** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**FORM 10-Q**

 

----

 
| **ý****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)**                                                                                                         |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                  |
|                                                                                                                                                                        |
| **FOR THE QUARTERLY PERIOD ENDED MARCH 31,  2006**                                                                                                                     |
|                                                                                                                                                                        |
| **or**                                                                                                                                                                      |
|                                                                                                                                                                        |
| **o****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)**                                                                                                             |
| **OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                  |
| **For the transition period from              to           ** |

** **

**Commission file number 0-20045**

 

----

 

**WATSON PHARMACEUTICALS, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

**311 Bonnie Circle**

**Corona, CA  92880-2882**

(Address of principal executive offices, including zip code)

 

**(951) 493-5300**

(Registrant’s telephone number, including area code)

 

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

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act.(Check one):

 
| Large accelerated filer ý |   | Accelerated filer o |   | Non-accelerated filer o |
|--------------------------------|--------|---------------------|--------|-------------------------|

 

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

 

The number of sharesoutstanding of the Registrant’s only class of common stock as of May 4,2006 was approximately 111,410,000.

 

 

----

 

**WATSON PHARMACEUTICALS, INC.**

** **

**TABLE OF CONTENTS**

** **

**FORM 10-Q FOR THE QUARTERLYPERIOD ENDED MARCH 31, 2006**

 
| **Part I. FINANCIAL INFORMATION**                                                                    | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|
|                                                                                                      |       |
| Item 1. Condensed Consolidated Financial Statements (Unaudited):                                          |       |
|                                                                                                      |       |
| Condensed  Consolidated Balance Sheets as of March 31, 2006 and December 31,  2005              |       |
|                                                                                                      |       |
| Condensed  Consolidated Statements of Income for the Three Months Ended March 31,  2006 and 2005     |       |
|                                                                                                      |       |
| Condensed  Consolidated Statements of Cash Flows for the Three Months Ended  March 31, 2006 and 2005 |       |
|                                                                                                      |       |
| Notes to  Condensed Consolidated Financial Statements                                                     |       |
|                                                                                                      |       |
| Item 2. Management’s Discussion and  Analysis of Financial Condition and Results of Operations       |       |
|                                                                                                      |       |
| Item  3. Quantitative and Qualitative Disclosure about Market Risk                                        |       |
|                                                                                                      |       |
| Item 4.  Controls and Procedures                                                                          |       |
|                                                                                                      |       |
| **Part II. OTHER INFORMATION AND SIGNATURES**                                                        | ** ** |
|                                                                                                      |       |
| Item 1.  Legal Proceedings                                                                                |       |
|                                                                                                      |       |
| Item 1A. Risk Factors                                                                                     |       |
|                                                                                                      |       |
| Item  2. Unregistered Sales of Equity Securities and Use of Proceeds                                      |       |
|                                                                                                      |       |
| Item 6. Exhibits                                                                                          |       |
|                                                                                                      |       |
| Signatures                                                                                                |       |

 

----

 

**WATSONPHARMACEUTICALS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(Unaudited;in thousands)**

 
| ** **                                       | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **ASSETS**                                       | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current assets:                                  |       |                     |       |                        |       |
| Cash and cash  equivalents                       |       | $                        | 559,734    |                        | $          | 467,451 |   |
| Marketable  securities                           |       | 168,127                  |       | 162,475                     |       |
| Accounts  receivable, net                        |       | 269,755                  |       | 333,832                     |       |
| Inventories                                      |       | 300,794                  |       | 278,062                     |       |
| Prepaid expenses  and other current assets       |       | 30,951                   |       | 31,014                      |       |
| Deferred tax  assets                             |       | 98,243                   |       | 87,596                      |       |
| Total current  assets                            |       | 1,427,604                |       | 1,360,430                   |       |
|                                             |       |                     |       |                        |       |
| Property and  equipment, net                     |       | 451,190                  |       | 436,149                     |       |
| Investments and  other assets                    |       | 62,482                   |       | 50,318                      |       |
| Deferred tax  assets                             |       | 25,355                   |       | 25,733                      |       |
| Product rights  and other intangibles, net       |       | 710,872                  |       | 751,808                     |       |
| Goodwill                                         |       | 479,859                  |       | 455,595                     |       |
| Total assets                                     |       | $                        | 3,157,362  |                        | $          | 3,080,033 |   |
|                                             |       |                     |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**    | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current liabilities:                             |       |                     |       |                        |       |
| Accounts payable  and accrued expenses           |       | $                        | 209,690    |                        | $          | 211,160 |   |
| Income taxes  payable                            |       | 62,918                   |       | 28,789                      |       |
| Current portion  of long-term debt               |       | 29,933                   |       | —                      |       |
| Deferred revenue                                 |       | 4,108                    |       | 5,721                       |       |
| Total current  liabilities                       |       | 306,649                  |       | 245,670                     |       |
|                                             |       |                     |       |                        |       |
| Long-term debt                                   |       | 573,947                  |       | 587,935                     |       |
| Deferred revenue                                 |       | 14,251                   |       | 13,891                      |       |
| Other long-term  liabilities                     |       | 2,052                    |       | 2,504                       |       |
| Deferred tax  liabilities                        |       | 120,666                  |       | 125,792                     |       |
| Total  liabilities                               |       | 1,017,565                |       | 975,792                     |       |
|                                             |       |                     |       |                        |       |
| Commitments and  contingencies                   |       |                     |       |                        |       |
|                                             |       |                     |       |                        |       |
| Stockholders’  equity:                      |       |                     |       |                        |       |
| Preferred stock                                  |       | —                   |       | —                      |       |
| Common stock                                     |       | 367                      |       | 367                         |       |
| Additional  paid-in capital                      |       | 921,074                  |       | 923,619                     |       |
| Unearned  compensation                           |       | —                   |       | (9,326                      | )          |
| Retained  earnings                               |       | 1,510,331                |       | 1,485,100                   |       |
| Accumulated  other comprehensive income          |       | 8,025                    |       | 4,481                       |       |
| Treasury stock,  at cost                         |       | (300,000                 | )          | (300,000                    | )          |
| Total  stockholders’ equity                 |       | 2,139,797                |       | 2,104,241                   |       |
| Total  liabilities and stockholders’ equity |       | $                        | 3,157,362  |                        | $          | 3,080,033 |   |

 

*Seeaccompanying Notes to Condensed Consolidated Financial Statements.*

 

1

----

 

**WATSON PHARMACEUTICALS, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF INCOME**

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

 
| ** **                                              | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                              | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **                                              | ** ** | ** **                             | ** ** | **Restated** | ** ** |
|                                                    |       |                                   |       |   |   |
| Net revenues                                            |       | $                                      | 407,233    |   | $ | 400,828 |   |
| Cost of sales  (excludes amortization, presented below) |       | 234,754                                |       | 206,950 |   |
| Gross profit                                            |       | 172,479                                |       | 193,878 |   |
|                                                    |       |                                   |       |   |   |
| Operating  expenses:                                    |       |                                   |       |   |   |
| Research and  development                               |       | 29,837                                 |       | 28,838 |   |
| Selling, general  and administrative                    |       | 66,750                                 |       | 63,651 |   |
| Amortization                                            |       | 41,100                                 |       | 40,638 |   |
| Total operating  expenses                               |       | 137,687                                |       | 133,127 |   |
| Operating income                                        |       | 34,792                                 |       | 60,751 |   |
|                                                    |       |                                   |       |   |   |
| Other income  (expense):                                |       |                                   |       |   |   |
| (Losses)  earnings on equity method investments         |       | (192                                   | )          | 122 |   |
| Gain on sales of  securities                            |       | 3,695                                  |       | — |   |
| Loss on early  extinguishment of debt                   |       | (720                                   | )          | — |   |
| Interest income                                         |       | 6,252                                  |       | 4,106 |   |
| Interest expense                                        |       | (3,301                                 | )          | (3,290 | ) |
| Other expense                                           |       | 105                                    |       | (224 | ) |
| Total other  income, net                                |       | 5,839                                  |       | 714 |   |
|                                                    |       |                                   |       |   |   |
| Income before  income taxes                             |       | 40,631                                 |       | 61,465 |   |
| Provision for  income taxes                             |       | 15,399                                 |       | 22,852 |   |
| Net income                                              |       | $                                      | 25,232     |   | $ | 38,613 |   |
|                                                    |       |                                   |       |   |   |
| Earnings per  share:                                    |       |                                   |       |   |   |
| Basic                                                   |       | $                                      | 0.25       |   | $ | 0.35 |   |
| Diluted                                                 |       | $                                      | 0.23       |   | $ | 0.32 |   |
|                                                    |       |                                   |       |   |   |
| Weighted average  shares outstanding:                   |       |                                   |       |   |   |
| Basic                                                   |       | 101,615                                |       | 109,136 |   |
| Diluted                                                 |       | 116,541                                |       | 124,104 |   |

 

*See accompanying Notes to Condensed ConsolidatedFinancial Statements.*

 

2

----

 

**WATSON PHARMACEUTICALS, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

(Unaudited; in thousands)

 
| ** **                                                           | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                           | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **                                                           | ** ** | ** **                             | ** ** | **Restated** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                           | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Net income                                                           |       | $                                      | 25,232     |   | $ | 38,613 |   |
| Reconciliation  to net cash provided by operating activities:        |       |                                   |       |   |   |
| Depreciation                                                         |       | 12,074                                 |       | 9,365 |   |
| Amortization                                                         |       | 41,100                                 |       | 40,638 |   |
| Deferred income  tax benefit                                         |       | (18,066                                | )          | (56 | ) |
| Provision for  inventory reserve                                     |       | 5,484                                  |       | 22,014 |   |
| Restricted stock  and stock option compensation                      |       | 2,850                                  |       | — |   |
| Losses (earnings)  on equity method investments                      |       | 192                                    |       | (122 | ) |
| Gain on sale of  securities                                          |       | (3,695                                 | )          | — |   |
| Loss on early  extinguishment of debt                                |       | 720                                    |       | — |   |
| Tax benefits  from employee stock plans                              |       | 185                                    |       | 1,490 |   |
| Mark to market  on derivative                                        |       | (453                                   | )          | (569 | ) |
| Other                                                                |       | (879                                   | )          | (1,992 | ) |
| Changes in  assets and liabilities (net of acquisition of business): |       |                                   |       |   |   |
| Accounts  receivable, net                                            |       | 64,440                                 |       | 21,435 |   |
| Inventories                                                          |       | (23,698                                | )          | (15,493 | ) |
| Prepaid expenses  and other current assets                           |       | 1,698                                  |       | 4,665 |   |
| Accounts payable  and accrued expenses                               |       | (4,524                                 | )          | (11,226 | ) |
| Deferred revenue                                                     |       | (1,253                                 | )          | (1,438 | ) |
| Income taxes  payable                                                |       | 34,129                                 |       | (2,867 | ) |
| Other assets                                                         |       | 174                                    |       | 910 |   |
| Total  adjustments                                                   |       | 110,478                                |       | 66,754 |   |
| Net cash  provided by operating activities                           |       | 135,710                                |       | 105,367 |   |
|                                                                 |       |                                   |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                           | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Additions to  property and equipment                                 |       | (9,600                                 | )          | (10,294 | ) |
| Acquisition of  product rights                                       |       | (165                                   | )          | (25 | ) |
| Acquisition of  business, net of cash acquired                       |       | (29,578                                | )          | — |   |
| Proceeds from  sale of marketable equity securities                  |       | 893                                    |       | — |   |
| Proceeds from  sale of investments                                   |       | 4,695                                  |       | — |   |
| Additions to  marketable securities                                  |       | (898                                   | )          | — |   |
| Additions to  long-term investments                                  |       | (12,500                                | )          | — |   |
| Other investing  activities, net                                     |       | (16                                    | )          | — |   |
| Net cash used in  investing activities                               |       | (47,169                                | )          | (10,319 | ) |
|                                                                 |       |                                   |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                           | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Repurchase of  common stock                                          |       | —                                 |       | (69,078 | ) |
| Principal  payments on acquisition liabilities                       |       | (3                                     | )          | (2 | ) |
| Proceeds from  stock plans                                           |       | 3,745                                  |       | 8,764 |   |
| Net cash  provided by (used in) financing activities                 |       | 3,742                                  |       | (60,316 | ) |
| Net increase in  cash and cash equivalents                           |       | 92,283                                 |       | 34,732 |   |
| Cash and cash  equivalents at beginning of period                    |       | 467,451                                |       | 298,653 |   |
| Cash and cash  equivalents at end of period                          |       | $                                      | 559,734    |   | $ | 333,385 |   |

 

*Seeaccompanying Notes to Condensed Consolidated Financial Statements.*

 

3

----

 

**WATSON PHARMACEUTICALS, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

 

**NOTE 1 –GENERAL**

 

WatsonPharmaceuticals, Inc. (“Watson” or the “Company”) is primarily engaged inthe development, manufacture, marketing, sale and distribution of brand andoff-patent (generic) pharmaceutical products. Watson was incorporated in 1985and began operations as a manufacturer and marketer of off-patent pharmaceuticals.Through internal product development and synergistic acquisitions of productsand businesses, the Company has grown into a diversified specialtypharmaceutical company. Watson operates manufacturing, distribution, researchand development and administrative facilities primarily in the United States ofAmerica (“U.S.”).

 

Theaccompanying Condensed Consolidated Financial Statements should be read inconjunction with the Company’s Annual Report on Form 10-K for the yearended December 31, 2005. Certain information and footnote disclosuresnormally included in annual financial statements prepared in accordance withgenerally accepted accounting principles have been condensed or omitted fromthe accompanying Condensed Consolidated Financial Statements. The year endbalance sheet was derived from the 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. Unless otherwise noted, all such adjustmentsare 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 resultsof operations and cash flows for the interim periods are not necessarilyindicative of the results of operations and cash flows that it may achievein future periods or for the full year.

 

In the year ended December 31, 2005 the Companyacquired additional common shares in Scinopharm Taiwan, Ltd. (“Scinopharm”),previously accounted for under the cost method, to an ownership level in excessof 20%. Accordingly, as required by Accounting Principles Board (“APB”) OpinionNo. 18, “The Equity Method of Accounting for Investments in Common Stock”(“APB 18”), results of operations, earnings per share and cash flows fromoperating and investing activities have been restated for the three monthsended March 31, 2005 to conform to current period presentation.

 

*MergerAgreement with Andrx Corporation*

 

On March 13, 2006, the Company announced adefinitive merger agreement to acquire all the outstanding shares of commonstock of Andrx Corporation (Nasdaq: ADRX) (“Andrx”) in an all-cash transactionfor $25 per share, or total consideration of approximately $1.9 billion. Andrx distributespharmaceutical products primarily to independent and chain pharmacies andphysicians’ offices and is considered a leader in formulating andcommercializing difficult-to-replicate controlled-release pharmaceuticalproducts and selective immediate-release products.

 

The consummation of the merger is subject tocustomary closing conditions, including approval of the transaction by Andrxstockholders and the receipt of applicable U.S. regulatory approvals. On May 3,2006, the Company and Andrx announced they had each received a request from theFederal Trade Commission (“FTC”) for additional information under theHart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (“HSR Act”),in connection with Watson’s pending acquisition of Andrx. The effect of thissecond request by the FTC is to extend the waiting period imposed by the HSRAct until 30 days after both Watson and Andrx have substantially complied withthe request. For additional information on Andrx, see the U.S. Securities andExchange Commission’s (“SEC”) website at www.sec.gov.

 

4

----

 

*ComprehensiveIncome*

 

Comprehensiveincome includes all changes in equity during a period except those thatresulted from investments by or distributions to the Company’s stockholders. Othercomprehensive income (loss) refers to revenues, expenses, gains and lossesthat, under generally accepted accounting principles, are included incomprehensive income (loss), but excluded from net income as these amounts arerecorded directly as an adjustment to stockholders’ equity. Watson’s othercomprehensive income (loss) is comprised of unrealized gains (losses) on itsholdings of publicly traded debt and equity securities, net of realized gains(losses) included in net income and foreign currency translation adjustments. Thecomponents of comprehensive income including attributable income taxesconsisted of the following (in thousands):

 
| ** **                                       | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                       | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | ** **                            | ** ** | **Restated** | ** ** |
| Net income                                       |       | $                                     | 25,232     |   | $ | 38,613 |   |
|                                             |       |                                  |       |   |   |
| Other  comprehensive income (loss):              |       |                                  |       |   |   |
| Unrealized gain  (loss) on securities            |       | 5,442                                 |       | (3,499 | ) |
| Less related  income taxes                       |       | (2,063                                | )          | 1,305 |   |
| Total unrealized  gain (loss) on securities, net |       | 3,379                                 |       | (2,194 | ) |
|                                             |       |                                  |       |   |   |
| Translation  gains                               |       | 165                                   |       | — |   |
| Total other  comprehensive income (loss)         |       | 3,544                                 |       | (2,194 | ) |
| Total  comprehensive income                      |       | $                                     | 28,776     |   | $ | 36,419 |   |

 

*Preferredand Common Stock*

 

As of March 31,2006 and December 31, 2005 there were 2,500,000 shares of no par value pershare preferred stock authorized, with none issued. As of March 31, 2006and December 31, 2005, there were 500,000,000 shares of $0.0033 par valueper share common stock authorized, with 111,356,000 and 110,205,000 sharesissued, respectively. Of the issued shares, 9,399,800 shares were held astreasury shares as of March 31, 2006 and December 31, 2005, respectively.

