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UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549


Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE

SECURITIES EXCHANGE ACT OF 1934


For the Fiscal Year Ended December 31,
2001

Commission file number: 0-27406

Connetics Corporation

(Exact name of registrant as specified in its
charter)


|                                                                                        |  |                                                
|--------------------------------------------------------------------------------------- |  | -----------------------------------------------
|Delaware(State or other jurisdiction of
	incorporation or organization)                 |  | 94-3173928(I.R.S. Employer
	Identification No.)
|                                                                                       
|3290 West Bayshore Road
	Palo Alto, California(Address of principal executive
	offices) |  | 94303(zip code)                                

Registrants telephone number, including
area code: (650) 843-2800

Securities registered pursuant to
Section 12(b) of the Act: None

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

Common Stock, $0.001 par value per
share


Preferred Share Purchase Rights


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 þ          No o

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

The aggregate market value of the voting stock
held by non-affiliates of the registrant was approximately
$225,516,073 as of March 22, 2002, based upon the closing
sale price on the Nasdaq National Market reported for that date.
The calculation excludes shares of common stock held by each
officer and director and by each person who owns 5% or more of
the outstanding common stock in that such persons may be deemed
to be affiliates. This determination of affiliate status is not
necessarily a conclusive determination for other purposes.

There were 30,566,234 shares of registrants
common stock issued and outstanding as of March 22, 2002.

DOCUMENTS INCORPORATED BY REFERENCE

The information required by Part III of this
Report, to the extent that it is not set forth in this Report,
is incorporated by reference to the registrants definitive
proxy statement for the Annual Meeting of Stockholders to be
held on May 16, 2002.



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TABLE OF CONTENTS



|                            |                                                                                               |                                                 |  |  |  |  |  | 
|--------------------------- | --------------------------------------------------------------------------------------------- | ----------------------------------------------- |  |  |  |  |  | 
|FORWARD-LOOKING INFORMATION
|PART I                     
|                            | Item 1. Business                                                                             
|                            | Item 2. Properties                                                                           
|                            | Item 3. Legal Proceedings                                                                    
|                            | Item 4. Submission of Matters to a Vote of Security Holders                                  
|PART II                    
|                            | Item 5. Market for the Companys Common Equity and Related Stockholder Matters               
|                            | Item 6. Selected Financial Data                                                              
|                            | Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                            | Item 7A. Quantitative and Qualitative Disclosures About Market Risk                          
|                            | Item 8. Financial Statements and Supplementary Data                                          
|                            | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 
|PART III                   
|                            | Item 10. Our Directors and Executive Officers                                                
|                            | Item 11. Executive Compensation                                                              
|                            | Item 12. Security Ownership of Certain Beneficial Owners and Management                      
|                            | Item 13. Certain Relationships and Related Transactions                                      
|PART IV                    
|                            | Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K                     
|SIGNATURES                 
|                            |                                                                                               | CONSOLIDATED BALANCE SHEETS                    
|                            |                                                                                               | CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
|INDEX TO EXHIBITS          
|Exhibit 3.5                
|Exhibit 10.4               
|Exhibit 10.5               
|Exhibit 10.12              
|Exhibit 10.13              
|Exhibit 10.39              
|Exhibit 10.49              
|Exhibit 10.54              
|Exhibit 10.55              
|Exhibit 10.56              
|Exhibit 21                 
|Exhibit 23.1               



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TABLE OF CONTENTS

|                                                                      |  |                                                                                        |      |      |    | 
|--------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------- | ---- | ---- | -- | 
|                                                                      |  |                                                                                        |      | Page
|                                                                      |  |                                                                                        |      |     
|Forward-Looking Information                                           |  |                                                                                        | 1    |     
|                                                                     
|PART I                                                               
|Item 1.                                                               |  | Business                                                                               |      |      | 1  | 
|Item 2.                                                               |  | Properties                                                                             |      |      | 22 | 
|Item 3.                                                               |  | Legal Proceedings                                                                      |      |      | 22 | 
|Item 4.                                                               |  | Submission of Matters to a Vote of Security
	Holders                                   |      |      | 22 | 
|                                                                     
|PART II                                                              
|Item 5.                                                               |  | Market for the Companys Common Equity and
	Related Stockholder Matters                |      |      | 22 | 
|Item 6.                                                               |  | Selected Financial Data                                                                |      |      | 23 | 
|Item 7.                                                               |  | Managements Discussion and Analysis of
	Financial Condition and Results of Operations |      |      | 25 | 
|Item 7A.                                                              |  | Quantitative and Qualitative Disclosures About
	Market Risk                            |      |      | 34 | 
|Item 8.                                                               |  | Financial Statements and Supplementary Data                                            |      |      | 35 | 
|Item 9.                                                               |  | Changes in and Disagreements with Accountants on
	Accounting and Financial Disclosure  |      |      | 35 | 
|                                                                     
|PART III                                                             
|Item 10.                                                              |  | Our Directors and Executive Officers                                                   |      |      | 35 | 
|Item 11.                                                              |  | Executive Compensation                                                                 |      |      | 37 | 
|Item 12.                                                              |  | Security Ownership of Certain Beneficial Owners
	and Management                        |      |      | 37 | 
|Item 13.                                                              |  | Certain Relationships and Related Transactions                                         |      |      | 37 | 
|                                                                     
|PART IV                                                              
|Item 14.                                                              |  | Exhibits, Financial Statement Schedules and
	Reports on Form 8-K                       |      |      | 37 | 
|Signatures                                                            |  |                                                                                        | 39   |     
|Consolidated Financial Statements and Report of
	Independent Auditors |  |                                                                                        | F-1  |     
|Index to Exhibits                                                     |  |                                                                                        | F-31 |     



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FORWARD-LOOKING INFORMATION

Our disclosure and analysis in this Report, in
other reports that we file with the Securities and Exchange
Commission, in our press releases and in public statements of
our officers contain forward-looking statements within the
meaning of Section 27A of the Securities Act, and
Section 21E of the Securities Exchange Act. Forward-looking
statements give our current expectations or forecasts of future
events. You can identify these statements by the fact that they
do not relate strictly to historical or current events. They use
words such as anticipate, estimate,
expect, will, may,
intend, plan, believe and
similar expressions in connection with discussion of future
operating or financial performance. These include statements
relating to future actions, prospective products or product
approvals, future performance or results of current and
anticipated products, sales efforts, expenses, the outcome of
contingencies such as legal proceedings, and financial
results.

Forward-looking statements may turn out to be
wrong. They can be affected by inaccurate assumptions or by
known or unknown risks and uncertainties. Many factors mentioned
in this Report  for example, governmental regulation
and competition in our industry  will be important in
determining future results. No forward-looking statement can be
guaranteed, and actual results may vary materially from those
anticipated in any forward-looking statement.

Although we believe that our plans, intentions
and expectations reflected in these forward-looking statements
are reasonable, we may not achieve these plans, intentions or
expectations. Forward-looking statements in this Report include,
but are not limited to, those relating to the commercialization
of our currently marketed products, the progress of our product
development programs, developments with respect to clinical
trials and the regulatory approval process, developments related
to acquisitions and clinical development of drug candidates, and
developments relating to the growth of our sales and marketing
capabilities. Actual results, performance or achievements could
differ materially from those contemplated, expressed or implied
by the forward-looking statements contained in this Report.
Important factors that could cause actual results to differ
materially from our forward-looking statements are set forth in
this Report. These factors are not intended to represent a
complete list of the general or specific factors that may affect
us. It should be recognized that other factors, including
general economic factors and business strategies, and other
factors not currently known to us, may be significant, presently
or in the future, and the factors set forth in this Report may
affect us to a greater extent than indicated. All
forward-looking statements attributable to us or persons acting
on our behalf are expressly qualified in their entirety by the
cautionary statements set forth in this Report. Except as
required by law, we do not undertake any obligation to update
any forward-looking statement, whether as a result of new
information, future events or otherwise.




PART I




Item 1.     Business

The Company

References in this Report to
Connetics, the Company, we,
our and us refer to Connetics
Corporation, a Delaware corporation, and its consolidated
subsidiaries. Our principal executive offices are located at
3290 West Bayshore Road, Palo Alto, CA 94303. Our telephone
number is (650) 843-2800. Connetics®,
Luxíq®, and OLUX®are registered trademarks, and LiquipatchTM and
the seven interlocking Cs design are
trademarks, of Connetics. All other trademarks or service marks
appearing in this Report are the property of their respective
companies. We disclaim any proprietary interest in the marks and
names of others.

Connetics is a specialty pharmaceutical company
focusing exclusively on the treatment of dermatological
conditions. We currently market two pharmaceutical products,
Luxíq® Foam (betamethasone valerate), 0.12%, and
OLUX® Foam (clobetasol propionate), 0.05%. Our commercial
business is focused on the dermatology marketplace, which is
characterized by a large patient population that is served by
relatively small number of treating physicians. Our two
dermatology products have clinically proven therapeutic

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advantages for the treatment of scalp dermatoses
in a novel formulation, and we are providing quality customer
service to dermatologists through our experienced sales and
marketing professionals.


In 2001 we established the Connetics Center for
Skin Biology, with a goal of connecting the scientific
understanding of skin disease with better treatment options. The
Center was created to bring together dermatologists and
pharmacologists from across the country to explore how topical
drugs interact with and penetrate the skin. The purpose of the
Center for Skin Biology is to learn how to optimize drug
penetration, distribution, and efficiency at the targeted
treatment site on the skin and to evaluate new chemical entities
for the development of innovative dermatological products. The
Center will assist in the continued development of innovative
topical dermatology products through rigorous scientific
evaluation of products and potential products. We believe this
novel approach to drug development will enable us to bring even
more effective and novel treatments to our product platform and
the dermatology market.

Our products, Luxíq and OLUX, compete in the
topical steroids market. According to IMS Health, in 2001, the
value of the retail topical steroid market for mid-potency and
high and super-high potency steroids was $850 million.
Luxíq competes in the mid-potency steroid market and OLUX
competes in the high- and super-high potency steroid market.

Dermatological diseases often persist for an
extended period of time and are treated with clinically proven
drugs that are currently delivered in a variety of formulations,
including solutions, creams, gels and ointments. These existing
delivery systems often inadequately address a patients
needs for efficacy and cosmetic elegance, and the failure to
address those needs may decrease patient compliance. We believe
that the proprietary foam delivery system unique to Luxíq
and OLUX has significant advantages over conventional therapies
for dermatoses, including more localized delivery of the active
agent. The foam formulation liquefies when applied to the skin,
and enables rapid penetration of the active therapeutic agent.
When the foam is applied, it dries quickly, and does not leave
any residue, stains or odor. We believe that the combination of
the increased efficacy and the cosmetic elegance of the foam may
actually improve patient compliance and satisfaction. In market
research sponsored by Connetics, 80% of patients said that they
preferred the foam over other topical delivery vehicles.

On March 21, 2001, we entered into a
definitive agreement to acquire Soltec Research Pty Ltd, a
division of Australia-based F. H. Faulding &
Co Limited. Under the agreement, Connetics acquired all of
Soltecs issued capital stock for approximately
U.S. $16.9 million. The acquisition of Soltec was
intended to provide Connetics powerful product innovation and
development capabilities and to fuel an extensive new product
pipeline as well as contributing revenue and profits to
Connetics financial results. For over 10 years Soltec
has been developing unique and highly effective means of
administering drugs to the skin. Prior to the acquisition,
Soltec leveraged its broad range of drug delivery technologies
by entering into license agreements with many well-known
dermatology companies around the world. Those license agreements
for marketed products bear royalties payable to Soltec. In
addition, Soltec provides a solid platform to keep our pipeline
filled with products as well as an opportunity to enter product
partnerships for over-the-counter and foreign markets.

The acquisition of Soltec established Connetics
as the only independent company serving the dermatology
specialty that has integrated product innovation, development
and commercialization capabilities, and enabled us to control
our innovative topical delivery technologies worldwide. As a
result of the acquisition, cash royalties and license fees
payable to Soltec in connection with agreements with Soltec are
now eliminated in consolidation. The acquisition of Soltec
provides us with a broad development platform of delivery
technologies to advance our pipeline and a talented group of
scientists to drive research and innovation. We gained worldwide
rights to a number of unique topical delivery systems, including
several distinctive aerosol foams including water-, ethanol-and
petrolatum- based foams. Consolidating the rights to these
technologies enables us to populate our own product development
portfolio, as well as pursue business development agreements
with other pharmaceutical companies.

Our Strategy

Our principal business objective is to be a
leading specialty pharmaceutical company focused on providing
innovative treatments in targeted fields, initially in the field
of dermatologic disease. To achieve this

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objective, we intend to continue to pursue our
commercial strategy of maximizing product sales by leveraging
novel delivery technologies, accelerating the processes of
getting products to market, and targeting specific market
opportunities with unmet needs. Key elements of our related
business and commercialization strategy include the following:




| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Maximizing Near-Term Commercial Opportunities
	for Luxíq and OLUX.We have a
	focused sales force dedicated to establishing Luxíq and
	OLUX as the standard of care. Our commercial strategy permits us
	to effectively reach the majority of the treating
	dermatologists. In 2001 we launched 50-gram cans of both
	products, and in 2002 we anticipate introducing physician
	samples. We also intend to expand the near-term commercial
	opportunities for Olux by seeking approval to market the product
	for the treatment of non-scalp dermatoses.
|
| |  | Advancing the Development of Novel Dermatology
	Drugs.We plan to continue to leverage
	our investment in Soltec and the Center for Skin Biology to
	enhance our ability to develop novel formulations and drug
	delivery technologies for the dermatology market.                                                                                                                                                                                                                                                                                       
|
| |  | Broadening Our Product Portfolio Through
	Development, License or Acquisition.We believe that we can leverage our
	dermatology-dedicated sales force by marketing additional
	products to the dermatology market. We are evaluating the
	licensing or acquisition of additional product candidates,
	several of which are in the field of dermatologic disease. We
	may also acquire additional technologies or businesses that we
	believe will enhance our research and development capabilities.                                                     
|
| |  | Collaborating Selectively With Pharmaceutical
	Companies.As we expand certain
	aspects of our development pipeline and delivery technologies,
	we intend to partner with pharmaceutical companies to gain
	access to additional marketing expertise, particularly as it
	relates to the over-the-counter pharmaceutical market. Our
	approach to partnership will be on a selective basis, seeking to
	maintain the highest possible value of our product candidates.                                                                                   

Our Products

Luxíq
Foam

Luxíq is a foam formulation of betamethasone
valerate, a mid-potency topical steroid prescribed for the
treatment of mild-to-moderate steroid-responsive scalp
dermatoses such as psoriasis, eczema and seborrheic dermatitis.
In our pivotal clinical trial, patients treated with Luxíq
experienced a statistically significant improvement over
patients treated with placebo or betamethasone valerate lotion.
We began selling Luxíq commercially in the United States in
April 1999.

OLUX
Foam

OLUX is a foam formulation of clobetasol
propionate, one of the most widely prescribed super high-potency
topical steroids. We began selling OLUX in November 2000 for the
short-term, topical treatment of inflammatory and pruritic
manifestations of moderate to severe corticosteroid-responsive
scalp dermatoses. In our pivotal clinical trial, patients
treated with OLUX experienced a statistically significant
improvement over patients treated with placebo or clobetasol
solution.

In December 2001, we filed a supplemental New
Drug Application, or sNDA, with the U.S. Food and Drug
Administration, requesting clearance to market OLUX for
non-scalp indications. The application is currently under review
with the FDA. The sNDA was based on results from a Phase IV
clinical trial of OLUX for the treatment of mild-to-moderate
non-scalp psoriasis. The results were first presented on
January 30, 2002 at the 26th Annual Hawaii Dermatology
Seminar. During the study, patients with mild to moderate
plaque-type psoriasis of non-scalp regions treated with OLUX
experienced a statistically significant improvement in clearance
of disease (p < 0.0001) over patients in the placebo group.
The 279-patient, placebo-controlled, randomized, double-blind,
Phase IV study was conducted at 17 clinical centers.
Patients self-administered either OLUX or placebo twice daily
for 14 days. They were evaluated using the Physicians
Static Global Assessment score as the primary endpoint, and
patients global assessment and erythema, scaling, plaque
thickness, and pruritus baselines as secondary endpoints. Using
the Physicians Static Global Assessment, 71%

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of patients treated with OLUX had complete or
almost complete clearance of disease compared with 22% of
patients treated with placebo based on a per protocol analysis.
There was no statistical difference in the reported adverse
events between the OLUX and placebo groups. The most common
adverse events reported were application site reactions (burning
and stinging at 5%).


A separate study conducted at Stanford University
School of Medicine, also presented at the Annual Hawaii
Dermatology Seminar, compared the effectiveness, patient
satisfaction, quality of life, and cost-effectiveness of two
clobetasol regimens in the treatment of psoriasis. In a
single-blind design, 29 patients were randomized to receive
either clobetasol foam on the skin and scalp or a combination of
clobetasol cream on the skin and lotion on the scalp for
14 days. Severity of disease and quality of life were
evaluated using several tools, including the Psoriasis Area
Severity Index and the Dermatology Life Quality Index. The trial
was conducted by Alexa Boer Kimball, M.D., M.P.H.,
Assistant Professor of Dermatology, Director Clinical Trials
Center at Stanford University School of Medicine.
Dr. Kimball reported that the increased improvement in
clinical severity, decreased application time, and increased
perception of relative efficacy, combined with similar cost of
treatment, suggest that Olux is a better choice than cream and
solution for some patients. This study supports our belief that
improved patient compliance with the foam will yield better
treatment results than the same active ingredient in a
traditional formulation.

Royalty-Bearing Products and Licensed
Technology

Ridaura.On
May 1, 2001, we announced the completion of the sale of all
of our rights and interests in Ridaura® (auranofin) to
Prometheus Laboratories, Inc., a California corporation. The
sale was made pursuant to an Asset Purchase Agreement dated
April 9, 2001 and closed on April 30, 2001. Ridaura is
an oral formulation of a gold salt which is prescribed for the
treatment of rheumatoid arthritis. The decision to divest the
product was consistent with our decision to focus exclusively on
dermatology.

