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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

---------------

FORM 10-K

(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934

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 91720
- ---------------------------------------- ----------
(Address of principal executive offices) (Zip Code)

(909) 270-1400
----------------------------------------------------
(Registrant's telephone number, including area code)

SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, $.0033 PAR VALUE

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 [ ]

Indicated 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. [ ]

AGGREGATE MARKET VALUE, AS OF MARCH 2, 1998, OF COMMON STOCK HELD BY
NON-AFFILIATES OF THE REGISTRANT: $2,975,020,943 BASED ON THE LAST REPORTED SALE
PRICE ON THE NEW YORK STOCK EXCHANGE.

NUMBER OF SHARES OF COMMON STOCK OUTSTANDING ON MARCH 2, 1998: 88,273,160

DOCUMENTS INCORPORATED BY REFERENCE

The registrant intends to file a definitive Proxy Statement pursuant to
Regulation 14A within 120 days after the end of the fiscal year ended December
31, 1997. Portions of such Proxy Statement are incorporated by reference in Part
III of this report.



PART I
ITEM 1. BUSINESS

OVERVIEW

Watson Pharmaceuticals, Inc., incorporated in 1985, is engaged in the
development, production, marketing and distribution of off-patent and branded
pharmaceutical products. Unless otherwise specified, reference to "Watson" or
the "Company" shall refer to Watson Pharmaceuticals, Inc. and its subsidiaries
and excludes The Rugby Group, Inc. (as discussed below).

OFF-PATENT PHARMACEUTICALS

The Company is recognized as one of the leaders in the off-patent
pharmaceutical industry. Pharmaceutical products initially sold on an exclusive
basis are known in the industry as branded (or proprietary) products. Off-patent
drugs are therapeutically equivalent to their brand name counterparts and are
generally sold at prices significantly less than branded products. Accordingly,
off-patent pharmaceuticals provide a safe, effective and cost efficient
alternative to users of these products.

BRANDED PHARMACEUTICALS

The Company's branded pharmaceutical business is focused primarily on
three therapeutic areas: Dermatology, Women's Health and NeuroPsychiatry. Watson
has strategically focused on these markets due to their perceived growth
opportunities. The nature of these markets and the identifiable base of
physician prescribers allow the Company to achieve significant market
penetration through its specialized sales forces.

The Company also markets several products that are promoted to primary
care physicians around the country. These products include two hypertension
products and a pain management drug. Watson promotes these three products
through its Primary Care sales group.

As a result of recent acquisitions, the proportionate revenues derived
from Watson's branded business have increased significantly. The following
information has been restated to reflect mergers accounted for under the pooling
of interests accounting method as discussed in "Summary of Recent Transactions,"
below.



FOR THE YEARS ENDED DECEMBER 31,
---------------------------------------------------
1997 1996 1995
--------------- --------------- ---------------
(in thousands) $ % $ % $ %
- -------------- -------- ---- -------- ---- -------- ----

Off-patent product sales $200,890 59% $189,275 75% $141,191 73%
Branded product sales 123,125 37% 34,364 14% 29,036 15%
Royalty income from branded sales 14,249 4% 27,162 11% 22,247 12%
-------- --- -------- --- -------- ---

Total revenues $338,264 100% $250,801 100% $192,474 100%
======== === ======== === ======== ===


The Company may choose to acquire additional branded products for
marketing and distribution purposes. Watson may also choose to enter into
collaborative or licensing agreements with various parties at various stages of
product development.

SUMMARY OF RECENT TRANSACTIONS

Several strategic acquisitions have supported the Company's growth over
the past year. The Company acquired Royce Laboratories, Inc. ("Royce"), a
developer and manufacturer of off-patent pharmaceutical products; and Oclassen
Pharmaceuticals, Inc. ("Oclassen"), a developer and marketer of Dermatology
products. During 1997, Watson also entered into an agreement to acquire The
Rugby Group, Inc. ("Rugby"), a developer and marketer of

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off-patent pharmaceutical products. The Rugby acquisition was completed on
February 27, 1998. A summary of these transactions is set forth below:




CONSIDERATION IN MILLIONS
-------------------------
ACQUIRED COMPANY MARKET DATE SHARES CASH TRANSACTION TYPE
- ---------------- ------------ ------- --------- -------- --------------------

Oclassen Pharmaceuticals Dermatology 2-27-97 6.6 Pooling of interests

Royce Laboratories Off-patent 4-16-97 5.2 Pooling of interests

The Rugby Group Off-patent 2-27-98 $67.5* Cash purchase

* - Excludes certain contingent payments



The Company also made several product acquisitions during the year.
These included the acquisition of certain oral contraceptive products from G.D.
Searle & Co. ("Searle") and the acquisition of a significant hypertension
product from Rhone-Poulenc Rorer ("RPR"). A summary of these product
acquisitions is set forth below:



CASH CONSIDERATION IN
PRODUCT THERAPEUTIC AREA DATE MILLIONS
- ------- ------------------- -------- ---------------------

Dilacor XR(R) Hypertension/Angina 6-30-97 $190.0 *

Genora(R), Levora(R), Nor QD(R) Oral contraceptives 10-15-97 $75.0 *

Trivora(R) Oral contraceptives 10-15-97 $45.0 *

* - Excludes certain contingent payments



The recent transactions above are more fully described in Note 2 of Notes to
Consolidated Financial Statements.

PRODUCTS

OFF-PATENT PHARMACEUTICALS

Watson manufactures and markets approximately 52 off-patent
prescription products in capsule or tablet forms in approximately 126 dosage
strengths. The Company markets its products to drug distributors, pharmaceutical
wholesalers, chain drug stores, hospitals, health maintenance organizations and
other drug companies. Some of the Company's more significant off-patent products
are:



PRODUCT THERAPEUTIC AREA DOSAGES BRANDED PRODUCT
- ------- ------------------- ------- ---------------

Diltiazem HCl extended release
capsules Hypertension/Angina 3 Dilacor XR(R)
Hydrocodone 7.5/500 Analgesic 1 Lortab(R)
Hydrocodone 7.5/750 Analgesic 1 Vicodin ES(R)
Estradiol tablets Hormonal Regulator 3 Estrace(R)
Butalbital, Aspirin, Caffeine, and
Codeine Phosphate Capsules Analgesic 1 Fiorinal(R)
Guanfacine Hypertension 2 Tenex(R)
Hydrocodone 10/500 Analgesic 1 Lortab(R)
Hydrocodone 10/650 Analgesic 1 Lorcet(R)10/650
Loxapine Central Nervous System 4 Loxitane(R)
Estropipate Hormonal Regulator 4 Ogen(R)


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Watson's sales of off-patent drugs have increased significantly in
recent years. The Company believes that this growth is attributable to a number
of factors, including (i) modification of certain federal and state laws to
permit or mandate substitution of off-patent drugs by pharmacists, (ii) the
enactment of abbreviated procedures for obtaining Food and Drug Administration
("FDA") approval to manufacture off-patent prescription drugs, (iii) changes in
government and third-party payor reimbursement policies to encourage cost
containment by health care providers and consumers, (iv) increased acceptance of
off-patent drugs by physicians, pharmacists and consumers, and (v) an increasing
number of products which have lost patent protection.

During 1997, seven dosages in the hydrocodone bitartrate/acetaminophen
product group accounted for approximately 21% of total revenues. In 1996 and
1995, six dosages in the hydrocodone bitartrate/acetaminophen product group
accounted for approximately 29% and 35%, respectively, of total revenues.

BRANDED PHARMACEUTICAL PRODUCTS

The Company markets its branded products to physicians through its four
principal sales groups: Dermatology, Women's Health, NeuroPsychiatric and
Primary Care.

DERMATOLOGY

Watson markets several products for the prevention and treatment of
skin diseases. These products are Monodox(R) (doxycycline monohydrate), for the
treatment of severe acne; Cordran(R) (flurandrenolide) and Cormax(TM)
(clobetasol propionate), for the treatment of dermatoses; Condylox(R) (podofilox
0.5%), for the treatment of genital warts; and Cinobac(R) (cinoxacin), for the
treatment of urinary tract infections. The Company acquired these products in
connection with its acquisition of Oclassen.

WOMEN'S HEALTH

The Company markets a variety of oral contraceptive products. These
products include Zovia(TM) (ethynodiol diacetate & ethinyl estradiol), Genora(R)
(norethindrone and ethinyl estradiol), Levora(R) (levonorgestrel), Nor QD(R)
(norethindrone) and Trivora(R) (levonorgestrel and ethinyl estradiol tablets,
USP - Triphasic Regimen).

NEUROPSYCHIATRIC

Watson markets three central nervous system products: Loxitane(R)
(loxapine succinate), for the treatment of psychotic disorders, Zarontin(R)
(ethosuximide) for the treatment of pediatric epilepsy, and Eldepryl(R)
(selegiline), a product of Somerset Pharmaceuticals, Inc. ("Somerset"). Watson
owns 50% of Somerset through a joint venture with another pharmaceutical
company. These products are sold into this growing specialty market, exclusively
to psychiatrists and neurologists.

PRIMARY CARE

The Company markets three products directly to primary care physicians.
These products are Norco(TM) (hydrocodone bitartrate & acetaminophen), a branded
off-patent analgesic; and Microzide(R) (hydrochlorothiazide) and Dilacor XR(R),
which are both used in the treatment of hypertension and angina. Norco(TM) and
Microzide(R) are internally developed products. Dilacor XR(R) was acquired from
RPR in 1997. The Company's Primary Care sales group was significantly expanded
in 1997 to support the promotion of this product. In 1997, sales of Dilacor
XR(R) accounted for approximately 19% of total revenues.

JOINT VENTURES

Watson has made substantial investments in pharmaceutical joint
ventures and expects to utilize this method of investment in the future. The
Company does not control these joint ventures or the commercial exploitation of
the branded and off-patent products they develop, manufacture and/or market.
Further, there is no assurance that such joint ventures will be profitable.

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The Company owns a 50% interest in Somerset, which manufactures and
markets the product Eldepryl(R), used in the treatment of Parkinson's disease.
Somerset is actively involved in research projects regarding additional
indications of Eldepryl(R) and other chemical compounds.

The Company owns a 50% interest in ANCIRC, a joint venture with Andrx
Corporation ("Andrx"), that is developing off-patent pharmaceutical products
utilizing the Andrx's controlled-release technology. As of March 2, 1998, ANCIRC
has two products under review with the FDA. Watson currently owns 18.5% of
Andrx, a publicly traded company that utilizes controlled-release technologies
to develop oral pharmaceutical products.

PRODUCT DEVELOPMENT

The Company devotes significant resources to the research and
development of off-patent and proprietary products. During the three years ended
December 31, 1997, the Company incurred research and development expenditures of
$18.1 million, $22.9 million and $24.6 million, respectively. There can be no
assurance that any of the products currently in development will receive the
required regulatory approvals from the FDA.

Watson's research and development strategy focuses on the following
product development areas: (i) the continuation of its existing oral immediate-
release products, (ii) the development of niche, difficult-to-produce off-patent
drugs, (iii) the development of sustained-release technologies and the
application of these technologies to existing products (iv) the application of
proprietary drug delivery technology for new product development in specialty
areas, and (v) medium-to-late stage new drug opportunities.

OFF-PATENT PRODUCT DEVELOPMENT

The Company's core development efforts will remain in the area of
off-patent prescription drugs. Watson will continue to focus on niche products
that offer significant opportunity, but which may not necessarily attract
numerous competitors. The Company will also focus on technically
difficult-to-formulate products, or products that require advanced manufacturing
technology. By emphasizing the development of difficult-to-formulate products,
the Company seeks markets with limited competition, thereby creating higher
margin sales from its off-patent products. In addition, when evaluating which
drug development projects to undertake, Watson considers whether the product,
once developed, will complement other products in its portfolio, or will
otherwise assist in making the Company's product line more complete.

The Company's acquisitions of Royce and Rugby have increased its
resources in the area of off-patent product development. The Company presently
has submissions for approval pending before the FDA representing 19 separate
products of varying dosage strengths. In addition, approximately 20 projects are
currently under development. During 1997 and through March 2, 1998, Watson
received 10 off-patent product approvals from the FDA.

Of the 52 off-patent products currently marketed by the Company, it
received the first abbreviated new drug application ("ANDA") approval for 38
products. As of March 2, 1998, the Company believed it held the only ANDA
approval for 15 of these products.

Over the next few years, patent protection on a relatively large number
of branded drugs will expire, thereby providing additional off-patent product
opportunities. The branded products targeted for off-patent development include
those with specialized or growing markets as well as those products with U.S.
sales of over $100 million.

ANCIRC was formed in 1994 to conduct research and development
activities in the area of controlled-release technologies. Since its founding,
ANCIRC has conducted development on a variety of projects and has filed two
submissions with the FDA. A total of 8 products are currently under development
at ANCIRC.

5


PROPRIETARY PRODUCT DEVELOPMENT

Watson is developing certain proprietary products, some of which
utilize novel drug delivery systems, that if and when developed, will require
FDA approval of a New Drug Application ("NDA") prior to marketing. The Company
is also developing proprietary products through a combination of internal and
collaborative programs, including joint ventures.

Based on data gathered during clinical studies, the Company has
focused its efforts on two products that utilize its proprietary injection
molding drug delivery technology. The Progesterone/Vaginal Insert and
Estradiol/Vaginal Insert, which will be used for hormone replacement therapy,
are currently in Phase II/III clinical studies. There can be no assurance that
any of these proprietary products, if and when fully developed, will contribute
materially to Watson's revenues in the future.

The Company is also involved in the development of a gum-delivery
technology and is developing two prescription pharmaceutical products in this
area. In 1994, an application was filed with the FDA for an off-patent version
of Nicorette(R), a nicotine gum product developed and marketed by Smith Kline
Beecham ("SKB"). In February 1996, SKB's Nicorette(R) was approved by the FDA as
an over-the-counter product and its exclusivity was extended to 1999.

The Company is also developing a psoralen-based phototherapeutic
product for use in PUVA therapy for indications in psoriasis and vitiligo.
Watson believes that this product will reduce the side effects characteristic of
current psoralen therapy.

In recent years, Somerset has increased its research and development
spending in order to 1) develop additional indications for selegiline (the
parent compound of Eldepryl(R)), using a transdermal delivery system and 2)
develop and evaluate different therapeutic areas using selegiline and other
compounds. In November 1997, Somerset announced completion of the Phase III
clinical trials of its selegiline transdermal system for the treatment of
Alzheimer's disease. Somerset reported that the preliminary analyses of the
efficacy data did not yield statistically significant differences between the
placebo and the selegiline treatment group. A Phase III clinical study using the
selegiline transdermal system in Major Depression was recently completed and is
currently undergoing evaluation. In addition, a Phase III clinical trial is
being conducted in Parkinson's disease.

SALES AND MARKETING

BRANDED PRODUCTS

The Company markets its branded products through its four sales groups:
Dermatology, Women's Health, NeuroPsychiatric and Primary Care. Each of these
sales groups focuses on physicians who specialize in the diagnosis and treatment
of different medical conditions and each offers products to satisfy the needs of
these specialty physicians. The Company believes that this focused marketing
approach enables it to develop highly knowledgeable and dedicated sales
representatives and to foster close professional relationships with physicians.

During 1997, the Company created or acquired the sales forces for each
therapeutic area as well as the marketing infrastructure to support sales
efforts in these specialty areas. The Company's branded products sales force has
grown to more than 300 representatives at the end of 1997. Approximately 140
sales representatives are in Primary Care, 60 are in Dermatology, 60 are in
NeuroPsychiatric, and 40 are in Women's Health. The Company's Dermatology sales
force, acquired in its merger with Oclassen, is one of the largest and best
trained in the country.

OFF-PATENT PRODUCTS

Customer service activities are an integral part of the Company's sales
and marketing operations. The Company uses its best efforts to maintain adequate
inventories, make timely delivery of its products and provide technical and
other service support to its customers. Rugby's strong telemarketing
organization and field force are expected to enhance the Company's sales and
marketing efforts in the off-patent product area.

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CUSTOMERS

The Company markets its products primarily to pharmaceutical
wholesalers, drug distributors, and chain drug stores that in turn market to
retailers, managed care entities, hospitals and government agencies. Watson
sells its dermatology products under the "Oclassen Pharmaceuticals" label. All
of the Company's other products are marketed as products of "Watson
Laboratories". Watson has witnessed a consolidation of its customers, as chain
drug stores and wholesalers merge or consolidate. In addition, a number of the
Company's customers have instituted source programs that limit the number of
suppliers of generic pharmaceutical products carried by that customer. As a
result of these developments, there is heightened competition among off-patent
drug producers for the business of this smaller and more selective customer
base.

