ventures |       | $                                | 420        |       | $          | (1,579 | ) | $ | 1,999 |   | -126.6% |   |
| *as % of  net revenues*                        | * *   | *0.1%*                           | * *   | *-0.4%*    | * *   | * * | * * | * * | * * |
|                                                |            |                                  |            |            |            |  |  |  |  |  |  |  |

 

The Company’sequity investments are accounted for under the equity-method when the Company’sownership does not exceed 50% and when the Company can exert significantinfluence over the management of the investee. The loss recorded during the three months ended March 31, 2004represents our equity in losses incurred by Somerset Pharmaceuticals, Inc.(Somerset), our joint venture with Mylan Laboratories, Inc., due to expensesassociated with ongoing trials, operational costs and the remaining U.S. Foodand Drug Administration (FDA) requirements relating to EmsamTM, a selegelinepatch for the treatment of depression.

 

***Gainon Sale of Securities***

*** ***
| ** **                  | ** ** | **Three Months Ended March 31,** | ** ** | **Change** | ** ** |
|-----------------------------|------------|----------------------------------|------------|------------|------------|
| **($ in thousands):**  | ** ** | **2005**                         | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                        |       |                             |       |       |       |   |   |   |   |
| Gain on sale of  securities |       | $                                | —     |       | $          | 3,938 |   | $ | (3,938 | ) | -100.0% |   |
| *as % of  net revenues*     | * *   | *0.0%*                           | * *   | *1.0%*     | * *   | * * | * * | * * | * * |
|                             |            |                                  |            |            |            |  |  |  |  |  |  |  |

 

The 2004 gain onsale of securities primarily resulted from the sale of a portion of ourinvestment in the common stock of Andrx Corporation (Andrx).  We sold 150,000 shares of Andrx common stockfor proceeds of $4.3 million.  We did notsell any securities during the three months ended March 31, 2005.  At March 31, 2005, we held approximately607,000 shares of Andrx common stock at a fair value of $13.8 million with agross unrealized holding gain of $12.2 million.

 

21

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***Losson Early Extinguishment of Debt***

*** ***
| ** **                            | ** ** | **Three Months Ended March 31,** | ** ** | **Change** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|------------|------------|
| **($ in thousands):**            | ** ** | **2005**                         | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                  |       |                             |       |       |       |   |   |   |   |
| Loss on early  extinguishment of debt |       | $                                | —     |       | $          | 14,006 |   | $ | (14,006 | ) | -100.0% |   |
| *as % of  net revenues*               | * *   | *0.0%*                           | * *   | *3.4%*     | * *   | * * | * * | * * | * * |
|                                       |            |                                  |            |            |            |  |  |  |  |  |  |  |

 

In February 2004,we repurchased $101.6 million of our 1998 Senior Notes for total considerationof $115.1 million, or a 13% premium over each note’s face value.  As a result of the repurchase, we incurredcharges of $14.0 million related to fees, expenses, and the premium paid.

 

***InterestExpense***

*** ***
| ** **                                            | ** ** | **Three Months Ended March 31,** | ** ** | **Change** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| **($ in thousands):**                            | ** ** | **2005**                         | ** ** | **2004**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                                  |       |                             |       |       |       |   |   |   |   |
| Interest expense  - convertible contingent debentures |       | $                                | 3,151      |       | $          | 3,151 |   | $ | — |   | —     |   |
| Interest expense  - senior unsecured notes            |       | 256                              |       | 1,909      |       | (1,653 | ) | (86.6)% |   |
| Interest and  fees on credit facility                 |       | 416                              |       | 418        |       | (2 | ) | (0.5)% |   |
| Change in  derivative value                           |       | (569                             | )          | (225       | )          | (344 | ) | 152.9% |   |
| Interest expense  - other                             |       | 36                               |       | 8          |       | 28 |   | 350.0% |   |
| Total interest  expense before capitalized interest   |       | 3,290                            |       | 5,261      |       | (1,971 | ) | (37.5)% |   |
| Capitalized  interest                                 |       | —                           |       | (1,519     | )          | 1,519 |   | (100.0)% |   |
| Total interest  expense                               |       | $                                | 3,290      |       | $          | 3,742 |   | $ | (452 | ) | (12.1)% |   |
| *as % of  net revenues*                               | * *   | *0.8%*                           | * *   | *0.9%*     | * *   |   |   |   |   |

 

Interest expensedecreased for the three month period ended March 31, 2005 due to the repurchaseof a portion of our 1998 Senior Notes in February 2004 and a decrease in thefair value of the derivative (as described in Note 7 in the accompanying Notesto Condensed Consolidated Financial Statements in this Quarterly Report).

 

**Liquidityand Capital Resources**

 

***Cashfrom Operations***

 

Watson’s primarysource of liquidity is cash from operations. Net working capital at March 31, 2005 was $1.13 billion compared to$1.11 billion at December 31, 2004 and $963.2 million at March 31, 2004.

 

We expect that 2005 cashflows from operating activities will continue to exceed net income.  In addition, management expects that 2005cash flows from operating activities and available cash balances will besufficient to fund our operating liquidity needs.

 

22

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Summarized cashflow information is as follows:

 
| ** **                                 | ** ** | **Three months ended March 31,** | ** ** |
|--------------------------------------------|------------|---------------------------------------|------------|
| **($ in thousands):**                 | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **                                 | ** ** | ** **                            | ** ** | ** ** | ** ** |
| Net cash  provided by operating activities |       | $                                     | 105,367    |   | $ | 10,025 |   |
|                                            |            |                                       |            |  |  |  |  |

 

Net cash provided byoperating activities increased during the three month period ended March 31,2005, as compared to the same period of the prior year, due primarily to adecrease in accounts receivable and the timing of annual tax payments in 2004.