Under the terms of the Asset Purchase Agreement,
we sold all of our, rights, interests and assets for or related
to the use, manufacture or sale of Ridaura in the United States
and Puerto Rico for $9.0 million in cash plus a royalty on
annual sales of Ridaura in excess of $4.0 million over the
next five years. Prometheus agreed to assume, effective as of
the closing date of the transaction, our obligations under the
Supply Agreement with Pharmascience, Inc., our obligations under
the Supply Agreement with SmithKline Beecham Corporation (now
known as GlaxoSmithKline), and certain of our obligations under
the SmithKline Beecham Asset Purchase Agreement pursuant to
which we originally acquired the rights to Ridaura.

Actimmune.In
December 1995, we entered into a license agreement with
Genentech to acquire exclusive U.S. development and
marketing rights to interferon gamma for dermatological
indications. Subsequent amendments to the original license
agreement expanded the fields of use for which the license
applies, and added Japan and Canada to the licensed territory.
Interferon gamma is one of a family of proteins involved in the
regulation of the immune system and has been shown to reduce the
frequency and severity of certain infections. We formed a
subsidiary, InterMune Pharmaceuticals, Inc. (now InterMune,
Inc.), to develop Actimmune for various infections and fungal
diseases. In March 2000, InterMune became a public company, and
effective April 1, 2000 we assigned our remaining rights
and obligations under the license with Genentech and the
corresponding supply agreement to InterMune. In exchange,
InterMune paid us approximately $6.1 million, of which
$0.9 million was paid to us in March 2001 and the balance
was paid in 2000. We retained the option to purchase the product
rights for potential dermatological applications of Actimmune,
and are entitled to receive royalties on Actimmune sales
beginning January 1, 2002.

Foam Technology.In
December 2001, we entered into an agreement granting Pharmacia
Corporation exclusive global rights, excluding Japan, to our
proprietary foam drug delivery technology for use with
Pharmacias Rogaine® hair loss treatment. The license
with Pharmacia will expand the reach of the foam vehicle to the
non-prescription (over-the-counter) pharmaceutical market. Under
the agreement, Pharmacia will pay us an undisclosed initial
licensing fee, milestone payments and a royalty on product
sales. Pharmacia will be responsible for most product
development activities and costs.

Before April 2001, Soltec had entered into a
number of other agreements for the foam technology. Soltec
licensed the technology to betamethasone valerate foam to
Celltech plc in Europe, and Celltech has licensed

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the worldwide rights to their patent on the
technology to Soltec. Soltec pays Celltech royalties on all
sales worldwide of foam formulations containing steroids.
Celltech markets their product as BettamousseTM (the
product equivalent of Luxíq). Soltec has license agreements
with Bayer (in the U.S.) and Pfizer and Mipharm
(internationally) for the use of pyrethrin foam for head
lice. That product is marketed in the U.S. as RID®, as
Banlice® in Australia, and as Milice in Italy. We receive
royalties on sales of those products, but the amount of
royalties was immaterial in 2001. Soltec has entered into
development agreements with other companies to develop the foam
for specific indications.


Liquipatch.Soltec
has entered into agreements with several companies to develop
LiquipatchTM for various indications. On
June 26, 2001, we announced that Soltec had entered into a
global licensing agreement with a major, international
healthcare company for Liquipatch. The agreement followed
successful pilot development work and gives the licensee the
exclusive, worldwide right to use the Liquipatch technology in a
particular field in dermatology, particularly for the delivery
of a topical over-the-counter product. The licensee will be
responsible for all development costs, and will be obligated to
pay license fees, milestone payments and royalties on future
product sales. Soltec has entered into development agreements
with other companies to develop Liquipatch for specific
indications.

Aerosol Spray.Soltec has licensed to a major
international company the rights to a super-concentrated aerosol
spray that is marketed in the U.S. and internationally. We
receive royalties on sales of the product. In 2001, on a
consolidated basis, we received $0.8 million in royalties
in connection with this agreement.

Sales and Marketing

We have an experienced, highly productive sales
and marketing organization, which is 100% dedicated to
dermatology. Through March 2001, we supplemented our sales force
with contract sales representatives to increase the frequency
and reach of our sales calls and to assist with the launch of
products. In March 2001, we discontinued using the contract
sales force. In April and May 2001, we hired 30 additional
full-time sales representatives and two additional regional
sales directors, to maximize our reach to the dermatologists
throughout the country. As of March 1, 2002, we had
77 employees in our sales and marketing organization,
including 62 field sales directors and representatives. We
believe we have created an incentive program that financially
rewards our sales force based on the number of topical steroid
prescriptions for our products written by the dermatologists in
their geographic territory.

Our marketing efforts are focused on assessing
and meeting the needs of dermatologists, dermatology nurses, and
physicians assistants. Our sales representatives focus on
cultivating relationships of trust and confidence with the
physicians they call upon. We use a variety of advertising,
promotional material (including journal advertising, promotional
materials, and rebate coupons), specialty publications,
participation in educational conferences, advisory board
meetings, and product internet sites to achieve our marketing
objectives. Beginning in the second quarter of 2002, we also
expect to have product samples available to distribute to
physicians. Of the 7,500 U.S. dermatologists our sales
force called on in 2001, we focused our efforts on the
approximately 6,500 dermatologists who are responsible for
approximately 90% of all prescriptions written by dermatologists
in the United States.

In addition to traditional marketing approaches
and field sales relationships with dermatologists, we use
internet marketing to convey basic information about our
products and our company. Our corporate website at
http://www.connetics.comincludes fundamental information
about the company as well as descriptions of ongoing research,
development and clinical work. Our product websites, at
http://www.luxiq.comand http://www.olux.com,
provide information about the products and their approved
indications, as well as copies of the full prescribing
information, the patient information booklet, and rebate coupons.

Competition

The specialty pharmaceutical industry is
characterized by intense market competition, extensive product
development and substantial technological change. We also face
competition from other manufacturers of prescription
pharmaceuticals for our dermatology products as well as other
products that we may develop and market in the future. Many of
our competitors are large, well-established pharmaceutical,
chemical, cosmetic

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or health care companies with considerably
greater financial, marketing, sales and technical resources than
those available to us. Additionally, many of our present and
potential competitors have research and development capabilities
that may allow such competitors to develop new or improved
products that may compete with our product lines. Our products
could be rendered obsolete or made uneconomical by the
development of new products to treat the conditions addressed by
our products, technological advances affecting the cost of
production, or marketing or pricing actions by one or more of
our competitors. Each of our products competes for a share of
the existing market with numerous products that have become
standard treatments recommended or prescribed by dermatologists.


Luxíq and Olux compete with a number of
corticosteroid brands in the super-, high- and mid-potency
categories for the treatment of inflammatory skin conditions.
Competing brands include Halog® and Ultravate®,
marketed by Bristol-Myers Squibb Company; Elocon® and
Diprolene®, marketed by Schering-Plough Corporation;
Locoid®, marketed by Ferndale Labs; Temovate® and
Cutivate®, marketed by Elan; and Psorcon®, marketed by
Dermik Laboratories, Inc. In addition, both Luxíq and Olux
compete with generic (non-branded) pharmaceuticals, which claim
to offer equivalent therapeutic benefits at a lower cost. In
some cases, insurers and other third-party payors seek to
encourage the use of generic products making branded products
less attractive, from a cost perspective, to buyers.

Many of our existing or potential competitors,
particularly large pharmaceutical companies, have substantially
greater financial, technical and human resources than we do. In
addition, many of these competitors have more collective
experience than we do in undertaking preclinical testing and
human clinical trials of new pharmaceutical products and
obtaining regulatory approvals for therapeutic products.
Accordingly, our competitors may succeed in obtaining FDA
approval for products more rapidly or successfully than we do.

We intend to compete on the basis of the quality
and efficacy of our products and unique drug delivery vehicles,
combined with the effectiveness of our marketing and sales
efforts. Competing successfully will depend on our continued
ability to attract and retain skilled and experienced personnel,
to identify, secure the rights to, and develop pharmaceutical
products and compounds, and to exploit these products and
compounds commercially before others are able to develop
competitive products.

Customers

Our customers include the nations leading
wholesale pharmaceutical distributors, such as McKesson HBOC,
Inc., Cardinal Health, Inc., Bergen Brunswig Corporation,
Bindley Western Industries, Inc., and major drug chains. During
2001, McKesson, Cardinal, Bindley and Bergen Brunswig accounted
for 29%, 26%, 18%, and 12%, respectively, of our gross product
revenues. The distribution network for pharmaceutical products
is subject to increasing consolidation. As a result, a few large
wholesale distributors control a significant share of the
market. In addition, the number of independent drug stores and
small chains has decreased as retail consolidation has occurred.
Further consolidation among, or any financial difficulties of,
distributors or retailers could result in the combination or
elimination of warehouses, which may result in reductions in
purchases of our products, returns of our products, or cause a
reduction in the inventory levels of distributors and retailers,
any of which could have a material adverse impact on our
business. If we lose any of these customer accounts, or if our
relationship with them were to deteriorate, our business could
also be materially and adversely affected.

Warehousing and Distribution

Currently, all of our product distribution
activities are handled by CORD Logistics, Inc., a national
warehousing corporation. CORD stores and distributes our
products from a warehouse in Tennessee. Upon the receipt of a
purchase order through electronic data input, phone, mail or
facsimile, the order is processed into CORDs inventory
system. After CORD ships the product to the customer placing the
order, usually within 24 hours, CORD automatically
processes the invoice on our behalf. Any delay or interruption
in the process or in payment could have a material effect on our
business.

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Research and Development and Product
Pipeline

Innovation by our research and development
operations is very important to the success of our business. Our
research and development expenses were $19.2 million in
2001, $21.9 million in 2000, and $21.3 million in
1999. Our goal is to discover, develop and bring to market
innovative products that address unmet healthcare needs, which
requires both clinical and manufacturing development. Our
substantial investment in research and development supports this
goal. We have the rights to a variety of pharmaceutical agents
in various stages of pre-clinical and clinical development in
several novel delivery technologies.

Our development activities involve work related
to product formulation, preclinical and clinical study
coordination, regulatory administration, manufacturing, and
quality control and assurance. Many pharmaceutical companies
conduct early stage research and drug discovery, but to obtain
the most value from our development portfolio, we are focusing
on later-stage development. This approach helps to minimize the
risk and time requirements for us to get a product on the
market. Our strategy involves targeting those product candidates
that we believe have the largest market potential, and then
rapidly evaluating and formulating new therapeutics by using
previously approved active ingredients reformulated in our
proprietary delivery system. This product development strategy
allows us to conduct limited preclinical safety trials, and to
move rapidly into safety and efficacy testing in humans with
products that offer significant improvements over existing
products. A secondary strategy is to evaluate the acquisition of
products from other companies.

Our relationship with Soltec led to our
development of Luxíq and Olux. Soltec has developed several
additional aerosol foams similar to our foam delivery system for
Luxíq and Olux, including water-, ethanol- and
petrolatum-based foams. We believe these formulations may offer
improved efficacy over traditional formulations due to greater
absorption of the active ingredient to the skin. In addition to
the potential for improved efficacy, the foam formulations
represent a cosmetically elegant alternative to existing
dermatologic treatments. Another invention by Soltec,
Liquipatch, is a multi-polymer gel-matrix delivery system that
applies to the skin like a normal gel and dries to form a very
thin, invisible, water-resistant film. This film enables a
controlled release of the active agent, which we believe will
provide a longer treatment period. We anticipate developing one
or more new products in the aerosol foam or Liquipatch
formulations, by incorporating leading dermatologic agents in
formulations that are tailored to treat specific diseases or
different areas of the body. We currently expect to seek
partners for over-the-counter market opportunities worldwide and
for development and commercialization of prescription products
outside the United States.

All products and technologies under development
require significant commitments of personnel and financial
resources. In addition to our in-house staff and resources, we
contract a substantial portion of development work to outside
parties. For example, we typically engage contract research
organizations to manage our clinical trials. We have contracts
with vendors to conduct product analysis and stability studies,
and we outsource all of our manufacturing scale-up and
production activities. We also use collaborative relationships
with pharmaceutical partners and academic researchers to augment
our product development activities, and from time to time we
enter agreements with academic or university-based researchers
to conduct various studies for us.

Several products require extensive clinical
evaluation and clearance by the FDA and comparable agencies in
other countries before we can sell them commercially. We
anticipate conducting simultaneous studies on several products
over the next several years. In particular, our intention is to
have several product candidates in formulation development at a
given time, and to target two product candidates for clinical
development each year. However, we regularly re-evaluate our
product development efforts. On the basis of these
reevaluations, we have in the past, and may in the future,
abandon development efforts for particular products. In
addition, any product or technology under development may not
result in the successful introduction of a new product.

In addition to Luxíq and Olux, we are
developing the foam technology for other disease indications.
Our most promising preclinical candidates include a
petrolatum-based foam as a line extension for Olux, an
antifungal foam, and an anti-acne foam. We are exploring the
anti-acne indication for Liquipatch as well. We have completed
pre-clinical work for our antifungal foam, and anticipate
beginning clinical trials in mid-2001. In late 2001, we decided
to delay beginning that clinical trial to re-formulate the foam
to eliminate a particular

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ingredient derived from cows. Although that
ingredient is still acceptable for U.S. products, we believed it
was prudent to reformulate the product before we commenced
clinical trials.


Patents and Proprietary Rights

Our success will depend in part on our ability
and our licensors ability to obtain and retain patent
protection for our products and processes, to preserve our trade
secrets, and to operate without infringing the proprietary
rights of third parties.

We own or are exclusively licensed under pending
applications and/or issued patents worldwide relating to
Luxíq and OLUX, recombinant human relaxin, and other
products in the earlier stages of research. Through Soltec, we
own over 20 patents related to the technologies developed
by Soltec, expiring between 2002 and 2018, and we have several
pending applications.

U.S. Patent 6,126,920 covers the delivery
technology that is the basis for OLUX and Luxíq,
specifically methods of treating various skin diseases, and in
particular, scalp psoriasis, using a foam pharmaceutical
composition comprising a corticosteroid active substance, a
propellant and a buffering agent. The Liquipatch technology is
covered by U.S. Patent 6,211,250.

With respect to patent applications that we or
our licensors have filed, and patents issued to us or our
licensors, we cannot assure you that:



| |   |                                                                                   
| | - | ----------------------------------------------------------------------------------
| |  | any of our or our licensors patent
	applications will issue as patents,          
|
| |  | any issued patents will provide competitive
	advantage to us, or                  
|
| |  | our competitors will not successfully challenge
	or circumvent any issued patents.

We rely on and expect to continue to rely on
unpatented proprietary know-how and continuing technological
innovation in the development and manufacture of many of our
principal products. We require all our employees, consultants
and advisors to enter into confidentiality agreements with us.
These agreements, however, may not provide adequate protection
for our trade secrets or proprietary know-how in the event of
any unauthorized use or disclosure of such information. In
addition, others may obtain access to or independently develop
similar or equivalent trade secrets or know-how.

Trademarks

We believe that trademark protection is an
important part of establishing product recognition. We own eight
registered trademarks and several trademark applications and
common law trademarks. United States federal registrations for
trademarks remain in force for 10 years and may be renewed
every 10 years after issuance, provided the mark is still
being used in commerce. However, any such trademark or service
mark registrations may not afford us adequate protection, and we
may not have the financial resources to enforce our rights under
any such trademark or service mark registrations. If we are
unable to protect our trademarks or service marks from
infringement, any goodwill developed in such trademarks or
service marks could be impaired.

Manufacturing

We contract with independent sources to
manufacture our products, which enables us to focus on product
and clinical development strengths, minimize fixed costs and
capital expenditures, and gain access to advanced manufacturing
process capabilities. Company policy and the FDA require that we
contract only with manufacturers that comply with current Good
Manufacturing Practice, or cGMP, regulations and other
applicable laws and regulations. Whether or not we have
manufacturing contracts with third-party manufacturers, we may
not be able to obtain adequate supplies of our products in a
timely fashion, on acceptable terms, or at all.

Miza Pharmaceuticals (formerly CCL
Pharmaceuticals) manufactures Luxíq and OLUX for us in
England. We are in the process of qualifying AccraPac Group to
manufacture physician samples, Luxíq and

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OLUX for us in the United States. On
March 12, 2002, we entered into an agreement with DPT
Laboratories, Ltd., to construct an aerosol filling line at
DPTs plant in Texas. The agreement is retroactive to
November 1, 2001. Pursuant to the agreement, DPT has agreed
to permit us to construct the aerosol line on DPTs
premises in Texas. We are responsible for the costs of the
construction and the related equipment. After the aerosol line
is completed, we will pay DPT monthly rent for the facility. DPT
and Connetics simultaneously entered into a manufacturing
agreement for DPT to manufacture and fill our commercial aerosol
products. DPT and Connetics are also party to a separate
research and development agreement for the manufacture of
clinical supplies for our aerosol products and product
candidates. While DPT manufactures other pharmaceutical products
and has passed inspection by the FDA in connection with those
products, we must still apply to the FDA to qualify DPT to
manufacture our commercial products for us in the United States.


Boehringer Ingelheim manufactured relaxin for us
for clinical uses under a long-term contract. Following the
failure of the pivotal clinical trial for relaxin, we entered
into discussions with Boehringer Ingelheim to discuss the future
of the contract. In December 2001 we mutually agreed to
terminate the contract, in exchange for a settlement payment by
Connetics. The final installment of the settlement is payable in
June 2002, after Boehringer Ingelheim delivers certain
documentation and reports to us. After that, neither party will
have any further obligations under the contract.

