**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-Q**

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**xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)**

**OF THE SECURITIES EXCHANGE ACT OF 1934**

**FORTHE QUARTERLY PERIOD ENDED JUNE 30, 2006**

**or**

**oTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)**

**OF THE SECURITIES EXCHANGE ACT OF 1934**

**Forthe transition period from                     to                     **

**Commissionfile number 001-13305**

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**WATSON PHARMACEUTICALS, INC.**

(Exact name of registrantas 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 mark whether the Registrant (1) hasfiled 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)has been subject to such filing requirements for the past 90 days.Yes x   Noo

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act. (Check one):
| Large accelerated filer x |   | Accelerated filer o |   | Non-accelerated filer o |
|---------------------------|--------|---------------------|--------|-------------------------|

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act). Yes oNo x

The number of shares outstanding of the Registrant’sonly class of common stock as of August 2, 2006 was approximately 102,219,000.

 

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**WATSONPHARMACEUTICALS, INC.**

**TABLE OFCONTENTS**

**FORM 10-QFOR THE QUARTERLY PERIOD ENDED JUNE 30, 2006**
| **Part I. FINANCIAL INFORMATION**              |
|------------------------------------------------|
|                                           |   |   |
| Item 1.                                        | ** ** | Condensed Consolidated Financial Statements  (Unaudited): |
|                                           | ** ** |   |
|                                           |   | Condensed  Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005 |
|                                           |   |   |
|                                           |   | Condensed Consolidated  Statements of Income for the Three and Six Months Ended June 30, 2006 and  2005 |
|                                           |   |   |
|                                           |   | Condensed Consolidated  Statements of Cash Flows for the Six Months Ended June 30, 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 4.                                        |   | Submission of  Matters to a Vote of Security Holders |
|                                           |   |   |
| Item  6.                                       |   | Exhibits |
|                                           |   |   |
| Signatures                                     |   |

 

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**WATSONPHARMACEUTICALS, INC.CONDENSED CONSOLIDATED BALANCE SHEETS(Unaudited; in thousands)**
|                                                  | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| **ASSETS**                                       | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current assets:                                  |       |              |       |                  |       |
| Cash and cash  equivalents                       |       | $                 | 600,411    |                  | $          | 467,451 |   |
| Marketable securities                            |       | 169,037           |       | 162,475               |       |
| Accounts  receivable, net                        |       | 347,813           |       | 333,832               |       |
| Inventories                                      |       | 310,421           |       | 278,062               |       |
| Prepaid expenses  and other current assets       |       | 33,425            |       | 31,014                |       |
| Deferred tax  assets                             |       | 110,950           |       | 87,596                |       |
| Total current  assets                            |       | 1,572,057         |       | 1,360,430             |       |
| Property and equipment,  net                     |       | 449,375           |       | 436,149               |       |
| Investments and other  assets                    |       | 63,348            |       | 50,318                |       |
| Deferred tax assets                              |       | 25,550            |       | 25,733                |       |
| Product rights and  other intangibles, net       |       | 600,662           |       | 751,808               |       |
| Goodwill                                         |       | 479,945           |       | 455,595               |       |
| Total assets                                     |       | $                 | 3,190,937  |                  | $          | 3,080,033 |   |
|                                             |       |              |       |                  |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**   | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current liabilities:                             |       |              |       |                  |       |
| Accounts payable  and accrued expenses           |       | $                 | 298,639    |                  | $          | 211,160 |   |
| Income taxes  payable                            |       | 63,895            |       | 28,789                |       |
| Current portion  of long-term debt               |       | 10,392            |       | —                |       |
| Deferred revenue                                 |       | 8,182             |       | 5,721                 |       |
| Total current  liabilities                       |       | 381,108           |       | 245,670               |       |
|                                             |       |              |       |                  |       |
| Long-term debt                                   |       | 574,013           |       | 587,935               |       |
| Deferred revenue                                 |       | 13,969            |       | 13,891                |       |
| Other long-term  liabilities                     |       | 1,772             |       | 2,504                 |       |
| Deferred tax  liabilities                        |       | 88,785            |       | 125,792               |       |
| Total  liabilities                               |       | 1,059,647         |       | 975,792               |       |
|                                             |       |              |       |                  |       |
| Commitments and  contingencies                   |       |              |       |                  |       |
|                                             |       |              |       |                  |       |
| Stockholders’ equity:                       |       |              |       |                  |       |
| Preferred stock                                  |       | —            |       | —                |       |
| Common stock                                     |       | 368               |       | 367                   |       |
| Additional paid-in  capital                      |       | 929,014           |       | 923,619               |       |
| Unearned compensation                            |       | —            |       | (9,326                | )          |
| Retained earnings                                |       | 1,494,713         |       | 1,485,100             |       |
| Accumulated other  comprehensive income          |       | 7,195             |       | 4,481                 |       |
| Treasury stock, at cost                          |       | (300,000          | )          | (300,000              | )          |
| Total  stockholders’ equity                 |       | 2,131,290         |       | 2,104,241             |       |
| Total  liabilities and stockholders’ equity |       | $                 | 3,190,937  |                  | $          | 3,080,033 |   |

*See accompanying Notes to CondensedConsolidated Financial Statements.*

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**WATSON PHARMACEUTICALS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF (LOSS) INCOME**

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

 
|                                                         | ** ** | **Three Months Ended**             | ** ** | **Six Months Ended**               | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                              | ** ** | **June 30,**                            | ** ** | **June 30,**                            | ** ** |
| ** **                                              | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** |
| ** **                                              | ** ** | ** **                                   | ** ** | **Restated**                                 | ** ** | ** ** | ** ** | **Restated** | ** ** |
| ** **                                              | ** ** | ** **                                   | ** ** | ** **                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenues                                            |       | $                                            | 510,356    |                                         | $          | 416,266 |   | $ | 917,589 |   | $ | 817,094 |   |
| Cost of sales (excludes  amortization, presented below) |       | 330,860                                      |       | 211,213                                      |       | 565,614 |   | 418,163 |   |
| Gross profit                                            |       | 179,496                                      |       | 205,053                                      |       | 351,975 |   | 398,931 |   |
|                                                    |       |                                         |       |                                         |       |   |   |   |   |
| Operating expenses:                                     |       |                                         |       |                                         |       |   |   |   |   |
| Research and  development                               |       | 31,125                                       |       | 31,486                                       |       | 60,962 |   | 60,324 |   |
| Selling, general  and administrative                    |       | 70,774                                       |       | 68,125                                       |       | 137,524 |   | 131,776 |   |
| Amortization                                            |       | 41,101                                       |       | 41,101                                       |       | 82,201 |   | 81,739 |   |
| Loss on  impairment                                     |       | 66,981                                       |       | —                                       |       | 66,981 |   | — |   |
| Total operating  expenses                               |       | 209,981                                      |       | 140,712                                      |       | 347,668 |   | 273,839 |   |
| Operating (loss) income                                 |       | (30,485                                      | )          | 64,341                                       |       | 4,307 |   | 125,092 |   |
|                                                    |       |                                         |       |                                         |       |   |   |   |   |
| Other income (expense):                                 |       |                                         |       |                                         |       |   |   |   |   |
| (Losses)  earnings on equity method investments         |       | 1,646                                        |       | (997                                         | )          | 1,454 |   | (875 | ) |
| Gain on sales of  securities                            |       | —                                       |       | —                                       |       | 3,695 |   | — |   |
| (Loss) on early  extinguishment of debt                 |       | 195                                          |       | —                                       |       | (525 | ) | — |   |
| Interest income                                         |       | 6,913                                        |       | 4,546                                        |       | 13,165 |   | 8,652 |   |
| Interest (expense)  income                              |       | (3,322                                       | )          | (3,624                                       | )          | (6,623 | ) | (6,914 | ) |
| Other expense                                           |       | (97                                          | )          | 185                                          |       | 8 |   | (39 | ) |
| Total other  income, net                                |       | 5,335                                        |       | 110                                          |       | 11,174 |   | 824 |   |
|                                                    |       |                                         |       |                                         |       |   |   |   |   |
| (Loss) income before  income taxes                      |       | (25,150                                      | )          | 64,451                                       |       | 15,481 |   | 125,916 |   |
| (Benefit) provision for  income taxes                   |       | (9,532                                       | )          | 24,002                                       |       | 5,867 |   | 46,854 |   |
| Net (loss) income                                       |       | $                                            | (15,618    | )                                            | $          | 40,449 |   | $ | 9,614 |   | $ | 79,062 |   |
|                                                    |       |                                         |       |                                         |       |   |   |   |   |
| (Loss) earnings per  share:                             |       |                                         |       |                                         |       |   |   |   |   |
| Basic                                                   |       | $                                            | (0.15      | )                                            | $          | 0.38 |   | $ | 0.09 |   | $ | 0.73 |   |
| Diluted                                                 |       | $                                            | (0.15      | )                                            | $          | 0.35 |   | $ | 0.09 |   | $ | 0.67 |   |
|                                                    |       |                                         |       |                                         |       |   |   |   |   |
| Weighted average shares  outstanding:                   |       |                                         |       |                                         |       |   |   |   |   |
| Basic                                                   |       | 101,666                                      |       | 106,359                                      |       | 101,742 |   | 107,740 |   |
| Diluted                                                 |       | 101,666                                      |       | 121,253                                      |       | 102,125 |   | 122,671 |   |

*See accompanying Notes to Condensed Consolidated FinancialStatements.*

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**WATSONPHARMACEUTICALS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited; in thousands)**
|                                                                       | ** ** | **Six Months Ended**               | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                            | ** ** | **June 30,**                            | ** ** |
| ** **                                                            | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** |
| ** **                                                            | ** ** | ** **                                   | ** ** | **Restated** | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                            | ** ** | ** **                                   | ** ** | ** ** | ** ** |
| Net income                                                            |       | $                                            | 9,614      |   | $ | 79,062 |   |
| Reconciliation to net  cash provided by operating activities:         |       |                                         |       |   |   |
| Depreciation                                                          |       | 24,569                                       |       | 19,639 |   |
| Amortization                                                          |       | 82,201                                       |       | 81,739 |   |
| Charge for asset  impairment                                          |       | 66,981                                       |       | — |   |
| Deferred income  tax provision                                        |       | (61,857                                      | )          | (12,130 | ) |
| Provision for  inventory reserve                                      |       | 10,701                                       |       | 29,584 |   |
| Restricted stock  and stock option compensation                       |       | 6,653                                        |       | — |   |
| (Earnings) losses  on equity method investments                       |       | (1,454                                       | )          | 875 |   |
| Gain on sale of  securities                                           |       | (3,695                                       | )          | — |   |
| Loss on early  extinguishment of debt                                 |       | 525                                          |       | — |   |
| Loss on sale of  fixed assets                                         |       | 166                                          |       | 620 |   |
| Tax benefits  from employee stock plans                               |       | 785                                          |       | 1,606 |   |
| Mark to market  on derivative                                         |       | (732                                         | )          | (841 | ) |
| Other                                                                 |       | (1,899                                       | )          | (1,006 | ) |
| Changes in  assets and liabilities (net of acquisition of business):  |       |                                         |       |   |   |
| Accounts  receivable, net                                             |       | (13,618                                      | )          | (19,799 | ) |
| Inventories                                                           |       | (38,542                                      | )          | 2,407 |   |
| Prepaid expenses  and other current assets                            |       | (776                                         | )          | 6,352 |   |
| Accounts payable  and accrued expenses                                |       | 84,425                                       |       | (5,893 | ) |
| Deferred revenue                                                      |       | (1,485                                       | )          | 3,858 |   |
| Income taxes  payable                                                 |       | 35,106                                       |       | (8,541 | ) |
| Other assets                                                          |       | (1,443                                       | )          | 1,412 |   |
| Total  adjustments                                                    |       | 186,611                                      |       | 99,882 |   |
| Net cash  provided by operating activities                            |       | 196,225                                      |       | 178,944 |   |
|                                                                  |       |                                         |       |   |   |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                            | ** ** | ** **                                   | ** ** | ** ** | ** ** |
| Additions to property  and equipment                                  |       | (18,179                                      | )          | (38,103 | ) |
| Acquisition of product  rights                                        |       | (302                                         | )          | (427 | ) |
| Acquisition of  business, net of cash acquired                        |       | (29,664                                      | )          | — |   |
| Proceeds from sale of  marketable equity securities                   |       | 2,203                                        |       | 220,083 |   |
| Proceeds from sale of  investments                                    |       | 4,695                                        |       | — |   |
| Additions to marketable  securities                                   |       | (3,944                                       | )          | — |   |
| Additions to long-term  investments                                   |       | (12,500                                      | )          | (1,500 | ) |
| Distribution from joint  venture                                      |       | 5,942                                        |       | 2,500 |   |
| Net cash (used  in) provided by investing activities                  |       | (51,749                                      | )          | 182,553 |   |
|                                                                  |       |                                         |       |   |   |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                            | ** ** | ** **                                   | ** ** | ** ** | ** ** |
| Payments to repurchase  1998 Senior Notes                             |       | (14,585                                      | )          | — |   |
| Repurchase of common  stock                                           |       | —                                       |       | (182,585 | ) |
| Principal payments on  long-term debt and other long-term liabilities |       | (4,214                                       | )          | (5 | ) |
| Proceeds from stock  plans                                            |       | 7,283                                        |       | 11,175 |   |
| Net cash used in  financing activities                                |       | (11,516                                      | )          | (171,415 | ) |
| Net increase in  cash and cash equivalents                            |       | 132,960                                      |       | 190,082 |   |
| Cash and cash  equivalents at beginning of period                     |       | 467,451                                      |       | 298,653 |   |
| Cash and cash equivalents at end of period                            |       | $                                            | 600,411    |   | $ | 488,735 |   |

*See accompanying Notes to Condensed ConsolidatedFinancial Statements.*

3

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**WATSONPHARMACEUTICALS, INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**NOTE 1 –GENERAL**

WatsonPharmaceuticals, Inc. (“Watson” or the “Company”) is primarily engaged in thedevelopment, manufacture, marketing, sale and distribution of brand andoff-patent (generic) pharmaceutical products. Watson was incorporated in 1985 and began operations as a manufacturerand marketer of off-patent pharmaceuticals. Through internal product development and synergistic acquisitions ofproducts and businesses, the Company has grown into a diversified specialtypharmaceutical company.  Watson operatesmanufacturing, distribution, research and development and administrativefacilities primarily in the United States of America (“U.S.”).

The accompanyingCondensed Consolidated Financial Statements should be read in conjunction withthe Company’s Annual Report on Form 10-K for the year ended December 31,2005.  Certain information and footnotedisclosures normally included in annual financial statements prepared inaccordance with generally accepted accounting principles have been condensed oromitted from the accompanying Condensed Consolidated Financial Statements.  The year end balance sheet was derived fromthe audited financial statements.  Theaccompanying interim financial statements are unaudited, but reflect alladjustments which are, in the opinion of management, necessary to presentfairly Watson’s consolidated financial position, results of operations and cashflows for the periods presented.  Unlessotherwise noted, all such adjustments are of a normal, recurring nature.  Certain reclassifications, none of whichaffected net income or retained earnings, have been made to prior periodamounts to conform to current period presentation.  The Company’s results of operations and cashflows for the interim periods are not necessarily indicative of the results ofoperations and cash flows that it may achieve in future periods or for the fullyear.

In the year ended December 31, 2005 the Company acquired additionalcommon shares in Scinopharm Taiwan, Ltd. (“Scinopharm”), previously accountedfor under the cost method, to an ownership level in excess of 20%. Accordingly,as required by Accounting Principles Board (“APB”) Opinion No. 18, “The EquityMethod of Accounting for Investments in Common Stock” (“APB 18”), results ofoperations, earnings per share and cash flows from operating and investingactivities have been restated for the three and six months ended June 30, 2005to conform to current period presentation.

*Merger Agreement with AndrxCorporation*

On March 13, 2006, the Company announced a definitivemerger agreement (the “Merger Agreement”) to acquire all the outstanding sharesof common stock of Andrx Corporation (Nasdaq: ADRX) (“Andrx”) in an all-cashtransaction for $25 per share, or total consideration of approximately $1.9billion.  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.

In connection with the transaction, on March 31,2006, the Company filed a Hart-Scott-Rodino (“HSR”) notification and reportform (“HSR Notification”) with the Department of Justice and the Federal TradeCommission (“FTC”) pursuant to the HSR Antitrust Improvements Act of 1976, asamended (“HSR Act”).  On May 1, 2006, theCompany and Andrx received a request for additional documentation from the FTCrelated to the HSR Notification, to which responses were submitted.

Consummation of the merger, which is expected tooccur in the third or fourth quarter of 2006, is subject to the satisfaction ofcertain customary closing conditions including, among others, (i) theexpiration of the applicable waiting period under the HSR Act, and (ii) no materialadverse effect, as defined in the Merger Agreement, as amended.

On July 7, 2006, Watson and Andrx amended the MergerAgreement.  Under the initial terms ofthe Merger Agreement, either Watson or Andrx could have terminated the MergerAgreement and abandoned the merger at any time on or after September 12,2006, subject to certain conditions.  Theamendment extends the September 12, 2006 date to November 13, 2006, in theevent that the merger cannot be consummated solely because: (i) the waitingperiod applicable to the consummation of the merger under the HSR Act has notexpired or been terminated, (ii) a governmental entity has enjoined orprohibited the consummation of the merger, or (iii) there is a pendingantitrust proceeding that would prohibit the consummation of the merger or thatwould otherwise have a material adverse effect for Watson and its subsidiaries,taken as a whole on a post-merger basis.

The amendment also provides that in the event thatthe representations and warranties that will be made by Andrx in the MergerAgreement are true and correct on September 12, 2006, then such representationsand warranties, with limited exceptions, will be deemed to be true on all datessubsequent to September 12, 2006.  Inaddition, in the event that no material adverse effect has occurred with regardto Andrx or its ability to consummate the merger on September 12, 2006, then nosuch material adverse effect will be deemed to exist on all dates subsequent toSeptember 12, 2006.  For additionalinformation on Andrx, see the U.S. Securities and Exchange Commission’s (“SEC”)website at www.sec.gov.

4

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*ComprehensiveIncome*

Comprehensive incomeincludes all changes in equity during a period except those that resulted frominvestments by or distributions to the Company’s stockholders.  Other comprehensive income (loss) refers torevenues, expenses, gains and losses that, under generally accepted accountingprinciples, are included in comprehensive income (loss), but excluded from netincome as these amounts are recorded directly as an adjustment to stockholders’equity.  Watson’s other comprehensiveincome (loss) is comprised of unrealized gains (losses) on its holdings ofpublicly traded debt and equity securities, net of realized gains (losses)included in net income and foreign currency translation adjustments.  The components of comprehensive income includingattributable income taxes consisted of the following (in thousands):
|                                                 | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                      | ** ** | ** **                                          | ** ** | **Restated**                                      | ** ** | ** ** | ** ** | **Restated** | ** ** |
| Net (loss)  income                              |       | $                                                   | (15,618    | )                                                 | $          | 40,449 |   | $ | 9,614 |   | $ | 79,062 |   |
|                                            |       |                                                |       |                                              |       |   |   |   |   |
| Other comprehensive  income (loss):             |       |                                                |       |                                              |       |   |   |   |   |
| Unrealized (loss) gain on securities            |       | (379                                                | )          | (1,794                                            | )          | 5,063 |   | (5,293 | ) |
| Less related income taxes                       |       | 144                                                 |       | 669                                               |       | (1,919 | ) | 1,974 |   |
| Total unrealized (loss) gain on securities, net |       | (235                                                | )          | (1,125                                            | )          | 3,144 |   | (3,319 | ) |
|                                            |       |                                                |       |                                              |       |   |   |   |   |
| Translation loss                                |       | (595                                                | )          | —                                            |       | (430 | ) | — |   |
| Total other  comprehensive (loss) income        |       | (830                                                | )          | (1,125                                            | )          | 2,714 |   | (3,319 | ) |
| Total comprehensive  (loss) income              |       | $                                                   | (16,448    | )                                                 | $          | 39,324 |   | $ | 12,328 |   | $ | 75,743 |   |

*Preferred and Common Stock*

As of June 30, 2006 and December 31, 2005 there were2,500,000 shares of no par value per share preferred stock authorized, withnone issued.  As of June 30, 2006 andDecember 31, 2005, there were 500,000,000 shares of $0.0033 par value per sharecommon stock authorized, with 111,568,000 and 110,205,000 shares issued, and102,168,000 and 100,805,000 outstanding, respectively.  Approximately 9,399,800 shares were held astreasury shares as of June 30, 2006 and December 31, 2005, respectively.

