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Allergan Finance LLC 10-K 2007

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-K


x                               ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2006

OR

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

For the transition period from                        to                  

Commission file number 0-20045


WATSON PHARMACEUTICALS, INC.

(Exact name of registrant as specified in its charter)


Nevada

 

95-3872914

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification No.)

 

311 Bonnie Circle, Corona, CA  92880 - 2882

(Address of principal executive offices, including ZIP code)

(951) 493-5300

(Registrant's telephone number, including area code)


Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class

 

 

 

Name of Each Exchange on Which Registered

 

Common Stock, $0.0033 par value

 

New York Stock Exchange

 

Securities registered pursuant to Section 12(g) of the Act:

None


Indicate by check mark if the registrant is a well known seasoned issuer (as defined in Rule 405 of the Securities Act). Yes   x  No  o

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes  o  No  x

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter 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  No  o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer.

See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer x

Accelerated filer o

Non-accelerated filer o

 

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

Aggregate market value of Common Stock held by non-affiliates of the Registrant, as of June 30, 2006:

$2,378,481,632 based on the last reported sales price on the New York Stock Exchange

Number of shares of Registrant’s Common Stock outstanding on February 22, 2007:  102,500,489

DOCUMENTS INCORPORATED BY REFERENCE

Part III incorporates certain information by reference from the registrant’s proxy statement for the 2007 Annual Meeting of Stockholders, to be held on May 4, 2007. Such proxy statement will be filed no later than 120 days after the close of the registrant’s fiscal year ended December 31, 2006.

 




WATSON PHARMACEUTICALS, INC.
TABLE OF CONTENTS
FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2006

 

 

 

PAGE

 

 

PART I

 

 

ITEM 1.

 

Business

 

3

ITEM 1A.

 

Risk Factors

 

19

ITEM 1B.

 

Unresolved Staff Comments

 

33

ITEM 2.

 

Properties

 

33

ITEM 3.

 

Legal Proceedings

 

34

ITEM 4.

 

Submission of Matters to a Vote of Security Holders

 

34

 

 

PART II

 

 

ITEM 5.

 

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

37

ITEM 6.

 

Selected Financial Data

 

39

ITEM 7.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

40

ITEM 7A.

 

Quantitative and Qualitative Disclosures About Market Risk

 

64

ITEM 8.

 

Financial Statements and Supplementary Data

 

65

ITEM 9.

 

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

 

65

ITEM 9A.

 

Controls and Procedures

 

65

ITEM 9B.

 

Other Information

 

66

 

 

PART III

 

 

ITEM 10.

 

Directors, Executive Officers and Corporate Governance

 

67

ITEM 11.

 

Executive Compensation

 

67

ITEM 12.

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

67

ITEM 13.

 

Certain Relationships and Related Transactions, and Director Independence

 

67

ITEM 14.

 

Principal Accounting Fees and Services

 

68

 

 

PART IV

 

 

ITEM 15.

 

Exhibits, Financial Statement Schedules

 

68

SIGNATURES

 

72

 

2




PART I

ITEM 1.                BUSINESS

Business Overview

Watson Pharmaceuticals, Inc. (“Watson”, the “Company” “we”, “us” or “our”) is engaged in the development, manufacture, marketing, sale and distribution of brand and off-patent (generic) pharmaceutical products. Watson operates manufacturing, distribution, research and development, and administrative facilities primarily in the United States (U.S.). As of December 31, 2006, we marketed more than 150 generic pharmaceutical products and 25 brand pharmaceutical products.

Our principal executive offices are located at 311 Bonnie Circle, Corona, California, 92880. Our Internet website address is www.watson.com. We do not intend this website address to be an active link or to otherwise incorporate by reference the contents of the website into this report. Our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and all amendments thereto, from 2000 to present, are available free of charge on our Internet website. These reports are posted on our Website as soon as reasonably practicable after such reports are electronically filed with the U.S. Securities and Exchange Commission (“SEC”). The public may read and copy any materials that we file with the SEC at the SEC’s Public Reference Room or electronically through the SEC website (www.sec.gov). Within the Investors section of our Website, we provide information concerning corporate governance, including our Corporate Governance Guidelines, Board Committee Charters and Composition, Code of Conduct and other information.

Acquisition of Andrx Corporation

On November 3, 2006, we acquired all the outstanding shares of common stock of Andrx Corporation in an all-cash transaction for $25 per share, or total consideration of approximately $1.9 billion. Andrx distributes pharmaceutical products primarily to independent and chain pharmacies and physicians’ offices and is considered a leader in formulating and commercializing difficult-to-replicate controlled-release pharmaceutical products and selective immediate-release products. 

Business Description

Prescription pharmaceutical products in the U.S. generally are marketed as either generic or brand pharmaceuticals. Generic pharmaceutical products are bioequivalents of their respective brand products and provide a cost-efficient alternative to brand products. Brand pharmaceutical products are marketed under brand names through programs that are designed to generate physician and consumer loyalty. Through our distribution operation, we distribute pharmaceutical products, primarily generics, which have been commercialized by others, as well as our own, to independent and chain pharmacies and physicians’ offices. As a result of the differences between the types of products we market and/or distribute, we operate and manage our business as three operating segments: Generic, Brand and Distribution.

Business Strategy

We apply three key strategies to grow and improve our Generic and Brand pharmaceutical businesses: (i) internal development of technologically challenging and high demand products, (ii) establishment of strategic alliances and collaborations and (iii) acquisition of products and companies that complement our existing portfolio. We believe that our three-pronged strategy will allow us to expand both our brand and generic product offerings, as well as our distribution operations. Based upon business conditions, our financial strength and other factors, we regularly reexamine our business strategies and may change them at anytime. See “Risks Related to Our Business.”

3




Generic Pharmaceutical Products

Watson is a leader in the development, manufacture and sale of generic pharmaceutical products. We currently market more than 150 generic pharmaceutical products. When patents or other regulatory exclusivity no longer protect a brand product, opportunities exist to introduce off-patent or generic counterparts to the brand product. These generic products are bioequivalent to their brand name counterparts and are generally sold at significantly lower prices than the brand product. As such, generic pharmaceuticals provide an effective and cost-efficient alternative to brand products. Our portfolio of generic products includes products we have internally developed, products we have licensed from third parties, and products we distribute for third parties. Net revenues from our generic products accounted for $1.5 billion or approximately 77% of our total net revenues in 2006.

With respect to generic products, our strategy is to continue to develop generic pharmaceuticals that are difficult to formulate or manufacture or will complement or broaden our existing product lines. We believe the acquisition of Andrx, with its expertise in formulating and commercializing difficult-to-replicate controlled-release pharmaceutical products, complements this strategy. Since the prices and unit volumes of our brand products will likely decrease upon the introduction of generic alternatives, we also intend to market generic alternatives to our brand products where market conditions and the competitive environment justify such activities. Additionally, we intend to distribute generic versions of third parties’ brand products (sometimes known as “Authorized Generics”) to the extent such arrangements continue to be complementary to our core business under applicable laws and regulations.

4




Our portfolio of generic pharmaceutical products includes the following products, which represented 70% of total Generic segment net revenues in 2006:

 

 

Comparable

 

 

 

Watson Generic Product

 

 

 

Brand Name

 

Therapeutic Classification

 

Bupropion hydrochloride

 

Zyban®

 

Aid to smoking cessation

 

Bupropion hydrochloride

 

Wellbutrin SR®

 

Antidepressant

 

Cartia XT®

 

Cardizem® CD

 

Anti-hypertensive

 

Glipizide ER

 

Glucotrol® XL

 

Anti-diabetic

 

Hydrocodone bitartrate/ acetaminophen

 

Lorcet®

 

Analgesic

 

Hydrocodone bitartrate/ acetaminophen

 

Vicodin®

 

Analgesic

 

Hydrocodone bitartrate/ acetaminophen

 

Lortab®

 

Analgesic

 

Hydrocodone bitartrate/ acetaminophen

 

Norco®/Anexsia

 

Analgesic

 

Levora®

 

Nordette®

 

Oral contraceptive

 

Low-Ogestrel®

 

Lo-Ovral®

 

Oral contraceptive

 

Microgestin®/Microgestin® Fe

 

Loestrin®/Loestrin® Fe

 

Oral contraceptive

 

Necon®

 

Ortho-Novum®

 

Oral contraceptive

 

Necon®

 

Modicon®

 

Oral contraceptive

 

Nicotine polacrilex gum

 

Nicorette®

 

Aid to smoking cessation

 

Nicotine transdermal system

 

Habitrol®

 

Aid to smoking cessation

 

Nifedipine ER

 

Adalat CC®

 

Anti-hypertensive

 

Oxycodone/acetaminophen

 

Percocet®

 

Analgesic

 

Oxycodone/HCL

 

Oxycontin®

 

Analgesic

 

Pravastatin sodium

 

Pravachol®

 

Cholesterol lowering agent

 

Quasense™

 

Seasonale®

 

Oral contraceptive

 

Testosterone cypionate injection

 

Depo-Testosterone®

 

Hormone replacement

 

Testosterone enanthate injection

 

Delatestryl®

 

Hormone replacement

 

TriNessa™

 

Ortho Tri-Cyclen®

 

Oral contraceptive

 

Trivora®

 

Triphasil®

 

Oral contraceptive

 

Zovia®

 

Demulen®

 

Oral contraceptive

 

 

We predominantly market our generic products to various drug wholesalers and national retail drugstore chains utilizing 25 sales and marketing professionals. We sell our generic products primarily under the “Watson Laboratories” and “Watson Pharma” labels, with the exception of our over-the-counter products which we sell under our “Rugby” label or under private label.

Generic Business Development

During 2006, we expanded our generic product line with the launch of 13 generic products. In April 2006, we launched pravastatin sodium, a cholesterol lowering agent and in September 2006, we launched QuasenseTM, an oral contraceptive. Additionally, beginning in September 2006, we earned commission revenue as a sales agent on behalf of Cephalon, Inc. from the launch of fentanyl citrate troche.

In 2006, including Andrx’s filings prior to our acquisition, our product development efforts resulted in the filing of 27 Abbreviated New Drug Applications (“ANDAs”). At December 31, 2006, we had more than 70 ANDAs on file. See our “Government Regulation and Regulatory Matters” section for a description of our process for obtaining U.S. Food and Drug Administration (“FDA”) approval for our

5




products. See also “Risks Related to our Business—Extensive industry regulation has had, and will continue to have, a significant impact on our business, especially our product development, manufacturing and distribution capabilities.”

Brand Pharmaceutical Products

Newly developed pharmaceutical products normally are patented and, as a result, are generally offered by a single provider when first introduced to the market. We currently market a number of patented products to physicians, hospitals, and other markets that we serve. We also market certain trademarked off-patent products directly to healthcare professionals. We classify these patented and off-patent trademarked products as our brand pharmaceutical products. Net revenues from our brand products accounted for $369 million or approximately 19% of our total net revenues in 2006.

Our Brand business segment currently develops, manufactures, markets, sells and distributes products primarily through two sales and marketing groups, Specialty Products and Nephrology.

Specialty Products

Our Specialty Products product line includes urology, anti-hypertensive, psychiatry, pain management and dermatology products and a genital warts treatment. We market these products to urologists, primary care physicians, endocrinologists, obstetricians and gynecologists. We actively promote the following products through this group: Trelstar® DEPOT and Trelstar® LA (collectively “Trelstar®”) and Oxytrol®. On September 13, 2006, Watson and Unimed Pharmaceuticals, Inc., a wholly owned subsidiary of Solvay Pharmaceuticals, Inc., and Laboratories Besins Iscovesco, settled outstanding patent litigation related to AndroGel®. Effective October 1, 2006, Watson began receiving revenues in connection with AndroGel®.

Nephrology

Our Nephrology product line consists of products for the treatment of iron deficiency anemia. Our primary product in the Nephrology group is Ferrlecit®, which is indicated for patients undergoing hemodialysis in conjunction with erythropoietin therapy. Ferrlecit®, introduced in 1999, was granted a five-year exclusivity period by the FDA as a new chemical entity. Regulatory exclusivity on Ferrlecit® ended in August 2004. See “Risks Related to our Business—Loss of revenues from Ferrlecit®, a significant product, could have a material adverse effect on our results of operations, financial condition and cash flows.”

We market our brand products through 333 sales professionals within the aforementioned specialized sales and marketing groups. Each of our sales and marketing groups focuses on physicians who specialize in the diagnosis and treatment of particular medical conditions and each group offers products to satisfy the unique needs of these physicians. We believe this focused sales and marketing approach enables us to foster close professional relationships with specialty physicians, as well as cover the primary care physicians who also prescribe in selected therapeutic areas. We generally sell our brand products under the “Watson Pharma” and the “Oclassen® Dermatologics” labels.

Our sales and marketing groups have targeted selected therapeutic areas predominately because of their potential growth opportunities and the size of the physician audience. We believe that the nature of these markets and the identifiable base of physician prescribers provide us with opportunities to achieve significant market penetration through our specialized sales forces. Typically, our brand products realize higher profit margins than our generic products. We intend to continue to expand our brand product portfolio through internal product development, strategic alliances and acquisitions.

6




Our portfolio of brand pharmaceutical products includes the following products, which represented 91% of total Brand segment net revenues in 2006:

Watson Brand Product

 

 

 

Active Ingredient

 

Therapeutic Classification

Actigall®

 

Ursodiol

 

Dissolution of gallstones

Androderm®

 

Testosterone (transdermal patch)

 

Male hormone replacement

Condylox®

 

Podofilox

 

Genital warts

Cordran®

 

Flurandrenolide

 

Anti-inflammatory and antipruritic

Ferrlecit®

 

Sodium ferric gluconate in sucrose injection

 

Hematinic

Fioricet®

 

Butalbital, caffeine and acetaminophen

 

Barbiturate and analgesic

Fiorinal®

 

Butalbital, caffeine and aspirin

 

Barbiturate and analgesic

INFeD®

 

Iron dextran

 

Hematinic

Norco®

 

Hydrocodone bitartrate & acetaminophen

 

Analgesic

Norinyl®

 

Norethindrone and ethinyl estradiol

 

Oral contraceptive

Nor-QD®

 

Norethindrone

 

Oral contraceptive

Oxytrol®

 

Oxybutnin (transdermal patch)

 

Overactive bladder

Trelstar® Depot

 

Triptorelin pamoate injection

 

Prostate cancer

Trelstar® LA

 

Triptorelin pamoate injection

 

Prostate cancer

Tri-Norinyl®

 

Norethindrone and ethinyl estradiol

 

Oral contraceptive

 

Brand Business Development

During 2006, we entered into an agreement with Solvay Pharmaceuticals for our Specialty Products sales force to promote AndroGel® to urologists in the United States.

Strategic Alliances and Collaborations

Through collaborative agreements and strategic alliances, we develop and manufacture products that are marketed by other pharmaceutical companies, including products that utilize our patented technologies and formulation capabilities. Pursuant to a Manufacturing and Supply Agreement and a License Agreement, we supply Fortamet® and Altoprev® to Sciele Pharma, Inc. (formerly known as First Horizon Pharmaceutical Corporation).

Through a research and development and supply agreement with Takeda Chemical Industries, Ltd. (“Takeda”), we provide contract research and development (“R&D”) and manufacturing services to develop a combination product consisting of Takeda’s Actos® (pioglitazone) and our extended-release metformin, which is administered once a day for the treatment of Type 2 diabetes. We are responsible for the formulation and manufacture of this combination product and Takeda is responsible for obtaining regulatory approval of and marketing this combination product, both in the U.S. and in other countries. Takeda submitted a New Drug Application (NDA) in 2006. Final approval will be subject to the satisfaction of certain conditions, including resolution of the Official Action Indicated status of our Davie, Florida facility.  

The Company holds a 50% interest in Somerset Pharmaceuticals, (“Somerset”) our joint venture with Mylan Laboratories, Inc. In February 2006, the FDA granted final approval for Emsam®, a selegiline patch for the treatment of depression being developed by Somerset. Emsam® was subsequently launched in April 2006. Somerset has an agreement with Bristol-Myers Squibb (“BMS”), whereby BMS has exclusive distribution rights to commercialize Emsam® in the U.S. and Canada. Somerset received milestone payments upon the approval and launch of Emsam® and will receive further milestone payments based on achievement of certain sales levels. Somerset supplies EmSam® to Bristol Myers-Squibb and receives royalties on product sales.