The Company ships products pursuant to purchase orders. In 1997, two
customers in the aggregate accounted for 23% of the Company's product sales, 12%
and 11%, individually. In 1996, sales to one customer accounted for 10% of
product sales. In 1995, no individual customer accounted for more than 10% of
product sales.

COMPETITION

The off-patent pharmaceutical industry is highly competitive, with
offerings from numerous off-patent manufacturers, as well as products from
off-patent divisions of major international innovator companies. Watson competes
in the marketplace by developing, acquiring or licensing pharmaceutical products
for indications that generally have relatively large patient populations or for
which limited or inadequate treatments are available. With respect to off-patent
pharmaceuticals, Watson's philosophy is to develop, acquire or license
therapeutic equivalents to previously patented products that are difficult-to-
formulate. There can be no assurance, however, that developments by others will
not render the Company's pharmaceutical products or technologies obsolete or
uncompetitive. In addition to product development, other competitive factors in
the pharmaceutical industry include product quality and price, reputation and
dissemination of technical information.

Revenues and gross profit derived from the sales of off-patent
pharmaceutical products tend to follow a pattern based on regulatory and
competitive factors unique to the off-patent pharmaceutical industry. As patents
for brand name products and related exclusivity periods mandated by regulatory
authorities expire, the first
off-patent manufacturer to receive regulatory approval for off-patent
equivalents of such products is generally able to achieve a relatively high
market share. As competing off-patent manufacturers receive regulatory approvals
on similar products, market share, revenues and gross profit typically decline.
Accordingly, the level of market share, revenues and gross profit attributable
to a particular off-patent product is normally related to the number of
competitors in that product's market and the timing of that product's regulatory
approval, in relation to competing approvals.

Watson therefore is dependent, in part, on its ability to develop and
rapidly introduce new products, the timing of regulatory approval of such
products and the number and timing of regulatory approvals of competing
products. In addition to competition from other off-patent drug manufacturers,
the Company faces competition from brand name companies as they increasingly
sell their products into the off-patent market directly by establishing,
acquiring or forming licensing or business arrangements with off-patent
pharmaceutical companies. No regulatory approvals are required for a brand name
manufacturer to market their products into the off-patent market. In addition,
brand name companies are increasingly pursuing strategies to prevent or delay
the introduction of off-patent competition. These strategies include, among
other things, seeking to establish regulatory obstacles to the bioequivalence of
off-patent drugs to the brand name products and instituting legal actions based
on a host of alleged infringements.

During 1996 and 1997, certain national drug wholesalers instituted
programs designed to provide cost savings to independent retail pharmacies on
their purchases of certain off-patent pharmaceutical products. Pursuant to the
programs, independent retail pharmacies generally agreed to purchase their
requirements of off-patent pharmaceutical products from one wholesaler and
permitted the wholesaler to select the product suppliers. Each wholesaler
encouraged off-patent drug suppliers to participate in its program by offering
to purchase the

7


wholesaler's requirements of particular products from a single supplier. Such
programs encouraged off-patent drug suppliers to aggressively bid to be the
exclusive supplier of products under the programs. These programs resulted in
reduced prices to non-wholesaler customers. As a result of the institution of
the programs, the off-patent drug industry experienced a significant reduction
in the prices charged by suppliers for many off-patent pharmaceutical products.

SUPPLIERS AND MATERIALS

The principal components used in the Company's business are active and
inactive pharmaceutical ingredients and certain packaging materials. Certain
components are available only from sole-source suppliers. In addition, the FDA
must approve suppliers of certain ingredients for the Company's products. The
development and regulatory approval of Watson's products are dependent upon its
ability to procure active ingredients and packaging materials from FDA-approved
sources. FDA approval of a new supplier would be required if, for example,
active ingredients or such packaging materials were no longer available from the
initially approved source. The qualification of a new supplier could potentially
delay the manufacture of the drug involved. Arrangements with foreign suppliers
are subject to certain additional risks, including the availability of
governmental clearances, export duties, political instability, currency
fluctuations and restrictions on the transfer of funds.

Although Watson considers its sources of supply to be adequate and, to
date, no significant difficulty has been encountered in obtaining materials
required for products, there can be no assurance that the Company will continue
to be able to obtain materials as required or at reasonable prices. An extended
inability to obtain material or significant price increases that cannot be
passed on to customers could have a material adverse effect on the Company.

Watson contracts for the manufacture of certain products and intends to
evaluate this strategy for certain future products. Outside contract
manufacturing enables the Company to direct its financial resources to product
in-licensing and acquisition, product development and sales and marketing
efforts. The selected outside manufacturers are required by the Federal Food,
Drug and Cosmetic Act and by FDA regulations to follow current Good
Manufacturing Practices ("cGMP"). Accordingly, the Company is dependent upon its
contract manufacturers to comply with such requirements or similar standards
imposed by foreign regulators. To ensure such compliance, quality assurance
audits of the contract manufacturers sites and batch records are performed to
determine compliance with cGMP requirements and to the Company's specifications.
In addition, the FDA conducts regular inspections and audits of firms subject to
cGMP requirements. Watson believes it has good relationships with its outside
contract manufacturers.

From time to time, certain outside suppliers have experienced
regulatory difficulties that have inhibited their ability to deliver products to
the Company. In the event a supplier has such a difficulty which cannot be
resolved within a reasonable time, the resulting delay could have a material
adverse effect on the Company.

PRODUCT LIABILITY

Product liability suits by consumers represent a continuing risk to
firms in the pharmaceutical industry. One method Watson employs to minimize such
risks is to enforce stringent quality control procedures. Although the Company
carries product liability insurance, it believes that no reasonable amount of
insurance can fully protect against all such risks due to the inherent risks
associated with the production of pharmaceuticals for human consumption.

PATENTS AND PROPRIETARY RIGHTS

Watson believes that protection of its patents, proprietary products,
technologies, processes and know-how is important to its business. The Company
maintains an active patent program to protect its technologies. To date, 15 U.S.
patents have been issued to the Company: five covering compositions of matter
for its oral delivery systems (which patents expire in 2003), five covering
aspects of its buccal systems (which expire between 2005 and 2010), two covering
aspects of its mucosal tissue drug delivery (which expire in 2007 and 2008), one
covering its microencapsulation composition used in its sustained release oral
potassium chloride product (expiring in 2006), one covering its chlorhexidine
compound (expiring in 2007) and one covering its cutaneous therapeutic devices

8


(expiring in 2009). The Company maintains an aggressive patent program, has
three additional United States patents pending and has several patent
applications at different stages of development. Recent changes to the patent
law resulting from passage of the Uruguay Round Agreements Act ("URAA") will
lengthen the term of some granted patents. Generally, patents have terms that
are the longer of 17 years from patent grant or 20 years from patent
application. The Company also seeks patent protection in major foreign
pharmaceutical markets, and has numerous foreign patents and patents pending.

There can be no assurance that Watson's patents or those of its
competitors would be held valid by a court of competent jurisdiction. There can
be no assurance that pending patents will result in issued patents, that patents
issued to or licensed by the Company will not be challenged or circumvented by
competitors, or that such patents will be found to be valid or sufficiently
broad to protect the Company's technology or to provide the Company with a
competitive advantage. Watson relies on non-disclosure agreements with certain
employees, consultants and other parties to protect, in part, trade secrets and
other proprietary technology. There can be no assurance that these agreements
will not be breached, that the Company will have adequate remedies for any
breach, or that others will not independently develop equivalent proprietary
information or that third-parties will not otherwise gain access to the
Company's trade secrets and proprietary knowledge.

Watson may find it necessary to initiate litigation to enforce its
patent rights, to protect its trade secrets or know-how and to determine the
scope and validity of the proprietary rights of others. Patent litigation can be
costly and time-consuming, and there can be no assurance that the Company's
litigation expenses will not be significant in the future or that the outcome of
such litigation will be favorable to the Company.

GOVERNMENT REGULATION

All pharmaceutical manufacturers are subject to extensive regulation by
the federal government, principally the FDA and, to a lesser extent, by state
and local governments. The Federal Food, Drug and Cosmetic Act and other federal
statutes and regulations govern or influence the testing, manufacture, safety,
labeling, storage, recordkeeping, approval, advertising, promotion, sale and
distribution of pharmaceutical products. Noncompliance with applicable
requirements can result in fines, recall or seizure of products, total or
partial suspension of production and/or distribution, refusal of the government
to enter into supply contracts or to approve NDAs or ANDAs, and criminal
prosecution. The FDA also has the authority to revoke previously granted drug
approvals.

Changes in FDA procedures have increased the time and expense involved
in obtaining NDA and ANDA approvals and in complying with the FDA's cGMP
standards. The ANDA drug development and approval process now averages
approximately two to five years. FDA approval is required before each dosage
form of any new drug can be marketed. Applications for FDA approval must contain
information relating to bioequivalency, product formulation, raw material
suppliers, stability, manufacturing processes, packaging, labeling and quality
control. FDA procedures require full-scale manufacturing equipment to be used to
produce test batches for FDA approval. Validation of manufacturing processes by
the FDA also is required before a Company can market new products. The FDA
conducts pre-approval and post-approval reviews and plant inspections to enforce
these rules. Supplemental filings are required for 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.

The Company's manufacturing operations are required to comply with cGMP
standards as interpreted by the FDA. This concept encompasses all aspects of the
production process, including validation and record keeping, and involves
changing and evolving standards. In recent years, the FDA has increased the
number of regular inspections to determine compliance with its cGMP standards.
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 a continuing possibility that from time to time the Company will be
adversely affected by regulatory actions despite its ongoing efforts and
commitment to achieve and maintain full compliance with all regulatory
requirements.

9


The Hatch-Waxman Act of 1984 extended the established abbreviated
application procedure for obtaining FDA approval for off-patent forms of
brand-name drugs originally marketed before 1962 which are off-patent or whose
market exclusivity has expired. This act also provides market exclusivity
provisions that could preclude the submission or delay the approval of a
competing ANDA. One such provision allows a five-year market exclusivity period
for NDAs involving new chemical compounds and a three-year market exclusivity
period for NDAs (including different dosage forms) containing new clinical
investigations essential to the approval of the application. The market
exclusivity provisions apply equally to patented and non-patented products.
Another provision may extend patents for up to five years as compensation for
reduction of the effective life of the patent as a result of time spent by the
FDA reviewing a drug application. Patents may also be extended pursuant to the
terms of the URAA.

The Generic Drug Enforcement Act of 1992 establishes penalties for
wrongdoing in connection with the development or submission of an ANDA by
authorizing the FDA to permanently or temporarily debar companies or individuals
from submitting or assisting in the submission of an ANDA, and to temporarily
deny approval and suspend applications to market off-patent 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 ANDA
under the Fraud, Untrue Statements of Material Facts, Bribery and Illegal
Gratuities Policy Act.

Medicaid, Medicare and other reimbursement legislation or programs
govern reimbursement levels, including requiring that all pharmaceutical
manufacturers rebate to individual states a percentage of their revenues arising
from Medicaid-reimbursed drug sales. The required rebate for off-patent drug
manufacturers is currently 11% of average net sales price for products marketed
under ANDAs. For products marketed under NDAs, manufacturers are required to
rebate the greater of 15.1% of average net sales price or, the difference
between average net sales price and the lowest net sales price during a
specified period. The Company believes that the federal and/or state governments
may continue to enact measures in the future aimed at reducing the cost of drugs
to the public. The Company cannot predict the nature of such measures or their
impact on the Company's profitability.

Federal, state and local laws of general applicability, such as laws
regulating working conditions also govern Watson. In addition, the Company is
subject, as are all manufacturers generally, to various federal, state and local
environmental protection laws and regulations, including those governing the
discharge of material into the environment. Compliance with such environmental
provisions is not expected to have a material effect on the earnings, cash
requirements or competitive position of the Company in the foreseeable future.
However, no assurance can be given that changes to, or compliance with, such
environmental provisions will not have a material effect on the Company's
earnings, cash requirements or competitive position.

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. In certain countries, these studies gave rise to claims for damages
from persons who believe they have been injured through the use of particular
pharmaceutical products.

SEASONALITY

The Company's business, taken as a whole, is not materially affected by
seasonal factors.

PERSONNEL

As of December 31, 1997, the Company had 1,020 full-time employees,
including 15 employees who hold Ph.D.'s. Of the Company's employees, 96 are
engaged in research and development, 358 in manufacturing, 165 in quality
assurance and quality control, 323 in sales and marketing, and 78 in
administration. Employees are not represented by unions and the Company has
never experienced a work stoppage.

10


CAUTIONARY STATEMENT FOR PURPOSES OF THE SAFE HARBOR PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995

This report contains forward-looking statements. The Company desires to
take advantage of the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995 and is including this statement for the express
purpose of availing itself of the protections of the safe harbor with respect to
all forward-looking statements. Several important factors, in addition to the
specific factors discussed in connection with such forward-looking statements
individually, could affect the future results of the Company and could cause
those results to differ materially from those expressed in the forward-looking
statements contained herein.

Such additional factors include, among other things, future economic,
competitive and regulatory conditions, demographic trends, financial market
conditions, the management of acquisitions and future business decisions of the
Company and its competitors, all of which are difficult or impossible to predict
accurately and many of which are beyond the control of the Company. Therefore,
the Company wishes to caution each reader of this report to consider carefully
these factors as well as the specific factors discussed with each
forward-looking statement in this report and as disclosed in the Company's
filings with the Securities and Exchange Commission as such factors, in some
cases, have affected, and in the future (together with other factors) could
affect, the ability of the Company to implement its business strategy and may
cause actual results to differ materially from those contemplated by the
statements expressed herein.

ITEM 2. PROPERTIES

The Company's headquarters are located in Corona, California and Watson
owns the related land and buildings. The Company maintains manufacturing
facilities in Corona, California, Miami, Florida, Copiague, New York and Dayton,
Ohio. The principal manufacturing site in Corona, California as well as the
facilities in Copiague, New York and Dayton, Ohio are owned. The Company leases
another manufacturing facility in Corona, California, as well as research and
development and manufacturing facilities in Miami, Florida. Watson's principal
research facilities are located in Corona, California and are owned by the
Company.

The facilities leased from third parties are subject to leases with
terms expiring, subject to renewal options, between 1998 and 2002 and with
current monthly base rental payments ranging from approximately $2,000 to
approximately $25,000. One property in Corona, California is leased from a trust
that includes the Company's Chairman and its Executive Vice President - Research
and Development. This lease expires, subject to renewal options, in 2000 and
provides for monthly base rental payments of $25,000. Some of the Company's
leases contain escalation provisions and require the Company to pay for
utilities, taxes, insurance and maintenance expenses.

Although the Company's facilities are adequate to meet its current
needs, Watson has plans to construct and acquire additional space to accommodate
its growth. In keeping with this strategy, the Company completed in 1996
construction of 100,000 square feet of additional manufacturing workspace in its
Corona, California location. During 1997, the Company continued construction of
a 90,000-square-foot manufacturing plant in Changzhou City, People's Republic of
China. This facility is expected to become operational in 1998. Recently,
construction began on 40,000 square feet of additional space for administrative
and research-related activities at Watson's headquarters location.

11


ITEM 3. LEGAL PROCEEDINGS

In October 1995, a class action complaint captioned JIMMY JACKSON V.
CIRCA PHARMACEUTICALS, INC., ET al., was filed against Circa, Lawrence Raisfeld
and Robert Shulman, former presidents of Circa, and Roger Jordan, president of
Vitarine Pharmaceuticals ("Vitarine") in the Circuit Court of Tallapoosa County,
Alabama. This suit is expected to settle for $225,000.

In November 1997, a suit was filed against Royce and Watson naming them
as defendants, along with five other corporations, in an action captioned
MICHAEL D. HARDY, INDIVIDUALLY AND MICHAEL D. HARDY AS EXECUTOR OF THE ESTATE OF
JUDITH MARIE HARDY V. ROYCE LABORATORIES, INC., ET AL. in the Western District
of Kentucky at Louisville. Plaintiff alleges that his wife suffered personal
injuries due to her ingestion of the drug quinine for leg cramps in June 1995,
and personal injuries leading to death due to its ingestion in April 1997. The
plaintiff seeks actual damages in the amount of six million dollars for personal
injuries suffered by his wife, actual damages in the amount of ten million
dollars for wrongful death and additional punitive damages. The parties to this
action are presently conducting discovery. It is contemplated that any liability
and defense costs will be covered by the Company's product liability insurance.
Watson and Royce intend to vigorously defend this action.