*Stock Repurchases*

During 2005, we repurchasedapproximately 9.4 million shares of our common stock at an aggregate cost of$300.0 million under the Company’s $300.0 million stock repurchase programapproved by the Board on February 10, 2005 (the “2005 Repurchase Program”).  This completed our stock repurchase programunder the 2005 Repurchase Program.

On February 15, 2006, theCompany’s Board of Directors authorized the expenditure of an additional $300.0million to repurchase shares of the Company’s outstanding common stock (the “2006Repurchase 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 10b5-1 promulgatedunder the Securities and Exchange Act of 1934, as amended.  A Rule 10b5-1 plan allows

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Watson to repurchase its shares during periods when it would normallynot be active in the market due to its internal trading blackout periods. Allsuch purchases must be made in accordance with a pre-defined plan that isestablished when the plan administrator is not aware of any material non-publicinformation.  At this time, the Companydoes not intend to repurchase common stock under the 2006 Repurchase Programgiven the pending acquisition of Andrx.

*Provisionsfor Sales Returns and Allowances*

As customary in the pharmaceutical industry, the Company’s grossproduct sales are subject to a variety of deductions in arriving at reportednet product sales.  When the Companyrecognizes revenue from the sale of its products, an estimate of various salesreturns and allowances is recorded which reduces product sales and accountsreceivable. These adjustments include estimates for chargebacks, rebates,returns, and other sales allowances.  These provisions are estimated based onhistorical payment experience, historical relationship to revenues, estimatedcustomer inventory levels and current contract sales terms with wholesale andindirect customers.

The Company’sprovision for chargebacks is the most significant and complex estimated salesallowance.  A chargeback represents anamount payable in the future to a wholesaler for the difference between theinvoice price paid to the Company by our wholesale customer for a particularproduct and the negotiated contract price that the wholesaler’s customer paysfor that product.  The Company’schargeback estimates take into consideration the current average chargeback ratesby product and estimated wholesaler inventory levels.  Watson continually monitors these assumptionsgiving consideration to current pricing trends and estimated wholesalerinventory levels and make adjustments to these estimates when the Company believesthat the actual chargeback amounts payable in the future will differ fromoriginal estimates.  The followingtable summarizes the activity in the Company’s major categories of salesreturns and allowances (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 six months ended June  30, 2005     |       | 434,548         |       | 165,358     |       | 60,265                                        |       | 28,886              |       | 689,057    |       |
| Credits and payments                                              |       | (456,724        | )          | (189,162    | )          | (65,512                                       | )          | (29,240             | )          | (740,638   | )          |
| Balance at June  30, 2005                                         |       | 107,375         |       | 125,144     |       | 39,236                                        |       | 10,260              |       | 282,015    |       |
| Provision related to sales in six months ended  December 31, 2005 |       | 501,276         |       | 180,512     |       | 59,608                                        |       | 30,614              |       | 772,010    |       |
| Credits and payments                                              |       | (469,046        | )          | (177,363    | )          | (53,551                                       | )          | (28,780             | )          | (728,740   | )          |
| Balance at  December 31, 2005                                     |       | 139,605         |       | 128,293     |       | 45,293                                        |       | 12,094              |       | 325,285    |       |
| Provision related to sales in six months ended June  30, 2006     |       | 567,776         |       | 201,959     |       | 84,287                                        |       | 34,570              |       | 888,292    |       |
| Credits and payments                                              |       | (539,685        | )          | (191,298    | )          | (85,478                                       | )          | (33,167             | )          | (849,328   | )          |
| Balance at June 30,  2006                                         |       | $               | 167,696    |        | $          | 138,954                                       |       | $                   | 44,102     |       | $          | 13,497 |   | $ | 364,249 |   |

*Earnings Per Share*

Basic earnings pershare is computed by dividing net income by the weighted average common sharesoutstanding during a period.  Dilutedearnings per share is based on the treasury stock method and includes theeffect from potential issuance of common stock, such as shares issuable uponconversion of the $575 million convertible contingent senior debentures (“CODES”),and the dilutive effect of stock options and restricted stock awardsoutstanding during the period.  Commonshare equivalents have been excluded where their inclusion would beanti-dilutive.  In accordance withEmerging Issues Task Force (“EITF”) Issue No. 04-8, “The Effect of ContingentlyConvertible Debt on Diluted Earnings per Share,” the Company is required to addapproximately 14.4 million shares associated with the conversion of the CODESto the number of shares

6

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outstanding for thecalculation of diluted earnings per share for all periods in which thesecurities were outstanding.  Areconciliation of the numerators and denominators of basic and diluted earningsper share consisted of the following (in thousands, except per share amounts):
|                                                     | ** ** | Three months ended                 | ** ** | **Six months ended**               | ** ** |
|-----------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                          | ** ** | **June 30,**                            | ** ** | **June 30,**                            | ** ** |
| ** **                                          | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** |
| ** **                                          | ** ** | ** **                                   | ** ** | **Restated**                                 | ** ** | ** ** | ** ** | **Restated** | ** ** |
|                                                |       |                                         |       |                                         |       |   |   |   |   |
| **(Loss) earnings per share -  basic**              |       |                                         |       |                                         |       |   |   |   |   |
| Net (loss)  income                                  |       | $                                            | (15,618    | )                                            | $          | 40,449 |   | $ | 9,614 |   | $ | 79,062 |   |
|                                                |       |                                         |       |                                         |       |   |   |   |   |
| Basic weighted  average common shares outstanding   |       | 101,666                                      |       | 106,359                                      |       | 101,742 |   | 107,740 |   |
|                                                |       |                                         |       |                                         |       |   |   |   |   |
| (Loss) earnings  per share - basic                  |       | $                                            | (0.15      | )                                            | $          | 0.38 |   | $ | 0.09 |   | $ | 0.73 |   |
|                                                |       |                                         |       |                                         |       |   |   |   |   |
| **(Loss) earnings per share -  assuming dilution**  |       |                                         |       |                                         |       |   |   |   |   |
| Net (loss)  income                                  |       | $                                            | (15,618    | )                                            | $          | 40,449 |   | $ | 9,614 |   | $ | 79,062 |   |
| Add: Interest  expense on CODES, net of tax         |       | —                                       |       | 1,808                                        |       | — |   | 3,430 |   |
| Net (loss)  income, adjusted                        |       | $                                            | (15,618    | )                                            | $          | 42,257 |   | $ | 9,614 |   | $ | 82,492 |   |
|                                                |       |                                         |       |                                         |       |   |   |   |   |
| Basic weighted  average common shares outstanding   |       | 101,666                                      |       | 106,359                                      |       | 101,742 |   | 107,740 |   |
| Effect of  dilutive securities:                     |       |                                         |       |                                         |       |   |   |   |   |
| Conversion of  CODES                                |       | —                                       |       | 14,357                                       |       | — |   | 14,357 |   |
| Dilutive stock  options                             |       | —                                       |       | 537                                          |       | 383 |   | 574 |   |
| Diluted weighted  average common shares outstanding |       | 101,666                                      |       | 121,253                                      |       | 102,125 |   | 122,671 |   |
|                                                |       |                                         |       |                                         |       |   |   |   |   |
| (Loss) earnings per  share - diluted                |       | $                                            | (0.15      | )                                            | $          | 0.35 |   | $ | 0.09 |   | $ | 0.67 |   |

 

Stock awards topurchase 10.4 million and 6.5 million common shares for the three month periodsended June 30, 2006 and 2005, respectively, were outstanding but were notincluded in the computation of diluted earnings per share because the optionswere antidilutive.  Stock awards topurchase 8.6 million and 6.5 million common shares for the six month periodsended June 30, 2006 and 2005, respectively, were outstanding but were notincluded in the computation of diluted earnings per share because the optionswere antidilutive.  Common stockequivalents relating to the CODES convertible into 14.4 million common shareswere not included in the computation of diluted earnings per share for thethree and six month periods ended June 30, 2006 because the CODES wereantidilutive.

*Recent Accounting Pronouncements*

In November 2004, the Financial Accounting StandardsBoard (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No.151, “Inventory Costs-an Amendment of ARB No. 43, Chapter 4” (“SFAS 151”).  SFAS 151 clarifies that items such asabnormal freight, handling costs, and wasted materials (spoilage) be recognizedas current period charges rather than as a portion of the inventory cost.  Unallocated overheads are to be recognized asan expense in the period 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 effective for inventorycosts incurred during fiscal years beginning after June 15, 2005.  The provision of this Statement shall beapplied prospectively.  The adoption ofSFAS 151 on January 1, 2006, did not have a material effect on our CondensedConsolidated Financial Statements.

InDecember 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-BasedPayment” (“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”),

7

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supersedes APB OpinionNo. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and amends SFASNo. 95, “Statement of Cash Flows” (“SFAS 95”). SFAS 123R requires all share-basedpayments to employees, including grants of employee stock options, to be recognizedin the financial statements based on their fair values. The intrinsic valuemethod as permitted under APB 25 together with the pro forma disclosurespreviously permitted under SFAS 123 no longer will be an alternative tofinancial statement recognition. Under SFAS 123R, the Company must determinethe appropriate fair value model to be used for valuing share-based payments,the amortization method for attributing compensation cost to reporting periodsand the transition method to be used at date of adoption.  The transition methodsinclude modified prospective and modified retrospective adoption options. Underthe modified retrospective option, prior periods may be restated either as ofthe 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 requiresany previously recorded unearned or deferred compensation accounts (i.e.contra-equity accounts) within stockholders’ equity be recorded as a reductionto additional paid-in capital balances rather than shown as contra equityaccounts as was permitted prior to January 1, 2006.  SFAS 95 is amended to requireexcess tax benefits be reported as a financing cash flow rather than as areduction in taxes paid within the Consolidated Statement of Cash Flows.  On January 1, 2006, the Company adoptedSFAS 123R using the modified prospective method option.

In March 2005, the SEC issued SEC Staff Accounting BulletinNo. 107 (“SAB 107”) which describes the SEC staff position as well assupplemental implementation guidance on the application  and adoption of SFAS 123R.  The Company has applied the provisions of SAB107 and its guidance in our adoption of SFAS 123R on January 1, 2006 (Refer toNOTE 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 requiresretrospective application to prior period financial statements involvingchanges in accounting principle unless it is impracticable to determine eitherthe period-specific or cumulative effect of the change.  This statement also requires that a change inthe method of depreciation, amortization or depletion of long-lived assets beaccounted for as a change in accounting estimate that is accounted forprospectively.  SFAS 154 also retainsmany provisions of APB 20 including those related to reporting a change inaccounting estimate, a change in the reporting entity and a correction of anerror and also carries forward provisions of SFAS 3 governing the reporting ofaccounting changes in interim financial statements.  SFAS 154 is effective for accounting changesand corrections of errors made in fiscal years beginning after December 15,2005.  The adoption of SFAS 154 onJanuary 1, 2006, did not have a material effect on our Consolidated FinancialStatements.

InJuly 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertaintyin Income Taxes – An Interpretation of FASB Statement No. 109” (“FIN 48”).  FIN 48 clarifies the accounting for theuncertainty in recognizing income taxes in an organization in accordance withFASB Statement No. 109 by providing detailed guidance for financial statementrecognition, measurement and disclosure involving uncertain tax positions.  FIN 48 requires an uncertain tax position tomeet a more-likely-than-not recognition threshold at the effective date to berecognized both upon the adoption of FIN 48 and in subsequent periods.  FIN 48 is effective for fiscal yearsbeginning after December 15, 2006.  Asthe provisions of FIN 48 will be applied to all tax positions upon initialadoption, the cumulative effect of applying the provisions of FIN 48 will bereported as an adjustment to the opening balance of retained earnings for thatfiscal year.  The Company is currentlyevaluating FIN 48 and the effect, if any, on our Condensed ConsolidatedFinancial Statements.

8

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**NOTE 2 –SHARE-BASED COMPENSATION**

As indicated above, effective January 1, 2006, theCompany adopted the modified prospective method of SFAS 123R which requires themeasurement and recognition of compensation expense for all share-basedcompensation awards made to employees and directors based on estimated fairvalues.  SFAS 123R eliminates previouslyavailable alternatives to account for share-based compensation transactions, asthe Company formerly did, using the recognition and measurement principles ofAPB 25 and related interpretations. Under the intrinsic value method of APB 25, no stock-based employeecompensation expense had been recognized for employee options in the Company’sCondensed Consolidated Statements of Income, as all employee options grantedunder the Company’s stock option plans or employee stock purchase plan (“ESPP”)either had an exercise price equal to the market value of the underlying commonstock on the date of grant or were deemed non-compensatory under APB 25 forcommon stock issued under our ESPP.  Inaccordance with the modified prospective method, the consolidated financialstatements for prior periods have not been restated to reflect, and do notinclude, the share-based compensation impact of FAS 123R.

*Stock Option Plans*

The Company has adoptedseveral stock option plans, all of which have been approved by the Company’sshareholders, that authorize the granting of options to purchase the Company’scommon shares subject to certain conditions. At June 30, 2006, the Company had reserved 14.9 million of its commonshares for issuance of share-based compensation awards under the Company’sstock option and restricted stock plans. Options are granted at the fair value of the shares underlying theoptions at the date of the grant and generally become exercisable over periodsranging from three to five years and expire in ten years.  In conjunction with certain of the Company’sacquisitions, Watson assumed stock option and warrant plans from the acquiredcompanies.  The options and warrants inthese plans were adjusted by the individual exchange ratios specified in eachtransaction.  No additional options orwarrants have been granted 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 Model requires the use ofsubjective and complex assumptions, including the option’s expected term andthe estimated future price volatility of the underlying stock, which determinethe fair value of the share-based awards. The Company’s estimate of expected term in 2006 was determined based onthe weighted average period of time that options granted are expected to beoutstanding considering current vesting schedules and the historical exercisepatterns of existing option plans. Beginning in 2005, the expected volatility assumption used in the OptionModel changed from being based on historical volatility to implied volatilitybased on traded options on the Company’s stock in accordance with guidanceprovided in SFAS 123R and SAB 107.  Priorto 2005, the Company’s measurement of expected volatility was based on thehistorical volatility of its stock.  Therisk-free interest rate used in the Option Model is based on the yield of U.S.Treasuries with a maturity closest to the expected term of the Company’s stockoptions.

9

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Thefollowing weighted average assumptions were used for stock options grantedduring the three and six months ended June 30, 2006 and 2005:
|                                                      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                           | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                           | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| Dividend yield                                       |       | None                             |       | None                           |       | None |   | None |   |
| Expected volatility                                  |       | 25                               | %          | 44                             | %          | 25 | % | 37 | % |
| Risk-free interest rate                              |       | 5.04                             | %          | 3.96                           | %          | 5.04 | % | 3.98 | % |
| Expected term                                        |       | 4.4                              |       | 5.3                            |       | 5.2 |   | 5.4 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| Weighted average fair  value per share at grant date |       | $                                | 8.22       |                           | $          | 13.51 |   | $ | 9.50 |   | $ | 12.12 |   |
|                                                      |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |

Effective January 1, 2006,in accordance with the provisions of SFAS 123R, share-based compensationexpense recognized during a period is based on the value of the portion ofshare-based awards that are expected to vest with employees.  Accordingly, the recognition of share-basedcompensation expense beginning January 1, 2006 has been reduced for estimatedfuture forfeitures.  SFAS 123R requiresforfeitures to be estimated at the time of grant with adjustments recorded insubsequent period compensation expense if actual forfeitures differ from thoseestimates.  Prior to 2006, we accountedfor forfeitures as they occurred for the disclosure of pro forma informationpresented in our Notes to Condensed Consolidated Financial Statements for priorperiods.  Share-based compensationexpense recognized under SFAS 123R includes share-based awards grantedsubsequent to December 31, 2005, based on the grant date fair value estimatedin accordance with the provisions of SFAS 123R as well as share-based awardsgranted prior to, but not yet vested as of December 31, 2005, based on thegrant date fair value estimated in accordance with the provisions of SFAS123.  In conjunction with the adoption ofSFAS 123R, we changed the method of recognizing share-based compensationexpense from the accelerated multiple-option approach to the ratablesingle-option approach.

As a result of adopting SFAS 123R on January 1, 2006, the Company’soperating income and net income before income tax was reduced by $2.7 millionand $4.5 million, and net income was reduced by $1.7 million ($0.02 per basicand diluted share) and $2.8 million ($0.03 per basic and diluted share) for thethree and six months ended June 30, 2006, related to the Company’s employeestock option plans, respectively.  Therewas no share-based employee compensation related expense recognized in thethree and six months ended June 30, 2005. Total stock option cost capitalized as part of inventory was $0.4million and $0.7 for three and six months ended June 30, 2006, respectively.There was no stock option cost capitalized as part of inventory in the threeand six months ended June 30, 2005.

On December 15, 2005 the Compensation Committee of the Board approvedthe accelerated vesting of certain unvested, out-of-the-money stock optionshaving an exercise price of $38.00 or greater. The acceleration of vesting was effective December 15, 2005, for stockoptions previously awarded to the Company’s employees, including its executiveofficers under the Company’s equity compensation plans.  In connection with the acceleration ofvesting terms of these options, the Company recognized an additional $6.9million, pre-tax non-cash compensation expense on a pro forma basis in accordancewith SFAS 123 in the three months ended December 31, 2005.  The acceleration action was taken in order toreduce the impact on future compensation expense of recognizing share basedpayment transactions within future periods’ consolidated statements of incomeupon adoption of SFAS 123R on January 1, 2006.

10

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A summary of the changes inthe Company’s stock option plans during the six months ended June 30, 2006 ispresented below (in thousands, except per share amounts):
|                                               | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted**          | ** ** | ** **    | ** ** |
|-----------------------------------------------|------------|------------|------------|--------------|------------|-----------------------|------------|---------------|------------|
| ** **                                    | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Average**           | ** ** | ** **    | ** ** |
| ** **                                    | ** ** | ** ** | ** ** | **Average**  | ** ** | **Remaining**         | ** ** | **Aggregate** | ** ** |
| ** **                                    | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual**       | ** ** | **Intrinsic** | ** ** |
| ** **                                    | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Term (Years)** | ** ** | **Value**     | ** ** |
|                                          |       |       |       |         |       |                  |       |          |       |
| Outstanding at  December 31, 2005             |       | 11,194     |       | $            | 36.76      |                  |       |          |       |   |
| Granted                                       |       | 202        |       | 28.98        |       |                  |       |          |       |
| Exercised                                     |       | (261       | )          | 19.23        |       |                  |       |          |       |
| Cancelled                                     |       | (346       | )          | 40.32        |       |                  |       |          |       |
| Outstanding at  June 30, 2006                 |       | 10,789     |       | $            | 36.93      |                  | 6.0        |          | $          | 747 |   |
|                                          |       |       |       |         |       |                  |       |          |       |
| Vested and  expected to vest at June 30, 2006 |       | 10,256     |       | $            | 37.30      |                  | 6.0        |          | $          | 742 |   |
|                                          |       |       |       |         |       |                  |       |          |       |
| Options exercisable at  June 30, 2006         |       | 8,035      |       | $            | 39.47      |                  | 5.2        |          | $          | 674 |   |

 

As of June 30, 2006, theCompany had $9.7 million of total unrecognized compensation expense, net ofestimated forfeitures, related to stock option grants, which will be recognizedover the remaining weighted average period of 1.6 years.

*Restricted Stock*

During 2005, theCompensation Committee of the Board authorized and issued restricted stock tothe Company’s employees, including its executive officers and certainnon-employee directors (the “Participants”) under the Company’s equitycompensation plans.  The restricted stockaward program offers Participants the opportunity to earn shares of our commonstock over time, rather than options that give Participants the right topurchase stock at a set price. Restricted stock awards are grants that entitlethe holder to shares of common stock subject to certain terms. Restricted stockawards generally have restrictions eliminated over a one to four yearperiod.  Restrictions generally lapse fornon-employee directors after one year. Restrictions generally lapse for employees over a two to four year period.  The fair value of restricted stock grants isbased on the fair market value of our common stock on the respective grantdates.  Restricted stock compensation isbeing amortized and charged to operations over the same period as therestrictions are eliminated for the Participants.