7




During 2006, we continued our generic product development alliance with Cipla Ltd. (“Cipla”), the second largest pharmaceutical company in India. Under the terms of the agreement announced in December 2002, Watson is responsible for conducting bioequivalence studies, pursuing regulatory approvals for all developed products and has exclusive U.S. marketing rights for the products. Cipla is responsible for development and manufacturing of products.

Following the acquisition of Andrx in November 2006, we assumed all of Andrx’s strategic alliances and collaborations, other than the ones the Federal Trade Commission (“FTC”) required us to divest in connection with approval of the acquisition. The following are examples of Andrx’s strategic alliances and collaborations:

·       Andrx’s May 2005 agreement with Amphastar Pharmaceuticals, Inc., a California-based generic and specialty pharmaceutical company, for certain exclusive marketing rights for both strengths of their proposed generic version of Sanofi’s Lovenox® (enoxaparin sodium) injectable product.

·       Andrx’s March 2005 agreement with Sciele Pharma, Inc. (formerly known as First Horizon Pharmaceutical Corporation) for the sale and licensing of certain rights and assets related to Andrx’s former Fortamet® and Altoprev® brand pharmaceutical products, and the manufacturing and supply of these products.

·       Andrx’s March 2004 and October 2004 agreements to market in the U.S. Genpharm Inc.’s generic version of Paxil® and Pletal®, respectively.

·       Andrx’s December 2003 agreement with Takeda for the development and marketing of a combination product of its approved 505(b)(2) NDA extended-release metformin and Takeda’s Actos® (pioglitazone), each of which is administered once a day for the treatment of Type 2 diabetes. Andrx is responsible for the formulation and manufacture of this combination product and Takeda is responsible for obtaining regulatory approval of and marketing this combination product, both in the U.S. and in other countries. Takeda submitted the NDA for the combination product in March 2006.

·       Andrx’s January 2003 agreement with L. Perrigo Company providing for Andrx’s manufacture and supply to Perrigo of its generic versions of Claritin-D® 24, Claritin RediTabs® and Claritin-D® 12, as store brand over-the-counter (“OTC”) products. This agreement followed the FDA’s determination that the Claritin line of products should be sold as OTC products, and not as prescription pharmaceuticals.    Claritin-D® 24 was launched in June 2003 and Claritin RediTabs® was launched in January 2004.

Financial Information About Segments

Watson evaluates the performance of its Brand, Generic and Distribution business segments based on net revenues, gross profit and net contribution. Summarized net revenues, gross profit and contribution information for each of the last three fiscal years is presented in Note 12—Operating Segments in the accompanying Notes to Consolidated Financial Statements in this Annual Report.

Research and Development

We devote significant resources to the research and development of brand and generic products and proprietary drug delivery technologies. We incurred research and development expenses of $131.0 million in 2006, $125.3 million in 2005 and $134.2 million in 2004. In conjunction with the acquisition of Andrx Corporation, we incurred an in-process research and development charge of $498 million. See Note 4—Acquisitions in the accompanying Notes to Consolidated Financial Statements in this Annual Report for further details on this charge.

8




Our research and development strategy focuses on the following product development areas:

·       off-patent drugs that are difficult to develop or manufacture, or that complement or broaden our existing product lines;

·       the development of sustained-release technologies and the application of these technologies to existing drug forms;

·       the application of proprietary drug-delivery technology for new product development in specialty areas;

·       the expansion of existing oral immediate-release products with respect to additional dosage strengths;

·       the acquisition of mid-to-late development-stage brand drugs; and

·       off-patent drugs that target smaller specialized or under-served markets.

As of December 31, 2006, we maintained research and development facilities in Corona, California; Danbury, Connecticut; Davie and Weston, Florida; Copiague, New York; Salt Lake City, Utah; Changzhou City, People’s Republic of China; and Mumbai, India.

We are presently developing a number of brand and generic products, some of which utilize novel drug-delivery systems, through a combination of internal and collaborative programs.

Pharmaceutical Distribution Operations

Our distribution business, which consists of our Anda, Anda Pharmaceuticals and Valmed (also known as VIP) subsidiaries (collectively “Anda”), distributes primarily generic pharmaceutical products to independent pharmacies, alternate care providers (hospitals, nursing homes and mail order pharmacies) and pharmacy chains, and generic products and certain selective brand products to physicians’ offices. Additionally, we sell to buying groups, which are independent pharmacies that band together to enhance their buying power. We believe that we are able to effectively compete in the distribution market, and therefore optimize our market share, based on three critical elements: (i) very competitive pricing, (ii) responsive customer service that includes, among other things, next day delivery to the entire U.S. and high levels of inventory for approximately 7,000 shelf-keeping units (SKUs), and (iii) well established telemarketing relationships with our customers, supplemented by our electronic ordering capabilities. While most of the approximate 7,000 SKUs in our distribution operations are for products we purchase from third party manufacturers, we also utilize these operations for the sale and marketing of our, and our collaborative partners’, generic products. We are the only U.S. generic pharmaceutical company that has meaningful distribution operations with direct access to independent pharmacies and we believe that our distribution operation is a strategic asset in the national distribution of generic pharmaceuticals.

Our growth in revenues in our distribution operations will primarily be dependent on the launch of new generic products, offset by the overall level of net price and unit declines on existing distributed products and subject to changes in market share.

Following Teva Pharmaceutical Industries Ltd.’s acquisition of Ivax Corporation in January 2006, approximately 19.7% of Anda’s 2006 net sales were derived from the products purchased from Teva or Ivax. Prior to Watson’s acquisition of Andrx on November 3, 2006, approximately 7.5% of Anda’s 2006 net sales from its distribution operations were derived from products purchased from Watson. Other than the combined Teva and Ivax entity and Watson (through November 3, 2006), no other company accounts for more than 10% of our SKUs or dollar volume in 2006.

Anda sells and receives orders for these products primarily using our telemarketing staff, as supplemented by our electronic ordering capabilities (Internet and hand-held ordering devices). Our

9




telemarketing staff is comprised of approximately 225 persons (including sales management), as well as sales personnel responsible for national accounts including the alternate care market. These telemarketers and national account personnel initiate approximately 80,000 phone calls per week to approximately 29,500 active accounts (approximately 14,500 independent pharmacies, 8,500 physicians and 6,500 non-warehousing pharmacy chain stores) throughout the U.S., Puerto Rico and Guam from our South Florida and Grand Island, New York offices. Our internally developed, proprietary ordering systems, including our Internet-based AndaNet, AndaMeds and VIPpharm, as well as our hand-held ordering devices, AndaConnect and VIPConnect, also allow our customers to place their orders electronically. During 2006 and 2005, pre- and post-acquisition, approximately 34% and 30%, respectively, of sales were generated through our order entry Internet sites, AndaConnect and VIPConnect. Furthermore, with our electronic Controlled Substance Ordering System (CSOS) launched in October 2005, we distribute Schedule II controlled substances (CII) via electronic orders to approved pharmacies, distributors and manufacturers, thereby enabling pharmacy customers to eliminate the use of the paper DEA 222 forms to order this category of brand and generic products.

In our distribution operations, we presently distribute products from our facilities in Weston, Florida and Groveport, Ohio. Our Ohio facility is strategically located near one of our overnight carrier’s main air package sorting facility. For the year ended December 31, 2006, approximately 50% of our distribution sales were shipped from each of these facilities, though this percentage can vary. While our Weston, Florida facility is operating near full capacity, our 355,000 square foot Ohio distribution center currently operates at approximately 45% capacity, and provides us with additional distribution capacity for the foreseeable future.

Customers

In our generic and brand operations, we sell our brand and generic pharmaceutical products primarily to drug wholesalers, retailers and distributors, including large chain drug stores, hospitals, clinics, government agencies and managed healthcare providers such as health maintenance organizations and other institutions.

Sales to certain of our customers accounted for 10% or more of our annual net revenues during the past three years. The following table illustrates those customers and the respective percentage of our net revenues for which they account:

Customer

 

 

 

2006

 

2005

 

2004

 

McKesson Corporation

 

 

17

%

 

 

16

%

 

 

15

%

 

AmeriSourceBergen Corp.

 

 

13

%

 

 

13

%

 

 

14

%

 

Cardinal Health, Inc.

 

 

9

%

 

 

9

%

 

 

11

%

 

Walgreen Co.

 

 

8

%

 

 

10

%

 

 

11

%

 

 

These customers comprise a significant part of the distribution network for pharmaceutical products in the U.S. In recent years, this distribution network has undergone significant consolidation, marked by mergers and acquisitions among wholesale distributors and large retail drug store chains. As a result, a small number of large, wholesale distributors and large chain drug stores control a significant share of the market. We expect that consolidation of drug wholesalers and retailers may adversely impact pricing and create other competitive pressures on drug manufacturers. Our pharmaceutical distribution business competes directly with our large wholesaler customers with respect to distribution of generic products.

The loss of any of these customers could materially and adversely affect our business, results of operations, financial condition and cash flows. See “Risk Relating to Investing in the Pharmaceutical Industry.”

10




Competition

The pharmaceutical industry is highly competitive. In our generic and brand product operations, we compete with different companies depending upon product categories, and within each product category, upon dosage strengths and drug delivery systems. Such competitors include the major brand name and generic manufacturers of pharmaceutical products, especially those doing business in the U.S. In addition to product development, other competitive factors in the pharmaceutical industry include product quality and price, reputation and service and access to proprietary and technical information. It is possible that developments by others will make our products or technologies noncompetitive or obsolete. This is particularly true in the case of certain Asian and other overseas competitors, who may be able to produce products at costs lower than those of domestic manufacturers.

Competing in the brand product business requires us to identify and bring to market new products embodying technological innovations. Successful marketing of brand products depends primarily on the ability to communicate their effectiveness, safety and value to healthcare professionals in private practice, group practices and managed care organizations. We anticipate that our brand product offerings will support our existing areas of therapeutic focus. Based upon business conditions and other factors, we regularly reevaluate our business strategies and may from time to time reallocate our resources from one therapeutic area to another, withdraw from a therapeutic area or add an additional therapeutic area in order to maximize our overall growth opportunities.

Our competitors in brand products include major brand name manufacturers of pharmaceuticals such as Johnson & Johnson, Novartis Pharmaceuticals Corporation (“Novartis”) and Pfizer Inc. Based on total assets, annual revenues and market capitalization, we are considerably smaller than these competitors and other national competitors in the brand product area. These competitors, as well as others, have been in business for a longer period of time, have a greater number of products on the market and have greater financial and other resources than we do. If we directly compete with them for the same markets and/or products, their financial strength could prevent us from capturing a meaningful share of those markets.

We actively compete in the generic pharmaceutical business. Revenues and gross profit derived from the sales of generic pharmaceutical products tend to follow a pattern based on certain regulatory and competitive factors. As patents and regulatory exclusivity for brand name products expire, the first off-patent manufacturer to receive regulatory approval for generic equivalents of such products is generally able to achieve significant market penetration. As competing off-patent manufacturers receive regulatory approvals on similar products, market share, revenues and gross profit typically decline, in some cases dramatically. Accordingly, the level of market share, revenues and gross profit attributable to a particular generic product normally is related to the number of competitors in that product’s market and the timing of that product’s regulatory approval and launch, in relation to competing approvals and launches. Consequently, we must continue to develop and introduce new products in a timely and cost-effective manner to maintain our revenues and gross profit. In addition to competition from other generic drug manufacturers, we face competition from brand name companies in the generic market. Many of these companies seek to participate in sales of generic products by, among other things, collaborating with other generic pharmaceutical companies or by marketing their own generic equivalent to their brand products as Authorized Generics. Our major competitors in generic products include Teva Pharmaceutical Industries, Ltd., Barr Laboratories, Inc., Mylan Laboratories, Inc., Mallinckrodt Pharmaceuticals Generics and Sandoz Pharmaceuticals. See “Risks Related to Our Business—The pharmaceutical industry is highly competitive.”

In our pharmaceutical distribution business, we compete with a number of large wholesalers and other distributors of pharmaceuticals, including McKesson Corporation, AmerisourceBergen Corporation and Cardinal Health, Inc., which distribute both brand and generic pharmaceutical products to their customers. These same companies are significant customers of our pharmaceuticals business. As generic products generally have higher gross margins, each of the large wholesalers, on an increasing basis, are offering

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pricing incentives on brand products if the customers purchase a large portion of their generic pharmaceutical products from the primary wholesaler. As we do not offer both brand and generic products to our customers, we are at times competitively disadvantaged and must compete with these wholesalers based upon our very competitive pricing for generic products, greater service levels and our well-established telemarketing relationships with our customers, supplemented by our electronic ordering capabilities. Additionally, generic manufacturers are increasingly marketing their products directly to smaller chains and thus increasingly bypassing wholesalers and distributors. Increased competition in the generic industry as a whole may result in increased price erosion in the pursuit of market share.

Manufacturing, Suppliers and Materials

We manufacture many of our own finished products at our plants in Corona, California; Davie, Florida; Carmel, New York; Copiague, New York; and Salt Lake City, Utah. As part of an ongoing effort to optimize our manufacturing operations, we announced several cost reduction initiatives that will take place by mid 2007, including the planned divestiture or closure of our Phoenix, Arizona injectable manufacturing facility and the closure of our Puerto Rico manufacturing facility in order to consolidate certain of our solid dosage manufacturing operations. In December 2005 we acquired a solid dosage manufacturing facility in Goa, India. The Goa facility is in the final stages of preparations to ensure that it will comply with the requirements of the current Good Manufacturing Practices (“cGMP”) for it to be approved by the FDA to supply product to the U.S. market.

Our manufacturing operations are subject to extensive regulatory oversight and could be interrupted at any time. Our Corona, California facility is currently subject to a consent decree of permanent injunction. In September 2005, the FDA placed our Davie, Florida manufacturing facility in Official Action Indicated (“OAI”) status relating to the FDA’s May 2005 cGMP inspection of the facility and the related issuance of a Form 483 List of Inspectional Observations. The effect of the OAI designation is that until the FDA is satisfied with (i) the Company’s responses to the inspectional observations and (ii) the results of their inspections of the Davie, Florida facility, FDA approval of product candidates to be manufactured at that facility will be withheld. During the OAI status, ANDAs continue to be submitted from the Davie, Florida facility and the FDA continues to review new product applications. The OAI status does not affect Watson’s other locations. See “Risks Related to Our Business—Extensive industry regulation has had, and will continue to have, a significant impact on our business, especially our product development, manufacturing and distribution capabilities.” Also refer to Legal Matters in “Note 14—Commitments and Contingencies” in the accompanying “Notes to Consolidated Financial Statements” in this Annual Report

For certain of our products, we contract with third parties for the manufacture of the products, some of which are currently available only from sole or limited suppliers. These third-party manufactured products include products that have historically accounted for a significant portion of our revenues, such as Ferrlecit®, bupropion hydrochloride sustained-release tablets and a number of our oral contraceptive products. Third-party manufactured products accounted for approximately 58%, 51% and 48% of our Generic and Brand product net revenues in 2006, 2005 and 2004 respectively, and 64%, 58% and 50% of our gross profit in 2006, 2005, and 2004 respectively.

We are dependent on third parties for the supply of the raw materials necessary to develop and manufacture our products, including the active and inactive pharmaceutical ingredients used in our products. We are required to identify the supplier(s) of all the raw materials for our products in the drug applications that we file with the FDA. If raw materials for a particular product become unavailable from an approved supplier specified in a drug application, we would be required to qualify a substitute supplier with the FDA, which would likely interrupt manufacturing of the affected product. To the extent practicable, we attempt to identify more than one supplier in each drug application. However, some raw

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materials are available only from a single source and, in some of our drug applications, only one supplier of raw materials has been identified, even in instances where multiple sources exist.