 

Cash flows fromoperations is expected to exceed $320 million in 2005.

 

***Changesin Working Capital***

 

Working capital atMarch 31, 2005 and December 31, 2004 is summarized as follows:

 
| **($ in thousands):**              | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** | **Increase  (Decrease)** | ** ** |
|-----------------------------------------|------------|---------------------|------------|------------------------|------------|--------------------------|------------|
| ** **                              | ** ** | ** **          | ** ** | ** **             | ** ** | ** **               | ** ** |
| Current Assets:                         |       |                |       |                   |       |                     |       |
| Cash and cash  equivalents              |       | $                   | 333,385    |                   | $          | 298,653                  |       | $ | 34,732 |   |
| Marketable  securities                  |       | 383,142             |       | 381,679                |       | 1,463                    |       |
| Accounts  receivable, net of allowances |       | 230,024             |       | 251,459                |       | (21,435                  | )          |
| Inventories                             |       | 314,778             |       | 321,299                |       | (6,521                   | )          |
| Other                                   |       | 106,415             |       | 117,096                |       | (10,681                  | )          |
| Total current  assets                   |       | 1,367,744           |       | 1,370,186              |       | (2,442                   | )          |
| Current  liabilities:                   |       |                |       |                   |       |                     |       |
| Accounts payable  and accrued expenses  |       | 181,475             |       | 192,701                |       | (11,226                  | )          |
| Other                                   |       | 58,959              |       | 62,928                 |       | (3,969                   | )          |
| Total current  liabilities              |       | 240,434             |       | 255,629                |       | (15,195                  | )          |
|                                    |       |                |       |                   |       |                     |       |
| Working Capital                         |       | $                   | 1,127,310  |                   | $          | 1,114,557                |       | $ | 12,753 |   |
|                                    |       |                |       |                   |       |                     |       |
| Current Ratio                           |       | 5.69                |       | 5.36                   |       |                     |       |
|                                         |            |                     |            |                        |            |                          |            |  |  |  |  |

 

The decrease inaccounts receivable at March 31, 2005 was due to higher mix of our brand versusgeneric receivables.  Brand products aretypically sold with shorter collection terms than generic products.

 

***CapitalExpenditures***

 

Our capitalexpenditures are summarized as follows:

 
| ** **                           | ** ** | **Three months ended March 31,** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|
| **($ in thousands):**           | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| ** **                           | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Additions to  property and equipment |       | $                                | 10,294     |   | $ | 23,169 |   |
|                                      |            |                                  |            |  |  |  |  |

 

Capitalexpenditures for the first quarter of 2005 included costs to support themanufacture of transdermal products in Salt Lake City, various additions tomachinery and equipment at our Watson locations and on-going construction of anew distribution facility in Gurnee, Illinois. We expect to spend approximately between $75 and $100 million inproperty and equipment additions in 2005. Most of the expected additions in 2005 will be related to our newdistribution facility.  Our new facilitywill replace an existing facility and should allow us to consolidate a portionof our existing operations upon expiration of our current lease obligations.

 

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***Debt and Borrowing Capacity***

 

Our debt and borrowing capacity at March 31,2005 and December 31, 2004 is summarized as follows:

 
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | **Increase**   | ** ** |
|----------------------------|------------|------------|------------|------------|------------|----------------|------------|
| **($ in thousands):** | ** ** | **2005**   | ** ** | **2004**   | ** ** | **(Decrease)** | ** ** |
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** **     | ** ** |
| Long-term debt             |       | $          | 587,724    |       | $          | 587,653        |       | $ | 71 |   |
| Debt to capital ratio      |       | 20.9%      |       | 20.8%      |       |           |       |
|                            |            |            |            |            |            |                |            |  |  |  |

 

In March 2003, we issued $575 million ofconvertible contingent senior debentures due in 2023 (CODES).  As of March 31, 2005, the entire amount ofthe CODES remained outstanding at an effective annual interest rate of approximately2.1%.

 

Between February and May 2004, we repurchased$135.9 million of our 1998 Senior Notes for total consideration of $152.5million, 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.  Interest expense in 2005 will decline as aresult of the repurchase.

 

In May 2003, we entered into an agreementwith a syndicate of lenders for a five-year, $300 million senior, unsecuredrevolving credit facility (the Credit Facility) for working capital and othergeneral corporate purposes.  As of March31, 2005, the total $300 million under the Credit Facility was available to us.Under the terms of the Credit Facility, each of our subsidiaries, other thanminor subsidiaries, entered into a full and unconditional guarantee on a jointand several basis.  In order to providesubsidiary guarantees in connection with the Credit Facility, we were requiredto issue similar guarantees to the 1998 Senior Note holders.  We are subject to, and, as of March 31, 2005,were in compliance with financial and operation covenants under the terms ofthe Credit Facility.  The agreementcurrently contains the following financial covenants:

 

•                  maintenanceof a minimum net worth of at least $1.6 billion at March 31, 2005 (the sumof $1.44 billion plus an amount equal to the sum of 50% of net income for eachfiscal quarter after December 31, 2002);

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

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

 

At March 31, 2005, our net worth was $2.2billion and our leverage ratio was 1.43 to 1.0.   Our interest coverage ratio for the threemonths ended March 31, 2005 was 32.2 to 1.0.

 

Under the Credit Facility, interest coverageratio, with respect to any financial covenant period, is defined as the ratioof EBITDA for such period to interest expense for such period.  The leverage ratio, for any financialcovenant period, is defined as the ratio of the outstanding principal amount offunded debt for the borrower and its subsidiaries at the end of such period, toEBITDA for such period.  EBITDA under theCredit Facility, for any covenant period, is defined as net income plus (1)depreciation and 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 losses and(7) minority interest expense in respect of equity holdings in affiliates;minus (1) extraordinary gains, (2) interest income and (3) other non-operating,non-cash income.