TheCompany’s operating income and net income before income tax provision wasreduced by $0.8 and $1.3 million and net income was reduced by $0.5 million ($0.00per basic and diluted share) and $0.8 million ($0.01 per basic and dilutedshare) for the three and six months ended June 30, 2006, related to the Company’srestricted stock plans, respectively. There was no restricted stock expense recognized in both the three andsix months ended June 30, 2005.  Totalrestricted stock cost capitalized as part of inventory was $0.2 million and$0.4 for the three and six months ended June 30, 2006, respectively. There wasno restricted stock cost capitalized as part of inventory in the three and sixmonths ended June 30, 2005.

11

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A summary of the changes inrestricted stock grants during the six months ended June 30, 2006 is presentedbelow (in thousands, except per share amounts):
| ** **                                                      | ** ** | ** ** | ** ** | ** **     | ** ** | **Weighted**     | ** ** | ** **    | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|----------------|------------|------------------|------------|---------------|------------|
| ** **                                                      | ** ** | ** ** | ** ** | **Weighted**   | ** ** | **Average**      | ** ** | ** **    | ** ** |
| ** **                                                      | ** ** | ** ** | ** ** | **Average**    | ** ** | **Remaining**    | ** ** | **Aggregate** | ** ** |
| ** **                                                      | ** ** | ** ** | ** ** | **Grant Date** | ** ** | **Contractual**  | ** ** | **Intrinsic** | ** ** |
| ** **                                                      | ** ** | **Shares** | ** ** | **Fair Value** | ** ** | **Term (Years)** | ** ** | **Value**     | ** ** |
|                                                            |       |       |       |           |       |             |       |          |       |
| Restricted shares  outstanding at December 31, 2005             |       | 315.5      |       | $              | 34.43      |             | 2.3        |          | $          | 10,863 |   |
| Granted                                                         |       | 83.7       |       | 29.05          |       |             |       | 2,431         |       |
| Vested                                                          |       | (5.0       | )          | 30.04          |       |             |       | (150          | )          |
| Cancelled                                                       |       | (23.6      | )          | 35.08          |       |             |       | (826          | )          |
| Restricted shares outstanding at June 30, 2006                  |       | 370.6      |       | $              | 33.24      |             | 2.0        |          | $          | 12,318 |   |
|                                                            |       |       |       |           |       |             |       |          |       |
| Restricted shares net of estimated forfeitures at June 30, 2006 |       | 251.4      |       | 33.24          |       | 2.0              |       | $             | 8,358      |   |

 

As of June 30, 2006, theCompany had $6.4 million of total unrecognized compensation expense, net ofestimated forfeitures, related to restricted stock grants, which will berecognized over the remaining weighted average period of 1.9 years.

*ESPP*

An ESPP was established for eligible employees to purchase shares ofthe Company’s common stock at 85% of the lower of the fair market value ofWatson common stock on the effective date of subscription or the date ofpurchase.  Under the ESPP, employees canauthorize the Company to withhold up to 15% of their compensation during any offeringperiod for common stock purchases, subject to certain limitations.  The ESPP was implemented on January 1, 2002and was qualified under Section 423 of the Internal Revenue Code.  The Board authorized an aggregate of 700,000shares of the Company’s common stock for issuance under the ESPP.  As of December 31, 2005, a total of 471,307shares were issued under the ESPP.  OnJune 29, 2005 the Compensation Committee of the Board terminated the ESPPeffective January 1, 2006.

The following weighted average assumptions were used for the ESPPduring the three and six months ended June 30, 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.  The following table provides the pro formaeffects on net income and earnings per share for the three and six months endedJune 30, 2005 as if the fair value recognition provisions of SFAS 123R had beenapplied to options and ESPP

12

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

|                                                                                                                                               | ** ** | **Three Months**                                           | ** ** | **Six Months**                                             | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **Ended**                                                       | ** ** | **Ended**                                                       | ** ** |
| ** **                                                                                                                                    | ** ** | **   June 30, 2005   ** | ** ** | **   June 30, 2005   ** | ** ** |
| ** **                                                                                                                                    | ** ** | **Restated**                                                    | ** ** | **Restated**                                                    | ** ** |
| Net income, as  reported                                                                                                                      |       | $                                                               | 40,449     |                                                            | $          | 79,062 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | 2,857                                                           |       | 5,947                                                           |       |
| Pro forma net  income                                                                                                                         |       | 37,592                                                          |       | 73,115                                                          |       |
| Add: Interest expense  on CODES                                                                                                               |       | 1,808                                                           |       | 3,430                                                           |       |
| Pro forma net  income, adjusted                                                                                                               |       | $                                                               | 39,400     |                                                            | $          | 76,545 |   |
|                                                                                                                                          |       |                                                            |       |                                                            |       |
| Earnings per  share:                                                                                                                          |       |                                                            |       |                                                            |       |
| Basic - as  reported                                                                                                                          |       | $                                                               | 0.38       |                                                            | $          | 0.73 |   |
| Basic - pro  forma                                                                                                                            |       | $                                                               | 0.35       |                                                            | $          | 0.68 |   |
|                                                                                                                                          |       |                                                            |       |                                                            |       |
| Diluted - as  reported                                                                                                                        |       | $                                                               | 0.35       |                                                            | $          | 0.67 |   |
| Diluted - pro forma                                                                                                                           |       | $                                                               | 0.33       |                                                            | $          | 0.62 |   |

 

**NOTE 3 –ACQUISITIONS**

*Acquisition of SekhsariaChemicals Ltd.*

On March 16, 2006, theCompany acquired Sekhsaria Chemicals Ltd. (“Sekhsaria”), a private companylocated in Mumbai, India that provides active pharmaceutical ingredient andfinished dosage formulation expertise to the global pharmaceuticalindustry.  The Company acquired all theoutstanding shares of Sekhsaria for approximately $29.5 million plusacquisition costs.  The transaction wasaccounted for as a purchase in accordance with SFAS No. 141, “BusinessCombinations” (“SFAS 141”) and accordingly, the tangible assets acquired wererecorded at fair value on acquisition date based on reasonable assumptions.

The results of operations ofSekhsaria have been included in the Company’s Condensed Consolidated FinancialStatements subsequent to the date of acquisition.  Pro forma results of operations have not beenpresented because the effect of the acquisition was not material.

*Additional Investment in Scinopharm*

The Company holds an equityinterest in Scinopharm.  In January 2006,we made an additional investment in Scinopharm of approximately $12.0 millionwhich increased our ownership share to approximately 31%.  Additionally, we have an option to acquire anadditional 44% interest in Scinopharm by January 2008 at a cost ofapproximately $80 million.

*Acquisition of ManufacturingFacility in Goa, India*

InOctober 2005, the Company entered into an asset purchase agreement to purchasea manufacturing facility located in Goa, India (“Goa”) from Dr. Reddy’sLaboratories, Ltd. (“Dr. Reddy”) for total cash

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consideration of approximately $16.4 millionplus acquisition costs.  The transactionincluded a manufacturing facility, machinery and equipment.

**NOTE 4 –INVESTMENTS**

The Company’s equity investments in publicly tradedcompanies are classified as available-for-sale and are recorded at fair valuebased on quoted market prices using the specific identification method.  These investments are classified as currentmarketable securities, or investment and other assets, as appropriate, on theCompany’s Condensed Consolidated Balance Sheets.

The Company’s debt investments in U.S. Treasury andagency securities are classified as available-for-sale and are recorded at fairvalue based on quoted market prices using the specific identification method.

The following tableprovides a summary of the fair value and unrealized holding gain (loss) relatedto Watson’s available-for-sale securities (in thousands):
| ** **                           | ** ** | **Cost, Including**  | ** ** | **Gross Unrealized** | ** ** | **Gross Unrealized** | ** ** | ** **          | ** ** |
|--------------------------------------|------------|---------------------------|------------|---------------------------|------------|---------------------------|------------|---------------------|------------|
| **At June 30, 2006**  | ** ** | **Accrued Interest** | ** ** | **Gains**                 | ** ** | **Losses**                | ** ** | **Fair Value** | ** ** |
|                                 |       |                      |       |                      |       |                      |       |                |       |
| Available-for-sale:                  |       |                      |       |                      |       |                      |       |                |       |
| U.S. Treasury  and agency securities |       | $                         | 156,226    |                      | $          | —                    |       | $                   | (1,274     | ) | $ | 154,952 |   |
| Equity  securities - current         |       | 1,575                     |       | 12,510                    |       | —                    |       | 14,085              |       |
| Current                              |       | 157,801                   |       | 12,510                    |       | (1,274                    | )          | 169,037             |       |
| Equity  securities - non-current     |       | 232                       |       | 1,250                     |       | —                    |       | 1,482               |       |
| Total                                |       | $                         | 158,033    |                      | $          | 13,760                    |       | $                   | (1,274     | ) | $ | 170,519 |   |

 
| ** **                              | ** ** | **Cost, Including**  | ** ** | **Gross Unrealized** | ** ** | **Gross Unrealized** | ** ** | ** **          | ** ** |
|-----------------------------------------|------------|---------------------------|------------|---------------------------|------------|---------------------------|------------|---------------------|------------|
| **At December 31, 2005** | ** ** | **Accrued Interest** | ** ** | **Gains**                 | ** ** | **Losses**                | ** ** | **Fair Value** | ** ** |
|                                    |       |                      |       |                      |       |                      |       |                |       |
| 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 |   |

 

Gross unrealized gains atJune 30, 2006 and December 31, 2005 primarily relate to our holdings in sharesof Andrx common stock.  The grossunrealized holding loss at June 30, 2006 and December 31, 2005 is attributableto adjustments, included in other comprehensive income, for the decline in fairvalue in the Company’s investment in U.S. Treasury and agency securities.

The Company’s netunrealized gain related to its available-for-sale securities increased $3.1million for the six month period ended June 30, 2006.  During the six month period ended June 30,2005, the Company’s net unrealized holding gain decreased $3.2 million.  These changes in the Company’s net unrealizedholding gain are included in other comprehensive loss.

*Current Investments*

The Company’s investmentin the common stock of Andrx, publicly traded on the Nasdaq Stock Market underthe symbol ADRX, is classified as a current investment on the Company’sCondensed Consolidated Balance Sheets at June 30, 2006 and December 31,2005.  The Company did not sell any of itsshares of Andrx during the six month periods ended June 30, 2005 and 2006.  (Refer to NOTE 1 – GENERAL.)

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The Company’s investmentsin U.S. Treasury and agency securities are classified as a current investmenton the Company’s Condensed Consolidated Balance Sheet at June 30, 2006 andDecember 31, 2005.

The contractualmaturities of the U.S. Treasury securities at June 30, 2006 are as follows (inthousands):

|                          | ** ** | **   Fair value   ** | ** ** |
|--------------------------|------------|---------------------------------------------------------|------------|
|                     |       |                                                    |       |
| Mature within  one year  |       | $                                                       | 153,057    |   |
| Mature within  two years |       | 1,895                                                   |       |
|                     |       | $                                                       | 154,952    |   |

 

*Non-current Investments*

The Company’s investments in the common stock ofNovaDel Pharma Inc. and Amarin Corporation plc (“Amarin”) are classified asnon-current investments and are included in investments and other assets on theCompany’s Condensed Consolidated Balance Sheets at June 30, 2006 and December31, 2005.

**NOTE 5 –OPERATING SEGMENTS**

Watson has twooperating segments: Brand and Generic. The brand business segment includes the Company’s lines of SpecialtyProducts and Nephrology products. Watson has aggregated its brand product linesin a single segment because of similarities in regulatory environment, methodsof distribution and types of customer. This segment includes patent-protected products and certain trademarkedoff-patent products that Watson sells and markets as Brand pharmaceuticalproducts.  The Generic business segmentincludes off-patent pharmaceutical products that are therapeutically equivalentto proprietary products.  The Companysells its Brand and Generic products primarily to pharmaceutical wholesalers,drug distributors and chain drug stores.

The Companyevaluates segment performance based on segment net revenues, gross profit andcontribution. Segment contribution represents segment gross profit less directresearch and development expenses and selling and marketing expenses.  The Company does not report depreciation expense, total assets, andcapital expenditures by segment as such information is not used by management,or has not been accounted for at the segment level.

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The “other”revenue classification for the three month period ended June 30, 2006 and 2005consists primarily of royalties and revenues from research, development andlicensing fees.  Net revenues and segmentcontribution information for the Company’s Brand and Generic segments,consisted of the following:
| ** **                                                | ** ** | **Three Months Ended June 30, 2006** | ** ** | **Three Months Ended June 30, 2005** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                | ** ** | **Generic**                                                   | ** ** | **Brand**                                                     | ** ** | **Total** | ** ** | **Generic** | ** ** | **Brand** | ** ** | **Total** | ** ** |
| ** **                                                | ** ** | ** **                                                    | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Product sales                                             |       | $                                                             | 419,441    |                                                          | $          | 88,051 |   | $ | 507,492 |   | $ | 312,453 |   | $ | 100,746 |   | $ | 413,199 |   |
| Other                                                     |       | 990                                                           |       | 1,874                                                         |       | 2,864 |   | 1,149 |   | 1,918 |   | 3,067 |   |
| ** **                                                | ** ** | ** **                                                    | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenues                                              |       | 420,431                                                       |       | 89,925                                                        |       | 510,356 |   | 313,602 |   | 102,664 |   | 416,266 |   |
| Cost of revenue  (excludes amortization, presented below) |       | 306,564                                                       |       | 24,296                                                        |       | 330,860 |   | 188,141 |   | 23,072 |   | 211,213 |   |
| Gross profit                                              |       | 113,867                                                       |       | 65,629                                                        |       | 179,496 |   | 125,461 |   | 79,592 |   | 205,053 |   |
| Gross margin                                              |       | 27                                                            | %          | 73                                                            | %          | 35 | % | 40 | % | 78 | % | 49 | % |
|                                                      |       |                                                          |       |                                                          |       |   |   |   |   |   |   |   |   |
| Research and  development                                 |       | 18,124                                                        |       | 13,001                                                        |       | 31,125 |   | 21,818 |   | 9,668 |   | 31,486 |   |
| Selling and marketing                                     |       | 13,526                                                        |       | 29,765                                                        |       | 43,291 |   | 11,688 |   | 30,532 |   | 42,220 |   |
| Contribution                                              |       | $                                                             | 82,217     |                                                          | $          | 22,863 |   | 105,080 |   | $ | 91,955 |   | $ | 39,392 |   | 131,347 |   |
| Contibution  margin                                       |       | 20                                                            | %          | 25                                                            | %          | 21 | % | 29 | % | 38 | % | 32 | % |
|                                                      |       |                                                          |       |                                                          |       |   |   |   |   |   |   |   |   |
| General and  administrative                               |       |                                                          |       |                                                          |       | 27,483 |   |   |   |   |   | 25,905 |   |
| Amortization                                              |       |                                                          |       |                                                          |       | 41,101 |   |   |   |   |   | 41,101 |   |
| Loss on impairment                                        |       |                                                          |       |                                                          |       | 66,981 |   |   |   |   |   | — |   |
| Operating income                                          |       |                                                          |       |                                                          |       | $ | (30,485 | ) |   |   |   |   | $ | 64,341 |   |
| Operating margin                                          |       |                                                          |       |                                                          |       | (6.0 | )% |   |   |   |   | 15 | % |

 
| ** **                                                | ** ** | **Six Months Ended June 30, 2006** | ** ** | **Six Months Ended June 30, 2005** | ** ** |
|-----------------------------------------------------------|------------|-------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                | ** ** | **Generic**                                                 | ** ** | **Brand**                                                   | ** ** | **Total** | ** ** | **Generic** | ** ** | **Brand** | ** ** | **Total** | ** ** |
| ** **                                                | ** ** | ** **                                                  | ** ** | ** **                                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Product sales                                             |       | $                                                           | 740,856    |                                                        | $          | 171,288 |   | $ | 912,144 |   | $ | 605,616 |   | $ | 205,272 |   | $ | 810,888 |   |
| Other                                                     |       | 1,665                                                       |       | 3,780                                                       |       | 5,445 |   | 2,235 |   | 3,971 |   | 6,206 |   |
| ** **                                                | ** ** | ** **                                                  | ** ** | ** **                                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenues                                              |       | 742,521                                                     |       | 175,068                                                     |       | 917,589 |   | 607,851 |   | 209,243 |   | 817,094 |   |
| Cost of revenue  (excludes amortization, presented below) |       | 523,948                                                     |       | 41,666                                                      |       | 565,614 |   | 371,331 |   | 46,832 |   | 418,163 |   |
| Gross profit                                              |       | 218,573                                                     |       | 133,402                                                     |       | 351,975 |   | 236,520 |   | 162,411 |   | 398,931 |   |
| Gross margin                                              |       | 29                                                          | %          | 76                                                          | %          | 38 | % | 39 | % | 78 | % | 49 | % |
|                                                      |       |                                                        |       |                                                        |       |   |   |   |   |   |   |   |   |
| Research and development                                  |       | 38,619                                                      |       | 22,343                                                      |       | 60,962 |   | 40,962 |   | 19,362 |   | 60,324 |   |
| Selling and marketing                                     |       | 26,464                                                      |       | 58,740                                                      |       | 85,204 |   | 22,948 |   | 58,000 |   | 80,948 |   |
| Contribution                                              |       | $                                                           | 153,490    |                                                        | $          | 52,319 |   | 205,809 |   | $ | 172,610 |   | $ | 85,049 |   | 257,659 |   |
| Contibution  margin                                       |       | 21                                                          | %          | 30                                                          | %          | 22 | % | 28 | % | 41 | % | 32 | % |
|                                                      |       |                                                        |       |                                                        |       |   |   |   |   |   |   |   |   |
| General and  administrative                               |       |                                                        |       |                                                        |       | 52,320 |   |   |   |   |   | 50,828 |   |
| Amortization                                              |       |                                                        |       |                                                        |       | 82,201 |   |   |   |   |   | 81,739 |   |
| Loss on impairment                                        |       |                                                        |       |                                                        |       | 66,981 |   |   |   |   |   | — |   |
| Operating income                                          |       |                                                        |       |                                                        |       | $ | 4,307 |   |   |   |   |   | $ | 125,092 |   |
| Operating margin                                          |       |                                                        |       |                                                        |       | 0 | % |   |   |   |   | 15 | % |

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**NOTE 6 –INVENTORIES**

Inventories consist offinished goods held for sale and distribution, raw materials andwork-in-process. Included in inventory at June 30, 2006 and December 31, 2005is approximately $3.9 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 of generic pharmaceutical products that arecapitalized only when the bioequivalence of the product is demonstrated or theproduct is already FDA approved and is awaiting a contractual triggering eventto enter the marketplace.

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

|                    | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------|------------|-------------------|------------|-----------------------|------------|
| ** **         | ** ** | **2006**          | ** ** | **2005**              | ** ** |
|               |       |              |       |                  |       |
| Raw materials      |       | $                 | 96,471     |                  | $          | 85,983 |   |
| Work-in-process    |       | 56,270            |       | 67,173                |       |
| Finished goods     |       | 157,680           |       | 124,906               |       |
| Total  inventories |       | $                 | 310,421    |                  | $          | 278,062 |   |

 

**NOTE 7 – ASSET IMPAIRMENT CHARGES**

InAccordance with SFAS No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets” (“SFAS 144”), Watson reevaluates the carrying value ofidentifiable intangible and long-lived assets for impairment whenever events orchanges in circumstances indicate that the carrying value may not berecoverable.  SFAS 144 defines impairmentas the condition that exists when the carrying amount of a long-lived assetexceeds its fair value.  An impairmentloss is recognized only if the carrying amount of a long-lived asset is notrecoverable and exceeds its fair value.

Inthe quarter ended June 30, 2006, revisions to the Company’s long range productsales forecast were deemed necessary as a result of a detailed analysis ofprescription trends and a review of sales and inventory data provided by ourlargest customers.  As a result of thesedownward revisions to our long range product sales forecast, the Companyconducted a product right impairment review. Results of our impairment review indicated future undiscounted cashflows for four product rights were less than their respective carryingvalues.  An analysis was undertaken todetermine the fair values for the four product rights and an impairment ofapproximately $67.0 million was recognized predominantly relating to Alora®(purchased in 1999) and Actigall®(purchased in 2002) for the three and six months ended June 30, 2006.