In addition, we obtain a significant portion of our raw materials from foreign suppliers. Arrangements with international raw material suppliers are subject to, among other things, FDA regulation, customs clearance, various import duties, foreign currency risk and other government clearances. Acts of governments outside the U.S. may affect the price or availability of raw materials needed for the development or manufacture of our products. In addition, any changes in patent laws in jurisdictions outside the U.S. may make it increasingly difficult to obtain raw materials for research and development prior to the expiration of the applicable U.S. or foreign patents. To assist in addressing our reliance of third party raw material and active and inactive pharmaceutical ingredient suppliers, in March 2006, we completed the acquisition of Mumbai, India-based Sekhsaria Chemicals, Ltd. that provides active pharmaceutical ingredients (“API”) and finished dosage formulation expertise to the global pharmaceutical industry, and in January 2006, we increased our investment in Scinopharm Taiwan, Ltd., a company that specializes in the development and manufacture of API. See “Risks Related to Our Business—If we are unable to obtain sufficient supplies from key suppliers that in some cases may be the only source of finished products or raw materials, our ability to deliver our products to the market may be impeded.”

Patents and Proprietary Rights

We believe patent protection of our proprietary products is important to our brand business. Our success with our brand products will depend, in part, on our ability to obtain, and successfully defend if challenged, patent or other proprietary protection for such products. We currently have a number of U.S. and foreign patents issued or pending. However, the issuance of a patent is not conclusive as to its validity or as to the enforceable scope of the claims of the patent. Accordingly, our patents may not prevent other companies from developing similar or functionally equivalent products or from successfully challenging the validity of our patents. If our patent applications are not approved or, even if approved, if such patents are circumvented or not upheld in a court of law, our ability to competitively market our patented products and technologies may be significantly reduced. Also, such patents may or may not provide competitive advantages for their respective products or they may be challenged or circumvented by competitors, in which case our ability to commercially market these products may be diminished. From time to time, we may need to obtain licenses to patents and other proprietary rights held by third parties to develop, manufacture and market our products. If we are unable to timely obtain these licenses on commercially reasonable terms, our ability to commercially market such products may be inhibited or prevented.

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

We may find it necessary to initiate litigation to enforce our patent rights, to protect our trade secrets or know-how or to determine the scope and validity of the proprietary rights of others. Litigation concerning patents, trademarks, copyrights and proprietary technologies can often be protracted and expensive and, as with litigation generally, the outcome is inherently uncertain.

Pharmaceutical companies with brand products are increasingly suing companies that produce off-patent forms of their brand name products for alleged patent and/or copyright infringement or other violations of intellectual property rights which may delay or prevent the entry of such a generic product into the market. For instance, when we file an ANDA seeking approval of a generic equivalent to a brand drug, we may certify under the Drug Price Competition and Patent Restoration Act of 1984 (the       Hatch-Waxman Act) to the FDA that we do not intend to market our generic drug until any patent listed

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by the FDA as covering the brand drug has expired, in which case, the ANDA will not be approved by the FDA until no earlier than the expiration of such patent(s). On the other hand, we could certify that any patent listed as covering the brand drug is invalid and/or will not be infringed by the manufacture, sale or use of our generic form of the brand drug. In that case, we are required to notify the brand product holder or the patent holder that such patent is invalid or is not infringed. If the patent holder sues us for patent infringement within 45 days from receipt of the notice, the FDA is then prevented from approving our ANDA for 30 months after receipt of the notice unless the lawsuit is resolved in our favor in less time or a shorter period is deemed appropriate by a court. In addition, increasingly aggressive tactics employed by brand companies to delay generic competition, including the use of Citizens Petitions and seeking changes to U.S. Pharmacopeia, have increased the risks and uncertainties regarding the timing of approval of generic products.

Because a balanced and fair legislative and regulatory arena is critical to the pharmaceutical industry, we will continue to devote management time and financial resources on government activities. We currently maintain an office and staff a full-time government affairs function in Washington, D.C. that maintains responsibility for keeping abreast of state and federal legislative activities.

Litigation alleging infringement of patents, copyrights or other intellectual property rights may be costly and time consuming. See “Risks Related to Our Business—Third parties may claim that we infringe their proprietary rights and may prevent us from manufacturing and selling some of our products.”

Government Regulation and Regulatory Matters

All pharmaceutical manufacturers, including Watson, are subject to extensive, complex and evolving regulation by the federal government, principally the FDA, and to a lesser extent, by the U.S. Drug Enforcement Administration (“DEA”), Occupational Safety and Health Administration and state government agencies, as well as by varying regulatory agencies in foreign countries where products or product candidates are being manufactured and/or marketed. The Federal Food, Drug and Cosmetic Act, the Controlled Substances Act and other federal statutes and regulations govern or influence the testing, manufacturing, packing, labeling, storing, record keeping, safety, approval, advertising, promotion, sale and distribution of our products.

FDA approval is required before any dosage form of any new drug, including an off-patent equivalent of a previously approved drug, can be marketed. The process for obtaining governmental approval to manufacture and market pharmaceutical products is rigorous, time-consuming and costly, and the extent to which it may be affected by legislative and regulatory developments cannot be predicted. We are dependent on receiving FDA and other governmental approvals prior to manufacturing, marketing and shipping new products. Consequently, there is always the risk the FDA or another applicable agency will not approve our new products, or the rate, timing and cost of such approvals will adversely affect our product introduction plans or results of operations. See “Risks Related to Our Business—If we are unable to successfully develop or commercialize new products, our operating results will suffer” and “—Extensive industry regulation has had, and will continue to have, a significant impact on our business, especially our product development, manufacturing and distribution capabilities.”

All applications for FDA approval must contain information relating to product formulation, raw material suppliers, stability, manufacturing processes, packaging, labeling and quality control. There are generally two types of applications for FDA approval that would be applicable to our new products:

·       New Drug Application (“NDA”).   We file a NDA when we seek approval for drugs with active ingredients and/or with dosage strengths, dosage forms, delivery systems or pharmacokinetic profiles that have not been previously approved by the FDA. Generally, NDAs are filed for newly developed brand products or for a new dosage form of previously approved drugs.

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·       ANDA.   We file an ANDA when we seek approval for off-patent, or generic equivalents of a previously approved drug.

The process required by the FDA before a previously unapproved pharmaceutical product may be marketed in the U.S. generally involves the following:

·       preclinical laboratory and animal tests;

·       submission of an investigational new drug application (“IND”), which must become effective before clinical trials may begin;

·       adequate and well-controlled human clinical trials to establish the safety and efficacy of the proposed product for its intended use;

·       submission of a NDA containing the results of the preclinical and clinical trials establishing the safety and efficacy of the proposed product for its intended use; and

·       FDA approval of a NDA.

Preclinical tests include laboratory evaluation of the product, its chemistry, formulation and stability, as well as animal studies to assess the potential safety and efficacy of the product. We then submit the results of these studies to the FDA as part of an IND, which must become effective before we may begin human clinical trials. The IND automatically becomes effective 30 days after receipt by the FDA unless the FDA, during that 30-day period, raises concerns or questions about the conduct of the trials as outlined in the IND. In such cases, the IND sponsor and the FDA must resolve any outstanding concerns before clinical trials can begin. In addition, an independent Institutional Review Board at the medical center proposing to conduct the clinical trials must review and approve any clinical study.

Human clinical trials are typically conducted in sequential phases:

·       Phase I.   During this phase, the drug is initially introduced into a relatively small number of healthy human subjects or patients and is tested for safety, dosage tolerance, absorption, metabolism, distribution and excretion.

·       Phase II.   This phase involves studies in a limited patient population to identify possible adverse effects and safety risks, to determine the efficacy of the product for specific targeted diseases or conditions, and to determine dosage tolerance and optimal dosage.

·       Phase III.   When Phase II evaluations demonstrate that a dosage range of the product is effective and has an acceptable safety profile, Phase III trials are undertaken to further evaluate dosage, clinical efficacy and to further test for safety in an expanded patient population at geographically dispersed clinical study sites.

·       Phase IV.   After a drug has been approved by the FDA, Phase IV studies are conducted to explore additional patient populations, compare the drug to a competitor, or to further study the risks, benefits and optimal use of a drug. These studies may be a requirement as a condition of the initial approval.

The results of product development, preclinical studies and clinical studies are then submitted to the FDA as part of a NDA, for approval of the marketing and commercial shipment of the new product. The NDA drug development and approval process currently averages approximately five to ten years.

FDA approval of an ANDA is required before we may begin marketing an off-patent or generic equivalent of a drug that has been approved under a NDA, or a previously unapproved dosage form of a drug that has been approved under a NDA. The ANDA approval process generally differs from the NDA approval process in that it does not typically require new preclinical and clinical studies; instead, it relies on the clinical studies establishing safety and efficacy conducted for the previously approved NDA drug. The ANDA process, however, typically requires data to show that the ANDA drug is bioequivalent (i.e.,

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therapeutically equivalent) to the previously approved drug. “Bioequivalence” compares the bioavailability of one drug product with another and, when established, indicates whether the rate and extent of absorption of a generic drug in the body are substantially equivalent to the previously approved drug. “Bioavailability” establishes the rate and extent of absorption, as determined by the time dependent concentrations of a drug product in the bloodstream needed to produce a therapeutic effect. Once submitted, the ANDA drug development and approval process generally takes less time than the NDA drug development and approval process since the ANDA process does not require new clinical trials establishing the safety and efficacy of the drug product.

Supplemental NDAs or ANDAs are required for, among other things, approval to transfer products from one manufacturing site to another and may be under review for a year or more. In addition, certain products may only be approved for transfer once new bioequivalency studies are conducted or other requirements are satisfied.

To obtain FDA approval of both NDAs and ANDAs, our manufacturing procedures and operations must conform to FDA quality system and control requirements generally referred to as cGMP, as defined in Title 21 of the U.S. Code of Federal Regulations. These regulations encompass all aspects of the production process from receipt and qualification of components to distribution procedures for finished products. They are evolving standards; thus, we must continue to expend substantial time, money and effort in all production and quality control areas to maintain compliance. The evolving and complex nature of regulatory requirements, the broad authority and discretion of the FDA, and the generally high level of regulatory oversight results in the continuing possibility that we may be adversely affected by regulatory actions despite our efforts to maintain compliance with regulatory requirements.

We are subject to the periodic inspection of our facilities, procedures and operations and/or the testing of our products by the FDA, the DEA and other authorities, which conduct periodic inspections to assess compliance with applicable regulations. In addition, in connection with its review of our applications for new products, the FDA conducts pre-approval and post-approval reviews and plant inspections to determine whether our systems and processes comply with cGMP and other FDA regulations. Among other things, the FDA may withhold approval of NDAs, ANDAs or other product applications of a facility if deficiencies are found at that facility. Vendors that supply finished products or components to us that we use to manufacture, package and label products are subject to similar regulation and periodic inspections.

Following such inspections, the FDA may issue notices on Form 483 and Warning Letters that could cause us to modify certain activities identified during the inspection. A Form 483 notice is generally issued at the conclusion of an FDA inspection and lists conditions the FDA investigators believe may violate cGMP or other FDA regulations. FDA guidelines specify that a Warning Letter be issued only for violations of “regulatory significance” for which the failure to adequately and promptly achieve correction may be expected to result in an enforcement action.

Our Corona, California facility is currently subject to a consent decree of permanent injunction and our Davie, Florida facility is currently under OAI status. See also “Manufacturing, Suppliers and Materials,” “Risks Related to Our Business—Extensive industry regulation has had, and will continue to have, a significant impact on our business, especially our product development, manufacturing and distribution capabilities” and Legal Matters in ”Note 14—Commitments and Contingencies” in the accompanying “Notes to Consolidated Financial Statements" in this Annual Report.

Failure to comply with FDA and other governmental regulations can result in fines, unanticipated compliance expenditures, recall or seizure of products, total or partial suspension of production and/or distribution, suspension of the FDA’s review of NDAs, ANDAs or other product application enforcement actions, injunctions and criminal prosecution. Under certain circumstances, the FDA also has the authority to revoke previously granted drug approvals. Although we have internal compliance programs, if these programs do not meet regulatory agency standards or if our compliance is deemed deficient in any

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significant way, it could have a material adverse effect on us. See “Risks Related to Our Business—Extensive industry regulation has had, and will continue to have, a significant impact on our business, especially our product development, manufacturing and distribution capabilities.”

The Generic Drug Enforcement Act of 1992 established penalties for wrongdoing in connection with the development or submission of an ANDA. Under this Act, the FDA has the authority to permanently or temporarily bar companies or individuals from submitting or assisting in the submission of an ANDA, and to temporarily deny approval and suspend applications to market generic drugs. The FDA may also suspend the distribution of all drugs approved or developed in connection with certain wrongful conduct and/or withdraw approval of an ANDA and seek civil penalties. The FDA can also significantly delay the approval of any pending NDA, ANDA or other regulatory submissions under the Fraud, Untrue Statements of Material Facts, Bribery and Illegal Gratuities Policy Act.

Government reimbursement programs include Medicare, Medicaid, TriCare, and State Pharmacy Assistance Programs established according to statute, government regulations and policy. Federal law requires that all pharmaceutical manufacturers, as a condition of having their products receive federal reimbursement under Medicaid, must pay rebates to state Medicaid programs on units of their pharmaceuticals that are dispensed to Medicaid beneficiaries. The required per-unit rebate is currently 11% of the average manufacturer price for products marketed under ANDAs. For products marketed under NDAs, manufacturers are required to rebate the greater of 15.1% of the average manufacturer price, or the difference between the average manufacturer price and the lowest net sales price to a non-government customer during a specified period. In some states, supplemental rebates are additionally required as a condition of including the manufacturer’s drug on the state’s Preferred Drug List.

The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (the “MMA”) requires that manufacturers report data to the Centers for Medicare and Medicaid Services (“CMS”) on pricing of drugs and biologicals reimbursed under Medicare Part B. These are generally drugs, such as injectable products, that are administered “incident to” a physician service, and in general are not self-administered. Effective January 1, 2005, average selling price (“ASP”) became the basis for reimbursement to physicians and suppliers for drugs and biologicals covered under Medicare Part B, replacing the average wholesale price (“AWP”) provided and published by pricing services. In general, Watson must comply with all reporting requirements for any drug or biological that is separately reimbursable under Medicare. Watson’s Ferrlecit®, InFed® and Trelstar® products are reimbursed under Medicare Part B and, as a result, the Company provides ASP data on these products to CMS on a quarterly basis.

Under Part D of the MMA, some Medicare beneficiaries are eligible to obtain subsidized prescription drug coverage from private sector providers. With the January 2006 implementation of the Part D drug benefit, usage of pharmaceuticals has increased as a result of the expanded access to medicines afforded by the new Medicare prescription drug benefit. However, such sales increases have been offset by increased pricing pressures due to the enhanced purchasing power of the private sector providers who negotiate on behalf of Medicare beneficiaries. While it is still difficult to predict the future impact the Medicare prescription drug coverage benefit will have on pharmaceutical companies, it is anticipated that further pricing pressures will continue into 2007 and beyond.

There has been enhanced political attention, governmental scrutiny and litigation at the federal and state levels of the prices paid or reimbursed for pharmaceutical products under Medicaid, Medicare and other government programs. See “Risks Related to Our Business—Investigations of the calculation of average wholesale prices may adversely affect our business.” See also Legal Matters in “Note 14—Commitments and Contingencies” in the accompanying “Notes to the Consolidated Financial Statements" in this Annual Report.

In order to assist us in commercializing products, we have obtained from government authorities and private health insurers and other organizations, such as Health Maintenance Organizations (“HMOs”) and

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Managed Care Organizations (“MCOs”), authorization to receive reimbursement at varying levels for the cost of certain products and related treatments. Third party payers increasingly challenge pricing of pharmaceutical products. The trend toward managed healthcare in the U.S., the growth of organizations such as HMOs and MCOs and legislative proposals to reform healthcare and government insurance programs could significantly influence the purchase of pharmaceutical products, resulting in lower prices and a reduction in product demand. Such cost containment measures and healthcare reform could affect our ability to sell our products and may have a material adverse effect on our business, results of operations, financial condition and cash flows. Due to the uncertainty surrounding reimbursement of newly approved pharmaceutical products, reimbursement may not be available for some of our products. Additionally, any reimbursement granted may not be maintained or limits on reimbursement available from third-party payers may reduce the demand for, or negatively affect the price of, those products.

Federal, state and local laws of general applicability, such as laws regulating working conditions, also govern us. In addition, we are subject, as are all manufacturers generally, to numerous and increasingly stringent federal, state and local environmental laws and regulations concerning, among other things, the generation, handling, storage, transportation, treatment and disposal of toxic and hazardous substances and the discharge of pollutants into the air and water. Environmental permits and controls are required for some of our operations, and these permits are subject to modification, renewal and revocation by the issuing authorities. Our environmental capital expenditures and costs for environmental compliance may increase in the future as a result of changes in environmental laws and regulations or increased manufacturing activities at any of our facilities. We could be adversely affected by any failure to comply with environmental laws, including the costs of undertaking a clean-up at a site to which our wastes were transported.