Government Regulation

Generally  Product Development.The pharmaceutical and biotechnology
industries are subject to regulation by the FDA under the Food,
Drug and Cosmetic Act, by the states under state food and drug
laws, and by similar agencies outside of the United States. In
order to clinically test, manufacture, and market products for
therapeutic use, we must satisfy mandatory procedures and safety
and effectiveness standards established by various regulatory
bodies. We have provided a more detailed explanation of the
standard we are subject to under Factors Affecting Our
Business and Prospects  We may spend a significant
amount of money to obtain FDA and other regulatory approvals,
which may never be granted and  We cannot
sell our current products and product candidates if we do not
obtain and maintain governmental approvals below.

We expect that all of our pharmaceutical products
will require regulatory approval by governmental agencies before
we can commercialize them, although the nature and extent of the
review process for our potential products will vary depending on
the regulatory categorization of particular products. Federal,
state, and international regulatory bodies govern or influence,
among other things, the testing, manufacture, labeling, storage,
record keeping, approval, advertising, and promotion of our
products on a product-by-product basis. Failure to comply with
applicable requirements can result in, among other things,
warning letters, fines, injunctions, penalties, recall or
seizure of products, total or partial suspension of production,
denial or withdrawal of approval, and criminal prosecution.
Accordingly, ongoing regulation by governmental entities in the
United States and other countries will be a significant factor
in the production and marketing of any pharmaceutical products
that we have or may develop.

Product development and approval within this
regulatory framework, and the subsequent compliance with
appropriate federal and foreign statutes and regulations, takes
a number of years and involves the expenditure of substantial
resources. Generally, a company must conduct pre-clinical
studies before it can obtain FDA approval for a new therapeutic
agent. The basic purpose of pre-clinical investigation is to
gather enough evidence on the potential new agent through
laboratory experimentation and animal testing, to determine if
it is reasonably safe to begin preliminary trials in humans. The
results of these studies are submitted as a part of an
investigational new drug application, which the FDA must review
before human clinical trials of an investigational drug can
start. We have filed and will continue to be required to sponsor
and file investigational new drug applications, and will be
responsible for initiating and overseeing the clinical studies
to demonstrate the safety and efficacy that are necessary to
obtain FDA approval of our products.

Clinical trials are normally done in phases and
generally take two to five years, but may take longer, to
complete. Phase I trials generally involve administration of a
product to a small number of patients to determine safety,
tolerance and the metabolic and pharmacologic actions of the
agent in humans and the side effects associated with increasing
doses. Phase II trials generally involve administration of
a product to a larger

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group of patients with a particular disease to
obtain evidence of the agents effectiveness against the
targeted disease, to further explore risk and side effect
issues, and to confirm preliminary data regarding optimal dosage
ranges. Phase I and Phase II trials can sometimes be
combined, with the FDAs concurrence, into a
Phase I/II trial. Phase III trials involve more
patients, and often more locations and clinical investigators
than the earlier trials. At least one such trial is required for
FDA approval to market a drug. Phase II and Phase III
trials can sometimes be combined, with the FDAs
concurrence, into a Phase II/III trial, which is an
accelerated clinical trial intended to provide sufficient data
for approval.


The rate of completion of our clinical trials
depends upon, among other factors, the rate at which patients
enroll in the study. Patient enrollment is a function of many
factors, including the size of the patient population, the
nature of the protocol, the proximity of patients to clinical
sites and the eligibility criteria for the study. Delays in
planned patient enrollment may result in increased costs and
delays, which could have a material adverse effect on our
business. In addition, side effects or adverse events that are
reported during clinical trials can delay, impede, or prevent
marketing approval.

Section 505(b)(2) of the Food, Drug and
Cosmetic Act makes it possible for a company to possibly
accelerate the FDA approval process. A so-called 505(b)(2)
application permits a sponsor of a drug to satisfy the
requirements for a full New Drug Application, or NDA, by relying
on published studies or the FDAs findings of safety and
effectiveness based on studies in a previously-approved NDA
sponsored by another person, together with the studies generated
on its own drug products. The FDA evaluates 505(b)(2)
applications using the same standards of approval for an NDA,
but the number of clinical trials required to support a
505(b)(2) application, and the amount of information in the
application itself, may be substantially less than that required
to support an NDA application. We used the 505(b)(2) application
process for both Luxíq and OLUX, but the 505(b)(2) process
may not be available for our other product candidates, and as a
result the FDA process may be longer for those product
candidates than it was for Luxíq and OLUX.

After we complete the clinical trials of a new
drug product, we must file an NDA with the FDA. We must receive
FDA clearance before we can commercialize the product, and the
FDA may not grant approval on a timely basis or at all. The FDA
can take between one and two years to review an NDA, and can
take longer if significant questions arise during the review
process. While various legislative and regulatory initiatives
have focused on the need to reduce FDA review and approval
times, the ultimate impact of such initiatives on our products
cannot be certain. In addition, if there are changes in FDA
policy while we are in product development, we may encounter
delays or rejections that we did not anticipate when we
submitted the new drug application or biologics license
application for that product. We may not obtain regulatory
approval for any products that we develop, even after committing
such time and expenditures to the process. Even if regulatory
approval of a product is granted, it may entail limitations on
the indicated uses for which the product may be marketed.

Our products will also be subject to foreign
regulatory requirements governing human clinical trials,
manufacturing and marketing approval for pharmaceutical
products. The requirements governing the conduct of clinical
trials, product licensing, pricing and reimbursement are
similar, but not identical, to FDA requirements, and they vary
widely from country to country.

Manufacturing.The
FDA regulates and inspects equipment, facilities, and processes
used in the manufacturing of pharmaceutical products before
providing approval to market a product. If after receiving
clearance from the FDA, we make a material change in
manufacturing equipment, location, or process, we may have to
undergo additional regulatory review. We must apply to the FDA
to change the manufacturer we use to produce any of our
products. We and our contract manufacturers must adhere to
current Good Manufacturing Practice and product-specific
regulations enforced by the FDA through its facilities
inspection program. The FDA also conducts regular, periodic
visits to re-inspect equipment, facilities, and processes after
the initial approval. If, as a result of these inspections, the
FDA determines that our (or our contract manufacturers)
equipment, facilities, or processes do not comply with
applicable FDA regulations and conditions of product approval,
the FDA may seek sanctions and/or remedies against us, including
suspension of our manufacturing operations.

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Post-Approval Regulation.The FDA continues to review marketed
products even after granting regulatory clearances, and later
discovery of previously unknown problems or failure to comply
with the applicable regulatory requirements may result in
restrictions on the marketing of a product or withdrawal of the
product from the market, recalls, seizures, injunctions or
criminal sanctions. In its regulation of advertising, the FDA
from time to time issues correspondence to pharmaceutical
companies alleging that some advertising or promotional
practices are false, misleading or deceptive. The FDA has the
power to impose a wide array of sanctions on companies for such
advertising practices.

Pharmacy Boards.We
are required in most states to be licensed with the state
pharmacy board as either a manufacturer, wholesaler, or
wholesale distributor. Many of the states allow exemptions from
licensure if our products are distributed through a licensed
wholesale distributor. The regulations of each state are
different, and the fact that we are licensed in one state does
not authorize us to sell our products in other states.
Accordingly, we undertake an annual review of our license status
and that of CORD to ensure continued compliance with the state
pharmacy board requirements.

Fraud and Abuse Regulations.We are subject to various federal and
state laws pertaining to health care fraud and
abuse, including anti-kickback laws and false claims laws.
Anti-kickback laws make it illegal for a prescription drug
manufacturer to solicit, offer, receive, or pay any remuneration
in exchange for, or to induce, the referral of business,
including the purchase or prescription of a particular drug. The
federal government has published regulations that identify
safe harbors or exemptions for certain payment
arrangements that do not violate the anti-kickback statutes. We
seek to comply with the safe harbors where possible. Due to the
breadth of the statutory provisions and the absence of guidance
in the form of regulations or court decisions addressing some of
our practices, it is possible that our practices might be
challenged under anti-kickback or similar laws. False claims
laws prohibit anyone from knowingly and willingly presenting, or
causing to be presented for payment to third party payors
(including Medicare and Medicaid) claims for reimbursed drugs or
services that are false or fraudulent, claims for items or
services not provided as claimed, or claims for medically
unnecessary items or services. Our activities relating to the
sale and marketing of our products may be subject to scrutiny
under these laws. Violations of fraud and abuse laws may be
punishable by criminal and/or civil sanctions, including fines
and civil monetary penalties, as well as the possibility of
exclusion from federal health care programs (including Medicare
and Medicaid).

We participate in the Medicaid rebate program
established by the Omnibus Budget Reconciliation Act of 1990.
Under the Medicaid rebate program, we pay a rebate to each state
Medicaid program for each unit of our product reimbursed by
those programs. As a manufacturer currently of single source
products only, the amount of the rebate for each of our products
is set by law as the greater of 15.1% of the average
manufacturer price of that product, or the difference between
the average manufacturer price and the best price available from
the company to any customer, with the final rebate amount
adjusted upward if increases in average manufacturer price since
product launch have outpaced inflation. The Medicaid rebate
amount is computed each quarter based on our submission to the
United States Department of Health and Human Services Centers
for Medicare and Medicaid Services of our current average
manufacturer price and best price for each of our products. The
terms of our participation in the Medicaid program could require
us to correct the prices that we reported in previous quarters,
if necessary. Any such corrections could result in a change
(positive or negative) in our Medicaid rebate liability for past
quarters. As part of our revenue recognition policy, we provide
reserves on this potential exposure at the time of product
shipment. In addition to penalties that may be applicable under
other federal statutes, the Medicaid rebate statute imposes
civil monetary penalties in amounts up to $100,000 per item for
the knowing submission of false information to the program.

Under amendments to the Omnibus Budget
Reconciliation Act of 1990 that became effective in October
1993, participation in the Medicaid program has required the
extension of comparable discounts to qualified purchasers under
the Public Health Services, or PHS, pharmaceutical pricing
program. The PHS pricing program extends discounts comparable to
the Medicaid rebate to a variety of community health clinics and
other entities that receive health services grants from the PHS,
as well as hospitals that serve a disproportionate share of poor
Medicare and Medicaid beneficiaries.

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We also make our products available to authorized
users of the Federal Supply Schedule, or FSS, of the General
Services Administration under an FSS contract negotiated by the
Department of Veterans Affairs. The Veterans Health Care Act of
1992, or VHCA, imposes a requirement that the prices a company
such as Connetics charges the Veterans Administration, the
Department of Defense, the Coast Guard, and the PHS be
discounted by a minimum of 24% off the average manufacturer
price charged to non-federal customers. Our computation of the
average price to non-federal customers is used in establishing
the FSS price for these four purchasers. The government
maintains the right to audit the accuracy of our computations.
Among the remedies available to the government for failure to
accurately calculate FSS pricing and the average manufacturer
price charged to non-federal customers is recoupment of any
overpayments made by FSS purchasers as a result of errors in
computations that affect the FSS price. The law also provides
that civil monetary penalties may be assessed for knowingly
providing false information in connection with discharging the
pricing and reporting requirements under the VHCA. The amount
that may be assessed is up to $100,000 for each item of
false information.

Marketing Exclusivity

Pharmaceutical companies can petition the FDA to
grant new drug product exclusivity for a drug, independent of
any orphan drug or patent term exclusivity accorded to that
drug. The exclusivity granted by the FDA essentially prevents
competition from other manufacturers who wish to put generic
versions of the product into U.S. commerce. The FDA has granted
us marketing exclusivity for foam-based products incorporating
clobetasol propionate for three years beginning in November
2000. The exclusivity prevents other parties from submitting or
getting approval for any application before the exclusive period
expires. The FDA determines whether a drug is eligible for
exclusivity on a case-by-case basis. The FDA may grant
three-year exclusivity provided that the application included at
least one new clinical investigation other than bioavailability
studies, the investigation was conducted or sponsored by the
drug company, and the reports of the clinical investigation were
essential to the approval of the application.

Third Party Reimbursement

Our operating results will depend in part on
whether adequate reimbursement is available for our products
from third-party payors, such as government entities, private
health insurers and managed care organizations. Medicare,
Medicaid, health maintenance organizations and other third-party
payors may not authorize or otherwise budget such reimbursement.
Such governmental and third-party payors increasingly are
seeking to negotiate the pricing of medical services and
products and to promote the use of generic, non-branded
pharmaceuticals through payor-based reimbursement policies
designed to encourage their use. In some cases, third-party
payors will pay or reimburse users or suppliers of a
prescription drug product only a portion of the product purchase
price. Consumers and third-party payors may not view our
marketed products as cost-effective, and consumers may not be
able to get reimbursement or reimbursement may be so low that we
cannot market our products on a competitive basis. If government
entities or other third-party payors do not provide adequate
reimbursement levels for our products, or if those reimbursement
policies increasingly favor the use of generic products, our
sales could decline and our business could be seriously harmed.

Furthermore, federal and state regulations govern
or influence the reimbursement to health care providers of fees
and capital equipment costs in connection with medical treatment
of certain patients. We cannot predict the likelihood that
federal and state legislatures will pass laws related to health
care reform or lowering pharmaceutical costs. Continued
significant changes in the health care system could have a
material adverse effect on our business.

Relaxin Development Program

Overview

In addition to our commercial business, we own
the development and commercialization rights to a recombinant
form of a natural human hormone called relaxin. Relaxin reduces
the hardening, or fibrosis, of

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skin and organ tissue, dilates existing blood
vessels and stimulates new blood vessel growth. Relaxin
circulates in the blood and has a broad spectrum of biological
activities.


On October 8, 2000, we announced that our
pivotal trial for scleroderma showed no statistically
significant difference between the response to relaxin and the
response to placebo with respect to the primary
endpoint of that trial. There were, however, statistically
significant responses with respect to secondary parameters
measured in that trial. Infertility, peripheral vascular
disease, cardiovascular disease, and kidney disease represent
opportunities for relaxins biologic properties of
enhancing blood flow.

Based on the result of the pivotal trial, and
following an extensive evaluation of other potential uses for
relaxin, on May 23, 2001, we announced our decision to
reduce our investment in relaxin in favor of focusing our
resources on expanding our dermatology business, and to pursue a
license partner or other strategic alternative for the relaxin
program. As part of that decision we reduced our work force by
eliminating 27 positions related to relaxin. Prior to May
2001, our strategy had been to retain U.S. rights for all
potential indications for the drug. We maintain North American
rights for relaxin and have entered into collaborative
relationships for this program for markets outside of the United
States. We have licensed rights to relaxin development and
commercialization to Paladin Labs, Inc. for Canada, and to F.H.
Faulding & Co. for Australia.

Relaxin
Alliances

Paladin Labs, Inc.In July 1999, we entered into a
collaboration and exclusive license agreement with Paladin for
the development and commercialization of relaxin in Canada.
Although we have discontinued our development efforts for
relaxin for scleroderma, Paladin has indicated that it will
continue the collaboration for other indications. Under the
terms of the agreement, Paladin would owe additional milestone
payments for the approval of indications other than scleroderma
for relaxin in Canada. Paladin is responsible for all
development and commercialization activities in Canada, and is
obligated to pay royalties on all sales of relaxin in Canada.

F.H. Faulding & Co., Ltd.In April 2000, we entered into a
collaboration and exclusive license agreement with Faulding for
the development and commercialization of relaxin in Australia.
Although we have discontinued our development efforts for
relaxin for scleroderma, Faulding has indicated that it will
continue the collaboration for other indications. Under the
agreement, Faulding would owe additional milestone payments for
the approval of non-scleroderma indications for relaxin in
Australia. Faulding is responsible for all development and
commercialization activities in Australia, and will pay
royalties on all sales of relaxin in Australia. In October 2001,
Faulding was acquired by Mayne Group Limited, Australias
largest private health care provider.

Genentech.In
September 1993, we entered into an agreement with Genentech,
which was subsequently amended in July 1994 and April 1996. The
agreement, as amended, grants to us exclusive rights, for
indications other than reproductive indications, to make, have
made, use, import and sell certain products derived from
recombinant human relaxin. Many of our relaxin patent rights are
owned by The Florey Institute, and we license them through
Genentech. Genentech retains co-exclusive rights for
reproductive indications. The agreement also includes technology
transfer, supply, and intellectual property provisions,
including a provision requiring us to meet milestones. If we
fail to achieve designated milestones, Genentech may terminate
the license. Upon termination, the patent rights and know-how we
licensed from Genentech would revert to Genentech, and under
certain circumstances depending on the reason for the
termination, Genentech would automatically receive a
non-exclusive, sublicensable and fully paid up license to our
relaxin technology.

Environmental Regulation

Our research and development activities involve
the controlled use of hazardous and biohazardous materials,
chemicals such as solvents and active pharmaceutical agents,
compressed gases, and certain radioactive materials, such as
hydrogen 3, carbon-14, and phosphorous-33. We are subject to
federal, state and local laws and regulations governing the use,
storage, handling and disposal of such materials and certain
waste products. Although we believe that our safety procedures
for handling and disposing of such materials comply

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with the standards prescribed by state, federal,
and local laws and regulations, we cannot completely eliminate
the risk of accidental contamination or injury from these
materials.


Compliance with federal, state and local law
regarding the discharge of materials into the environment or
otherwise relating to the protection of the environment has not
had, and is not expected to have, any adverse effect on our
capital expenditures, earnings or competitive position. We are
not presently a party to any litigation or administrative
proceeding with respect to our compliance with such
environmental standards. In addition, we do not anticipate being
required to expend any funds in the near future for
environmental protection in connection with our operations.

Employees

As of March 1, 2002, we had 162 full-time
employees. Of the full-time employees, 77 were engaged in sales
and marketing, 57 were in research and development and 28 were
in general and administrative positions. We believe our
relations with our employees are good.

Factors Affecting Our Business and
Prospects

There are many factors that affect our business
and results of operations, some of which are beyond our control.
The following is a description of some of the important factors
that may cause the actual results of our operations in future
periods to differ materially from the results currently expected
or desired. Due to the foregoing factors, we believe that
quarter-to-quarter comparisons of our results of operations are
not a good indication of our future performance.