The Company is involved in various other disputes and litigation
matters that arise in the ordinary course of business. The litigation process is
inherently uncertain and it is possible that the resolution of these disputes
and lawsuits may adversely affect the Company. In management's opinion, Watson
is not currently involved in any legal proceedings which, individually or in the
aggregate, could have a material effect on its consolidated financial condition,
operations or cash flows.

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 Company's fiscal year ended December 31, 1997.

ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT

PRINCIPAL OCCUPATION AND POSITION
NAME AGE AND OFFICE WITH REGISTRANT
- ---- --- ---------------------------------
Allen Chao, Ph.D. 52 Chairman of the Company since May 1996, Chief
Executive Officer and Director since 1983 and a
co-founder of the Company.

David C. Hsia, Ph.D. 53 Executive Vice President - Scientific Affairs
since July 1997, and a co-founder of the Company.

Chato Abad 44 Vice President - Finance and Principal Financial
and Accounting Officer since June 1997 and
Corporate Controller since joining the Company in
1987.

Fred Wilkinson 41 Executive Vice President - Sales and Marketing
since July 1997 and Vice President - Sales and
Marketing since joining the Company in June 1996.

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

12


PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

The Company's common stock began trading on the New York Stock Exchange
on September 17, 1997 under the symbol "WPI." Previously, the Company's common
stock traded on the Nasdaq National Market Tier of The Nasdaq Stock Market under
the symbol "WATS". The following table sets forth the quarterly high and low
share price information for the years ended December 31, 1997 and 1996, as
adjusted to retroactively reflect the October 1997 two-for-one stock split in
the form of a 100% stock dividend:

1996, BY QUARTER HIGH LOW
---------------- --------- -----------
First $ 24.750 $ 18.500
Second $ 24.250 $ 18.250
Third $ 20.000 $ 13.000
Fourth $ 23.000 $ 15.875

1997, BY QUARTER
----------------
First $ 23.063 $ 17.688
Second $ 22.250 $ 16.000
Third $ 30.375 $ 21.625
Fourth $ 34.125 $ 27.000

As of March 2, 1998, there were approximately 9,000 holders of record
of the Company's common stock, which does not include those who held in street
or nominee name.

Since its initial public offering in February 1993, the Company has not
paid a cash dividend on its common stock and does not anticipate paying
dividends in the foreseeable future.

13


ITEM 6. SELECTED FINANCIAL DATA



SELECTED CONSOLIDATED FINANCIAL DATA (1)
(IN THOUSANDS, EXCEPT EARNINGS PER SHARE)

FOR THE YEARS ENDED DECEMBER 31, (1)
--------------------------------------------------------
1997 1996 1995 1994 1993
--------- --------- -------- -------- --------

Product sales $ 324,015 $ 223,639 $170,227 $127,894 $ 99,022
Royalty income 14,249 27,162 22,247 1,209
--------- --------- -------- -------- --------

Total revenues 338,264 250,801 192,474 129,103 99,022
--------- --------- -------- -------- --------

Cost of revenues 125,057 101,921 81,417 62,495 51,185
Research and development 18,055 22,895 24,562 23,525 18,621
Selling, general and administrative 50,937 38,891 34,873 30,368 30,836
Amortization of product rights 7,213 386 306
Merger expenses (1) 14,718 13,939
--------- --------- -------- -------- --------

Total operating expenses 215,980 164,093 155,097 116,388 100,642
--------- --------- -------- -------- --------

Operating income (loss) 122,284 86,708 37,377 12,715 (1,620)
Equity in earnings of joint ventures 10,694 17,909 22,766 24,968 24,688
Investment and other income (2) 11,620 9,861 12,905 7,896 17,962
Gain from (provision for) legal settlement (3) 2,299 (7,633)
Partnership loss (7,644)
--------- --------- -------- -------- --------
22,314 27,770 35,671 35,163 27,373
--------- --------- -------- -------- --------
Income before provision (benefit)
for income taxes 144,598 114,478 73,048 47,878 25,753
Provision (benefit) for income taxes (4) 54,414 35,916 24,867 10,853 (21,917)
--------- --------- -------- -------- --------

Net income $ 90,184 $ 78,562 $ 48,181 $ 37,025 $ 47,670
========= ========= ======== ======== ========

Basic earnings per share (1) $ 1.04 $ 0.92 $ 0.58 $ 0.45 $ 0.60
========= ========= ======== ======== ========
Diluted earnings per share (1) $ 1.01 $ 0.89 $ 0.56 $ 0.44 $ 0.59
========= ========= ======== ======== ========
Weighted average shares
outstanding, no dilution (1) 86,991 85,028 83,317 81,849 78,982
========= ========= ======== ======== ========
Weighted average shares
outstanding, diluted basis (1) 89,325 88,081 85,515 83,563 81,128
========= ========= ======== ======== ========





DECEMBER 31, (1)
-------------------------------------------------------------------------
1997 1996 1995 1994 1993
--------- --------- ---------- --------- ----------

Current assets $ 246,765 $ 326,203 $ 234,754 $ 206,814 $ 183,115
Working capital 146,925 292,948 195,091 178,479 151,002
Total assets 754,981 472,854 364,235 298,468 265,825
Long-term debt 2,385 3,864 3,758 5,091 2,143
Liability from acquisition of product rights 95,000
Deferred tax liabilities 36,887 12,226
Deferred partnership liability 14,033 15,242
Total stockholders' equity 565,010 423,108 320,088 249,330 206,092


14



(1) The Company merged with Circa Pharmaceuticals, Inc. ("Circa"), in July
1995, with Oclassen Pharmaceuticals, Inc. ("Oclassen"), in February
1997, and with Royce Laboratories, Inc. ("Royce"), in April 1997. These
transactions were accounted for as pooling of interests, and
consequently, the consolidated financial data presented include those
of Circa, Oclassen, and Royce for all periods presented. The costs
associated with these mergers were $13.9 million in 1995 and $14.7
million in 1997.

In October 1997, the Company effected a two-for-one stock split in the
form of a 100% stock dividend. Share and per share amounts for all
reported periods have been restated to reflect the stock split.

(2) Included in investment and other income for the years ended December
31, 1995, 1994, and 1993 were gains from the sale of common stock of
Marsam Pharmaceuticals, Inc. ("Marsam") of $6.2 million, $3.2 million,
and $14.5 million, respectively. The Company has no remaining
investment in Marsam.

(3) The gain from (provision for) legal settlement was the result of
lawsuits in which Circa was a defendant. All of these lawsuits were
settled by the first quarter of 1996.

(4) As a result of the pooling of interest accounting for the Company's
1995 merger with Circa, an income tax benefit of $29.8 million was
recorded for the year 1993. This tax benefit resulted from a reduction
in the valuation allowance for Circa's net deferred tax assets. These
net deferred tax assets represented net operating loss and tax credit
carryforwards generated by Circa prior to its merger with the Company.

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 involve risks and
uncertainties. Such risks and uncertainties are discussed below in "Factors That
May Affect Future Results."

GENERAL

The Company derives its revenues from the development, manufacture and
sale of pharmaceutical products. From the Company's founding in 1983 until
mid-1995, revenues were generated primarily from sales of off-patent versions of
branded pharmaceutical products. In order to create a more predictable and
diverse revenue stream, Watson has recently made significant investments in
branded pharmaceutical businesses and products. As compared with off-patent
products, branded products offer stronger competitive protection and typically
sell at higher and more stable margins.

As the Company diversifies its product portfolio, off-patent products
remain an integral component of the Company's current and future revenues. In
recent years, the Company has expanded its product offering through internal
development and acquisitions. Watson will continue to invest significant
resources in the development of difficult-to-produce, niche products for its
off-patent business.

BRANDED PHARMACEUTICALS

In 1997, a strategy was developed to target three specialty therapeutic
areas: Women's Health, Dermatology and NeuroPsychiatric. The Company invested
significant resources in the acquisition and development of products and
personnel for these focus areas. Specialty sales groups were either created or
acquired to successfully promote newly purchased products. Watson's total sales
force grew from approximately 20 representatives in late 1996 to more than 300
by the end of 1997. Acting as the cornerstone in the sales infrastructure is the
Primary Care sales division. This group provides key support for Watson's pain
and hypertension products and also provides a direct link to the Primary Care
physician for products promoted by the specialty sales groups.

15


Also in 1997, Watson secured its revenue stream from Dilacor XR(R)
(diltiazem hydrochloride) by purchasing the rights to this branded product. This
transaction provided Watson full control over the marketing and distribution of
Dilacor XR(R) and any off-patent versions to be offered by the Company. Prior to
this acquisition, the Company owned a royalty interest in the product.

ACQUISITION OF PRODUCT RIGHTS TO DILACOR XR(R) - On June 30, 1997, the
Company obtained the exclusive U.S. and certain worldwide marketing, sales, and
distribution rights to Dilacor XR(R) for $190.0 million in cash, future
royalties, and an inventory supply agreement. The Company's Primary Care sales
group promotes Dilacor XR(R).

This product has been available in the U.S. for the treatment of
hypertension since June 1992 and was approved for the treatment of chronic
stable angina in March 1995. In October 1997, Andrx Corporation received
regulatory approval and began to market an off-patent form of Dilacor XR(R). In
response, the Company has introduced its own off-patent alternative, which was
well received in the market. Due to this recent off-patent competition, the
Company's product sales and gross profits from Dilacor XR(R) are likely to
decline in future periods.

ACQUISITION OF PRODUCTS FROM G. D. SEARLE & CO. ("SEARLE") - In the
fourth quarter of 1997, the Company acquired the U.S. rights to certain Searle
branded off-patent oral contraceptive products. The Food and Drug Administration
("FDA") approved one of these products, Trivora(R) (levonorgestrel and ethinyl
estradiol), in February 1998. Under the terms of this agreement, cash of $85.0
million was paid through December 31, 1997, which included $5.0 million for
Trivora(R). The Company will pay a total of $45.0 million for Trivora(R), with
the remaining $40.0 million to be paid in 1998. The Company also acquired the
U.S. rights to additional oral contraceptive products from Searle (the "Future
Products"). Payment for these products is due upon achievement of certain
events, which include in certain instances, approvals by the FDA. If all
contingent events occur before July 1, 1999, the aggregate acquisition cost for
the Future Products will be $48.5 million plus certain contingent payments. The
Searle products complement Watson's existing oral contraceptive line and are
sold through the Company's Women's Health division.

ACQUISITION OF OCLASSEN PHARMACEUTICALS, INC. ("OCLASSEN") - In
February 1997, the Company acquired Oclassen. Watson issued approximately 6.6
million shares of its common stock for all of the outstanding common shares of
Oclassen. At the acquisition date, the value of the Watson shares issued was
$135.0 million. Oclassen markets specialty pharmaceutical products to prevent
and treat skin diseases. Currently, the following five products are marketed:
Monodox(R) (doxycycline monohydrate), Condylox(R) (podofilox 0.5%), Cordran(R)
(flurandrenolide), Cinobac(R) (cinoxacin) and Cormax(TM) (clobetasol
propionate). The Company's Dermatology sales group promotes the Oclassen
products.

ACQUISITION OF PRODUCTS FROM COCENSYS, INC. ("COCENSYS") - In October
1997, the Company acquired two products and two co-promotion agreements from
CoCensys. In addition, Watson hired certain sales and marketing personnel from
CoCensys. A total of $9.0 million was paid. The products purchased from CoCensys
are sold through the NeuroPsychiatric sales group and are expected to serve the
needs of a growing specialty market for the treatment of psychiatric disorders,
epilepsy, schizophrenia and pain.

OFF-PATENT PHARMACEUTICALS

During 1997 and through early 1998, Watson increased its off-patent
product offerings through acquisitions and internal development.

ACQUISITION OF ROYCE LABORATORIES, INC. ("ROYCE") - In April 1997, the
Company acquired Royce. Royce develops and manufactures off-patent prescription
drugs in solid dosage forms (tablets and capsules). The Royce product portfolio
and development pipeline complemented the Company's business, with little
overlap. The Company issued approximately 5.2 million shares of its common stock
(valued at $98 million on the merger date) for all of the outstanding common
shares of Royce. All Royce products are now marketed directly by the Company
under the "Watson Laboratories" label.

16


1998 PURCHASE OF THE RUGBY GROUP, INC. ("RUGBY") - On February 27,
1998, Watson completed its acquisition of Rugby from Hoechst Marion Roussel,
Inc. Rugby develops, manufactures, and markets a wide array of off-patent
pharmaceutical products. The agreement provided for an initial payment of
approximately $67.5 million in cash and contingent payments based on certain
future sales and operating results.

INTERNAL PRODUCT DEVELOPMENT - In 1997, Watson received Food and Drug
Administration ("FDA") approval for 10 off-patent products in 23 separate dosage
strengths.

OTHER SIGNIFICANT INVESTMENTS AND JOINT VENTURES

1995 ACQUISITION OF CIRCA - In July 1995, the Company merged with Circa
in a pooling of interests transaction. Circa manufactured off-patent
pharmaceuticals and held investments in Somerset Pharmaceuticals, Inc.
("Somerset"), Andrx Corporation ("Andrx"), and the ANCIRC joint venture with
Andrx. The Company issued approximately 37.4 million shares of its common stock
for all of the outstanding common shares of Circa. On the merger date, the value
of this acquisition was approximately $680 million.

PREVIOUS ROYALTY AGREEMENT - Prior to the Company's June 1997 purchase
of the rights to Dilacor XR(R) from Rhone-Poulenc Rorer, Inc. ("RPR"), Circa and
RPR were partners in the development of this product. Since 1993, the Company
has earned royalties from RPR's sales of Dilacor XR(R). Revenues earned under
this royalty arrangement were $14.2 million in 1997 (earned through the
termination date of June 30, 1997), $27.2 million in 1996 and $22.2 million in
1995.

SOMERSET JOINT VENTURE - The Company owns 50% of the outstanding shares
of Somerset, which markets the product Eldepryl(R) for the treatment of
Parkinson's disease. Somerset is also developing additional indications for
selegiline (the parent compound of Eldepryl(R)), using a transdermal delivery
system. The Company recorded equity in earnings from this joint venture of $12.7
million in 1997, $20.1 million in 1996, and $24.8 million in 1995. Orphan drug
exclusivity expired for Eldepryl(R) in June 1996. During 1997 and 1996, a number
of competitors introduced off-patent tablets to compete with Eldepryl(R)
capsules. The introduction of off-patent competition and increased research and
development spending in support of various clinical trials has significantly
reduced Somerset's contribution to the Company's operating results. Management
expects the Company's earnings from Somerset to continue to decline from current
levels.

INVESTMENT IN ANDRX - In 1994, the Company acquired a 7.5% interest in
Andrx, a drug delivery company utilizing controlled-released technologies to
develop oral pharmaceutical products. Watson increased its ownership interest in
Andrx in October 1995 and again in June 1997. At December 31, 1997, the Company
owned approximately 18.5% of the outstanding shares of Andrx. Following Andrx'
initial public offering in June 1996 (Nasdaq: ADRX), the fair value of this
investment has increased by $55.2 million to $92.2 million at December 31, 1997.

ANCIRC JOINT VENTURE - In 1994, the Company and Andrx formed a joint
venture, ANCIRC, to develop off-patent pharmaceutical products utilizing Andrx'
controlled-release technology. During 1995, Watson increased its ownership
interest in this joint venture from 40% to 50%. The Company utilizes the equity
method to account for this joint venture and recognized losses from ANCIRC of
approximately $2.0 million, $2.0 million and $1.7 million in 1997, 1996 and
1995, respectively. To date, ANCIRC has filed two abbreviated new drug
applications ("ANDA") with the FDA.

QUARTERLY FLUCTUATIONS

The Company's results of operations on a quarterly basis have
fluctuated in the past, and may continue to fluctuate. The Company believes such
fluctuations are primarily due to new product introductions and to a variety of
additional factors including, but not limited to, purchasing practices of the
Company's customers and changes in the degree of competition regarding the
Company's products.