 

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***Long-term Obligations***

 

The following table lists our enforceable andlegally binding obligations as of March 31, 2005.  Some of the amounts included herein are basedon management’s estimates and assumptions about these obligations, includingtheir duration, the possibility of renewal, anticipated actions by thirdparties, and other factors.  Becausethese estimates and assumptions are necessarily subjective, the enforceable andlegally binding obligation we will actually pay in future periods may vary fromthose reflected in the table:

 
| ** **                                                        | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------|------------|
| **(in thousands):**                                               | ** ** | **Total**                  | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **After 5  years** | ** ** |
|                                                              |       |                       |       |   |   |   |   |   |   |   |   |
| Long-term and other debt                                          |       | $                          | 589,151    |   | $ | 8 |   | $ | 14,132 |   | $ | 11 |   | $ | 575,000 |   |
| Liabilities incurred for acquisitions of  products and businesses |       | 4,148                      |       | 2,074 |   | 2,074 |   | — |   | — |   |
| Operating lease obligations                                       |       | 39,011                     |       | 6,140 |   | 15,913 |   | 4,769 |   | 12,189 |   |
| Total contractual cash obligations                                |       | $                          | 632,310    |   | $ | 8,222 |   | $ | 32,119 |   | $ | 4,780 |   | $ | 587,189 |   |

 

The Company is involved in certain minorjoint venture arrangements that are intended to complement the Company’s corebusiness and markets.  The Company hasthe discretion to provide funding on occasion for working capital or capitalexpenditures.  The Company makes anevaluation of additional funding based on an assessment of the venture’sbusiness opportunities.  The Companybelieves that any possible commitments arising from the current arrangementswill not be significant to the Company’s financial condition or results ofoperations.

 

The Company does not have any materialoff-balance sheet arrangements that have, or are reasonably likely to have, acurrent or future effect on our financial condition, changes in financialconditions, revenues or expenses, results of operations, liquidity, capitalexpenditures or capital resources.

 

Under the Company’s existing stock repurchaseprogram approved by the Board of Directors (Board) on February 10, 2005, werepurchased approximately 2.2 million shares of our common stock during thefirst quarter of 2005 at an aggregate cost of approximately $69.1 million.  As of March 31, 2005, the Company hadapproximately $230.9 million available for future repurchases of its commonstock under this $300.0 million Board authorization.  This program provides for purchases of commonstock to be made in the open market or in privately negotiated transactionsthrough February 2006.  The stockrepurchase program is not expected to affect our compliance with our debtcovenants.  Based on current stockprices, completion of the stock repurchase plan would not materially impact theCompany’s liquidity.

 

*Recent accounting pronouncements*

 

In November 2004, the Financial AccountingStandards Board (FASB) issued Statement of Financial Accounting Standards(SFAS) No. 151, “Inventory Costs-an Amendment of ARB No. 43, Chapter 4” (SFAS151).  SFAS 151 requires that accountingfor items such as idle facility expense, freight, handling costs, and wastedmaterials (spoilage) be recognized as current period charges regardless ofwhether they meet the criterion of “so abnormal.”  In addition, SFAS 151 requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities.  SFAS 151 is effective for inventory costsincurred during fiscal years beginning after June 15, 2005.  The provision of SFAS 151 shall be appliedprospectively.  The Company believes thatthe adoption of SFAS 151 will not have a material effect on our CondensedConsolidated Financial Statements.

 

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In December 2004, the FASB issued SFASNo. 123 (revised 2004), “Share-Based Payment” (SFAS 123R), which replacesSFAS No. 123, “Accounting for Stock-Based Compensation,” (SFAS 123)and supercedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”.SFAS 123R requires all share-based payments to employees, including grantsof employee stock options, to be recognized in the financial statements basedon their fair values. The pro forma disclosures previously permitted underSFAS 123 no longer will be an alternative to financial statementrecognition. Under SFAS 123R, the Company must determine the appropriate fairvalue model to be used for valuing share-based payments, the amortizationmethod for compensation cost and the transition method to be used at 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 the method of adoption or the effect of adoptingSFAS 123R, and it has not determined whether the adoption will result inamounts that are similar to the current pro forma disclosures underSFAS 123.

 

In April 2005, the Securities and ExchangeCommission (SEC) announced an amendment to Regulation S-X to amend the date forcompliance with FAS 123R.  The amendmentrequires each registrant that is not a small business issuer to adopt FAS 123Rin the first fiscal year commencing after June 15, 2005.  The Company is required to adopt SFAS 123Rbeginning January 1, 2006.  Adoption ofFAS 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 ESPP grants rather than disclose the pro forma impact on ourconsolidated net income within the footnotes to our consolidated financialstatements, as is our current practice.

 

**CAUTIONARYNOTE REGARDING FORWARD-LOOKING STATEMENTS**

 

Any statements made in this report that arenot statements of historical fact or that refer to estimated or anticipatedfuture events are forward-looking statements. We have based our forward-looking statements on our management’s beliefsand assumptions based on information available to our management at the timethese statements are made.  Suchforward-looking statements reflect our current perspective of our business,future performance, existing trends and information as of the date of thisfiling.  These include, but are notlimited to, our beliefs about future revenue and expense levels and growthrates, prospects related to our strategic initiatives and business strategies,express or implied assumptions about government regulatory action or inaction,anticipated product approvals and launches, business initiatives and product developmentactivities, assessments related to clinical trial results, product performanceand competitive environment, and anticipated financial performance. Withoutlimiting the generality of the foregoing, words such as *“may,”“will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “would,”“estimate,” “continue,” or “pursue,”* or the negative othervariations thereof or comparable terminology, are intended to identifyforward-looking statements.  Thestatements are not guarantees of future performance and involve certain risks,uncertainties and assumptions that are difficult to predict.