**NOTE 8 – GOODWILL AND OTHER INTANGIBLE ASSETS**

Watson tests its goodwill and intangible assetswith indefinite lives by comparing the fair value of each of the Company’sreporting units to the respective carrying value of the reporting units.  The Company performs this impairment testingannually during the second quarter and when events occur or circumstanceschange that would more likely than not reduce the fair value of a reportingunit below its carrying amount.  TheCompany’s two reporting units are Brand and Generic pharmaceuticalproducts.  The carrying value of eachreporting unit is determined by assigning the assets employed in, andliabilities relating to, to those reporting units, including the existinggoodwill and intangible assets.  Goodwillis considered impaired if the carrying amount exceeds the fair value of thereporting unit.  During the secondquarter of 2006, Watson performed its annual assessment for the impairment ofgoodwill and determined there was no indication of impairment.

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Duringthe six months ended June 30, 2006, in conjunction with the acquisition ofSekhsaria, the total purchase price in excess of the fair value of net assetsacquired amounted to $24.3 million (See Note 3 —ACQUISITIONS).  This entire amount wasrecorded as an addition to goodwill under the Generic pharmaceutical productsegment.  Goodwill for the Company’sreporting units consisted of the following (in thousands):

|                                  | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2006**          | ** ** | **2005**              | ** ** |
|                             |       |              |       |                  |       |
| Brand pharmaceutical  products   |       | $                 | 368,105    |                  | $          | 368,105 |   |
| Generic pharmaceutical  products |       | 111,840           |       | 87,490                |       |
| Total goodwill                   |       | $                 | 479,945    |                  | $          | 455,595 |   |

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

|                                                    | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2006**          | ** ** | **2005**              | ** ** |
|                                               |       |              |       |                  |       |
| Product rights and related  intangibles            |       | $                 | 1,200,569  |                  | $          | 1,269,513 |   |
| Less accumulated  amortization                     |       | (599,907          | )          | (517,705              | )          |
| Total product rights  and related intangibles, net |       | $                 | 600,662    |                  | $          | 751,808 |   |

 

Assuming no additions, disposals or additional adjustments are made tothe carrying values and/or useful lives of the assets, annual amortizationexpense on product rights and related intangibles is estimated to beapproximately $160.3 million in 2006, $157.7 in 2007, $46.7 million in 2008,$45.7 in 2009 and $38.6 million in 2010. The Company’s current product rights and related intangibles have aweighted average useful life of approximately fourteen years.

**NOTE 9 – LONG-TERM DEBT**

Long-termdebt consisted of the following (in thousands):
|                                                                                                                                     | ** ** | **June 30,**                            | ** ** | **December 31,**                        | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                                                          | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** |
|                                                                                                                                |       |                                         |       |                                         |       |
| CODES, face  amount of $575 million, due 2023, net of unamortized discount                                                          |       | $                                            | 573,987    |                                         | $          | 573,849 |   |
| Senior unsecured  notes, 7.125% (“1998 Senior Notes”), face amount of $14 million, due 2008,  net of unamortized discount |       | —                                       |       | 14,054                                       |       |
| Other notes  payable                                                                                                                |       | 10,418                                       |       | 32                                           |       |
|                                                                                                                                |       | 584,405                                      |       | 587,935                                      |       |
| Less: Current  portion of long-term debt                                                                                            |       | 10,392                                       |       | —                                       |       |
| Total long-term  debt                                                                                                               |       | $                                            | 574,013    |                                         | $          | 587,935 |   |

*CODES*

In March 2003, theCompany issued $575 million of CODES. The CODES, which are convertible into shares of Watson’s common stockupon the occurrence of certain events, are due in March 2023, with interestpayments due semi-annually in March and September at an effective annualinterest rate of 2.1%, excluding changes in fair value of the contingentinterest derivative. At June 30, 2006 and December 31, 2005, the unamortizeddiscount for the CODES for both periods was $1.0 and 1.2 million, respectively.

The CODES areconvertible into Watson’s common stock at a conversion price of approximately$40.05 per share (subject to certain adjustments upon certain events such as(i) stock splits or dividends, (ii) material stock distributions orreclassifications, (iii) distribution of stock purchase rights at less thancurrent market rates or

18

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(iv) a distributionof assets or common stock to our shareholders or subsidiaries).  The CODES may be converted, at the option ofthe holders, prior to maturity under any of the following circumstances:

·                  duringany quarterly conversion period (period from and including the thirtiethtrading day in a fiscal quarter to, but not including, the thirtieth tradingday in the immediately following fiscal quarter) if the closing sale price pershare of Watson’s common stock for a period of at least 20 trading days during the30 consecutive trading-day period ending on the first day of such conversionperiod is more than 125% ($50.06) of the conversion price in effect on thatthirtieth day;

·                  onor before March 15, 2018, during the five business-day period following any 10 consecutivetrading-day period in which the daily average trading price for the CODES forsuch ten-day period was less than 105% of the average conversion value for thedebentures during that period.  Thisconversion feature represents an embedded derivative.  However, based on the de minimis valueassociated with this feature, no value has been assigned at issuance and atJune 30, 2005;

·                  duringany period, following the earlier of (a) the date the CODES are rated by bothStandard & Poor’s Rating Services and Moody’s Investor Services, Inc., and(b) April 21, 2003, when the long-term credit rating assigned to the CODES byeither Standard & Poor’s or Moody’s (or any successors to these entities)is lower than “BB” or “Ba3”, respectively, or when either of these ratingagencies does not have a rating then assigned to the CODES for any reason,including any withdrawal or suspension of a rating assigned to the CODES.  This conversion feature represents anembedded derivative.  However, based onthe de minimis value associated with this feature, no value has been assignedat issuance and at June 30, 2005;

·                  ifthe CODES have been called for redemption; or

·                  uponthe occurrence of specified corporate transactions.

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

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

In addition, theholders of the CODES have the right to receive contingent interest paymentsduring any six-month period from March 15 to September 14 and from September 15to March 14, commencing on September 15, 2003, if the average trading price ofthe CODES for the five trading days ending on the second trading dayimmediately preceding the relevant six-month period equals 120% or more of theprincipal amount of the CODES.  Theinterest rate used to calculate the contingent interest is the greater of 5% ofthe Company’s then-current estimated per annum borrowing rate for seniornon-convertible fixed-rate debt with a maturity date and other terms comparableto that of the CODES or 0.33% per annum. This contingent interest payment feature is an embedded derivative andhas been bifurcated and recorded separately in the Condensed ConsolidatedBalance Sheets in other long-term liabilities. The initial fair value assigned to the embedded derivative was $1.9million, which is recorded as a discount to the CODES.  Changes to the fair value of this embeddedderivative are reflected as an adjustment to interest expense.  The current value of the embedded derivativewas $ 0.2 and $0.9 million at June 30, 2006 and December 31, 2005, respectively.

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*1998 Senior Notes*

In May 1998,Watson issued $150 million of its 1998 Senior Notes.  The Company is required to make interest onlypayments due semi-annually in May and November at an effective annual rate of7.2%.  In February 2004, the Company initiated atender offer to purchase all of its outstanding 1998 Senior Notes and a relatedconsent solicitation.  The Companyreceived tenders of its 1998 Senior Notes and deliveries of related consentsfrom holders of approximately $101.6 million of the $150 million aggregateprincipal amount of 1998 Senior Notes outstanding.  In May 2004, the Company acquired anadditional $34.3 million of its outstanding 1998 Senior Notes in an open markettransaction.  On March 31, 2006,the Company initiated a redemption notice to the holders of all of itsoutstanding 1998 Senior Notes.  As aresult, the remaining 1998 Senior Notes were redeemed on May 23, 2006.

*CreditFacility*

In May 2003, we enteredinto an agreement with a syndicate of lenders for a five-year, $300 millionsenior, unsecured revolving credit facility (the “Credit Facility”) for workingcapital and other general corporate purposes. On September 8, 2005, we entered into a Second Amendment to the CreditFacility on substantially the same terms and conditions except the feestructure was reduced and certain defined terms were added or amended.  On March 6, 2006, we entered into a ThirdAmendment to the Credit Facility which, among other things, permits the Companyto repurchase up to $300.0 million of its common stock.  As of June 30, 2006, the total $300 millionunder the Credit Facility was available to us. Watson’s assets generally areheld by, and its operations generally are conducted through its subsidiaries.  Within the meaning of Regulation S-X, Rule 3-10,the Company has no assets or operations independent of its subsidiaries.  Under the terms of the Credit Facility, eachof our subsidiaries, other than minor subsidiaries, entered into a full andunconditional guarantee on a joint and several basis.  In order to provide subsidiary guarantees inconnection with the Credit Facility, we were required to issue similarguarantees to the 1998 Senior Note holders. The subsidiary guarantees related to both the Credit Facility and the1998 Senior Notes are full and unconditional, on a joint and several basis, andare given by all subsidiaries other than minor subsidiaries.  As of June 30, 2006 and December 31, 2005,the Company had not drawn any funds from the Credit Facility.  Watson is subject to certain financial andoperational covenants, all of which, as of June 30, 2006, the Company was incompliance.

**NOTE 10 – FINANCIAL INSTRUMENTS**

*Fairvalue of Financial Instruments*

The Company’s financialinstruments consist primarily of cash and cash equivalents, marketablesecurities, accounts and other receivables, investments, trade accountspayable, senior subordinated notes, CODES and embedded derivatives related tothe issuance of the CODES.  The carryingamounts of cash and cash equivalents, marketable securities, accounts and otherreceivables and trade accounts payable are representative of their respectivefair values due to their relatively short maturities.  The fair values of investments in companiesthat are publicly traded are based on quoted market prices.  The fair value of investments in privatelyheld companies, or cost-method investments, are based on historical cost,adjusted for any write-down related to impairment.  The Company estimates the fair value of itsfixed rate long-term obligations based on quoted market rates of interest andmaturity schedules for similar issues. The carrying value of these obligations approximates their fairvalue.  The fair value of the embeddedderivatives related to the CODES is based on a present value technique usingdiscounted expected future cash flows.

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*DerivativeFinancial Instruments*

The Company’sderivative financial instruments consist of embedded derivatives related to itsCODES.  These embedded derivativesinclude certain conversion features and a contingent interest feature.   See Note 8 for a more detailed descriptionof these features of the CODES.  Althoughthe conversion features represent embedded derivative financial instruments,based on the de minimis value of these features at the time of issuance and atJune 30, 2006, no value has been assigned to these instruments.  The contingent interest feature providesunique tax treatment under the Internal Revenue Service’s Contingent DebtRegulations.  In essence, interestaccrues, for tax purposes, on the basis of the instrument’s comparable yield(the yield at which the issuer would issue a fixed rate instrument with similarterms). This embedded derivative is reported on the Company’s CondensedConsolidated Balance Sheets at fair value and the changes in the fair value ofthe embedded derivative are reported as gains or losses in the Company’sCondensed Consolidated Statements of Income.

The carrying valueof the Company’s derivative financial instruments, which approximates fairvalue, decreased $0.7 million from $0.9 million at December 31, 2005 to $0.2million at June 30, 2006.  The change infair value was recorded as a reduction of interest expense during therespective period.

**NOTE 11 – COMMITMENTS AND CONTINGENCIES**

*Facility and EquipmentLeases*

The Company has enteredinto long-term operating leases for certain facilities and equipment.  The terms of the operating leases for theCompany’s facilities require the Company to pay property taxes, normalmaintenance expenses and maintain minimum insurance coverage.  Total rental expense for operating leases forthe six months ended June 30, 2006 and 2005 were $4.1 million and $5.5 million,respectively.

Futureminimum lease payments under all non-cancelable operating leases consist ofapproximately $4.1 million remaining in 2006, $6.7 million in 2007, $4.7million in 2008, $3.7 million in 2009, $2.4 million in 2010 and $13.8 millionthereafter.

*Employee Retirement Plans*

The Company maintainscertain defined contribution retirement plans covering substantially allemployees.  The Company contributes tothe plans based upon the employee contributions.  Watson’s contributions to these retirementplans for the three and six months ended June 30, 2006 were $1.7 million and$3.6 million, respectively. Watson’s contributions to these retirement plansfor the three and six months ended June 30, 2005 were $1.6 million and $3.3million, respectively.  The Company doesnot sponsor any defined benefit retirement plans or postretirement benefitplans.

*LegalMatters*

The Company is party tocertain lawsuits and legal proceedings, which are described in “PART I, ITEM 3.LEGAL PROCEEDINGS,” of our Annual Report on Form 10-K for the year endedDecember 31, 2005.  The following is adescription of material developments during the period covered by thisQuarterly Report and through the filing of this Quarterly Report, and should beread in conjunction with the Annual Report referenced above.

*Cipro Litigation.* In the action pending in theWisconsin Court of Appeals*(Barbara A.Meyers, et. al. v. Bayer AG, et. al., Appeal No. 2003AP2840)*,on June 8, 2006, the defendants filed a petition for review with the WisconsinSupreme Court.  On June 26, 2006, theplaintiffs opposed the petition for review. On July 26, 2006, the Wisconsin Supreme Court granted the defendants’petition for review.  The petition willbe decided after it has been fully briefed by the parties.

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*Governmental Reimbursement Investigations And Drug PricingLitigation.* Withrespect to the Drug Pricing Litigation pending against the Company and certainsubsidiaries, the plaintiffs in the Class Action case in the Multi-DistrictLitigation in U.S. District Court for the District of Massachusetts (*In re: Pharmaceutical Industry Average WholesalePrice Litigation, MDL Docket No. 1456*) have filed a motion requesting that different classes ofplaintiffs (including individuals who made co-payments for drugs reimbursed byMedicare and third-party payors, such as insurance companies and union healthbenefit funds) be certified by the Court so that the Court can decide whetherthe Company and the other defendants must pay damages to members of the classeswho do not choose to be excluded from the class.  The Company has filed an opposition to theMotion for Class Certification, and a hearing has been scheduled for September12, 2006.  In addition, the AttorneyGeneral’s Office in Idaho has requested that the Company meet to discusswhether that office should bring claims against the Company.  Additional actions in other states areanticipated.  These actions, if successful, could adversely affect theCompany and may have a material adverse effect on the Company’s business,results of operations, financial condition and cash flows.

*FDA Matters. *With respect to the May 13, 2002, consentdecree entered in connection with the Company’s Corona, California, facility (*United States of America v. Watson Laboratories, Inc., and Allen Y.Chao*, United States District Court for the Central District ofCalifornia, EDCV-02-412-VAP), the U.S. Food and Drug Administration conductedan inspection of the facility from July 9 – 21, 2006.  At the conclusion of the inspection no formalobservations were made and no FDA Form 483 was issued.  However, if in the future, the FDA determinesthat, with respect to its Corona facility, Watson has failed to comply with theconsent decree or FDA regulations, including cGMPs, the consent decree allowsthe FDA to order Watson to take a variety of actions to remedy thedeficiencies. These actions could include ceasing manufacturing and relatedoperations at the Corona facility, and recalling affected products.  Such actions, if taken by the FDA, couldadversely affect the Company, its results of operations, financial positionand/or cash flows.

*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 August 8, 2006,approximately 170 cases were pending against Watson and/or its affiliates instate and federal courts, representing claims by approximately 1,345plaintiffs. Discovery is ongoing. 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.

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

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**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS**

The followingdiscussion of our financial condition and the results of operations should beread in conjunction with the Condensed Consolidated Financial Statements andnotes thereto included elsewhere in this Quarterly Report on Form 10-Q (“QuarterlyReport”).  This discussion containsforward-looking statements that are subject to known and unknown risks,uncertainties and other factors that may cause our actual results to differmaterially from those expressed or implied by such forward-lookingstatements.  These risks, uncertaintiesand other factors include, among others, those identified under “CautionaryNote Regarding Forward-Looking Statements” and elsewhere in this QuarterlyReport and under “Risks Related to our Business” in our Annual Report on Form10-K for the year ended December 31, 2005.

**Overview**

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

Prescription pharmaceuticalproducts in the U.S. are generally marketed as either generic or brandpharmaceuticals.  Generic pharmaceuticalproducts are bioequivalents of their respective brand products and provide acost-efficient alternative to brand products. Brand pharmaceutical products aremarketed under brand names through programs that are designed to generatephysician and consumer loyalty.  As aresult of the differences between the two types of products, we currentlyoperate and manage our business as two segments: Generic and Brand.

The Company has announcedseveral recent cost reduction initiatives including the closure of our PuertoRico manufacturing facility and the planned divestiture of our Phoenix, Arizonainjectable facility by early 2007.  TheCompany is also establishing a foreign operating infrastructure to supply theU.S. market which includes a recently acquired solid dose manufacturingfacility in Goa, India; an increased investment in a Chinese/Taiwanese companyspecializing in the development and manufacture of active pharmaceuticalingredients (“API”); and the acquisition of Mumbai, India-based SekhsariaChemicals, Ltd. that provides API and finished dosage formulation expertise tothe global pharmaceutical industry.

On March 13, 2006, the Company announced a definitive merger agreement (the“Merger Agreement”) to acquire all the outstanding shares of common stock ofAndrx Corporation (Nasdaq: ADRX) (“Andrx”) in an all-cash transaction for $25per share, or total consideration of approximately $1.9 billion.  Andrx distributes pharmaceutical productsprimarily to independent and chain pharmacies and physicians’ offices and isconsidered a leader in formulating and commercializing difficult-to-replicatecontrolled-release pharmaceutical products and selective immediate-releaseproducts.  The consummation of the mergeris subject to U.S. regulatory approval. Following the close of the merger, Watson will have three operatingsegments: Generic, Brand and Distribution. The following discussion does not include or incorporate the anticipatedimpact of Andrx on our business, results of operations, financial condition,cash flows or expectations for 2006.  Foradditional information on the merger with Andrx, refer to NOTE 1 – GENERAL inthe accompanying Notes to Condensed Consolidated Financial Statements in thisQuarterly Report.

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**Results of Operations**

***ThreeMonths Ended June 30, 2006 Compared to the Three Months Ended June 30, 2005***

***NetRevenues***

|                                     | ** ** | **Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|-------------------------------------|------------|-----------------------------------------------------|------------|------------|------------|
| **($ in thousands):**     | ** ** | **2006**                                            | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                |       |                                                |       |       |       |   |   |   |   |
| Generic segment                     |       |                                                |       |       |       |   |   |   |   |
| Generics                            |       | $                                                   | 340,848    |       | $          | 234,484 |   | $ | 106,364 |   | 45.4 | % |
| Generic oral contraceptives         |       | 78,593                                              |       | 77,969     |       | 624 |   | 0.8 | % |
| Total generic  product sales        |       | 419,441                                             |       | 312,453    |       | 106,988 |   | 34.2 | % |
| Other                               |       | 990                                                 |       | 1,149      |       | (159 | ) | (13.8 | )% |
| Total generic  segment net revenues |       | 420,431                                             |       | 313,602    |       | 106,829 |   | 34.1 | % |
| * *                            | * *   | * *                                            | * *   | * *   | * *   | * * | * * | * * | * * |
| Brand segment                       |       |                                                |       |       |       |   |   |   |   |
| Specialty Products                  |       | 44,434                                              |       | 54,710     |       | (10,276 | ) | (18.8 | )% |
| Nephrology                          |       | 43,617                                              |       | 46,036     |       | (2,419 | ) | (5.3 | )% |
| Total brand  product sales          |       | 88,051                                              |       | 100,746    |       | (12,695 | ) | (12.6 | )% |
| Other                               |       | 1,874                                               |       | 1,918      |       | (44 | ) | (2.3 | )% |
| Total brand  segment net revenues   |       | 89,925                                              |       | 102,664    |       | (12,739 | ) | (12.4 | )% |
| * *                            | * *   | * *                                            | * *   | * *   | * *   | * * | * * | * * | * * |
| Total net  revenues                 |       | $                                                   | 510,356    |       | $          | 416,266 |   | $ | 94,090 |   | 22.6 | % |

* *

*GenericSegment*

Our generic pharmaceutical business develops, manufactures, markets,sells and distributes generic products that are the therapeutic equivalent totheir brand name counterparts and are generally sold at prices significantlyless than the brand product. As such, generic products provide an effective andcost-efficient alternative to brand products. When patents or other regulatoryexclusivity no longer protect a brand product, opportunities exist to introduceoff-patent or generic counterparts to the brand product. Our portfolio ofgeneric products includes products we have internally developed, products wehave licensed from third parties, and products we distribute for third parties.

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

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

Our Generics product line includes oral dosage, transdermal, injectibleand transmucosal products used for a variety of indications including painmanagement, depression, hypertension and smoking cessation.

For the three months ended June 30, 2006, revenues from our Genericsegment increased $106.8 million or 34% over sales from the prior yearperiod.  Sales increased due to certainrecently launched authorized generic products including oxycodone HClcontrolled-release tablets that were launched during the fourth quarter of 2005and pravastatin sodium tablets that were launched during the second quarter of2006.  Sales from these authorizedgeneric products were $115.6 million during the second quarter of 2006.  Excluding these recently

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launched authorized generic products, revenues in our Generic segmentdeclined by $8.8 million or 3% compared to the same period in 2005.  This decline was due primarily to lowerpricing on the Company’s existing products.