17


RESULTS OF OPERATIONS

The following table summarizes selected components of the Company's
results of operations, in thousands of dollars and as percentages of revenues.
The table reflects the Company's mergers with Circa, Oclassen, and Royce for all
periods presented.




YEARS ENDED DECEMBER 31,
---------------------------------------------------------------------------
1997 1996 1995
---------------------- --------------------- ---------------------
$ % $ % $ %
--------- ------ --------- ------ --------- ------

REVENUES:
Product sales $ 324,015 95.8% $ 223,639 89.2% $ 170,227 88.4%
Royalty income 14,249 4.2% 27,162 10.8% 22,247 11.6%
--------- ------ --------- ------ --------- ------

Total revenues 338,264 100.0% 250,801 100.0% 192,474 100.0%
--------- ------ --------- ------ --------- ------
OPERATING EXPENSES:
Cost of revenues 125,057 37.0% 101,921 40.6% 81,417 42.3%
Research and development 18,055 5.3% 22,895 9.1% 24,562 12.8%
Selling, general and administrative 50,937 15.1% 38,891 15.5% 34,873 18.1%
Amortization of product rights 7,213 2.1% 386 0.2% 306 0.2%
Merger expenses 14,718 4.4% 13,939 7.2%
--------- ------ --------- ------ --------- ------

Total operating expenses 215,980 63.9% 164,093 65.4% 155,097 80.6%
--------- ------ --------- ------ --------- ------

Operating income 122,284 36.2% 86,708 34.7% 37,377 19.4%

OTHER INCOME:
Equity in earnings of joint ventures 10,694 3.2% 17,909 7.1% 22,766 11.8%
Investment and other income (net) 11,620 3.4% 9,861 3.9% 12,905 6.7%
--------- ------ --------- ------ --------- ------

Total other income 22,314 6.6% 27,770 11.1% 35,671 18.5%
--------- ------ --------- ------ --------- ------
Income before provision for income taxes 144,598 42.7% 114,478 45.7% 73,048 38.0%
Provision for income taxes 54,414 16.1% 35,916 14.3% 24,867 12.9%
--------- ------ --------- ------ --------- ------

NET INCOME $ 90,184 26.6% $ 78,562 31.4% $ 48,181 25.1%
========= ====== ========= ====== ========= ======


YEARS ENDED DECEMBER 31, 1997 AND 1996

Revenues for the year ended December 31, 1997 were $338.3 million
compared to $250.8 million for the year ended December 31, 1996, an increase of
$87.5 million or 34.9%. The increase in revenues was composed of a $100.4
million increase in product sales, partially offset by a $12.9 million decrease
in royalty income. The increase in product sales was largely due to sales of
Dilacor XR(R), which was purchased from RPR in June 1997. The Company also
experienced 1997 sales increases in Dermatological products, Women's Health
products, core off-patent products and new products approved or acquired during
the year. These sales increases were partially offset by decreased sales of
certain strengths in the Company's hydrocodone product line.

18


Royalty income decreased $12.9 million or 47.5% in 1997 as compared
with 1996 due to the Company's purchase of the Dilacor XR(R)product line from
RPR in June 1997.

Gross profit margins increased to 61.4% in 1997 from 54.4% in 1996. The
increase in the gross profit margin was due largely to sales of Dilacor XR(R),
higher sales of Dermatological branded products and sales of new products
introduced in 1997. The increased gross profit margin from these products was
partially offset by a decline in gross profit margins of certain core off-patent
products.

Research and development expenses decreased from $22.9 million in 1996
to $18.1 million in 1997. Following the mergers with Royce and Oclassen, the
Company consolidated certain research and development functions and eliminated
duplicate programs.

Selling, general and administrative expenses increased from $38.9
million in 1996 to $50.9 million in 1997. The increase consists of a $16.8
million increase in sales and marketing expenses and a $4.8 million decrease in
general and administrative costs. The Company incurred increased sales and
marketing costs as it expanded its branded products sales and marketing efforts.
The Company increased its sales force from approximately 20 representatives in
late 1996 to more than 300 at December 31, 1997.

As a result of the mergers of Royce and Oclassen with Watson, and the
subsequent consolidation of many of the administrative functions, the Company
has experienced a decrease in its general and administrative expenses. As a
percentage of revenues, general and administrative costs decreased from 7.4% to
4.0% from 1996 to 1997, respectively. This decrease reflects efficiencies
achieved following the mergers and the fact that the Company's revenue growth
outpaced the growth in administrative costs.

Amortization expense in 1997 increased from $386,000 to $7.2 million
due to the amortization associated with product rights acquired during the year.
Amortization expense in 1997 was primarily due to the purchase of Dilacor XR(R).
The Company has capitalized these product rights and is amortizing them over the
estimated 17-year life of the product.

In 1997, the Company recorded one-time charges of $14.7 million for
costs incurred in connection with the mergers of Royce and Oclassen. These costs
included investment banking fees and other merger-related expenses. No such
expenses were incurred in 1996.

Equity in earnings from joint ventures decreased $7.2 million or 40.2%
to $10.7 million in 1997 compared to $17.9 million in 1996, due primarily to
lower earnings from Somerset. The decrease in Somerset earnings is due in part
to the loss of exclusivity for Eldepryl(R) in June 1996. During 1997 and 1996, a
number of competitors introduced off-patent tablets to compete with Eldepryl(R)
capsules. Increased competition and research and development spending in support
of various clinical trials have significantly reduced Somerset's contribution to
the Company's operating results. Management expects the Company's earnings from
Somerset to continue to decline.

Investment and other income increased 17.2% to $11.6 million in 1997
from $9.9 million in 1996 due to higher average cash and marketable securities
balances in 1997.

The provision for income taxes increased to $54.4 million in 1997,
compared to $35.9 million in 1996. The effective income tax rate was 38.0% and
31.0% for the years ended December 31, 1997 and 1996, respectively. The increase
in the Company's effective income tax rate was due primarily to the
non-deductibility of a significant portion of merger expenses incurred in 1997
and lower earnings from Somerset which are partially exempt from tax.

Net income increased to $90.2 million in 1997 from $78.6 million in
1996. As a percentage of revenues, net income decreased to 26.7% in 1997 from
31.3% in 1996 principally due to certain non-recurring merger expenses related
to the mergers with Royce and Oclassen and the higher effective tax rate in
1997. Exclusive of merger expenses of $14.7 million and related income taxes,
net income for 1997 would have been $103.1 million (or $1.15) per share, an
increase of 31.3% over 1996.

19


YEARS ENDED DECEMBER 31, 1996 AND 1995

Revenues for the year ended December 31, 1996 were $250.8 million
compared to $192.5 million for the year ended December 31, 1995, an increase of
$58.3 million or 30.3%. The increase in revenues was composed of a $53.4 million
increase in product sales and a $4.9 million increase in royalty income. The
increase in product sales was due to: (i) sales of products introduced in 1996
which totaled $26.1 million; (ii) a $24.9 million increase in sales relating to
products introduced during the fourth quarter of fiscal 1995 and; (iii) a net
increase in sales of the Company's other core products, defined generally as
products available in the market place for at least twelve months. These
increases were partially offset by decreased sales of certain strengths of
hydrocodone products.

Royalty income increased 22.1% in 1996 as compared with 1995 due to
increased demand for Dilacor XR(R). In June 1997, Watson purchased the product
rights to Dilacor XR(R).

Gross profit margins increased to 54.4% in 1996 from 52.2% in 1995.
This favorable increase was due to higher than average gross margins earned on
the sales of certain core products and new products introduced during 1996.

Research and development expenses decreased slightly from $24.6 million
in 1995 to $22.9 million in 1996. Following the merger with Circa, the Company
integrated the two research and development departments of Watson and Circa into
one, eliminating duplicate programs.

Selling, general and administrative expenses increased from $35.2
million in 1995 to $39.3 million in 1996. As a percentage of revenues, these
costs decreased from 18.3% to 15.7% from 1995 to 1996, respectively, which
reflects management's cost control efforts and the fact that the Company's
revenue growth outpaced the growth in selling, general and administrative
expenses.

In connection with the merger with Circa, the Company recorded a
one-time $13.9 million merger-related charge. This charge included investment
banking fees and other costs related to the consolidation of operations of the
two companies. No such expenses were incurred in 1996.

Equity in earnings from joint ventures decreased $4.9 million or 21.3%
to $17.9 million in 1996 compared to $22.8 million in 1995. These earnings
primarily represent earnings from Somerset and ANCIRC. Equity in earnings from
Somerset decreased from $24.8 million in 1995 to $20.1 million in 1996 in part
due to: (i) the loss of exclusivity for Eldepryl(R) in June 1996 and, (ii)
increased research and development expenditures in support of the Phase III
clinical trials. During 1996, three competitors introduced off-patent tablets to
compete with Eldepryl(R) capsules. The Company's portion of ANCIRC's losses
increased slightly from $1.7 million in 1995 to $2.0 million in 1996.

Investment and other income decreased $3.0 million or 23.6% to $9.9
million in 1996 from $12.9 million in 1995. This decrease was due to the 1995
recognition of a $6.2 million gain from the sale of Marsam Pharmaceuticals, Inc.
common stock, a stock held for investment purposes. This was partially offset by
an increase in interest income in 1996 which resulted from higher short-term
interest rates on a larger base of invested cash.

The provision for income taxes increased to $35.9 million in 1996,
compared to $24.9 million in 1995. The effective income tax rates were 31.0% and
34.0% for the years ended December 31, 1996 and 1995, respectively. The higher
effective income tax rate in 1995 resulted primarily from the non-deductibility
of a significant portion of merger expenses incurred in that year.

Net income increased to $78.6 million in 1996 from $48.2 million in
1995. As a percentage of revenues, net income increased to 31.3% in 1996 from
25.0% in 1995 principally due to: (i) revenue growth and continued cost control
efforts during 1996 and, (ii) the one-time merger expenses related to the merger
with Circa in 1995.

20


LIQUIDITY AND CAPITAL RESOURCES

The Company's working capital decreased from $292.9 million at December
31, 1996 to $146.9 million at December 31, 1997. This $146.0 million decrease
was primarily due to the product right acquisitions of Dilacor XR(R) ($140.0
million), and Women's Health products from Searle ($85.0 million), and the
increased investment in Andrx ($15.3 million). The overall decrease was
partially offset by 1997 cash flow from operations ($97.0 million).

The Company invested $14.6 million in capital expenditures during 1997.
This investment consisted of land, leasehold and building improvement additions
of $7.2 million and machinery, research and lab equipment additions of $7.4
million. Watson expects to invest approximately $25.0 million in capital
improvements in 1998.

At December 31, 1997, the Company had notes payable outstanding of
approximately $3.2 million. These notes are unsecured, include interest at fixed
rates ranging from 8.1% to 13.5% per annum and require monthly payments ranging
from $94,000 in 1998 to $78,000 through August 2001. In addition, two credit
facilities are available to the Company with unsecured borrowing commitments
totaling $95.0 million. Watson has made no borrowings against these credit
facilities as of December 31, 1997.

The Company's purchase of the rights to Dilacor XR(R) was structured
with a $40.0 million cash payment in June 1997 and a $55.0 million payment in
July 1997. At December 31, 1997, the remaining scheduled payments are due as
follows:

DUE DATE AMOUNT
-------- -------------
January 1, 1998 $45.0 million
January 1, 1999 30.0 million
January 1, 2000 15.0 million
January 1, 2001 5.0 million
-------------
Total $95.0 million
=============

The Company's cash and marketable securities totaled $114.9 million at
December 31, 1997. Management believes that the Company's cash and marketable
securities, plus cash provided from operations will be sufficient to meet its
normal operating requirements during the coming year. However, the Company has
entered into certain acquisitions that are expected to require significant
future cash payments. To date, the Company has used existing cash to fund its
acquisitions, including approximately $67.5 million paid in February 1998
pursuant to the Rugby acquisition. However, Watson may require the use of its
existing credit facilities or additional funding in order to meet its remaining
acquisition commitments. At the present time, the Company is pursuing financing
alternatives, which include modifications of its current credit facilities, a
public or private debt offering or some combination of these alternatives.
Management expects to complete acceptable financing arrangements in the near
future.

The Company continues to review additional opportunities to acquire or
invest in companies, technologies, product rights and other investments that are
compatible with its existing business. Watson could use sources other than cash,
such as financing alternatives discussed herein, to fund additional acquisitions
or investments. If such acquisition or investment is completed, the Company's
operating results and financial condition could change materially in future
periods.

Management believes inflation does not have, and has not had, a
significant impact on the Company's revenues or operations.


ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Substantially all of the Company's liquid investments are at fixed
interest rates and therefore the fair value of these instruments is affected by
changes in market interest rates. However, all of the Company's liquid
investments mature within one year. As a result, the Company believes that the
market risk arising from its holding of these financial instruments is minimal.

21


The Company's investment in Andrx, which was stated at a fair value of
$92.2 million at December 31, 1997, is composed of 2.7 million shares of Andrx
common stock. Andrx common stock has traded on The Nasdaq Stock Market, under
the symbol "ADRX", since its initial public offering in June 1996. As a publicly
traded equity security, this investment has exposure to price risk. The
following table sets forth the Andrx quarterly high and low share price
information from its initial public offering through December 31, 1997:

HIGH LOW
------ ------
1996, BY QUARTER
Second $17.50 $12.00
Third $15.50 $11.00
Fourth $17.63 $12.75

1997, BY QUARTER
First $26.75 $15.25
Second $38.75 $20.50
Third $45.63 $31.75
Fourth $47.00 $28.75

FACTORS THAT MAY AFFECT FUTURE RESULTS

The Securities and Exchange Commission ("SEC") encourages companies to
disclose forward-looking information so investors may better understand a
company's future prospects and make informed investment decisions. This report
contains such forward-looking statements made pursuant to the safe harbor
provisions of the Securities Litigation Reform Act of 1995. The reader must
carefully consider all such statements as they inherently involve certain risks
and uncertainties that could cause actual results to differ materially from the
Company's forward-looking statements. The reader should carefully evaluate such
statements in light of risk factors described herein or in the Company's other
SEC filings.

The Company's future results of operations will depend, to a
significant extent, upon its ability to introduce new off-patent and branded
pharmaceutical products. Future operating results may vary significantly on an
annual or quarterly basis depending on the timing of, and the Company's ability
to obtain, FDA approvals for such products and FDA approvals for shipment of
such products. Newly introduced off-patent products with limited or no
off-patent competition are typically sold at higher prices, often resulting in
increased gross profit margins. As competition from other manufacturers
intensifies, selling prices typically decline. The Company's future operating
results may also be affected by a variety of additional factors, including
customer purchasing practices and changes in the degree of competition affecting
the Company's products. Introduction by other companies of competitive products
could have a material adverse effect on the operating results and financial
condition of the Company.

The Company has been involved in a number of significant merger and
acquisition transactions. These transactions have been motivated by many
factors, including the desire to expand and diversify the Company's product
portfolio, the desire to obtain new technologies and the desire to attract key
personnel. Growth through acquisition presents significant risks, including
those associated with the ability to integrate and successfully operate acquired
businesses, the ability to develop and implement operational and financial
systems to manage rapidly growing operations, the substantial management time
devoted to such activities, the possibility of undisclosed liabilities, risks
related to product transition and the ability to realize anticipated benefits of
the combined entity.

The Company has instituted a program in order to become year 2000
compliant. The ultimate cost of this program has not been and is not expected to
be material to the Company's consolidated financial position or results of
operations. Although management believes the Company has an adequate program in
place in order to become year 2000 compliant, there can be no assurance that the
program ultimately will be successful.

22


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The information required by this item is contained in the financial
statements set forth in Item 14(a) under the caption "Consolidated Financial
Statements" as a part of this report.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

There have been no changes in or disagreements with accountants on
accounting or financial disclosure matters during the Company's fiscal years
ended December 31, 1997, 1996 and 1995.

23


PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

DIRECTORS

The information concerning directors of the Company required under this
Item is incorporated herein by reference to the Company's definitive proxy
statement pursuant to Regulation 14A, to be filed with the Commission not later
than 120 days after the close of the Company's fiscal year ended December 31,
1997.

EXECUTIVE OFFICERS

The information concerning executive officers of the Company required
under this Item is provided under Item 4 A.