Risks Related to Our Business



| |                                                                                                                    
| | -------------------------------------------------------------------------------------------------------------------
| | Our operating results may fluctuate, and
	this fluctuation could cause financial results to be below
	expectations.

Our operating results may fluctuate from period
to period for a number of reasons, and even a relatively small
revenue shortfall may cause a periods results to be below
our expectations or projections. A revenue shortfall could arise
from any number of factors, some of which we cannot control. For
example, we may face:



| |   |                                                                                         
| | - | ----------------------------------------------------------------------------------------
| |  | lower than expected demand for our products,                                            
|
| |  | changes in the governments or private
	payors reimbursement policies for our products,
|
| |  | changes in wholesale buying patterns,                                                   
|
| |  | increased competition from new or existing
	products, or                                
|
| |  | changes in our product pricing strategies.                                              

Of these, we would only have control over changes
in our product pricing strategies, and of course there may be
other factors that affect our revenues in any given period.



| |                                                                                                                         
| | ------------------------------------------------------------------------------------------------------------------------
| | If we do not obtain the capital necessary
	to fund our operations, we will be unable to develop or market
	our products.

Product revenue from sales of our marketed
products does not currently cover the full cost of developing
products in our pipeline. We currently believe that our
available cash resources will be sufficient to fund our
operating and working capital requirements for the next
18 months. If in the future our product revenue does not
continue to grow or we are unable to raise additional funds when
needed, we may not be able to market our products as planned or
continue development of our other products. Accordingly, we may
need to raise additional funds through public or private
financings, strategic relationships or other arrangements.

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| |                                                                                          
| | -----------------------------------------------------------------------------------------
| | If we do not achieve and sustain
	profitability, stockholders may lose their
	investment.

Except for fiscal year 2000, we have lost money
every year since our inception. We had net losses of
$27.3 million in 1999 and net income of $27.0 million in
2000. If we exclude a gain of $43.0 million on sales of
stock we held in InterMune, and the associated income tax, our
net loss for 2000 would have been $15.0 million. We had a
net loss of $16.7 for the year ended December 31, 2001. Our
accumulated deficit was $109.5 million at December 31,
2001. We may incur additional losses during the next few years.
If we do not eventually achieve and maintain profitability, our
stock price may decline.



| |                                                                                                                                                            
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our total revenue depends on receiving
	royalties and contract payments from third parties, and we
	cannot control the amount or timing of those
	revenues.

We generate contract and royalty revenue by
licensing our products to third parties for specific territories
and indications. Our reliance on licensing arrangements with
third parties carries several risks, including the possibilities
that:



| |   |                                                                                                                                                                                            
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | a product development contract may expire or a
	relationship may be terminated, and we will not be able to
	attract a satisfactory alternative corporate partner within a
	reasonable time,
|
| |  | we may be contractually bound to terms that, in
	the future, are not commercially favorable to us, and                                                                                     
|
| |  | royalties generated from licensing arrangements
	may be insignificant.                                                                                                                     

If any of these risks occurs, we may not be able
to successfully develop our products.



| |                                                                                                                                                                                           
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we fail to protect our proprietary
	rights, competitors may be able to use our technologies, which
	would weaken our competitive position, reduce our revenues and
	increase our costs.

Our commercial success depends in part on our
ability and the ability of our licensors to obtain and maintain
patent protection on technologies, to preserve trade secrets,
and to operate without infringing the proprietary rights of
others. The foam technology used in Luxíq and OLUX is
covered by one issued patent.

We are pursuing several U.S. and international
patent applications, although we cannot be sure that any of
these patents will ever be issued. We also have acquired rights
from the assignment of rights to patents and patent applications
from certain of our consultants and officers. These patents and
patent applications may be subject to claims of rights by third
parties. If there are conflicting claims to the same patent or
patent application, we may not prevail and, even if we do have
some rights in a patent or application, those rights may not be
sufficient for the marketing and distribution of products
covered by the patent or application.

The patents and applications in which we have an
interest may be challenged as to their validity or
enforceability. Challenges may result in potentially significant
harm to our business. The cost of responding to these challenges
and the inherent costs to defend the validity of our patents,
including the prosecution of infringements and the related
litigation, could be substantial whether or not we are
successful. Such litigation also could require a substantial
commitment of managements time. A judgment adverse to us
in any patent interference, litigation or other proceeding
arising in connection with these patent applications could
materially harm our business.

The ownership of a patent or an interest in a
patent does not always provide significant protection. Others
may independently develop similar technologies or design around
the patented aspects of our technology. We only conduct patent
searches to determine whether our products infringe upon any
existing patents when we think such searches are appropriate. As
a result, the products and technologies we currently market, and
those we may market in the future, may infringe on patents and
other rights owned by others. If we are unsuccessful in any
challenge to the marketing and sale of our products or
technologies, we may be required to license the disputed rights,
if the holder of those rights is willing, or to cease marketing
the challenged products, or to modify our products to avoid
infringing upon those rights. Under these circumstances, we may
not be able to obtain a license to such intellectual property on
favorable terms, if at all. We may not succeed in any attempt to
redesign our products or processes to avoid infringement.

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| |                                                                                  
| | ---------------------------------------------------------------------------------
| | We rely on our employees and consultants to
	keep our trade secrets confidential.

We rely on trade secrets and unpatented
proprietary know-how and continuing technological innovation in
developing and manufacturing our products. We require each of
our employees, consultants and advisors to enter into
confidentiality agreements prohibiting them from taking our
proprietary information and technology or from using or
disclosing proprietary information to third parties except in
specified circumstances. The agreements also provide that all
inventions conceived by an employee, consultant or advisor, to
the extent appropriate for the services provided during the
course of the relationship, shall be our exclusive property,
other than inventions unrelated to us and developed entirely on
the individuals own time. Nevertheless, these agreements
may not provide meaningful protection of our trade secrets and
proprietary know-how if they are used or disclosed. Despite all
of the precautions we may take, people who are not parties to
confidentiality agreements may obtain access to our trade
secrets or know-how. In addition, others may independently
develop similar or equivalent trade secrets or know-how.



| |                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------
| | If we do not successfully partner or
	commercialize relaxin, we may lose fundamental intellectual
	property rights to the product.

Licenses with Genentech, Inc. and The Howard
Florey Institute of Experimental Physiology and Medicine require
us to use our best efforts to commercialize relaxin. Our failure
to successfully commercialize relaxin may result in the
reversion of our rights under these licenses to Genentech and
the Florey Institute. The termination of these agreements and
subsequent reversion of rights could prevent us from leveraging
our additional patents and know-how by securing a partnership
arrangement for the relaxin program.



| |                                                                                                                                                                        
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our use of hazardous materials exposes us
	to the risk of environmental liabilities, and we may incur
	substantial additional costs to comply with environmental
	laws.

Our research and development activities involve
the controlled use of hazardous materials, chemicals and various
radioactive materials. We are subject to laws and regulations
governing the use, storage, handling and disposal of these
materials and certain waste products. In the event of accidental
contamination or injury from these materials, we could be liable
for any damages that result and any liability could exceed our
resources. We may also be required to incur significant costs to
comply with environmental laws and regulations as our research
activities increase.

Risks Related to Our Products



| |                                                                                                                                                           
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------
| | We currently rely on a sole source to
	manufacture Luxíq and OLUX, and future manufacturing
	difficulties could delay future revenues from product
	sales.

We currently have no manufacturing or
distribution facilities for any of our products. Instead, we
contract with third parties to manufacture our products for us.
Typically, these manufacturing contracts are short-term.
Currently, Miza Pharmaceuticals is our sole source manufacturer
for Luxíq and OLUX. We are in the process of qualifying
Accra Pac Group, Inc. to manufacture physician samples,
Luxíq, and OLUX for us, but we have not yet received
permission from the FDA to manufacture commercial product at
that location. On March 12, 2002, we entered into
agreements with DPT to construct an aerosol filling line at
DPTs plant in Texas and to manufacture and fill our
commercial aerosol products. DPT cannot manufacture our products
until the aerosol line is completed, at which time we will have
to apply to the FDA to qualify DPT to manufacture our commercial
products for us in the United States.

Manufacturing facilities are subject to ongoing
periodic inspection by the FDA and corresponding state agencies,
including unannounced inspections, and must be licensed before
they can be used in commercial manufacturing of our products. If
Miza cannot provide us with our product requirements in a timely
and cost-effective manner, or if the product they are able to
supply cannot meet commercial requirements for shelf life, our
sales of marketed products could be reduced and we could suffer
delays in the progress of clinical trials for products under
development. In addition, any commercial dispute with any of
suppliers could result in delays in the manufacture of product,
and affect our ability to commercialize our products. We cannot
be certain that manufacturing sources will continue to be
available or that we can continue to out-source the manufacturing

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of our products on reasonable or acceptable
terms. Any loss of a manufacturer or any difficulties that could
arise in the manufacturing process could significantly affect
our inventories and supply of products available for sale. If we
are unable to supply sufficient amounts of our products on a
timely basis, our market share could decrease and,
correspondingly, our profitability could decrease.




| |                                                                                                                                                       
| | ------------------------------------------------------------------------------------------------------------------------------------------------------
| | If our contract manufacturers fail to
	comply with cGMP regulations, we may be unable to meet demand
	for our products and may lose potential revenue.

All of our contractors must comply with the
applicable FDA cGMP regulations, which include quality control
and quality assurance requirements as well as the corresponding
maintenance of records and documentation. If Miza is not able to
comply with the applicable cGMP regulations and other FDA
regulatory requirements, our sales of marketed products could be
reduced and we could suffer delays in the progress of clinical
trials for products under development. We do not have control
over our third-party manufacturers compliance with these
regulations and standards. The cGMP validation of a new facility
and the approval of that manufacturer for a new drug product may
take a year or more before manufacture can begin at the
facility. Delays in obtaining FDA validation of a replacement
manufacturing facility could cause an interruption in the supply
of our products. Our business interruption insurance, which
covers the loss of income for up to $8.0 million, may not
completely mitigate the harm to our business from the
interruption of the manufacturing of products caused by certain
events, as the loss of a manufacturer could still have a
negative effect on our sales, margins and market share, as well
as our overall business and financial results.

If our supply
of finished products is interrupted, our ability to maintain our
inventory levels could suffer.

We try to maintain inventory levels that are no
greater than necessary to meet our current projections. Any
interruption in the supply of finished products could hinder our
ability to timely distribute finished products. If we are unable
to obtain adequate product supplies to satisfy our
customers orders, we may lose those orders and our
customers may cancel other orders and stock and sell competing
products. This in turn could cause a loss of our market share
and negatively affect our revenues.

Supply interruptions may occur and our inventory
may not always be adequate. Numerous factors could cause
interruptions in the supply of our finished products including
shortages in raw material required by our manufacturers, changes
in our sources for manufacturing, our failure to timely locate
and obtain replacement manufacturers as needed and conditions
effecting the cost and availability of raw materials.



| |                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------
| | We cannot sell our current products and
	product candidates if we do not obtain and maintain governmental
	approvals.

Pharmaceutical companies are subject to heavy
regulation by a number of national, state and local agencies. Of
particular importance is the FDA in the United States. It has
jurisdiction over all of our business and administers
requirements covering testing, manufacture, safety,
effectiveness, labeling, storage, record keeping, approval,
advertising and promotion of our products. Failure to comply
with applicable regulatory requirements could, among other
things, result in fines; suspensions of regulatory approvals of
products; product recalls; delays in product distribution,
marketing and sale; and civil or criminal sanctions.

The process of obtaining and maintaining
regulatory approvals for pharmaceutical products, and obtaining
and maintaining regulatory approvals to market these products
for new indications, is lengthy, expensive and uncertain. The
manufacturing and marketing of drugs, including our products,
are subject to continuing FDA and foreign regulatory review, and
later discovery of previously unknown problems with a product,
manufacturing process or facility may result in restrictions,
including withdrawal of the product from the market. The FDA is
permitted to revisit and change its prior determinations and it
may change its position with regard to the safety or
effectiveness of our products. Even if the FDA approves our
products, the FDA is authorized to impose post-marketing
requirements such as:



| |   |                                                                                                            
| | - | -----------------------------------------------------------------------------------------------------------
| |  | testing and surveillance to monitor the product
	and its continued compliance with regulatory requirements,

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| |   |                                                                                                                                                                          
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | submitting products for inspection and, if any
	inspection reveals that the product is not in compliance, the
	prohibition of the sale of all products from the same lot,
|
| |  | suspending manufacturing,                                                                                                                                                
|
| |  | recalling products, and                                                                                                                                                  
|
| |  | withdrawing marketing clearance.                                                                                                                                         

Even before any formal regulatory action, we
could voluntarily decide to cease distribution and sale or
recall any of our products if concerns about the safety or
effectiveness develop.

To market our products in countries outside of
the United States, we and our partners must obtain similar
approvals from foreign regulatory bodies. The foreign regulatory
approval process includes all of the risks associated with
obtaining FDA approval, and approval by the FDA does not ensure
approval by the regulatory authorities of any other country.

In its regulation of advertising, the FDA from
time to time issues correspondence to pharmaceutical companies
alleging that some advertising or promotional practices are
false, misleading or deceptive. The FDA has the power to impose
a wide array of sanctions on companies for such advertising
practices, and the receipt of correspondence from the FDA
alleging these practices can result in the following:



| |   |                                                                                                                                                                        
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | incurring substantial expenses, including fines,
	penalties, legal fees and costs to comply with the FDAs
	requirements,                                              
|
| |  | changes in the methods of marketing and selling
	products,                                                                                                             
|
| |  | taking FDA-mandated corrective action, which may
	include placing advertisements or sending letters to physicians
	rescinding previous advertisements or promotion, and
|
| |  | disruption in the distribution of products and
	loss of sales until compliance with the FDAs position is
	obtained.                                                   

In recent years, various legislative proposals
have been offered in Congress and in some state legislatures
that include major changes in the health care system. These
proposals have included price or patient reimbursement
constraints on medicines and restrictions on access to certain
products. We cannot predict the outcome of such initiatives, and
it is difficult to predict the future impact of the broad and
expanding legislative and regulatory requirements affecting us.



| |                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------
| | We may spend a significant amount of money
	to obtain FDA and other regulatory approvals, which may never be
	granted.

Successful product development in our industry is
highly uncertain, and the process of obtaining FDA and other
regulatory approvals is lengthy and expensive. Very few research
and development projects produce a commercial product. Product
candidates that appear promising in the early phases of
development may fail to reach the market for a number of
reasons, including that the product candidate did not
demonstrate acceptable clinical trial results even though it
demonstrated positive preclinical trial results, or that the
product candidate was not effective in treating a specified
condition or illness, or that the FDA did not approve our
product candidate for its intended use.

To obtain approval, we must show in preclinical
and clinical trials that our products are safe and effective,
and the marketing and manufacturing of pharmaceutical products
are subject to rigorous testing procedures. The FDA approval
processes require substantial time and effort, the FDA continues
to modify product development guidelines, and the FDA may not
grant approval on a timely basis or at all. Clinical trial data
can be the subject of differing interpretation, and the FDA has
substantial discretion in the approval process. The FDA may not
interpret our clinical data the way we do. The FDA may also
require additional clinical data to support approval. The FDA
can take between one and two years to review new drug
applications, or longer if significant questions arise during
the review process. We may not be able to obtain FDA approval to
conduct clinical trials or to manufacture and market any of the
products we develop, acquire or license. Moreover, the

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costs to obtain approvals could be considerable
and the failure to obtain or delays in obtaining an approval
could have a significant negative effect on our business.




| |                                                                                                                                     
| | ------------------------------------------------------------------------------------------------------------------------------------
| | If Luxíq and OLUX do not sustain
	market acceptance, our revenues will not be predictable and may
	not cover our operating expenses.

Our future revenues will depend upon
dermatologist and patient acceptance of Luxíq and OLUX.
Factors that could affect acceptance of Luxíq and OLUX
include:



| |   |                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------
| |  | satisfaction with existing alternative therapies,                                                                
|
| |  | the effectiveness of our sales and marketing
	efforts,                                                           
|
| |  | the cost of the product as compared with
	alternative therapies, and undesirable and unforeseeable side
	effects.

We cannot predict the potential long-term patient
acceptance of, or the effects of competition and managed health
care on, sales of either product.



| |                                                                                                                                
| | -------------------------------------------------------------------------------------------------------------------------------
| | We rely on third parties to conduct
	clinical trials for our products, and those third parties may
	not perform satisfactorily.

We do not have the ability to independently
conduct clinical studies, and we rely on third parties to
perform this function. If these third parties do not perform
satisfactorily, we may not be able to locate acceptable
replacements or enter into favorable agreements with them, if at
all. If we are unable to rely on clinical data collected by
others, we could be required to repeat, extend the duration of,
or increase the size of, clinical trials, which could
significantly delay commercialization and require significantly
greater expenditures.



| |                                                                                                                                                
| | -----------------------------------------------------------------------------------------------------------------------------------------------
| | If we are unable to develop new products,
	our expenses may continue to exceed our revenue indefinitely,
	without any return on the investment.

We currently have a variety of new products in
various stages of research and development and are working on
possible improvements, extensions and reformulations of some
existing products. These research and development activities, as
well as the clinical testing and regulatory approval process,
which must be completed before commercial quantities of these
developments can be sold, will require significant commitments
of personnel and financial resources. Delays in the research,
development, testing or approval processes will cause a
corresponding delay in revenue generation from those products.
Regardless of whether they are ever released to the market, the
expense of such processes will have already been incurred.

We re-evaluate our research and development
efforts regularly to assess whether our efforts to develop a
particular product or technology are progressing at a rate that
justifies our continued expenditures. On the basis of these
re-evaluations, we have abandoned in the past, and may abandon
in the future, our efforts on a particular product or
technology. Products we are researching or developing may never
be successfully released to the market. If we fail to take a
product or technology from the development stage to market on a
timely basis, we may incur significant expenses without a
near-term financial return.



| |                                                                                                                                                                   
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we do not successfully integrate new
	products into our business, we may not be able to sustain
	revenue growth and we may not be able to compete
	effectively.