 

*StockRepurchases*

 

During 2005, we repurchased approximately 9.4million shares of our common stock at an aggregate cost of $300.0 million underthe Company’s $300.0 million stock repurchase program approved by the Board ofDirectors of Watson (“Board”) on February 10, 2005 (the “2005 RepurchaseProgram”). This completed our stock repurchase under the 2005 Repurchase Program.

 

On February 15, 2006, the Board authorized theexpenditure of an additional $300.0 million to repurchase shares of the Company’soutstanding common stock (the “2006 Repurchase Program”). Repurchases areauthorized to be made in open market or privately negotiated transactions fromtime to time in compliance with the SEC Rule 10b-18, subject to marketconditions, applicable legal requirements and other factors. Additionally, theBoard has authorized that purchases may be made under Rule 10b5-1promulgated under the Securities and Exchange Act of 1934, as amended. A Rule 10b5-1plan allows Watson to repurchase its shares during periods when it wouldnormally not be active in the market due to its internal trading blackoutperiods. All such purchases must be made in accordance with a pre-defined planthat is established when the plan administrator is not aware of any materialnon-public information. At this time, the Company does not intend to repurchasecommon stock under the 2006 Repurchase Program as a result of its pendingacquisition of Andrx.

 

5

----

 

*Provisions for Sales Returns and Allowances*

 

As customary in the pharmaceutical industry, theCompany’s gross product sales are subject to a variety of deductions inarriving at reported net product sales. When the Company recognizes revenuefrom the sale of its products, an estimate of various sales returns andallowances is recorded which reduces product sales and accounts receivable.These adjustments include estimates for chargebacks, rebates, returns, andother sales allowances. These provisionsare estimated based on historical payment experience, historical relationshipto revenues, estimated customer inventory levels and current contract salesterms with wholesale and indirect customers.

 

The Company’s provision for chargebacks is the most significant and complexestimated sales allowance. A chargeback represents an amount payable in thefuture to a wholesaler for the difference between the invoice price paid to theCompany by our wholesale customer for a particular product and the negotiatedcontract price that the wholesaler’s customer pays for that product. TheCompany’s chargeback estimates take into consideration the current averagechargeback rates by product and estimated wholesaler inventory levels. Watson continuallymonitors the assumptions giving consideration to current pricing trends andestimated wholesaler inventory levels and make adjustments to these estimateswhen the Company believes that the actual chargeback amounts payable in thefuture will differ from original estimates. The following tablesummarizes the activity in the Company’s major categories of sales returns andallowances (in thousands):

 
| ** **                                                                 | ** ** | **Chargebacks** | ** ** | **Rebates** | ** ** | **Returns and  Other  Allowances** | ** ** | **Cash  Discounts** | ** ** | **Total**  | ** ** |
|----------------------------------------------------------------------------|------------|-----------------|------------|-------------|------------|------------------------------------|------------|---------------------|------------|------------|------------|
| ** **                                                                 | ** ** | ** **      | ** ** | ** **  | ** ** | ** **                         | ** ** | ** **          | ** ** | ** ** | ** ** |
| Balance at  December 31, 2004                                         |       | $               | 129,551    |        | $          | 148,948                            |       | $                   | 44,483     |       | $          | 10,614 |   | $ | 333,596 |   |
| Provision  related to sales in first quarter 2005                          |       | 191,725         |       | 76,409      |       | 32,788                             |       | 13,709              |       | 314,631    |       |
| Credits and  payments                                                      |       | (227,678        | )          | (104,597    | )          | (37,512                            | )          | (14,153             | )          | (383,940   | )          |
| Balance at  March 31, 2005                                            |       | 93,598          |       | 120,760     |       | 39,759                             |       | 10,170              |       | 264,287    |       |
| Provision  related to sales in three quarters ended December 31, 2005 |       | 744,099         |       | 269,461     |       | 87,085                             |       | 45,791              |       | 1,146,436  |       |
| Credits and  payments                                                      |       | (698,092        | )          | (261,928    | )          | (81,551                            | )          | (43,867             | )          | (1,085,438 | )          |
| Balance at  December 31, 2005                                         |       | 139,605         |       | 128,293     |       | 45,293                             |       | 12,094              |       | 325,285    |       |
| Provision  related to sales in first quarter 2006                          |       | 255,933         |       | 90,199      |       | 38,771                             |       | 15,479              |       | 400,382    |       |
| Credits and  payments                                                      |       | (258,087        | )          | (110,058    | )          | (46,868                            | )          | (16,058             | )          | (431,071   | )          |
| Balance at  March 31, 2006                                            |       | $               | 137,451    |        | $          | 108,434                            |       | $                   | 37,196     |       | $          | 11,515 |   | $ | 294,596 |   |

 

The balance of the Company’s allowances for rebateshas declined due to efficiencies in processing as well as an acceleration inthe frequency of payments.  The increasein the balance of the Company’s chargeback allowances is the result of changesin our customer inventory mix.

 

*Earnings PerShare*

 

Basicearnings per share is computed by dividing net income by the weighted averagecommon shares outstanding during a period. Diluted earnings per share is basedon the treasury stock method and includes the effect from potential issuance ofcommon stock, such as shares issuable upon conversion of the $575 millionconvertible contingent senior debentures (“CODES”), and the dilutive effect ofstock options and restricted stock awards outstanding during the period. Commonshare equivalents have been excluded where their inclusion would beanti-dilutive. In accordance with Emerging Issues Task Force (“EITF”) Issue No. 04-8,“The Effect of Contingently Convertible Debt on Diluted Earnings per Share,”the Company is required to add approximately 14.4 million shares associatedwith the 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 reconciliation of the numerators anddenominators of basic and diluted earnings per share

 

6

----

 

consisted of thefollowing (in thousands, except per share amounts):

 
| ** **                                          | ** ** | **Three months ended  March 31,** | ** ** |
|-----------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                          | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **                                          | ** ** | ** **                             | ** ** | **Restated** | ** ** |
|                                                |       |                                   |       |   |   |
| **Earnings  per share - basic**                     | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Net income                                          |       | $                                      | 25,232     |   | $ | 38,613 |   |
|                                                |       |                                   |       |   |   |
| Basic weighted  average common shares outstanding   |       | 101,615                                |       | 109,136 |   |
|                                                |       |                                   |       |   |   |
| Earnings per  share - basic                         |       | $                                      | 0.25       |   | $ | 0.35 |   |
|                                                |       |                                   |       |   |   |
| **Earnings  per share - assuming dilution**         | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Net income                                          |       | $                                      | 25,232     |   | $ | 38,613 |   |
| Add: Interest  expense on CODES, net of tax         |       | 1,675                                  |       | 1,621 |   |
| Net income,  adjusted                               |       | $                                      | 26,907     |   | $ | 40,234 |   |
|                                                |       |                                   |       |   |   |
| Basic weighted  average common shares outstanding   |       | 101,615                                |       | 109,136 |   |
| Effect of  dilutive securities:                     |       |                                   |       |   |   |
| Conversion of  CODES                                |       | 14,357                                 |       | 14,357 |   |
| Dilutive stock  options                             |       | 569                                    |       | 611 |   |
| Diluted weighted  average common shares outstanding |       | 116,541                                |       | 124,104 |   |
|                                                |       |                                   |       |   |   |
| Earnings per  share - diluted                       |       | $                                      | 0.23       |   | $ | 0.32 |   |

 

Stock awardsto purchase 7.9 million and 6.6 million common shares for the three monthperiods ended March 31, 2006 and 2005, respectively, were outstanding but werenot included in the computation of diluted earnings per share because theoptions were antidilutive.

 

*RecentAccounting 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 clarifies that items such as abnormal freight, handling costs,and wasted materials (spoilage) be recognized as current period charges ratherthan as a portion of the inventory cost. Unallocated overheads are to berecognized as an expense in the period in which they are incurred. In addition,this Statement requires that allocation of fixed production overheads to thecosts of conversion be based on the normal capacity of the productionfacilities. This Statement is effective for inventory costs incurred duringfiscal years beginning after June 15, 2005. The provision of thisStatement shall be applied prospectively. The adoption of SFAS 151 on January 1,2006, did not have a material effect on our Condensed Consolidated FinancialStatements.

 

In December 2004,the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS123R”), which replaces SFAS No. 123, “Accounting for Stock-BasedCompensation” (“SFAS 123”) as well as SFAS No. 148, “Accounting forStock-Based Compensation-Transition and Disclosure” (“SFAS 148”), supersedesAccounting Principles Board (“APB”) Opinion No. 25, “Accounting for StockIssued to Employees” (“APB 25”) and amends SFAS No. 95, “Statement of CashFlows” (“SFAS 95”). SFAS 123Rrequires all share-based payments to employees, including grants of employeestock options, to be recognized in the financial statements based on their fairvalues. The intrinsic value method as permitted under APB 25 together with thepro forma disclosures previously permitted under SFAS 123 no longer willbe an alternative to financial statement recognition. Under SFAS 123R, theCompany must determine the appropriate fair value model to be used for valuingshare-based payments, the amortization method for attributing compensation costto reporting periods and the transition method to be used at date ofadoption. The transition methodsinclude modified

 

7

----

 

prospective and modified retrospective adoption options. Under the modifiedretrospective option, prior periods may be restated either as of thebeginning of the year of adoption or for all periods presented. The modifiedprospective method requires that compensation expense be recorded for allunvested stock options at the beginning of the first quarter of adoption ofSFAS 123R, while the modified retrospective method would recordcompensation expense for all unvested stock options beginning with the firstperiod restated. SFAS 123R also requires any previously recorded unearned ordeferred compensation accounts (i.e. contra-equity accounts) withinstockholders’ equity be recorded as a reduction to additional paid-in capitalbalances rather than shown as contra equity accounts as was permitted prior to January 1,2006. SFAS 95 is amendedto require excess tax benefits be reported as a financing cash flow rather thanas a reduction in taxes paid within the Consolidated Statement of Cash Flows. OnJanuary 1, 2006, the Company adopted SFAS 123R using the modifiedprospective method option.

 

In March 2005, the SEC issued SEC StaffBulletin No. 107 (“SAB 107”) which describes the SEC staff position aswell as supplemental implementation guidance on the application  and adoption of SFAS 123R. The Company hasapplied the provisions of SAB 107 and its guidance in its adoption of SFAS 123Ron January 1, 2006 (Refer to NOTE 2 – SHARE-BASED COMPENSATION).

 

In May 2005, the FASB issued SFAS No. 154,“Accounting Changes and Error Corrections” (“SFAS 154”), which replaces APBOpinion No. 20, “Accounting Changes” (“APB 20”) and SFAS No. 3, “ReportingAccounting Changes in Interim Financial Statements” (“SFAS 3”). SFAS 154applies to all voluntary changes in accounting principle and changes therequirements for the accounting for and reporting of a change in accountingprinciple. SFAS 154 also requires retrospective application to prior periodfinancial statements involving changes in accounting principle unless it isimpracticable to determine either the period-specific or cumulative effect of thechange. This statement also requires that a change in the method ofdepreciation, amortization or depletion of long-lived assets be accounted foras a change in accounting estimate that is accounted for prospectively. SFAS154 also retains many provisions of APB 20 including those related to reportinga change in accounting estimate, a change in the reporting entity and acorrection of an error and also carries forward provisions of SFAS 3 governingthe reporting of accounting changes in interim financial statements. SFAS 154is effective for accounting changes and corrections of errors made in fiscalyears beginning after December 15, 2005. The adoption of SFAS 154 on January 1,2006, did not have a material effect on our Consolidated Financial Statements.

 

**NOTE 2 –SHARE-BASED COMPENSATION**

 

Asindicated above, effective January 1, 2006, the Company adopted themodified prospective method of SFAS 123R which requires the measurement andrecognition of compensation expense for all share-based compensation awardsmade to employees and directors based on estimated fair values. SFAS 123R eliminatespreviously available alternatives to account for share-based compensationtransactions, as the Company formerly did, using the recognition andmeasurement principles of APB 25 and related interpretations. Under theintrinsic value method of APB 25, no stock-based employee compensation expense hadbeen recognized for employee options in the Company’s Condensed Consolidated Statementsof Income, as all employee options granted under the Company’s stock optionplans or employee stock purchase plan (“ESPP”) either had an exercise priceequal to the market value of the underlying common stock on the date of grantor were deemed non-compensatory under APB 25 for common stock issued under ourESPP. In accordance with the modified prospective method, the consolidatedfinancial statements for prior periods have not been restated to reflect, anddo not include, the share-based compensation impact of FAS 123R.

 

*Stock Option Plans*

 

The Company has adopted several stock option plans,all of which have been approved by the Company’s shareholders, that authorizethe granting of options to purchase the Company’s common shares subject tocertain conditions. At March 31, 2006, the Company had reserved 15.3million of its common shares for issuance of

 

8

----

 

share-based compensation awards under the Company’s stock option andrestricted stock plans. Options are granted at the fair value of the sharesunderlying the options at the date of the grant and generally becomeexercisable over periods ranging from three to five years and expire in tenyears. In conjunction with certain of the Company’s acquisitions, Watsonassumed stock option and warrant plans from the acquired companies. The optionsand warrants in these plans were adjusted by the individual exchange ratiosspecified in each transaction. No additional options or warrants have beengranted under any of the assumed plans.

 

TheCompany estimates the fair value of its stock option plans and the ESPP usingthe Black-Scholes option pricing model (the “Option Model”). The Option Modelrequires the use of subjective and complex assumptions, including the option’sexpected term and the estimated future price volatility of the underlyingstock, which determine the fair value of the share-based awards. The Company’s estimateof expected term in 2006 was determined based on the weighted average period oftime that options granted are expected to be outstanding considering currentvesting schedules and the historical exercise patterns of existing option plans.Beginning in 2005, the expected volatility assumption used in the Option Modelchanged from being based on historical volatility to implied volatility basedon traded options on the Company’s stock in accordance with guidance providedin SFAS 123R and SAB 107. Prior to 2005, the Company’s measurement of expectedvolatility was based on the historical volatility of its stock. The risk-freeinterest rate used in the Option Model is based on the yield of U.S. Treasurieswith a maturity closest to the expected term of the Company’s stock options.

 

Thefollowing weighted average assumptions were used for stock options grantedduring the three months ended March 31, 2006 and 2005:

 

| ** **                                           | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                           | ** ** | **2006**                               | ** ** | **2005** | ** ** |
|                                                 |       |                                   |       |   |   |
| Dividend yield                                       |       | None                                   |       | None |   |
| Expected  volatility                                 |       | 25                                     | %          | 26 | % |
| Risk-free  interest rate                             |       | 4.67                                   | %          | 4.00 | % |
| Expected term                                        |       | 4.8 years                              |       | 5.5 years |   |
|                                                 |       |                                   |       |   |   |
| Weighted average  fair value per share at grant date |       | $                                      | 9.25       |   | $ | 9.87 |   |
|                                                      |            |                                        |            |  |  |  |  |

 

Effective January 1, 2006, in accordance withthe provisions of SFAS 123R, share-based compensation expense recognized duringa period is based on the value of the portion of share-based awards that are expectedto vest with employees. Accordingly, the recognition of share-basedcompensation expense beginning January 1, 2006 has been reduced forestimated future forfeitures. SFAS 123R requires forfeitures to be estimated atthe time of grant with adjustments recorded in subsequent period compensationexpense if actual forfeitures differ from those estimates. Prior to 2006, weaccounted for forfeitures as they occurred for the disclosure of pro formainformation presented in our Notes to Condensed Consolidated FinancialStatements for prior periods. Share-based compensation expense recognized underSFAS 123R includes share-based awards granted subsequent to December 31,2005, based on the grant date fair value estimated in accordance with theprovisions of SFAS 123R as well as share-based awards granted prior to, but notyet vested as of December 31, 2005, based on the grant date fair valueestimated in accordance with the provisions of SFAS 123. In conjunction withthe adoption of SFAS 123R, we changed the method of recognizing share-basedcompensation expense from the accelerated multiple-option approach to theratable single-option approach.

 

As a result of adopting SFAS 123R on January 1,2006, the Company’s operating income and net income before income tax provisionwas reduced by $1.8 million and net income was reduced by $1.1 million ($0.02per

 

9

----

 

basic share, $0.01 per diluted share) for the three months ended March 31,2006, related to the Company’s employee stock option plans. There was noshare-based employee compensation related expense recognized in the threemonths ended March 31, 2005. Total stock option cost capitalized as part ofinventory was $0.3 million and $0 for three months ended March 31, 2006and 2005, respectively.

 

On December 15, 2005 the Compensation Committeeof the Board approved the accelerated vesting of certain unvested,out-of-the-money stock options having an exercise price of $38.00 or greater. Theacceleration of vesting was effective December 15, 2005, for stock optionspreviously awarded to the Company’s employees, including its executive officersunder the Company’s equity compensation plans. In connection with theacceleration of vesting terms of these options, the Company recognized anadditional $6.9 million, pre-tax non-cash compensation expense on a pro formabasis in accordance with SFAS 123 in the three months ended December 31,2005. The acceleration action was taken in order to reduce the impact on futurecompensation expense of recognizing share based payment transactions withinfuture periods’ consolidated statements of income upon adoption of SFAS 123R onJanuary 1, 2006.