*BrandSegment*

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

Our Specialty Products product line includes urology and a number ofother non-promoted products.

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

For the threemonths ended June 30, 2006, revenues from our Specialty Products groupdeclined approximately $10.3 million or 19%. The decrease in sales from our Specialty Products group for the threemonths ended June 30, 2006, ascompared to the prior year period was primarily attributable to a decrease inprescription volumes for our non-promoted specialty products and a reduction inwholesaler inventory levels as a result of our entry into inventory managementagreements with several of our large wholesale customers during 2005.  Saleslevels in the prior year period were also impacted by higher levels ofwholesaler buying in anticipation of price increases prior to entering into theinventory management agreements with those wholesalers.

***Gross Profit (Gross Margin)***

|                                       | ** ** | **Three Months Ended June 30,** | ** ** |
|---------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **Change** | ** ** |
|                                  |       |                                                |       |   |   |   |   |
| Overall  Consolidated Gross Margin    |       | 35.2                                                | %          | 49.3 | % | (14.1 | )% |
|                                  |       |                                                |       |   |   |   |   |
| Generic pharmaceutical products       |       | 26.9                                                | %          | 39.8 | % | (12.9 | )% |
| Brand pharmaceutical products         |       | 72.4                                                | %          | 77.1 | % | (4.7 | )% |
| Gross margin on  product net revenues |       | 34.8                                                | %          | 48.9 | % | (14.1 | )% |

Gross profitrepresents net revenues less cost of sales. Cost of sales includes the cost of manufacturing and packaging for theproducts we manufacture, the cost of products we purchase from third parties,our profit-sharing or royalty payments made to third parties, changes to ourinventory reserves and excess capacity utilization charges, whereapplicable.  Amortization of acquiredproduct rights is not included in our cost of sales.

Gross margins forour Generic segment declined to 26.9% from 39.8% in the year ago period.  The decrease in gross margin from our Genericsegment for the three months ended June 30, 2006 was primarily due to sales of oxycodone HCl controlled-release tablets andpravastatin sodium tablets during the second quarter of 2006.  Sales from these authorized generic productsgenerated $6.8 million of gross profit on $115.6 million of revenues.  Excluding these newly launched products, thegross margin for our Generic segment was 34.7%. Margins in our Generic segment were also adversely impacted by plantrationalization costs of $5.9 million in the second quarter and price declinesover the past year on existing products.

During the secondquarter of 2006, gross margins from our Brand segment decreased primarily dueto higher costs and lower production levels in our Salt Lake City, Utahtransdermal manufacturing facility. Margins were also impacted by plant rationalization costs incurred inconnection with the planned divestiture of our Phoenix, Arizona sterilemanufacturing facility.

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***Researchand Development Expenses***

|                                                | ** ** | **Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|------------------------------------------------|------------|-----------------------------------------------------|------------|------------|------------|
| **($ in thousands):**                | ** ** | **2006**                                            | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                           |       |                                                |       |       |       |   |   |   |   |
| Research and  development expenses by segment: |       |                                                |       |       |       |   |   |   |   |
| Generic                                        |       | $                                                   | 18,124     |       | $          | 21,818 |   | $ | (3,694 | ) | (16.9 | )% |
| Brand                                          |       | 13,001                                              |       | 9,668      |       | 3,333 |   | 34.5 | % |
| Total research  and development expenses       |       | $                                                   | 31,125     |       | $          | 31,486 |   | $ | (361 | ) | (1.1 | )% |
| *as a %  of net revenues*                      | * *   | *6.1*                                               | *%*        | *7.6*      | *%*        | * * | * * | * * | * * |

Research anddevelopment expenses consist predominantly of personnel costs, contractresearch, development and facilities costs associated with the development ofour products.   The level ofresearch and development expenses are influenced greatly by the commencementand termination of development programs and clinical studies during eachquarter.

Research anddevelopment expenses within our Generic segment decreased during the threemonths ended June 30,2006, as compared to the same period of the prior year, due to lower biostudycosts in the current period.

Research anddevelopment expenses within our Brand segment increased during the three monthsended June 30, 2006, as compared to the same period of the prior year,primarily due to the commencement of Phase III studies on the gel formulationof oxybutynin for overactive bladder.

***Selling,General and Administrative Expenses***
| ** **                                          | ** ** | **Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------------------|------------|------------|------------|
| **($ in thousands):**                     | ** ** | **2006**                                            | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                                |       |                                                |       |       |       |   |   |   |   |
| Selling and  marketing expenses by segment:         |       |                                                |       |       |       |   |   |   |   |
| Generic                                             |       | $                                                   | 13,526     |       | $          | 11,688 |   | $ | 1,838 |   | 15.7 | % |
| Brand                                               |       | 29,765                                              |       | 30,532     |       | (767 | ) | (2.5 | )% |
| Total segment  selling and marketing expenses       |       | 43,291                                              |       | 42,220     |       | 1,071 |   | 2.5 | % |
|                                                |       |                                                |       |       |       |   |   |   |   |
| Corporate general and administrative                |       | 27,483                                              |       | 25,905     |       | 1,578 |   | 6.1 | % |
| Total selling,  general and administrative expenses |       | $                                                   | 70,774     |       | $          | 68,125 |   | $ | 2,649 |   | 3.9 | % |
| *as a %  of net revenues*                           | * *   | *13.9*                                              | *%*        | *16.4*     | *%*        | * * | * * | * * | * * |

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

Generic segment selling and marketing expenses increased during thethree months ended June 30, 2006 as compared to the same period of the prioryear primarily due to higher distribution costs.

Brand segment selling and marketing expenses decreased during the threemonths ended June 30, 2006 as compared to the same period of the prior year dueto lower product spending for Oxytrol during the current quarter.

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Corporate general and administrative increased during three monthsended June 30, 2006 as compared to the same period of the prior year due tohigher corporate insurance costs and administrative costs associated with our recentlyacquired operations in India.

***Amortization***
|                                 | ** ** | **Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|-----------------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                                            | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                            |       |                                                |       |       |       |   |   |   |   |
| Amortization                    |       | $                                                   | 41,101     |       | $          | 41,101 |   | $ | — |   | 0.0 | % |
| *as a %  of net revenues*       | * *   | *8.1*                                               | *%*        | *9.9*      | *%*        | * * | * * | * * | * * |
|                                 |            |                                                     |            |            |            |  |  |  |  |  |  |  |

 

The Company’samortizable assets consist primarily of acquired product rights.

***Losson Impairment***
|                                       | ** ** | **Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|---------------------------------------|------------|-----------------------------------------------------|------------|------------|------------|
| **($ in thousands):**       | ** ** | **2006**                                            | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                  |       |                                                |       |       |       |   |   |   |   |
| Loss on  impairment of product rights |       | $                                                   | 66,981     |       | $          | — |   | $ | 66,981 |   | 100.0 | % |
| *as a %  of net revenues*             | * *   | *13.1*                                              | *%*        | *0.0*      | *%*        | * * | * * | * * | * * |
|                                       |            |                                                     |            |            |            |  |  |  |  |  |  |  |

 

During the secondquarter of 2006, the Company recognized a $67.0 million loss on impairment ofproduct rights as a result of the reduction in our long range sales forecastfor certain non-promoted products, predominantly Alora® and Actigall® (refer to Note 7 in the accompanying Notes to CondensedConsolidated Financial Statements in this Quarterly Report).

***Earnings(Losses) on Equity Method Investments***
|                                                 | ** ** | **Three Months Ended June 30,** | ** ** | **Change**   | ** ** |
|-------------------------------------------------|------------|-----------------------------------------------------|------------|--------------|------------|
| **($ in thousands):**                 | ** ** | **2006**                                            | ** ** | **2005**     | ** ** | **Dollars** | ** ** | **%** | ** ** |
| ** **                                      | ** ** | ** **                                          | ** ** | **Restated** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                            | ** ** | ** **                                          | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Earnings  (losses) on equity method investments |       | $                                                   | 1,646      |         | $          | (997 | ) | $ | 2,643 |   | (265.1 | )% |
| *as a %  of net revenues*                       | * *   | *0.3*                                               | *%*        | *-0.2*       | *%*        | * * | * * | * * | * * |
|                                                 |            |                                                     |            |              |            |  |  |  |  |  |  |  |

The Company’sequity investments are accounted for under the equity-method when the Company’sownership does not exceed 50% and when the Company can exert significantinfluence over the management of the investee.  Inthe year ended December 31, 2005 the Company acquired additional common sharesin Scinopharm Taiwan, Ltd. (“Scinopharm”), previously accounted for under thecost method, to an ownership level of approximately 24%. Accordingly, asrequired by Accounting Principles Board (“APB”) Opinion No. 18, “The EquityMethod of Accounting for Investments in Common Stock” (“APB 18”), loss onequity method investments has been restated for all periods presented toconform to current period presentation. In January 2006, we made an additional $12.0 million investment inScinopharm which increased our ownership share to approximately 31%.

The earningsrecorded during the three months ended June 30, 2006 consists primarily of our equity in earnings ofSomerset Pharmaceuticals, Inc., our joint venture with Mylan Laboratories, Inc.(“Somerset”).  Somerset has developedEmsam®, a selegeline patch forthe treatment of depression.  On February28, 2006, the U.S. Food and Drug

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Administration (“FDA”)granted Somerset final approval for Emsam® and Bristol-Myers Squibb launched Emsam® in the second quarter of2006.  As a result of thisapproval, the Company expects Somerset to be profitable for the remainder of2006.

***InterestIncome***

|                                 | ** ** | **Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|-----------------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                                            | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                            |       |                                                |       |       |       |   |   |   |   |
| Interest income                 |       | $                                                   | 6,913      |       | $          | 4,546 |   | $ | 2,367 |   | 52.1 | % |
| *as a %  of net revenues*       | * *   | *1.4*                                               | *%*        | *1.1*      | *%*        | * * | * * | * * | * * |
|                                 |            |                                                     |            |            |            |  |  |  |  |  |  |  |

 

Interest incomeincreased during thethree months ended June 30, 2006 as compared to the same period of the prioryear due to higher balances of cash and marketable securities and higher interestrates on invested balances in the current quarter.

***InterestExpense***
|                                                                                           | ** ** | **Three Months Ended June 30,** | ** ** | **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                                                     |       | 150                                                 |       | 255        |       | (105 | ) | (41.2 | )% |
| Interest and  fees on credit facility                                                     |       | 248                                                 |       | 426        |       | (178 | ) | (41.8 | )% |
| Change in  derivative value                                                               |       | (278                                                | )          | (272       | )          | (6 | ) | 2.2 | % |
| Interest expense  - other                                                                 |       | 51                                                  |       | 64         |       | (13 | ) | (20.3 | )% |
| Interest expense                                                                          |       | $                                                   | 3,322      |       | $          | 3,624 |   | $ | (302 | ) | (8.3 | )% |
| *as a %  of net revenues*                                                                 | * *   | *0.7*                                               | *%*        | *0.9*      | *%*        | * * | * * | * * | * * |

 

Interest expensedecreased for the three month period ended June 30, 2006 due to the redemption ofthe 1998 Senior Notes in the current quarter and due to reduced undrawn fees onthe Company’s credit facility.

***Provisionfor Income Taxes***
|                                 | ** ** | **Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|-----------------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                                            | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                            |       |                                                |       |       |       |   |   |   |   |
| Provision for  income taxes     |       | $                                                   | (9,532     | )          | $          | 24,002 |   | $ | (33,534 | ) | (139.7 | )% |
| *as a % of net revenues*        | * *   | *-1.9*                                              | *%*        | *5.8*      | *%*        | * * | * * | * * | * * |
| *Effective  tax rate*           | * *   | *-37.9*                                             | *%*        | *37.2*     | *%*        | * * | * * | * * | * * |
|                                 |            |                                                     |            |            |            |  |  |  |  |  |  |  |

 

The provision forincome taxes differs from the amount computed by applying the statutory U.S.federal income tax rate primarily due to state taxes and other factors which,combined, increases the effective tax rate.

The Companyrecorded an income tax benefit in the three months ended June 30, 2006 related to the lossbefore income taxes.

28

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***SegmentContribution***
|                                 | ** ** | **Three Months Ended June 30,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|-----------------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                                            | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                            |       |                                                |       |       |       |   |   |   |   |
| Segment  contribution           |       |                                                |       |       |       |   |   |   |   |
| Generic                         |       | $                                                   | 82,217     |       | $          | 91,955 |   | $ | (9,738 | ) | (10.6 | )% |
| Brand                           |       | 22,863                                              |       | 39,392     |       | (16,529 | ) | (42.0 | )% |
|                            |       | $                                                   | 105,080    |       | $          | 131,347 |   | $ | (26,267 | ) | (20.0 | )% |
| *as % of  net revenues*         | * *   | *20.6*                                              | *%*        | *31.6*     | *%*        | * * | * * | * * | * * |

 

Generic segmentcontribution decreased for the three months ended June 30, 2006, as compared to the sameperiod of the prior year, due to lower gross profit and higher selling andmarketing expenses.

Brand segmentcontribution decreased for the three months ended June 30, 2006, as compared to the sameperiod of the prior year, primarily due to a decrease in sales of SpecialtyProducts, lower gross margins and higher research and development expenses.

For moreinformation on segment contribution, refer to above Management’s Discussion andAnalysis of Financial Condition and Results of Operations and Note 5 in theaccompanying Notes to Condensed Consolidated Financial Statements in thisQuarterly Report.

**Resultsof Operations**

***SixMonths Ended June 30, 2006 Compared to the Six Months Ended June 30, 2005***

***NetRevenues***

|                                     | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|-------------------------------------|------------|---------------------------------------------------|------------|------------|------------|
| **($ in thousands):**     | ** ** | **2006**                                          | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                |       |                                              |       |       |       |   |   |   |   |
| Generic segment                     |       |                                              |       |       |       |   |   |   |   |
| Generics                            |       | $                                                 | 586,291    |       | $          | 446,005 |   | $ | 140,286 |   | 31.5 | % |
| Generic OC’s                   |       | 154,565                                           |       | 159,612    |       | (5,047 | ) | (3.2 | )% |
| Total generic  product sales        |       | 740,856                                           |       | 605,617    |       | 135,239 |   | 22.3 | % |
| Other                               |       | 1,665                                             |       | 2,235      |       | (570 | ) | (25.5 | )% |
| Total generic segment  net revenues |       | 742,521                                           |       | 607,852    |       | 134,669 |   | 22.2 | % |
| * *                            | * *   | * *                                          | * *   | * *   | * *   | * * | * * | * * | * * |
| Brand segment                       |       |                                              |       |       |       |   |   |   |   |
| Specialty Products                  |       | 83,504                                            |       | 118,172    |       | (34,668 | ) | (29.3 | )% |
| Nephrology                          |       | 87,784                                            |       | 87,099     |       | 685 |   | 0.8 | % |
| Total brand  product sales          |       | 171,288                                           |       | 205,271    |       | (33,983 | ) | (16.6 | )% |
| Other                               |       | 3,780                                             |       | 3,971      |       | (191 | ) | (4.8 | )% |
| Total brand  segment net revenues   |       | 175,068                                           |       | 209,242    |       | (34,174 | ) | (16.3 | )% |
| * *                            | * *   | * *                                          | * *   | * *   | * *   | * * | * * | * * | * * |
| Total net  revenues                 |       | $                                                 | 917,589    |       | $          | 817,094 |   | $ | 100,495 |   | 12.3 | % |

29

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*GenericSegment*

For the six months ended June 30, 2006, revenues from our Genericsegment increased $134.7 million or 22% over sales from the prior yearperiod.  Sales increased due to certainrecently launched authorized generic products including oxycodone HClcontrolled-release tablets that were launched during the fourth quarter of 2005and pravastatin sodium tablets that were launched during the second quarter of2006.  Sales from these authorizedgeneric products were $146.1 million during the six months ended June 30, 2006.  Excluding these recently launched authorizedgeneric products, revenues in our Generic segment declined by $10.8 million or2%.  This decline was due primarily tolower pricing on the Company’s existing products.

For 2006, we expect total net revenues in the Generic segment to rangebetween $1.4 and $1.5 billion.  We expectsales in the second half of 2006 to increase slightly from first half levels asthe Company expects to launch several new products later in the year.

*BrandSegment*

The $34.7 millionor 29% decrease in sales from our Specialty Products group for the six months ended June 30, 2006,as compared to the same prior year period, was primarily attributable to adecrease in prescription volumes for our non-promoted specialty products and areduction in wholesaler inventory levels resulting from our entry intoinventory management agreements with some of our larger customers during2005.  The reduction in sales for theperiod 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 levelsin the prior year period were also impacted by high levels of wholesaler buyingin anticipation of price increases prior to entering into the inventorymanagement agreements with those wholesalers.

For 2006, we expect total net revenues for our Brand segment to beapproximately $350 to $360 million.

***Gross Profit (Gross Margin)***
|                                       | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------|------------|---------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                          | ** ** | **2005** | ** ** | **Change** | ** ** |
|                                  |       |                                              |       |   |   |   |   |
| Overall  Consolidated Gross Margin    |       | 38.4                                              | %          | 48.8 | % | (10.4 | )% |
|                                  |       |                                              |       |   |   |   |   |
| Generic pharmaceutical products       |       | 29.3                                              | %          | 38.7 | % | (9.4 | )% |
| Brand pharmaceutical products         |       | 75.7                                              | %          | 77.2 | % | (1.5 | )% |
| Gross margin on  product net revenues |       | 38.0                                              | %          | 48.4 | % | (10.4 | )% |

Gross margins forour Generic segment declined to 29.3% from 38.7% in the year ago period.  The decrease in gross margin from our Genericsegment was primarily due to sales of oxycodone HCl controlled-release tablets for the six monthsended June 30, 2006 and pravastatin sodium tablets during thesecond quarter of 2006 each of which are lower margin products.

30

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We expect ourconsolidated gross margins to improve in the second half of 2006 due toexpected new product launches and reductions in our manufacturing costs as wewind down our Puerto Rico manufacturing operations.  For 2006, we expect consolidated grossmargins of approximately 41%.

***Researchand Development Expenses***

|                                                | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------|------------|------------|------------|
| **($ in thousands):**                | ** ** | **2006**                                          | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                           |       |                                              |       |       |       |   |   |   |   |
| Research and  development expenses by segment: |       |                                              |       |       |       |   |   |   |   |
| Generic                                        |       | $                                                 | 38,619     |       | $          | 40,962 |   | $ | (2,343 | ) | (5.7 | )% |
| Brand                                          |       | 22,343                                            |       | 19,362     |       | 2,981 |   | 15.4 | % |
| Total research  and development expenses       |       | $                                                 | 60,962     |       | $          | 60,324 |   | $ | 638 |   | 1.1 | % |
| *as a %  of net revenues*                      | * *   | *6.6*                                             | *%*        | *7.4*      | *%*        | * * | * * | * * | * * |

 

Research anddevelopment expenses within our Generic segment decreased during the six monthsended June 30,2006, as compared to the same period of the prior year, due to lower biostudycosts particularly in the second quarter of 2006.

Research anddevelopment expenses within our Brand segment increased during the six monthsended June 30, 2006, as compared to the same period of the prior year,primarily due to the commencement of Phase III studies on the gel formulationof oxybutynin for overactive bladder.

Research anddevelopment investment for 2006 is estimated to range between 6.5% and 7% ofexpected total net revenue.  Research anddevelopment spending is expected to fluctuate during the remaining quarters of2006 in tandem with the timing of clinical study costs associated with (i) theCompany’s generic product pipeline, (ii) the continuation of Phase III studieson the silodosin product for benign prostatic hyperplasia, as well as (iii) thecontinuation of Phase III studies on the next generation formulation ofoxybutynin for overactive bladder.