When we acquire or develop new products and
product lines, we must be able to integrate those products and
product lines into our systems for marketing, sales and
distribution. If these products or product lines are not
integrated successfully, the potential for growth is limited.
The new products we acquire or develop could have channels of
distribution, competition, price limitations or marketing
acceptance different from our current products. As a result, we
do not know whether we will be able to compete effectively and
obtain market acceptance in any new product categories. A new
product may require us to significantly increase our sales force
and incur additional marketing, distribution and other
operational expenses. These additional expenses could negatively
affect our gross margins and operating results. In addition,
many of these expenses

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could be incurred prior to the actual
distribution of new products. Because of this timing, if the new
products are not accepted by the market or if they are not
competitive with similar products distributed by others, the
ultimate success of the acquisition or development could be
substantially diminished.


Risks Related to Our Industry



| |                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------
| | We face intense competition, which may
	limit our commercial opportunities and our ability to become
	profitable.

The specialty pharmaceutical industry is highly
competitive. Competition in our industry occurs on a variety of
fronts, including developing and bringing new products to market
before others, developing new technologies to improve existing
products, developing new products to provide the same benefits
as existing products at less cost and developing new products to
provide benefits superior to those of existing products.

Most of our competitors are large,
well-established companies in the fields of pharmaceuticals and
health care. Many of these companies have substantially greater
financial, technical and human resources than we have to devote
to marketing, sales, research and development and acquisitions.
Some of these competitors have more collective experience than
we do in undertaking preclinical testing and human clinical
trials of new pharmaceutical products and obtaining regulatory
approvals for therapeutic products. As a result, they have a
greater ability to undertake more extensive research and
development, marketing and pricing policy programs. Our
competitors may develop new or improved products to treat the
same conditions as our products treat or make technological
advances reducing their cost of production so that they may
engage in price competition through aggressive pricing policies
to secure a greater market share to our detriment. Our
commercial opportunities will be reduced or eliminated if our
competitors develop and market products that are more effective,
have fewer or less severe adverse side effects or are less
expensive than our products. These competitors also may develop
products that make our current or future products obsolete. Any
of these events could have a significant negative impact on our
business and financial results, including reductions in our
market share and gross margins.

Our products compete with generic
pharmaceuticals, which claim to offer equivalent benefit at a
lower cost. In some cases, insurers and other health care
payment organizations encourage the use of these less expensive
generic brands through their prescription benefits coverages and
reimbursement policies. These organizations may make the generic
alternative more attractive to the patient by providing
different amounts of reimbursement so that the net cost of the
generic product to the patient is less than the net cost of our
prescription brand product. Aggressive pricing policies by our
generic product competitors and the prescription benefits
policies of insurers could cause us to lose market share or
force us to reduce our margins in response.



| |                                                                                                                                                                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our sales depend on payment and
	reimbursement from third party payors, and if they reduce or
	refuse payment or reimbursement, the use and sales of our
	products will suffer, we may not increase our market share, and
	our revenues and profitability will suffer.

Our products commercial success is
dependent, in part, on whether third-party reimbursement is
available for the use of our products by hospitals, clinics,
doctors and patients. Third-party payors include state and
federal governments, under programs such as Medicare and
Medicaid, and private insurance plans and health maintenance
organizations. Over 70% of the U.S. population now participates
in some version of managed care. Because of the size of the
patient population covered by managed care organizations, it is
important to our business that we market our products to them
and to the pharmacy benefit managers that serve many of these
organizations. Managed care organizations and other third-party
payors try to negotiate the pricing of medical services and
products to control their costs. Managed care organizations and
pharmacy benefit managers typically develop formularies to
reduce their cost for medications. Formularies can be based on
the prices and therapeutic benefits of the available products.
Due to their lower costs, generics are often favored. The
breadth of the products covered by formularies varies
considerably from one managed care organization to another, and
many formularies include alternative and competitive products
for treatment of particular medical conditions. Exclusion of a
product from a formulary can lead to its sharply reduced usage
in the managed care organization patient population.

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Third-party payors may not authorize or otherwise
budget for the reimbursement of our products, and reimbursement
may not be available to consumers or may not be sufficient to
allow our products to be marketed on a competitive basis. In the
U.S., there have been, and we expect there will continue to be,
a number of state and federal proposals that could limit the
amount that state or federal governments will pay to reimburse
the cost of drugs. In addition, we believe the increasing
emphasis on managed care in the U.S. has and will continue to
put pressure on the price and usage of our products, which may
in turn adversely impact product sales. Further, when a new
therapeutic product is approved, the availability of
governmental and/or private reimbursement for that product is
uncertain, as is the amount for which that product will be
reimbursed.

Payment or reimbursement of only a portion of the
cost of our prescription products could make our products less
attractive, from a net-cost perspective, to patients, suppliers
and prescribing physicians. The reimbursement policies of these
entities may not be adequate for our products to compete on a
price basis. If our products are not included within an adequate
number of formularies or adequate reimbursement levels are not
provided, or if those policies increasingly favor generic
products, our market share and gross margins could be negatively
affected, as could our overall business and financial condition.
We cannot predict the availability or amount of reimbursement
for our products or product candidates, and current
reimbursement policies for existing products may change at any
time. Changes in reimbursement policies or health care cost
containment initiatives that limit or restrict reimbursement for
our products may cause our revenues to decline.

If product
liability lawsuits are brought against us, we may incur
substantial costs.

Our industry faces an inherent risk of product
liability claims from allegations that our products resulted in
adverse effects to the patient or others. These risks exist even
with respect to those products that are approved for commercial
sale by the FDA and manufactured in facilities licensed and
regulated by the FDA. Our insurance may not provide adequate
coverage against potential product liability claims or losses.
We also cannot be certain that our current coverage will
continue to be available in the future on reasonable terms, if
at all. Even if we are ultimately successful in product
liability litigation, the litigation would consume substantial
amounts of our financial and managerial resources, and might
create adverse publicity, all of which would impair our ability
to generate sales. If we were found liable for any product
liability claims in excess of our coverage or outside of our
coverage, the cost and expense of such liability could severely
damage our business, financial condition and profitability.

Risks Related to Our Stock

Our stock
price is volatile and the value of your investment in our stock
could decline in value.

The market prices for securities of specialty
pharmaceutical companies like Connetics have been and are likely
to continue to be highly volatile. As a result, investors in
these companies often buy at very high prices only to see the
price drop substantially a short time later, resulting in an
extreme drop in value in the stock holdings of these investors.
In the past two fiscal years, the price of our common stock has
ranged from a low of $4.06 per share to a high of $26.88 per
share. In addition, the volatility could result in securities
class action litigation. Any litigation would likely result in
substantial costs, and divert our managements attention
and resources.



| |                                                                                                                                                                                     
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our charter documents and Delaware law
	contain provisions that could delay or prevent a change in
	control, even if the change in control would be beneficial to
	our stockholders.

Our certificate of incorporation authorizes our
board of directors to issue undesignated preferred stock and to
determine the rights, preferences, privileges and restrictions
of the preferred stock without further vote or action by our
stockholders. The issuance of preferred stock could make it more
difficult for third parties to acquire a majority of our
outstanding voting stock. We also have a stockholder rights
plan, which entitles existing stockholders to rights, including
the right to purchase shares of preferred stock, in the event of
an acquisition of 15% or more of our outstanding common stock,
or an unsolicited tender offer for such shares. We have also
entered into change in control agreements with our
directors, officers, and key employees.

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Those change in control agreements provide for
severance payments to be made in the event of a change in
control of the company. Provisions of Delaware law, our rights
plan, our charter documents, and other arrangements, including a
provision eliminating the ability of stockholders to take
actions by written consent, could delay or make difficult the
removal of our current management or a merger, tender offer or
proxy contest involving us. Further, our stock option and
purchase plans generally provide for the assumption of such
plans or substitution of an equivalent option of a successor
corporation or, alternatively, at the discretion of the board of
directors, exercise of some or all of the option stock,
including non-vested shares, or acceleration of vesting of
shares issued pursuant to stock grants, upon a change of control
or similar event.





Item 2.Properties

We currently lease 52,468 square feet of
laboratory and office space at 3400 and 3290 West Bayshore
Road in Palo Alto, California. We lease this space under two
lease agreements that will expire in January 2003 and April 2005
respectively. We also lease 13,464 square feet of office space
at 3294 West Bayshore Road in Palo Alto, California that we
are currently subleasing to a third party. Our subsidiary,
Soltec, owns certain land and real property consisting of
laboratory and office space at 8 Macro Court, Rowville,
Victoria, Australia. In addition, we have contracted with DPT
Laboratories to construct a 12,000 square foot aerosol filling
line in San Antonio, Texas. We will make rental payments to DPT
when the aerosol line is completed. We believe that our existing
facilities are adequate to meet our requirements for the near
term and that additional space will be available on commercially
reasonable terms if needed.




Item 3.Legal
Proceedings

We are not a party to any material legal
proceedings.




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 2001.




PART II




Item 5.Market
for the Companys Common Equity and Related Stockholder
Matters

Our common stock is traded on the Nasdaq National
Market under the symbol CNCT. The following table
sets forth for the periods indicated the low and high closing
prices for our common stock.

|     |                |      |   |       |  |  |   |       | 
|---- | -------------- | ---- | - | ----- |  |  | - | ----- | 
|     |                | High |   | Low  
|     |                |      |   |      
|2000 |                |      |   |       |  |  |   |      
|     | First Quarter  |      | $ | 15.13 |  |  | $ | 7.69  | 
|     | Second Quarter |      |   | 14.69 |  |  |   | 6.13  | 
|     | Third Quarter  |      |   | 24.31 |  |  |   | 14.75 | 
|     | Fourth Quarter |      |   | 26.88 |  |  |   | 4.13  | 
|2001 |                |      |   |       |  |  |   |      
|     | First Quarter  |      | $ | 7.81  |  |  | $ | 4.38  | 
|     | Second Quarter |      |   | 7.69  |  |  |   | 4.06  | 
|     | Third Quarter  |      |   | 7.80  |  |  |   | 5.65  | 
|     | Fourth Quarter |      |   | 13.95 |  |  |   | 6.46  | 

On March 22, 2002, we had approximately 176
stockholders of record of our common stock.

We have never declared or paid cash dividends on
our common stock, and our loan agreement with a bank lender
prohibits us from declaring or paying a dividend without the
banks prior written consent. We currently intend to retain
all available funds for use in our business, and do not
anticipate paying any cash dividends in the foreseeable future.

22



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##### Table of Contents






Item 6.Selected
Financial Data

The selected consolidated financial data that
appears on the following page has been derived from our audited
consolidated financial statements. This historical data should
be read in conjunction with our Consolidated Financial
Statements and the related Notes to Consolidated Financial
Statements contained in this Report, and with the
Managements Discussion and Analysis of Financial
Condition and Results of Operations in Item 7 of this
Report. The selected consolidated statement of operations data
for each of the three years in the period ended
December 31, 2001, and the selected consolidated balance
sheet data as of December 31, 2001 and 2000, are derived
from and qualified by reference to the audited consolidated
financial statements included elsewhere in this Report. The
selected consolidated statement of operations data for the years
ended December 31, 1998 and 1997, and the selected
consolidated balance sheet data as of December 31, 1999,
1998 and 1997, are derived from audited financial statements not
included in this Report.

Connetics Corporation

Selected Consolidated Financial Data

|                              |                                                                                              |                                              |                                    |         |        |         |   |        |        |         |   |         |        |         |   |         |        |         |   |         |        |         |  
|----------------------------- | -------------------------------------------------------------------------------------------- | -------------------------------------------- | ---------------------------------- | ------- | ------ | ------- | - | ------ | ------ | ------- | - | ------- | ------ | ------- | - | ------- | ------ | ------- | - | ------- | ------ | ------- | -
|                              |                                                                                              |                                             
|                              |                                                                                              | Years Ended December 31,                    
|                              |                                                                                              |                                             
|                              |                                                                                              | 2001                                         |                                    | 2000    |        | 1999    |   | 1998   |        | 1997   
|                              |                                                                                              |                                              |                                    |         |        |         |   |        |        |        
|                              |                                                                                              |                                             
|                              |                                                                                              | (In thousands, except per share amounts)    
|Statement of Operations Data: |                                                                                              |                                              |                                    |         |        |         |   |        |        |         |   |         |        |         |   |         |        |         |   |        
|                              | Revenues:                                                                                    |                                              |                                    |         |        |         |   |        |        |         |   |         |        |         |   |         |        |         |   |         |       
|                              |                                                                                              | Product                                      |                                    | $       | 30,923 |         |   | $      | 20,095 |         |   | $       | 16,595 |         |   | $       | 7,473  |         |   | $       | 6,803  |        
|                              |                                                                                              | Royalty                                      |                                    |         | 1,097  |         |   |        |       |         |   |         |       |         |   |         |       |         |   |         |       |        
|                              |                                                                                              | Contract and other                           |                                    |         | 2,044  |         |   |        | 20,679 |         |   |         | 10,311 |         |   |         | 1,648  |         |   |         |       |        
|                              |                                                                                              |                                              |                                    |         |        |         |   |        |        |         |   |         |        |         |   |         |        |         |   |        
|                              |                                                                                              |                                              | Total revenues                     |         |        | 34,064  |   |        |        | 40,774  |   |         |        | 26,906  |   |         |        | 9,121   |   |         |        | 6,803   |  
|                              | Operating costs and expenses:                                                                |                                              |                                    |         |        |         |   |        |        |         |   |         |        |         |   |         |        |         |   |         |       
|                              |                                                                                              | Cost of product revenues                     |                                    |         | 3,123  |         |   |        | 3,868  |         |   |         | 5,229  |         |   |         | 1,374  |         |   |         | 1,149  |        
|                              |                                                                                              | License amortization                         |                                    |         |       |         |   |        |       |         |   |         | 6,160  |         |   |         | 6,720  |         |   |         | 7,124  |        
|                              |                                                                                              | Research and development                     |                                    |         | 19,156 |         |   |        | 21,875 |         |   |         | 21,309 |         |   |         | 11,446 |         |   |         | 17,162 |        
|                              |                                                                                              | Selling, general and administrative          |                                    |         | 36,062 |         |   |        | 26,673 |         |   |         | 20,834 |         |   |         | 11,680 |         |   |         | 8,966  |        
|                              |                                                                                              | Acquired in-process research and development |                                    |         | 1,080  |         |   |        |       |         |   |         | 1,000  |         |   |         | 4,000  |         |   |         |       |        
|                              |                                                                                              | Loss on program termination                  |                                    |         | 1,142  |         |   |        |       |         |   |         |       |         |   |         |       |         |   |         |       |        
|                              |                                                                                              |                                              |                                    |         |        |         |   |        |        |         |   |         |        |         |   |         |        |         |   |        
|                              |                                                                                              |                                              | Total operating costs and expenses |         |        | 60,563  |   |        |        | 52,416  |   |         |        | 54,532  |   |         |        | 35,220  |   |         |        | 34,401  |  
|                              |                                                                                              |                                              | Loss from operations               |         |        | (26,499 | ) |        |        | (11,642 | ) |         |        | (27,626 | ) |         |        | (26,099 | ) |         |        | (27,598 | )
|                              | Gain on sale of investment(1)                                                                |                                              |                                    | 122     |        |         |   | 42,967 |        |         |   |        |        |         |   |        |        |         |   |        |       
|                              | Gain on sale of license rights                                                               |                                              |                                    |        |        |         |   |       |        |         |   |        |        |         |   |        |        |         |   | 525     |       
|                              | Gain on sale of Ridaura product line(2)                                                      |                                              |                                    | 8,002   |        |         |   |       |        |         |   |        |        |         |   |        |        |         |   |        |       
|                              | Interest income (expense), net                                                               |                                              |                                    | 1,978   |        |         |   | 1,873  |        |         |   | 343     |        |         |   | (496    | )      |         |   | (862    | )     
|                              |                                                                                              |                                              |                                    |         |        |         |   |        |        |         |   |         |        |         |   |         |        |         |   |        
|                              | Income (loss) before income taxes and
	cumulative effect of a change in accounting principle |                                              |                                    | (16,397 | )      |         |   | 33,198 |        |         |   | (27,283 | )      |         |   | (26,595 | )      |         |   | (27,935 | )     
|                              | Income tax                                                                                   |                                              |                                    | (345    | )      |         |   | (1,010 | )      |         |   |        |        |         |   |        |        |         |   |        |       
|                              |                                                                                              |                                              |                                    |         |        |         |   |        |        |         |   |         |        |         |   |         |        |         |   |        
|                              | Income (loss) before cumulative effect of
	change in accounting principle                    |                                              |                                    | (16,742 | )      |         |   | 32,188 |        |         |   | (27,283 | )      |         |   | (26,595 | )      |         |   | (27,935 | )     
|                              | Cumulative effect of change in accounting
	principle, net of tax(3)                          |                                              |                                    |        |        |         |   | (5,192 | )      |         |   |        |        |         |   |        |        |         |   |        |       
|                              |                                                                                              |                                              |                                    |         |        |         |   |        |        |         |   |         |        |         |   |         |        |         |   |        
|                              | Net income (loss)                                                                            |                                              | $                                  | (16,742 | )      |         | $ | 26,996 |        |         | $ | (27,283 | )      |         | $ | (26,595 | )      |         | $ | (27,935 | )     
|                              |                                                                                              |                                              |                                    |         |        |         |   |        |        |         |   |         |        |         |   |         |        |         |   |        