ITEM 11. EXECUTIVE COMPENSATION

The information required under this Item is incorporated herein by
reference to the Company's definitive proxy statement pursuant to Regulation
14A, to be filed with the Commission not later than 120 days after the close of
the Company's fiscal year ended December 31, 1997.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required under this Item is incorporated herein by
reference to the Company's definitive proxy statement pursuant to Regulation
14A, to be filed with the Commission not later than 120 days after the close of
the Company's fiscal year ended December 31, 1997.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required under this Item is incorporated herein by
reference to the Company's definitive proxy statement pursuant to Regulation
14A, to be filed with the Commission not later than 120 days after the close of
the Company's fiscal year ended December 31, 1997.

24


PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(A) 1. CONSOLIDATED FINANCIAL STATEMENTS
The following are included herein under Item 8:
Reports of Independent Public Accountants.
Consolidated Balance Sheets as of December 31, 1997 and 1996.
Consolidated Statements of Income for each of the three years
in the period ended December 31, 1997.
Consolidated Statements of Cash Flows for each of the three
years in the period ended December 31, 1997.
Consolidated Statements of Stockholders' Equity for each of
the three years in the period ended December 31,
1997.
Notes to Consolidated Financial Statements.

(A) 2. FINANCIAL STATEMENT SCHEDULES:
II. Valuation and Qualifying Accounts

All other schedules are omitted because they are not applicable or the
required information is included in the Consolidated Financial Statements or
notes thereto.

(A) 3. EXHIBITS

25


EXHIBIT
NO. DESCRIPTION
- ------- -----------

2.1 Agreement and Plan of Merger among the Company, Gum
Acquisition Corp. and Circa Pharmaceuticals, Inc., filed as
Exhibit 2.1 to the Company's Registration Statement on Form
S-4, Reg. No. 33-60211 ("33-60211") and hereby incorporated
by reference.

2.2 Agreement and Plan of Merger among the Company, Opalacq Co.
and Oclassen Pharmaceuticals, Inc. dated as of September 25,
1996, as amended effective November 14, 1996, and as amended
effective December 31, 1996, filed as Exhibit 2.1 to the
Company's Registration Statement on Form S-4, Reg. No.
333-16275 ("333-16275") and hereby incorporated by reference.

2.3 Agreement and Plan of Merger among the Company, Dolphins
Acquisition Corp. and Royce Laboratories, Inc. dated as of
December 24, 1996, filed as Exhibit 2.1 to the Company's
Registration Statement on Form S-4, Reg. No. 333-20029
("333-20029") and hereby incorporated by reference.

3.1 Articles of Incorporation of the Company and all amendments
thereto, filed as Exhibit 3.1 to the Company's Quarterly
Report on Form 10-Q for the quarter ended June 30, 1995 and
Exhibit 3.1(A) to the Company's Quarterly Report on Form 10-Q
for the quarter ended June 30, 1996 and hereby incorporated
by reference.

3.2 Bylaws of the Company, as amended as of July 18, 1995, filed
as Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q
for the quarter ended June 30, 1995 and hereby incorporated
by reference.

4.1 Loan Agreement between the Company, its subsidiaries and Bank
of America NT & SA dated August 19, 1994, filed as Exhibit
4.1 to the Company's Quarterly Report on Form 10-Q for the
quarter ended September 30, 1994 and hereby incorporated by
reference.

4.1(a) Amendment to loan agreement between the Company, its
subsidiaries and Bank of America NT & SA dated as of February
26, 1996, filed as Exhibit 4.1 to the Company's Annual Report
on Form 10-K for the fiscal year ended December 31, 1995 and
hereby incorporated by reference.

4.1(b) Amendment to loan agreement between the Company, its
subsidiaries and Bank of America NT & SA dated as of December
31, 1996, filed as Exhibit 4.1(b) to the Company's Annual
Report on Form 10-K for the fiscal year ended December 31,
1996 and hereby incorporated by reference.

4.2 Credit Agreement between the Company, its subsidiaries and
Mellon Bank, N.A. dated December 19, 1997.

4.2(a) Amendment Number One to Credit Agreement between the Company,
its subsidiaries and Mellon Bank, N.A. dated January 23,
1998.

10.1 Lease between Westgate Associates and the Company dated
October 1991 and addendums thereto, filed as Exhibit 10.5 to
the Company's Registration Statement on Form S-1, Reg. No.
33-46229 ("33-46229") and hereby incorporated by reference.

10.2 Industrial Real Estate Lease, as amended, dated August 8,
1995, between Hsi-Hsiung Hsu Hwa Chao (Chao Family) Trust I
and the Company, filed as Exhibit 10.1 to the Company's
Quarterly Report on Form 10-Q for the quarter ended September
30, 1995 and hereby incorporated by reference.

10.3 Lease and Option Termination Agreement between Watson
Laboratories, Inc. and Research Property Associates dated
January 31, 1997, filed as Exhibit 10.3 to the Company's
Annual Report on Form 10-K for the fiscal year ended December
31, 1996 and hereby incorporated by reference.

26


10.4 Lease between Bayview Associates and Oclassen
Pharmaceuticals, Inc. dated November 15, 1988, filed as
Exhibit 10.4 to the Company's Annual Report on Form 10-K for
the fiscal year ended December 31, 1996 and hereby
incorporated by reference.

10.4(a) Amendment to lease between Limar Realty Corporation #11
(successor in interest to Bayview Associates) and Oclassen
Pharmaceuticals, Inc., dated October 10, 1995, filed as
Exhibit 10.4(a) to the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1996 and hereby
incorporated by reference.

10.5 Grant of Option to Purchase Real Estate by and between Dr.
Alec Keith, Mr. Wallace C. Snipes and Zetachron, Incorporated
dated July 1, 1987, filed as Exhibit 10.8 to 33-46229 and
hereby incorporated by reference.

*10.6 The Company's 1985 Stock Incentive Plan, filed as Exhibit
10.11 to 33-46229 and hereby incorporated by reference.

*10.7 1991 Stock Option Plan of the Company as revised, filed as
Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q
for the quarter ended June 30, 1995 and hereby incorporated
by reference.

*10.7(a) Amendment to the 1991 Stock Option Plan of the Company, filed
as Exhibit 10.6(a) to the Company's Quarterly Report on Form
10-Q for the quarter ended June 30, 1996 and hereby
incorporated by reference.

*10.7(b) Amendment to the 1991 Stock Option Plan of the Company, filed
as Exhibit 10.6(a) to the Company's Quarterly Report on Form
10-Q for the quarter ended March 31, 1997 and hereby
incorporated by reference.

*10.8 1995 Non-Employee Directors' Stock Option Plan, as amended,
filed as Exhibit 10.2 to the Company's Quarterly Report on
Form 10-Q for the quarter ended June 30, 1995 and hereby
incorporated by reference.

10.9 Form of the Company's Employee Invention, Confidential
Information Agreement, filed as Exhibit 10.22 to 33-46229 and
hereby incorporated by reference.

10.10 Purchase Agreement relating to the Company's purchase of 132
Business Center Drive property, filed as Exhibit 10.15 to the
Company's Annual Report on Form 10-K for the fiscal year
ended December 31, 1993 and hereby incorporated by reference.

10.11 Purchase and Sale Agreement between the Company, its
subsidiaries and AETNA Real Estate Associates dated October
18, 1994 regarding the acquisition of 311 Bonnie Circle,
Corona, California, filed as Exhibit 10.1 to the Company's
Quarterly Report on Form 10-Q for the quarter ended September
30, 1994 and hereby incorporated by reference.

*10.12 Senior Executive Employment Agreement dated as of May 29,
1995 between the Company and Allen Chao, filed as Exhibit
10.1 to 33-60211 and hereby incorporated by reference.

*10.13 Form of Senior Executive Employment Agreement dated as of May
29, 1995 between the Company and David C. Hsia, filed as
Exhibit 10.2 to 33-60211 and hereby incorporated by
reference.

27


10.14 Release, Exit and Consulting Agreement between Alec D. Keith
Ph.D. and the Company, dated July 18, 1996, filed as Exhibit
10.15 to the Company's Quarterly Report on Form 10-Q for the
quarter ended September 30, 1996 and hereby incorporated by
reference.

10.15 Intellectual Property Agreement between Alec D. Keith, Ph.D.
and the Company dated as of July 18, 1996, filed as Exhibit
10.15 to the Company's Annual Report on Form 10-K for the
fiscal year ended December 31, 1996 and hereby incorporated
by reference.

*10.16 Employment Agreement with Dr. Melvin Sharoky dated April 26,
1991 as amended January 19, 1993 and July 17, 1995, filed as
Exhibit 10.3 to the Company's Quarter Report on Form 10-Q for
the quarter ended June 30, 1995 and hereby incorporated by
reference.

*10.16(a) Amendment to the Employment Agreement with Dr. Melvin
Sharoky dated February 12, 1997, filed as Exhibit 10.16(a) to
the Company's Annual Report on Form 10-K for the fiscal year
ended December 31, 1996 and hereby incorporated by reference.

*10.17 Form of Employment Agreement between the Company, Oclassen
Pharmaceuticals, Inc., and Glenn A. Oclassen, filed as
Exhibit 10.1 to 333-16275 and hereby incorporated by
reference.

*10.20 Form of Employment Agreement between Royce Laboratories, Inc.
and Patrick J. McEnany, filed as Exhibit 10.1 to Royce
Laboratories, Inc.'s Current Report on Form 8-K dated January
8, 1997 and hereby incorporated by reference.

*10.20(a) Consulting Agreement between Patrick J. McEnany and the
Company dated January 31, 1998.

*10.20(b) Amendment to Stock Option Agreement between Patrick J.
McEnany and the Company dated January 29, 1998.

10.21 License Agreement between the Company and Rorer
Pharmaceutical Products, Inc., dated June 30, 1997, filed as
Exhibit 10.1 to the Company's Current Report 8-K dated June
30, 1997 and hereby incorporated by reference.

10.22 Inventory Purchase Agreement between the Company and
Rhone-Poulenc Rorer Pharmaceuticals, Inc., dated June 30,
1997, filed as Exhibit 10.2 to the Company's Current Report
8-K dated June 30, 1997 and hereby incorporated by reference.

10.23 Manufacturing and Supply Agreement between the Company and
Rhone-Poulenc Rorer Pharmaceuticals, Inc., dated June 30,
1997, filed as Exhibit 10.3 to the Company's Current Report
8-K dated June 30, 1997 and hereby incorporated by reference.

10.24 Agreement Regarding Partnership Termination by and among
Rhone-Poulenc Rorer Inc., Rhone-Poulenc Rorer
Pharmaceuticals, Inc., Watson Pharmaceuticals, Inc., Circa
Pharmaceuticals, Inc., and BOL, Inc., dated June 30, 1997,
filed as Exhibit 10.4 to the Company's Current Report 8-K
dated June 30, 1997 and hereby incorporated by reference.

10.25 Asset Purchase Agreement among the Company, G. D. Searle &
Co. and SCS Pharmaceuticals, dated September 30, 1997, filed
as Exhibit 10.1 to the Company's Current Report 8-K dated
October 16, 1997 and hereby incorporated by reference.

10.26 Supply Agreement between the Company and G. D. Searle & Co.,
dated October 16, 1997, filed as Exhibit 10.2 to the
Company's Current Report 8-K dated October 16, 1997 and
hereby incorporated by reference.

28


10.27 Stock Purchase Agreement among the Company, Hoechst Marion
Roussel, Inc. and Marisub, Inc. dated August 25, 1997.

10.27(a) Amendment to Stock Purchase Agreement among the Company,
Hoechst Marion Roussel, Inc. and Marisub, Inc. dated
November 26, 1997.

10.27(b) Second Amendment to Stock Purchase Agreement by and among the
Company, Hoechst Marion Roussel, Inc. and Marisub, Inc.
dated February 27, 1998.

10.28 Supply and License Agreement by and between Hoechst Marion
Roussel, Inc. and The Rugby Group, Inc. dated February 27,
1998.

10.29 Contract Manufacturing Agreement by and between Hoechst
Marion Roussel, Inc. and The Rugby Group, Inc. dated February
27, 1998.

22.1 Subsidiaries of the Company.

23.1 Consent of Price Waterhouse LLP.

23.2 Consent of Deloitte & Touche LLP.

23.3 Consent of Arthur Andersen LLP.

27.1 Financial Data Schedule (EDGAR version only).

99.1 Consolidated Financial Statements of Somerset
Pharmaceuticals, Inc. and Subsidiaries for the years ended
December 31, 1997, 1996 and 1995.

- ------------------------------
*Compensation Plan or Agreement
(B) REPORTS ON FORM 8-K: None

29


SIGNATURES

Pursuant to the requirements of Section 13 or 15 (d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

WATSON PHARMACEUTICALS, INC.
(Registrant)

By: /s/ ALLEN CHAO
-------------------------
Allen Chao, Ph.D.
Chairman and Chief Executive Officer
(Principal Executive Officer)


By: /s/ CHATO ABAD
------------------------
Chato Abad
Vice President-Finance
(Principal Financial and Accounting Officer)
Date: March 16, 1998

Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.



SIGNATURE TITLE DATE
- ----------------------------- --------------------------- -------------------


/s/ ALLEN CHAO Chairman and March 16, 1998
- ----------------------------- Chief Executive Officer
Allen Chao, Ph.D.

/s/ MICHEL J. FELDMAN Secretary and Director March 16, 1998
- -----------------------------
Michel J. Feldman

/s/ MICHAEL FEDIDA Director March 16, 1998
- -----------------------------
Michael Fedida

/s/ ALBERT F. HUMMEL Director March 16, 1998
- -----------------------------
Albert F. Hummel

/s/ ALEC D. KEITH Director March 16,1998
- -----------------------------
Alec D. Keith, Ph.D.

/s/ MELVIN SHAROKY Director March 16, 1998
- -----------------------------
Melvin Sharoky, M.D.

/s/ RONALD R. TAYLOR Director March 16, 1998
- -----------------------------
Ronald R. Taylor

/s/ ANDREW L. TURNER Director March 16,1998
- -----------------------------
Andrew L. Turner




INDEX TO FINANCIAL STATEMENTS

PAGE
----

REPORTS OF INDEPENDENT ACCOUNTANTS ........................................ F-2

CONSOLIDATED BALANCE SHEETS

as of December 31, 1997 and 1996 ...................................... F-5

CONSOLIDATED STATEMENTS OF INCOME

for each of the three years in the period ended
December 31, 1997 ..................................................... F-6

CONSOLIDATED STATEMENTS OF CASH FLOWS

for each of the three years in the period ended December 31, 1997 ..... F-7

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

for each of the three years in the period ended December 31, 1997 ..... F-9

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ................................ F-10

FINANCIAL STATEMENT SCHEDULE:

II. Valuation and Qualifying Accounts ................................. F-26

All other schedules are omitted because they are not applicable or the required
information is included in the Consolidated Financial Statements or notes
thereto.



REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders
of Watson Pharmaceuticals, Inc.

In our opinion, based upon our audits and the reports of other auditors, the
consolidated financial statements listed in the accompanying index on page F-1
present fairly, in all material respects, the financial position of Watson
Pharmaceuticals, Inc. and its subsidiaries at December 31, 1997 and 1996, and
the results of their operations and their cash flows for each of the three years
in the period ended December 31, 1997, in conformity with generally accepted
accounting principles. These financial statements are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We did not audit the financial
statements of Somerset Pharmaceuticals, Inc. (Somerset), an entity which is 50%
owned by the Company. The Company's investment in Somerset aggregated
$27,643,000 and $24,653,000 at December 31, 1997 and 1996, respectively, and its
equity in the earnings of Somerset totaled $12,672,000, $20,100,000 and
$24,800,000 for the years ended December 31, 1997, 1996, and 1995, respectively.
In addition, we did not audit the financial statements of Oclassen
Pharmaceuticals, Inc. (Oclassen), a wholly owned subsidiary, which statements
reflect total assets of $35,900,000 at December 31, 1996, and total revenues of
$34,421,000 and $29,247,000 for the years ended December 31, 1996 and 1995,
respectively. Those financial statements were audited by other auditors whose
reports thereon have been furnished to us, and our opinion expressed herein,
insofar as it relates to the amounts included for Somerset and Oclassen, is
based solely on the reports of each of the respective other auditors. We
conducted our audits of the these statements in accordance with generally
accepted auditing standards which require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits and the respective reports of other auditors provide a reasonable basis
for the opinion expressed above.