***Selling,General and Administrative Expenses***
|                                                     | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------------|------------|------------|------------|
| **($ in thousands):**                     | ** ** | **2006**                                          | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                                |       |                                              |       |       |       |   |   |   |   |
| Selling and  marketing expenses by segment:         |       |                                              |       |       |       |   |   |   |   |
| Generic                                             |       | $                                                 | 26,464     |       | $          | 22,948 |   | $ | 3,516 |   | 15.3 | % |
| Brand                                               |       | 58,740                                            |       | 58,000     |       | 740 |   | 1.3 | % |
| Total segment  selling and marketing expenses       |       | 85,204                                            |       | 80,948     |       | 4,256 |   | 5.3 | % |
|                                                |       |                                              |       |       |       |   |   |   |   |
| Corporate general and administrative                |       | 52,320                                            |       | 50,828     |       | 1,492 |   | 2.9 | % |
| Total selling,  general and administrative expenses |       | $                                                 | 137,524    |       | $          | 131,776 |   | $ | 5,748 |   | 4.4 | % |
| *as a %  of net revenues*                           | * *   | *15.0*                                            | *%*        | *16.1*     | *%*        | * * | * * | * * | * * |

Generic segment selling and marketing expenses increased during the sixmonths ended June 30, 2006 as compared to the same period of the prior year primarilydue to higher distribution costs.

Selling, generaland administrative expenses for 2006 are estimated to range between 14.5% and15% of expected total net revenue.

31

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***Amortization***
|                                 | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|---------------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                                          | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                            |       |                                              |       |       |       |   |   |   |   |
| Amortization                    |       | $                                                 | 82,201     |       | $          | 81,739 |   | $ | 462 |   | 0.6 | % |
| *as a % of net revenues*        | * *   | *9.0*                                             | *%*        | *10.0*     | *%*        | * * | * * | * * | * * |
|                                 |            |                                                   |            |            |            |  |  |  |  |  |  |  |

 

The Company’samortizable assets consist primarily of acquired product rights.

We expectquarterly amortization expense for the remainder of 2006 to be approximately$39.4 million after recognizing a loss on impairment of product rights in thecurrent quarter (refer to “Loss on Impairment” below).

We expectquarterly amortization expense for the remainder of 2006 to be approximately$39.4 million after recognizing a loss on impairment of product rights in thecurrent quarter.

***Losson Impairment***
|                                       | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|---------------------------------------|------------|---------------------------------------------------|------------|------------|------------|
| **($ in thousands):**       | ** ** | **2006**                                          | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                  |       |                                              |       |       |       |   |   |   |   |
| Loss on impairment of  product rights |       | $                                                 | 66,981     |       | $          | — |   | $ | 66,981 |   | 100.0 | % |
| *as a % of net revenues*              | * *   | *7.3*                                             | *%*        | *0.0*      | *%*        | * * | * * | * * | * * |
|                                       |            |                                                   |            |            |            |  |  |  |  |  |  |  |

 

During the secondquarter of 2006, the Company recognized a $67.0 million loss on impairment ofproduct rights resulting from a downward revision of long range product salespredominantly relating to Alora® and Actigall®(refer to Note 7 in the accompanying Notes to Condensed Consolidated FinancialStatements in this Quarterly Report).

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

|                                                 | ** ** | **Six Months Ended June 30,** | ** ** | **Change**   | ** ** |
|-------------------------------------------------|------------|---------------------------------------------------|------------|--------------|------------|
| **($ in thousands):**                 | ** ** | **2006**                                          | ** ** | **2005**     | ** ** | **Dollars** | ** ** | **%** | ** ** |
| ** **                                      | ** ** | ** **                                        | ** ** | **Restated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Earnings (losses) on  equity method investments |       | $                                                 | 1,454      |         | $          | (875 | ) | $ | 2,329 |   | (266.2 | )% |
| *as a % of net revenues*                        | * *   | *0.2*                                             | *%*        | *-0.1*       | *%*        | * * | * * | * * | * * |
|                                                 |            |                                                   |            |              |            |  |  |  |  |  |  |  |

The earnings onequity method investments recorded during the six months ended June 30, 2006 consistprimarily of our share of earnings generated by Somerset.  Somerset has developed Emsam®, a selegeline patch for thetreatment of depression.  On February 28,2006, the FDA granted Somerset final approval for Emsam® and Bristol-Myers Squibb launched Emsan® in the second quarter of2006.  As a result of thisapproval, the Company expects Somerset to be profitable for the remainder of2006.

32

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***Gainon Sale of Securities***

|                                 | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|---------------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                                          | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                            |       |                                              |       |       |       |   |   |   |   |
| Gain on sale of  securities     |       | $                                                 | 3,695      |       | $          | — |   | $ | 3,695 |   | 100.0 | % |
| *as a % of net revenues*        | * *   | *0.4*                                             | *%*        | *0.0*      | *%*        | * * | * * | * * | * * |
|                                 |            |                                                   |            |            |            |  |  |  |  |  |  |  |

 

The 2006 gain onsale of securities resulted from the sale of our investment in Adheris,Inc.  We received cash proceeds of $4.7million from our sale of our entire investment in Adheris, Inc. and may receiveadditional proceeds upon the achievement of certain earn-out milestones.  We did not sell any securities during the sixmonths ended June 30, 2005.

***InterestIncome***
|                                 | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|---------------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                                          | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                            |       |                                              |       |       |       |   |   |   |   |
| Interest income                 |       | $                                                 | 13,165     |       | $          | 8,652 |   | $ | 4,513 |   | 52.2 | % |
| *as a % of net revenues*        | * *   | *1.4*                                             | *%*        | *1.1*      | *%*        | * * | * * | * * | * * |
|                                 |            |                                                   |            |            |            |  |  |  |  |  |  |  |

 

Interest incomeincreased during the sixmonths ended June 30, 2006 as compared to the same period of the prior year dueto higher balances of cash and marketable securities and higher rates of returnon invested balances in the current period.

***InterestExpense***

|                                       | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|---------------------------------------|------------|---------------------------------------------------|------------|------------|------------|
| **($ in thousands):**       | ** ** | **2006**                                          | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                                  |       |                                              |       |       |       |   |   |   |   |
| Interest expense -  CODES             |       | $                                                 | 6,302      |       | $          | 6,302 |   | $ | — |   | 0.0 | % |
| Interest expense - 1998  Senior Notes |       | 406                                               |       | 511        |       | (105 | ) | (20.5 | )% |
| Interest and fees on  credit facility |       | 495                                               |       | 842        |       | (347 | ) | (41.2 | )% |
| Change in derivative  value           |       | (731                                              | )          | (841       | )          | 110 |   | (13.1 | )% |
| Interest expense -  other             |       | 151                                               |       | 100        |       | 51 |   | 51.0 | % |
| Interest expense                      |       | $                                                 | 6,623      |       | $          | 6,914 |   | $ | (291 | ) | (4.2 | )% |
| *as a % of net revenues*              | * *   | *0.7*                                             | *%*        | *0.8*      | *%*        | * * | * * | * * | * * |

 

Interest expensedecreased for the six month period ended June 30, 2006 due to the redemption ofthe 1998 Senior Notes in the quarter ended June 30, 2006 and due to reducedfees on the credit facility.

33

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***Provisionfor Income Taxes***

|                                 | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|---------------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                                          | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                            |       |                                              |       |       |       |   |   |   |   |
| Provision for income  taxes     |       | $                                                 | 5,867      |       | $          | 46,854 |   | $ | (40,987 | ) | (87.5 | )% |
| *as a % of  net revenues*       | * *   | *0.6*                                             | *%*        | *5.7*      | *%*        | * * | * * | * * | * * |
| *Effective tax rate*            | * *   | *37.9*                                            | *%*        | *37.2*     | *%*        | * * | * * | * * | * * |
|                                 |            |                                                   |            |            |            |  |  |  |  |  |  |  |

 

The provision forincome taxes decreased in the six months ended June 30, 2006 due to reducedlevels of income before income taxes. The higher effective tax rate for the six months ended June 30, 2006, ascompared to the same period of the prior year, primarily reflect limitations onthe deductibility of charitable contributions during the period and the effectof the adoption of Statementof Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-BasedPayment” (“SFAS 123R”) during the current period.  Beginning January 1, 2006, in conjunctionwith the adoption of SFAS 123R, incentive stock option deductions areconsidered a permanent difference which has the impact of increasing oureffective tax rate in the period.

***SegmentContribution***
|                                 | ** ** | **Six Months Ended June 30,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|---------------------------------------------------|------------|------------|------------|
| **($ in thousands):** | ** ** | **2006**                                          | ** ** | **2005**   | ** ** | **Dollars** | ** ** | **%** | ** ** |
|                            |       |                                              |       |       |       |   |   |   |   |
| Segment  contribution           |       |                                              |       |       |       |   |   |   |   |
| Generic                         |       | $                                                 | 153,490    |       | $          | 172,610 |   | $ | (19,120 | ) | (11.1 | )% |
| Brand                           |       | 52,319                                            |       | 85,049     |       | (32,730 | ) | (38.5 | )% |
|                            |       | $                                                 | 205,809    |       | $          | 257,659 |   | $ | (51,850 | ) | (20.1 | )% |
| *as % of  net revenues*         | * *   | *22.4*                                            | *%*        | *31.5*     | *%*        | * * | * * | * * | * * |

 

Generic segmentcontribution decreased for the six months ended June 30, 2006, as compared tothe same period of the prior year, due to lower gross profit and higher sellingand marketing expenses.

Brand segmentcontribution decreased for the six months ended June 30, 2006, as compared tothe same period of the prior year, primarily due to a decrease in sales of SpecialtyProducts and higher research and development and selling and marketingexpenses.

For moreinformation on segment contribution, refer to above Management’s Discussion andAnalysis of Financial Condition and Results of Operations and Note 5 in theaccompanying Notes to Condensed Consolidated Financial Statements in thisQuarterly Report.

**Liquidityand Capital Resources**

***Cashfrom Operations***

Watson’s primarysource of liquidity is cash from operations. Net working capital at June 30, 2006 was $1.19 billion compared to $1.11billion at December 31, 2005 and $1.08 billion at June 30, 2005.

34

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We expect that 2006 cash flows from operatingactivities will continue to exceed net income. In addition, management expects that 2006 cash flows from operatingactivities and available cash balances will be sufficient to fund our operatingliquidity needs.

Summarized cashflow information is as follows:

|                                            | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------------|------------|
| **($ in thousands):**            | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
|                                       |       |                                              |       |   |   |
| Net cash provided by  operating activities |       | $                                                 | 196,225    |   | $ | 178,944 |   |
|                                            |            |                                                   |            |  |  |  |  |

#  

Net cash provided byoperating activities increased during the six month period ended June 30, 2006,as compared to the same period of the prior year, due primarily to an increasein accounts payable (refer to discussion under “Changes in Working Capital”)offset by an increase in inventories.

Cash flows fromoperations are expected to range between $325 and $340 million in 2006.

***Changesin Working Capital***

Working capital at June30, 2006 and December 31, 2005 is summarized as follows:
|                                         | ** ** | **June 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** |
|-----------------------------------------|------------|-------------------|------------|-----------------------|------------|----------------|------------|
| **($ in thousands):**         | ** ** | **2006**          | ** ** | **2005**              | ** ** | **(Decrease)** | ** ** |
|                                    |       |              |       |                  |       |           |       |
| Current Assets:                         |       |              |       |                  |       |           |       |
| Cash and cash  equivalents              |       | $                 | 600,411    |                  | $          | 467,451        |       | $ | 132,960 |   |
| Marketable  securities                  |       | 169,037           |       | 162,475               |       | 6,562          |       |
| Accounts  receivable, net of allowances |       | 347,813           |       | 333,832               |       | 13,981         |       |
| Inventories                             |       | 310,421           |       | 278,062               |       | 32,359         |       |
| Other                                   |       | 144,375           |       | 118,610               |       | 25,765         |       |
| Total current  assets                   |       | 1,572,057         |       | 1,360,430             |       | 211,627        |       |
| Current  liabilities:                   |       |              |       |                  |       |           |       |
| Accounts payable  and accrued expenses  |       | 298,639           |       | 211,160               |       | 87,479         |       |
| Current portion  of long-term debt      |       | 10,392            |       | —                |       | 10,392         |       |
| Other                                   |       | 72,077            |       | 34,510                |       | 37,567         |       |
| Total current  liabilities              |       | 381,108           |       | 245,670               |       | 135,438        |       |
|                                    |       |              |       |                  |       |           |       |
| Working Capital                         |       | $                 | 1,190,949  |                  | $          | 1,114,760      |       | $ | 76,189 |   |
|                                    |       |              |       |                  |       |           |       |
| Current Ratio                           |       | 4.12              |       | 5.54                  |       |           |       |

 

The increase ininventory at June 30, 2006 was primarily due to the launch of authorizedgeneric pravastatin sodium tablets during the second quarter of 2006.  Accounts payable increased at June 30, 2006primarily due to higher royalties payable on sales of oxycodone extended-release and pravastatinsodium tablets.  Current portionof long-term debt increased at June 30, 2006 as we assumed debt in ouracquisition of Sekhsaria Chemicals, Ltd. (“Sekhsaria”) which we plan to repayprior to the end of 2006.

35

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***CapitalExpenditures***

Our capitalexpenditures are summarized as follows:

|                                      | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------|------------|---------------------------------------------------|------------|
| **($ in thousands):**      | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
|                                 |       |                                              |       |   |   |
| Additions to property  and equipment |       | $                                                 | 18,179     |   | $ | 38,103 |   |
|                                      |            |                                                   |            |  |  |  |  |

Capital expenditures forthe six months ended June 30, 2006 included additions to machinery andequipment at various Watson locations. We expect to spend approximately $50 million for property and equipmentadditions in 2006.

***Debtand Borrowing Capacity***

Our debt and borrowingcapacity at June 30, 2006 and December 31, 2005 is summarized as follows:
|                                    | ** ** | **June 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** |
|------------------------------------|------------|-------------------|------------|-----------------------|------------|----------------|------------|
| **($ in thousands):**    | ** ** | **2006**          | ** ** | **2005**              | ** ** | **(Decrease)** | ** ** |
|                               |       |              |       |                  |       |           |       |
| Current portion  of long-term debt |       | $                 | 10,392     |                  | $          | —         |       | $ | 10,392 |   |
| Long-term debt                     |       | 574,013           |       | 587,935               |       | (13,922        | )          |
| Total debt                         |       | $                 | 584,405    |                  | $          | 587,935        |       | $ | (3,530 | ) |
| Debt to capital  ratio             |       | 21.5              | %          | 21.8                  | %          |           |       |

 

In March 2003, we issued$575 million of our CODES.  As of June30, 2006, the entire amount of the CODES remained outstanding at an effectiveannual interest rate of approximately 2.1%.

In May 1998, weissued $150 million of our 1998 Senior Notes. On March 31, 2006, the Company initiated a redemption notice to theholders of all of its outstanding 1998 Senior Notes.  As a result, the remaining 1998 Senior Noteswere redeemed on May 23, 2006.

In May 2003, we enteredinto an agreement with a syndicate of lenders for a five-year, $300 millionsenior, unsecured revolving credit facility (the “Credit Facility”) for workingcapital and other general corporate purposes. On September 8, 2005, we entered into a Second Amendment to the CreditFacility on substantially the same terms and conditions except the feestructure was reduced and certain defined terms were added or amended.  On March 6, 2006, we entered into a ThirdAmendment to the Credit Facility which, among other things, permits the Companyto repurchase up to $300.0 million of its common stock.  As of June 30, 2006, the total $300 millionunder the Credit Facility was available to us. Watson’s assets generally are held by, and its operations generally areconducted through its subsidiaries. Within the meaning of Regulation S-X, Rule 3-10, the Company has noassets or operations independent of its subsidiaries.  Under the terms of the Credit Facility, eachof our subsidiaries, other than minor subsidiaries, entered into a full andunconditional guarantee on a joint and several basis.  In order to provide subsidiary guarantees inconnection with the Credit Facility, we were required to issue similarguarantees to the 1998 Senior Note holders. The subsidiary guarantees related to both the Credit Facility and the1998 Senior Notes are full and unconditional, on a joint and several basis, andare given by all subsidiaries other than minor subsidiaries.  As of June 30, 2006 and December 31, 2005,the Company had not drawn any funds from the Credit Facility.  Watson is subject to certain financial andoperational covenants, all of which, as of June 30, 2006, the Company was incompliance.  The Credit Facilitycurrently contains the following financial covenants:

·                  maintenance of aminimum net worth of at least $1.7 billion at June 30, 2006;

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

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

At June 30, 2006, our networth was $2.1 billion and our leverage ratio was 1.45 to 1.0.   Our interest coverage ratio for the sixmonths ended June 30, 2006 was 28.5 to 1.0.

Under the CreditFacility, interest coverage ratio, with respect to any financial covenantperiod, is defined as the ratio of EBITDA for such period to interest expensefor such period.  The leverage ratio, forany financial covenant period, is defined as the ratio of the outstanding principalamount of funded debt for the borrower and its subsidiaries at the end of suchperiod, to EBITDA for such period. EBITDA under the Credit Facility, for any covenant period, is defined asnet income plus (1) depreciation and amortization, (2) interest expense, (3)provision for income taxes, (4) extraordinary or unusual losses, (5) non-cashportion of nonrecurring losses and charges, (6) other non-operating, non-cashlosses and (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***

The following table listsour enforceable and legally binding long-term obligations as of June 30,2006.  Some of the amounts included hereinare based on management’s estimates and assumptions about these obligations,including their duration, the possibility of renewal, anticipated actions bythird parties, and other factors. Because these estimates and assumptions are necessarily subjective, theenforceable and legally binding long-term obligations we will actually pay infuture periods may vary from 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                                         |       | $                                                                        | 765,887    |   | $ | 25,669 |   | $ | 30,213 |   | $ | 20,125 |   | $ | 689,880 |   |
| Liabilities  incurred for acquisitions of products and businesses |       | 1,772                                                                    |       | 1,100 |   | 472 |   | — |   | 200 |   |
| Operating lease  obligations                                      |       | 35,437                                                                   |       | 4,143 |   | 15,089 |   | 4,289 |   | 11,916 |   |
| Total  contractual cash obligations                               |       | $                                                                        | 803,096    |   | $ | 30,912 |   | $ | 45,774 |   | $ | 24,414 |   | $ | 701,996 |   |

 

The Company is involvedin certain minor joint venture arrangements that are intended to complement theCompany’s core business and markets.  TheCompany has the discretion to provide funding on occasion for working capitalor capital expenditures.  The Companymakes an evaluation of additional funding based on an assessment of the venture’sbusiness opportunities.  The Companybelieves that any possible commitments arising from the current arrangementswill not be significant to the Company’s financial condition or results ofoperations.

The Company does not haveany material off-balance sheet arrangements that have, or are reasonably likelyto have, a current or future effect on our financial condition, changes infinancial conditions, revenues or expenses, results of operations, liquidity,capital expenditures or capital resources.

*Stock Repurchases*

During 2005, we repurchased approximately 9.4 million shares of ourcommon stock at an aggregate cost of approximately $300.0 million under theCompany’s $300.0 million stock repurchase program approved by the Board onFebruary 10, 2005 (the “2005 Repurchase Program”).  This completed our stock repurchases underthe 2005 Repurchase Program.  The 2005Repurchase Program did not affect our compliance with our debt covenants anddid not materially impact the Company’s liquidity.

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On February 15, 2006, the Company’s Board of Directors authorized theexpenditure of an additional $300.0 million to repurchase shares of the Company’soutstanding common stock (the “2006 Repurchase Program”).  Repurchases are authorized to be made in openmarket or privately negotiated transactions from time to time in compliancewith the Securities and Exchange Commission’s (“SEC”) Rule 10b-18, subject tomarket conditions, applicable legal requirements and other factors.Additionally, the Board has authorized that purchases may be made under Rule 10b5-1promulgated under the Securities and Exchange Act of 1934, as amended. A Rule10b5-1 plan 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 repurchase common stock under the 2006 RepurchaseProgram as a result of the financial obligations associated with the Company’spending acquisition of Andrx.

*Merger Agreement with Andrx*

OnMarch 13, 2006, the Company announced the Merger Agreement to acquire all theoutstanding shares of common stock of Andrx in an all-cash transaction for $25per share, or total consideration of approximately $1.9 billion.  On July 10, 2006, the Company announcedan amendment to the Merger Agreement pursuant to which, among other things, thedeadline to close the transaction was extended from September 12, 2006 toNovember 13, 2006.  Andrx isconsidered a leader in formulating and commercializing difficult-to-replicatecontrolled-release pharmaceutical products and selective immediate-releaseproducts.  For additional information onthe merger with Andrx, refer to NOTE 1 – GENERAL in the accompanying Notes toCondensed Consolidated Financial Statements in this Quarterly Report.