 

We caution the reader that certain important factors may affect ouractual operating results and could cause such results to differ materially fromthose expressed or implied by forward-looking statements.  We believe the risks and uncertaintiesdiscussed under the Section entitled “Risks Related to Our Business,” and otherrisks 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.

 

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# **RisksRelated to Our Business**

 

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

 

*Risks Associated With 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 a significant extentupon our ability to successfully commercialize new brand and generic productsin a timely manner.  There are numerousdifficulties in developing and commercializing new products, including:

 

•                  developing,testing and 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 andcommercialization of new products, including legal actions brought by ourcompetitors;

 

•                  experiencingdelays or unanticipated costs; and

 

•                  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 drugproduct has expired or been litigated, causing additional delays in obtainingapproval.

 

Asa result of these and other difficulties, products currently in development byWatson may or may not receive timely regulatory approvals, or approvals atall,  necessary for marketing by Watsonor other third-party partners.  This riskparticularly exists with respect to the development of proprietary productsbecause of the uncertainties, higher costs and lengthy time frames associatedwith research and development of such products and the inherent unproven marketacceptance of such products. If any of our products, when acquired or developedand approved, cannot be successfully or timely commercialized, our operatingresults could be adversely affected.  Wecannot guarantee that any investment we make in developing products will berecouped, even if we are successful in commercializing those products.

 

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

 

During 2004, we increased our planned expenditures for the developmentand marketing of our brand business. During 2005 and thereafter, we may further increase the amounts weexpend for our brand business segment. For example, we plan to initiate Phase III clinical studies in thesecond half of 2005 on our next generation Oxytrol® product and on oursilodosin product for treatment of benign prostatic hyperplasia in late May of2005.  We cannot be sure these businessexpenditures will result in the successful discovery, development or launch ofbrand products that will prove to be commercially successful or will improvethe long-term profitability of our business.

 

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**Our grossprofit may fluctuate from period to period depending upon our product salesmix, our product pricing, and our costs to manufacture or purchase products.**

 

Our future results of operations, financial conditionand cash flows depend to a significant extent upon our brand and genericproduct sales mix.  Our sales of brandproducts tend to create higher gross margins than our sales of genericproducts.  As a result, our sales mix(the proportion of total sales between brand products and generic products)will significantly impact our gross profit from period to period.  During the three months ended March 31, 2005,sales of our brand products and generic products accounted for approximately26% and 74%, respectively, of our net product sales.  During that same period, brand products andgeneric products contributed approximately 42% and 58%, respectively, to ourgross profits.  Factors that may causeour sales mix to vary include:

 

•                  the amount of new productintroductions;

 

•                  marketing exclusivity, if any, whichmay be obtained on certain new products;

 

•                  the level of competition in themarketplace for certain products;

 

•                  the availability of raw materialsand finished products from our suppliers;

 

•                  the scope and outcome ofgovernmental regulatory action that may involve us; and

 

•                  periodic dependence on a smallnumber of products for a significant portion of net revenue or income.

 

The profitability of our product sales is also dependent upon theprices we are able to charge for our products, the costs to purchase productsfrom third parties, and our ability to manufacture our products in a costeffective manner.

 

**Loss ofrevenues from Ferrlecit®, a significant product, could have a material adverseeffect on our results of operations, financial condition and cash flows.**

 

During 2004 we lost regulatory exclusivity onour Ferrlecit® product, which will allow generic applicants to submit AbbreviatedNew Drug Applications (ANDAs) for Ferrlecit®. In 2004, Ferrlecit® accounted for approximately 8% of our net revenuesand 15% of our gross profit.  In February2004, we submitted a Citizen’s Petition to the FDA requesting that the FDA notapprove any ANDA for a generic version of Ferrlecit® until certainmanufacturing, physiochemical and safety and efficacy criteria aresatisfied.  During the third quarter of2004, we submitted a second Citizen’s Petition to the FDA requesting that theFDA refuse to accept for substantive review any ANDA referencing Ferrlecit®until the FDA establishes guidelines for determining whether the genericproduct is the same complex as Ferrlecit®. We cannot predict whether the FDA will grant or deny our Citizen’sPetitions or when it may take such action. We believe it will be difficult for a competitor to demonstrate to theFDA that its product is the same as Ferrlecit® and that, in the absence of sucha showing, the FDA should require the applicant to submit a New DrugApplication (NDA) supported by clinical studies, independently demonstratingsafety and efficacy.  However, if a genericversion of Ferrlecit® or other competitive product is approved by the FDA andenters the market, our net revenues could significantly decline, which couldhave a material adverse effect on our results of operations, financialcondition 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 joint ventures and othercollaborations and may use these and other methods to develop or commercializeproducts in the future.  Thesearrangements typically involve other pharmaceutical companies as partners thatmay be competitors of ours in certain markets. In many instances, we will not control these joint ventures orcollaborations or the commercial exploitation of the licensed products, andcannot assure you that these ventures will be profitable.  Although restrictions contained in certain ofthese

 

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programs have not had a material adverse impact on the marketing of ourown products to date, any such marketing restrictions could affect futurerevenues and have a material adverse effect on our operations. Our results ofoperations may suffer if existing joint ventures or collaboration partnerswithdraw, or if these products are not timely developed, approved orsuccessfully commercialized.

 

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

 

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

 

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

 

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

 

**If brandpharmaceutical companies are successful in limiting the use of generics throughtheir legislative and regulatory efforts, our sales of generic products maysuffer.**

 

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

 

•                  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.