As part of the MMA, companies are required to file with the FTC and the Department of Justice certain types of agreements entered into between brand and generic pharmaceutical companies related to the manufacture, marketing and sale of generic versions of brand drugs. This requirement could affect the manner in which generic drug manufacturers resolve intellectual property litigation and other disputes with brand pharmaceutical companies, and could result generally in an increase in private-party litigation against pharmaceutical companies. The impact of this requirement, and the potential private-party lawsuits associated with arrangements between brand name and generic drug manufacturers, is uncertain and could adversely affect our business.

Continuing studies of the proper utilization, safety and efficacy of pharmaceuticals and other health care products are being conducted by industry, government agencies and others. Such studies, which increasingly employ sophisticated methods and techniques, can call into question the utilization, safety and efficacy of previously marketed products and in some cases have resulted, and may in the future result, in the discontinuance of their marketing.

Our distribution operations and our customers are subject to various regulatory requirements, including requirements from the DEA, FDA, and State Boards of Pharmacy and Health, among others. These include licensing, registration, recordkeeping, security and reporting requirements. In particular, several states and the federal government have begun to enforce drug pedigree laws which require the tracking of all transactions involving prescription drugs beginning with the manufacturer and down to the pharmacy or other health care provider dispensing or administering prescription drug products. For example, effective July 1, 2006, the Florida Department of Health, began enforcement of the drug pedigree requirements for distribution of prescription drugs in the State of Florida. Pursuant to Florida law and regulations, we are required to maintain records documenting the chain of custody of prescription drug products we distribute beginning with our purchase of such products from the manufacturer. We are required to provide documentation of this prior transaction(s) to our customers in Florida, including pharmacies and other health care entities. Several other states have proposed to implement similar drug pedigree requirements. In addition, federal law currently requires that a “non-authorized distributor of

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record,” when making a wholesale distribution, must provide a drug pedigree documenting the prior purchase of a prescription drug from the manufacturer or from an “authorized distributor of record.” In cases where we are not an “authorized distributor of record” we would need to maintain such records. FDA had announced its intent to impose additional drug pedigree requirements (e.g., tracking of lot numbers and documentation of all transactions) through implementation of drug pedigree regulations which were to have taken effect on December 1, 2006. However, a federal appeals court has issued a preliminary injunction to several wholesale distributors granting an indefinite stay of these regulations pending a challenge to the regulations by these wholesale distributors.

In connection with the acquisition of Andrx, both Watson and Andrx agreed to divest certain overlapping products and abide by the terms of the Decision and Order (the “Order”) entered by FTC in December 2006, which includes certain reporting requirements and technical assistance. Failure to abide by the terms of the Order, which expires in December 2016, could result in, among other things, civil penalties.

Seasonality

There are no significant seasonal aspects to our business, except in our distribution operations where shipments of pharmaceutical products indicated for cold and flu symptoms are typically higher during the fourth quarter as customers supplement inventories in anticipation of the cold and flu season.

Backlog

Due to the relatively short lead-time required to fill orders for our products, backlog of orders is not material to our business.

Employees

As of December 31, 2006, we had 5,830 employees. Of our employees, approximately 592 are engaged in research and development, 2,211 in manufacturing, 1,147 in quality assurance and quality control, 1,223 in sales and marketing, and 657 in administration. We believe our relations with our employees are good.

ITEM 1A.        RISK FACTORS

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

Any statements made in this report that are not statements of historical fact or that refer to estimated or anticipated future events are forward-looking statements. We have based our forward-looking statements on our management’s beliefs and assumptions based on information available to our management at the time these statements are made. Such forward-looking statements reflect our current perspective of our business, future performance, existing trends and information as of the date of this filing. These include, but are not limited to, our beliefs about future revenue and expense levels and growth rates, prospects related to our strategic initiatives and business strategies, including the integration of, and synergies associated with, our acquisition of Andrx, express or implied assumptions about government regulatory action or inaction, anticipated product approvals and launches, (including the removal of Andrx’s OAI status at our Davie Florida facility and the associated witholding of FDA approval of product candidates manufactured at that facility), and if and when, the hold of Andrx’s approvals will be lifted, business initiatives and product development activities, assessments related to clinical trial results, product performance 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 other variations thereof or comparable terminology, are intended to identify forward-looking statements. The statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict.

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We caution the reader that these statements are based on certain assumptions, risks and uncertainties, many of which are beyond our control. In addition, certain important factors may affect our actual operating results and could cause such results to differ materially from those expressed or implied by forward-looking statements. We believe the risks and uncertainties discussed under the Section entitled “Risks Related to Our Business,” and other risks and uncertainties detailed herein and from time to time in our SEC filings, may cause our actual results to vary materially than those anticipated in any forward-looking statement.

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

Risks Related to Our Business

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

Risks Associated With Investing In the Business of Watson

Our operating results and financial condition may fluctuate.

Our operating results and financial condition may fluctuate from quarter to quarter and year to year for a number of reasons.  The following events or occurrences, among others, could cause fluctuations in our financial performance from period to period:

·       development of new competitive products or generics by others;

·       the timing and receipt of FDA approvals or lack of approvals;

·       changes in the amount we spend to develop, acquire or license new products, technologies or businesses;

·       changes in the amount we spend to promote our products;

·       delays between our expenditures to acquire new products, technologies or businesses and the generation of revenues from those acquired products, technologies or businesses;

·       changes in treatment practices of physicians that currently prescribe our products;

·       changes in reimbursement policies of health plans and other similar health insurers, including changes that affect newly developed or newly acquired products;

·       increases in the cost of raw materials used to manufacture our products;

·       manufacturing and supply interruptions, including failure to comply with manufacturing specifications;

·       changes in prescription levels and the effect of economic changes in hurricane and other natural disaster-affected areas;

·       the impact on our employees, customers, patients, manufacturers, suppliers, vendors, and other companies we do business with and the resulting impact on the results of operations associated with the possible mutation of the avian form of influenza from birds or other animal species to humans, current human morbidity, and mortality levels persist following such potential mutation;

·       the mix of products that we sell during any time period;

·       lower than expected demand for our products;

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·       our responses to price competition;

·       expenditures as a result of legal actions;

·       market acceptance of our products;

·       the impairment and write-down of goodwill or other intangible assets;

·       implementation of new or revised accounting or tax rules or policies;

·       disposition of primary products, technologies and other rights;

·       termination or expiration of, or the outcome of disputes relating to, trademarks, patents, license agreements and other rights;

·       increases in insurance rates for existing products and the cost of insurance for new products;

·       general economic and industry conditions, including changes in interest rates affecting returns on cash balances and investments that affect customer demand;

·       seasonality of demand for our products;

·       our level of research and development activities;

·       new accounting standards and/or changes to existing accounting standards that would have a material effect on our consolidated financial position, results of operations or cash flows;

·       costs and outcomes of any tax audits or any litigation involving intellectual property, customers or other issues; and

·       timing of revenue recognition related to licensing agreements and/or strategic collaborations.

As a result, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful, and these comparisons should not be relied upon as an indication of future performance.  The above factors may cause our operating results to fluctuate and adversely affect our financial condition and results of operations.

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

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

·       developing, testing and manufacturing products in compliance with regulatory standards in a timely manner;

·       receiving requisite regulatory approvals for such products in a timely manner;

·       the availability, on commercially reasonable terms, of raw materials, including API and other key ingredients;

·       developing and commercializing a new product is time consuming, costly and subject to numerous factors, including legal actions brought by our competitors, that may delay or prevent the development and commercialization of new products;

·       experiencing delays or unanticipated costs; and

·       commercializing generic products may be substantially delayed by the listing with the FDA of patents that have the effect of potentially delaying approval of the off-patent product by up to 30 months.

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As a result of these and other difficulties, products currently in development by Watson or Andrx may or may not receive timely regulatory approvals, or approvals at all, necessary for marketing by Watson or other third-party partners. This risk particularly exists with respect to the development of proprietary products because of the uncertainties, higher costs and lengthy time frames associated with research and development of such products and the inherent unproven market acceptance of such products. If any of our products, when acquired or developed and approved, cannot be successfully or timely commercialized, our operating results could be adversely affected. We cannot guarantee that any investment we make in developing products will be recouped, even if we are successful in commercializing those products. Furthermore, until the FDA removes the pending OAI designation, product candidates to be manufactured at our Davie, Florida facility will be withheld.

Our brand pharmaceutical expenditures may not result in commercially successful products.

Developing and commercializing brand pharmaceutical products is more costly than generic products. During 2006, we increased our planned expenditures for the development and marketing of our brand business. During 2007 and thereafter, we may further increase the amounts we expend for our brand business segment. For example, we initiated Phase III clinical studies during the second quarter of 2006 on our next generation oxybutynin gel product and will incur ongoing expenditures for the Phase III clinical studies on our silodosin product for treatment of benign prostatic hyperplasia. We cannot be sure these business expenditures will result in the successful discovery, development or launch of brand products that will prove to be commercially successful or will improve the long-term profitability of our business. If such business expenditures do not result in successful discovery, development or launch of commercially successful brand products it would adversely affect our results of operations and financial condition.

Loss of revenues from Ferrlecit® , a significant product, 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 ANDAs for Ferrlecit®. In 2006, Ferrlecit® accounted for approximately 7% of our net revenues and 17% of our gross profit. In February 2004, we submitted a Citizen’s Petition to the FDA requesting that the FDA not approve any ANDA for a generic version of Ferrlecit® until certain manufacturing, physiochemical and safety and efficacy criteria are satisfied. During the third quarter of 2004, we submitted a second Citizen’s Petition to the FDA requesting that the FDA refuse to accept for substantive review any ANDA referencing Ferrlecit® until the FDA establishes guidelines for determining whether the generic product is the same complex as Ferrlecit®. In October 2006, the Company submitted a supplement to its Citizen’s Petition, reiterating our request for the FDA to establish guidelines for determining what data are needed to prove that generic formulations of Ferrlecit® contain the same active complex as Ferrlecit®. We cannot predict whether the FDA will grant or deny our Citizen’s Petitions or when it may take such action. If a generic version of Ferrlecit® or other competitive product is approved by the FDA and enters the market, our net revenues could significantly decline, which could have a material adverse effect on our results of operations, financial condition and cash flows. We have assumed for the purpose of amortizing our Ferrlecit® product rights that there will be a generic competitor to Ferrlecit beginning in 2008.

A large percentage of our Ferrlecit® sales are made to dialysis centers. In recent years, there has been significant consolidation of the dialysis business, marked by mergers and acquisitions among dialysis centers. As a result, a small number of customers control a significant share of the injectable iron market. In 2006, our largest customer for Ferrlecit® accounted for roughly 35% of our Ferrlecit® sales. Continued consolidation may adversely impact pricing and create other competitive pressures on suppliers of injectable iron. Additionally, loss of any significant Ferrlecit® customer could materially adversely affect our business, results of operations, financial condition and cash flow.

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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 in integrating the technologies, products and businesses that we acquire and/or experiencing significant charges to earnings that may adversely affect our stock price and financial condition. These risks are particularly relevant with respect to our acquisition of Andrx.

We regularly review potential acquisitions of technologies, products and businesses complementary to our business. Acquisitions typically entail many risks and could result in difficulties in integrating operations, personnel, technologies and products. For example, in March 2006, we acquired all the outstanding shares of Sekhsaria and in November 2006, we acquired all the outstanding shares of Andrx Corporation. If we are not able to successfully integrate our acquisitions, we may not obtain the advantages and synergies that the acquisitions were intended to create, which may adversely affect our business, results of operations, financial condition and cash flows, our ability to develop and introduce new products and the market price of our stock. Integrating two geographically distant companies can be a time consuming and expensive process. Watson’s headquarters are in California. Andrx’s headquarters were in Florida. Sekhsaria’s headquarters are in India. In addition, in connection with acquisitions, we could experience disruption in our business, technology and information systems, customer or employee base, including diversion of management’s attention from our continuing operations. There is also a risk that key employees of companies that we acquire or key employees necessary to successfully commercialize technologies and products that we acquire may seek employment elsewhere, including with our competitors. Furthermore, there may be overlap between the products or customers of Watson and the companies that we acquire that may create conflicts in relationships or other commitments detrimental to the integrated businesses. For example, in our distribution operations, our main competitors are McKesson Corporation, AmerisourceBergen Corporation and Cardinal Health, Inc., which are all significant customers of our generic and brand operations and who collectively accounted for approximately 39% of our annual net revenues in 2006. The impact of our acquisition of Andrx may result in any or all of the following risks: the businesses will not be integrated successfully; the anticipated synergies from the acquisition may not be fully realized or may take longer to realize than expected; and the disruption of our 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 of acquiring businesses or products, or entering into other significant transactions, we have experienced, and will likely continue to experience, significant charges to earnings for merger and related expenses that may include transaction costs, closure costs or acquired in-process research and development charges. These costs may include substantial fees for investment bankers, attorneys, accountants and financial printing costs and severance and other closure costs associated with the elimination of duplicate or discontinued products, operations and facilities. Charges that we may incur in connection with acquisitions could adversely affect our results of operations for particular quarterly or annual periods.

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

We have made substantial investments in joint ventures and other collaborations and may use these and other methods to develop or commercialize products in the future. These arrangements typically involve other pharmaceutical companies as partners that may be competitors of ours in certain markets. In many instances, we will not control these joint ventures or collaborations or the commercial exploitation of the licensed products, and cannot assure you that these ventures will be profitable. Although restrictions contained in certain of these programs have not had a material adverse impact on the marketing of our own products to date, any such marketing restrictions could affect future revenues and have a material adverse effect on our operations. Our results of operations may suffer if existing joint venture or collaboration partners withdraw, or if these products are not timely developed, approved or successfully commercialized.

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

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

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

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

If pharmaceutical companies are successful in limiting the use of generics through their legislative, regulatory and other efforts, our sales of generic products may suffer.

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

·       pursuing new patents for existing products which may be granted just before the expiration of one patent, which could extend patent protection for additional years or otherwise delay the launch of generics;

·       selling the brand product as an authorized generic, either by the brand company directly, through an affiliate or by a marketing partner;

·       using the Citizen’s Petition process to request amendments to FDA standards;

·       seeking changes to U.S. Pharmacopeia, an organization which publishes industry recognized compendia of drug standards;

·       attaching patent extension amendments to non-related federal legislation; and

·       engaging in state-by-state initiatives to enact legislation that restricts the substitution of some generic drugs, which could have an impact on products that we are developing.

·       Seeking patents on methods of manufacturing certain active pharmaceutical ingredients.

If pharmaceutical companies are successful in limiting the use of generic products through these or other means, our sales of generic products may decline. If we experience a material decline in generic product sales, our results of operations, financial condition and cash flows will suffer.

If competitors are successful in limiting competition for certain generic products through their legislative, regulatory and litigation efforts, our sales of certain generic products may suffer.

Certain of our competitors have recently challenged our ability to distribute authorized generics during the competitors’ 180-day period of ANDA exclusivity under the Hatch-Waxman Act. Under the challenged arrangements, we have obtained rights to market and distribute under a brand manufacturer’s NDA a generic alternative of the brand product. Some of our competitors have challenged the propriety of these arrangements by filing Citizen’s Petitions with the FDA, initiating lawsuits alleging violation of the

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antitrust and consumer protection laws, and seeking legislative intervention. The FDA and courts that have considered the subject to date have ruled that there is no prohibition in the Federal Food, Drug, and Cosmetic Act against distributing authorized generic versions of a brand drug. However, on January 30, 2007, legislation was introduced in the U.S. Senate, and on February 5, 2007, similar legislation was introduced in the U.S. House of Representatives, that would prohibit the marketing of authorized generics during the 180-day period of ANDA exclusivity under the Hatch-Waxman Act. Further, the Deficit Reduction Act of 2005 added provisions to the Medicaid Rebate Program that, effective January 1, 2007, may have the effect of increasing an NDA holder’s Medicaid Rebate liability if it permits another manufacturer to market an authorized generic version of its brand product. This may affect the willingness of brand manufacturers to continue arrangements, or enter into future arrangements, permitting us to market authorized generic versions of their brand products. If so, or if distribution of authorized generic versions of brand products is otherwise restricted or found unlawful, it could have a material adverse effect on our results of operations, financial condition and cash flows.