Thetransaction is anticipated to be financed with Watson’s existing cash reservesand an aggregate of $1.15 billion available under a Senior Credit Facilityprovided to Watson from a syndicate of banks (the “Merger Financing”).  The Merger Financing consists of a $500million revolving credit facility and a $650 million senior term loanfacility.  The revolving credit facilitywould have a five year term and the senior term facility would mature in five years.  We expect both facilities will bear interestequal to LIBOR plus 0.75% (subject to certain adjustments).

*Recent accounting pronouncements*

InNovember 2004, the Financial Accounting Standards Board (“FASB”) issued SFASNo. 151, “Inventory Costs-an Amendment of ARB No. 43, Chapter 4” (“SFAS 151”).  SFAS 151 clarifies that items such asabnormal freight, handling costs, and wasted materials (spoilage) be recognizedas current period charges rather than as a portion of the inventory cost.  Unallocated overheads are to be recognized asan expense in the period 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 effective for inventorycosts incurred during fiscal years beginning after June 15, 2005.  The provision of this Statement shall beapplied prospectively.  The adoption ofSFAS 151 on January 1, 2006, did not have a material effect on our CondensedConsolidated Financial Statements.

InDecember 2004, the FASB issued SFAS 123R, which replaces SFAS No. 123, “Accountingfor Stock-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” (“APB25”) 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 methods includemodified prospective and modified retrospective adoption options. Under themodified retrospective 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

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123R also requires any unearned or deferredcompensation accounts (i.e. contra-equity accounts) within stockholders’ equitybe recorded as reductions to additional paid-in capital balances rather thanshown as contra equity accounts as was required prior to January 1, 2006.  SFAS95 is amended to require excess tax benefits be reported as a financing cashflow rather than as a reduction in taxes paid within the Consolidated Statementof Cash Flows.  On January 1,2006, the Company adopted SFAS 123R using the modified prospective methodoption.

InMarch 2005, the SEC issued SEC Staff Accounting Bulletin No. 107 (“SAB 107”)which describes the SEC staff position as well as supplemental implementationguidance on the application and adoption of SFAS 123R.  The Company has applied the provisions of SAB107 and its guidance in our adoption of SFAS 123R on January 1, 2006.

InMay 2005, the FASB issued SFAS No. 154, “Accounting Changes and ErrorCorrections” (“SFAS 154”), which replaces APB Opinion No. 20, “AccountingChanges” (“APB 20”) and SFAS No. 3, “Reporting Accounting Changes in InterimFinancial Statements” (“SFAS 3”). SFAS 154 applies to all voluntary changes inaccounting principle and changes the requirements for the accounting for andreporting of a change in accounting principle. 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 requiresthat a change in the method of depreciation, amortization or depletion oflong-lived assets be accounted for as a change in accounting estimate that isaccounted for prospectively.  SFAS 154also retains many provisions of APB 20 including those related to reporting achange 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 154 is effective for accounting changesand corrections of errors made in fiscal years beginning after December 15,2005.  The adoption of SFAS 154 onJanuary 1, 2006, did not have a material effect on our Consolidated FinancialStatements.

In July 2006, the FASBissued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — AnInterpretation of FASB Statement No. 109” (“FIN 48”).  FIN 48 clarifies the accounting for theuncertainty in recognizing income taxes in an organization in accordance withFASB Statement No. 109 by providing detailed guidance for financial statementrecognition, measurement and disclosure involving uncertain tax positions.  FIN 48 requires an uncertain tax position tomeet a more-likely-than-not recognition threshold at the effective date to berecognized both upon the adoption of FIN 48 and in subsequent periods.  FIN 48 is effective for fiscal yearsbeginning after December 15, 2006.  As theprovisions of FIN 48 will be applied to all tax positions upon initialadoption, the cumulative effect of applying the provisions of FIN 48 will bereported as an adjustment to the opening balance of retained earnings for thatfiscal year.  The Company is currentlyevaluating FIN 48 and the effect, if any, on our Condensed ConsolidatedFinancial Statements.

**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK**

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

**InvestmentRisk**

As of June 30,2006, our total holdings in equity securities of other companies, includingequity-method investments and available-for-sale securities, were$63.3 million.  Of this amount, wehad equity-method investments of $47.5 million and publicly traded equitysecurities (available-for-sale securities) at fair value totaling $15.6 million($14.1 million that was included in “Marketable securities” and $1.5 millionthat was included in “Investments and other assets”).  The fair values of these investments aresubject to significant fluctuations due to volatility of the stock market andchanges in general economic conditions. Based on the fair value of the publicly traded equity securities we heldat June 30, 2006, an assumed 25%, 40% and 50% adverse

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change in the marketprices of these securities would result in a corresponding decline in totalfair value of approximately $3.9 million, $6.2 million and$7.8 million, respectively.

At June 30, 2006,our investment in Andrx consisted of approximately 607,000 shares of Andrxcommon stock with a cost of $1.6 million and a fair market value of $14.1 million.  Because Andrx is a publicly traded equitysecurity, our holdings of Andrx have exposure to investment risk.  On March 13, 2006, the Company announced theMerger Agreement with Andrx.  On July 10,2006, the Company announced an amendment to the Merger Agreement pursuant towhich, among other things, the deadline to close the transaction was extendedfrom September 12, 2006 to November 13, 2006. For additionalinformation on the merger with Andrx, refer to NOTE 1 – GENERAL in theaccompanying Notes to Condensed Consolidated Financial Statements in thisQuarterly Report.

The followingtable sets forth the Andrx high and low market price per share information,based on published financial sources, for 2006 and 2005 and further reflectsthe volatility of the stock price:

|                      | ** ** | **   High   ** | ** ** | **   Low   ** | ** ** |
|----------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| **2006, by quarter** | ** ** | ** **                                   | ** ** | ** **                                  | ** ** |
| First                |       | $                                            | 24.29      |                                        | $          | 16.07 |   |
| Second               |       | $                                            | 23.91      |                                        | $          | 22.50 |   |
|                 |       |                                         |       |                                        |       |
| **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 our investmentsand identify and recognize losses, for income statement purposes, when eventsand circumstances indicate that any declines in the fair values of suchinvestments, below our accounting basis, are other than temporary.**

**Interest Rate Risk**

Our exposure to interest rate risk relates primarilyto our non-equity investment portfolio. Our cash is invested in A-rated money market mutual funds, short-termsecurities and auction rate securities. Consequently, our interest rate andprincipal risk are minimal.

During 2004, we acquired a significant amount of U.S.Treasury securities classified as available-for-sale securities, with nosecurity having a maturity in excess of two years.  These securities are exposed to interest ratefluctuations.  Because of the short-termnature of these investments, we are subject to minimal interest rate risk anddo not believe that an increase in market rates would have a significantnegative impact on the realized value of our portfolio.

Based on quotedmarket rates of interest and maturity schedules for similar debt issues, weestimate that the fair values of our CODES and our 1998 Senior Notesapproximated their carrying values on June 30, 2006.  While changes in market interest rates mayaffect the fair value of our fixed-rate debt, we believe the effect, if any, ofreasonably possible near-term changes in the fair value of such debt on ourfinancial condition, results of operations or cash flows will not be material.

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

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

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**ITEM4.  CONTROLS AND PROCEDURES**

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

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

There have been nochanges in the Company’s internal control over financial reporting, during the threemonths ended June 30, 2006, that has materially affected, or is reasonablylikely to materially affect, the Company’s internal control over financialreporting.

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**PART II. OTHER INFORMATION AND SIGNATURES**

**ITEM 1. LEGAL PROCEEDINGS**

The Company is party to certain lawsuits and legalproceedings, which are described in “PART I, ITEM 3. LEGAL PROCEEDINGS,” of ourAnnual Report on Form 10-K for the year ended 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 the AnnualReport referenced above.

*CiproLitigation.* In the action pending in the Wisconsin Courtof Appeals*(Barbara A. Meyers, et. al. v.Bayer AG, et. al., Appeal No. 2003AP2840)*, on June 8, 2006, thedefendants filed a petition for review with the Wisconsin Supreme Court.  On June 26, 2006, the plaintiffs opposed thepetition for review.  On July 26, 2006,the Wisconsin Supreme Court granted the defendants’ petition for review.  The petition will be decided after it hasbeen fully briefed by the parties.

*Governmental Reimbursement Investigations And DrugPricing Litigation.*With respect to the Drug Pricing Litigation pending against the Company andcertain subsidiaries, the plaintiffs in the Class Action case in theMulti-District Litigation in U.S. District Court for the District ofMassachusetts (*In re: PharmaceuticalIndustry Average Wholesale Price Litigation, MDL Docket No. 1456*) have filed a motion requesting thatdifferent classes of plaintiffs (including individuals who made co-payments fordrugs reimbursed by Medicare and third-party payors, such as insurancecompanies and union health benefit funds) be certified by the Court so that theCourt can decide whether the Company and the other defendants must pay damagesto members of the classes who do not choose to be excluded from the class.  The Company has filed an opposition to theMotion for Class Certification, and a hearing has been scheduled for September12, 2006.  In addition, the AttorneyGeneral’s Office in Idaho has requested that the Company meet to discusswhether that office should bring claims against the Company.  Additional actions in other states areanticipated.  These actions, if successful, could adversely affect theCompany and may have a material adverse effect on the Company’s business,results of operations, financial condition and cash flows.

*FDA Matters. *With respect to the May 13, 2002, consentdecree entered in connection with the Company’s Corona, California, facility (*United States of America v. Watson Laboratories, Inc., and Allen Y.Chao*, United States District Court for the Central District ofCalifornia, EDCV-02-412-VAP), the U.S. Food and Drug Administration conductedan inspection of the facility from July 9 — 21, 2006.  At the conclusion of the inspection no formalobservations were made and no FDA Form 483 was issued.  However, if in the future, the FDA determinesthat, with respect to its Corona facility, Watson has failed to comply with theconsent decree or FDA regulations, including cGMPs, the consent decree allowsthe FDA to order Watson to take a variety of actions to remedy thedeficiencies. These actions could include ceasing manufacturing and relatedoperations at the Corona facility, and recalling affected products.  Such actions, if taken by the FDA, could adverselyaffect the Company, its results of operations, financial position and/or cashflows.

*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 August 8, 2006,approximately 170 cases were pending against Watson and/or its affiliates instate and federal courts, representing claims by approximately 1,345plaintiffs. Discovery is ongoing. 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.

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**ITEM 1A.  RISK FACTORS**

**CAUTIONARYNOTE REGARDING FORWARD-LOOKING STATEMENTS**

Any statements made in this report that are not statements ofhistorical fact or that refer to estimated or anticipated future events areforward-looking statements.  We havebased our forward-looking statements on our management’s beliefs andassumptions based on information available to our management at the time thesestatements are made.  Suchforward-looking statements reflect our current perspective of our business,future performance, existing trends and information as of the date of thisfiling.  These include, but are notlimited to, our beliefs about future revenue and expense levels and growthrates, prospects related to our strategic initiatives and business strategies,express or implied assumptions about government regulatory action or inaction,anticipated product approvals and launches, business initiatives and productdevelopment activities, assessments related to clinical trial results, productperformance and competitive environment, and anticipated financial performance.Without limiting the generality of the foregoing, words such as *“may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “would,”“estimate,” “continue,” or “pursue,”* or the negative othervariations thereof or comparable terminology, are intended to identifyforward-looking statements.  Thestatements are not guarantees of future performance and involve certain risks,uncertainties and assumptions that are difficult to predict.

We caution the reader thatthese statements are based on certain assumptions, risks and uncertainties,many of which are beyond our control.  Inaddition, certain important factors may affect our actual operating results andcould cause such results to differ materially from those expressed or impliedby forward-looking statements.  Webelieve the risks and uncertainties discussed under the Section entitled “RisksRelated to Our Business,” and other risks and uncertainties detailed herein andfrom time to time in our SEC filings, may affect our actual results.

We disclaim any obligationto publicly update any forward-looking statements, whether as a result of newinformation, future events or otherwise, except as required by law.  This discussion is provided as permitted bythe Private Securities Litigation Reform Act of 1995.

# **Risks Related to Our Business**

We operate in a rapidlychanging environment that involves a number of risks, some of which are beyondour control.  The following discussionhighlights some of these risks and others are discussed elsewhere in thisannual report.  These and other riskscould materially and adversely affect our business, financial condition,operating results or cash flows.

*Risks Associated With InvestingIn the Business of Watson*

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

Our future results ofoperations will depend to a significant extent upon our ability to successfullycommercialize new brand and generic products in a timely manner.  There are numerous difficulties in developingand 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;

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

·                  experiencingdelays or unanticipated costs; and

·                  commercializinggeneric products may be substantially delayed by the listing with the FDA ofpatents that have the effect of potentially delaying approval of the off-patentproduct by up to 30 months.

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

**Our brand pharmaceuticalexpenditures may not result in commercially successful products.**

Developing andcommercializing brand pharmaceutical products is more costly than genericproducts.  During 2005, we increased ourplanned expenditures for the development and marketing of our brandbusiness.  During 2006 and thereafter, wemay further increase the amounts we expend for our brand business segment.  For example, we initiated Phase III clinicalstudies during the second quarter of 2006 on our next generation Oxytrol®product and will incur ongoing expenditures for the Phase III clinical studieson our silodosin product for treatment of benign prostatic hyperplasia.  We cannot be sure these business expenditureswill result in the successful discovery, development or launch of brandproducts that will prove to be commercially successful or will improve thelong-term profitability of our business, which would adversely affect ourresults of operations and financial condition.

**Our gross profit may fluctuate from period toperiod depending upon our product sales mix, our product pricing, and our coststo manufacture or purchase products.**

Our future results ofoperations, financial condition and cash flows depend to a significant extentupon our brand and generic product sales mix.  Our sales of brand products tend to createhigher gross margins than our sales of generic products.  As a result, our sales mix (the proportion oftotal sales between brand products and generic products) will significantlyimpact our gross profit from period to period. During 2005, sales of our brand products and generic products accountedfor approximately 24% and 76%, respectively, of our net product sales.  During that same period, brand products andgeneric products contributed approximately 38% and 62%, respectively, to ourgross profits.  Factors that may causeour sales mix to vary include:

·                  the amount of newproduct introductions;

·                  marketing exclusivity,if any, which may be obtained on certain brand products;

·                  the level of competitionin the marketplace for certain products;

·                  the availability of rawmaterials and finished products from our suppliers;

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

·                  periodic dependence on asmall number of products for a significant portion of net revenue or income.

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The profitability of our product sales is also dependent upon theprices we are able to charge for our products, the costs to purchase productsfrom third parties, and our ability to manufacture our products in a costeffective manner.  Our gross profits areexpected to change significantly after the consummation of our transaction withAndrx, due in part to the significant amounts of revenue generated by Andrx’sdistribution business, which typically generates lower gross margins than ourGenerics business. 

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

During 2004 we lost regulatory exclusivity on our Ferrlecit® product,which will allow generic applicants to submit Abbreviated New Drug Applications(“ANDAs”) for Ferrlecit®.  In 2005,Ferrlecit® accounted for approximately 9% of our net revenues and 16% of ourgross profit.  In February 2004, wesubmitted a Citizen’s Petition to the FDA requesting that the FDA not approveany ANDA for a generic version of Ferrlecit® until certain manufacturing,physiochemical and safety and efficacy criteria are satisfied.  During the third quarter of 2004, wesubmitted a second Citizen’s Petition to the FDA requesting that the FDA refuseto accept for substantive review any ANDA referencing Ferrlecit® until the FDAestablishes guidelines for determining whether the generic product is the samecomplex as Ferrlecit®.  We cannot predictwhether the FDA will grant or deny our Citizen’s Petitions or when it may takesuch action.  We believe it will bedifficult for a competitor to demonstrate to the FDA that its product is thesame as Ferrlecit® and that, in the absence of such a showing, the FDA shouldrequire the applicant to submit a New Drug Application (“NDA”) supported byclinical studies, independently demonstrating safety and efficacy.  However, if a generic version of Ferrlecit®or other competitive product is approved by the FDA and enters the market, ournet revenues could significantly decline, which could have a material adverseeffect on our results of operations, financial condition and cash flows.

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

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

**If we are unable toadequately protect our technology or enforce our patents, our business couldsuffer.**

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

We also rely on tradesecrets and proprietary know-how that we seek to protect, in part, throughconfidentiality agreements with our partners, customers, employees andconsultants.  It is possible that theseagreements will be breached or that they will not be enforceable in everyinstance, and that we will not have adequate remedies for any such breach.  It is also possible that our trade secretswill become known or independently developed by our competitors.

If we are unable toadequately protect our technology, trade secrets or propriety know-how, orenforce our patents, our results of operations, financial condition and cashflows could suffer.

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**If brand pharmaceutical companies are successfulin limiting the use of generics through their legislative and regulatoryefforts, our sales of generic products may suffer.**

Many brand pharmaceuticalcompanies increasingly have used state and federal legislative and regulatorymeans to delay generic competition. These efforts have included:

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

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

**If competitors are successful in limitingcompetition for certain generic products through their legislative, regulatoryand litigation efforts, our sales of certain generic products may suffer.**

Certain of our competitors have recently challenged our ability todistribute Authorized Generics during the competitors’ 180 day period of ANDAexclusivity under the Hatch-Waxman Act. Under the challenged arrangements, we have obtained rights to market anddistribute under a brand manufacturer’s NDA a generic alternative of the brandproduct.  Some of our competitors havechallenged the propriety of these arrangements by filing Citizen’s Petitionswith the FDA, initiating lawsuits alleging violation of the antitrust and consumerprotection laws, and seeking legislative intervention.  The FDA and courts that have considered thesubject to date have ruled that there is no prohibition in the Federal Food,Drug, and Cosmetic Act against distributing authorized generic versions of abrand drug. However, on July 19, 2006, legislation was introduced in theU.S. Senate, and on July 28, 2006, similar legislation was introduced inthe U.S. House of Representatives, that would prohibit the marketing ofAuthorized Generics during the 180 day period of ANDA exclusivity under theHatch-Waxman Act.  Further, the DeficitReduction Act of 2005 added provisions to the Medicaid Rebate Program that,effective January 1, 2007, may have the effect of increasing an NDA holder’sMedicaid Rebate liability if it permits another manufacturer to market anauthorized generic version of its brand product.  This may affect the willingness of brandmanufacturers to continue arrangements, or enter into future arrangements,permitting us to market authorized generic versions of their brandproducts.  If so, or if distribution ofauthorized generic versions of brand products is otherwise restricted or foundunlawful, it could have a material adverse effect on our results of operations,financial condition and cash flows.

**From time to time we mayneed to rely on licenses to proprietary technologies, which may be difficult orexpensive to obtain.**

We may need to obtainlicenses to patents and other proprietary rights held by third parties todevelop, manufacture and market products. If we are unable to timely obtain these licenses on commerciallyreasonable terms, our ability to commercially market our products may beinhibited or prevented.

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**Third parties may claim that weinfringe their proprietary rights and may prevent us from manufacturing andselling some of our products**.

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

**As a part of our business strategy,we plan to consider and, as appropriate, make acquisitions of technologies,products and businesses, which may result in us experiencing difficulties inintegrating the technologies, products and businesses that we acquire and/orexperiencing significant charges to earnings that may adversely affect ourstock price and financial condition. These risks are particularly relevant withrespect to our acquisition of Andrx.**

We regularly review potentialacquisitions of technologies, products and businesses complementary to ourbusiness.  Acquisitions typically entailmany risks and could result in difficulties in integrating operations,personnel, technologies and products. For example, in March 2006, we announced that we have entered into adefinitive merger agreement to acquire all the outstanding shares of Andrx andacquired all the outstanding shares of Sekhsaria.  If we are not able to successfully integrateour acquisitions, we may not obtain the advantages and synergies that theacquisitions were intended to create, which may adversely affect our business,results of operations, financial condition and cash flows, our ability todevelop and introduce new products and the market price of our stock.  Integrating two geographically distantcompanies can be a time consuming and expensive process. Watson’s headquartersare in California. Andrx’s headquarters are in Florida. Sekhsaria’sheadquarters are in India.  In addition,in connection with acquisitions, we could experience disruption in our business,customer or employee base, including diversion of management’s attention fromour continuing operations.  There is alsoa risk that key employees of companies that we acquire or key employeesnecessary to successfully commercialize technologies and products that weacquire may seek employment elsewhere, including with our competitors.  Furthermore, there may be overlap between theproducts or customers of Watson and the companies that we acquire that maycreate conflicts in relationships or other commitments detrimental to theintegrated businesses. The impact of our pending acquisition of Andrx,including our ability to obtain governmental approvals for the acquisition onthe terms and schedule agreed to in the Merger Agreement, as amended, mayresult in any or all of the following risks: the businesses will not beintegrated successfully; the anticipated synergies from the acquisition may notbe fully realized or may take longer to realize than expected; disruption ofour business, which could harm relationships with our current customers,employees or suppliers, and could adversely affect our expenses, pricing,third-party relationships and revenues.