 

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

 

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**Ifcompetitors are successful in limiting competition for certain generic productsthrough their legislative, regulatory and litigation efforts, our sales ofcertain generic products may suffer.**

 

Certainof our competitors have recently challenged our ability to distribute genericalternatives of certain brand products (sometimes called “Authorized Generics”)during the competitors’ 180 day period of ANDA exclusivity under theHatch-Waxman Act.  Under the challengedarrangements, we have obtained rights to market and distribute under a brandmanufacturer’s NDA a generic alternative of the brand product.  Some of our competitors have challenged thepropriety of these arrangements by filing Citizen Petitions with the FDA,initiating lawsuits alleging violation of the antitrust and consumer protectionlaws, and seeking legislative intervention. To date, these efforts have been unsuccessful, but remainunresolved.  The FDA and courts that haveconsidered the subject to date have ruled that there is no prohibition in theFederal Food, Drug and Cosmetic Act against distributing authorized genericversions of a brand drug.  However, ifour competitors’ attempts to restrict such arrangements are successful, or ifdistribution of authorized generic versions of brand drugs is otherwiserestricted or found unlawful, it could have a material adverse effect on ourresults 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 other proprietary rightsheld by third parties to develop, manufacture and market products.  If we are unable to timely obtain theselicenses on commercially reasonable terms, our ability to commercially exploit ourproducts may be inhibited or prevented.

 

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

 

**As 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 review potential acquisitions oftechnologies, products and businesses complementary to our business.  Acquisitions typically entail many risks andcould result in difficulties in integrating operations, personnel, technologiesand products.  If we are not able tosuccessfully integrate our acquisitions, we may not obtain the advantages thatthe acquisitions were intended to create, which may adversely affect ourbusiness, results of operations, financial condition and cash flows, ourability to develop and introduce new products and the market price of ourstock.  In addition, in connection withacquisitions, we could experience disruption in

 

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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 maycreate conflicts in relationships or other commitments detrimental to theintegrated businesses.

 

In addition, as a result of acquiring businesses or products, orentering into other significant transactions, we have experienced, and willlikely continue to experience, significant charges to earnings for merger andrelated expenses that may include transaction costs, closure costs or acquiredin-process research and development charges. These costs may include substantial fees for investment bankers,attorneys, accountants and financial printing costs and severance and otherclosure costs associated with the elimination of duplicate or discontinuedproducts, operations and facilities. Charges that we may incur in connection with acquisitions couldadversely affect our results of operations for particular quarterly or annualperiods.

 

**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 all the raw materialsfor our products in our applications with the FDA.  To the extent practicable, we attempt toidentify more than one supplier in each drug application.  However, some products and raw materials areavailable only from a single source and, in some of our drug applications, onlyone supplier of products and raw materials has been identified, even ininstances where multiple sources exist. Among others, this includes products that have historically accountedfor a significant portion of our revenues, such as Ferrlecit® 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 reasonable cost, or if raw materials for a particularproduct become unavailable from an approved supplier and we are required toqualify a new supplier with the FDA, our profit margins and market share forthe affected product could decrease, as well as delay our development and salesand marketing efforts.

 

Our arrangements with foreign suppliers are subject to certainadditional risks, including the availability of government clearances, exportduties, political instability, war, acts of terrorism, currency fluctuationsand restrictions on the transfer of funds. For example, we obtain a significant portion of our raw materials fromforeign suppliers.  Arrangements withinternational raw material suppliers are subject to, among other things, FDAregulation, customs clearances, various import duties and other governmentclearances.  Acts of governments outsidethe U.S. may affect the price or availability of raw materials needed for the developmentor manufacture of our products. In addition, recent changes in patent laws injurisdictions outside the U.S. may make it increasingly difficult to obtain rawmaterials for research and development prior to the expiration of theapplicable 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 product manufacturers, includingus, have liberal return policies and have been willing to give customerspost-sale inventory allowances.  Underthese arrangements, from time to time, we give our customers credits on ourgeneric products that our customers hold in inventory after we have decreasedthe market prices of the same generic products. Therefore, if new competitors enter the marketplace and significantlylower the prices of any of their competing products, we would likely reduce theprice of our product.  As a result, wewould be obligated to provide significant credits to our customers who are thenholding inventories of such products, which could reduce sales revenue andgross margin for the period the credit is provided.  Like our competitors, we also give creditsfor chargebacks to wholesale customers that have contracts with us for theirsales to hospitals, group purchasing organizations, pharmacies or other retailcustomers.  Achargeback represents an amount payable in the future to a wholesaler for thedifference between the invoice

 

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pricepaid to us by our wholesale customer for a particular product and thenegotiated contract price that the wholesaler’s customer pays for thatproduct.  Although weestablish reserves based on our prior experience and our best estimates of theimpact that these policies may have in subsequent periods, we cannot ensurethat our reserves are adequate or that actual product returns, allowances andchargebacks will not exceed our estimates, which could adversely affect ourfinancial condition, cash flows and market price of our stock.

 

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

 

Many government and third-party payors, includingMedicare, Medicaid, HMOs and MCOs, reimburse doctors and others for thepurchase of certain prescription drugs based on a drug’s average wholesaleprice, or AWP.  In the past severalyears, state and federal government agencies have conducted ongoinginvestigations of manufacturers’ reporting practices with respect to AWP, inwhich they have suggested that reporting of inflated AWP’s have led toexcessive payments for prescription drugs. For example, beginning in July 2002, we and certain of our subsidiaries,as well as numerous other pharmaceutical companies, were named as defendants invarious state and federal court actions alleging improper or fraudulentpractices related to the reporting of AWP of certain products, and otherimproper acts, in order to increase prices and market shares. We have alsoreceived notices or subpoenas from the attorneys general of various states,including Florida, Nevada, New York, California and Texas, indicatinginvestigations, claims and/or possible lawsuits relating to pharmaceuticalpricing issues and whether allegedly improper actions by pharmaceuticalmanufacturers led to excessive payments by Medicare and/or Medicaid.  These actions, if successful, could adverselyaffect us and may have a material adverse effect on our business, results of operations,financial condition 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 our products involvean inherent risk of product liability claims and the associated adversepublicity.  Insurance coverage isexpensive and may be difficult to obtain, and may not be available in thefuture on acceptable terms, or at all. Although we currently maintain product liability insurance for ourproducts in amounts we believe to be commercially reasonable, if the coveragelimits of these insurance policies are not adequate, a claim brought againstWatson, whether covered by insurance or not, could have a material adverseeffect on our business, results of operations, financial condition and cashflows.