23



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|                                                                            |                                                                                     |                                          |       |         |       |      |      |        |      |      |       |         |       |   |       |         |       |   |       |         |       |  
|--------------------------------------------------------------------------- | ----------------------------------------------------------------------------------- | ---------------------------------------- | ----- | ------- | ----- | ---- | ---- | ------ | ---- | ---- | ----- | ------- | ----- | - | ----- | ------- | ----- | - | ----- | ------- | ----- | -
|                                                                            |                                                                                     |                                         
|                                                                            |                                                                                     | Years Ended December 31,                
|                                                                            |                                                                                     |                                         
|                                                                            |                                                                                     | 2001                                     |       | 2000    |       | 1999 |      | 1998   |      | 1997
|                                                                            |                                                                                     |                                          |       |         |       |      |      |        |      |     
|                                                                            |                                                                                     |                                         
|                                                                            |                                                                                     | (In thousands, except per share amounts)
|Basic Earnings Per Share                                                   |                                                                                     |                                          |       |         |       |      |      |        |      |      |       |         |       |   |       |         |       |   |       |        
|                                                                            | Income (loss) per share before cumulative
	effect of change in accounting principle |                                          | $     | (0.56   | )     |      | $    | 1.13   |      |      | $     | (1.21   | )     |   | $     | (1.61   | )     |   | $     | (2.69   | )    
|                                                                            | Cumulative effect of change in accounting
	principle, net of tax                    |                                          |       |        |       |      |      | (0.18  | )    |      |       |        |       |   |       |        |       |   |       |        |      
|Net income (loss) per share                                                 |                                                                                     | $                                        | (0.56 | )       |       | $    | 0.95 |        |      | $    | (1.21 | )       |       | $ | (1.61 | )       |       | $ | (2.69 | )      
|Diluted Earnings Per Share                                                 |                                                                                     |                                          |       |         |       |      |      |        |      |      |       |         |       |   |       |         |       |   |       |        
|                                                                            | Income (loss) per share before cumulative
	effect of change in accounting principle |                                          | $     | (0.56   | )     |      | $    | 1.07   |      |      | $     | (1.21   | )     |   | $     | (1.61   | )     |   | $     | (2.69   | )    
|                                                                            | Cumulative effect of change in accounting
	principle, net of tax                    |                                          |       |        |       |      |      | (0.17  | )    |      |       |        |       |   |       |        |       |   |       |        |      
|Net income (loss) per share                                                 |                                                                                     | $                                        | (0.56 | )       |       | $    | 0.90 |        |      | $    | (1.21 | )       |       | $ | (1.61 | )       |       | $ | (2.69 | )      
|                                                                            | Shares used to calculate basic net earnings
	(loss) per share                       |                                          |       | 29,861  |       |      |      | 28,447 |      |      |       | 22,619  |       |   |       | 16,533  |       |   |       | 10,412  |      
|                                                                            | Shares used to calculate diluted net earnings per
	share                            |                                          |       | 29,861  |       |      |      | 30,086 |      |      |       | 22,619  |       |   |       | 16,533  |       |   |       | 10,412  |      
|Pro forma amounts assuming the accounting change
	was applied retroactively |                                                                                     |                                          |       |         |       |      |      |        |      |      |       |         |       |   |       |         |       |   |       |        
|                                                                            | Net income (loss)                                                                   |                                          | $     | (16,742 | )     |      | $    | 32,188 |      |      | $     | (30,968 | )     |   | $     | (28,102 | )     |   | $     | (27,935 | )    
|                                                                            | Earnings per share                                                                  |                                          |       |         |       |      |      |        |      |      |       |         |       |   |       |         |       |   |       |         |      
|                                                                            |                                                                                     | Basic                                    |       | $       | (0.56 | )    |      | $      | 1.13 |      |       | $       | (1.37 | ) |       | $       | (1.70 | ) |       | $       | (2.69 | )
|                                                                            |                                                                                     | Diluted                                  |       | $       | (0.56 | )    |      | $      | 1.07 |      |       | $       | (1.37 | ) |       | $       | (1.70 | ) |       | $       | (2.69 | )
|                                                                            |                                                                                     |                                          |       |         |       |      |      |        |      |      |       |         |       |   |       |         |       |   |       |        
|Balance Sheet Data:                                                         |                                                                                     |                                          |       |         |       |      |      |        |      |      |       |         |       |   |       |         |       |   |       |        
|                                                                            | Cash, cash equivalents short-term investments and
	restricted cash                  |                                          | $     | 48,476  |       |      | $    | 80,184 |      |      | $     | 26,299  |       |   | $     | 23,020  |       |   | $     | 14,346  |      
|                                                                            | Working capital                                                                     |                                          |       | 44,026  |       |      |      | 71,030 |      |      |       | 13,401  |       |   |       | 12,464  |       |   |       | 6,687   |      
|                                                                            | Total assets                                                                        |                                          |       | 72,327  |       |      |      | 85,713 |      |      |       | 30,410  |       |   |       | 31,394  |       |   |       | 31,068  |      
|                                                                            | Total stockholders equity                                                          |                                          |       | 61,354  |       |      |      | 72,606 |      |      |       | 14,288  |       |   |       | 12,452  |       |   |       | 10,809  |      
|                                                                            |                                                                                     |                                          |       |         |       |      |      |        |      |      |       |         |       |   |       |         |       |   |       |        



---



|    |                                                                                                                                                                                                                                                                                              
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | In the fourth quarter of 2000, we recorded a
	$43.0 million gain on the sale of securities.                                                                                                                                                                                                  
|   
|(2) | In April 2001 we sold our rights to Ridaura
	including inventory to Prometheus Laboratories, Inc. for
	$9.0 million in cash plus a royalty on annual sales in
	excess of $4.0 million for the next five years. We
	recognized a gain of $8.0 million in connection with the
	sale of Ridaura.
|   
|(3) | Effective January 1, 2000, we changed our
	method of accounting for non-refundable license fees in
	accordance with Staff Accounting Bulletin 101,
	Revenue Recognition in Financial Statements. Please
	refer to Note 1 of the Notes to Consolidated Financial
	Statements.               

24



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##### Table of Contents






Item 7.     Managements
Discussion and Analysis of Financial Condition and Results of
Operations

The following discussion should be read in
conjunction with the Consolidated Financial Statements and Notes
filed with this Report.

Overview

Our commercial business is focused on the
dermatology marketplace, which is characterized by a large
patient population that is served by relatively small, and
therefore more accessible, groups of treating physicians. We
currently market two pharmaceutical products, Luxíq and
OLUX. Both products have clinically proven therapeutic
advantages and we are providing quality customer service to
physicians through our experienced sales and marketing staff. In
December 2001, we filed a supplemental New Drug Application, or
sNDA, with the FDA, requesting clearance to market OLUX for
non-scalp indications. The application is currently under review
with the FDA.

In April 2001, we completed the acquisition of
Soltec for approximately $16.9 million. We accounted for
this transaction using the purchase method and allocated
$1.1 million of the purchase price to in-process research
and development, based on an independent valuation, and the
balance to the tangible assets of Soltec, existing technology
and goodwill. As we are now focusing on our dermatology
business, in April 2001 we sold our rights to Ridaura, including
inventory, to Prometheus for $9.0 million in cash plus a
royalty on annual sales in excess of $4.0 million for the
next five years.

In addition to our commercial business, we own
the rights to a recombinant form of a natural hormone called
relaxin. On May 23, 2001, we announced our decision to
reduce our investment in the development of relaxin and to
search for licensing opportunities or other strategic
alternatives for the product. We eliminated 27 employee
positions related to relaxin. In 2001, we recorded a
$1.1 million charge representing estimated costs accrued in
connection with the reduction in workforce and the wind down of
relaxin development contracts.

Results of Operations



| |         
| | --------
| | Revenues

|                               |                            |                                                      |   |        |        |      |   |        |        |  |   |       |        | 
|------------------------------ | -------------------------- | ---------------------------------------------------- | - | ------ | ------ | ---- | - | ------ | ------ |  | - | ----- | ------ | 
|                               |                            |                                                     
|                               |                            | Years Ended December 31,                            
|                               |                            |                                                     
|                               |                            | 2001                                                 |   | 2000   |        | 1999
|                               |                            |                                                      |   |        |        |     
|                               |                            |                                                     
|                               |                            | (In thousands)                                      
|Product:                       |                            |                                                      |   |        |        |      |   |        |        |  |   |      
|                               | OLUX                       |                                                      | $ | 14,996 |        |      | $ | 1,211  |        |  | $ |      |       
|                               | Luxíq                      |                                                      |   | 13,848 |        |      |   | 10,973 |        |  |   | 6,025 |       
|                               | Ridaura                    |                                                      |   | 2,015  |        |      |   | 6,013  |        |  |   | 5,737 |       
|                               | Other                      |                                                      |   | 64     |        |      |   |       |        |  |   |      |       
|                               | Actimmune                  |                                                      |   |       |        |      |   | 1,898  |        |  |   | 4,833 |       
|                               |                            |                                                      |   |        |        |      |   |        |        |  |   |      
|                               |                            | Total product revenues                               |   | $      | 30,923 |      |   | $      | 20,095 |  |   | $     | 16,595 | 
|License, contract and royalty: |                            |                                                      |   |        |        |      |   |        |        |  |   |      
|                               | Royalty                    |                                                      |   | 1,097  |        |      |   |       |        |  |   |      |       
|                               | InterMune                  |                                                      |   | 771    |        |      |   | 6,768  |        |  |   | 500   |       
|                               | Celltech (formerly Medeva) |                                                      |   | 756    |        |      |   | 11,500 |        |  |   | 8,000 |       
|                               | Paladin Labs, Inc.         |                                                      |   | 53     |        |      |   | 703    |        |  |   | 400   |       
|                               | Suntory Ltd.               |                                                      |   |       |        |      |   | 1,319  |        |  |   | 879   |       
|                               | Other contracts            |                                                      |   | 464    |        |      |   | 389    |        |  |   | 532   |       
|                               |                            |                                                      |   |        |        |      |   |        |        |  |   |      
|                               |                            | Total license, contract, royalty and other
	revenues |   |        | 3,141  |      |   |        | 20,679 |  |   |       | 10,311 | 
|                               |                            |                                                      |   |        |        |      |   |        |        |  |   |      
|                               |                            | Total revenues                                       |   | $      | 34,064 |      |   | $      | 40,774 |  |   | $     | 26,906 | 
|                               |                            |                                                      |   |        |        |      |   |        |        |  |   |      

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Our product revenues in 2001 were
$30.9 million compared to $20.1 million in 2000 and
$16.6 million in 1999. The increase in total product sales
in 2001 was due to continued sales growth of Luxíq, and to
our first full year of sales of OLUX, which we launched in
November 2000. We also recognized product revenue on sales of
Ridaura, until the April 2001 sale of that product line to
Prometheus. Effective April 1, 2000, in connection with our
agreement with InterMune, we sold our remaining Actimmune
product rights. The increase in total product sales in 2000 over
1999 was due primarily due to sales growth of Luxíq and the
launch of OLUX in November 2000. When we acquired Soltec in
April 2001, we began to recognize royalty revenue in association
with royalty bearing contracts to which Soltec is a party.

License, contract, royalty and other revenues
were $3.1 million in 2001 compared to $20.7 million in
2000 and $10.3 million in 1999. The decrease in license
revenue in 2001 was in part due to our decision in May 2001 to
reduce our investment in the development of relaxin. Through the
end of 2001, we had not entered into any new licensing
opportunities or other strategic alternatives for the product.

The increase in license revenues for 2000 over
1999 includes $4.4 million related to revenue recognized in
2000 which had been deferred to January 1, 2000 in
connection with the change in accounting principle in accordance
with SAB 101, a one-time $5.0 million milestone payment
from Celltech, $1.5 million paid by InterMune in connection
with our sublicense agreement, and approximately
$4.1 million revenue previously deferred that was
recognized on the cancellation of relaxin contracts.

In 1999, we recorded $8.0 million in license
revenue ($4.0 million of a license fee and
$4.0 million for quarterly reimbursements of product
development costs) in connection with our agreement with Medeva
in relation to the development of relaxin. In addition, we
recorded $0.9 million for a milestone payment made by
Suntory, and $0.4 million for a license fee paid by Paladin
Labs. Payments made by Suntory and Paladin Labs are associated
with collaboration agreements for relaxin.

In 2000, InterMune purchased the remaining United
States commercial rights and revenue rights to Actimmune
effective April 1, 2000. As part of the transaction,
InterMune paid $5.2 million, which included the prepayment
of a $1.0 million obligation owed in 2002.

We expect license revenue to fluctuate
significantly depending on whether we enter into additional
collaborations, when and whether we or our partners achieve
milestones under existing agreements, and on new business
opportunities that we may identify.



| |                         
| | ------------------------
| | Cost of Product Revenues

Our cost of product revenues includes the costs
of manufacturing Luxíq, OLUX, Ridaura (until April 2001),
and Actimmune (until April 2000), royalty payments based on a
percentage of our product revenues and product freight and
distribution costs from CORD, the third party that handles all
of our product distribution activities. We recorded cost of
product revenues of $3.1 million in 2001 compared to
$3.9 million in 2000 and $5.2 million in 1999. The
decrease in cost of product revenues from 2000 to 2001 is
primarily due to a reduction in royalty expense. When we
acquired Soltec, we began to eliminate all intercompany
transactions in consolidation, which included our royalty
expense and Soltecs related royalty income. The decrease
in cost of product revenues from 1999 to 2000 is primarily due
to a change in product mix arising from discontinued sales of
Actimmune effective April 1, 2000. Actimmune had higher
manufacturing costs than our other products.



| |                         
| | ------------------------
| | Research and Development

Research and development expenses include
salaries and benefits, laboratory supplies, external research
programs, clinical studies and allocated overhead costs such as
rent, supplies and utilities. In addition to clinical site
payments, clinical costs include costs of manufacturing clinical
supplies and costs associated with

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##### Table of Contents



product stability studies. Research and
development expenses were $19.2 million in 2001,
$21.9 million in 2000, and $21.3 million in 1999. In
2001, our research and development expenses primarily consisted
of:




| |   |                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------
| |  | $6.1 million on new dermatology product
	efforts,                                                                
|
| |  | $4.9 million on relaxin development efforts
	prior to the May 2001 decision to reduce investment in the
	program,
|
| |  | $7.6 million development efforts to expand
	the usage of existing dermatology products, and                      
|
| |  | $0.6 million to integrate Soltec into our
	research and development efforts from April 2001.                     

In 2000, our research and development expenses
primarily consisted of:



| |   |                                                                                               
| | - | ----------------------------------------------------------------------------------------------
| |  | $10.8 million toward the manufacturing
	scale-up of relaxin,                                  
|
| |  | $6.3 million for conducting a Phase II/III
	trial of relaxin for the treatment of scleroderma,
|
| |  | $1.8 on increased personnel in our organization,
	and                                         
|
| |  | $1.8 million in expenses associated with the
	initiation of clinical trials of relaxin.       

We expect research and development expenses to
remain at the same level for the next few quarters, due to
clinical trial activities for new disease indications,
preclinical activities associated with technologies acquired
from Soltec, pre-manufacturing start-up costs associated with
qualifying a new supplier for Luxíq and OLUX, and possible
acquisitions of new technologies and products. We are unable to
predict the level of spending until near the end of the various
programs because of the uncertainty of FDA approval of clinical
study programs.

Pharmaceutical products that we develop
internally can take several years to research, develop and bring
to market a new prescription medicine in the United States. Drug
development in the U.S. is a process that includes several steps
defined by the FDA. The process begins with the filing of an
Initial Drug Application, which, if successful, allows
opportunity for clinical study of the potential new medicine.
Clinical development typically involves three phases of study,
Phase I, II, and III, and the most significant costs associated
with clinical development are the Phase III trials as they tend
to be the longest and largest studies conducted during the drug
development process. The successful development of our products
is highly uncertain, and an estimation of product completion
dates and completion costs can vary significantly for each
product and are difficult to predict. The lengthy process of
seeking these approvals, and the subsequent compliance with
applicable statutes and regulations, require the expenditure of
substantial resources. Any failure by us to obtain, or any delay
in obtaining, regulatory approvals could materially adversely
affect our business. In responding to an NDA, the FDA may grant
marketing approval, request additional information or deny the
application if it determines that the application does not
provide an adequate basis for approval. For additional
discussion of the risks and uncertainties associated with
completing development of potential products, see Factors
Affecting Our Business and Prospects  We cannot sell
our current products and product candidates if we do not obtain
and maintain governmental approvals,  We
may spend a significant amount of money to obtain FDA and other
regulatory approvals, which may never be grantedand
 If we are unable to develop new products,
our expenses may continue to exceed our revenue indefinitely,
without any return on the investment.



| |                                              
| | ---------------------------------------------
| | Selling, General and Administrative
	Expenses

Selling, general and administrative expenses were
$36.1 million in 2001, $26.7 million in 2000, and
$20.8 million in 1999. The increase in 2001 was primarily
due to:



| |   |                                                                                                                        
| | - | -----------------------------------------------------------------------------------------------------------------------
| |  | the addition of 32 employees in our sales
	and marketing organizations,                                                
|
| |  | additional market research and sales costs
	related to the OLUX launch and the launch of OLUX and Luxíq
	50 gram units,
|
| |  | $1.1 million for the amortization of
	intangibles associated with the acquisition of Soltec in 2001,
	and              
|
| |  | $2.6 million in non-cash stock compensation
	charges.                                                                  

27



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The increase in expenses in 2000 over 1999 was
primarily due to:



| |   |                                                                                             
| | - | --------------------------------------------------------------------------------------------
| |  | expenses associated with launching OLUX in the
	fourth quarter of 2000; and                 
|
| |  | increases in the number of personnel in our sales
	and marketing and clinical organizations.