In addition, as a result ofacquiring businesses or products, or entering into other significanttransactions, we have experienced, and will likely continue to experience,significant charges to earnings for merger and related expenses that mayinclude transaction costs, closure costs or acquired in-process research anddevelopment charges.  These costs mayinclude substantial fees for investment bankers, attorneys, accountants andfinancial printing costs and severance and other closure costs associated withthe elimination of duplicate or discontinued products, operations andfacilities.  Charges that we may incur inconnection with acquisitions could adversely affect our results of operationsfor particular quarterly or annual periods.

**Antitrust authorities may attempt to delay orprevent our acquisition of Andrx.**

On March 31, 2006, we made a premerger filing underthe Hart Scott Rodino Act (“HSR Act”), with the Federal Trade Commission(“FTC”), and the Antitrust Division of the Department of Justice. On May 1,2006, Watson and Andrx each received a request for additional information fromthe FTC, pursuant to the HSR Act, in connection with the Andrx acquisition. Theeffect of the second request is to extend the waiting period imposed by the HSRAct until thirty days after we have substantially complied with such request,unless that period is voluntarily extended by the parties or terminated earlierby the FTC.  The companies continue towork closely with the FTC in response to the request.  However, we cannot consummate the transactionwith Andrx until the applicable waiting period under the HSR Act expires or isterminated.  On July 7, 2006, the partiesentered into an amendment to the Merger Agreement to allow additional time toconfer with the FTC concerning its review of the transaction.

**If we are unable to obtainsufficient supplies from key suppliers that in some cases may be the onlysource of finished products or raw materials, our ability to deliver ourproducts to the market may be impeded.**

We are required to identifythe supplier(s) of all the raw materials for our products in our applicationswith the FDA.  To the extent practicable,we attempt to identify more than one supplier in each drug application.  However, some products and raw materials areavailable only from a single source and, in some of our drug

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applications, only one supplier of productsand raw materials has been identified, even in instances where multiple sourcesexist.  Among others, this includesproducts that have historically accounted for a significant portion of ourrevenues, such as Ferrlecit®, bupropion sustained release tablets and asignificant number of our oral contraceptive products.  From time to time, certain of our outsidesuppliers have experienced regulatory or supply-related difficulties that haveinhibited their ability to deliver products and raw materials to us, causingsupply delays or interruptions.  To theextent any difficulties experienced by our suppliers cannot be resolved withina reasonable 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 withforeign suppliers are subject to certain additional risks, including theavailability of government clearances, export duties, political instability,war, acts of terrorism, currency fluctuations and restrictions on the transferof funds.  For example, we obtain asignificant portion of our raw materials from foreign suppliers.  Arrangements with international raw materialsuppliers are subject to, among other things, FDA regulation, customsclearances, various import duties and other government clearances.  Acts of governments outside the U.S. mayaffect the price or availability of raw materials needed for the development ormanufacture of our products. In addition, recent changes in patent laws injurisdictions outside the U.S. may make it increasingly difficult to obtain rawmaterials for research and development prior to the expiration of theapplicable U.S. or foreign patents.

**Our policies regarding returns,allowances and chargebacks, and marketing programs adopted by wholesalers, mayreduce our revenues in future fiscal periods**.

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

**Investigations of thecalculation of average wholesale prices may adversely affect our business.**

Many government and third-party payors, including Medicare, Medicaid,Health Maintenance Organizations (“HMOs”) and Managed Care Organizations (“MCOs”),reimburse doctors and others for the purchase of certain prescription drugsbased on a drug’s average wholesale price (“AWP”).  In the past several years, state and federalgovernment agencies have conducted ongoing investigations of manufacturers’reporting practices with respect to AWP, in which they have suggested thatreporting of inflated AWP’s have led to excessive payments for prescriptiondrugs.  For example, beginning in July2002, we and certain of our subsidiaries, as well as numerous otherpharmaceutical companies, were named as defendants in various state and federalcourt actions alleging improper or fraudulent practices related to thereporting of AWP of certain products, and other improper acts, in order toincrease prices and market shares. Additional actions are anticipated. These actions, if successful, could adversely affect us and may have amaterial adverse effect on our business, results of operations, financialcondition and cash flows.

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**Thedesign, development, manufacture and sale of our products involves the risk ofproduct liability claims by consumers and other third parties, and insuranceagainst such potential claims is expensive and may be difficult to obtain.**

The design, development,manufacture and sale of our products involve an inherent risk of productliability claims and the associated 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 currentlymaintain product liability insurance for our products in amounts we believe tobe commercially reasonable, if the coverage limits of these insurance policiesare not adequate, a claim brought against Watson, whether covered by insuranceor not, could have a material adverse effect on our business, results ofoperations, financial condition and cash flows.

**The loss of our key personnelcould cause our business to suffer.**

The success of our presentand future operations will depend, to a significant extent, upon theexperience, abilities and continued 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.  Wecannot assure you that we will be able to attract and retain keypersonnel.  We have entered intoemployment agreements with all of our senior executive officers, including Dr.Chao.  We do not carry key-man lifeinsurance on any of our officers.

**Rising insurance costscould negatively impact profitability.**

Thecost of insurance, including workers compensation, product liability andgeneral liability insurance, have risen significantly in recent years and mayincrease in 2006.  In response, we mayincrease deductibles and/or decrease certain coverages to mitigate thesecosts.  These increases, and ourincreased risk due to increased deductibles and reduced coverages, could have anegative impact on our results of operations, financial condition and cashflows.

**Implementation ofenterprise resource planning systems could cause business interruptions andnegatively affect our profitability and cash flows.**

Fromtime to time, we may implement new enterprise resource planning (“ERP”) systemsand software, or upgrades to existing systems and software, to further enhanceour operations.  Implementation of ERPsystems and software carry risks such as cost overruns, project delays andbusiness interruptions and delays.  If weexperience a material business interruption as a result of suchimplementations, it could have a material adverse effect on our business,results of operations, financial condition and cash flows.

**Significant balances ofintangible assets, including product rights and goodwill acquired, are subjectto impairment testing and may result in impairment charges, which willadversely affect our results of operations and financial condition.**

Asignificant amount of our total assets is related to acquired product rightsand goodwill.  As of December 31, 2005,the carrying value of our product rights and other intangible assets wasapproximately $750 million and the carrying value of our goodwill wasapproximately $460 million.

For example, in thequarter ended June 30, 2006, revisions to the Company’s long range productsales forecast were deemed necessary as a result of a detailed analysis ofprescription trends and a review of sales and inventory data provided by ourlargest customers.  As a result of thesedownward revisions to our long range product sales forecast, the Companyconducted a product right impairment review. Results of our impairment review indicated future undiscounted cashflows for four product rights were less than their respective carryingvalues.  An analysis was undertaken todetermine the fair values for the four product rights and an impairment ofapproximately $67.0 million was recognized predominantly relating to Alora® (purchased in 1999) and Actigall® (purchased in 2002) for the threeand six months ended June 30, 2006. As of June 30, 2006, the carrying value ofour product rights and other intangible assets was approximately $601 million andthe carrying value of our goodwill was approximately $480 million.

Ourproduct rights are stated at cost, less accumulated amortization.  We determine original fair value andamortization periods for product rights based on our assessment of variousfactors impacting estimated useful lives and cash flows of the acquiredproducts.  Such factors include theproduct’s position in its life cycle, the existence or absence of like productsin the market, various other competitive and regulatory issues and contractualterms.  Significant changes to any ofthese factors would require us to perform an impairment test on the affectedasset and, if evidence of impairment exists, we would be required to take animpairment charge with respect to the asset. Such a charge would adversely affect our results of operations andfinancial condition.

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Goodwill is tested forimpairment annually and when events occur or circumstances change that couldpotentially reduce the fair value of the reporting unit.  Impairment testing compares the fair value ofthe reporting unit to its carrying amount. An impairment, if any, would be recorded in operating income and couldhave a significant adverse effect on our results of operations and financialcondition.

**Issuance of debt or equitysecurities could materially change our operating results and financialcondition.**

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

*Risks Relating To Investing Inthe Pharmaceutical Industry*

**Extensive industryregulation has had, and will continue to have, a significant impact on ourbusiness, especially our product development, manufacturing and distributioncapabilities.**

All pharmaceuticalcompanies, including Watson, are subject to extensive, complex, costly andevolving regulation by the federal government, principally the FDA and to a lesserextent by the U.S. Drug Enforcement Administration (“DEA”) and state governmentagencies.  The Federal Food, Drug andCosmetic Act, the Controlled Substances Act and other federal statutes andregulations govern or influence the testing, manufacturing, packing, labeling,storing, record keeping, safety, approval, advertising, promotion, sale anddistribution of our products.

Under these regulations, weare subject to periodic inspection of our facilities, procedures and operationsand/or the testing of our products by the FDA, the DEA and other authorities,which conduct periodic inspections to confirm that we are in compliance withall applicable regulations.  In addition,the FDA conducts pre-approval and post-approval reviews and plant inspectionsto determine whether our systems and processes are in compliance with currentGood Manufacturing Practices (“cGMP”) and other FDA regulations.  Following such inspections, the FDA may issuenotices on Form 483 and warning letters that could cause us to modify certainactivities identified during the inspection. A Form 483 notice is generally issued at the conclusion of a FDAinspection and lists conditions the FDA inspectors believe may violate cGMP orother FDA regulations.  FDA guidelinesspecify that a warning letter is issued only for violations of “regulatorysignificance” for which the failure to adequately and promptly achievecorrection may be expected to result in an enforcement action.

Our principal manufacturingfacility in Corona, California (which manufactured products representingapproximately 17% of our total product net revenues for 2005) is currentlysubject to a consent decree of permanent injunction.  Similarly, Andrx’s principal manufacturingfacility in Davie, Florida, is currently under Official Action Indicated(“OAI”) status by the FDA. While on OAI status, Andrx is not eligible to obtainapprovals for products manufactured at its Davie, Florida facility.  We cannot assure you that the FDA willdetermine that we have adequately corrected deficiencies at our manufacturingsites (including the one referenced above), that subsequent FDA inspectionswill not result in additional inspectional observations at such sites, thatapproval of any of the pending or subsequently submitted NDAs, ANDAs orsupplements to such applications by Watson, Andrx  or their subsidiaries will be granted or thatthe FDA will not seek to impose additional sanctions against Watson, Andrx  or any of their subsidiaries.  The range of possible sanctions includes, amongothers, FDA issuance of adverse publicity, product recalls or seizures, fines,total or partial suspension of production and/or distribution, suspension ofthe FDA’s review of product applications, enforcement actions, injunctions, andcivil or criminal prosecution.  Any suchsanctions, if imposed, could materially harm our operating results andfinancial condition.  Under certaincircumstances, the FDA also has the authority to revoke previously granted drugapprovals.  Similar sanctions as detailedabove may be available to the FDA under a consent decree, depending upon theactual terms of such decree.  Although weand Andrx have instituted internal compliance programs, if these programs donot meet regulatory

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agencystandards or if compliance is deemed deficient in any significant way, it couldmaterially harm our business.  Certain ofour vendors are subject to similar regulation and periodic inspections.

The process for obtaininggovernmental approval to manufacture and market pharmaceutical products isrigorous, time-consuming and costly, and we cannot predict the extent to whichwe may be affected by legislative and regulatory developments.  We are dependent on receiving FDA and othergovernmental or third-party approvals prior to manufacturing, marketing andshipping our products.  Consequently,there is always the chance that we will not obtain FDA or other necessaryapprovals, or that the rate, timing and cost of such approvals, will adverselyaffect our product introduction plans or results 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 arrangementsbetween manufacturers of brand and generic products could adversely affect ourbusiness.**

As part of the Medicare PrescriptionDrug, Improvement, and Modernization Act of 2003 (the “MMA”), companies arerequired to file with the Federal Trade Commission (“FTC”) and the Departmentof Justice certain types of agreements entered into between brand and genericpharmaceutical companies related to the manufacture, marketing and sale ofgeneric versions of brand drugs.  Thisrequirement could affect the manner in which generic drug manufacturers resolveintellectual property litigation and other disputes with brand pharmaceuticalcompanies and could result generally in an increase in private-party litigationagainst pharmaceutical companies or additional investigations or proceedings bythe FTC or other governmental authorities. The impact of this requirement, and the potential private-party lawsuitsassociated with arrangements between brand name and generic drug manufacturers,is uncertain and could adversely affect our business.

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

In order to assist us incommercializing products, we have obtained from government authorities andprivate health insurers and other organizations, such as HMOs and MCOs,authorization to receive reimbursement at varying levels for the cost ofcertain products and related treatments. Third party payors increasingly challenge pricing of pharmaceuticalproducts.  The trend toward managedhealthcare in the U.S., the growth of organizations such as HMOs and MCOs andlegislative proposals to reform healthcare and government insurance programscould significantly influence the purchase of pharmaceutical products,resulting in lower prices and a reduction in product demand.  Such cost containment measures and healthcarereform could affect our ability to sell our products and may have a materialadverse effect on our business, results of operations and financialcondition.  Additionally, there isuncertainty surrounding the implementation of the provisions of Part D of theMMA.  Depending on how such provisionsare implemented, reimbursement may not be available for some of Watson’sproducts.  Additionally, anyreimbursement granted may not be maintained or limits on reimbursementavailable from third-party payors may reduce the demand for, or negativelyaffect the price of, those products and could harm significantly our business,results of operations, financial condition and cash flows.  We may also be subject to lawsuits relatingto reimbursement programs that could be costly to defend, divert management’sattention and adversely affect our operating results.

**The pharmaceutical industry ishighly competitive.**

We face strong competition in both ourgeneric and brand product businesses. The intensely competitive environment requires an ongoing, extensivesearch for technological innovations and the ability to market productseffectively, including the ability to communicate the effectiveness, safety andvalue of brand products to healthcare professionals in private practice, grouppractices and MCOs. Our competitors vary depending upon product categories, andwithin each product category, upon dosage strengths and drug-delivery systems.Based

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on total assets, annual revenues, andmarket capitalization, we are smaller than certain of our national andinternational competitors in the brand product arena.  Most of our competitors have been in businessfor a longer period of time than Watson, have a greater number of products onthe market and have greater financial and other resources than we do.  If we directly compete with them for the samemarkets and/or products, their financial strength could prevent us fromcapturing a profitable share of those markets. It is possible that developmentsby our competitors will make our products or technologies noncompetitive orobsolete.

Revenues and gross profitderived from the sales of generic pharmaceutical products tend to follow apattern based on certain regulatory 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-patent manufacturers receive regulatory approvals onsimilar products or as brand manufacturers launch generic versions of suchproducts (for which no separate regulatory approval is required), market share,revenues and gross profit typically decline, in some cases dramatically.  Accordingly, the level of market share,revenue and gross profit attributable to a particular generic product normallyis related to the number of competitors in that product’s market and the timingof that product’s regulatory approval and launch, in relation to competingapprovals and launches.  Consequently, wemust continue to develop and introduce new products in a timely andcost-effective manner to maintain our revenues and gross margins.  Additionally, as new competitors enter themarket, there may be increased pricing pressure on certain products, whichwould result in lower gross margins. This is particularly true in the case of certain Asian and otheroverseas competitors, who may be able to produce products at costs lower thanthe costs of domestic manufacturers.  Ifwe experience substantial competition from Asian or other overseas competitorswith lower production costs, our profit margins will suffer.

**Sales of our products maycontinue to be adversely affected by the continuing consolidation of ourdistribution network and the concentration of our customer base.**

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

For the year endedDecember 31, 2005, our four largest customers accounted for 16%, 13%, 10% and9% respectively, of our net revenues. The loss of any of these customers could materially adversely affect ourbusiness, results of operations, financial condition and our cash flows.  In addition, none of our customers are partyto any long-term supply agreements with us, and thus are able to changesuppliers freely should they wish to do so.

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

**(a) Recent Sales of Unregistered Securities**

There were nounregistered sales of equity securities.

**(b) Use of Proceeds**

N/A.

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

OnFebruary 10, 2005, the Board authorized a program to repurchase up to $300.0million common shares of Watson’s common stock over a period of one year (the “2005 Repurchase Program”).  During 2005, under the 2005 RepurchaseProgram, 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 the expenditure of anadditional $300.0 million to repurchase shares of the Company’s outstandingcommon stock (the “2006 Repurchase Program”). Under the 2006 Repurchase Program, the repurchases can be made in openmarket or privately negotiated transactions from time to time in compliancewith the Securities and Exchange Commission’s Rule 10b-18, subject to marketconditions, applicable legal requirements and other factors. Additionally, theBoard has authorized that purchases under the 2006 Repurchase Program may bemade under Rule 10b5-1 promulgated under the Securities and Exchange Act of1934, as amended.  A Rule 10b5-1 planallows Watson to repurchase its shares during periods when it would normallynot be active in the market due to its internal trading blackout periods. Allsuch purchases must be made in accordance with a pre-defined plan that isestablished when the plan administrator is not aware of any material non-publicinformation.

No common stock has beenrepurchased under the 2006 Repurchase Program during the second quarter of2006.  At this time, the Company does notintend to repurchase common stock under the 2006 Repurchase Program as a resultof the financial obligations associated with the Company’s pending acquisitionof Andrx.

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**ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

At our Annual Meeting of Stockholders held on May 5,2006, the following proposals were set before the stockholders for their vote:

Proposal 1.           To elect three persons as Class IIDirectors to a three-year term and until their successors are duly elected andqualified.
|                                           | ** ** | **Jack**      | ** ** | **Ronald R.** | ** ** | **Andrew L.** | ** ** |
|-------------------------------------------|------------|---------------|------------|--------------------|------------|--------------------|------------|
| ** **                                | ** ** | **Michelson** | ** ** | **Taylor**         | ** ** | **Turner**         | ** ** |
| Votes*“For”*                    |       | 87,430,756    |       | 85,407,364         |       | 87,427,489         |       |
| Votes to *“Withhold Authority”* |       | 1,193,641     |       | 3,217,033          |       | 1,196,908          |       |

 

The terms of the following directors continued after the annualmeeting:
|                    | ** ** | **Expiration**   | ** ** |
|--------------------|------------|------------------|------------|
| **Class III** | ** ** | **of Term** | ** ** |
| Allen Chao, Ph.D   |       | 2007             |       |
| Michel J.  Feldman |       | 2007             |       |
| Fred G. Weiss      |       | 2007             |       |

 
| Class I       | ** ** | ** ** | ** ** |
|--------------------|------------|------------|------------|
| Michael J.  Fedida |       | 2008       |       |
| Albert F. Hummel   |       | 2008       |       |
| Catherine M. Klema |       | 2008       |       |

 

Proposal 2.            To ratify of the appointment ofPricewaterhouseCoopers LLP as the Company’s independent auditor for the yearending December 31, 2006:

Votes*“For”*— 86,263,665 shares

Votes*“Against”*— 1,838,955 shares

Votes*“Abstained”*— 521,776 shares

Broker “Non-Vote*”*— 0shares

**ITEM 6. EXHIBITS**

(a) Exhibits:

Reference is hereby made to theExhibit Index on page 56.

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.
|                            | ** ** | **WATSON  PHARMACEUTICALS, INC.**                          |
|----------------------------|------------|------------------------------------------------------------|
|                       | ** ** | (Registrant)                                               |
| ** **                 | ** ** | ** **                                                 |
| ** **                 | ** ** | ** **                                                 |
|                       | By:        | **/s/  Charles P. Slacik**                                 |
|                       |       | Charles P.  Slacik                                         |
|                       |       | Executive Vice  President – Chief Financial Officer   |
|                       |       | (Principal Financial  Officer)                             |
|                       |       |                                                       |
|                       |       |                                                       |
|                       | By:        | **/s/ R.  Todd Joyce**                                     |
|                       |       | R. Todd Joyce                                              |
|                       |       | Vice President –  Corporate Controller and  Treasurer |
|                       |       | (Principal  Accounting Officer)                            |
|                       |       |                                                       |
| Date:  August 9, 2006 |       |                                                       |

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**WATSON PHARMACEUTICALS, INC.**

**EXHIBITINDEX TO FORM 10-Q**

**For the Quarterly Period Ended June 30, 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. |

 

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