 

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

 

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

 

**Rising insurance costs could negativelyimpact profitability.**

 

The cost of insurance, including workerscompensation, product liability and general liability insurance, have risensignificantly in recent years and may increase in 2005.  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 of operations, financial condition and cash flows.

 

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**Implementation of enterprise resourceplanning systems could cause business interruptions and negatively affect ourprofitability and cash flows.**

 

During 2004, we implemented an enterpriseresource planning (ERP) system to improve customer service, enhance operatingefficiencies, and provide more effective management of businessoperations.  From time to time, we mayimplement new ERP systems and software, or upgrades to existing systems andsoftware, to further enhance our operations. Implementation of ERP systems and software carry risks such as costoverruns, project delays and business interruptions and delays.  If we experience a material businessinterruption as a result of such implementations, it could adversely effectaffect us, and could have a material adverse effect on our business, results ofoperations, financial condition and cash flows.

 

**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 isrelated to acquired product rights and goodwill.  As of March 31, 2005, the carrying value ofour product rights and other intangible assets was approximately $870 millionand the carrying value 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 annuallyand when events occur or circumstances change that could potentially reduce thefair value of the reporting unit. Impairment testing compares the fair value of the reporting unit to itscarrying amount.  An impairment, if any,would be recorded in operating income and could have a significant adverseaffect on our results of operations and financial condition.

 

**Issuance of debt or equity securities couldmaterially change our operating results and financial condition.**

 

We may consider issuing additional debt orequity securities in the future to fund potential acquisitions or investment,to refinance 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, are subject toextensive, complex, costly and evolving regulation by the federal government,principally the FDA and to a lesser extent by the U.S. Drug Enforcement Agency(DEA) and state government agencies.  TheFederal Food, Drug and Cosmetic Act, the Controlled Substances Act and otherfederal statutes and regulations govern or influence the testing,manufacturing, packing, labeling, storing, record keeping, safety, approval,advertising, promotion, sale and distribution of our products.

 

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

 

Our principal manufacturing facility in Corona, California is currentlysubject to a consent decree of permanent injunction.  We cannot assure you that the FDA willdetermine that we have adequately corrected deficiencies at our manufacturingsites (including the one referenced above), that subsequent FDA inspectionswill not result in additional inspectional observations at such sites, thatapproval of any of the pending or subsequently submitted NDAs, ANDAs orsupplements to such applications by Watson or its subsidiaries will be grantedor that the FDA will not seek to impose additional sanctions against Watson orany of its subsidiaries.  The range ofpossible sanctions includes, among others, FDA issuance of adverse publicity,product recalls or seizures, fines, total or partial suspension of productionand/or distribution, suspension of the FDA’s review of product applications,enforcement actions, injunctions, and civil or criminal prosecution.  Any such sanctions, if imposed, couldmaterially harm our operating results and financial condition.  Under certain circumstances, the FDA also hasthe authority to revoke previously granted drug approvals.  Similar sanctions as detailed above may beavailable to the FDA under a consent decree, depending upon the actual terms ofsuch decree.  Although we have institutedinternal compliance programs, if these programs do not meet regulatory agencystandards or if compliance is deemed deficient in any significant way, it couldmaterially harm our business.  Certain ofour vendors are subject to similar regulation and periodic inspections.

 

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

 

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

 

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

 

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**Healthcarereform and a reduction in the reimbursement levels by governmental authorities,HMOs, MCOs or other third-party payors may****adversely affect our business.**

 

In order to assist us in commercializing products, we have obtainedfrom government authorities and private health insurers and otherorganizations, such as Health Maintenance Organizations (HMOs) and Managed CareOrganizations (MCOs), authorization to receive reimbursement at varying levelsfor the cost of certain products and related treatments.  Third party payors increasingly challengepricing of pharmaceutical products.  Thetrend toward managed healthcare in the U.S., the growth of organizations suchas HMOs and MCOs and legislative proposals to reform healthcare and governmentinsurance programs could significantly influence the purchase of pharmaceuticalproducts, resulting in lower prices and a reduction in product demand.  Such cost containment measures and healthcarereform could affect our ability to sell our products and may have a materialadverse effect on our business, results of operations and financialcondition.  Additionally, there isuncertainty surrounding the implementation of the provisions of the MedicarePart D Prescription 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.

# ** **

 **Thepharmaceutical industry is highly competitive.**

 

We face strong competition in both our generic andbrand product businesses.  The intenselycompetitive environment requires an ongoing, extensive search for technologicalinnovations and the ability to market products effectively, including theability to communicate the effectiveness, safety and value of brand products tohealthcare professionals 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 competitors havebeen in business for a longer period of time than Watson, have a greater numberof products on the market and have greater financial and other resources thanwe do.  If we directly compete with themfor the same markets and/or products, their financial strength could prevent usfrom capturing a profitable share of those markets. It is possible thatdevelopments by our competitors will make our products or technologiesnoncompetitive or obsolete.