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

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

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

The manufacture, use and sale of new products that are the subject of conflicting patent rights have been the subject of substantial litigation in the pharmaceutical industry. These lawsuits relate to the validity and infringement of patents or proprietary rights of third parties. We may have to defend against charges that we violated patents or proprietary rights of third parties. This is especially true in the case of generic products on which the patent covering the brand product is expiring, an area where infringement litigation is prevalent, and in the case of new brand products 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 of others, we could lose our right to develop or manufacture products or could be required to pay monetary damages or royalties to license proprietary rights from third parties. Although the parties to patent and intellectual property disputes in the pharmaceutical industry have often settled their disputes through licensing or similar arrangements, the costs associated with these arrangements may be substantial and could include ongoing royalties. Furthermore, we cannot be certain that the necessary licenses would be available to us on commercially reasonable terms. As a result, an adverse determination in a judicial or administrative proceeding or failure to obtain necessary licenses could prevent us from manufacturing and selling a number of our products, which could harm our business, financial condition, results of operations and cash flows.

Our distribution operations are highly dependent upon a primary courier service.

Product deliveries within our newly acquired distribution operations are highly dependent on overnight delivery services to deliver our products in a timely and reliable manner, typically by overnight service. Since 2004, our distribution operations has shipped a substantial portion of products via one courier’s air and ground delivery service. Our contract with this courier expires in July 2009, but may terminated by either party for no reason with 60 days written notice. Additionally, our Groveport, Ohio facility is strategically located next to one of the courier’s air hubs. If the courier terminates the agreement without cause or we cannot renew the courier’s contract on favorable terms, enter into a contract with an

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equally reliable overnight courier to perform and offer the same service level at similar or more favorable rates, our business, results of operations, financial condition and cash flows could be adversely affected.

Our distribution operations concentrate on generic products and therefore are subject to the risks of the generic industry.

The ability of our distribution operations to provide consistent, sequential quarterly growth is affected, in large part, by our participation in the launch of new products by us and other generic manufacturers and the subsequent advent and extent of competition encountered by these products. This competition can result in significant and rapid declines in pricing with a corresponding decrease in net sales of our distribution operations. Our margins can also be affected by the risks inherent to the generic industry.

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

We are required to identify the supplier(s) of all the raw materials for our products in our applications with the FDA. To the extent practicable, we attempt to identify more than one supplier in each drug application. However, some products and raw materials are available only from a single source and, in some of our drug applications, only one supplier of products and raw materials has been identified, even in instances where multiple sources exist. Among others, this includes products that have historically accounted for a significant portion of our revenues, such as Ferrlecit®, bupropion sustained release tablets and a significant number of our oral contraceptive products. For example, our current supply agreement for Ferrlecit expires in 2009. From time to time, certain of our outside suppliers have experienced regulatory or supply-related difficulties that have inhibited their ability to deliver products and raw materials to us, causing supply delays or interruptions. To the extent any difficulties experienced by our suppliers cannot be resolved or extentions of our key supply agreements cannot be negotiated within a reasonable time and on commercially reasonable terms, or if raw materials for a particular product become unavailable from an approved supplier and we are required to qualify a new supplier with the FDA, or if we are unable to do so, our profit margins and market share for the affected product could decrease or be eliminated, as well as delay our development and sales and marketing efforts. Such outcomes could have a material adverse effect on our business, results of operations, financial condition and cash flows.

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

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

Based on industry practice, generic product manufacturers, including Watson, have liberal return policies and 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 hold in inventory after we have decreased the market prices of the same generic products. Therefore, if new competitors enter the marketplace and significantly lower the prices of any of their competing products, we would likely reduce the price of our product. As a result, we would be obligated to provide significant credits to our customers who are then holding inventories of such products, which could reduce

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sales revenue and gross margin for the period the credit is provided. Like our competitors, we also give credits for chargebacks to wholesale customers that have contracts with us for their sales to hospitals, group purchasing organizations, pharmacies or other retail customers. A chargeback represents an amount payable in the future to a wholesaler for the difference between the invoice price paid to us by our wholesale customer for a particular product and the negotiated contract price that the wholesaler’s customer pays for that product. Although we establish reserves based on our prior experience and our best estimates of the impact that these policies may have in subsequent periods, we cannot ensure that our reserves are adequate or that actual product returns, allowances and chargebacks will not exceed our estimates, which could adversely affect our financial condition, cash flows and market price of our stock.

Investigations of the calculation of average wholesale prices may adversely affect our business.

Many government and third-party payors, including Medicare, Medicaid, HMOs and MCOs, reimburse doctors and others for the purchase of certain prescription drugs based on a drug’s AWP. In the past several years, state and federal government agencies have conducted ongoing investigations of manufacturers’ reporting practices with respect to AWP, in which they have suggested that reporting of inflated AWP’s have led to excessive payments for prescription drugs. For example, beginning in July 2002, we and certain of our subsidiaries, as well as numerous other pharmaceutical companies, were named as defendants in various state and federal court actions alleging improper or fraudulent practices related to the reporting of AWP of certain products, and other improper acts, in order to increase prices and market shares. Additional actions are anticipated. These actions, if successful, could adversely affect us and may have a material adverse effect on our business, results of operations, financial condition and cash flows.

The design, development, manufacture and sale of our products involves the risk of product liability claims by consumers and other third parties, and insurance against 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 product liability claims and the associated adverse publicity. Insurance coverage is expensive and may be difficult to obtain, and may not be available in the future on acceptable terms, or at all. Although we currently maintain product liability insurance for our products in amounts we believe to be commercially reasonable, if the coverage limits of these insurance policies are not adequate, a claim brought against Watson, whether covered by insurance or not, could have a material adverse effect on our business, results of operations, financial condition and cash flows.

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

The success of our present and future operations will depend, to a significant extent, upon the experience, abilities and continued services of key personnel. For example, although we have other senior management personnel, a significant loss of the services of Allen Chao, Ph.D., our Chairman and Chief Executive Officer, or other senior executive officers without hiring a suitable successor, could cause our business to suffer. We cannot assure you that we will be able to attract and retain key personnel. We have entered into employment agreements with all of our senior executive officers, including Dr. Chao. We do not carry key-man life insurance on any of our officers.

Rising insurance costs could negatively impact profitability.

The cost of insurance, including workers compensation, product liability and general liability insurance, have risen significantly in recent years and may increase in 2007. In response, we may increase deductibles and/or decrease certain coverages to mitigate these costs. These increases, and our increased risk due to increased deductibles and reduced coverages, could have a negative impact on our results of operations, financial condition and cash flows.

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Implementation of enterprise resource planning systems could cause business interruptions and negatively affect our profitability and cash flows.

From time to time, we may implement new enterprise resource planning (“ERP”) systems and software, or upgrades to existing systems and software, to further enhance our operations. Implementation of ERP systems and software carry risks such as cost overruns, project delays and business interruptions and delays. We plan to implement a new phase of an ERP system into our U.S. manufacturing operation during 2007. If we experience a material business interruption as a result of such implementations, it could have a material adverse effect on our business, results of operations, financial condition and cash flows.

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

A significant amount of our total assets is related to acquired intangibles and goodwill. As of December 31, 2006, the carrying value of our product rights and other intangible assets was approximately $779.3 million and the carrying value of our goodwill was approximately $890.5 million.

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

Our other significant intangible assets include acquired core technology and customer relationships, which are intangible assets with definite lives, and the Anda trade name, which is an intangible asset with an indefinite life, as we intend to use the Anda trade name indefinitely.

Our acquired core technology and customer relationships intangible assets are stated at cost, less accumulated amortization.  We determined the original fair value of our other intangible assets by performing a discounted cash flow analysis, which is based on our assessment of various factors.  Such factors include existing operating margins, the number of existing and potential competitors, product pricing patterns, product market share analysis, product approval and launch dates, the effects of competition, customer attrition rates, consolidation within the industry and generic product lifecycle estimates.  Our other intangible assets with definite lives are tested for impairment when there are significant changes to any of these factors.  Our other intangible assets with indefinite lives are tested for impairment annually, or more frequently if there are significant changes to any of the above factors.  If evidence of impairment exists, we would be required to take an impairment charge with respect to the tested asset.   Such a charge would adversely affect our results of operations and financial condition.

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

Issuance of debt or equity securities could materially change our operating results and financial condition.

We may consider issuing additional debt or equity securities in the future to fund potential acquisitions or investments, to refinance existing debt, or for general corporate purposes. If a material

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acquisition or investment is completed, our operating results and financial condition could change materially in future periods. However, no assurance can be given that additional funds will be available on satisfactory terms, or at all, to fund such activities.

Our business could suffer as a result of manufacturing difficulties or delays.

The manufacture of certain of our products and product candidates, particularly our controlled-release products and our oral contraceptive products, are more difficult than the manufacture of immediate-release products. Successful manufacturing of these types of products requires precise manufacturing process controls, API that conforms to very tight tolerances for specific characteristics and equipment that operates consistently within narrow performance ranges. Manufacturing complexity, testing requirements, and safety and security processes combine to increase the overall difficulty of manufacturing these products and resolving manufacturing problems that we may encounter.

Our manufacturing and other processes utilize sophisticated equipment, which sometimes requires a significant amount of time to obtain and install. Although we endeavor to properly maintain our equipment and spare parts on hand, our business could suffer if certain manufacturing or other equipment, or a portion or all of our facilities were to become inoperable for a period of time. This could occur for various reasons, including catastrophic events such as earthquake, hurricane or explosion, unexpected equipment failures or delays in obtaining components or replacements thereof, as well as construction delays or defects and other events, both within and outside of our control. Our inability to timely manufacture any of our significant products could adversely affect our results of operations, financial condition, and cash flows.

Unanticipated changes in our tax rates or exposure to additional income tax liabilities could affect our profitability.

We are subject to income taxes in both the U.S. and other foreign jurisdictions. Our effective tax rate could be adversely affected by changes in the mix of earnings in countries with different statutory tax rates, changes in the valuation of deferred tax assets and liabilities, changes in or interpretations of tax laws including pending tax law changes (such as the research and development credit), changes in our manufacturing activities and changes in our future levels of research and development spending. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Service and other tax authorities. We regularly assess the likelihood of outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. There can be no assurance that the outcomes from these continuous examinations will not have an adverse effect on our provision for income taxes and estimated income tax liabilities.

Risks Relating To Investing In the Pharmaceutical Industry

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

All pharmaceutical companies, including Watson, are subject to extensive, complex, costly and evolving regulation by the federal government, principally the FDA and to a lesser extent by the DEA and state government agencies, as well as by varying regulatory agencies in foreign countries where products or product candidates are being manufactured and/or marketed. The Federal Food, Drug and Cosmetic Act, the Controlled Substances Act and other federal statutes and regulations govern or influence the testing, manufacturing, packing, labeling, storing, record keeping, safety, approval, advertising, promotion, sale and distribution of our products.

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Under these regulations, we are subject to periodic inspection of our facilities, procedures and operations and/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 with all applicable regulations. In addition, the FDA conducts pre-approval and post-approval reviews and plant inspections to determine whether our systems and processes are in compliance with cGMP and other FDA regulations. Following such inspections, the FDA may issue notices on Form 483 and warning letters that could cause us to modify certain activities identified during the inspection. A Form 483 notice is generally issued at the conclusion of a FDA inspection and lists conditions the FDA inspectors believe may violate cGMP or other FDA regulations. FDA guidelines specify that a warning letter is issued only for violations of “regulatory significance” for which the failure to adequately and promptly achieve correction may be expected to result in an enforcement action.

Our manufacturing facility in Corona, California (which manufactured products representing approximately 14% of our total product net revenues for 2006) is currently subject to a consent decree of permanent injunction. Similarly, our manufacturing facility in Davie, Florida, is currently under OAI status by the FDA. While on OAI status, we are not eligible to obtain approvals for products manufactured at our Davie, Florida facility. We cannot assure you that the FDA will determine that we have adequately corrected deficiencies at our respective manufacturing sites (including the ones referenced above), that subsequent FDA inspections will not result in additional inspectional observations at such sites, that approval of any of the pending or subsequently submitted NDAs, ANDAs or supplements to such applications by Watson or our subsidiaries will be granted or that the FDA will not seek to impose additional sanctions against Watson or any of its subsidiaries. The range of possible sanctions includes, among others, FDA issuance of adverse publicity, product recalls or seizures, fines, total or partial suspension of production and/or distribution, suspension of the FDA’s review of product applications, enforcement actions, injunctions, and civil or criminal prosecution. Any such sanctions, if imposed, could materially harm our operating results and financial condition. Under certain circumstances, the FDA also has the authority to revoke previously granted drug approvals. Similar sanctions as detailed above may be available to the FDA under a consent decree, depending upon the actual terms of such decree. Although we have instituted internal compliance programs, if these programs do not meet regulatory agency standards or if compliance is deemed deficient in any significant way, it could materially harm our business. Certain of our vendors are subject to similar regulation and periodic inspections.

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

Our distribution operations and our customers are subject to various regulatory requirements, including requirements from the DEA, FDA, State Boards of Pharmacy and Health, among others. These include licensing, registration, recordkeeping, security and reporting requirements. In particular, several states and the federal government have begun to enforce drug pedigree laws which require the tracking of all transactions involving prescription drugs beginning with the manufacturer and down to the pharmacy or other health care provider dispensing or administering prescription drug products. For example, effective July 1, 2006, the Florida Department of Health, began enforcement of the drug pedigree requirements for distribution of prescription drugs in the State of Florida. Pursuant to Florida law and regulations, we are required to maintain records documenting the chain of custody of prescription drug products we distribute beginning with our purchase of such products from the manufacturer. We are required to provide

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documentation of this prior transaction(s) to our customers in Florida, including pharmacies and other health care entities. Several other states have proposed to implement similar drug pedigree requirements. In addition, federal law currently requires that a “non-authorized distributor of record,” when making a wholesale distribution, must provide a drug pedigree documenting the prior purchase of a prescription drug from the manufacturer or from an “authorized distributor of record.” In cases where we are not an “authorized distributor of record” we would need to maintain such records. FDA had announced its intent to impose additional drug pedigree requirements (e.g., tracking of lot numbers and documentation of all transactions) through implementation of drug pedigree regulations which were to have taken effect on December 1, 2006. However, a federal appeals court has issued a preliminary injunction to several wholesale distributors granting an indefinite stay of these regulations pending a challenge to the regulations by these wholesale distributors.

We are also subject to numerous and increasingly stringent federal, state and local environmental laws and regulations concerning, among other things, the generation, handling, storage, transportation, treatment and disposal of toxic and hazardous substances and the discharge of pollutants into the air and water. Environmental permits and controls are required for some of our operations, and these permits are subject to modification, renewal and revocation by the issuing authorities. Our environmental capital expenditures and costs for environmental compliance may increase in the future as a result of changes in environmental laws and regulations or increased manufacturing activities at any of our facilities. We could be adversely affected by any failure to comply with environmental laws, including the costs of undertaking a clean-up at a site to which our wastes were transported.

Federal regulation of arrangements between manufacturers of brand and generic products could adversely affect our business.

As part of the MMA, companies are required to file with the FTC and the Department of Justice certain types of agreements entered into between brand and generic pharmaceutical companies related to the manufacture, marketing and sale of generic versions of brand drugs. This requirement could affect the manner in which generic drug manufacturers resolve intellectual property litigation and other disputes with brand pharmaceutical companies and could result generally in an increase in private-party litigation against pharmaceutical companies or additional investigations or proceedings by the FTC or other governmental authorities. The impact of this requirement, and the potential private-party lawsuits associated with arrangements between brand name and generic drug manufacturers, is uncertain and could adversely affect our business.