 

A summary of the changes in the Company’s stockoption plans during the three months ended March 31, 2006 is presentedbelow (in thousands, except per share amounts):

 
| ** **                                          | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term (Years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-----------------------------------------------------|------------|------------|------------|----------------------------------------|------------|-------------------------------------------------------------|------------|---------------------------------|------------|
|                                                |       |       |       |                                   |       |                                                        |       |                            |       |
| Outstanding at  December 31, 2005              |       | 11,194     |       | $                                      | 36.76      |                                                        |       |                            |       |   |
| Granted                                             |       | 165        |       | 29.56                                  |       |                                                        |       |                            |       |
| Exercised                                           |       | (55        | )          | (26.79                                 | )          |                                                        |       |                            |       |
| Cancelled                                           |       | (155       | )          | (40.73                                 | )          |                                                        |       |                            |       |
| Outstanding at  March 31, 2006                 |       | 11,149     |       | $                                      | 36.65      |                                                        | 6.1        |                            | $          | 8,771 |   |
|                                                |       |       |       |                                   |       |                                                        |       |                            |       |
| Vested and  expected to vest at March 31, 2006 |       | 10,363     |       | $                                      | 37.18      |                                                        | 6.1        |                            | $          | 8,154 |   |
|                                                |       |       |       |                                   |       |                                                        |       |                            |       |
| Options  exercisable at March 31, 2006         |       | 8,106      |       | $                                      | 39.29      |                                                        | 5.3        |                            | $          | 6,061 |   |

 

As of March 31, 2006, the Company had $9.7million of total unrecognized compensation expense, net of estimatedforfeitures, related to stock option grants, which will be recognized over theremaining weighted average period of 1.7 years.

 

*Restricted Stock*

 

During 2005, the Compensation Committee of the Boardauthorized and issued restricted stock to the Company’s employees, includingits executive officers and certain non-employee directors (the “Participants”)under the Company’s equity compensation plans. The restricted stock awardprogram offers Participants the opportunity to earn shares of our common stockover time, rather than options that give Participants the right to purchasestock at a set price. Restricted stock awards are grants that entitle theholder to shares of common stock subject to certain terms. Restricted stockawards generally have restrictions eliminated over a one to four year period. Restrictionsgenerally lapse for non-employee directors after one year. Restrictionsgenerally lapse for employees over a two to four year period. The fair value ofrestricted stock grants is based on the fair market value of our common stock onthe respective grant dates. Restricted stock compensation is being amortizedand charged to operations over the same period as the restrictions areeliminated for the Participants.

 

The Company’s operating income and net income beforeincome tax provision was reduced by $0.5 million and net income was reduced by$0.3 million ($0.00 per basic share, $0.00 per diluted share) for the threemonths ended March 31, 2006, related to the Company’s restricted stockplans. There was no restricted stock expense

 

10

----

 

recognized in the three months ended March 31, 2005. Total restrictedstock cost capitalized as part of inventory was $0.2 million and $0 forthree months ended March 31, 2006 and 2005, respectively.

 

A summary of the changes in restricted stock grantsduring the three months ended March 31, 2006 is presented below (inthousands, except per share amounts):

 
| ** **                                                             | ** ** | **Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** | **Weighted  Average  Remaining  Contractual  Term (Years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|------------------------------------------------------------------------|------------|------------|------------|-----------------------------------------------|------------|-------------------------------------------------------------|------------|---------------------------------|------------|
|                                                                   |       |       |       |                                          |       |                                                        |       |                            |       |
| Restricted  shares outstanding at December 31, 2005               |       | 315.5      |       | $                                             | 34.46      |                                                        | 2.3        |                            | $          | 10,871 |   |
| Granted                                                                |       | 68.5       |       | 29.39                                         |       |                                                        |       | 2,014                           |       |
| Vested                                                                 |       | —     |       | —                                        |       |                                                        |       | —                          |       |
| Cancelled                                                              |       | (14.9      | )          | 35.10                                         |       |                                                        |       | (524                            | )          |
| Restricted  shares outstanding at March 31, 2006                  |       | 369.1      |       | $                                             | 33.49      |                                                        | 2.7        |                            | $          | 12,361 |   |
|                                                                   |       |       |       |                                          |       |                                                        |       |                            |       |
| Restricted  shares net of estimated forfeitures at March 31, 2006 |       | 229.7      |       | $                                             | 33.57      |                                                        | 2.7        |                            | $          | 7,711 |   |

 

As of March 31, 2006, the Company had $5.0million of total unrecognized compensation expense, net of estimatedforfeitures, related to restricted stock grants, which will be recognized overthe remaining weighted average period of 2.1 years.

 

*ESPP*

 

An ESPP was established for eligible employees topurchase shares of the Company’s common stock at 85% of the lower of the fairmarket value of Watson common stock on the effective date of subscription orthe date of purchase. Under the ESPP, employees can authorize the Company towithhold up to 15% of their compensation during any offering period for commonstock purchases, subject to certain limitations. The ESPP was implemented on January 1,2002 and was qualified under Section 423 of the Internal Revenue Code. TheBoard authorized an aggregate of 700,000 shares of the Company’s common stockfor issuance under the ESPP. As of December 31, 2005, a total of 471,307shares were issued under the ESPP. On June 29, 2005 the CompensationCommittee of the Board terminated the ESPP effective January 1, 2006.

 

The following weightedaverage assumptions were used for the ESPP during the three months ended March 31,2005:

 

| Dividend yield                                       |   | None     |   |
|------------------------------------------------------|--------|----------|--------|
| Expected  volatility                                 |   | 26       | %      |
| Risk-free  interest rate                             |   | 4.00     | %      |
| Expected term                                        |   | 6 months |   |
|                                                 |   |     |   |
| Weighted average  fair value per share at grant date |   | $        | 7.31   |   |
|                                                      |        |          |        |  |

 

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

 

Prior to 2006, the Company determined stock-basedcompensation expense using the intrinsic value method of APB 25 and we providedthe disclosures required by SFAS 123, as amended by SFAS 148. Thefollowing table provides the pro forma effects on net income and earnings pershare for the three months ended March 31, 2005 as if the fair valuerecognition provisions of SFAS 123R had been applied to options and ESPP grants

 

11

----

 

under the Company’semployee compensation plans (in thousands, except per share amounts):

 
| ** **                                                                                                                                    | ** ** | **Restated** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------|------------|
| Net income, as  reported                                                                                                                      |       | $            | 38,613     |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | 3,091        |       |
| Pro forma net  income                                                                                                                         |       | 35,522       |       |
| Add: Interest  expense on CODES                                                                                                               |       | 1,622        |       |
| Pro forma net  income, adjusted                                                                                                               |       | $            | 37,144     |   |
|                                                                                                                                          |       |         |       |
| Earnings per  share:                                                                                                                          |       |         |       |
| Basic - as  reported                                                                                                                          |       | $            | 0.35       |   |
| Basic - pro forma                                                                                                                             |       | $            | 0.33       |   |
|                                                                                                                                          |       |         |       |
| Diluted - as  reported                                                                                                                        |       | $            | 0.32       |   |
| Diluted - pro  forma                                                                                                                          |       | $            | 0.30       |   |

 

**NOTE 3 –ACQUISITIONS**

 

*Acquisition of Sekhsaria Chemicals Ltd.*

 

OnMarch 16, 2006, the Company acquired Sekhsaria Chemicals Ltd. (“Sekhsaria”),a private company located in Mumbai, India that provides active pharmaceuticalingredient and finished dosage formulation expertise to the globalpharmaceutical industry. The Company acquired all the outstanding shares ofSekhsaria for approximately $29.5 million plus acquisition costs. Thetransaction was accounted for as a purchase in accordance with SFAS No. 141,“Business Combinations” “SFAS 141” and accordingly, the tangible assetsacquired were recorded at fair value on acquisition date based on reasonableassumptions. The initial purchase price was allocated as follows (inthousands):

 
| Current assets                    |   | $       | 6,578  |   |
|-----------------------------------|--------|---------|--------|--------|
| Property and equipment            |   | 17,517  |   |
| Goodwill                          |   | 24,264  |   |
| Accounts payable and current debt |   | (18,294 | )      |
| Other non-current liabilities     |   | (523    | )      |
|                              |   | $       | 29,542 |   |

 

Theresults of operations of Sekhsaria have been included in the Company’sCondensed Consolidated Financial Statements subsequent to the date ofacquisition. Pro forma results of operations have not been presented becausethe effect of the acquisition was not material. The Company is planning anadditional investment in Sekhsaria in order to repay existing debt.

 

*Additional Investment in Scinopharm*

 

TheCompany holds an equity interest in Scinopharm. In January 2006, we madean additional investment in Scinopharm of approximately $12.0 million whichincreased our ownership share to approximately 31%. Additionally, we have anoption to acquire an additional 44% interest in Scinopharm at a cost ofapproximately $80 million within the next 21 months.

 

12

----

 

*Acquisition of Manufacturing Facility in Goa, India*

 

In October 2005, the Company entered into anasset purchase agreement to purchase a manufacturing facility located in Goa,India (“Goa”) from Dr. Reddy’s Laboratories, Ltd. (“Dr. Reddy”) fortotal cash consideration of approximately $16.4 million plus acquisition costs.The transaction included a manufacturing facility, machinery and equipment.

 

**NOTE 4 –INVESTMENTS**

 

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

 

TheCompany’s debt investments in U.S. Treasury and agency securities areclassified as available-for-sale and are recorded at fair value based on quotedmarket prices using the specific identification method.

 

Thefollowing table provides a summary of the fair value and unrealized holdinggain (loss) related to Watson’s available-for-sale securities (in thousands):

 
| ** **                           | ** ** | **Cost, Including  Accrued Interest** | ** ** | **Gross Unrealized  Gains** | ** ** | **Gross Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|-----------------------------|------------|------------------------------|------------|----------------|------------|
| At  March 31, 2006              |       |                                  |       |                        |       |                         |       |           |       |
|                                 |       |                                  |       |                        |       |                         |       |           |       |
| Available-for-sale:                  |       |                                  |       |                        |       |                         |       |           |       |
| U.S. Treasury  and agency securities |       | $                                     | 155,430    |                        | $          | —                       |       | $              | (1,728     | ) | $ | 153,702 |   |
| Equity  securities - current         |       | 1,581                                 |       | 12,844                      |       | —                       |       | 14,425         |       |
| Current                              |       | 157,011                               |       | 12,844                      |       | (1,728                       | )          | 168,127        |       |
| Equity  securities - non-current     |       | 232                                   |       | 1,713                       |       | —                       |       | 1,945          |       |
| Total                                |       | $                                     | 157,243    |                        | $          | 14,557                       |       | $              | (1,728     | ) | $ | 170,072 |   |

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

 

Grossunrealized gains at March 31, 2006 and December 31, 2005 primarilyrelate to our holdings in shares of Andrx Corporation (“Andrx”) common stock. Thegross unrealized holding loss at March 31, 2006 and December 31, 2005is attributable to adjustments, included in other comprehensive income, for thedecline in fair value in the Company’s investment in U.S. Treasury and agency securities.

 

TheCompany’s net unrealized gain related to its available-for-sale securities increased$3.4 million for the three month period ended March 31, 2006. During thethree month period ended March 31, 2005, the Company’s net unrealizedholding gain decreased $2.2 million. These changes in the Company’s netunrealized holding gain are included in other comprehensive loss.

 

*Current Investments*

 

TheCompany’s investment in the common stock of Andrx, publicly traded on theNasdaq Stock Market under the symbol ADRX, is classified as a currentinvestment on the Company’s Condensed Consolidated

 

13

----

 

Balance Sheets at March 31, 2006 and December 31, 2005. TheCompany did not sell any of its shares of Andrx during the three month periodsended March 31, 2005 and 2006. (Refer to NOTE 1 – GENERAL.)

 

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

 

Thecontractual maturities of the U.S. Treasury and agency securities at March 31,2006 are as follows (in thousands):

 

| ** **              | ** ** | **Fair value** | ** ** |
|-------------------------|------------|----------------|------------|
|                    |       |           |       |
| Mature within one year  |       | $              | 152,053    |   |
| Mature within two years |       | 1,649          |       |
|                    |       | $              | 153,702    |   |

 

*Non-currentInvestments*

 

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

 

**NOTE 5 –OPERATING SEGMENTS**

 

Watsonhas two operating segments: Brand and Generic. The brand business segmentincludes the Company’s lines of Specialty Products and Nephrology products.Watson has aggregated its brand product lines in a single segment because ofsimilarities in regulatory environment, methods of distribution and types ofcustomer. This segment includes patent-protected products and certaintrademarked off-patent products that Watson sells and markets as Brandpharmaceutical products. The Generic business segment includes off-patentpharmaceutical products that are therapeutically equivalent to proprietaryproducts. The Company sells its Brand and Generic products primarily topharmaceutical wholesalers, drug distributors and chain drug stores.

 

TheCompany evaluates segment performance based on segment net revenues, grossprofit and contribution. Amortization of acquired product rights is notincluded in the calculation of segment gross profit or contribution. Segmentcontribution represents segment gross profit less direct research anddevelopment expenses and selling and marketing expenses. The Company does not report depreciationexpense, total assets, and capital expenditures by segment as such information isnot used by management, or has not been accounted for at the segment level.

 

The “other”revenue classification for the three month period ended March 31, 2006 and2005 consists primarily of royalties and revenues from research, development andlicensing fees. Net revenues and segment

 

14

----

 

contribution informationfor the Company’s Brand and Generic segments, consisted of the following:

 
| ** **                                                | ** ** | **Three Months Ended March 31, 2006** | ** ** | **Three Months Ended March 31, 2005** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                | ** ** | **Generic**                                | ** ** | **Brand**                                  | ** ** | **Total** | ** ** | **Generic** | ** ** | **Brand** | ** ** | **Total** | ** ** |
| ** **                                                | ** ** | ** **                                 | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Product sales                                             |       | $                                          | 321,415    |                                       | $          | 83,237 |   | $ | 404,652 |   | $ | 293,163 |   | $ | 104,526 |   | $ | 397,689 |   |
| Other                                                     |       | 675                                        |       | 1,906                                      |       | 2,581 |   | 1,086 |   | 2,053 |   | 3,139 |   |
| ** **                                                | ** ** | ** **                                 | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenues                                              |       | 322,090                                    |       | 85,143                                     |       | 407,233 |   | 294,249 |   | 106,579 |   | 400,828 |   |
| Cost of revenue  (excludes amortization, presented below) |       | 217,384                                    |       | 17,370                                     |       | 234,754 |   | 183,190 |   | 23,760 |   | 206,950 |   |
| Gross profit                                              |       | 104,706                                    |       | 67,773                                     |       | 172,479 |   | 111,059 |   | 82,819 |   | 193,878 |   |
| Gross margin                                              |       | 33                                         | %          | 80                                         | %          | 42 | % | 38 | % | 78 | % | 48 | % |
|                                                      |       |                                       |       |                                       |       |   |   |   |   |   |   |   |   |
| Research and  development                                 |       | 20,495                                     |       | 9,342                                      |       | 29,837 |   | 19,144 |   | 9,694 |   | 28,838 |   |
| Selling and  marketing                                    |       | 12,938                                     |       | 28,975                                     |       | 41,913 |   | 11,260 |   | 27,468 |   | 38,728 |   |
| Contribution                                              |       | $                                          | 71,273     |                                       | $          | 29,456 |   | 100,729 |   | $ | 80,655 |   | $ | 45,657 |   | 126,312 |   |
| Contibution  margin                                       |       | 22                                         | %          | 35                                         | %          | 25 | % | 27 | % | 43 | % | 32 | % |
|                                                      |       |                                       |       |                                       |       |   |   |   |   |   |   |   |   |
| General and  administrative                               |       |                                       |       |                                       |       | 24,837 |   |   |   |   |   | 24,923 |   |
| Amortization                                              |       |                                       |       |                                       |       | 41,100 |   |   |   |   |   | 40,638 |   |
| Operating income                                          |       |                                       |       |                                       |       | $ | 34,792 |   |   |   |   |   | $ | 60,751 |   |
| Operating margin                                          |       |                                       |       |                                       |       | 9 | % |   |   |   |   | 15 | % |

 

**NOTE 6 –INVENTORIES**

 

Inventoriesconsist of finished goods held for sale and distribution, raw materials andwork-in-process. Included in inventory at March 31, 2006 and December 31,2005 is approximately $8.2 and $6.0 million, respectively, of inventory that ispending approval by the U.S. Food and Drug Administration (“FDA”) or has notbeen launched due to contractual restrictions. 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.

 

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

 
| ** **         | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------|------------|--------------------------|------------|-----------------------------|------------|
|               |       |                     |       |                        |       |
| Raw materials      |       | $                        | 96,767     |                        | $          | 85,983 |   |
| Work-in-process    |       | 61,210                   |       | 67,173                      |       |
| Finished goods     |       | 142,817                  |       | 124,906                     |       |
| Total  inventories |       | $                        | 300,794    |                        | $          | 278,062 |   |

 

**NOTE 7 –GOODWILL AND OTHER INTANGIBLE ASSETS**

 

Watson tests itsgoodwill and intangible assets with indefinite lives by comparing the fairvalue of each of the Company’s reporting units to the respective carrying valueof the reporting units. The Company performs this impairment testing annuallyduring the second quarter and when events occur or circumstances change thatwould more likely than not reduce the fair value of a reporting unit below itscarrying amount. The Company’s two reporting units are Brand and Genericpharmaceutical products. The carrying value of each reporting unit isdetermined by assigning the assets and liabilities, including the existinggoodwill and intangible assets, to those reporting units. Goodwill is consideredimpaired if the carrying amount exceeds the fair value of the asset.