PRICE WATERHOUSE LLP

Costa Mesa, California
February 2, 1998, except as to
Note 2, which is as of February 27, 1998

F-2


INDEPENDENT AUDITORS' REPORT

To the Board of Directors of
Somerset Pharmaceuticals, Inc.:

We have audited the accompanying consolidated balance sheets of Somerset
Pharmaceuticals, Inc. and subsidiaries as of December 31, 1997 and 1996, and
related consolidated statements of income, stockholders' equity, and cash flows
for each of the three years in the period ended December 31, 1997 (not presented
separately herein). These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of Somerset Pharmaceuticals, Inc. and
subsidiaries as of December 31, 1997 and 1996, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1997 in conformity with generally accepted accounting principles.

Deloitte & Touche LLP

Pittsburgh, Pennsylvania
February 4, 1998

F-3


REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To Oclassen Pharmaceuticals, Inc.;

We have audited the balance sheets of Oclassen Pharmaceuticals, Inc.
(a Delaware corporation) as of December 31, 1995 and 1996, and the related
statements of income, stockholders' equity (deficit) and cash flows for the
years then ended (not presented herein). These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

We have conducted our audits in accordance with generally accepted
auditing standards. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the financial statements referred to above present
fairly, in all material respects, the financial position of Oclassen
Pharmaceuticals, Inc. as of December 31, 1995 and 1996, and the results of its
operations and its cash flows for each of the years then ended in conformity
with generally accepted accounting principles.

ARTHUR ANDERSEN LLP

Oakland California
January 17, 1997

F-4



WATSON PHARMACEUTICALS, INC.

CONSOLIDATED BALANCE SHEETS
(In Thousands Except Share Data)


DECEMBER 31, DECEMBER 31,
1997 1996
------------ ------------
ASSETS

Current assets:
Cash and cash equivalents $ 82,837 $ 158,221
Marketable securities 32,102 80,966
Accounts receivable, net of allowances for
doubtful accounts of $2,140 and $2,206 65,044 32,845
Royalty receivable 5,554
Inventories 46,967 32,429
Prepaid expenses and other current assets 416 6,381
Deferred tax assets 19,399 9,807
--------- ---------
Total current assets 246,765 326,203
Property and equipment, net 88,004 78,429
Investments and other assets 131,083 66,051
Product rights, net 289,129 2,171
--------- ---------

$ 754,981 $ 472,854
========= =========

LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
Accounts payable and accrued expenses $ 44,423 $ 31,758
Income taxes payable 9,553 472
Current portion of long-term debt 864 1,025
Current liability from acquisition of product rights 45,000
--------- ---------
Total current liabilities 99,840 33,255
Long-term debt 2,385 3,864
Long-term liability from acquisition of product rights 50,000
Deferred tax liabilities 36,887 12,226
--------- ---------
Total liabilities 189,112 49,345
--------- ---------
Commitments and contingencies

Minority interest 859 401
--------- ---------
Stockholders' equity:
Preferred stock; no par; 2,500,000 shares authorized;
none outstanding
Common stock; par value of $.0033; 500,000,000 shares
authorized; 87,882,233 and 85,432,702 shares
issued and outstanding 290 282
Additional paid-in capital 256,682 231,511
Retained earnings 275,037 184,853
Unrealized gain, net of tax 33,025 7,189
Notes receivable from stockholders (24) (727)
--------- ---------
565,010 423,108
--------- ---------
$ 754,981 $ 472,854
========= =========


See accompanying notes to consolidated financial statements.

F-5



WATSON PHARMACEUTICALS, INC.

CONSOLIDATED STATEMENTS OF INCOME
(In thousands, Except Earnings per Share)

YEARS ENDED DECEMBER 31,
------------------------------
1997 1996 1995
-------- -------- --------
REVENUES:
Product sales $324,015 $223,639 $170,227
Royalty income 14,249 27,162 22,247
-------- -------- --------
Total revenues 338,264 250,801 192,474
-------- -------- --------
OPERATING EXPENSES:
Cost of revenues 125,057 101,921 81,417
Research and development 18,055 22,895 24,562
Selling, general and administrative 50,937 38,891 34,873
Amortization of product rights 7,213 386 306
Merger expenses 14,718 13,939
-------- -------- --------
Total operating expenses 215,980 164,093 155,097
-------- -------- --------

OPERATING INCOME 122,284 86,708 37,377
OTHER INCOME:
Equity in earnings of joint ventures 10,694 17,909 22,766
Investment and other income (net) 11,620 9,861 12,905
-------- -------- --------
Total other income 22,314 27,770 35,671
-------- -------- --------

Income before provision for income taxes 144,598 114,478 73,048
Provision for income taxes 54,414 35,916 24,867
-------- -------- --------
NET INCOME $ 90,184 $ 78,562 $ 48,181
======== ======== ========

Basic earnings per share $ 1.04 $ 0.92 $ 0.58
======== ======== ========
Diluted earnings per share $ 1.01 $ 0.89 $ 0.56
======== ======== ========
Weighted average shares
outstanding, no dilution 86,991 85,028 83,317
======== ======== ========
Weighted average shares
outstanding diluted basis 89,325 88,081 85,515
======== ======== ========


See accompanying notes to consolidated financial statements.

F-6





WATSON PHARMACEUTICALS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)

FOR THE YEARS ENDED DECEMBER 31,
-----------------------------------
1997 1996 1995
--------- --------- ---------

CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 90,184 $ 78,562 $ 48,181
--------- --------- ---------
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation 7,381 7,283 6,019
Amortization 7,213 1,342 1,347
Deferred income tax (benefit) provision (1,948) 20,399 8,215
Decrease in deferred partnership liability (14,033)
Dividends received from Somerset 8,000 18,000 18,000
Equity in earnings of joint ventures (9,012) (14,684) (19,067)
Gain on sale of marketable securities (6,243)
(Recovery of) provision for doubtful accounts (66) 604 467
Tax benefit related to stock option plan 10,882 7,752 6,808
Changes in assets and liabilities:
Accounts receivable (32,133) (1,857) (11,637)
Royalty receivable 5,554 2,651 (8,205)
Inventories (14,538) (2,332) (8,359)
Prepaid expenses and other current assets 5,965 (1,053) (18)
Other assets (2,155) (2,386) 91
Accounts payable and accrued expenses 12,665 (4,123) 8,561
Income taxes payable 9,081 (2,512) 3,263
Other liabilities (744) (211)
--------- --------- ---------
Total adjustments 6,889 28,340 (15,002)
--------- --------- ---------
Net cash provided by operating activities 97,073 106,902 33,179
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Additions to property and equipment (14,605) (12,835) (23,877)
Disposals of property and equipment 965 460 1,463
Purchases of marketable securities (130,321) (840,969) (387,280)
Proceeds from maturities of marketable securities 179,118 801,179 396,725
Proceeds from sale of common stock 7,005
Acquisition of product rights (144,171) (2,000)
Investment in Andrx (15,307) (15,645)
Additions to investments and other assets (6,496) (3,090) (818)
--------- --------- ---------

Net cash used in investing activities $(130,817) $ (55,255) $ (24,427)
--------- --------- ---------


See accompanying notes to consolidated financial statements.

F-7





WATSON PHARMACEUTICALS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)

FOR THE YEARS ENDED DECEMBER 31,
-----------------------------------
1997 1996 1995
--------- --------- ---------

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of long-term debt $ $ 743 $ 171
Principal payments on long-term debt (1,640) (886) (1,561)
Principal payments on liability for acquisitition of product rights (55,000)
Proceeds from exercise of stock options 15,000 9,210 12,204
--------- --------- ---------
Net cash (used in) provided by financing activities (41,640) 9,067 10,814
--------- --------- ---------
Net (decrease) increase in cash and cash equivalents (75,384) 60,714 19,566
Cash and cash equivalents at beginning of year 158,221 97,507 77,941
--------- --------- ---------
Cash and cash equivalents at end of year $ 82,837 $ 158,221 $ 97,507
========= ========= =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest $ 336 $ 422 $ 472
Income taxes $ 36,734 $ 10,376 $ 6,765

SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIES:
Acquisition of product rights:
Fair value of assets acquired $(294,171) $ (2,000)
Fair value of liabilities assumed 150,000
========= =========
$(144,171) $ (2,000)
========= =========


See accompanying notes to consolidated financial statements.

F-8





WATSON PHARMACEUTICALS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(In Thousands)

ADDITIONAL RECEIVABLE UNEARNED
COMMON STOCK PAID-IN RETAINED UNREALIZED FROM COMPENSATION-
SHARES AMOUNT CAPITAL EARNINGS GAIN (LOSS) STOCKHOLDERS STOCK AWARDS
------ ------ ---------- --------- ----------- ------------ -------------

BALANCE AT DECEMBER 31, 1994 82,638 $ 273 $ 195,305 $ 58,110 $ (870) $ (653) $ (2,814)

Exercise of options/warrants 1,214 4 7,867 9
Tax benefit related to exercise of options 6,808
Amortization of unearned compensation 1,958
Common stock issued in private placement 322 1 4,438
Adjustment for unrealized gain 1,491
Net income 48,181
------ ----- --------- --------- ------ ------ --------

BALANCE AT DECEMBER 31, 1995 84,174 278 214,418 106,291 621 (644) (856)

Exercise of options/warrants 1,259 4 9,331 (83)
Tax benefit related to exercise of options 7,762
Amortization of unearned compensation 856
Adjustment for unrealized gain 6,568
Net income 78,562
------ ----- --------- --------- ------ ------ --------

BALANCE AT DECEMBER 31, 1996 85,433 282 231,511 184,853 7,189 (727)

Exercise of options/warrants 2,449 8 14,289 703
Tax benefit related to exercise of options 10,882
Adjustment for unrealized gain 25,836
Net income 90,184
------ ----- --------- --------- -------- ------ --------

BALANCE AT DECEMBER 31, 1997 87,882 $ 290 $ 256,682 $ 275,037 $ 33,025 $ (24) $
====== ===== ========= ========= ======== ===== ========


TOTAL
STOCKHOLDERS'
EQUITY
-------------
BALANCE AT DECEMBER 31, 1994 $ 249,351

Exercise of options/warrants 7,880
Tax benefit related to exercise of options 6,808
Amortization of unearned compensation 1,958
Common stock issued in private placement 4,439
Adjustment for unrealized gain 1,491
Net income 48,181
---------

BALANCE AT DECEMBER 31, 1995 320,108

Exercise of options/warrants 9,252
Tax benefit related to exercise of options 7,762
Amortization of unearned compensation 856
Adjustment for unrealized gain 6,568
Net income 78,562
---------

BALANCE AT DECEMBER 31, 1996 423,108

Exercise of options/warrants 15,000
Tax benefit related to exercise of options 10,882
Adjustment for unrealized gain 25,836
Net income 90,184
---------

BALANCE AT DECEMBER 31, 1997 $ 565,010
=========

See accompanying notes to consolidated financial statements.

F-9




WATSON PHARMACEUTICALS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. DESCRIPTION OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES

DESCRIPTION OF BUSINESS AND PRINCIPLES OF CONSOLIDATION

Watson Pharmaceuticals, Inc. ("Watson" or the "Company") is engaged in
the development, production, marketing and distribution of off-patent and
proprietary pharmaceutical products. The consolidated financial statements
include the accounts of wholly owned and majority owned subsidiaries after
elimination of intercompany accounts and transactions. The preparation of
consolidated financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts in the financial statements and accompanying notes.
Actual results could differ from those estimates.

The Company's significant wholly owned subsidiaries include Watson
Laboratories, Inc. ("Watson Labs"), Circa Pharmaceuticals, Inc. ("Circa"),
Oclassen Pharmaceuticals, Inc. ("Oclassen"), and Royce Laboratories, Inc.
("Royce"). Circa, Oclassen and Royce were acquired by Watson in July 1995,
February 1997 and April 1997, respectively. All three acquisitions were
accounted for as poolings of interests, and accordingly, the Company's
consolidated financial statements have been restated to include the results of
operations, financial position and cash flows from all three entities (Note 2).

Investments are accounted for under the equity method of accounting
where the Company can exert significant influence and ownership does not exceed
50%. These investments include Somerset Pharmaceuticals, Inc. and ANCIRC.
Investments in which the Company holds less than a 20% interest and does not
exert significant influence are accounted for under the cost method of
accounting. The Company's investment in Andrx Corporation ("Andrx") is accounted
for under the cost method of accounting.

FAIR VALUE OF FINANCIAL INSTRUMENTS

The carrying amounts of cash, cash equivalents, marketable securities,
accounts and other receivables, accounts payable, accrued expenses and debt
approximate fair value. The fair value of cash equivalents, marketable
securities and the Company's investment in Andrx is based on quoted market
prices at December 31, 1997 and 1996.

CASH, CASH EQUIVALENTS AND MARKETABLE SECURITIES

The fair market value of the Company's cash, cash equivalents and
marketable securities, all of which mature in 1998, consisted of the following:


DECEMBER 31
1997 1996
-------- --------
(IN THOUSANDS)
Fixed income securities:
U.S. government and
government agency securities $ 27,996 $ 69,121
State-issued securities 2,300 3,405
Corporate bonds 4,500 16,936
Commerical paper 41,472 107,276
Equity securities 3,006 17,547
Money market, time deposits and cash 35,665 24,902
-------- --------
$114,939 $239,187
======== ========

F-10


WATSON PHARMACEUTICALS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Cash equivalents are highly liquid investments with original maturities
of three months or less. Investments with maturity dates between three and
twelve months are considered to be marketable securities. All of the Company's
debt and equity securities are classified as available-for-sale securities.
Unrealized gains or losses on these securities are excluded from earnings and
are reported as a separate component of stockholders' equity, net of applicable
income taxes, until realized. Realized gains and losses are determined on the
specific identification method and are reported in investment and other income.
Realized gains and losses were not material for the years ended December 31,
1997 and 1996. In 1995, the Company realized a gain of $6.2 million from the
sales of marketable securities.

INVENTORIES

Inventories are stated at the lower of cost (first-in, first-out
method) or market.

PROPERTY AND EQUIPMENT

Property and equipment are stated at cost, less accumulated
depreciation. Major renewals and improvements are capitalized, while routine
maintenance and repairs are expensed as incurred. At the time properties are
retired from service, the cost and accumulated depreciation are removed from the
respective accounts and the related gains or losses are reflected in income.

Depreciation expense is computed principally on the straight-line
basis, over estimated useful lives of two to ten years for furniture, fixtures
and equipment and thirty years for buildings and building improvements.
Leasehold improvements and assets recorded under capital leases are amortized on
the straight-line basis over the respective lease terms or the estimated useful
life of the assets, ranging from five to thirty years.

PRODUCT RIGHTS

Product rights are stated at cost, less accumulated amortization, and
are amortized ratably over estimated lives of 17 years or less. The accumulated
amortization related to product rights was $8.5 million and $1.3 million at
December 31, 1997 and 1996, respectively.

POTENTIAL IMPAIRMENT OF LONG-LIVED ASSETS

The Company annually evaluates its long-lived assets, including product
rights, for potential impairment. When circumstances indicate that the carrying
amount of the asset may not be recoverable, as demonstrated by estimated future
cash flows, an impairment loss would be recorded based on fair value.

REVENUE RECOGNITION

The Company recognizes revenue, net of sales discounts and allowances,
from the sale of its pharmaceutical products upon shipment.

PRODUCT SALES TO MAJOR CUSTOMERS

In 1997, two customers in the aggregate accounted for 23% of the
Company's product sales, 12% and 11%, individually. In 1996, one customer
accounted for 10% of product sales. In 1995, no individual customer accounted
for more than 10% of product sales.

RESEARCH AND DEVELOPMENT ACTIVITIES

The costs associated with the development, testing and approval of
pharmaceutical products are expensed as incurred.

F-11


WATSON PHARMACEUTICALS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

INCOME TAXES

Income taxes are accounted for using an asset and liability approach
which requires the recognition of deferred tax assets and liabilities for the
expected future tax consequences of temporary differences between the financial
statement and tax bases of assets and liabilities at the applicable tax rates. A
valuation allowance is provided when it is more likely than not that some
portion or all of the deferred tax assets will not be realized.

EARNINGS PER SHARE ("EPS")

Basic earnings per share is computed by dividing net income by the
weighted average number of common shares outstanding in each year. Diluted
earnings per share is computed by dividing net income by the weighted average
number of common shares outstanding plus any potential dilution that could occur
if options and warrants were converted into common stock in each year.