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

In order to assist us in commercializing products, we have obtained from government authorities and private health insurers and other organizations, such as HMOs and MCOs, authorization to receive reimbursement at varying levels for the cost of certain products and related treatments. Third party payors increasingly challenge pricing of pharmaceutical products. The trend toward managed healthcare in the U.S., the growth of organizations such as HMOs and MCOs and legislative proposals to reform healthcare and government insurance programs could significantly influence the purchase of pharmaceutical products, resulting in lower prices and a reduction in product demand. Such cost containment measures and healthcare reform could affect our ability to sell our products and may have a material adverse effect on our business, results of operations and financial condition. Additionally, there is uncertainty surrounding the implementation of the provisions of Part D of the MMA. Depending on how such provisions are implemented, reimbursement may not be available for some of Watson’s products. Additionally, any reimbursement granted may not be maintained or limits on reimbursement available from third-party payors may reduce the demand for, or negatively affect the price of, those products and could harm

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significantly our business, results of operations, financial condition and cash flows. We may also be subject to lawsuits relating to reimbursement programs that could be costly to defend, divert management’s attention and adversely affect our operating results.

The pharmaceutical industry is highly competitive.

We face strong competition in both our generic and brand product businesses. The intensely competitive environment requires an ongoing, extensive search for technological innovations and the ability to market products effectively, including the ability to communicate the effectiveness, safety and value of brand products to healthcare professionals in private practice, group practices and MCOs. Our competitors vary depending upon product categories, and within each product category, upon dosage strengths and drug-delivery systems. Based on total assets, annual revenues, and market capitalization, we are smaller than certain of our national and international competitors in the brand product arena. Most of our competitors have been in business for a longer period of time than Watson, have a greater number of products on the market and have greater financial and other resources than we do. If we directly compete with them for the same markets and/or products, their financial strength could prevent us from capturing a profitable share of those markets. It is possible that developments by our competitors will make our products or technologies noncompetitive or obsolete.

Revenues and gross profit derived from the sales of generic pharmaceutical products tend to follow a pattern based on certain regulatory and competitive factors. As patents for brand name products and related exclusivity periods expire, the first generic manufacturer to receive regulatory approval for generic equivalents of such products is generally able to achieve significant market penetration. As competing off-patent manufacturers receive regulatory approvals on similar products or as brand manufacturers launch generic versions of such products (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 normally is related to the number of competitors in that product’s market and the timing of that product’s regulatory approval and launch, in relation to competing approvals and launches. Consequently, we must continue to develop and introduce new products in a timely and cost-effective manner to maintain our revenues and gross margins. Additionally, as new competitors enter the market, there may be increased pricing pressure on certain products, which would result in lower gross margins. This is particularly true in the case of certain Asian and other overseas competitors, who may be able to produce products at costs lower than the costs of domestic manufacturers. If we experience substantial competition from Asian or other overseas competitors with lower production costs, our profit margins will suffer.

We also face strong competition in our distribution operations, where we compete with a number of large wholesalers and other distributors of pharmaceuticals, including McKesson Corporation, AmerisourceBergen Corporation and Cardinal Health, Inc., which market both brand and generic pharmaceutical products to their customers. These companies are significant customers of our pharmaceutical business. As generic products generally have higher gross margins, each of the large wholesalers, on an increasing basis, are offering pricing incentives on brand products if the customers purchase a large portion of their generic pharmaceutical products from the primary wholesaler. As we do not offer both brand and generic products to our customers, we are at times competitively disadvantaged and must compete with these wholesalers based upon our very competitive pricing for generic products, greater service levels and our well-established telemarketing relationships with our customers, supplemented by our electronic ordering capabilities. The large wholesalers have historically not used telemarketers to sell to their customers, but may do so in the future. Additionally, generic manufacturers are increasingly marketing their products directly to smaller chains and thus increasingly bypassing wholesalers and distributors. Increased competition in the generic industry as a whole may result in increased price erosion in the pursuit of market share.

32




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

Our principal customers in our brand and generic pharmaceutical operations are wholesale drug distributors and major retail drug store chains. These customers comprise a significant part of the distribution network for pharmaceutical products in the U.S. This distribution network is continuing to undergo significant consolidation marked by mergers and acquisitions among wholesale distributors and the growth of large retail drug store chains. As a result, a small number of large wholesale distributors and large chain drug stores control a significant share of the market. We expect that consolidation of drug wholesalers and retailers will increase pricing and other competitive pressures on drug manufacturers, including Watson.

For the year ended December 31, 2006, our four largest customers accounted for 17%, 13%, 9% and 8% respectively, of our net revenues. The loss of any of these customers could materially adversely affect our business, results of operations, financial condition and our cash flows. In addition, none of our customers are party to any long-term supply agreements with us, and thus are able to change suppliers freely should they wish to do so.

ITEM 1B.  UNRESOLVED STAFF COMMENTS

Not applicable.

ITEM 2.                PROPERTIES

We conduct our operations using a combination of owned and leased properties. We believe that these facilities are suitable for the purposes for which we use them.

Our owned properties consist of facilities used for R&D, manufacturing, distribution (including warehousing and storage) and administrative functions. The following table provides a summary of locations of our significant owned properties:

Location

 

 

 

Primary Use

 

Segment

Carmel, New York

 

Manufacturing

 

Generic

Changzhou City,
Peoples Republic of China

 

Manufacturing, R&D

 

 

Coleraine, Northern Ireland

 

Manufacturing

 

Generic

Copiague, New York

 

Manufacturing, R&D

 

Generic

Corona, California

 

Manufacturing, R&D, Administration

 

Generic/Brand

Davie, Florida

 

Manufacturing, R&D, Administration

 

Generic/Brand

Grand Island, New York

 

Sales and Marketing, Administration

 

Distribution

Goa, India

 

Manufacturing

 

Generic

Gurnee, Illinois

 

Distribution

 

Generic/Brand

Humacao, Puerto Rico

 

Manufacturing

 

Generic

Mumbai, India

 

Manufacturing, R&D

 

Generic

Phoenix, Arizona

 

Manufacturing

 

Generic/Brand

Salt Lake City, Utah

 

Manufacturing, R&D

 

Generic/Brand

 

33




Properties that we lease are primarily located throughout the U.S. and include R&D, manufacturing support, distribution (including warehousing and storage), sales and marketing, and administrative facilities. The following table provides a summary of locations of our significant leased properties:

Location

 

 

 

Primary Use

 

Segment

Brewster, New York

 

Distribution

 

Generic/Brand

Davie, Florida

 

Manufacturing, Administration

 

Generic/Brand

Groveport, Ohio

 

Distribution, Administration

 

Distribution

Morristown, New Jersey

 

Sales and Marketing, Administration

 

Generic/Brand

Mt. Prospect, Illinois

 

Manufacturing support

 

Generic/Brand

Mumbai, India

 

Administration, R&D

 

Generic

Shanghai, Peoples Republic of China

 

Sales and Marketing, Administration

 

Generic

Sunrise, Florida

 

Distribution, Administration

 

Generic

Weston, Florida

 

Distribution, R&D, Administration

 

Generic

Weston, Florida

 

Distribution, Sales and Marketing, Administration

 

Distribution

 

Our leased properties are subject to various lease terms and expirations.

We believe that we have sufficient facilities to conduct our operations during 2007. However, we continue to evaluate the purchase or lease of additional properties, as our business requires.

ITEM 3.                LEGAL PROCEEDINGS

For information regarding legal proceedings, refer to Legal Matters in “Note 14—Commitments and Contingencies” in the accompanying “Notes to Consolidated Financial Statements” in this Annual Report.

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

No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 2006.

Executive Officers of the Registrant

Below are our executive officers as of March 1, 2007.

Name

 

 

 

Age

 

Principal Position with Registrant

Allen Chao, Ph.D.

 

61

 

Chairman, President and Chief Executive Officer

Edward F. Heimers

 

60

 

Executive Vice President, President of Brand Division

Thomas R. Russillo

 

63

 

Executive Vice President, President of Generic Division

Albert Paonessa, III

 

47

 

Executive Vice President, Chief Operating Officer, Anda, Inc.

David A. Buchen

 

42

 

Senior Vice President, General Counsel, and Secretary

Charles D. Ebert, Ph.D.

 

53

 

Senior Vice President, Research and Development

Thomas R. Giordano

 

56

 

Senior Vice President, Chief Information Officer

David C. Hsia, Ph.D.

 

62

 

Senior Vice President, Scientific Affairs

Susan Skara

 

56

 

Senior Vice President, Human Resources

Gordon Munro, Ph.D.

 

60

 

Senior Vice President, Quality Assurance

 

Allen Chao, Ph.D.

Allen Chao, Ph.D., age 61, a co-founder of Watson, has been our Chief Executive Officer since 1985 and Chairman since May 1996. Dr. Chao has served as our President since November 2004, and from

34




February 1998 to October 2002. Dr. Chao serves on the Board of Directors of Somerset, a research and development pharmaceutical company, which is fifty percent owned by Watson. He also serves on the Board of Directors of Accuray, Inc., a developer of medical devices for the treatment of cancers. Dr. Chao received a Ph.D. in Industrial and Physical Pharmacy from Purdue University in 1973.

Edward F. Heimers

Edward F. Heimers, age 60, has served as Executive Vice President and President of the Brand Division since May 2005. Prior to joining Watson, Mr. Heimers was Senior Vice President, Marketing for Innovex, a contract sales organization and a division of Quintiles Transnational Corp. from 2000 to 2005. Prior to joining Innovex, he was Senior Vice President, Sales for Novartis from 1996 to 1999. From 1987 to 1996, Mr. Heimers held various positions, including Senior Vice President, Specialty Products and Senior Vice President, Primary Care Marketing and Sales at Sandoz Pharmaceutical Corporation and from 1978 to 1987 held a number of marketing positions at Schering-Plough. Mr. Heimers received his undergraduate degree in Biology from New York University and a Juris Doctor from Syracuse University.

Thomas R. Russillo

Thomas R. Russillo, age 63, was appointed Executive Vice President and President of the Generics Division on September 5, 2006. Prior to joining Watson, Mr. Russillo served as a consultant to the Company from February to November, 2006, in connection with the Company’s integration planning related to the acquisition of Andrx Corporation. From January 2005 until September 1, 2006 Mr. Russillo served as a consultant to various clients in the pharmaceutical industry. From 1990 through 2004, Mr. Russillo served as President, Ben Venue Laboratories, a division of Boehringer Ingelheim. Prior to Ben Venue, he held a number of senior positions with Baxter International, most recently as Managing Director, International Medical Technology. Additionally, he is a past chairman of the National Association of Pharmaceutical Manufacturers and board member for the Generic Pharmaceutical Association. Mr. Russillo received his undergraduate degree in biology from Fordham University in 1965.

David A. Buchen

David A. Buchen, age 42, has served as Senior Vice President, General Counsel and Secretary since November 2002. From November 2000 to November 2002, Mr. Buchen served as Vice President and Associate General Counsel. From February 2000 to November 2000, he served as Vice President and Senior Corporate Counsel. From November 1998 to February 2000, he served as Senior Corporate Counsel and as Corporate Counsel. He also served as Assistant Secretary from February 1999 to November 2002. Mr. Buchen serves on the Board of Directors of Somerset. Prior to joining Watson, Mr. Buchen was Corporate Counsel at Bausch & Lomb Surgical (formerly Chiron Vision Corporation) from November 1995 until November 1998 and was an attorney with the law firm of Fulbright & Jaworski, LLP. Mr. Buchen received a B.A. in Philosophy from the University of California, Berkley in 1985, and a Juris Doctor with honors from George Washington University Law School in 1989.

Charles D. Ebert, Ph.D.

Charles D. Ebert, Ph.D., age 53, has served as our Senior Vice President, Research and Development since May 2000. He served as our Senior Vice President, Proprietary Research and Development from June 1999 to May 2000. Before joining Watson, Dr. Ebert served TheraTech, Inc. as its Vice President, Research and Development from 1987 to 1992 and as its Senior Vice President, Research and Development since 1992. Dr. Ebert serves on the Board of Directors of Somerset. Dr. Ebert received a B.S. in Biology from the University of Utah in 1977 and a Ph.D. in Pharmaceutics from the University of Utah in 1981.

35




Thomas R. Giordano

Thomas R. Giordano, age 56, was appointed Senior Vice President, Chief Information Officer of Watson on December 11, 2006. Mr. Giordano joined Watson following the Company’s acquisition of Andrx, where he served as Senior Vice President, Chief Information Officer and Chief Project Management Officer since 2002. Prior to joining Andrx, he was Senior Vice President and Global Chief Information Officer for Burger King Corporation, a subsidiary of Diageo Plc from 1998 to 2001. He has also held the position of Senior Vice President and Chief Information Officer for Racal Data Group and AVEX Electronics. Mr. Giordano received his undergraduate degree in economics from St. Peters College in New Jersey in 1979, participated in graduate studies at New York University, New York and completed the Information Systems Executive Management Program at Harvard Business School.

David C. Hsia, Ph.D.

David C. Hsia, Ph.D., age 62, has served as our Senior Vice President, Scientific Affairs since May 1995 and has been a Vice President of Watson since 1985. Dr. Hsia is also co-founder of Watson. He has been involved in the development of pharmaceutical formulations for oral contraceptives, sustained-release products and novel dosage forms for over 20 years. Dr. Hsia received a Ph.D. in industrial and physical pharmacy from Purdue University in 1975.

Albert Paonessa III

Albert Paonessa, age 47, joined Watson as our Executive Vice President, Chief Operating Officer of Anda, Inc., our Distribution company following our acquisition of Andrx. Mr. Paonessa was appointed Anda, Inc. Executive Vice President and Chief Operating Officer in August 2005 and had been with Anda since Andrx acquired Valmed Pharmaceuticals, Inc. in March 2000. From March 2000 through January 2002, Mr. Paonessa was Vice President, Operations of Valmed. In January 2002, he became Vice President, Information Systems at Anda and in January 2004 was appointed Senior Vice President, Sales at Anda.

Susan Skara

Susan Skara, age 56, has served as our Senior Vice President, Human Resources since November 2002. Ms. Skara joined Watson in March 1999 as Vice President, Human Resources, a position she held until her promotion to Senior Vice President in November 2002. Prior to joining Watson, Ms. Skara worked for Apria Healthcare and last held the position of Senior Vice President of Human Resources from November 1996 to June 1998. Ms. Skara received a B.A. in French from California State University, Fullerton.

Gordon Munro, Ph.D.

Gordon Munro, Ph.D, age 60, has served as our Senior Vice President, Quality Assurance since June 2004. Prior to joining Watson, Dr. Munro was the Director of Inspection and Enforcement, at the United Kingdom Medicines and Healthcare Products Regulatory Agency from 1997 to 2004, and from 2002 to 2004, he was also Acting Head of Medicines. From 1970 to 1997, he held various positions, including the Director of Quality and Compliance at GlaxoWelcome. Dr. Munro received a B.S. in Pharmacy and a Masters in Analytical Chemistry from the University of Strathclyde, Scotland, and a Ph.D. in Analytical Chemistry from the Council of National Academy Awards.

Our executive officers are appointed annually by the Board of Directors, hold office until their successors are chosen and qualified, and may be removed at any time by the affirmative vote of a majority of the Board. We have employment agreements with each of our executive officers. David Hsia is the brother-in-law of Allen Chao. There are no other family relationships between any director and executive officer of Watson.

36




PART II

ITEM 5.                MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

(a) Market for Registrant’s Common Equity

Our common stock is traded on the New York Stock Exchange under the symbol “WPI.” The following table sets forth the quarterly high and low share trading price information for the periods indicated:

 

 

High

 

Low

 

Year ended December 31, 2006:

 

 

 

 

 

First

 

$

35.27

 

$

27.90

 

Second

 

$

30.48

 

$

22.86

 

Third

 

$

27.17

 

$

21.35

 

Fourth

 

$

27.33

 

$

24.31

 

Year ended December 31, 2005:

 

 

 

 

 

First

 

$

32.60

 

$

27.99

 

Second

 

$

31.99

 

$

28.47

 

Third

 

$

36.75

 

$

28.20

 

Fourth

 

$

36.93

 

$

32.04

 

 

As of February 22, 2007, there were approximately 3,100 registered holders of our common stock.

We have not paid any cash dividends since our initial public offering in February 1993, and do not anticipate paying any cash dividends in the foreseeable future.

(b) Recent Sales of Unregistered Securities

There were no unregistered sales of equity securities.

(c) Issuer Purchases of Equity Securities

There were no purchases of common stock by the Company during the fourth quarter of 2006.

(d) Securities Authorized for Issuance Under Equity Compensation Plans

For information regarding securities authorized for issuance under equity compensation plans, refer to “Note 11—Stockholders’ Equity” in the accompanying “Notes to Consolidated Financial Statements” in this Annual Report.