 

Revenues and gross profit derived from the sales of genericpharmaceutical products tend to follow a pattern based on certain regulatoryand competitive factors.  As patents forbrand name products and related exclusivity periods expire, the first genericmanufacturer to receive regulatory approval for generic equivalents of suchproducts is generally able to achieve significant market penetration.  As competing off-patent manufacturers receiveregulatory approvals on similar products or as brand manufacturers launch genericversions of such products (for which no separate regulatory approval isrequired), market share, revenues and gross profit typically decline, in somecases dramatically.  Accordingly, thelevel of market share, revenue and gross profit attributable to a particulargeneric product normally is related to the number of competitors in thatproduct’s market and the timing of that product’s regulatory approval andlaunch, in relation to competing approvals and launches.  Consequently, we must continue to develop andintroduce new products in a timely and cost-effective manner to maintain ourrevenues and gross margins. Additionally, as new competitors enter the market, there may beincreased pricing pressure on certain products, which would result in lower grossmargins.  This is particularly true inthe case of certain overseas competitors, who may be able to produce productsat costs lower than the costs of domestic manufacturers.  If we experience substantial competition fromoverseas competitors with lower production costs, our profit margins willsuffer.

 

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

 

For the year ended December 31, 2004, our four largest customersaccounted for 15%, 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.

 

**ITEM 3.  QUANTITATIVE ANDQUALITATIVE DISCLOSURE ABOUT MARKET RISK**

 

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

 

**Investment Risk**

 

As of March 31, 2005, our total holdings inequity securities of other companies, including equity-method investments andavailable-for-sale securities, were $44.0 million.  Of this amount, we had equity-methodinvestments of $5.5 million and publicly traded equity securities(available-for-sale securities) at fair value totaling $16.9 million ($13.8million that was included in “Marketable securities” and $3.1 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 March 31, 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 $4.2 million, $6.8 million and $8.5 million,respectively.

 

At March 31, 2005, our investment in Andrxconsisted of approximately 607,000 shares of Andrx common stock with a fairmarket value of $13.8 million.  BecauseAndrx is a publicly traded equity security, our holdings of Andrx have exposureto investment risk.   The market price ofAndrx common shares has been, and may continue to be volatile.  For example, on March 31, 2005, the finaltrading day of the quarter, the closing price of Andrx was $22.67.  On May 6, 2005, before the filing of thisForm 10-Q, the closing price of Andrx common stock was $20.32.

 

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The following table sets forth the Andrx highand low market price per share information, based on published financialsources, for 2005 and 2004 and further reflects the volatility of the stockprice:

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

 

**We regularly review the carryingvalue of our investments and identify and recognize losses, for incomestatement purposes, when events and circumstances indicate that any declines inthe fair values of such investments, below our accounting basis, are other thantemporary.**

 

**Interest Rate Risk**

 

Our exposure to interest rate risk relates primarily to our non-equityinvestment portfolio.  Our cash isinvested in A-rated money market mutual funds, short-term securities andauction rate securities. Consequently, our interest rate and principal risk areminimal.

 

During 2004, we acquired a significant amount of U.S. Treasurysecurities classified as available-for-sale securities, with no security havinga maturity in excess of two years.  Thesesecurities are exposed to interest rate fluctuations.  Because of the short-term nature of theseinvestments, we are subject to minimal interest rate risk and do not believethat an increase in market rates would have a significant negative impact onthe realized value of our portfolio.

 

Based on quoted market rates of interest andmaturity schedules for similar debt issues, we estimate that the fair values ofour CODES and our 1998 Senior Notes approximated their carrying values on March31, 2005.  While changes in marketinterest rates may affect the fair value of our fixed-rate debt, we believe theeffect, if any, of reasonably possible near-term changes in the fair value ofsuch debt on our financial condition, results of operations or cash flows willnot be material.

 

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

 

We do not believe that inflation has had asignificant impact on our revenues or operations.

 

**ITEM4.  CONTROLS AND PROCEDURES**

 

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

 

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respect to such entities are necessarily substantially more limitedthan those it maintains with respect to its consolidated subsidiaries.

 

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

 

There have been no changes in the Company’sinternal control over financial reporting, during the three months ended March31, 2005, that has materially affected, or is reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

 

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**PART II. OTHER INFORMATION AND SIGNATURES**

 

**ITEM1.  LEGAL PROCEEDINGS**

 

The Company is party to certain lawsuits and legal proceedings, whichare described in “Part I, Item 3. Legal Proceedings,” of our Annual Report onForm 10-K for the year ended December 31, 2004. The following is a description of material developments during theperiod covered by this Quarterly Report and through the filing of thisQuarterly Report, and should be read in conjunction with the Annual Reportreferenced above.

 

*Phen-fen litigation.*  With respect to the phentermine hydrochlorideproduct liability lawsuits pending against the Company, certain subsidiaries,and others, additional actions raising similar issues have been filed, and someactions have been settled or otherwise dismissed.  As of May 6, 2005, approximately 370 caseswere pending against Watson and its affiliates in numerous state and federalcourts.  Most of the cases involvemultiple plaintiffs, and several were filed or certified as class actions.  The Company believes it will be fullyindemnified by Rugby’s former owner, Aventis Pharmaceuticals (Aventis, formerlyknown as Hoechst Marion Roussel, Inc., and now known as Sanofi-Aventis) for thedefense of all such cases and for any liability that may arise out of thesecases.  Aventis is currently controllingthe defense of all these matters as the indemnifying party under its agreementswith the Company.