In 1997, the Company adopted Statement of Financial Accounting
Standards No. 128, "Earnings per Share", ("SFAS 128"). In accordance with the
implementation provisions of SFAS 128, the Company has restated earnings per
share in the Consolidated Statements of Income for the years ended December 31,
1996 and 1995. The unaudited quarterly data for the first three quarters of 1997
and for 1996 presented in Note 10 have also been restated to comply with the
provisions of SFAS 128. A reconciliation of the numerators and the denominators
of basic and diluted earnings per share for the years ended December 31, 1997,
1996, and 1995 is as follows (in thousands, except for EPS):




YEARS ENDED DECEMBER 31,
---------------------------
1997 1996 1995
------- ------- -------

Basic EPS computation
Net income (numerator) $90,184 $78,562 $48,181
Weighted average shares outstanding (denominator) 86,991 85,028 83,317
Basic EPS $ 1.04 $ 0.92 $ 0.58
======= ======= =======

Diluted EPS Computation
Net income (numerator) $90,184 $78,562 $48,181
Weighted average shares outstanding 86,991 85,028 83,317
Assumed exercise of all outstanding
stock options 2,334 3,053 2,198
------- ------- -------
Weighted average shares outstanding
diluted basis (denominator) $89,325 $88,081 $85,515

Diluted EPS $ 1.01 $ 0.89 $ 0.56
======= ======= =======



In October 1997, the Company effected a two-for-one stock split in the
form of a 100% stock dividend. All share and per share amounts for the reported
periods have been restated to reflect the stock split.

CONCENTRATION OF CREDIT RISK

The Company is subject to a concentration of credit risk with respect
to its trade receivable balance, all of which are due from service providers,
distributors, wholesalers and chain drug stores in the health care and
pharmaceutical industries throughout the United States. The Company performs
ongoing credit evaluations of its customers and maintains reserves for potential
uncollectible accounts. Actual losses from uncollectible accounts have been
within management's expectations.

F-12


WATSON PHARMACEUTICALS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

RECENT ACCOUNTING PRONOUNCEMENTS

In June 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 130 ("SFAS 130"), "Reporting Comprehensive
Income". SFAS 130 establishes standards for the reporting and disclosure of
comprehensive income (revenues, expenses, gains and losses) in a full set of
general-purpose financial statements.

The Financial Accounting Standards Board issued Statement of Financial
Accounting Standards No. 131 ("SFAS 131"), "Disclosures about Segments of an
Enterprise and Related Information," in June 1997. SFAS 131 establishes
standards for the reporting of information about operating segments of a
business. Generally, financial information is required to be reported on the
basis that it is used internally by management for evaluating segment
performance.

SFAS 130 and SFAS 131 address disclosure matters and will have no
effect on the Company's consolidated financial position, results of operations
or cash flows. The Company will adopt SFAS 130 and SFAS 131 in 1998.

RECLASSIFICATIONS

Certain amounts in the 1995 and 1996 financial statements have been
reclassified to conform with the 1997 presentation. These reclassifications had
no effect on net income or retained earnings.

2. MERGERS AND ACQUISITIONS

ACQUISITION OF ROYCE

On April 16, 1997, the stockholders of Royce approved the merger with
Watson and Royce became a wholly owned subsidiary of the Company. Royce
develops, manufactures and markets off-patent prescription drugs in solid dosage
forms (tablets and capsules). Under the terms of the Royce merger agreement,
Royce stockholders received 0.19 share of the Company's common stock for each
Royce share. Accordingly, the Company issued approximately 5.2 million shares of
its common stock for all of the outstanding common shares of Royce. The merger
qualified as a tax-free reorganization for federal income tax purposes and was
accounted for as a pooling of interests. The Company's consolidated financial
statements have been retroactively restated to include the results of Royce for
all periods presented. A one-time charge of $5.8 million for merger-related
expenses was recorded in the quarter ended June 30, 1997. These expenses
included investment banking fees and other costs related to the consolidation of
operations between the two companies.

ACQUISITION OF OCLASSEN

On February 26, 1997, the stockholders of Oclassen approved the merger
with Watson and Oclassen became a wholly owned subsidiary of the Company.
Oclassen develops specialty prescription pharmaceuticals to prevent and treat
skin diseases, and markets these products to dermatologists. Under the terms of
the Oclassen merger agreement, Oclassen stockholders received 0.37 share of the
Company's common stock for each Oclassen share. Accordingly, the Company issued
approximately 6.6 million shares of its common stock for all of the outstanding
common shares of Oclassen. The merger qualified as a tax-free reorganization for
federal income tax purposes and was accounted for as a pooling of interests. The
Company's consolidated financial statements have been retroactively restated to
include the results of Oclassen for all periods presented. A one-time charge of
$8.9 million for merger-related expenses was recorded in the quarter ended March
31, 1997. These expenses included investment banking fees and other costs
related to the consolidation of operations between the two companies.

F-13


WATSON PHARMACEUTICALS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Combined and separate results of Watson, Oclassen, and Royce during the
periods preceding the mergers are summarized as follows (in thousands):



WATSON OCLASSEN ROYCE COMBINED
-------- -------- -------- --------

TWO MONTHS ENDED FEBRUARY 28, 1997 (UNAUDITED)

Total revenues $ 30,845 $ 8,222 n/a $ 39,067
Total Costs $ 19,371 $ 7,468 n/a $ 26,839
-------- -------- -------- --------
Net income $ 11,474 $ 754 n/a $ 12,228

FOUR MONTHS ENDED APRIL 30, 1997 (UNAUDITED

Total revenues $ 62,708 $ 16,255 $ 6,138 $ 85,101
Total Costs $ 46,854 $ 13,285 $ 6,010 $ 66,149
-------- -------- -------- --------
Net income $ 15,854 $ 2,970 $ 128 $ 18,952


YEAR ENDED DECEMBER 31, 1996

Total revenues $194,120 $ 34,364 $ 22,317 $250,801
Total Costs $120,822 $ 29,906 $ 21,511 $172,239
-------- -------- -------- --------
Net income $ 73,298 $ 4,458 $ 806 $ 78,562


YEAR ENDED DECEMBER 31, 1995

Total revenues $152,935 $ 29,036 $ 10,503 $192,474
Total Costs $105,045 $ 26,409 $ 12,839 $144,293
-------- -------- -------- --------
Net income $ 47,890 $ 2,627 $ (2,336) $ 48,181



The combined financial results of the Company, Oclassen, and Royce
include adjustments and reclassifications made to conform accounting policies
and financial statement presentations of the three companies. Intercompany
transactions between the three companies for the periods presented were not
material.

SUBSEQUENT EVENT-ACQUISITION OF THE RUGBY GROUP, INC. ("RUGBY")

On February 27, 1998, Watson completed its acquisition of Rugby from
Hoechst Marion Roussel, Inc. Rugby develops, manufactures, and markets a wide
array of off-patent pharmaceutical products. Under the terms of the agreement,
the Company acquired Rugby and its ANDAs, which include several licensed
products, plus Rugby's sales and marketing operations for U.S. off-patent
pharmaceuticals. The transaction also included Rugby's product development group
and product pipeline. The agreement provided for an initial payment of
approximately $67.5 million in cash and contingent payments based on certain
future sales and operating results.

ACQUISITION OF PRODUCTS FROM G. D. SEARLE & CO. ("SEARLE")

In the fourth quarter of 1997, the Company acquired the U.S. rights to
certain Searle branded off-patent oral contraceptive products. The FDA approved
one of these products, Trivora(R) (levonorgestrel and ethinyl estradiol), in
February 1998. Under the terms of this agreement, cash of $85.0 million was paid
through December 31, 1997, which included $5.0 million for Trivora(R). The
Company will pay a total of $45.0 million for Trivora(R), with the remaining
$40.0 million to be paid in 1998. The Company also acquired the U.S. rights to
additional oral contraceptive products from Searle (the "Future Products").
Payment for these products is due upon achievement of certain events, which
include in certain instances, approvals by the FDA.

F-14


WATSON PHARMACEUTICALS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

If all contingent events occur before July 1, 1999, the aggregate
acquisition cost for the Future Products will be $48.5 million plus certain
contingent payments.

ACQUISITION OF PRODUCTS FROM COCENSYS, INC. ("COCENSYS")

In October 1997, the Company acquired two products and two co-promotion
agreements from CoCensys. In addition, Watson also hired certain sales and
marketing personnel from CoCensys. A total of $9.0 million was paid from
available cash to fund this acquisition.

ACQUISITION OF PRODUCT RIGHTS TO DILACOR XR(R)

On June 30, 1997, the Company obtained the exclusive U. S. and certain
worldwide marketing, sales, and distribution rights to Dilacor XR(R) for $190.0
million in cash (payable as set forth below), future royalties, and an inventory
supply agreement. These product rights were capitalized and are amortized on the
straight-line basis over 17 years. The Company made scheduled payments to RPR of
$95.0 million through December 31, 1997, from its available cash. The remaining
scheduled payments are due as follows:

DUE DATE AMOUNT
--------------- -------------
January 1, 1998 $45.0 million
January 1, 1999 30.0 million
January 1, 2000 15.0 million
January 1, 2001 5.0 million
-------------
Total $95.0 million
==============

Prior to the Company's purchase of the rights to Dilacor XR(R), Circa
and RPR were partners in the development of this product. Since 1993, the
Company has earned royalties from RPR's sales of Dilacor XR(R). Revenues earned
under this royalty arrangement were $14.2 million in 1997 (earned through the
termination date of June 30, 1997), $27.2 million in 1996 and $22.2 million in
1995.

ACQUISITION OF CIRCA

On July 17, 1995, the stockholders of the Company and Circa approved
the merger with Watson and Circa became a wholly owned subsidiary of the
Company. Under the terms of the Circa merger agreement, Circa stockholders
received 0.86 share of the Company's common stock for each Circa share.
Accordingly, the Company issued approximately 37.4 million shares of its common
stock for all of the outstanding common shares of Circa. The merger qualified as
a tax-free reorganization and was accounted for as a pooling of interests. The
Company's consolidated financial statements have been retroactively restated to
include the results of Circa for all periods presented. A one-time charge of
$13.9 million for merger-related expenses was recorded in the quarter ended
September 30, 1995. These expenses included investment banking fees and other
costs related to the consolidation of operations between the two companies.

Prior to its merger with the Company, Circa maintained stock award
plans for key employees and officers. The stock granted under these plans
contained certain vesting provisions which required unearned compensation to be
recorded for the fair market value of the shares issued. The stock awards were
converted to equivalent common shares in the Company pursuant to the merger
exchange ratio. Compensation expense was charged on the straight-line basis to
selling, general and administrative expense over the related vesting periods and
was fully amortized during the year ended December 31, 1996.

F-15


WATSON PHARMACEUTICALS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

3. BALANCE SHEET COMPONENTS


DECEMBER 31,
----------------------
1997 1996
--------- ---------
(IN THOUSANDS)
INVENTORIES:
Raw materials $ 16,905 $ 12,477
Work-in-process 9,303 7,150
Finished goods 20,759 12,802
--------- ---------
$ 46,967 $ 32,429
========= =========
PROPERTY AND EQUIPMENT:
Buildings and improvements $ 48,206 $ 37,859
Leaseholds improvements 8,722 9,499
Land and land improvements 5,261 4,937
Machinery and equipment 50,449 46,872
Research and laboratory equipment 9,707 9,969
Furniture and fixtures 3,183 4,156
--------- ---------
125,528 113,292
Less accumulated depreciation and amortization (47,681) (40,256)
--------- ---------
77,847 73,036
Construction in progress 10,157 5,393
--------- ---------
$ 88,004 $ 78,429
========= =========
ACCOUNTS PAYABLE AND ACCRUED EXPENSES:
Trade accounts payable $ 24,824 $ 18,485
Accrued payroll and benefits 5,684 3,688
Contract obligations and reserves 2,449 2,651
Royalties and other accruals 11,466 6,934
--------- ---------
$ 44,423 $ 31,758
========= =========


F-16



WATSON PHARMACEUTICALS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


4. LONG-TERM INVESTMENTS

Investments and other assets consisted of the following:


DECEMBER 31,
1997 1996
-------- --------
(IN THOUSANDS)

Investments in joint ventures $ 31,626 $ 27,434
Other long-term investments 92,233 33,730
Other assets 7,224 4,887
-------- --------

$131,083 $ 66,051
======== ========


INVESTMENT IN SOMERSET PHARMACEUTICALS,INC.("SOMERSET") JOINT VENTURE

The Company owns 50% of the outstanding common stock of Somerset and
utilizes the equity method to account for this investment. Somerset manufactures
and markets the product Eldepryl(R), which is used in the treatment of
Parkinson's disease. Income recognized from Somerset was approximately $12.7
million, $20.1 million, and $24.8 million in 1997, 1996, and 1995, respectively.
Income is composed of the Company's 50% share of Somerset's earnings and
management fees, offset by amortization of goodwill. The net excess of the cost
of this investment over the fair value of net assets acquired was $6.4 million
and $7.4 million at December 31, 1997 and 1996, respectively. Such goodwill is
amortized on the straight-line basis over 15 years.

Somerset has been notified by the Internal Revenue Service ("IRS") that
it may be subject to additional income taxes and interest for its 1993, 1994,
and 1995 tax years. The IRS has proposed adjustments relating to credits claimed
under Internal Revenue Code Section 936. These proposed adjustments amount to
approximately $13.0 million of additional income tax and interest charges, 50%
of which would be Watson's share. Management of Somerset believes that it has
complied with all relevant tax laws and intends to vigorously defend its
position on this matter.

INVESTMENT IN OTHER JOINT VENTURES

The Company has entered into several other joint ventures, including
ANCIRC, the Company's collaboration with Andrx, and two agreements with
China-based Changzhou No. 4 Pharmaceuticals Factory. Watson recognized losses
from other joint ventures of approximately $2.0 million, $2.2 million, and $1.7
million in 1997, 1996, and 1995, respectively.

F-17



WATSON PHARMACEUTICALS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

COMBINED RESULTS FOR UNCONSOLIDATED INVESTMENTS IN JOINT VENTURES

The following aggregate financial information is provided for
unconsolidated investments in joint ventures accounted for using the equity
method:

YEARS ENDED DECEMBER 31,
-------------------------------
1997 1996 1995
-------- -------- ---------
(IN THOUSANDS)

Net revenues $ 73,489 $101,512 $107,365
======== ======== ========
Gross profit $ 39,640 $ 88,840 $ 93,748
======== ======== ========
Net income $ 12,924 $ 31,564 $ 41,099
======== ======== ========

DECEMBER 31,
-----------------
1997 1996
------- -------
(IN THOUSANDS)
Current assets $60,604 $46,572
Other assets 8,508 10,342
------- -------
Total assets $69,112 $56,914
======= =======

Current liabilities $18,300 $20,123
Other liabilities 1,309 --
Stockholders' equity 49,503 36,791
------- -------

Total liabilities and stockholders' equity $69,112 $56,914
======= =======

OTHER LONG-TERM INVESTMENTS

Other long-term investments are comprised primarily of the Company's
investment in Andrx. Andrx develops advanced controlled-release drug delivery
systems and distributes certain off-patent pharmaceutical products manufactured
by others. Andrx trades publicly on the Nasdaq Stock Market, under the symbol
ADRX. At December 31, 1997, the Company owned 2.7 million common shares of
Andrx, which represents approximately 18.5% of the total Andrx common shares
outstanding. This investment included 600,000 shares of Andrx purchased in June
1997 for $15.3 million in cash. Watson accounts for this investment using the
cost method, adjusted to fair value. At December 31, 1997, the Company recorded
an unrealized gain of $33.1 million (net of income taxes of $22.1 million) on
its investment in Andrx, which is included as a separate component of
stockholders' equity.

F-18


WATSON PHARMACEUTICALS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

5. DEBT


Long-term debt consisted of the following:
DECEMBER 31,
----------------------
1997 1996
------- -------
(IN THOUSANDS)
Note payable to bank, unsecured,
at a fixed rate of 8.1% per annum,
payable in monthly installments of $78,
including interest, due August 2001 $ 2,904 $ 3,577

Other notes payable 345 1,312
------- -------
3,249 4,889

Less current portion (864) (1,025)
------- -------

$ 2,385 $ 3,864
======= =======

At December 31, 1997, annual maturities of long-term debt consisted of the
following:

YEARS ENDING DECEMBER 31, (IN THOUSANDS)
-----------------------------------------

1998 $ 864
1999 1,002
2000 858
2001 525
2002 -
-------
$ 3,249
=======

At December 31, 1997, the Company maintained two financing agreements,
which are summarized as follows.