We expect selling, general and administrative
expenses to remain consistent or be slightly higher in 2002 due
to the launch of physician samples of OLUX and Luxíq, and
the commencement of marketing efforts relating to the
anticipated outcome of clinical trials for antifungal foam and
anti-acne foam.



| |                                              
| | ---------------------------------------------
| | Acquired In-Process Research and
	Development

We recorded a charge of $1.1 million for
acquired in-process research and development associated with the
acquisition of Soltec, which was consummated in the second
quarter of 2001. The acquired in-process research and
development consists of several projects that involve the use of
novel technologies to improve the delivery of drugs. Several of
these projects are being developed in connection with other
companies who own rights to the drugs. We may earn milestone and
other fees under these arrangements and, if the drugs are
successfully developed, will be entitled to royalties based on
net sales. The projects are in various stages of development and
are subject to substantial risks. We currently estimate that
completion of the first projects will occur in 2002 and we
expect to incur research and development expenses of up to
$1.4 million, assuming all drugs are successfully developed
(before considering any research funding from our partners). The
value of the in-process research and development was determined
by an independent valuation firm using a discounted cash flow
analysis with a discount rate of 20%. In addition, the stage of
completion of each project was considered in determining the
value.

These projects may not meet either technological
or commercial success. The products under development have no
foreseeable alternative future uses. The estimates we used in
valuing in-process research and development were based on
assumptions we believe to be reasonable, but they are inherently
uncertain and unpredictable. Our assumptions may be incomplete
or inaccurate, and unanticipated events and circumstances may
occur. Accordingly, actual results may vary from the results
projected for purposes of determining the fair value of the
acquired in-process research and development.

In 1999, we recorded a $1.0 million license
fee charge in connection with our licensing agreement with
Soltec for exclusive rights to certain applications of a broad
range of unique topical delivery technologies. We determined
that it was highly uncertain whether the amount paid for this
license would be realized, as it related to pre-FDA approved
products and was dependent on additional research and
development. Consequently, we expensed the full amount of the
license.



| |                           
| | --------------------------
| | Charge for Relaxin Program

In the second quarter of 2001 we recorded a
$6.0 million charge representing estimated costs accrued in
connection with the reduction in workforce and the wind down of
relaxin development contracts. In the fourth quarter of 2001 we
reversed $4.9 million of this charge due to the settlement
of potential amounts owed. For additional information, see
Note 7 in our Notes to Consolidated Financial Statements
for a discussion of the relationship with Boehringer
Ingelheim.



| |                                          
| | -----------------------------------------
| | Interest and Other Income (Expense),
	Net

Interest income was $2.5 million for 2001,
compared with $2.1 million for 2000, and $1.1 million
for 1999. The increase in interest income in 2001 over 2000
arose from the high cash and investment balance from the sale of
InterMune shares in December 2000, which generated income in
2001. The increase in interest income in 2000 over 1999 was due
to higher cash and short-term investment balances.

Interest expense was $46,000 in 2001, compared
with $235,000 in 2000 and $868,000 in 1999. The decreases in
interest expense in 2001 over 2000 and in 2000 over 1999
resulted from lower interest expense associated with lower
balances outstanding for obligations under capital leases, and
long term debt.

28



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Other income (expense) was a net expense of
$519,000 in 2001 compared with zero in 2000 and net income of
$143,000 in 1999. The net other expense in 2001 was primarily
due to a $555,000 net loss on a foreign exchange forward
contract partially offset by rents received from a sublease
arrangement. The contract was entered into in relation to a
business combination and does not qualify as a hedge under
SFAS 133. The purpose of the contract was to lock in to the
purchase price paid for Soltec. The foreign exchange forward
contract was terminated on the closing date of the acquisition
of Soltec. Net other income in 1999 was related to gains on
sales of excess property and equipment.



| |             
| | ------------
| | Income Taxes

Income tax expense was $345,000 in 2001, compared
to $1.0 million in 2000 and zero in 1999. Income tax
expense in 2001 arose from the taxable operating results of our
foreign subsidiary, Soltec. The increase in income tax expense
in 2000 compared to 1999 arose from the pre-tax income in 2000
as compared to net losses in 1999. Our results for 2000 reflect
a gain of $43.0 million on the sale of securities. For a
more complete description of our income tax position, refer to
Note 11 in our Notes to Consolidated Financial Statements.



| |                                
| | -------------------------------
| | Change in Accounting
	Principle

Effective January 1, 2000, we changed our
method of accounting for nonrefundable up-front license fees to
recognize such fees over the expected research and development
period. The $5.2 million cumulative effect of the change in
accounting principle, calculated as of January 1, 2000, was
reported as a charge in the year ended December 31, 2000.
The cumulative effect was initially recorded as deferred revenue
and is being recognized as revenue over the research and
development period of the agreements. During the year ended
December 31, 2000, the impact of this change in accounting
method (excluding the cumulative effect itself) increased net
income by $4.4 million or $0.15 per share. This increase
consists of $4.9 million revenue deferred in the cumulative
effect that was recognized as income in 2000 under the new
accounting method, offset by the impact of deferring upfront
fees received in 2000. During 2000, approximately
$4.1 million of revenue deferred as a component of the
cumulative effect charge was fully recognized in the fourth
quarter when two of our collaboration partners terminated their
agreements with us as a result of the failure of relaxin to meet
the primary endpoint in a Phase III trial, and we were released
from further obligations. Revenue for 2001 includes $132,000 of
revenue previously recognized and included in the cumulative
effect adjustment. The unamortized balance of deferred revenue
at December 31, 2001 of approximately $659,000 is expected
to be recognized as revenue of approximately $132,000 per year
during the years ending 2002 through 2006. The pro formaamounts presented in the statement of operations were
calculated assuming the accounting change had been in effect for
prior periods, and was made retroactive to prior periods.



| |                  
| | -----------------
| | Net Income (Loss)

In 2001, we had a net loss of $16.7 million,
compared to net income of $27.0 million in 2000 and a net
loss of $27.3 million in 1999. We expect to incur losses
for the foreseeable future. These losses are expected to
fluctuate from period to period based on timing of product
revenues, clinical material purchases, clinical trial expenses,
and possible acquisitions of new products and technologies.

Liquidity and Capital Resources

Sources and Use of Cash.We have financed our operations to
date primarily through proceeds from equity financings, sale of
investments, collaborative arrangements with corporate partners,
bank loans, gross margins and product revenues. At
December 31, 2001, cash, cash equivalents and short-term
investments totaled $46.3 million, compared to
$79.9 million at December 31, 2000, and accounts
receivable totaled $5.4 million compared to
$2.7 million at December 31, 2000. Our cash balances
are held in a variety of interest-bearing instruments including
high-grade corporate bonds, commercial paper and money market
accounts.

Cash Flows from Operating Activities.Cash used in operations for 2001 was
$24.6 million compared with $15.3 million in 2000 and
$14.1 million in 1999. Net loss of $16.7 million for
2001 was affected by

29



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non-cash charges of $2.0 million of
depreciation and amortization expense and $555,000 in other
expense related to the foreign exchange forward contract, a
one-time in-process research and development charge of
$1.1 million related to the Soltec acquisition, a one-time
$1.1 million charge related to the reduction in the relaxin
program, and non-cash compensation charges in the amount of
$2.6 million, more than offset by the $8.0 million
gain on the sale of Ridaura. The primary reason for the decrease
in operating cash flows in 2001 was that we had a $122,000 gain
on the sale of InterMune stock in 2001 compared to a
$43.0 million gain in 2000 and an unfavorable change in
working capital accounts of approximately $5.9 million.


Net income of $27.0 million for 2000 was
affected by the gain on sale of InterMune stock of
$43.0 million and non-cash charges of $764,000 of
depreciation and amortization expense and $1.0 million
non-cash compensation expense. The primary reason for the
decrease in operating cash flows during 2000 was due to the
decrease in accrued and other current liabilities.

Net loss of $27.3 million for 1999 was
affected by non-cash charges of $6.7 million depreciation
and amortization expense and $1.3 million deferred
compensation expense. Cash outflow for 1999 was primarily for
operating activities, including growth in inventory due
primarily to carrying three products, and increases in accounts
receivable due to higher product sales. Cash usage was partially
offset by an increase in accounts payable and accrued
liabilities related to higher development, sales and marketing
expenses.

Cash Flows from Investing Activities.Investing activities used $29.9
million in cash during 2001 compared to cash provided by
investing activities of $44.2 million in 2000 and cash used
of $10.3 million in 1999. The principal uses of cash for
investing activities in 2001 were net purchases of short-term
investments and the acquisition of Soltec, which were partially
offset by proceeds from the sale of Ridaura. The increase in
cash from investing activities in 2000 was primarily related to
$43.0 million of proceeds from the sale of shares of
InterMune stock. Cash outlays in 1999 were principally for
purchases of short-term investments.

Cash Flows from Financing Activities.Financing activities used
$0.2 million in 2001 compared to cash provided by financing
activities of $21.3 million in 2000 and $18.2 million
in 1999. In 2001 cash was used in financing activities to pay
off bank debt and in the purchase of certificates of deposit
that restricted cash to satisfy the requirements of an operating
lease agreement and as collateral on various officer personal
loans. The principal sources of cash from financing activities
were the sale of common stock: $2.5 million in 2001 pursuant to
the exercise of warrants and stock options. This was partially
offset by additions to restricted cash in connection with the
requirements of an operating lease arrangement and collateral on
various officer loans, $23.9 million in 2000 (including
$20 million from a private placement), and
$27.2 million in 1999 (including $21.9 million in a
public offering).

Working Capital.Working capital decreased to
$44.0 million at December 31, 2001 from
$71.0 million at December 31, 2000. Our working
capital primarily decreased as we used cash in operations and
acquired Soltec. The decrease was partially offset by the sale
of Ridaura. The increase in working capital in 2000 compared to
1999 was due to a $20.0 million private placement of our
common stock, the $5.2 million sale of Actimmune rights to
InterMune, and the $43.0 million of proceeds from the sale
of stock of InterMune, partially offset by cash used for
operations.

Contractual Obligations and Commercial
Commitments.As of December 31,
2001, we had the following contractual obligations and
commitments:

|                                      |  |                        |              |         |  |             |             |             |  |          |             |  |  |   |             |  |  |   |             | 
|------------------------------------- |  | ---------------------- | ------------ | ------- |  | ----------- | ----------- | ----------- |  | -------- | ----------- |  |  | - | ----------- |  |  | - | ----------- | 
|                                      |  |                       
|                                      |  | Payments Due by Period
|                                      |  |                       
|Contractual Obligations               |  | Total                  |              | <1 year |  | 1  3 years |             | 4  5 years |  | >5 years
|                                      |  |                        |              |         |  |             |             |             |  |         
|Operating Leases(1)                   |  | $                      | 6.0 million  |         |  | $           | 2.7 million |             |  | $        | 3.0 million |  |  | $ | 0.3 million |  |  | $ |            | 
|Unconditional Purchase Obligations(2) |  | $                      | 1.5 million  |         |  | $           | 1.5 million |             |  | $        |            |  |  | $ |            |  |  | $ |            | 
|Capital Expenditure
	Obligations(3)   |  | $                      | 2.7 million  |         |  | $           | 2.4 million |             |  | $        | 0.1 million |  |  | $ | 0.1 million |  |  | $ | 0.1 million | 
|                                      |  |                        |              |         |  |             |             |             |  |          |             |  |  |   |             |  |  |   |             | 
|Total Contractual Cash Obligations    |  | $                      | 10.2 million |         |  | $           | 6.6 million |             |  | $        | 3.1 million |  |  | $ | 0.4 million |  |  | $ | 0.1 million | 
|                                      |  |                        |              |         |  |             |             |             |  |          |             |  |  |   |             |  |  |   |             | 

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---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | We lease laboratory and office facilities under
	noncancelable operating leases, which expire through 2005. We
	also lease various automobiles and office equipment under
	similar leases, expiring through 2004. These obligations are to
	be partially offset by $570,000 to be received from a subleasing
	arrangement with a third party.                                                                                                                                                                                                                                      
|   
|(2) | Represents commitments to purchase Luxíq and
	OLUX from Miza Pharmaceuticals during 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   
|(3) | In March 2002 we entered into an agreement with
	DPT to construct an aerosol filling line at DPTs plant in
	Texas. This agreement is retroactive to November 1, 2001,
	to cover certain pre-construction payments we made in December
	2001. Under the agreement we committed to pay for construction
	of the aerosol line, which we currently estimate will cost
	approximately $2.3 million. We are also obligated to pay
	approximately $56,000 per year in rent, for an indefinite period
	of time, for the pro rata portion of DPTs facility
	allocated to the aerosol line.

As of December 31, 2001, we had no
off-balance sheet financing arrangements or commitments other
than those disclosed in the table above.

Restricted Cash and Cash
Equivalents.As of December 31,
2001, $2.1 million of our total cash and cash equivalents
balance was restricted cash, held in various certificates of
deposit, for specific purposes: $764,000 relates to collateral
on various officer personal loans; $450,000 relates to overdraft
protection on our operating account; and $924,000 relates to a
deposit required in connection with a noncancelable operating
lease.

We believe our existing cash, cash equivalents
and short-term investments, cash generated from product sales
and collaborative arrangements with corporate partners, will be
sufficient to fund our operating expenses, debt obligations and
capital requirements through at least the next 12 months.
Our future capital uses and requirements depend on numerous
factors, including the progress of our research and development
programs, the progress of clinical testing, the time and costs
involved in building and qualifying a new aerosol filling
facility, the time and costs involved in obtaining regulatory
approvals, the cost of filing, prosecuting, and enforcing patent
claims and other intellectual property rights, competing
technological and market developments, the level of product
revenues, and the possible acquisition of new products and
technologies. Therefore such capital uses and requirements may
increase in future periods. As a result, we may require
additional funds prior to reaching profitability and may attempt
to raise additional funds through equity or debt financings,
collaborative arrangements with corporate partners or from other
sources. We are currently evaluating a number of business
development opportunities, including the possibility of
acquiring or in-licensing other products. If we successfully
reach agreements with third parties, these transactions may
require us to use some of our available cash, or to raise
additional cash by liquidating some of our investment portfolio
and/or issuing stock in connection with the transaction.

We currently have no commitments for any
additional financings. If we need to raise additional money to
fund our operations, funding may not be available to us on
acceptable terms, or at all. If we are unable to raise
additional funds when needed, we may not be able to market our
products as planned or continue development of our other
products, or we could be required to delay, scale back or
eliminate some or all of our research and development programs.

Critical Accounting Policies

The fundamental objective of financial reporting
is to provide useful information that allows a reader to
comprehend our business activities. To aid in that
understanding, we have identified our critical accounting
policies which are used in preparing the consolidated
financial statements. These policies have the potential to have
a more significant impact on our financial statements, either
because of the significance of the financial statement item to
which they relate, or because they require us to make estimates
and judgments due to the uncertainty involved in measuring, at a
specific point in time, events that are continuous in nature.

Revenue Recognition.We record contract revenue for
research and development as it is earned based on the
performance requirements of the contract. We recognize
non-refundable contract fees for which no further performance
obligations exist, and for which we have no continuing
involvement, on the earlier of when the

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payments are received or when collection is
assured. Commencing January 1, 2000, we recognize revenue
from non-refundable upfront license fees ratably over the period
in which we have continuing development obligations when, at the
time the agreement is executed, there remains significant risk
due to the incomplete state of the products development.
Revenue associated with substantial at risk
performance milestones, as defined in the respective agreements,
is recognized based upon the achievement of the milestones. We
recognize revenue under research and development cost
reimbursement contracts as the related costs are incurred.
Royalty expenses directly related to product sales are
classified in cost of product revenues. Royalties related to
agreements with Soltec are now eliminated in consolidation.


Returns, Rebates and Chargebacks
Reserves.We are obligated to accept
from customers the return of pharmaceuticals that have reached
their expiration date. As part of our revenue recognition
policy, we estimate future product returns, rebates and
chargeback payments. These estimates determine our revenue
reserves. We make these estimates based primarily on our past
return and rebate experience. We also consider the volume and
price mix of products in the retail channel, trends in
distributor inventory, economic trends that might impact patient
demand for our products (including competitive environment), the
economic value of the rebates being offered and other factors.
In the past, actual returns, rebates and chargebacks have not
generally exceeded our reserves. However, actual returns,
rebates and chargebacks in the future period are inherently
uncertain, and the terms of our participation in the Medicaid
program could require us to adjust the prices that we reported
in previous quarters, if necessary. Any such corrections could
result in a change (positive or negative) in our Medicaid rebate
liability for past quarters, although we would record the
expense in the quarter in which the adjustment was made. If we
changed our assumptions and estimates, our revenue reserves
would change, which would impact the net revenue we report. In
addition, if actual returns, rebates and chargebacks are
significantly greater than the reserves we have established, the
actual results would decrease our reported revenue. Conversely,
if actual returns, rebates and chargebacks are significantly
less than our reserves, this would increase our reported revenue.

Goodwill, Purchased Intangibles and Other
Long-Lived Assets  Impairment Assessments.Under current accounting standards
that are to be modified at the start of our next fiscal year, we
make judgments about the remaining useful lives of goodwill,
purchased intangible assets and other long-lived assets whenever
events or changes in circumstances indicate an other than
temporary impairment in the remaining value of the assets
recorded on our balance sheet. In order to judge the remaining
useful life of an asset, we make various assumptions about the
value of the asset in the future. This may include assumptions
about future prospects for the asset and typically involves
computation of the estimated future cash flows to be generated.
Based on these judgments and assumptions, we determine whether
we need to take an impairment charge to reduce the value of the
asset stated on our balance sheet to reflect its actual fair
value. Judgments and assumptions about future values and
remaining useful lives are complex and often subjective. They
can be affected by a variety of factors, including external
factors such as changes in our business strategy and our
internal forecasts. Although we believe the judgments and
assumptions we have made in the past have been reasonable and
appropriate, different judgments and assumptions could
materially impact our reported financial results. More
conservative assumptions of the anticipated future benefits from
these assets would result in greater impairment charges, which
would decrease net income and result in lower asset values on
our balance sheet. Conversely, less conservative assumptions
would result in smaller impairment charges and higher asset
values. For more details about how we make these judgments,
see Note 1 in our Notes to Consolidated Financial Statements.