 

15

----

 

During the second quarter of 2005, Watson performed its annualassessment for the impairment of goodwill and determined there was noindication of impairment.

 

During the three months ended March 31, 2006,in conjunction with the acquisition of Sekhsaria, the total purchase price inexcess of the fair value of net assets acquired amounted to $24.3 million (SeeNote 3 –ACQUISITIONS). This entire amount was recorded as an addition to goodwill underthe Generic pharmaceutical product segment. Goodwill for the Company’s reportingunits consisted of the following (in thousands):

 
| ** **                       | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                             |       |                     |       |                        |       |
| Brand pharmaceutical  products   |       | $                        | 368,105    |                        | $          | 368,105 |   |
| Generic  pharmaceutical products |       | 111,754                  |       | 87,490                      |       |
| Total goodwill                   |       | $                        | 479,859    |                        | $          | 455,595 |   |

 

Other intangible assets consist primarily of productrights. The original cost and accumulated amortization of these intangibleassets are as follows (in thousands):

 
| ** **                                         | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                                               |       |                     |       |                        |       |
| Product rights and related intangibles             |       | $                        | 1,269,678  |                        | $          | 1,269,513 |   |
| Less accumulated amortization                      |       | (558,806                 | )          | (517,705                    | )          |
| Total product  rights and related intangibles, net |       | $                        | 710,872    |                        | $          | 751,808 |   |

 

Assuming no additions, disposals or adjustments aremade to the carrying values and/or useful lives of the assets, annualamortization expense on product rights and related intangibles is estimated tobe approximately $164.0 million in each of 2006 and 2007 and $53.0 million in eachof 2008 and 2009 and $45.0 million in 2010. The Company’s current productrights and related intangibles have a weighted average useful life ofapproximately fourteen years.

 

**NOTE 8 – LONG-TERM DEBT**

 

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

 
| ** **                                                                                                                         | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                                                                                                                               |       |                     |       |                        |       |
| CODES, face  amount of $575 million, due 2023, net of unamortized discount                                                         |       | $                        | 573,918    |                        | $          | 573,849 |   |
| Senior unsecured  notes, 71/8% (“1998 Senior Notes”), face amount of $14  million, due 2008, net of unamortized discount |       | 14,778                   |       | 14,054                      |       |
| Other notes  payable                                                                                                               |       | 15,184                   |       | 32                          |       |
|                                                                                                                               |       |                     | 603,886    |                        |       | 587,935 |   |
| Less: Current portion of long-term debt                                                                                            |       |                     | 29,933     |                        |       | — |   |
| Total long-term  debt                                                                                                              |       | $                        | 573,947    |                        | $          | 587,935 |   |

 

*CODES*

 

In March 2003,the Company issued $575 million of CODES. The CODES, which are convertible intoshares of Watson’s common stock upon the occurrence of certain events, are duein March 2023, with interest payments due semi-annually in March and September atan effective annual interest rate of 2.1%, excluding changes in fair value ofthe contingent interest derivative. At March 31, 2006 and December 31,2005, the unamortized discount for the CODES for both periods was $1.1 and 1.2 million,respectively.

 

16

----

 

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

 

•                  during any quarterly conversionperiod (period from and including the thirtieth trading day in a fiscal quarterto, but not including, the thirtieth trading day in the immediately followingfiscal quarter) if the closing sale price per share of Watson’s common stockfor a period of at least 20 trading days during the 30 consecutive trading-dayperiod ending on the first day of such conversion period is more than 125%($50.06) of the conversion price in effect on that thirtieth day;

 

•                  on or before March 15, 2018,during the five business-day period following any 10 consecutive trading-dayperiod in which the daily average trading price for the CODES for such ten-dayperiod was less than 105% of the average conversion value for the debenturesduring that period. This conversion feature represents an embedded derivative. However,based on the de minimis value associated with this feature, no value has beenassigned at issuance and at March 31, 2005;

 

•                  during any period, following theearlier of (a) the date the CODES are rated by both Standard &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 by either Standard &Poor’s or Moody’s (or any successors to these entities) is lower than “BB” or “Ba3”,respectively, or when either of these rating agencies does not have a ratingthen assigned to the CODES for any reason, including any withdrawal orsuspension of a rating assigned to the CODES. This conversion featurerepresents an embedded derivative. However, based on the de minimis valueassociated with this feature, no value has been assigned at issuance and at March 31,2005;

 

•                  if the CODES have been called forredemption; or

 

•                  upon the occurrence of specifiedcorporate transactions.

 

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

 

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

 

Inaddition, the holders of the CODES have the right to receive contingentinterest payments during any six-month period from March 15 to September 14and from September 15 to March 14, commencing on September 15,2003, if the average trading price of the CODES for the five trading daysending on the second trading day immediately preceding the relevant six-monthperiod equals 120% or more of the principal amount of the CODES. The interestrate used to calculate the contingent interest is the greater of 5% of theCompany’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 paymentfeature is an embedded derivative and has been bifurcated and recordedseparately in the Condensed Consolidated Balance Sheets in other long-termliabilities. The initial fair value assigned to the embedded derivative was$1.9 million, which is recorded as a discount to the CODES. Changes to the fairvalue of this embedded derivative

 

17

----

 

are reflected as an adjustment to interest expense. The current valueof the embedded derivative was $ 0.5 and $0.9 million at March 31, 2006and December 31, 2005, respectively.

 

*1998Senior Notes*

 

In May 1998,Watson issued $150 million of its 1998 Senior Notes. The Company is required tomake interest only payments due semi-annually in May and November atan effective annual rate of 7.2%. In February 2004, the Company initiated a tender offer topurchase all of its outstanding 1998 Senior Notes and a related consentsolicitation. The Company received tenders of its 1998 Senior Notes anddeliveries of related consents from holders of approximately $101.6 million ofthe $150 million aggregate principal amount of 1998 Senior Notes outstanding. InMay 2004, the Company acquired an additional $34.3 million of itsoutstanding 1998 Senior Notes in an open market transaction. On March 31,2006, the Company initiated a redemption notice to the holders of all of itsoutstanding 1998 Senior Notes. As a result, the Company has reclassified theremaining 1998 Senior Notes as current liabilities in the accompanyingCondensed Consolidated Financial Statements as at March 31, 2006.

 

*CreditFacility*

 

In May 2003, the Company entered into anagreement with a syndicate of lenders for a five-year, $300 million senior,unsecured revolving credit facility (the “Credit Facility”) for working capitaland other general corporate purposes. On September 8, 2005, the Companyentered into a Second Amendment to the Credit Facility on substantially thesame terms and conditions except the fee structure was reduced and certaindefined terms were added or amended. On March 6, 2006, the Company enteredinto a Third Amendment to the Credit Facility which, among other things,permits the Company to repurchase up to $300.0 million of its common stock. Asof December 31, 2005, the total $300 million under the Credit Facility wasavailable to the Company. Watson’s assets generally are held by, and itsoperations generally are conducted through, its subsidiaries. Within themeaning of Regulation S-X, Rule 3-10, the Company has no assets oroperations independent of its subsidiaries. Under the terms of the CreditFacility, each of our subsidiaries, other than minor subsidiaries, entered intoa full and unconditional guarantee on a joint and several basis. In order toprovide subsidiary guarantees in connection with the Credit Facility, theCompany was required to issue similar guarantees to the 1998 Senior Note holders.The subsidiary guarantees related to both the Credit Facility and the 1998Senior Notes are full and unconditional, on a joint and several basis, and aregiven by all subsidiaries other than minor subsidiaries. As of March 31,2006 and December 31, 2005, the Company had not drawn any funds from theCredit Facility. Watson is subject to certain financial and operationalcovenants, all of which, as of March 31, 2006, the Company was incompliance.

 

**NOTE 9 –FINANCIAL INSTRUMENTS**

 

*Fairvalue of Financial Instruments*

 

TheCompany’s financial 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 cashequivalents, marketable securities, accounts and other receivables and tradeaccounts payable are representative of their respective fair values due totheir relatively short maturities. The fair values of investments in companiesthat are publicly traded are based on quoted market prices. The fair value ofinvestments in privately held companies, or cost-method investments, are basedon historical cost, adjusted for any write-down related to impairment. TheCompany estimates the fair value of its fixed rate long-term obligations basedon quoted market rates of interest and maturity schedules for similar issues. Thecarrying value of these obligations approximates their fair value. The fair valueof the embedded derivatives related to the CODES is based on a present valuetechnique using discounted expected future cash flows.

 

18

----

 

*DerivativeFinancial Instruments*

 

TheCompany’s derivative financial instruments consist of embedded derivativesrelated to its CODES. These embedded derivatives include certain conversionfeatures and a contingent interest feature. See Note 8 for a more detaileddescription of these features of the CODES. Although the conversion featuresrepresent embedded derivative financial instruments, based on the de minimisvalue of these features at the time of issuance and at March 31, 2006, novalue has been assigned to these instruments. The contingent interest featureprovides unique tax treatment under the Internal Revenue Service’s ContingentDebt Regulations. In essence, interest accrues, for tax purposes, on the basisof the instrument’s comparable yield (the yield at which the issuer would issuea fixed rate instrument with similar terms). This embedded derivative isreported on the Company’s Condensed Consolidated Balance Sheets at fair valueand the changes in the fair value of the embedded derivative are reported asgains or losses in the Company’s Condensed Consolidated Statements of Income.

 

Thecarrying value of the Company’s derivative financial instruments, whichapproximates fair value, decreased $0.4 million from $0.9 million at December 31,2005 to $0.5 million at March 31, 2006. The change in fair value was recordedas a reduction of interest expense during the respective period.

 

**NOTE 10 –COMMITMENTS AND CONTINGENCIES**

 

*Facility and Equipment Leases*

 

The Company has entered into long-term operatingleases for certain facilities and equipment. The terms of the operating leasesfor the Company’s facilities require the Company to pay property taxes, normalmaintenance expenses and maintain minimum insurance coverage. Total rentalexpense for operating leases for the three months ended March 31, 2006 and2005 were $2.1 million and $2.9 million, respectively.

 

Future minimum lease payments under allnon-cancelable operating leases consist of approximately $6.2 million remainingin 2006, $6.7 million in 2007, $4.7 million in 2008, $3.7 million in 2009, $2.4million in 2010 and $13.8 million thereafter.

 

*Employee Retirement Plans*

 

The Company maintains certain defined contributionretirement plans covering substantially all employees. The Company contributesto the plans based upon the employee contributions. Watson’s contributions tothese retirement plans for the three months ended March 31, 2006 and 2005were $1.9 million and $1.8 million, respectively. The Company does not sponsorany defined benefit retirement plans or postretirement benefit plans.

 

*Legal Matters*

 

The Companyis party to certain lawsuits and legal proceedings, which are described in “PART I,ITEM 3. LEGAL PROCEEDINGS,” of our Annual Report on Form 10-K for the yearended December 31, 2005. The following is a description of materialdevelopments during the period covered by this Quarterly Report and through thefiling of this Quarterly Report, and should be read in conjunction with theAnnual Report referenced above.

 

*Cipro Litigation.*  In the action pending in the Wisconsin Courtof Appeals *(Barbara A. Meyers, et. Al. v.Bayer AG, et. al., Appeal No. 2003AP2840)*, on May 9, 2006,the appellate court reversed the circuit court’s order granting the defendants’Motion to Dismiss and remanded the case to the circuit court for furtherproceedings.

 

*Governmental Reimbursement Investigations And Drug Pricing Litigation.*With respect to the Drug Pricing Litigationpending against the Company and certain subsidiaries, an additional actionraising similar allegations was filed by the Attorney General of the State of Hawaiion April 27, 2006. *(State of Hawaii v. AbbottLaboratories, Inc., et al, Civil Action No. 06-1-0720-04 EEH, CircuitCourt of the First Circuit, State of Hawaii,*). In the action filed

 

19

----

 

by Erie County, New York *(County of Erie v. AbbottLaboratories, Inc., et al., Index Number 2005-2439, New York Supreme Courtfor Erie County,)*the Company filed a Motion to Dismiss thecomplaint on**March 10, 2006. Additional actionsin other states are anticipated. 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.

 

*Hormone Replacement Therapy Litigation.*With respect to the hormone replacementtherapy product liability lawsuits pending against the Company, certain of itssubsidiaries, and others, additional actions raising similar issues have beenfiled, and some actions or claims have been dismissed. As of May 8, 2006,approximately 107 cases were pending against Watson and/or its affiliates instate and federal courts, representing claims by approximately 307 plaintiffs. Discoveryis ongoing. These actions, if successful, could adversely affect the Companyand may have a material adverse effect on the Company’s business, resultsof operations, financial condition and cash flows.

 

Watsonand its affiliates are involved in various other disputes, governmental and/orregulatory inspections, inquires, investigations and proceedings, andlitigation matters that arise from time to time in the ordinary course ofbusiness. The process of 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.

 

20

----

 

**ITEM 2.  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

Thefollowing discussion of our financial condition and the results of operationsshould be read in conjunction with the Condensed Consolidated FinancialStatements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q(“Quarterly Report”). This discussion contains forward-looking statements thatare subject to known and unknown risks, uncertainties and other factors that may causeour actual results to differ materially from those expressed or implied by suchforward-looking statements. These risks, uncertainties and other factorsinclude, among others, those identified under “Cautionary Note RegardingForward-Looking Statements” and elsewhere in this Quarterly Report and under “RisksRelated to our Business” in our Annual Report on Form 10-K for the year endedDecember 31, 2005.

 

**Overview**

 

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

 

Prescription pharmaceutical products in the U.S. aregenerally marketed as either generic or brand pharmaceuticals. 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 thedifferences between the two types of products, we currently operate and manageour business as two segments: Generic and Brand.

 

Duringthe fourth quarter of 2005, the Company announced a plan to close its soliddosage manufacturing facility in Puerto Rico as part of an ongoing effortto optimize the capacity utilization of the Company’s manufacturing operations.The Company plans to transfer product manufacturing from its Humacao, PuertoRico facility to its Carmel, New York. and Corona, California sites anddiscontinue manufacturing operations at the Puerto Rico facility over the next12 to 18 months. Under SFAS No. 146, “Accounting for CostsAssociated with Exit or Disposal Activities,” costs associated with exit ordisposal activities will be recognized when the liability is incurred ratherthan at the date of a commitment to an exit or disposal plan. Accordingly,additional cash costs will be recognized in future periods as we transitionproduction to other sites and we incur product transfer, severance anddecommissioning costs.

 

On March 13, 2006, the Company announced adefinitive merger agreement to acquire all the outstanding shares of commonstock of Andrx Corporation (Nasdaq: ADRX) (“Andrx”) in an all-cash transactionfor $25 per share, or total consideration of approximately $1.9 billion. Andrxdistributes pharmaceutical products primarily to independent and chainpharmacies and physicians’ offices and is considered a leader in formulatingand commercializing difficult-to-replicate controlled-release pharmaceuticalproducts and selective immediate-release products. The consummation of themerger is subject to customary closing conditions, including approval of thetransaction by Andrx stockholders and the receipt of applicable U.S. regulatoryapprovals. Following the close of the merger, Watson will have three operatingsegments: Generic, Brand and Distribution. The following discussion does notinclude or incorporate the anticipated impact of Andrx on our business, resultsof operations, financial condition, cash flows or expectations for 2006.

 

21

----

 

**Resultsof Operations**

 

***NetRevenues***

 
| ** **                          | ** ** | **Three Months Ended March 31,** | ** ** | **Change** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|------------|------------|
| **($ in thousands):**          | ** ** | **2006**                              | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                |       |                                  |       |       |       |   |   |   |   |
| Generic segment                     |       |                                  |       |       |       |   |   |   |   |
| Generics                            |       | $                                     | 245,443    |       | $          | 211,520 |   | $ | 33,923 |   | 16.0 | % |
| Generic oral  contraceptives        |       | 75,972                                |       | 81,643     |       | (5,671 | ) | (6.9 | )% |
| Total generic  product sales        |       | 321,415                               |       | 293,163    |       | 28,252 |   | 9.6 | % |
| Other                               |       | 675                                   |       | 1,086      |       | (411 | ) | (37.8 | )% |
| Total generic  segment net revenues |       | 322,090                               |       | 294,249    |       | 27,841 |   | 9.5 | % |
| * *                            | * *   | * *                              | * *   | * *   | * *   | * * | * * | * * | * * |
| Brand segment                       |       |                                  |       |       |       |   |   |   |   |
| Specialty  Products                 |       | 39,070                                |       | 63,463     |       | (24,393 | ) | (38.4 | )% |
| Nephrology                          |       | 44,167                                |       | 41,063     |       | 3,104 |   | 7.6 | % |
| Total brand  product sales          |       | 83,237                                |       | 104,526    |       | (21,289 | ) | (20.4 | )% |
| Other                               |       | 1,906                                 |       | 2,053      |       | (147 | ) | (7.2 | )% |
| Total brand  segment net revenues   |       | 85,143                                |       | 106,579    |       | (21,436 | ) | (20.1 | )% |
| * *                            | * *   | * *                              | * *   | * *   | * *   | * * | * * | * * | * * |
| Total net  revenues                 |       | $                                     | 407,233    |       | $          | 400,828 |   | $ | 6,405 |   | 1.6 | % |

* *

*Generic Segment*

 

Our generic pharmaceutical business develops,manufactures, markets, sells and distributes generic products that are thetherapeutic equivalent to their brand name counterparts and are generally soldat prices significantly less than the brand product. As such, generic productsprovide an effective and cost-efficient alternative to brand products. Whenpatents or other regulatory exclusivity no longer protect a brand product,opportunities exist to introduce off-patent or generic counterparts to thebrand product. Our portfolio of generic products includes products we haveinternally developed, products we have licensed from third parties, andproducts we distribute for third parties.