 

*Cipro® Litigation. *On March 31, 2005, the U.S. District Courtfor the Eastern District of New York granted summary judgment in theconsolidated action (*In re: CiprofloxacinHydrochloride Antitrust Litigation, MDL Docket No. 001383*) in favorof the defendants on all of plaintiffs’ claims, denied the plaintiffs’ motionsfor class certification, and directed the clerk of the court to close thecase.  The clerk entered judgment onApril 5, 2005.  Plaintiffs are expectedto appeal.  In the action pending in theCalifornia Superior Court for the County of San Diego (*In re: CiproCases I & II, JCCP Proceeding Nos. 4154 & 4220*), on April14, 2005, the court granted the parties’ joint request for a stay of allproceedings, vacated all previously set dates and deadlines in the case, andset a further status conference for October 14, 2005, at which time the partiesare to report on the status of the appeal of the consolidated action.  In the action pending in the Kansas StateCourt (*Sandhaus v. Bayer, et al., Johnson County Dist.Court Case No. 00CV06193*), on April 22, 2005, the court granted theparties’ joint motion to stay all proceedings pending the outcome of the appealin the consolidated action, vacated all pending dates and settings, and set astatus conference for October 7, 2005, at which time the parties are to reporton the status of the appeal in the consolidated action.

 

*Governmental Reimbursement Investigations andDrug Pricing Litigation.*  With respect to the Drug Pricing Litigationpending against the Company and certain subsidiaries, additional actions raisingsimilar allegations were filed in April and May 2005.  As of May 6, 2005, in addition to theconsolidated action pending in the United States District Court for theDistrict of Massachusetts (*In re: PharmaceuticalIndustry Average Wholesale Price Litigation, MDL Docket No.*1456),there were approximately 33 cases pending against the Company or itssubsidiaries and other third parties, including actions by seven StateAttorneys General, the City of New York, and numerous counties in New YorkState.  Additional actions areanticipated.

 

These actions, if successful, could adverselyaffect the Company and may have a material adverse effect on the Company’sbusiness, results of operations, financial condition and cash flows.

 

*FDA Matters.*   In May 2002, Watson reached an agreementwith the FDA on the terms of a consent decree with respect to its Corona,California manufacturing facility.  Thecourt approved the consent decree on May 13, 2002 (*UnitedStates of America v. Watson Laboratories, Inc., and Allen Y. Chao*,United States District Court for the Central District of California,EDCV-02-412-VAP).  From April 5, 2005through April 13, 2005, the FDA conducted an inspection of the Company’sCorona, California facility.  At theconclusion of the inspection no formal observations were made and no FDA Form483 was issued. However, if, in the future, the FDA determines that, withrespect to its Corona facility, Watson has failed to comply with the consentdecree or FDA regulations, including cGMPs, the consent decree allows the FDAto order Watson to take a variety of actions to

 

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remedy the deficiencies. These actions could include ceasingmanufacturing and related operations at the Corona facility, and recalling affectedproducts.  Such actions, if taken by theFDA, could adversely affect the Company, its results of operations, financialposition and/or cash flows.

 

*Securities Litigation.*  On March 14, 2005, the appellants in theaction pending in the U.S. Court of Appeals for the Ninth Circuit (*Pension Fund v. Watson Pharmaceuticals, Inc., USCA Docket No. 04-56791*)filed their opening brief.  Thedefendants filed their answering brief on April 27, 2005, and the appellantsare required to file their reply brief, if any, on or before May 11, 2005.

 

Watson and its affiliates are involved invarious other 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 matters through litigation or other means isinherently uncertain and it is possible that an unfavorable resolution of thesematters will adversely affect the Company, its results of operations, financialcondition and cash flows.

 

**ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

 

There were no unregistered sales of equity securities.

 

**IssuerPurchases of Equity Securities**

 

The following table summarizes the Company’s purchases of common stockduring the first quarter of 2005:

 
| **Period**                                  | ** ** | **Total Number of  Shares  Purchased**                  | ** ** | **Average Price  Paid Per  Share** | ** ** | **Total Number of  Shares Purchased  as Part of  Publicly Announced  Plans or Programs** | ** ** | **Approximate  Dollar Value of  Shares that May Yet Be  Purchased Under the  Plans or Programs** | ** ** |
|---------------------------------------------|------------|---------------------------------------------------------|------------|------------------------------------|------------|------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **(In thousands, except average price paid per share)** | ** ** | ** **                         | ** ** |
|                                        |       |                                                    |       |                               |       |                                                                                     |       |                                                                                             |       |
| February 15, 2005 through February 28, 2005 |       | 1,392                                                   |       | $                                  | 30.32      |                                                                                     | 1,392      |                                                                                             | $          | 257,786 |   |
|                                        |       |                                                    |       |                               |       |                                                                                     |       |                                                                                             |       |
| March 1, 2005 through March 31, 2005        |       | 850                                                     |       | $                                  | 31.61      |                                                                                     | 850        |                                                                                             | $          | 230,922 |   |
|                                        |       |                                                    |       |                               |       |                                                                                     |       |                                                                                             |       |
| **Total**                                   |       | 2,242                                                   |       |                               |       | 2,242                                                                                    |       |                                                                                             |       |

 

In February 2005, the Board authorized a program torepurchase shares of Watson’s common stock. The Board approved the repurchase of up to $300.0 million of shares overa period of one year.  This programprovides for purchases to be made in the open market or in privately negotiatedtransactions.  Additionally, the Boardresolved that purchases may be made under Rule 10b5-1 promulgated under theSecurities and Exchange Act of 1934, as amended.  The repurchase of shares will be made usingour cash resources.  The repurchaseprogram may be suspended or discontinued at any time without prior notice.

 

As of March 31, 2005, the Company had approximately$230.9 million available for future repurchases of its common stock under this$300.0 million Board authorization.

 

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**ITEM 6.  EXHIBITS**

 

(a) Exhibits:

 

Reference is hereby made to theExhibit Index on page 43.

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned, 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:  May 9, 2005 |       |                                                      |
|                         |            |                                                           |            |  |

 

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**WATSON PHARMACEUTICALS, INC.**

 

**EXHIBIT INDEX TO FORM 10-Q**

**For the Quarterly Period Ended March 31, 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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