In 1997, the Company entered into an agreement with a bank (the "1997
financing agreement") that provided for a $50.0 million revolving, unsecured
line of credit which expires on March 31, 1998. This commitment was subsequently
increased to $75.0 million in January 1998. The 1997 financing agreement
provides favorable interest rates equal to the bank's Base Rate (8.50% per annum
at December 31, 1997) or a LIBOR Rate (as defined in the 1997 financing
agreement) plus 0.75%. Under the 1997 financing agreement, the Company must
maintain specified financial ratios and comply with certain restrictive
covenants. No borrowings have been made under the 1997 financing agreement.

In 1994, the Company entered into an agreement with a bank (the "1994
financing agreement"), which has been amended and which provided for several
financing facilities. As of December 31, 1997, the facilities available under
the 1994 financing agreement were (i) a $20.0 million revolving, unsecured line
of credit which expires on August 31, 1998, and (ii) the balance of an original
$5.0 million term loan. The 1994 financing agreement provides for variable
interest rates for the $20.0 million revolving, unsecured line of credit equal
to the bank's Reference Rate (8.50% per annum at December 31, 1997) minus 0.25%
or other short-term rates based on various interest rate bases. Under the 1994
financing agreement, the Company must maintain specified financial ratios and
comply with certain restrictive covenants. With the exception of the original
$5.0 million term loan noted above, no borrowings have been made under the 1994
financing agreement.

F-19



WATSON PHARMACEUTICALS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

6. INCOME TAXES

The provision for income taxes is summarized as follows:


FOR THE YEARS ENDED DECEMBER 31,
-------------------------------
1997 1996 1995
-------- -------- --------
Current provision: (in thousands)
Federal $ 46,990 $ 11,059 $ 13,182
State 9,372 4,458 3,585
-------- -------- --------

56,362 15,517 16,767
-------- -------- --------
Deferred provision (benefit):
Federal (2,228) 17,364 7,622
State 280 3,035 478
-------- -------- --------
(1,948) 20,399 8,100
-------- -------- --------

Provision for income taxes $ 54,414 $ 35,916 $ 24,867
======== ======== ========

The exercise of stock options represents a tax benefit and has been
reflected as a reduction of income taxes payable and an increase to additional
paid-in capital. Such benefits recorded were $10.9 million, $7.8 million and
$6.8 million for the years ended December 31, 1997, 1996 and 1995, respectively.
Income taxes of $1.6 million have been provided for the possible distribution of
approximately $21.0 million of undistributed earnings related to the Company's
investments in joint ventures.

Reconciliations between the statutory federal income tax rate and the
Company's effective income tax rate were as follows:

FOR THE YEARS ENDED DECEMBER 31,
--------------------------------
1997 1996 1995
---- ---- ----

Expected tax at federal statutory rate 35% 35% 35%
State income tax, net of federal benefit 4 5 5
Research tax credits and other credits (1) (1)
Dividends received deduction (2) (4) (7)
Non-deductible merger expenses 2 3
Other (1) (4) (1)
--- --- ---
38% 31% 34%
=== === ===

F-20


WATSON PHARMACEUTICALS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Deferred tax assets and liabilities are measured based on the
difference between the financial statement and tax bases of assets and
liabilities at the applicable tax rates. The significant components of the
Company's net deferred tax assets and liabilities were:


DECEMBER 31,
------------------
1997 1996
------- -------
(in thousands)
Benefits from NOL carryforwards 5,319 4,492
Difference in accounting for inventory and receivables 8,900 8,299
Difference in depreciation for book and tax purposes (7,351) (5,544)
Difference in investment basis for book and tax (1,590) (1,205)
Unrealized gains - SFAS 115 (22,093) (4,800)
Valuation allowance (5,529) (7,854)
Other 4,856 4,193
------- -------
(17,488) (2,419)
======= =======

The Company had net operating loss ("NOL") carryforwards at December
31, 1997 of approximately $15.0 million and $13.0 million for federal and
Florida state income tax purposes, respectively. During 1997, the Company
utilized NOL carryforwards of approximately $2.0 million to offset federal
income. Due to restrictions imposed as a result of ownership changes to acquired
subsidiaries, the amount of the NOL carryforward available to offset future
taxable income is subject to limitation. The annual NOL utilization may be
further limited if additional changes in ownership occur. The Company's NOL
carryforwards will begin to expire in 2003.

7. STOCKHOLDERS' EQUITY

PREFERRED STOCK

In 1992, the Company authorized 2.5 million shares of no par preferred
stock. The Board of Directors has the authority to fix the rights, preferences,
privileges and restrictions, including dividend rates, conversion and voting
rights, terms and prices of redemptions and liquidation preferences without vote
or action by the stockholders. At December 31, 1997, no preferred stock was
issued.

STOCK OPTION PLANS

The Company has adopted several stock option plans that authorize the
granting of options to purchase the Company's common stock subject to certain
conditions. Under these plans, the Company has reserved 5.0 million shares for
issuance at December 31, 1997. The options are granted at the fair market value
of the shares underlying the options at the date of the grant, generally become
exercisable over a five-year period and expire in ten years. In conjunction with
the mergers with Circa, Oclassen, and Royce, certain stock option and warrant
plans were assumed by the Company. The options and warrants in these plans were
adjusted by the individual exchange ratios specified in each merger agreement.
No additional options or warrants will be granted under any of the assumed
plans.

F-21


WATSON PHARMACEUTICALS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The Company adopted the disclosure provisions of Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS
123"), in 1996. As permitted by SFAS 123, the Company measures compensation cost
in accordance with Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issued to Employees", and related interpretations, but provides pro forma
disclosures of net income and earnings per share as if the fair value method (as
defined in SFAS 123) had been applied beginning in 1995. Had compensation cost
been determined using the fair value method prescribed by SFAS 123, the
Company's net income and earnings per share would have been as follows:




FOR THE YEARS ENDED DECEMBER 31,
--------------------------------------------
1997 1996 1995
-------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

Net income As reported $ 90,184 $ 78,562 $ 48,181
======== ========== ==========

Pro forma $ 82,182 $ 72,472 $ 43,021
======== ========== ==========

Basic earnings per share As reported $ 1.04 $ 0.92 $ 0.58
======== ========== ==========

Pro forma $ 0.94 $ 0.85 $ 0.52
======== ========== ==========

Diluted earnings per share As reported $ 1.01 $ 0.89 $ 0.56
======== ========== ==========

Pro forma $ 0.92 $ 0.82 $ 0.50
======== ========== ==========


The weighted average fair value of the options have been estimated on
the date of grant using the Black-Scholes option pricing model with the
following weighted average assumptions used for grants in 1997, 1996 and 1995,
respectively: no dividend yield; expected volatility of 49%, 51% and 55%;
risk-free interest rate of 6.15%, 6.18% and 6.43% per annum; and expected terms
ranging from approximately three to eight years. Weighted averages are used
because of varying assumed exercise dates.

A summary of the status of the Company's stock option plans as of
December 31, 1997, 1996 and 1995, and for the years then ended is presented
below (shares in thousands):



YEARS ENDED DECEMBER 31,
----------------------------------------------------------------------------------
1997 1996 1995
------------------------ ------------------------ ------------------------
WEIGHTED- WEIGHTED- WEIGHTED-
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
------- --------- ------- --------- ------- ---------

Outstanding at beginning of year 7,615 $ 12.39 8,295 $ 11.24 5,653 $ 7.26
Granted 2,388 $ 23.25 1,215 $ 17.88 3,923 $ 15.71
Exercised (2,399) $ 5.97 (1,150) $ 7.56 (1,111) $ 6.40
Canceled (564) $ 18.49 (745) $ 16.08 (170) $ 13.72
------ ------ ------

Outstanding at end of year 7,040 $ 17.77 7,615 $ 12.39 8,295 $ 11.24
====== ====== ======

Weighted average fair value of options
granted during the year $12.28 $ 8.42 $ 7.34
====== ====== ======


F-22


WATSON PHARMACEUTICALS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following table summarizes information about stock options
outstanding at December 31, 1997 (shares in thousands):



WEIGHTED AVERAGE WEIGHTED AVERAGE
WEIGHTED AVERAGE EXERCISE PRICE EXERCISE PRICE
RANGE OF SHARES REMAINING OF SHARES SHARES OF SHARES
EXERCISE PRICES OUTSTANDING CONTRACTUAL LIFE OUTSTANDING EXERCISABLE EXERCISABLE
---------------- ----------- ----------------- ---------------- ----------- ----------------

$ 3 to $ 13 1,760 5.6 $ 7 1,408 $ 7
$ 13 to $ 19 3,051 7.8 $ 18 1,225 $ 18
$ 19 to $ 33 1,947 9.1 $ 25 122 $ 21
$ 33 to $ 51 282 2.9 $ 39 252 $ 39
----- ----

$ 3 to $ 51 7,040 7.4 $ 18 3,007 $ 15
===== ====



8. RELATED PARTIES

The Company leases a portion of its facilities from related parties.
The related aggregate rent expense in 1997, 1996 and 1995 was $309,000, $432,000
and $432,000, respectively, and was allocated to cost of revenues, research and
development and selling, general and administrative expenses.

The Company had notes receivable due from related parties in the
amounts of $2.0 million and $2.4 million at December 31, 1997 and 1996,
respectively. The $2.0 million note will mature in April 1998; the $2.4 million
note was repaid during 1997.

9. COMMITMENTS AND CONTINGENCIES

FACILITY AND EQUIPMENT LEASES

The Company has entered into operating leases for certain facilities
and equipment. The terms of the operating leases for the Company's facilities
require the Company to pay property taxes, normal maintenance expenses and
maintain minimum insurance coverage. Total rental expense for operating leases
in 1997, 1996 and 1995, including rent paid to related parties, was $2.5
million, $2.1 million and $2.0 million, respectively.

At December 31, 1997, future minimum lease payments under all
noncancelable operating leases consisted of the following:

YEARS ENDING DECEMBER 31, (IN THOUSANDS)

1998 $ 2,779
1999 2,594
2000 654
2001 251
2002 and after 99
-------

$ 6,377
=======

F-23


WATSON PHARMACEUTICALS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

EMPLOYEE RETIREMENT PLAN

The Company maintains a 401(k) retirement plan covering substantially
all employees. Monthly contributions are made by the Company based upon the
employee contributions to the plan. The Company contributed approximately
$398,000, $472,000 and $296,000 to the retirement plan for the years ended
December 31, 1997, 1996, and 1995, respectively.

LEGAL MATTERS

In March 1996, the Company paid $2.7 million in settlement of all
outstanding claims related to an inquiry by the United States Department of
Justice as to possible violations of the False Claims Act in respect of drugs
sold by Circa prior to cessation of these product sales in 1990. The Company had
established a reserve at December 31, 1995 for the full amount of the
settlement.

The Company is involved in various disputes and litigation matters
which arise in the ordinary course of business. The litigation process is
inherently uncertain and it is possible that the resolution of these disputes
and lawsuits may adversely affect the Company. Management believes, however,
that the ultimate resolution of such matters will not have a material adverse
impact on the Company's consolidated financial position or results of
operations.

F-24


WATSON PHARMACEUTICALS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

10. QUARTERLY FINANCIAL DATA (UNAUDITED)

The Company's unaudited quarterly financial and market price
information is as follows (in thousands, except per share data):




FOURTH THIRD SECOND FIRST
1997 QUARTER QUARTER QUARTER QUARTER
- ---- --------- -------- -------- --------

Revenues $ 109,764 $ 91,817 $ 70,943 $ 65,740
Costs and expenses 66,091 53,612 46,649 49,628
--------- -------- -------- --------

Operating income 43,673 38,205 24,294 16,112
Other income, net 3,058 4,230 7,376 7,650
Provision for income taxes 17,308 14,837 12,558 9,711
--------- -------- -------- --------

Net income $ 29,423 $ 27,598 $ 19,112 $ 14,051
========= ======== ======== ========

Basic earnings per share $ 0.33 $ 0.32 $ 0.22 $ 0.16
========= ======== ======== ========

Diluted earnings per share $ 0.33 $ 0.31 $ 0.22 $ 0.16
========= ======== ======== ========

Market price per share: High $ 34.13 $ 30.38 $ 22.25 $ 23.06
Low $ 27.00 $ 21.63 $ 16.00 $ 17.69





FOURTH THIRD SECOND FIRST
1996 QUARTER QUARTER QUARTER QUARTER
- ---- -------- -------- -------- --------

Revenues $ 67,292 $ 62,333 $ 61,619 $ 59,557
Costs and expenses 42,948 40,914 41,049 39,182
-------- -------- -------- --------

Operating income 24,344 21,419 20,570 20,375
Other income, net 6,792 7,385 6,762 6,831
Provision for income taxes 10,164 9,609 8,513 7,630
-------- -------- -------- --------

Net income $ 20,972 $ 19,195 $ 18,819 $ 19,576
======== ======== ======== ========

Basic earnings per share $ 0.25 $ 0.23 $ 0.22 $ 0.23
======== ======== ======== ========

Diluted earnings per share $ 0.24 $ 0.22 $ 0.21 $ 0.22
======== ======== ======== ========

Market price per share: High $ 23.00 $ 20.00 $ 24.25 $ 24.75
Low $ 15.88 $ 13.00 $ 18.25 $ 18.50


The quarterly data above were restated, as applicable, to reflect the
adoption of SFAS 128 and for acquisitions in 1997 accounted for under the
pooling of interests method as further discussed in Note 1 and Note 2,
respectively. Accordingly, this information varies from historical Form 10-Q
filings with the Securities and Exchange Commission prior to the effective dates
of these transactions.

F-25




WATSON PHARMACEUTICALS, INC.

SCHEDULE II - VALUATION & QUALIFYING ACCOUNTS
(IN THOUSANDS)

BALANCE AT CHARGE TO BALANCE AT
BEGINNING COSTS AND DEDUCTIONS/ END OF
OF PERIOD EXPENSES OTHER PERIOD
---------- --------- ----------- ----------

YEAR END 1997:
Allowance for doubtful accounts $ 2,206 $ - $ (66) $ 2,140

YEAR END 1996:
Allowance for doubtful accounts $ 1,602 $ 1,749 $ (1,145) $ 2,206

YEAR END 1995:
Allowance for doubtful accounts $ 1,135 $ 600 $ (133) $ 1,602


F-26




WATSON PHARMACEUTICALS, INC.
EXHIBIT INDEX
1997 FORM 10-K

EXHIBIT
NO. DESCRIPTION
- ------- -----------

4.2 Credit Agreement between the Company, its subsidiaries and
Mellon Bank, N.A. dated December 19, 1997.

4.2(a) Amendment Number One to Credit Agreement between the Company,
its subsidiaries and Mellon Bank, N.A. dated as of January
23, 1998.

10.20(a) Consulting Agreement between Patrick J. McEnany and the
Company dated January 31, 1998.

10.20(b) Amendment to Stock Option Agreement between Patrick J.
McEnany and the Company dated January 29, 1998.

10.27 Stock Purchase Agreement among the Company, Hoechst Marion
Roussel, Inc. and Marisub, Inc. dated August 25, 1997. *

10.27(a) Amendment to Stock Purchase Agreement among the Company,
Hoechst Marion Roussel, Inc. and Marisub, Inc. dated
November 26, 1997.

10.27(b) Second Amendment to Stock Purchase Agreement by and among the
Company, Hoechst Marion Roussel, Inc. and Marisub, Inc.
dated February 27, 1998. *

10.28 Supply and License Agreement by and between Hoechst Marion
Roussel, Inc. and The Rugby Group, Inc. dated February 27,
1998. *

10.29 Contract Manufacturing Agreement by and between Hoechst
Marion Roussel, Inc. and The Rugby Group, Inc. dated February
27, 1998. *

22.1 Subsidiaries of the Company.

23.1 Consent of Price Waterhouse LLP.

23.2 Consent of Deloitte & Touche LLP.

23.3 Consent of Arthur Andersen LLP.

27.1 Financial Data Schedule (EDGAR version only).

99.1 Consolidated Financial Statements of Somerset
Pharmaceuticals, Inc. and Subsidiaries for the years ended
December 31, 1997, 1996 and 1995.

(*) The Company has submitted a confidential treatment request relating to
certain provisions of these agreements with the Securities and Exchange
Commission.