 

Other revenues include royalties and revenues earnedunder research and development agreements, other agreements and royalties. Revenuesrecognized from research, development and licensing agreements (includingmilestone payments) are deferred and recognized over the entire contractperformance period, starting with the contract’s commencement, but not prior tothe removal of any contingencies for each individual milestone. We recognizethis revenue based upon the pattern in which the revenue is earned or theobligation is fulfilled.

 

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

 

Our Generics product line includes oral dosage,transdermal, injectable and transmucosal products used for a variety of indicationsincluding pain management, depression, hypertension and smoking cessation.

 

Sales from our Generics product line for the threemonths ended March 31, 2006 increased $33.9 million or 16% over sales fromthe prior year period. This increase in sales was mainly attributable to the Company’slaunch of an authorized generic version of oxycodone extended-release tablets duringthe fourth quarter of 2005 which was partially offset by price erosion withinour Generics product line.

 

Sales from our Generic OC product line for the threemonths ended March 31, 2006 decreased $5.7 million or 7% from the prioryear period. The reduction in sales was caused by price erosion in oralcontraceptive products since the first quarter of 2005.

 

22

----

 

The decrease in other revenues in the threemonths ended March 31, 2006 for the Generic segment was primarily relatedto a decline in the amount of deferred revenue recognized in the quarter.

 

We expect total net revenues in the Generic segmentin 2006 to range between $1.4 and $1.5 billion as a result of new productlaunches, including the introduction of pravastatin sodium tablets through adistribution agreement with Bristol-Myers Squibb Company.

 

*Brand Segment*

 

Ourbrand pharmaceutical business develops, manufactures, markets, sells anddistributes products within two sales and marketing groups: Specialty Productsand Nephrology.

 

Our Specialty Products product line includes urologyand a number of other non-promoted products.

 

OurNephrology product line consists of products for the treatment of irondeficiency anemia and is generally marketed to nephrologists and dialysiscenters. The key product of the Nephrology group is Ferrlecit®, which is usedto treat low iron levels in patients undergoing hemodialysis in conjunctionwith erythropoietin therapy.

 

The $24.4million or 38% decrease in sales from our Specialty Products group for the three months ended March 31,2006, as compared to the same prior year period, was attributable to a decreasein prescription volumes and a reduction in wholesaler inventory levels resultingfrom our entry into inventory management agreements with some of our largercustomers during 2005. The reduction in sales for the period was partially offset by sales of our Trelstar® Depot and Trelstar® LAproducts for the palliative treatment of advanced prostate cancer launched inthe second quarter of 2005. Sales levels in the prior year period were impactedby wholesaler buying in anticipation of price increases.

 

Salesfrom our Nephrology business increased $3.1 million or 8% due to slight increasesin sales of our Ferrlecit® product.

 

The decrease in other revenues in the threemonths ended March 31, 2006 for the Brand segment was primarily related toa decline in the amount of deferred revenue recognized in the quarter.

 

We expect total net revenues in the Brand segment in2006 to range between $350 and $360 million.

 

***GrossProfit (Gross Margin)***

 

| ** **                            | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------------------------------|------------|---------------------------------------|------------|
| ** **                            | ** ** | **2006**                              | ** ** | **2005** | ** ** | **Change** | ** ** |
|                                  |       |                                  |       |   |   |   |   |
| Overall Consolidated Gross Margin     |       | 42.4                                  | %          | 48.4 | % | (6.0 | )% |
|                                  |       |                                  |       |   |   |   |   |
| Generic  pharmaceutical products      |       | 32.4                                  | %          | 37.5 | % | (5.1 | )% |
| Brand  pharmaceutical products        |       | 79.1                                  | %          | 77.3 | % | 1.8 | % |
| Gross margin on  product net revenues |       | 42.0                                  | %          | 48.0 | % | (6.0 | )% |

 

Grossprofit represents net revenues less cost of sales. Cost of sales includes thecost of manufacturing and packaging for the products we manufacture, the costof products we purchase from third parties, our profit-sharing or royaltypayments made to third parties, changes to our inventory reserves and excesscapacity

 

23

----

 

utilization charges, where applicable. Amortization of acquired productrights is included in operating expenses.

 

Thedecrease in gross margin from our Generic segment for the three months ended March 31,2006 was primarily due to price erosion, the introduction of a third party manufacturedproduct (“Authorized Generic”) during the fourth quarter of 2005 with lowermargins and excess capacity utilization charges as a result of the anticipatedclosure of our Puerto Rico facility.

 

Grossmargin from our Brand segment increased as we increased production levels at certainmanufacturing facilities resulting in more efficient unit overhead absorption duringthe three months ended March 31, 2006 as compared to the same period ofthe prior year.

 

Overallconsolidated gross margins are expected to be 41% for the remainder of 2006.

 

***Researchand Development Expenses***

 
| ** **                                     | ** ** | **Three Months Ended March 31,** | ** ** | **Change** | ** ** |
|------------------------------------------------|------------|---------------------------------------|------------|------------|------------|
| **($ in thousands):**                     | ** ** | **2006**                              | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                           |       |                                  |       |       |       |   |   |   |   |
| Research and  development expenses by segment: |       |                                  |       |       |       |   |   |   |   |
| Generic                                        |       | $                                     | 20,495     |       | $          | 19,144 |   | $ | 1,351 |   | 7.1 | % |
| Brand                                          |       | 9,342                                 |       | 9,694      |       | (352 | ) | (3.6 | )% |
| Total research  and development expenses       |       | $                                     | 29,837     |       | $          | 28,838 |   | $ | 999 |   | 3.5 | % |
| *as a%  of net revenues*                       | * *   | *7.3*                                 | *%*        | *7.2*      | *%*        | * * | * * | * * | * * |

 

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

 

Researchand development expenses within our Generic segment increased during the threemonths ended March 31, 2006, as compared to the same period of the prioryear, due to increased activity in the number of generic products beingdeveloped.

 

Researchand development expenses within our Brand segment decreased during the threemonths ended March 31, 2006, as compared to the same period of the prioryear, primarily due to the timing of the commencement of development programsand clinical studies between the two periods.

 

Researchand development investment for 2006 is estimated to range between 6.5% and 7%of expected total net revenue. Research and development spending is expected tofluctuate during the remaining quarters of 2006 in tandem with the timing ofclinical study costs associated with (i) the Company’s generic productpipeline, (ii) the continuation of Phase III studies on the silodosinproduct for benign prostatic hyperplasia, as well as (iii) the initiationof Phase III studies on the next generation formulation of oxybutynin foroveractive bladder.

 

24

----

 

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

 
| ** **                                          | ** ** | **Three Months Ended March 31,** | ** ** | **Change** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------|------------|------------|------------|
| **($ in thousands):**                          | ** ** | **2006**                              | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                                |       |                                  |       |       |       |   |   |   |   |
| Selling and  marketing expenses by segment:         |       |                                  |       |       |       |   |   |   |   |
| Generic                                             |       | $                                     | 12,938     |       | $          | 11,260 |   | $ | 1,678 |   | 14.9 | % |
| Brand                                               |       | 28,975                                |       | 27,468     |       | 1,507 |   | 5.5 | % |
| Total segment  selling and marketing expenses       |       | 41,913                                |       | 38,728     |       | 3,185 |   | 8.2 | % |
|                                                |       |                                  |       |       |       |   |   |   |   |
| Corporate  general and administrative               |       | 24,837                                |       | 24,923     |       | (86 | ) | (0.3 | )% |
| Total selling,  general and administrative expenses |       | $                                     | 66,750     |       | $          | 63,651 |   | $ | 3,099 |   | 4.9 | % |
| *as a%  of net revenues*                            | * *   | *16.4*                                | *%*        | *15.9*     | *%*        | * * | * * | * * | * * |

 

Selling,general and administrative expenses consist mainly of personnel costs,facilities costs, insurance and professional services costs, which support oursales, marketing, human resources, finance and administration functions.

 

Generic and Brand segment selling and marketing expensesincreased during the three months ended March 31, 2006, as compared to thesame period of the prior year, due to higher personnel costs related to commissions,stock option and restricted stock expense as well as increased facility chargesrelated to the opening of our Gurnee, Illinois distribution facility in thethird quarter of 2005.

 

Selling,general and administrative expenses for 2006 are estimated to range between 14.5%and 15% of expected total net revenue.

 

***Amortization***

 
| ** **                 | ** ** | **Three Months Ended March 31,** | ** ** | **Change** | ** ** |
|----------------------------|------------|---------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                              | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                       |       |                                  |       |       |       |   |   |   |   |
| Amortization               |       | $                                     | 41,100     |       | $          | 40,638 |   | $ | 462 |   | 1.1 | % |
| *as a%  of net revenues*   | * *   | *10.1*                                | *%*        | *10.1*     | *%*        | * * | * * | * * | * * |
|                            |            |                                       |            |            |            |  |  |  |  |  |  |  |

 

TheCompany’s amortizable assets consist primarily of acquired product rights.

 

Weexpect amortization expense in 2006 to approximate 2005 levels.

 

***(Losses)Earnings on Equity Method Investments***

 
| ** **                                      | ** ** | **Three Months Ended March 31,** | ** ** | **Change**   | ** ** |
|-------------------------------------------------|------------|---------------------------------------|------------|--------------|------------|
| **($ in thousands):**                      | ** ** | **2006**                              | ** ** | **2005**     | ** ** | **Dollars** | ** ** | **%** | ** ** |
| ** **                                      | ** ** | ** **                            | ** ** | **Restated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| (Losses)  earnings on equity method investments |       | $                                     | (192       | )            | $          | 122 |   | $ | (314 | ) | (257.4 | )% |
| *as a%  of net revenues*                        | * *   | *0.0*                                 | *%*        | *0.0*        | *%*        | * * | * * | * * | * * |
|                                                 |            |                                       |            |              |            |  |  |  |  |  |  |  |

 

TheCompany’s equity investments are accounted for under the equity-method when theCompany’s ownership does not exceed 50% and when the Company can exertsignificant influence over the management of the investee. In the year ended December 31, 2005,the Company acquired additional common shares in Scinopharm Taiwan, Ltd. (“Scinopharm”),previously accounted for under the cost method, to an ownership level ofapproximately 24%. Accordingly, as required by Accounting Principles Board (“APB”)Opinion No. 18,

 

25

----

 

“The Equity Method of Accounting for Investments in Common Stock” (“APB18”), loss on equity method investments has been restated for all periodspresented to conform to current period presentation. In January 2006,we made an additional $12.0 million investment in Scinopharm which increasedour ownership share to approximately 31%.

 

Theloss recorded during the three months ended March 31, 2006 represents ourequity in losses incurred by Somerset Pharmaceuticals, Inc., our jointventure with Mylan Laboratories, Inc. Somerset has developed Emsam®, a selegeline patch for thetreatment of depression. On February 28, 2006, the U.S. Food and DrugAdministration (“FDA”) granted Somerset final approval for Emsam®. As a result of this approval, theCompany expects Somerset to be profitable for the remainder of 2006.

 

***Gainon Sale of Securities***

 
| ** **                 | ** ** | **Three Months Ended March 31,** | ** ** | **Change** | ** ** |
|----------------------------|------------|---------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                              | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                       |       |                                  |       |       |       |   |   |   |   |
| Gain on sale of securities |       | $                                     | 3,695      |       | $          | — |   | $ | 3,695 |   | 100.0 | % |
| *as a%  of net revenues*   | * *   | *0.9*                                 | *%*        | *0.0*      | *%*        | * * | * * | * * | * * |
|                            |            |                                       |            |            |            |  |  |  |  |  |  |  |

 

The2006 gain on sale of securities resulted from the sale of our investment in Adheris, Inc.We received cash proceeds of $4.7 million from our sale of our entireinvestment in Adheris, Inc. and may receive additional proceeds uponthe achievement of certain earn-out milestones. We did not sell any securitiesduring the three months ended March 31, 2005.

 

***Losson Early Extinguishment of Debt***

 
| ** **                           | ** ** | **Three Months Ended March 31,** | ** ** | **Change** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|------------|------------|
| **($ in thousands):**           | ** ** | **2006**                              | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                 |       |                                  |       |       |       |   |   |   |   |
| Loss on early extinguishment of debt |       | $                                     | 720        |       | $          | — |   | $ | 720 |   | 100.0 | % |
| *as a%  of net revenues*             | * *   | *0.2*                                 | *%*        | *0.0*      | *%*        | * * | * * | * * | * * |
|                                      |            |                                       |            |            |            |  |  |  |  |  |  |  |

 

On March 31,2006, the Company initiated a redemption notice to the holders of all of itsoutstanding senior unsecured 7 1/8% notes (“1998 Senior Notes”). The 1998Senior Notes will be redeemed on May 23, 2006. As a result, the Companyhas accrued an amount representing redemption fees, expenses, and premium onthe redemption.

 

26

----

 

***InterestExpense***

 
| ** **                                                                                | ** ** | **Three Months Ended March 31,** | ** ** | **Change** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|------------|------------|
| **($ in thousands):**                                                                | ** ** | **2006**                              | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                                                                      |       |                                  |       |       |       |   |   |   |   |
| Interest expense  - convertible contingent senior debentures due 2023 (“CODES”) |       | $                                     | 3,151      |       | $          | 3,151 |   | $ | — |   | 0.0 | % |
| Interest expense  - 1998 Senior Notes                                                     |       | 256                                   |       | 256        |       | — |   | 0.0 | % |
| Interest and  fees on credit facility                                                     |       | 247                                   |       | 416        |       | (169 | ) | (40.6 | )% |
| Change in  derivative value                                                               |       | (453                                  | )          | (569       | )          | 116 |   | (20.4 | )% |
| Interest expense  - other                                                                 |       | 100                                   |       | 36         |       | 64 |   | 177.8 | % |
| Interest expense                                                                          |       | $                                     | 3,301      |       | $          | 3,290 |   | $ | 11 |   | 0.3 | % |
| *as a%  of net revenues*                                                                  | * *   | *0.8*                                 | *%*        | *0.8*      | *%*        | * * | * * | * * | * * |

 

Interestexpense increased for the three month period ended March 31, 2006, due toa smaller decrease in the fair value of the derivative (as described in Note 7in the accompanying Notes to Condensed Consolidated Financial Statements inthis Quarterly Report) and lower interest expense – other which was partiallyoffset by reduced fees on the credit facility. Quarterly interest expense forthe remainder of the year will decline slightly as a result of the redemptionof the 1998 Senior Notes.

 

***Provisionfor Income Taxes***

 
| ** **                 | ** ** | **Three Months Ended March 31,** | ** ** | **Change** | ** ** |
|----------------------------|------------|---------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                              | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                       |       |                                  |       |       |       |   |   |   |   |
| Provision for income taxes |       | $                                     | 15,399     |       | $          | 22,852 |   | $ | (7,453 | ) | (32.6 | )% |
| *as a%  of net revenues*   | * *   | *3.8*                                 | *%*        | *5.7*      | *%*        | * * | * * | * * | * * |
| *Effective  tax rate*      | * *   | *37.9*                                | *%*        | *37.2*     | *%*        | * * | * * | * * | * * |
|                            |            |                                       |            |            |            |  |  |  |  |  |  |  |

 

Theprovision for income taxes differs from the amount computed by applying the statutoryU.S. federal income tax rate primarily due to state taxes and other factorswhich, combined, increases the effective tax rate, offset by charitablecontributions of inventory and tax credits that decreases the effective taxrate.

 

Theprovision for income taxes decreased in the three months ended March 31,2006, due to reduced levels of income before income taxes. The higher effectivetax rate for the three months ended March 31, 2006, as compared to thesame period of the prior year, primarily reflect limitations on thedeductibility of charitable contributions during the period, the expiration ofthe research and development tax credit during 2005 and the effect of theadoption of Statement ofFinancial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-BasedPayment” (“SFAS 123R”) during the current period. Beginning January 1,2006, in conjunction with the adoption of SFAS 123R, incentive stock optiondeductions are considered a permanent difference which has the impact ofincreasing our effective tax rate in the period.

 

27

----

 

***SegmentContribution***

 
| ** **                 | ** ** | **Three Months Ended March 31,** | ** ** | **Change** | ** ** |
|----------------------------|------------|---------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                              | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                       |       |                                  |       |       |       |   |   |   |   |
| Segment contribution       |       |                                  |       |       |       |   |   |   |   |
| Generic                    |       | $                                     | 71,273     |       | $          | 79,569 |   | $ | (8,296 | ) | (10.4 | )% |
| Brand                      |       | 29,456                                |       | 43,604     |       | (14,148 | ) | (32.4 | )% |
|                       |       | $                                     | 100,729    |       | $          | 123,173 |   | $ | (22,444 | ) | (18.2 | )% |
| *as% of  net revenues*     | * *   | *24.6*                                | *%*        | *30.7*     | *%*        | * * | * * | * * | * * |

 

Genericsegment contribution decreased for the three months ended March 31, 2006,as compared to the same period of the prior year, due to lower gross profit,higher research and development and selling and marketing expenses.