37




(e) Performance Graph

The following graph compares the cumulative 5-year total return attained by shareholders on Watson Pharmaceuticals’s common stock relative to the cumulative total returns of the S & P 500 index and the Dow Jones US Pharmaceuticals index. The graph tracks the performance of a $100 investment in our common stock and in each of the indexes (with the reinvestment of all dividends) from 12/31/2001 to 12/31/2006.

GRAPHIC

 

 

12/31/01

 

12/31/02

 

12/31/03

 

12/31/04

 

12/31/05

 

12/31/06

 

 

Watson Pharmaceuticals

 

 

100.00

 

 

 

90.06

 

 

 

146.54

 

 

 

104.52

 

 

 

103.57

 

 

 

82.92

 

 

S & P 500

 

 

100.00

 

 

 

77.90

 

 

 

100.24

 

 

 

111.15

 

 

 

116.61

 

 

 

135.03

 

 

Dow Jones US Pharmaceuticals

 

 

100.00

 

 

 

79.62

 

 

 

87.15

 

 

 

79.93

 

 

 

78.61

 

 

 

89.92

 

 

 

The stock price performance included in this graph is not necessarily indicative of future stock price performance.

38




ITEM 6.                SELECTED FINANCIAL DATA

WATSON PHARMACEUTICALS, INC.
FINANCIAL HIGHLIGHTS

(In thousands, except per share amounts)

 

 

Years Ended December 31,

 

 

 

2006

 

2005(1)

 

2004(1)

 

2003(1)

 

2002(1)

 

Operating Highlights:

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

1,979,244

 

$

1,646,203

 

$

1,640,551

 

$

1,457,722

 

$

1,223,198

 

Gross profit (excluding amortization)

 

$

745,761

 

$

793,789

 

$

819,757

 

$

833,071

 

$

651,316

 

Operating (loss) income(2)

 

$

(422,096

)

$

218,512

 

$

265,940

 

$

338,913

 

$

269,364

 

Net (loss) income(2)

 

$

(445,005

)

$

138,557

 

$

150,018

 

$

201,728

 

$

173,787

 

Basic (loss) earnings per share

 

$

(4.37

)

$

1.32

 

$

1.37

 

$

1.88

 

$

1.63

 

Diluted (loss) earnings per share(3)

 

$

(4.37

)

$

1.22

 

$

1.26

 

$

1.74

 

$

1.62

 

Weighted average shares outstanding:

 

 

 

 

 

 

 

 

 

 

 

Basic

 

101,761

 

104,949

 

109,174

 

107,488

 

106,675

 

Diluted(3)

 

101,761

 

120,021

 

124,727

 

120,727

 

107,367

 

 

 

 

At December 31,

 

 

 

2006

 

2005

 

2004

 

2003

 

2002

 

Balance Sheet Highlights:

 

 

 

 

 

 

 

 

 

 

 

Current assets(1)

 

$

1,261,676

 

$

1,353,543

 

$

1,361,136

 

$

1,309,704

 

$

898,270

 

Working capital(1)

 

$

571,747

 

$

1,107,873

 

$

1,105,507

 

$

971,019

 

$

522,805

 

Total assets(1)

 

$

3,760,577

 

$

3,077,187

 

$

3,231,956

 

$

3,268,134

 

$

2,648,334

 

Total debt

 

$

1,231,204

 

$

587,935

 

$

587,653

 

$

722,535

 

$

415,237

 

Deferred tax liabilities(1)

 

$

203,860

 

$

126,718

 

$

141,691

 

$

144,359

 

$

152,834

 

Total stockholders’ equity(1)

 

$

1,680,388

 

$

2,100,469

 

$

2,230,690

 

$

2,042,146

 

$

1,784,728

 


(1)          Prior to the Andrx Acquisition the Company held common shares in Andrx, which were previously classified as available-for-sale securities and recorded at fair value based upon quoted market prices with temporary differences between cost and fair value presented as accumulated other comprehensive income within stockholders’ equity, net of any related tax effect. As required by Accounting Research Bulletin (“ARB”) No. 51, “Consolidated Financial Statements” (“ARB 51”), earnings (loss) on equity method investments has been restated for all periods presented to account for our investment in common shares of Andrx prior to the Andrx Acquisition using the equity method of accounting in accordance with Accounting Principles Board (“APB”) Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock” (“APB 18”). Accumulated other comprehensive income (loss) has also been restated for all periods presented to reflect these changes. Accordingly, the selected consolidated financial data for all periods prior to the Andrx Acquisition has been prepared as if this investment had been accounted for using the equity method since our initial investment. The restatement increased (decreased) net income from 2005 to 2002 by $324, ($5), ($351) and ($1,246), respectively.

(2)          For discussion on comparability of operating income and net income, please refer to financial line item discussion in our Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Annual Report.

(3)          Diluted earnings per share have been restated for the year ended December 31, 2003 to conform to Emerging Issues Task Force Issue No. 04-8, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share”.

39




ITEM 7.                MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Except for the historical information contained herein, the following discussion contains forward-looking statements that are subject to known and unknown risks, uncertainties and other factors that may cause actual results to differ materially from those expressed or implied by such forward-looking statements. We discuss such risks, uncertainties and other factors throughout this report and specifically under the caption “Cautionary Note Regarding Forward-Looking Statements” just preceding this Item in this Form 10-K. In addition, the following discussion of financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements and Notes thereto included elsewhere in this report.

GENERAL

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

As of December 31, 2006, we marketed more than 150 generic pharmaceutical products and more than 20 brand pharmaceutical products. Prescription pharmaceutical products in the U.S. are generally marketed as either generic or brand pharmaceuticals. Generic pharmaceutical products are bioequivalents of their respective brand products and provide a cost-efficient alternative to brand products. Brand pharmaceutical products are marketed under brand names through programs that are designed to generate physician and consumer loyalty.

The Company has announced several recent cost reduction initiatives that will take place by early 2007 including the closure of our Puerto Rico manufacturing facility and the planned divestiture of our Phoenix, Arizona injectable manufacturing facility. The Company is also establishing a foreign operating infrastructure to supply the U.S. market which includes a recently acquired solid dose manufacturing facility in Goa, India; an increased investment in a Chinese/Taiwanese company specializing in the development and manufacture of active pharmaceutical ingredients (“API”); and the acquisition of Mumbai, India-based Sekhsaria Chemicals, Ltd. (“Sekhsaria”) that provides API and finished dosage formulation expertise to the global pharmaceutical industry.

On November 3, 2006, the Company acquired all the outstanding shares of common stock of Andrx Corporation (“Andrx”) in an all-cash transaction for $25 per share, or total consideration of approximately $1.9 billion (the “Andrx Acquisition”). Andrx distributes pharmaceutical products primarily to independent and chain pharmacies and physicians’ offices and is considered a leader in formulating and commercializing difficult-to-replicate controlled-release pharmaceutical products and selective immediate-release products. As a result of the Andrx Acquisition, Watson now has three operating segments: Generic, Brand and Distribution. For additional information on the Andrx Acquisition, refer to NOTE 4—Acquisitions in the accompanying Notes to Condensed Consolidated Financial Statements in this Annual Report and to our Current Report on Form 8-K filed on November 6, 2006 and Current Report on Form 8-K/A filed on January 17, 2007.

Prior to the Andrx Acquisition the Company held common shares in Andrx, which were previously classified as available-for-sale securities and recorded at fair value based upon quoted market prices with temporary differences between cost and fair value presented as accumulated other comprehensive income within stockholders’ equity, net of any related tax effect. As required by Accounting Research Bulletin (“ARB”) No. 51, “Consolidated Financial Statements” (“ARB 51”), earnings (loss) on equity method investments has been restated for all periods presented to account for our investment in common shares of Andrx prior to the Andrx Acquisition using the equity method of accounting in accordance with Accounting Principles Board (“APB”) Opinion No. 18, “The Equity Method of Accounting for

40




Investments in Common Stock” (“APB 18”). Accumulated other comprehensive income (loss) has also been restated for all periods presented to reflect these changes.

YEAR ENDED DECEMBER 31, 2006 COMPARED TO 2005

Overview

Prior to the Andrx Acquisition, Watson had two reportable operating segments: Generic and Brand. The Generic segment includes off-patent pharmaceutical products that are therapeutically equivalent to proprietary products. The Brand segment includes the Company’s lines of Specialty Products and Nephrology products. Watson has aggregated its Brand product lines in a single segment because of similarities in regulatory environment, methods of distribution and types of customer. This segment includes patent-protected products and certain trademarked off-patent products that Watson sells and markets as Brand pharmaceutical products. The Company sells its Brand and Generic products primarily to pharmaceutical wholesalers, drug distributors and chain drug stores. Following the Andrx Acquisition, a third operating segment was added representing the Anda distribution business. The Distribution segment mainly distributes generic pharmaceutical products manufactured by third parties, as well as by Watson, primarily to independent pharmacies, pharmacy chains, pharmacy buying groups and physicians’ offices. Sales are principally generated through an in-house telemarketing staff and through internally developed ordering systems. The Distribution segment operating results exclude Watson Generic and Brand products, which are included in their respective segment results.

As of January 1, 2005, the Company began to evaluate segment performance based on segment net revenues, gross profit and contribution. Segment contribution represents segment gross profit less direct research and development expenses and selling and marketing expenses. The Company has not allocated corporate general and administrative expenses, amortization, or impairment losses by segment as such information has not been used by management, or has not been accounted for at the segment level. Segment financial data for all periods presented reflect this change in evaluating the associated segment results.

41




Results of Operations

Results of operations, including segment net revenues, segment gross profit and segment contribution information for the Company’s Generic, Brand and Distribution segments, consisted of the following:

 

 

Years Ended December 31,

 

 

 

2006

 

2005

 

 

 

Generic

 

Brand

 

Distribution

 

Total

 

Generic

 

Brand

 

Total

 

Product sales

 

$

1,501,251

 

$

354,070

 

 

$

92,796

 

 

$

1,948,117

 

$

1,242,584

 

$

389,545

 

$

1,632,129

 

Other

 

15,559

 

15,402

 

 

166

 

 

31,127

 

4,357

 

9,717

 

14,074

 

Net revenues

 

1,516,810

 

369,472

 

 

92,962

 

 

1,979,244

 

1,246,941

 

399,262

 

1,646,203

 

Cost of sales(1)

 

1,059,234

 

92,184

 

 

82,065

 

 

1,233,483

 

760,845

 

91,569

 

852,414

 

Gross profit

 

457,576

 

277,288

 

 

10,897

 

 

745,761

 

486,096

 

307,693

 

793,789

 

Gross margin

 

30.2

%

75.0

%

 

11.7

%

 

37.7

%

39.0

%

77.1

%

48.2

%

Research and development

 

83,551

 

47,472

 

 

 

 

131,023

 

80,879

 

44,384

 

125,263

 

Selling and marketing

 

52,882

 

112,258

 

 

8,409

 

 

173,549

 

48,914

 

113,428

 

162,342

 

Contribution

 

$

321,143

 

$

117,558

 

 

$

2,488

 

 

441,189

 

$

356,303

 

$

149,881

 

506,184

 

Contibution margin

 

21.2

%

31.8

%

 

2.7

%

 

22.3

%

28.6

%

37.5

%

30.7

%

Corporate general and administrative

 

 

 

 

 

 

 

 

 

131,511

 

 

 

 

 

98,657

 

Amortization

 

 

 

 

 

 

 

 

 

163,710

 

 

 

 

 

163,939

 

In-process research and development

 

 

 

 

 

 

 

 

 

497,800

 

 

 

 

 

 

Loss on impairment

 

 

 

 

 

 

 

 

 

70,264

 

 

 

 

 

25,076

 

Operating (loss) income

 

 

 

 

 

 

 

 

 

$

(422,096

)

 

 

 

 

$

218,512

 

Operating margin

 

 

 

 

 

 

 

 

 

(21.3

)%

 

 

 

 

13.3

%


(1)          Excludes amortization.

Generic Segment

Net Revenues

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

Other revenues include royalties and, beginning in 2006, commission revenue earned as a sales agent of Cephalon, Inc., from the sale of fentanyl citrate troche.

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

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

Net product sales from our Generics segment during the year ended December 31, 2006 increased $258.7 million or 20.8% over the prior year. Sales increased due to the inclusion of Andrx for the two month period ended December 31, 2006 (the “Andrx Results”) and due to sales of certain Authorized Generic products including oxycodone HCl controlled-release tablets, launched during the fourth quarter of 2005, and pravastatin sodium tablets, launched during the second quarter of 2006. Sales from the Andrx

42




Results and these authorized generic products totaled $336.5 million during the year ended December 31, 2006 and $18.5 million during the year ended December 31, 2005. Excluding the Andrx Results and these authorized generic products, net product sales in our Generic segment declined by $59.4 million or 5%. This decline was mainly due to lower pricing on the Company’s existing products.

The increase in other revenues in the year ended December 31, 2006 within the Generics segment was primarily related to commission revenues earned on sales of fentanyl citrate troche during the second half of 2006.

Generic product sales for 2007 should approximate 2006 levels as the full year effect of the Andrx Acquisition and planned new product launches are expected to offset the loss of sales from normal generic price erosion of our existing products and the a loss of revenues from certain Authorized Generic products that contributed to year over year growth in 2006.

Other revenue should increase in 2007 due to the full year impact of commission revenues from fentanyl citrate troche, the addition of royalties from the licensing of a patent in early 2007 (refer to “Note 15—Subsequent Events” in the accompanying “Notes to Consolidated Financial Statements” in this Annual Report), and other licensing activities that are expected to generate revenue during the year.

Gross Profit Margin (Gross Margin)

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

Gross margins for our Generic segment declined to 30.2% for the year ended December 31, 2006 from 39.0% in the year ago period. The decrease in gross margin from our Generic segment was primarily due to sales of oxycodone HCl controlled-release tablets and pravastatin sodium tablets during 2006 and decreased margins from the Andrx Results due partly to purchase accounting charges during the period. Sales from the Andrx Results and these authorized generic products generated $24.9 million of gross profit on $336.5 million of revenues. Margins in our Generic segment were also adversely impacted by plant rationalization costs of $15.9 million in the year ended December 31, 2006 and price declines over the past year on existing products.

We expect our generic gross margins to improve in 2007 as new product launches, increased other revenue, lower plant closure costs, and a reduction in the sales of certain low margin Authorized Generic products should offset the impact of expected price erosion.

Research and Development Expenses

Research and development expenses consist predominantly of personnel costs, contract research, development and facilities costs associated with the development of our products.

Research and development expenses within our Generic segment increased $2.7 million or 3.3% during the year ended December 31, 2006, as compared to the prior year, mainly due to the Andrx Results.

For 2007, we expect generic research and development spending to be approximately 6.7% to 7.3% of total generic revenue.

Selling and Marketing Expenses

Selling and marketing expenses consist mainly of personnel costs, facilities costs, insurance, depreciation, distribution costs and travel costs.

43




Generic segment selling and marketing expenses increased $4.0 million or 8.1% during the year ended December 31, 2006 as compared to the prior year primarily due to higher distribution costs related to higher unit sales.

For 2007, we expect generic sales and marketing spending to increase approximately 10% from 2006 levels due primarily to higher distribution costs associated with the full year impact of sales associated with the Andrx Acquisition.

Brand Segment

Net Revenues

Our Brand segment develops, manufactures, markets, sells and distributes products within two sales and marketing groups: Specialty Products and Nephrology.

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

Our Nephrology product line consists of products for the treatment of iron deficiency anemia and is generally marketed to nephrologists and dialysis centers. The major product of the Nephrology group is Ferrlecit®, which is used to treat low iron levels in patients undergoing hemodialysis in conjunction with erythropoietin therapy.

The decrease in net product sales from our Brand segment of $35.5 million or 9.1% for the year ended December 31, 2006 compared to the prior year was primarily attributable to a decrease in prescription volumes for our non-promoted products within our Specialty Products product line.  Brand segment product sales were also impacted by a reduction in wholesaler inventories during 2006.

For 2007, we expect Brand product sales to be similar to 2006 levels.

Other revenues in the Brand segment consist of co-promotion revenues, royalties, and revenues (including the amortization of deferred revenue) relating to our obligation to manufacture and supply two brand products to a third party. This contract manufacturing agreement was assumed as part of the acquisition of Andrx.