 

Brandsegment contribution decreased for the three months ended March 31, 2006,as compared to the same period of the prior year, primarily due to a decreasein sales of Specialty Products and due to higher research and development andselling and marketing expenses.

 

Formore information on segment contribution, refer to above Management’sDiscussion and Analysis of Financial Condition and Results of Operations andNote 5 in the accompanying Notes to Condensed Consolidated Financial Statementsin this Quarterly Report.

 

**Liquidityand Capital Resources**

 

***Cashfrom Operations***

 

Watson’sprimary source of liquidity is cash from operations. Net working capital at March 31,2006, was $1.12 billion compared to $1.11 billion at December 31, 2005 and$1.13 billion at March 31, 2005.

 

Weexpect that 2006 cash flows from operating activities will continue to exceednet income. In addition, management expects that 2006 cash flows from operatingactivities and available cash balances will be sufficient to fund our operatingliquidity needs.

 

Summarizedcash flow information is as follows:

 
| ** **                                | ** ** | **Three months ended March 31,** | ** ** |
|-------------------------------------------|------------|---------------------------------------|------------|
| **($ in thousands):**                | ** ** | **2006**                              | ** ** | **2005** | ** ** |
|                                      |       |                                  |       |   |   |
| Net cash provided by operating activities |       | $                                     | 135,710    |   | $ | 105,367 |   |
|                                           |            |                                       |            |  |  |  |  |

 

Netcash provided by operating activities increased during the three month periodended March 31, 2005, as compared to the same period of the prior year,due primarily to a decrease in accounts receivable and the timing of annual taxpayments in 2006.

 

Cashflows from operations is expected to range between $325 and $350 million in 2006.

 

28

----

 

***Changesin Working Capital***

 

Workingcapital at March 31, 2006 and December 31, 2005 is summarized asfollows:

 
| **($ in thousands):**              | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** | **Increase  (Decrease)** | ** ** |
|-----------------------------------------|------------|--------------------------|------------|-----------------------------|------------|--------------------------|------------|
|                                    |       |                     |       |                        |       |                     |       |
| Current Assets:                         |       |                     |       |                        |       |                     |       |
| Cash and cash  equivalents              |       | $                        | 559,734    |                        | $          | 467,451                  |       | $ | 92,283 |   |
| Marketable  securities                  |       | 168,127                  |       | 162,475                     |       | 5,652                    |       |
| Accounts  receivable, net of allowances |       | 269,755                  |       | 333,832                     |       | (64,077                  | )          |
| Inventories                             |       | 300,794                  |       | 278,062                     |       | 22,732                   |       |
| Other                                   |       | 129,194                  |       | 118,610                     |       | 10,584                   |       |
| Total current  assets                   |       | 1,427,604                |       | 1,360,430                   |       | 67,174                   |       |
| Current  liabilities:                   |       |                     |       |                        |       |                     |       |
| Accounts payable  and accrued expenses  |       | 209,690                  |       | 211,160                     |       | (1,470                   | )          |
| Current portion  of long-term debt      |       | 29,933                   |       | —                      |       | 29,933                   |       |
| Other                                   |       | 67,026                   |       | 34,510                      |       | 32,516                   |       |
| Total current  liabilities              |       | 306,649                  |       | 245,670                     |       | 60,979                   |       |
|                                    |       |                     |       |                        |       |                     |       |
| Working Capital                         |       | $                        | 1,120,955  |                        | $          | 1,114,760                |       | $ | 6,195 |   |
|                                    |       |                     |       |                        |       |                     |       |
| Current Ratio                           |       | 4.66                     |       | 5.54                        |       |                     |       |

 

Thedecrease in accounts receivable at March 31, 2006 was due to the timing ofcash collections from our customers and from the modification of payment termsfor a significant customer to our standard terms. Current portion of long-termdebt increased at March 31, 2006 as we reclassified our 1998 Senior Notesto current liabilities as we initiated redemption procedures in the quarter andwe assumed debt in our acquisition of Sekhsaria Chemicals, Ltd. (“Sekhsaria”), bothof which we plan to repay prior to the end of 2006.

 

***CapitalExpenditures***

 

Ourcapital expenditures are summarized as follows:

 
| ** **                          | ** ** | **Three months ended March 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|
| **($ in thousands):**          | ** ** | **2006**                              | ** ** | **2005** | ** ** |
|                                |       |                                  |       |   |   |
| Additions to property and equipment |       | $                                     | 9,600      |   | $ | 10,294 |   |
|                                     |            |                                       |            |  |  |  |  |

 

Capitalexpenditures for the first quarter of 2006 included additions to machinery andequipment at various Watson locations. We expect to spend approximately $70 millionfor property and equipment additions in 2006.

 

29

----

 

***Debtand Borrowing Capacity***

 

Ourdebt and borrowing capacity at March 31, 2006 and December 31, 2005is summarized as follows:

 
| **($ in thousands):**    | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** | **Increase  (Decrease)** | ** ** |
|------------------------------------|------------|--------------------------|------------|-----------------------------|------------|--------------------------|------------|
|                               |       |                     |       |                        |       |                     |       |
| Current portion  of long-term debt |       | $                        | 29,933     |                        | $          | —                   |       | $ | 29,933 |   |
| Long-term debt                     |       | 573,947                  |       | 587,935                     |       | (13,988                  | )          |
| Total debt                         |       | $                        | 603,880    |                        | $          | 587,935                  |       | $ | 15,945 |   |
| Debt to capital  ratio             |       | 22.0                     | %          | 21.8                        | %          |                     |       |

 

In March 2003,we issued $575 million of our CODES. As of March 31, 2006, the entireamount of the CODES remained outstanding at an effective annual interest rateof approximately 2.1%.

 

In May 1998,we issued $150 million of our 1998 Senior Notes. The Company is required tomake interest only payments due semi-annually in May and November atan effective annual rate of 7.2%. On March 31, 2006, the Company initiateda redemption notice to the holders of all of its outstanding 1998 Senior Notes.As a result, the Company has reclassified the remaining 1998 Senior Notes ascurrent liabilities in the accompanying Condensed Consolidated FinancialStatements as at March 31, 2006. We expect to redeem these notes by May 23,2006.

 

In May 2003, we entered into an agreement witha syndicate of lenders for a five-year, $300 million senior, unsecuredrevolving credit facility (the “Credit Facility”) for working capital and othergeneral corporate purposes. On September 8, 2005, we entered into a SecondAmendment to the Credit Facility on substantially the same terms and conditionsexcept the fee structure was reduced and certain defined terms were added oramended. On March 6, 2006, we entered into a Third Amendment to the CreditFacility which, among other things, permits the Company to repurchase up to$300.0 million of its common stock. As of December 31, 2005, the total$300 million under the Credit Facility was available to us. Watson’s assetsgenerally are held by, and its operations generally are conducted through, itssubsidiaries. Within the meaning of Regulation S-X, Rule 3-10, the Companyhas no assets or operations independent of its subsidiaries. Under the terms ofthe Credit Facility, each of our subsidiaries, other than minor subsidiaries,entered into a full and unconditional guarantee on a joint and several basis. Inorder to provide subsidiary guarantees in connection with the Credit Facility,we were required to issue similar guarantees to the 1998 Senior Note holders. Thesubsidiary guarantees related to both the Credit Facility and the 1998 SeniorNotes are full and unconditional, on a joint and several basis, and are givenby all subsidiaries other than minor subsidiaries. As of March 31, 2006and December 31, 2005, the Company had not drawn any funds from the CreditFacility. Watson is subject to certain financial and operational covenants, allof which, as of March 31, 2006, the Company was in compliance. The Credit Facility currently contains thefollowing financial covenants:

 

•                  maintenance of a minimum net worth ofat least $1.7 billion at March 31, 2006;

•                  maintenance of a maximum leverageratio not greater than 2.25 to 1.0; and

•                  maintenance of a minimum interestcoverage ratio of at least 7.0 to 1.0.

 

At March 31,2006, our net worth was $2.1 billion and our leverage ratio was 1.38 to 1.0. Ourinterest coverage ratio for the three months ended March 31, 2006 was 29.5to 1.0.

 

Underthe Credit Facility, interest coverage ratio, with respect to any financialcovenant period, is defined as the ratio of EBITDA for such period to interestexpense for such period. The leverage ratio, for any financial covenant period,is defined as the ratio of the outstanding principal amount of funded debt forthe borrower and its subsidiaries at the end of such period, to EBITDA for suchperiod. EBITDA under the Credit Facility, for

 

30

----

 

any covenant period, is defined as net income plus (1) depreciationand amortization, (2) interest expense, (3) provision for incometaxes, (4) extraordinary or unusual losses, (5) non-cash portion ofnonrecurring losses and charges, (6) other non-operating, non-cash lossesand (7) minority interest expense in respect of equity holdings inaffiliates; minus (1) extraordinary gains, (2) interest income and (3) othernon-operating, non-cash income.

 

***Long-termObligations***

 

Thefollowing table lists our enforceable and legally binding obligations as of March 31,2006. Some of the amounts included herein are based on management’s estimatesand assumptions about these obligations, including their duration, the possibilityof renewal, anticipated actions by third parties, and other factors. Becausethese estimates and assumptions are necessarily subjective, the enforceable andlegally binding obligation we will actually pay in future periods may varyfrom those reflected in the table:

 
| ** **                                                        | ** ** | **Payments Due by Period (Including Interest)** | ** ** |
|-------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| **(in thousands):**                                               | ** ** | **Total**                                       | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **After 5  years** | ** ** |
|                                                              |       |                                            |       |   |   |   |   |   |   |   |   |
| Long-term and  other debt                                         |       | $                                               | 778,080    |   | $ | 37,859 |   | $ | 30,216 |   | $ | 20,125 |   | $ | 689,880 |   |
| Liabilities  incurred for acquisitions of products and businesses |       | 2,051                                           |       | 1,100 |   | 472 |   | — |   | 479 |   |
| Operating lease  obligations                                      |       | 37,454                                          |       | 6,167 |   | 15,082 |   | 4,289 |   | 11,916 |   |
| Total  contractual cash obligations                               |       | $                                               | 817,585    |   | $ | 45,126 |   | $ | 45,770 |   | $ | 24,414 |   | $ | 702,275 |   |

 

TheCompany is involved in certain minor joint venture arrangements that areintended to complement the Company’s core business and markets. The Company hasthe discretion to provide funding on occasion for working capital or capitalexpenditures. The Company makes an evaluation of additional funding based on anassessment of the venture’s business opportunities. The Company believes thatany possible commitments arising from the current arrangements will not besignificant to the Company’s financial condition or results of operations.

 

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

 

*StockRepurchases*

 

During 2005, we repurchased approximately 9.4million shares of our common stock at an aggregate cost of approximately $300.0million under the Company’s $300.0 million stock repurchase program approved bythe Board of Directors of Watson (“Board”) on February 10, 2005 (the “2005Repurchase Program”). This completes our stock repurchases under the 2005Repurchase Program. The 2005 Repurchase Program did not affect our compliancewith our debt covenants and did not materially impact the Company’s liquidity.

 

On February 15, 2006, the Board authorized theexpenditure of an additional $300.0 million to repurchase shares of the Company’soutstanding common stock (the “2006 Repurchase Program”). Repurchases areauthorized to be made in open market or privately negotiated transactions fromtime to time in compliance with the Securities and Exchange Commission’s (“SEC”)Rule 10b-18, subject to market conditions, applicable legal requirementsand other factors. Additionally, the Board has authorized that purchases may bemade under Rule 10b5-1 promulgated under the Securities and Exchange Actof 1934, as amended. A Rule 10b5-1 plan allows Watson to repurchase itsshares during periods when it would normally not be active in the market due toits internal trading blackout periods. All such purchases must be made inaccordance with a pre-defined plan that is established when the planadministrator is not aware of any material

 

31

----

 

non-public information. At this time, the Company does not intend torepurchase common stock under the 2006 Repurchase Program as a result of itspending acquisition of Andrx.

 

*MergerAgreement with Andrx*

 

On March 13, 2006, the Company announced adefinitive merger agreement to acquire all the outstanding shares of commonstock of Andrx (Nasdaq: ADRX) in an all-cash transaction for $25 per share, ortotal consideration of approximately $1.9 billion. Andrx is considered a leaderin formulating and commercializing difficult-to-replicate controlled-release pharmaceuticalproducts and selective immediate-release products.

 

The consummation of the merger is subject tocustomary closing conditions, including approval of the transaction by Andrxstockholders and the receipt of applicable U.S. regulatory approvals.  On May 3, 2006, the Company and Andrxannounced they had each received a request from the Federal Trade Commission (“FTC”)for additional information under the Hart-Scott-Rodino Antitrust ImprovementsAct of 1976, as amended (“HSR Act”), in connection with Watson’s pendingacquisition of Andrx.  The effect of thissecond request by the FTC is to extend the waiting period imposed by the HSRAct until 30 days after both Watson and Andrx have substantially complied withthe request.  For additional informationon Andrx, see the SEC website at www.sec.gov.

 

The transaction is anticipated to be financed withWatson’s existing cash reserves and an aggregate of $1.15 billion availableunder a Senior Credit Facilities Commitment Letter provided to Watson from theCanadian Imperial Bank of Commerce (the “Merger Financing”). The MergerFinancing consists of a $500 million revolving credit facility and a $650 millionsenior term loan facility. The revolving credit facility would have a five yearterm and the senior term facility would mature in five years. We expect both facilitieswill bear interest equal to LIBOR plus 0.75% (subject to certain adjustments).

 

*Recentaccounting pronouncements*

 

In November 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 151, “Inventory Costs-anAmendment of ARB No. 43, Chapter 4” (“SFAS 151”). SFAS 151 clarifies thatitems such as abnormal freight, handling costs, and wasted materials (spoilage)be recognized as current period charges rather than as a portion of theinventory cost. Unallocated overheads are to be recognized as an expense in theperiod in which they are incurred. In addition, this Statement requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities. This Statement is effectivefor inventory costs incurred during fiscal years beginning after June 15,2005. The provision of this Statement shall be applied prospectively. Theadoption of SFAS 151 on January 1, 2006, did not have a material effect onour Condensed Consolidated Financial Statements.

 

In December 2004,the FASB issued SFAS 123R, which replaces SFAS No. 123, “Accounting forStock-Based Compensation” (“SFAS 123”) as well as SFAS No. 148, “Accountingfor Stock-Based Compensation-Transition and Disclosure” (“SFAS 148”),supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”(“APB 25”) and amends SFAS No. 95, “Statement of Cash Flows” (“SFAS 95”). SFAS 123R requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the financial statements based on their fair values. Theintrinsic value method as permitted under APB 25 together with the pro formadisclosures previously permitted under SFAS 123 no longer will be analternative to financial statement recognition. Under SFAS 123R, the Companymust determine the appropriate fair value model to be used for valuingshare-based payments, the amortization method for attributing compensation costto reporting periods and the transition method to be used at date ofadoption. The transition methodsinclude modified prospective and modified retrospective adoption options. Underthe modified retrospective option, prior periods may be restated either asof the beginning of the year of adoption or for all periods presented. Themodified prospective method requires that compensation expense be recorded forall unvested stock options at the beginning of the first quarter of adoption ofSFAS 123R, while the modified retrospective method would recordcompensation expense for all unvested stock options beginning with the firstperiod restated. SFAS 123R also requires any unearned or deferred compensationaccounts (i.e. contra-equity accounts) within stockholders’ equity be recordedas reductions to additional paid-in capital balances rather than shown ascontra equity accounts as was required prior to January 1, 2006. SFAS 95 is amended to require excess taxbenefits be reported as a financing cash flow rather than as a reduction intaxes paid within the Consolidated Statement of Cash Flows. On January 1,2006, the Company adopted SFAS 123R using the modified prospective methodoption.

 

In March 2005, the SEC issued SEC StaffBulletin No. 107 (“SAB 107”) which describes the SEC staff position aswell as supplemental implementation guidance on the application  and adoption of SFAS 123R. The

 

32

----

 

Company has applied the provisions of SAB 107 and its guidance in itsadoption of SFAS 123R on January 1, 2006 (Refer to NOTE 2 – SHARE-BASEDCOMPENSATION).

 

In May 2005, the FASB issued SFAS No. 154,“Accounting Changes and Error Corrections” (“SFAS 154”), which replaces APBOpinion No. 20, “Accounting Changes” (“APB 20”) and SFAS No. 3, “ReportingAccounting Changes in Interim Financial Statements” (“SFAS 3”). SFAS 154applies to all voluntary changes in accounting principle and changes therequirements for the accounting for and reporting of a change in accountingprinciple. SFAS 154 also requires retrospective application to prior periodfinancial statements involving changes in accounting principle unless it isimpracticable to determine either the period-specific or cumulative effect ofthe change. This statement also requires that a change in the method ofdepreciation, amortization or depletion of long-lived assets be accounted foras a change in accounting estimate that is accounted for prospectively. SFAS154 also retains many provisions of APB 20 including those related to reportinga change in accounting estimate, a change in the reporting entity and acorrection of an error and also carries forward provisions of SFAS 3 governingthe reporting of accounting changes in interim financial statements. SFAS 154is effective for accounting changes and corrections of errors made in fiscalyears beginning after December 15, 2005. The adoption of SFAS 154 on January 1,2006, did not have a material effect on our Consolidated Financial Statements.

 

**ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUTMARKET RISK**

 

We areexposed to market risk for changes in the market values of our investments (“InvestmentRisk”) and the impact of interest rate changes (“Interest Rate Risk”). We havenot used derivative financial instruments in our investment portfolio. Thequantitative and qualitative disclosures about market risk are set forth below.

 

**InvestmentRisk**

 

As of March 31,2006, our total holdings in equity securities of other companies, includingequity-method investments and available-for-sale securities, were $64.4 million.Of this amount, we had equity-method investments of $47.8 million and publiclytraded equity securities (available-for-sale securities) at fair value totaling$16.3 million ($14.4 million that was included in “Marketable securities” and $1.9million that was included in “Investments and other assets”). The fair valuesof these investments are subject to significant fluctuations due to volatilityof the stock market and changes in general economic conditions. Based on thefair value of the publicly traded equity securities we held at March 31, 2006,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 $4.1 million, $6.5 million and $8.2 million,respectively.

 

At March 31,2006, our investment in Andrx consisted of approximately 607,000 shares ofAndrx common stock with a cost of $1.6 million and a fair market value of $14.4million. Because Andrx is a publicly traded equity security, our holdings ofAndrx have exposure to investment risk. The market price of Andrx common shareshas been, and may continue to be volatile. For example, on March 31,2006, the final trading day of the quarter, the closing price of Andrx was $23.74.On May 5, 2006, before the filing of this Form 10-Q, the closingprice of Andrx common stock was $23.59.

 

33

----

 

Thefollowing table sets forth the Andrx high and low market price per shareinformation, based on published financial sources, for 2006 and 2005 andfurther reflects the volatility of the stock price:

 
| ** **           | ** ** | **High**   | ** ** | **Low**    | ** ** |
|----------------------|------------|------------|------------|------------|------------|
| **2006, by quarter** | ** ** | ** ** | ** ** | ** ** | ** ** |
| First                |       | $          | 24.29      |       | $          | 16.07 |   |
|                 |       |       |       |       |       |
| **2005, by quarter** | ** ** | ** ** | ** ** | ** ** | ** ** |
| First                |       | $          | 24.47      |       | $          | 20.55 |   |
| Second               |       | $          | 23.38      |       | $          | 19.15 |   |
| Third                |       | $          | 22.50      |       | $          | 12.74 |   |
| Fourth               |       | $          | 18.45      |       | $          | 14.35 |   |

 

We regularly review the carrying value of ourinvestments and identify and recognize losses, for income statement purposes,when events and circumstances indicate that any declines in the fair values ofsuch investments, below our accounting basis, are other than temporary.

 

**Interest Rate Risk**

 

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

 

During2004, we acquired a significant amount of U.S. Treasury securities classifiedas available-for-sale securities, with no security having a maturity in excessof two years. These securities are exposed to interest rate fluctuations. Becauseof the short-term nature of these investments, we are subject to minimalinterest rate risk and do not believe that an increase in market rates wouldhave a significant negative impact on the realized value of our portfolio.

 

Based on quoted market rates of interest and maturityschedules for similar debt issues, we estimate that the fair values of ourCODES and our 1998 Senior Notes approximated their carrying values on March 31,2006. While changes in market interest rates may affect the fair value ofour fixed-rate debt, we believe the effect, if any, of reasonably possiblenear-term changes in the fair value of such debt on our financial condition,results of operations or cash flows will not be material.

 

Atthis time, we are not party to any interest rate or derivative hedging contractsand have no material foreign exchange or commodity price risks.

 

We donot believe that inflation has had a significant impact on our revenues oroperations.

 

**ITEM 4.  CONTROLS AND PROCEDURES**

 

TheCompany maintains disclosure controls and procedures that are designed toensure that information required to be disclosed in the Company’s Exchange Actreports is recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and forms, and that such information isaccumulated and communicated to the Company’s management, including itsPrincipal Executive Officer and Principal Financial Officer, as appropriate, toallow timely decisions regarding required disclosure. In designing andevaluating the disclosure controls and procedures, management recognized thatany controls and procedures, no matter how well designed and operated, canprovide only reasonable assurance of achieving the desired control objectives,and management necessarily was required to apply its judgment in evaluating thecost-benefit relationship of possible controls and procedures. Also, theCompany has investments in certain unconsolidated entities. As the Company doesnot control or manage these entities, its disclosure controls and procedureswith

 

34

----

 

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

 

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

 

Therehave been no changes in the Company’s internal control over financialreporting, during the three months ended March 31, 2006, that hasmaterially affected, or is reasonably likely to materially affect, the Company’sinternal control over financial reporting.

 

35

----

 

**PART II. OTHER INFORMATION AND SIGNATURES**

 

**ITEM 1.  LEGAL PROCEEDINGS**

 

The Company is party tocertain lawsuits and legal proceedings, which are described in “PART I,ITEM 3. LEGAL PROCEEDINGS,” of our Annual Report on Form 10-K for the yearended December 31, 2005. The following is a description of materialdevelopments during the period covered by this Quarterly Report and through thefiling of this Quarterly Report, and should be read in conjunction with theAnnual Report referenced above.

* *

*Cipro Litigation.*  In the action pending in the Wisconsin Courtof Appeals *(Barbara A. Meyers, et. Al. v.Bayer AG, et. al., Appeal No. 2003AP2840)*, on May 9, 2006,the appellate court reversed the circuit court’s order granting the defendants’Motion to Dismiss and remanded the case to the circuit court for furtherproceedings.

* *

*Governmental Reimbursement Investigations And Drug Pricing Litigation.*With respect to the Drug Pricing Litigationpending against the Company and certain subsidiaries, an additional actionraising similar allegations was filed by the Attorney General of the State ofHawaii on April 27, 2006. *(State of Hawaii v. AbbottLaboratories, Inc., et al, Civil Action No. 06-1-0720-04 EEH, CircuitCourt of the First Circuit, State of Hawaii,*). In the action filedby Erie County, New York *(County of Erie v. AbbottLaboratories, Inc., et al., Index Number 2005-2439, New York Supreme Courtfor Erie County,)*the Company filed a Motion to Dismiss the complainton**March 10, 2006. Additional actionsin other states are anticipated. 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.

 

*Hormone Replacement Therapy Litigation.*With respect to the hormone replacementtherapy product liability lawsuits pending against the Company, certain of itssubsidiaries, and others, additional actions raising similar issues have beenfiled, and some actions or claims have been dismissed. As of May 8, 2006,approximately 107 cases were pending against Watson and/or its affiliates instate and federal courts, representing claims by approximately 307 plaintiffs. Discoveryis ongoing. These actions, if successful, could adversely affect the Companyand may have a material adverse effect on the Company’s business, resultsof operations, financial condition and cash flows.

 

Watsonand its affiliates are involved in various other disputes, governmental and/orregulatory inspections, inquires, investigations and proceedings, andlitigation matters that arise from time to time in the ordinary course ofbusiness. The process of 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.

 

36

----

 

**ITEM 1A.  RISK FACTORS**

 

**CAUTIONARY NOTE REGARDING FORWARD-LOOKINGSTATEMENTS**

 

Any statements made in this report that are notstatements of historical fact or that refer to estimated or anticipated futureevents are forward-looking statements. We have based our forward-lookingstatements on our management’s beliefs and assumptions based on informationavailable to our management at the time these 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 not limited to, our beliefs about future revenueand expense levels and growth rates, prospects related to our strategicinitiatives and business strategies, express or implied assumptions aboutgovernment regulatory action or inaction, anticipated product approvals andlaunches, business initiatives and product development activities, assessmentsrelated to clinical trial results, product performance and competitiveenvironment, and anticipated financial performance. Without limiting thegenerality of the foregoing, words such as *“may,” “will,” “expect,” “believe,”“anticipate,” “intend,” “could,” “would,” “estimate,” “continue,” or “pursue,”*or the negative other variations thereof or comparable terminology, areintended to identify forward-looking statements. The statements are notguarantees of future performance and involve certain risks, uncertainties andassumptions that are difficult to predict.

 

We caution the reader that these statements arebased on certain assumptions, risks and uncertainties, many of which are beyondour control. In addition, certain important factors may affect our actualoperating results and could cause such results to differ materially from thoseexpressed or implied by forward-looking statements. We believe the risks anduncertainties discussed under the Section entitled “Risks Related to OurBusiness,” and other risks and uncertainties detailed herein and from time totime in our SEC filings, may affect our actual results.

 

We disclaim any obligation to publicly update anyforward-looking statements, whether as a result of new information, futureevents or otherwise, except as required by law. This discussion is provided aspermitted by the Private Securities Litigation Reform Act of 1995.

 

# **Risks Related to OurBusiness**

# ** **

We operate in a rapidly changing environment thatinvolves a number of risks, some of which are beyond our control. The followingdiscussion highlights some of these risks and others are discussed elsewhere inthis annual report. These and other risks could materially and adversely affectour business, 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 asignificant extent upon our ability to successfully commercialize new brand andgeneric products in a timely manner. There are numerous difficulties indeveloping 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;

 

37

----

 

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

 

•                  experiencingdelays or unanticipated costs; and

 

•                  commercializinggeneric products may be substantially delayed by the listing with the FDAof patents that have the effect of potentially delaying approval of theoff-patent product by up to 30 months.

 

As a result of these and other difficulties,products currently in development by Watson may or may not receivetimely regulatory approvals, or approvals at all, necessary for marketing byWatson or other third-party partners. This risk particularly exists withrespect to the development of proprietary products because of the uncertainties,higher costs and lengthy time frames associated with research and developmentof such products and the inherent unproven market acceptance of such products.If any of our products, when acquired or developed and approved, cannot besuccessfully or timely commercialized, our operating results could be adverselyaffected. We cannot guarantee that any investment we make in developingproducts will be recouped, even if we are successful in commercializing thoseproducts.

 

**Our brand pharmaceutical expenditures may not result incommercially successful products.**

 

Developing and commercializing brand pharmaceuticalproducts is more costly than generic products. During 2005, we increased ourplanned expenditures for the development and marketing of our brand business. During2006 and thereafter, we may further increase the amounts we expend for ourbrand business segment. For example, we plan to initiate Phase III clinicalstudies during 2006 on our next generation Oxytrol® product and will incurongoing expenditures for the Phase III clinical studies on our silodosinproduct for treatment of benign prostatic hyperplasia. We cannot be sure thesebusiness expenditures will result in the successful discovery, development orlaunch of brand products that will prove to be commercially successful or willimprove the long-term profitability of our business, which would adverselyaffect our results of operations and financial condition.

 

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

 

Our futureresults of operations, financial condition and cash flows depend to asignificant extent upon our brand and generic product sales mix. Our sales ofbrand products tend to create higher gross margins than our sales of genericproducts. As a result, our sales mix (the proportion of total sales betweenbrand products and generic products) will significantly impact our gross profitfrom period to period. During 2005, sales of our brand products and genericproducts accounted for approximately 24% and 76%, respectively, of our netproduct sales. During that same period, brand products and generic productscontributed approximately 38% and 62%, respectively, to our gross profits. Factorsthat may cause our sales mix to vary include:

 

•                  the amountof new product introductions;

 

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

 

•                  the levelof competition in the marketplace for certain products;

 

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

 

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

 

38

----

 

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

 

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

 

**Loss of revenues fromFerrlecit®, a significant product, could have a material adverse effect on ourresults of operations, financial condition and cash flows.**

 

During 2004 we lost regulatory exclusivity on ourFerrlecit® product, which will allow generic applicants to submit AbbreviatedNew Drug Applications (“ANDAs”) for Ferrlecit®. In 2005, Ferrlecit® accountedfor approximately 9% of our net revenues and 16% of our gross profit. In February 2004,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 are satisfied. Duringthe third quarter of 2004, we submitted a second Citizen’s Petition to the FDArequesting that the FDA refuse to accept for substantive review any ANDAreferencing Ferrlecit® until the FDA establishes guidelines for determiningwhether the generic product is the same complex as Ferrlecit®. We cannotpredict whether the FDA will grant or deny our Citizen’s Petitions or when it may takesuch action. We believe it will be difficult for a competitor to demonstrate tothe FDA that its product is the same as Ferrlecit® and that, in the absence ofsuch a showing, the FDA should require the applicant to submit a New DrugApplication (“NDA”) supported by clinical studies, independently demonstratingsafety and efficacy. However, if a generic version of Ferrlecit® or othercompetitive product is approved by the FDA and enters the market, our netrevenues could significantly decline, which could have a material adverseeffect on our results of operations, financial condition and cash flows.

 

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

 

We have made substantial investments in jointventures and other collaborations and may use these and other methods todevelop or commercialize products in the future. These arrangements typicallyinvolve other pharmaceutical companies as partners that may be competitorsof ours in certain markets. In many instances, we will not control these jointventures or collaborations or the commercial exploitation of the licensedproducts, and cannot assure you that these ventures will be profitable. Althoughrestrictions contained in certain of these programs have not had a materialadverse impact on the marketing of our own products to date, any such marketingrestrictions could affect future revenues and have a material adverse effect onour operations. Our results of operations may suffer if existing jointventures or collaboration partners withdraw, or if these products are nottimely developed, approved or successfully commercialized.

 

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

 

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

 

We also rely on trade secrets and proprietaryknow-how that we seek to protect, in part, through confidentiality agreementswith our partners, customers, employees and consultants. It is possible thatthese agreements will be breached or that they will not be enforceable in everyinstance, and that we will not have adequate remedies for any such breach. Itis also possible that our trade secrets will become known or independentlydeveloped by our competitors.

 

39

----

 

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

 

**If brand pharmaceuticalcompanies are successful in limiting the use of generics through theirlegislative and regulatory efforts, our sales of generic products may suffer.**

 

Many brand pharmaceutical companies increasinglyhave used state and federal legislative and regulatory means to delay genericcompetition. These efforts 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’s Petition process to request amendments to FDA standards;

 

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

 

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

 

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

 

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

 

**If competitors aresuccessful in limiting competition for certain generic products through theirlegislative, regulatory and litigation efforts, our sales of certain genericproducts may suffer.**

 

Certain of our competitors have recently challengedour ability to distribute Authorized Generics during the competitors’ 180 dayperiod of ANDA exclusivity under the Hatch-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 ourcompetitors have challenged the propriety of these arrangements by filingCitizen’s Petitions with the FDA, initiating lawsuits alleging violation of theantitrust and consumer protection laws, and seeking legislative intervention. TheFDA and courts that have considered the subject to date have ruled that thereis no prohibition in the Federal Food, Drug, and Cosmetic Act againstdistributing authorized generic versions of a brand drug. However, the DeficitReduction Act of 2005 added provisions to the Medicaid Rebate Program that,effective January 1, 2007, may have the effect of increasing an NDAholder’s Medicaid Rebate liability if it permits another manufacturer to marketan authorized generic version of its brand product. This may affect thewillingness of brand manufacturers to continue arrangements, or enter intofuture arrangements, permitting us to market authorized generic versions oftheir brand products. If so, or if distribution of authorized generic versionsof brand products is otherwise restricted or found unlawful, it could have amaterial adverse effect on our results of operations, financial condition andcash 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 andother proprietary rights held by third parties to develop, manufacture andmarket products. If we are unable to timely obtain these licenses oncommercially reasonable terms, our ability to commercially market our products may beinhibited or prevented.

 

40

----

 

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

 

The manufacture, use and sale of new products thatare the subject of conflicting patent rights have been the subject of substantiallitigation in the pharmaceutical industry. These lawsuits relate to thevalidity and infringement of patents or proprietary rights of third parties. Wemay have to defend against charges that we violated patents or proprietaryrights of third parties. This is especially true in the case of genericproducts on which the patent covering the brand product is expiring, an areawhere infringement litigation is prevalent, and in the case of new brandproducts where a competitor has obtained patents for similar products. Litigationmay be costly and time-consuming, and could divert the attention of ourmanagement and technical personnel. In addition, if we infringe on the rightsof others, we could lose our right to develop or manufacture products or couldbe required to pay monetary damages or royalties to license proprietary rightsfrom third parties. Although the parties to patent and intellectual propertydisputes in the pharmaceutical industry have often settled their disputesthrough licensing or similar arrangements, the costs associated with thesearrangements may be substantial and could include ongoing royalties. Furthermore,we cannot be certain that the necessary licenses would be available to us oncommercially reasonable terms. As a result, an adverse determination in ajudicial or administrative proceeding or failure to obtain necessary licensescould prevent us from manufacturing and selling a number of our products, whichcould harm our business, financial condition, results of operations and cash flows.