Other revenue also includes revenues recognized from research, development and licensing agreements (including milestone payments and deferred revenue related to certain contract manufacturing arrangements). Revenues from development agreements are deferred and recognized over the entire contract performance period, starting with the contracts commencement, but not prior to the removal of any contingencies for each individual milestone. We recognize this revenue based upon the pattern in which the revenue is earned or the obligation is fulfilled.

The increase in other revenues in the year ended December 31, 2006 within the Brand segment was primarily attributable to our share of profits on the AndroGel® co-promotion agreement, which commenced in the fourth quarter of 2006, and to deferred revenue recognized from the Andrx Results.

During 2007, we expect other revenue to be higher due to the full year effect of the Androgel co-promotional agreement and Andrx Acquisition.

Gross Profit Margin (Gross Margin)

Gross margins for our Brand segment declined to 75.0% for the year ended December 31, 2006 from 77.1% in the prior year period. The decrease in gross margin from our Brand segment was primarily due to $5.8 million in plant rationalization costs at our Phoenix facility during the year that was allocated to the Brand segment in 2006.

The margin reduction within our Brand segment from plant rationalization costs was partly offset by higher levels of other revenues during the year ended December 31, 2006 as compared to the prior year.

44




Research and Development Expenses

Research and development expenses within our Brand segment increased $3.1 million or 7.0% during the year ended December 31, 2006, as compared to the prior year. We expect 2007 Brand research and development spending to be consistent with 2006 levels.

Selling and Marketing Expenses

Brand segment selling and marketing expenses decreased during the year ended December 31, 2006 as compared to the prior year due to lower product spending for Oxytrol® during the current year.

For 2007, we expect Brand selling and marketing spending to be slightly lower than 2006 levels.

Distribution Segment

Our Distribution segment mainly distributes generic pharmaceutical products manufactured by third parties, as well as by Watson, primarily to independent pharmacies, pharmacy chains, pharmacy buying groups and physicians’ offices. Sales are principally generated through an in-house telemarketing staff and through internally developed ordering systems. The Distribution segment operating results exclude Watson Generic and Brand products, which are included in their respective segment results. Distribution segment results have been included in Watson’s operating results since the date of the Andrx Acquisition.

Gross margins within the Distribution segment have been adversely impacted due to acquisition accounting inventory charges of approximately $5.7 million during the period.

Segment Contribution

 

 

Years Ended December 31,

 

Change

 

($ in thousands):

 

      2006      

 

      2005       

 

Dollars

 

%

 

Segment contribution

 

 

 

 

 

 

 

 

 

 

 

 

 

Generic

 

 

$

321,143

 

 

 

$

356,303

 

 

$

(35,160

)

(9.9

)%

Brand

 

 

117,558

 

 

 

149,881

 

 

(32,323

)

(21.6

)%

Distribution

 

 

2,488

 

 

 

 

 

2,488

 

100.0

%

 

 

 

$

441,189

 

 

 

$

506,184

 

 

$

(64,995

)

(12.8

)%

as % of net revenues

 

 

22.3

%

 

 

30.7

%

 

 

 

 

 

 

Generic segment contribution decreased for the year ended December 31, 2006, as compared to the same period of the prior year, primarily due to:

·       A reduction in gross profit due to price reductions on certain generic products and plant rationalization costs incurred during the year;

·       An increase in research and development expenses mainly due to the Andrx Results in the period; and

·       An increase in selling and marketing primarily due to higher distribution costs as a result of higher unit sales.

Brand segment contribution decreased during the year ended December 31, 2006, as compared to the same period of the prior year, primarily due to:

·       A decrease in sales of certain Specialty Products due to a decrease in prescription volumes for our non-promoted products and a reduction in wholesaler inventory levels;

45




·       A decrease in gross margins due to plant rationalization costs related to our Phoenix facility; and

·       An increase in research and development expenses.

The Distribution segment was added as a third reporting segment following the Andrx Acquisition. Results have been included within Watson’s operating results since the date of the Andrx Acquisition

For more information on segment contribution, refer to above Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 12—Operating Segments in the accompanying Notes to Consolidated Financial Statements in this Annual Report.

Corporate General and Administrative Expenses

 

 

Years Ended December 31,

 

Change

 

($ in thousands):

 

     2006     

 

     2005     

 

Dollars

 

%

 

Corporate general and administrative expenses

 

$

131,511

 

 

$

98,657

 

 

$

32,854

 

33.3

%

as % of net revenues

 

6.6

%

 

6.0

%

 

 

 

 

 

 

Corporate general and administrative expenses consist mainly of personnel costs, facilities costs, insurance, depreciation, distribution costs, litigation costs and professional services costs which are general in nature and not directly related to specific segment operations.

Corporate general and administrative expenses increased in 2006 compared to the prior year due to higher general and administrative costs related to international operations, the Andrx Results, Andrx acquisition costs, higher stock award costs and litigation settlements during the period.

In 2007, general and administrative expenses will increase as a result of the Andrx Acquisition.

Amortization

 

 

Years Ended December 31,

 

Change

 

($ in thousands):

 

      2006      

 

      2005      

 

Dollars

 

%

 

Amortization

 

 

$

163,710

 

 

 

$

163,939

 

 

 

$

(229

)

 

(0.1

)%

as % of net revenues

 

 

8.3

%

 

 

10.0

%

 

 

 

 

 

 

 

 

The Company’s amortizable assets consist primarily of acquired product rights. Amortization costs were relatively unchanged for 2006 from 2005 levels. Amortization in 2007 is expected to increase representing additional amortization on intangible assets from the Andrx Acquisition. In 2007, Andrx Acquisition related amortization expense is expected to be approximately $19 million.

In-Process Research and Development

 

 

Years Ended December 31,

 

Change

 

($ in thousands):

 

      2006      

 

     2005     

 

Dollars

 

%

 

In-process research and development

 

 

$

497,800

 

 

 

$

 

 

$

497,800

 

100.0

%

as % of net revenues

 

 

25.2

%

 

 

0.0

%

 

 

 

 

 

 

The charge for in-process research and development (“IPR&D”) reflects the estimated fair value of IPR&D projects that, as of the closing date of the Andrx Acquisition, will not have reached technical feasibility and will have no alternative future use. IPR&D projects included in our valuation include over thirty controlled or immediate release products at various stages of research and development. These IPR&D projects have been valued through discounted cash flow analysis utilizing the “income” approach at rates commensurate with their perceived risks, which for these IPR&D projects ranged between

46




19-20%. A partial list of cash flow considerations utilized for each of the IPR&D projects included an evaluation of a project’s estimated cost to complete, future product prospects and competition, product lifecycles, expected date of market introduction and expected pricing and cost structure.

Loss on Impairment

 

 

Years Ended December 31,

 

Change

 

($ in thousands):

 

     2006     

 

     2005     

 

Dollars

 

%

 

Loss on impairment

 

 

$

70,264

 

 

 

$

25,076

 

 

$

45,188

 

180.2

%

as % of net revenues

 

 

3.6

%

 

 

1.5

%

 

 

 

 

 

 

When events or changes in circumstances indicate that some portion of long lived assets may have become unrecoverable, an assessment is performed using a variety of methodologies, including analysis of undiscounted future cash flows, estimates of sales proceeds and independent appraisals. If such assets are impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds the estimated fair market value of the assets.

During the second quarter of 2006, the Company recognized a $67.0 million loss on impairment of product rights resulting from a downward revision of long range product sales predominantly relating to Alora® and Actigall® (refer to Note 7—Goodwill, Product Rights and Other Intangibles in the accompanying Notes to Condensed Consolidated Financial Statements in this Annual Report). During the fourth quarter of 2006, the Company recognized a $3.3 million additional impairment charge related primarily to the closing of our manufacturing facility in Puerto Rico (see below).

In the year ended December 31, 2005, we recognized a $25.1 million impairment charge primarily relating to a write-down of our Puerto Rico facility as a result of our decision to close our manufacturing facility in Puerto Rico, transfer product manufacturing to our Carmel, New York and Corona, California sites and discontinue manufacturing operations at our Puerto Rico facility.

Loss on Early Extinguishment of Debt

 

 

Years Ended December 31,

 

Change

 

($ in thousands):

 

      2006      

 

      2005      

 

Dollars

 

%

 

Loss on early extinguishment of debt

 

 

$

(525

)

 

 

$

 

 

 

$

(525

)

 

(100.0

)%

as % of net revenues

 

 

0.0

%

 

 

0.0

%

 

 

 

 

 

 

 

 

On March 31, 2006, the Company initiated a redemption notice to the holders of all of its outstanding senior unsecured 7 1/8% notes (“1998 Senior Notes”). The 1998 Senior Notes were redeemed on May 23, 2006 resulting in charges of $0.5 million related to fees, expenses, unamortized discount, and premiums paid.

Interest Income

 

 

Years Ended December 31,

 

Change

 

($ in thousands):

 

     2006     

 

     2005     

 

Dollars

 

%

 

Interest income

 

 

$

28,418

 

 

 

$

19,321

 

 

$

9,097

 

47.1

%

as % of net revenues

 

 

1.4

%

 

 

1.2

%

 

 

 

 

 

 

Interest income increased during the year ended December 31, 2006 as compared to the same period of the prior year due to higher balances of cash and marketable securities and higher rates of return on invested balances in the current period. Interest income is expected to decline in 2007 due to the use of available cash, cash equivalents and marketable securities to finance the Andrx Acquisition.

47




Interest Expense

 

 

Years Ended December 31,

 

Change

 

($ in thousands):

 

     2006     

 

     2005     

 

Dollars

 

%

 

Interest expense—convertible contingent senior debentures due 2023 (“CODES”)

 

 

$

12,605

 

 

 

$

12,605

 

 

$

 

0.0

%

Interest expense—CIBC senior credit facility

 

 

8,121

 

 

 

 

 

8,121

 

100.0

%

Interest expense—senior unsecured notes issued in May 1998 (“1998 Senior Notes”)

 

 

406

 

 

 

1,021

 

 

(615

)

(60.2

)%

Interest and fees on credit facility

 

 

850

 

 

 

1,479

 

 

(629

)

(42.5

)%

Change in derivative value

 

 

(664

)

 

 

(756

)

 

92

 

(12.2

)%

Interest expense—other

 

 

764

 

 

 

175

 

 

589

 

336.6

%

Interest expense

 

 

$

22,082

 

 

 

$

14,524

 

 

$

7,558

 

52.0

%

as % of net revenues

 

 

1.1

%

 

 

0.9

%

 

 

 

 

 

 

Interest expense increased for the year ended December 31, 2006 over the prior year due to interest expense incurred on debt issued to finance the Andrx Acquisition during the period.

Other Income/(Expense)

 

 

Years Ended December 31,

 

Change

 

 

($ in thousands):

 

 

      2006      

 

      2005      

 

Dollars

 

%

 

Other income (expense) consists of:

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) on equity method investments, restated

 

 

$

2,066

 

 

 

$

(2,347

)

 

$

4,413

 

(188.0

)%

Gain (loss) on sale of securities

 

 

3,546

 

 

 

(401

)

 

3,947

 

(984.3

)%

Other expense

 

 

(276

)

 

 

(627

)

 

351

 

(56.0

)%

 

 

 

$

5,336

 

 

 

$

(3,375

)

 

$

8,711

 

(258.1

)%

as % of net revenues

 

 

0.3

%

 

 

-0.2%

 

 

 

 

 

 

 

Earnings (Loss) on Equity Method Investments

The Company’s equity investments are accounted for under the equity-method when the Company’s ownership does not exceed 50% and when the Company can exert significant influence over the management of the investee.

In the year ended December 31, 2006 the Company completed the Andrx Acquisition. Prior to the Andrx Acquisition the Company held common shares in Andrx, which were previously classified as available-for-sale securities and recorded at fair value based upon quoted market prices with temporary differences between cost and fair value presented as a separate component of stockholders’ equity, net of any related tax effect. As required by ARB 51, earnings (loss) on equity method investments has been restated for all periods presented to account for our investment in common shares of Andrx prior to the Andrx Acquisition using the equity method of accounting in accordance with APB 18.

The loss recorded during the year ended December 31, 2005 represents our share of losses incurred by Scinopharm Taiwan Ltd. (“Scinopharm”) and Somerset Pharmaceuticals, Inc. (“Somerset”), our joint venture with Mylan Laboratories, Inc. (“Mylan”). Loss on equity method investments in 2005 was reduced by our share of equity earnings in Andrx. Improved results at both Scinopharm and Somerset contributed

48




primarily to the change from a net loss to net earnings on equity method investments for the year ended December 31, 2006.

Gain (Loss) on Sale of Securities

The 2006 gain on sale of securities resulted primarily from the sale of our investment in Adheris, Inc. We received cash proceeds of $4.7 million from our sale of our entire investment in Adheris, Inc. and may receive additional proceeds upon the achievement of certain earn-out milestones. The 2005 $0.4 million loss on sale of securities resulted from the sale of our remaining investment in Genelabs Technologies, Inc. (“Genelabs”) for proceeds of $1.4 million.

Provision for Income Taxes

 

 

Years Ended December 31,

 

Change

 

 

($ in thousands):

 

 

      2006      

 

      2005      

 

Dollars

 

%

 

Provision for income taxes, restated

 

 

$

34,056

 

 

 

$

81,377

 

 

$

(47,321

)

(58.2

)%

as a % of net revenues

 

 

1.7

%

 

 

4.9

%

 

 

 

 

 

Effective tax rate

 

 

-8.3%

 

 

 

37.0

%

 

 

 

 

 

 

The provision for income taxes decreased for the year ended December 31, 2006 over the prior year due to reduced levels of income before income taxes. In 2006, the loss before income taxes included an IPR&D charge of $497.8 million for which no tax benefit has been provided. We have provided a tax provision at 39.2% on the remaining income. The rate for 2006 of 39.2% is higher compared to the rate in 2005 due in part to the effect of the adoption of Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”) during the current year. Beginning January 1, 2006, in conjunction with the adoption of SFAS 123R, incentive stock option deductions are considered a permanent difference which has the impact of increasing our effective tax rate in the year. The tax rate was also increased because there was a lower ratio of pretax income to permanent differences.

YEAR ENDED DECEMBER 31, 2005 COMPARED TO 2004

Overview

During 2004 and 2005, Watson had two reportable operating segments: Generic and Brand.

Prior to July 1, 2004, the Brand products segment included the Company’s lines of Women’s Health, General Products and Nephrology products. Following a formal realignment of our business strategy announced in June 2004, the Company refocused operational resources on three core business areas: Specialty Products, Nephrology and Generic products. The Brand business segment includes products serving the specialty markets in urology and nephrology. The realignment combines the bulk of the Company’s oral contraceptive products (formerly in the Women’s Health division) with certain other generic products (formerly in the General Products division) in an expanded Generic business segment. Following the realignment, products formerly included in Women’s Health and General Products that have not been included within the expanded Generic business segment are included within the Specialty Products group as part of the Brand segment. All segment results have been presented to reflect this realignment. As of January 1, 2005, the Company began to evaluate segment performance based on segment net revenues, gross profit and contribution. Segment contribution represents segment gross profit less direct research and development expenses and selling and marketing expenses. The Company has not allocated corporate general and administrative expenses, amortization, or impairment losses by segment as such information has not been used by management, or has not been accounted for at the segment level. Segment financial data for all periods presented reflect this change in evaluating the associated segment results.

49




Results of Operations

Results of operations, including segment net revenues, segment gross profit and segment contribution information for the Company’s Generic and Brand segments, as revised, consisted of the following:

 

 

Years Ended December 31,

 

 

 

2005

 

2004

 

 

 

Generic

 

Brand

 

Total

 

Generic

 

Brand

 

Total

 

Product sales

 

$

1,242,584

 

$

389,545

 

$

1,632,129

 

$

1,239,420

 

$

363,795

 

$

1,603,215

 

Other

 

4,357

 

9,717

 

14,074

 

18,591

 

18,745

 

37,336

 

Net revenues

 

1,246,941

 

399,262

 

1,646,203

 

1,258,011

 

382,540

 

1,640,551

 

Cost of sales(1)

 

760,845

 

91,569

 

852,414

 

743,822

 

76,972

 

820,794

 

Gross profit

 

486,096

 

307,693

 

793,789

 

514,189

 

305,568