 

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

 

Weregularly review potential acquisitions of technologies, products andbusinesses complementary to our business. Acquisitions typically entail manyrisks and could result in difficulties in integrating operations, personnel,technologies and products. For example, in March 2006, we announced thatwe have entered into a definitive merger agreement to acquire all theoutstanding shares of Andrx and acquired all the outstanding shares ofSekhsaria. If we are not able to successfully integrate our acquisitions, we may notobtain the advantages that the acquisitions were intended to create, which may adverselyaffect our business, results of operations, financial condition and cash flows,our ability to develop and introduce new products and the market price of ourstock. Integrating two geographically distant companies can be a time consumingand expensive process. In addition, in connection with acquisitions, we couldexperience disruption in our business or employee base, including diversion ofmanagement’s attention from our continuing operations. There is also a riskthat key 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 beoverlap between the products or customers of Watson and the companies that weacquire that may create conflicts in relationships or other commitmentsdetrimental to the integrated businesses.

 

In addition, as a result of acquiring businesses orproducts, or entering into other significant transactions, we have experienced,and will likely continue to experience, significant charges to earnings formerger and related expenses that may include transaction costs, closurecosts or acquired in-process research and development charges. These costs may includesubstantial fees for investment bankers, attorneys, accountants and financialprinting costs and severance and other closure costs associated with theelimination of duplicate or discontinued products, operations and facilities. Chargesthat we may incur in connection with acquisitions could adversely affectour results of operations for particular quarterly or annual periods.

 

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

 

We are required to identify the supplier(s) of allthe raw materials for our products in our applications with the FDA. To theextent practicable, we attempt to identify more than one supplier in each drugapplication. However, some products and raw materials are available only from asingle source and, in some of our drug

 

41

----

 

applications, only one supplier of products and raw materials has beenidentified, even in instances where multiple sources exist. Among others, thisincludes products that have historically accounted for a significant portion ofour revenues, such as Ferrlecit®, bupropion sustained release tablets and asignificant number of our oral contraceptive products. From time to time,certain of our outside suppliers have experienced regulatory or supply-relateddifficulties that have inhibited their ability to deliver products and rawmaterials to us, causing supply delays or interruptions. To the extent 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 subjectto certain additional risks, including the availability of governmentclearances, export duties, political instability, war, acts of terrorism,currency fluctuations and restrictions on the transfer of funds. For example,we obtain a significant portion of our raw materials from foreign suppliers. Arrangementswith international raw material suppliers are subject to, among other things,FDA regulation, customs clearances, various import duties and other governmentclearances. Acts of governments outside the U.S. may affect the price oravailability of raw materials needed for the development or manufacture of ourproducts. In addition, recent changes in patent laws in jurisdictions outsidethe U.S. may make it increasingly difficult to obtain raw materials forresearch and development prior to the expiration of the applicable U.S. orforeign patents.

 

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

 

Based on industry practice, generic product manufacturers,including Watson, have liberal return policies and have been willing to givecustomers post-sale inventory allowances. Under these arrangements, from timeto time, we give our customers credits on our generic products that ourcustomers hold in inventory after we have decreased the market prices of thesame generic products. Therefore, if new competitors enter the marketplace andsignificantly lower the prices of any of their competing products, we wouldlikely reduce the price of our product. As a result, we would be obligated toprovide significant credits to our customers who are then holding inventoriesof such products, which could reduce sales revenue and gross margin for theperiod the credit is provided. Like our competitors, we also give credits forchargebacks to wholesale customers that have contracts with us for their salesto hospitals, group purchasing organizations, pharmacies or other retailcustomers. A chargeback represents an amount payablein the future to a wholesaler for the difference between the invoice price paidto us by our wholesale customer for a particular product and the negotiatedcontract price that the wholesaler’s customer pays for that product. Although we establish reserves based on ourprior experience and our best estimates of the impact that these policies may havein subsequent periods, we cannot ensure that our reserves are adequate or thatactual product returns, allowances and chargebacks will not exceed ourestimates, which could adversely affect our financial condition, cash flows andmarket price of our stock.

 

**Investigations of the calculation of average wholesale prices may adverselyaffect our business.**

 

Manygovernment and third-party payors, including Medicare, Medicaid, HealthMaintenance Organizations (“HMOs”) and Managed Care Organizations (“MCOs”),reimburse doctors and others for the purchase of certain prescription drugsbased on a drug’s average wholesale price (“AWP”). In the past several years,state and federal government agencies have conducted ongoing investigations ofmanufacturers’ reporting practices with respect to AWP, in which they havesuggested that reporting of inflated AWP’s have led to excessive payments forprescription drugs. For example, beginning in July 2002, we and certain ofour subsidiaries, as well as numerous other pharmaceutical companies, werenamed as defendants in various state and federal court actions allegingimproper or fraudulent practices related to the reporting of AWP of certainproducts, and other improper acts, in order to increase prices and marketshares. Additional actions are anticipated. These actions, if successful, couldadversely affect us and may have a material adverse effect on ourbusiness, results of operations, financial condition and cash flows.

 

42

----

 

**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 difficultto obtain.**

 

The design, development, manufacture and sale of ourproducts involve an inherent risk of product liability claims and theassociated adverse publicity. Insurance coverage is expensive and may bedifficult to obtain, and may not be available in the future on acceptableterms, or at all. Although we currently maintain product liability insurancefor our products in amounts we believe to be commercially reasonable, if thecoverage limits of these insurance policies are not adequate, a claim broughtagainst Watson, whether covered by insurance or not, could have a materialadverse effect on our business, results of operations, financial condition andcash flows.

 

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

 

The success of our present and future operationswill depend, to a significant extent, upon the experience, abilities andcontinued services of key personnel. For example, although we have other seniormanagement personnel, a significant loss of the services of Allen Chao, Ph.D.,our Chairman and Chief Executive Officer, or other senior executive officers,could cause our business to suffer. We cannot assure you that we will be ableto attract and retain key personnel. We have entered into employment agreementswith all of our senior executive officers, including Dr. Chao. We do notcarry key-man life insurance on any of our officers.

 

**Rising insurance costs could negatively impactprofitability.**

 

The cost of insurance, includingworkers compensation, product liability and general liability insurance, haverisen significantly in recent years and may increase in 2006. In response,we may increase deductibles and/or decrease certain coverages to mitigatethese costs. These increases, and our increased risk due to increaseddeductibles and reduced coverages, could have a negative impact on our results of operations, financial conditionand cash flows.

 

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

 

From time to time, we may implementnew enterprise resource planning (“ERP”) systems and software, or upgrades toexisting systems and software, to further enhance our operations. Implementationof ERP systems and software carry risks such as cost overruns, project delaysand business interruptions and delays. If we experience a material businessinterruption as a result of such implementations, it could have a materialadverse effect on our business, results of operations, financial condition andcash 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 is relatedto acquired product rights and goodwill. As of December 31, 2005, thecarrying value of our product rights and other intangible assets wasapproximately $750 million and the carrying value of our goodwill wasapproximately $460 million.

 

Our product rights are stated at cost, lessaccumulated amortization. We determine original fair value and amortizationperiods for product rights based on our assessment of various factors impactingestimated useful lives and cash flows of 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. Significant changes to any of these factors wouldrequire us to perform an impairment test on the affected asset and, ifevidence of impairment exists, we would be required to take an impairmentcharge with respect to the asset. Such a charge would adversely affect ourresults of operations and financial condition.

 

43

----

 

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

 

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

 

Wemay consider issuing additional debt or equity securities in the future tofund potential acquisitions or investments, to refinance existing debt, or forgeneral 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 thatadditional funds will be available on satisfactory terms, or at all, to fundsuch activities.

 

*Risks Relating To Investing In the Pharmaceutical Industry*

 

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

 

All pharmaceutical companies, including Watson, aresubject to extensive, complex, costly and evolving regulation by the federalgovernment, principally the FDA and to a lesser extent by the U.S. DrugEnforcement Administration (“DEA”) and state government agencies. The FederalFood, Drug and Cosmetic Act, the Controlled Substances Act and other federalstatutes and regulations govern or influence the testing, manufacturing,packing, labeling, storing, record keeping, safety, approval, advertising,promotion, sale and distribution of our products. We are subject to similarregulation in foreign countries where we manufacture and/or distribute ourproducts.

 

Under these regulations, we are subject to periodicinspection of our facilities, procedures and operations and/or the testing ofour products by the FDA, the DEA and other authorities, which conduct periodicinspections to confirm that we are in compliance with all applicable regulations.In addition, the FDA conducts pre-approval and post-approval reviews and plantinspections to determine whether our systems and processes are in compliancewith current Good Manufacturing Practices (“cGMP”) and other FDA regulations. Followingsuch inspections, the FDA may issue notices on Form 483 and warningletters that could cause us to modify certain activities identified during theinspection. A Form 483 notice is generally issued at the conclusion of aFDA inspection and lists conditions the FDA inspectors believe may violatecGMP or other FDA regulations. FDA guidelines specify that a warning letter isissued only for violations of “regulatory significance” for which the failureto adequately and promptly achieve correction may be expected to result inan enforcement action.

 

Our principal manufacturing facility in Corona,California (which manufactured products representing approximately 17% of ourtotal product net revenues for 2005) is currently subject to a consent decreeof permanent injunction. We cannot assure you that the FDA will determine thatwe have adequately corrected deficiencies at our manufacturing sites (includingthe one referenced above), that subsequent FDA inspections will not result inadditional inspectional observations at such sites, that approval of any of thepending or subsequently submitted NDAs, ANDAs or supplements to suchapplications by Watson or its subsidiaries will be granted or that the FDA willnot seek to impose additional sanctions against Watson or any of its subsidiaries.The range of possible sanctions includes, among others, FDA issuance of adversepublicity, product recalls or seizures, fines, total or partial suspension ofproduction and/or distribution, suspension of the FDA’s review of productapplications, enforcement actions, injunctions, and civil or criminalprosecution. Any such sanctions, if imposed, could materially harm ouroperating results and financial condition. Under certain circumstances, the FDAalso has the authority to revoke previously granted drug approvals. Similarsanctions as detailed above may be available to the FDA under a consentdecree, depending upon the actual terms of such decree. Although we haveinstituted internal compliance programs, if these programs do not meetregulatory

 

44

----

 

agency standards or if compliance is deemed deficient in anysignificant way, it could materially harm our business. Certain of our vendorsare subject to similar regulation and periodic inspections.

 

The process for obtaining governmental approval tomanufacture and market pharmaceutical products is rigorous, time-consuming andcostly, and we cannot predict the extent to which we may be affected bylegislative and regulatory developments. We are dependent on receiving FDA andother governmental or third-party approvals prior to manufacturing, marketingand shipping our products. Consequently, there is always the chance that wewill not obtain FDA or other necessary approvals, or that the rate, timing andcost of such approvals, will adversely affect our product introduction plans orresults of operations. We carry inventories of certain product(s) inanticipation of launch, and if such product(s) are not subsequently launched,we may be required to write-off the related inventory.

 

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

 

Aspart of the Medicare Prescription Drug, Improvement, and Modernization Actof 2003 (the “MMA”), companies are required to file with the FTC and theDepartment of Justice certain types of agreements entered into between brandand generic pharmaceutical companies related to the manufacture, marketing andsale of generic versions of brand drugs. 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. The impact of this requirement, and thepotential private-party lawsuits associated with arrangements between brandname and generic drug manufacturers, is uncertain and could adversely affectour business.

 

**Healthcare reform anda reduction in the reimbursement levels by governmental authorities, HMOs, MCOsor other third-party payors may adversely affect our business.**

 

In order to assist us in commercializing products,we have obtained from government authorities and private health insurers andother organizations, such as HMOs and MCOs, authorization to receivereimbursement at varying levels for the cost of certain products and relatedtreatments. Third party payors increasingly challenge pricing of pharmaceuticalproducts. The trend toward managed healthcare in the U.S., the growth oforganizations such as HMOs and MCOs and legislative proposals to reform healthcareand government insurance programs could significantly influence the purchase ofpharmaceutical products, resulting in lower prices and a reduction in productdemand. Such cost containment measures and healthcare reform could affectour ability to sell our products and may have a material adverse effect onour business, results of operations and financial condition. Additionally,there is uncertainty surrounding the implementation of the provisions of Part Dof the MMA. Depending on how such provisions are implemented, reimbursement may notbe available for some of Watson’s products. Additionally, any reimbursementgranted may not be maintained or limits on reimbursement available fromthird-party payors may reduce the demand for, or negatively affect theprice of, those products and could harm significantly our business, results ofoperations, financial condition and cash flows. We may also be subject tolawsuits relating to reimbursement programs that could be costly to defend,divert management’s attention and adversely affect our operating results.

 

**The pharmaceutical industry is highly competitive.**

 

Weface strong competition in both our generic and brand product businesses. Theintensely competitive environment requires an ongoing, extensive search fortechnological innovations and the ability to market products effectively,including the ability to communicate the effectiveness, safety and value ofbrand products to healthcare professionals in private practice, group practicesand MCOs. Our competitors vary depending upon product categories, and withineach product category, upon dosage strengths and drug-delivery systems. Based

 

45

----

 

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 have been in business for a longerperiod of time than Watson, have a greater number of products on the market andhave greater financial and other resources than we do. If we directly competewith them for the same markets and/or products, their financial strength couldprevent us from capturing a profitable share of those markets. It is possiblethat developments by our competitors will make our products or technologiesnoncompetitive or obsolete.

 

Revenues and gross profit derived from the sales ofgeneric pharmaceutical products tend to follow a pattern based on certainregulatory and competitive factors. As patents for brand name products andrelated exclusivity periods expire, the first generic manufacturer to receiveregulatory approval for generic equivalents of such products is generally ableto achieve significant market penetration. As competing off-patentmanufacturers receive regulatory approvals on similar products or as brandmanufacturers launch generic versions of such products (for which no separateregulatory approval is required), market share, revenues and gross profittypically decline, in some cases dramatically. Accordingly, the level of marketshare, revenue and gross profit attributable to a particular generic productnormally is related to the number of competitors in that product’s market andthe timing of that product’s regulatory approval and launch, in relation tocompeting 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 be increased pricing pressure on certain products, which wouldresult in lower gross margins. This is particularly true in the case of certainAsian and other overseas competitors, who may be able to produce productsat costs lower than the costs of domestic manufacturers. If we experiencesubstantial competition from Asian or other overseas competitors with lowerproduction costs, our profit margins will suffer.

 

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

 

Our principal customers are wholesale drugdistributors and major retail drug store chains. These customers comprise asignificant part of the distribution network for pharmaceutical productsin the U.S. This distribution network is continuing to undergo significantconsolidation marked by mergers and acquisitions among wholesale distributorsand the growth of large retail drug store chains. As a result, a small numberof large wholesale distributors and large chain drug stores control a significantshare of the market. We expect that consolidation of drug wholesalers andretailers will increase pricing and other competitive pressures on drugmanufacturers, including Watson.

 

For theyear ended December 31, 2005, our four largest customers accounted for16%, 13%, 10% and 9% respectively, of our net revenues. The loss of any ofthese customers could materially adversely affect our business, results ofoperations, financial condition and our cash flows. In addition, none of ourcustomers are party to any long-term supply agreements with us, and thus areable to change suppliers freely should they wish to do so.

 

46

----

 

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

 

**(a) Recent Sales ofUnregistered Securities**

 

There were nounregistered sales of equity securities.

 

**(b) Use of Proceeds**

 

N/A.

 

**(c) Issuer Purchasesof Equity Securities**

 

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

 

On February 15, 2006, the Board authorized theexpenditure of an additional $300.0 million to repurchase shares of the Company’soutstanding common stock (the “2006 Repurchase Program”). Under the 2006Repurchase Program, the repurchases can be made in open market or privatelynegotiated transactions from time to time in compliance with the Securities andExchange Commission’s Rule 10b-18, subject to market conditions,applicable legal requirements and other factors. Additionally, the Board hasauthorized that purchases under the 2006 Repurchase Program may be madeunder Rule 10b5-1 promulgated under the Securities and Exchange Act of1934, as amended. A Rule 10b5-1 plan allows Watson to repurchase itsshares during periods when it would normally not be active in the market due toits internal trading blackout periods. All such purchases must be made inaccordance with a pre-defined plan that is established when the planadministrator is not aware of any material non-public information.

 

No common stock has been repurchased under the 2006Repurchase Program during the first quarter of 2006.

 

**ITEM 6. EXHIBITS**

 

(a) Exhibits:

 

Referenceis hereby made to the Exhibit Index on page 49.

 

47

----

 

**SIGNATURES**

 

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

 

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

 

 

Date:  May 10, 2006

 

48

----

 

**WATSON PHARMACEUTICALS, INC.**

** **

**EXHIBIT INDEX TO FORM 10-Q**

**For the Quarterly Period Ended March 31, 2006**

 
| **Exhibit  No.** | ** ** | **Description**                                                                                                                                      |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1             |       | Certification of Chairman  and Chief Executive Officer pursuant to Rule 13a-14a of the Securities  Exchange Act of 1934.                        |
|             |       |                                                                                                                                                 |
| 31.2             |       | Certification of Executive  Vice President and Chief Financial Officer pursuant to Rule 13a-14a of  the Securities Exchange Act of 1934.        |
|             |       |                                                                                                                                                 |
| 32.1             |       | Certification of Chairman  and Chief Executive Officer pursuant to Rule 13a-14(d) of the  Securities Exchange Act of 1934.                 |
|             |       |                                                                                                                                                 |
| 32.2             |       | Certification of Executive  Vice President and Chief Financial Officer pursuant to  Rule 13a-14(d) of the Securities Exchange Act of 1934. |

 

49

----