Recent Accounting Pronouncements

SFAS 141.In
July 2001, the Financial Accounting Standards Board, or FASB,
issued Statement of Financial Accounting Standards, or SFAS,
No. 141, Business Combinations (SFAS 141),
which requires all business combinations initiated after
June 30, 2001 to be accounted for using the purchase method
of accounting. As a result, use of the pooling-of-interests
method is prohibited for business combinations initiated after
that date. SFAS 141 also establishes criteria for separate
recognition of intangible assets acquired in a business
combination. We adopted SFAS 141 effective July 1,
2001. The adoption of SFAS 141 had no impact on our
financial position or results of operations.

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SFAS 142.In
July 2001, the FASB issued SFAS No. 142,
Goodwill and Other Intangible Assets
(SFAS 142), which addresses the financial accounting and
reporting for acquired goodwill and other intangible assets.
Under SFAS 142, we are no longer required to amortize
goodwill and intangible assets with indefinite lives, but will
be required to periodically review these for impairment.
Intangible assets determined to have definitive lives will
continue to be amortized over their useful lives. SFAS 142
is effective for years ending after December 15, 2001. We
adopted SFAS 142 effective January 1, 2002, and
reclassified amounts to goodwill that were previously allocated
to assembled workforce. Upon adoption, we ceased the
amortization of goodwill currently representing expense of
$0.7 million per year. Although we have not completed the
transactional impairment test, we currently do not expect the
results of such test to have a material effect on our financial
position or results of operations.

SFAS 144.In
October 2001, the FASB issued SFAS No. 144,
Accounting for the Impairment or Disposal of Long-Lived
Assets (SFAS 144), which establishes a single
accounting model for the impairment or disposal of long-lived
assets, including discontinued operations. SFAS 144
supersedes SFAS 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed
Of. SFAS 144 requires that long-lived assets to be
disposed of by sale be measured at the lower of carrying amount
or fair value less cost to sell, whether reported in continuing
operations or in discontinued operations. SFAS 144 excludes
from the definition of long-lived assets goodwill and other
intangibles that are not amortized in accordance with
SFAS 142. SFAS 144 also expands the reporting of
discontinued operations to include components of an entity that
have been or will be disposed of rather than limiting such
discontinuance to a segment of a business. SFAS 144 is
effective for years ending after December 15, 2001. We
adopted SFAS 144 effective January 1, 2002, and it did
not have a significant impact on our financial position or
results of operations.

Factors That May Affect Forward-Looking
Statements

A wide range of factors could materially affect
our future developments and performance, including the following:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | We have experienced operating losses every year
	since our incorporation and expect to incur additional losses
	for at least the next few years. Losses are expected to
	fluctuate from period to period based on timing of product
	revenues, clinical material purchases, possible acquisitions of
	new products and technologies, scale-up activities and clinical
	activities. Therefore, the time for us to reach profitability is
	uncertain and we may never be able to generate revenue from our
	products now under development or achieve profitability on a
	sustained basis.
|
| |  | There are risks related to the management of the
	marketing and sales of our products. Our success depends in part
	on our ability to effectively manage the distribution of our
	products and to market and sell our products successfully. If
	Luxíq and OLUX do not sustain market acceptance, our
	financial condition and results of operations will be adversely
	affected. Future revenues from sales are uncertain as we are
	subject to patent risks and competition from new products.                                                                                        
|
| |  | We do not have manufacturing capabilities, and we
	receive all of our products (including clinical trial material)
	from contract manufacturing companies. We currently have no
	manufacturing facilities nor do we intend to develop such
	capabilities in the near future. If any of our contract
	manufacturers were to fail to provide product to us on a timely
	basis, we might have to delay clinical trials or commercial
	sales, which would have a material adverse effect on our results
	of operations.                                                                     
|
| |  | We are subject to uncertainties associated with
	product development and market acceptance. We have several
	product candidates in clinical or preclinical development.
	Products under development may not be safe and effective or
	approved by the FDA, or we may not be able to produce them in
	commercial quantities at reasonable costs, and the products may
	not gain satisfactory market acceptance.                                                                                                                                                                          
|
| |  | Our future capital uses and requirements depend
	on numerous factors, including costs associated with the
	research, development, clinical testing and obtaining regulatory
	approvals of products in our pipeline; enforcing patent claims
	and intellectual property rights; acquisition of new products and                                                                                                                                                                                                                                                                          

33



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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | technologies; commercialization activities and
	the ability to establish collaborative arrangements. Such
	requirements may increase in the future and we may attempt to
	raise additional funds through equity or debt financings,
	collaborative arrangements or from other sources. Future
	financings could have a dilutive effect on our stockholders.                                                                                                                                                                                                                                                                                                                                                                                      
|
| |  | A key element of our strategy is to in-license or
	acquire additional marketed or late-stage development products.
	That strategy involves risks. A portion of the funds needed to
	acquire, develop and market any new products may come from our
	existing cash, which will result in fewer resources available to
	our current products and clinical programs. We may also have to
	recruit additional qualified employees to manage the
	development, marketing, sale and distribution of newly acquired
	products. Newly acquired products may not achieve the marketing
	or therapeutic success that we, industry analysts, or others
	expect of them at the time of acquisition.                                                          
|
| |  | Our success will depend in part on our ability to
	preserve our trade secrets, to operate without infringing the
	proprietary rights of third parties, and to obtain patent
	protection for our products and processes. Products or processes
	that we make, use or sell may be covered by patents held by
	third parties that could prevent us from practicing the subject
	matter, require us to obtain licenses, or redesign our products
	or processes to avoid infringement. The patent positions can be
	highly uncertain and involve complex legal and factual
	questions. Accordingly, we cannot predict the breadth of such
	claims. Patent disputes are frequent and we could in the future
	be involved in material patent litigation.

This list of factors that may affect future
performance and the accuracy of forward-looking statements is
illustrative, but not exhaustive. Accordingly, you should
evaluate all forward-looking statements with the understanding
of their inherent uncertainty.

Our Business Strategy May Cause Fluctuating
Operating Results

Our operating results and financial condition may
fluctuate from quarter to quarter and year to year depending
upon the relative timing of events or uncertainties that may
arise. For example, the following events or occurrences could
cause fluctuations in our financial performance from period to
period:



| |   |                                                                                                                                                                 
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | changes in the levels we spend to develop new
	product lines,                                                                                                   
|
| |  | changes in the amount we spend to promote our
	products,                                                                                                        
|
| |  | changes in treatment practices of physicians that
	currently prescribe our products,                                                                            
|
| |  | changes in reimbursement policies of health plans
	and other similar health insurers, including changes that affect
	newly developed or newly acquired products,
|
| |  | forward-buying patterns by wholesalers that may
	result in significant quarterly swings in revenue reporting,                                                   
|
| |  | increases in the cost of raw materials used to
	manufacture our products,                                                                                       
|
| |  | the development of new competitive products by
	others,                                                                                                         
|
| |  | the mix of products that we sell during any time
	period, and                                                                                                   
|
| |  | our responses to price competition.                                                                                                                             




Item 7A.     Quantitative
and Qualitative Disclosures About Market Risk

Interest Rate Risk.Our holdings of financial instruments
comprise a mix of securities that may include
U.S. corporate debt, U.S. government debt, and
commercial paper. All such instruments are classified as
securities available for sale. Generally, we do not invest in
portfolio equity securities or commodities or use financial
derivatives for trading purposes. Our market risk exposure
consists principally of exposure to

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##### Table of Contents



reductions in interest rates. The table below
presents the principal amounts and weighted average interest
rates by year of maturity for our investment portfolio as of
December 31, 2001 (in thousands):


|                               |  |      |        |      |  |       |   |            |  |   |        |  |  |   |        | 
|------------------------------ |  | ---- | ------ | ---- |  | ----- | - | ---------- |  | - | ------ |  |  | - | ------ | 
|                               |  | 2002 |        | 2003 |  | Total |   | Fair Value
|                               |  |      |        |      |  |       |   |           
|Available-for-sale securities  |  | $    | 42,734 |      |  |       |  |            |  | $ | 42,734 |  |  | $ | 42,734 | 
|Weighted average interest rate |  |      | 5.67   | %    |  |       |  |            |  |   |        |  |  |   |        | 

Foreign Currency Exchange Risk.We make payments to Miza
Pharmaceuticals in pounds sterling, and the amounts we owe to
Boehringer Ingelheim in 2002 are payable in Euros. Certain
payments by third parties to Soltec are made in local currency
or Australian dollars, and payments by Soltec to Celltech are
made in Australian dollars. If the U.S. dollar depreciates
against the pound, the Euro or the Australian dollar, the
payments that we must make will increase, which will increase
our expenses. We currently do not hedge our exposure to changes
in foreign currency exchange rates. Interest income from our
investments is sensitive to changes in the general level of
U.S. interest rates, particularly since the majority of our
investments are in short-term instruments. Due to the nature of
our short-term investments, we have concluded that we face
minimal material market risk exposure.




Item 8.     Financial
Statements and Supplementary Data

Our consolidated financial statements and related
financial information are filed as a separate section to this
Report. Please refer to Item 14(a) for an Index to
Consolidated Financial Statements.




Item 9.     Changes
in and Disagreements with Accountants on Accounting and
Financial Disclosure

We have had no changes in or disagreements with
our independent public accountants on accounting and financial
disclosure.




PART III




Item 10.     Our
Directors and Executive Officers

Information regarding our Board of Directors is
incorporated by reference to the sections entitled
Election of Directors and Further Information
Concerning the Board of Directors in our Proxy Statement
(2002 Proxy Statement) to be filed with the
Securities and Exchange Commission relating to our annual
meeting of stockholders to be held May 16, 2002.

The following table shows information about our
executive officers as of March 22, 2002:

|                   |  |     |    |          |  |                                                                                      
|------------------ |  | --- | -- | -------- |  | -------------------------------------------------------------------------------------
|Name               |  | Age |    | Position
|                   |  |     |    |         
|Thomas G. Wiggans  |  |     | 50 |          |  | President, Chief Executive Officer and Director                                      
|C. Gregory Vontz   |  |     | 41 |          |  | Chief Operating Officer; Executive Vice President                                    
|John L. Higgins    |  |     | 32 |          |  | Chief Financial Officer; Executive Vice
	President, Finance and Corporate Development
|Katrina J. Church  |  |     | 40 |          |  | Exec. Vice President, Legal Affairs, General
	Counsel and Secretary                  
|Robert G. Lederer  |  |     | 57 |          |  | Sr. Vice President, Commercial Operations                                            
|Linda Fenney, M.D. |  |     | 51 |          |  | Sr. Vice President, Research, Product Development
	and Regulatory Affairs            
|Rebecca Gardiner   |  |     | 39 |          |  | Sr. Vice President, Human Resources and
	Organizational Dynamics                     
|Jay Finster        |  |     | 38 |          |  | Sr. Vice President, Marketing                                                        

Thomas G. Wigganshas served as President, Chief
Executive Officer and as a director of Connetics since July
1994. From February 1992 to April 1994, Mr. Wiggans served
as President and Chief Operating Officer of CytoTherapeutics, a
biotechnology company. From 1980 to February 1992,
Mr. Wiggans served in various

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positions at Ares-Serono Group, a pharmaceutical
company, including President of its U.S. pharmaceutical
operations and Managing Director of its U.K. pharmaceutical
operations. From 1976 to 1980 he held various sales and
marketing positions with Eli Lilly & Co., a
pharmaceutical company. He is currently a director of the
Biotechnology Industry Organization (BIO), and a member of its
Executive Committee, and its Emerging Company Section. He is
also Chairman of the Biotechnology Institute, a non-profit
educational organization. He is currently a director of Paladin
Labs, a public Canadian pharmaceutical company, and a private
biotechnology company. Mr. Wiggans received his B.S. in
Pharmacy from the University of Kansas and his M.B.A. from
Southern Methodist University.


C. Gregory Vontzjoined Connetics as Executive Vice
President, Chief Commercial Officer in December of 1999, and has
served as Chief Operating Officer since January 2001. Before
joining the Company, Mr. Vontz spent 12 years with
Genentech, Inc., most recently as Director of New Markets and
Healthcare Policy. Before joining Genentech, Inc. in 1987,
Mr. Vontz worked for Merck & Co., Inc.
Mr. Vontz received his B.S. in Chemistry from the
University of Florida and his M.B.A. from the Haas School of
Business at University of California at Berkeley.

John L. Higginshas
served as Chief Financial Officer since September 1997, as
Executive Vice President, Finance and Administration, since
January 2000, and as Executive Vice President, Finance and
Administration and Corporate Development since January 2002. He
served as Vice President, Finance and Administration from the
time he joined Connetics through December 1999. Before joining
Connetics, he was a member of the executive management team at
BioCryst Pharmaceuticals, Inc. Before joining BioCryst in 1994,
Mr. Higgins was a member of the healthcare banking team of
Dillon, Read & Co. Inc., an investment banking firm. He
served on the Board of Directors of InterMune Pharmaceuticals,
Inc. and currently serves as a director of a private company. He
received his A.B. from Colgate University.

Katrina J. Churchjoined Connetics as Vice President,
Legal Affairs and Corporate Counsel in June 1998, and has served
as Secretary since September 1998. She served as Senior Vice
President, Legal Affairs and General Counsel from January 2000
through December 2001, and has served as Executive Vice
President since January 2002. Prior to joining Connetics,
Ms. Church served in various positions at VISX,
Incorporated, most recently as Vice President, General Counsel.
Before joining VISX in 1991, Ms. Church practiced law with
the firm Hopkins & Carley in San Jose, California.
Ms. Church received her J.D. from the New York University
School of Law, and her A.B. from Duke University.

Robert G. Ledererjoined Connetics as Senior Vice
President, Marketing and Sales in July 1998, and has served as
Senior Vice President, Commercial Operations since January 1999.
Before joining Connetics, Mr. Lederer spent 15 years
with Serono Laboratories, most recently as the Executive Vice
President for Business Operations. Before joining Serono,
Mr. Lederer held sales and management positions with Becton
Dickinson and Genovese Drugs. Mr. Lederer serves as a board
member for an infertility patient advocacy organization, a
not-for-profit organization. He also serves on the Board of
Advisors for a small start-up company. Mr. Lederer received
his B.A. from St. Johns University in New York.

Linda Fenney, M.D.joined Connetics in February 2001, and
currently serves as Senior Vice President, Research, Product
Development and Regulatory Affairs. Prior to joining Connetics,
Dr. Fenney was President of the Ischemia Research and
Education Foundation where she previously served as Vice
President, Clinical Research/ Government Programs. Previously,
Dr. Fenney held the position of Vice President of Medical
Affairs at Eclipse Surgical Technologies. Dr. Fenney also
held various positions at Syntex and Roche, including Director
Safety and Surveillance & Associate Medical Director,
Cardiovascular Therapy, during this time she also held a
voluntary clinical faculty position at Stanford University,
Department of Cardiology. Dr. Fenney earned her M.D. from
University of London. She was a resident in internal medicine at
Stanford University Medical Center and a fellow in Cardiology at
the Veterans Administration Medical Center in Palo Alto, CA.

Rebecca Gardinerjoined Connetics in 1996 as Director
of Human Resources. She has served as Vice President of Human
Resources since December 1999 and as Senior Vice President Human
Resources and Organizational Dynamics since January 2002. She
worked at COR Therapeutics from 1990 to 1996 in the positions of
Manager of Research Administration, Manager of Human Resources,
and Senior Manager of

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Human Resources. Ms. Gardiner also worked at
Genelabs as Manager of Research Administration from 1988 to
1990, at Genentech in 1987, and in various hospital
administration positions from 1984 to 1987. Ms. Gardiner
received her B.A. from UC Santa Barbara and her M.P.A. in
Health Sciences from the University of San Francisco.


Joseph Jay
Finsterjoined Connetics as Senior
Vice President, Marketing in January 2002, and has spent more
than 14 years in the biotechnology and pharmaceutical
industry. Before joining Connetics, Mr. Finster spent
12 years at Genentech, Inc. most recently serving as
Director of Cardiovascular Marketing. He also held various
senior roles in product development, product launch and
management and marketing. Mr. Finster received his B.A. in
Pre-Medical Studies, Biology, from University of Notre Dame.




Item 11.     Executive
Compensation

Information regarding executive compensation is
incorporated by reference to the information set forth under the
caption Executive Compensation and Related
Information in our 2002 Proxy Statement.




Item 12.     Security
Ownership of Certain Beneficial Owners and
Management

Information regarding the beneficial ownership of
our common stock by certain beneficial owners and by our
directors and management is incorporated into this item by
reference to the information set forth under the caption
Stock Ownership in our 2002 Proxy Statement




Item 13.     Certain
Relationships and Related Transactions

Information regarding certain relationships and
related transactions is incorporated by reference to the
information set forth under the caption Certain
Relationships and Related Transactions in our 2002 Proxy
Statement.




PART IV




Item 14.     Exhibits,
Financial Statement Schedules and Reports on
Form 8-K

(a)1.     Financial
Statements. The following Consolidated Financial Statements
and Report of Independent Auditors are filed as part of this
Report:

|                                                                                                                    |  |      |     | 
|------------------------------------------------------------------------------------------------------------------- |  | ---- | --- | 
|                                                                                                                    |  | Page
|                                                                                                                    |  |     
|Report of Ernst & Young LLP, Independent
	Auditors                                                                  |  |      | F-2 | 
|Consolidated Balance Sheets as of
	December 31, 2001 and 2000                                                       |  |      | F-3 | 
|Consolidated Statements of Operations for each of
	the three years in the period ended December 31, 2001            |  |      | F-4 | 
|Consolidated Statements of Stockholders
	Equity for each of the three years in the period ended
	December 31, 2001 |  |      | F-5 | 
|Consolidated Statements of Cash Flows for each of
	the three years in the period ended December 31, 2001            |  |      | F-6 | 
|Notes to Consolidated Financial Statements                                                                          |  |      | F-7 | 

2.     Financial
Statement Schedules

The following additional consolidated financial
statement schedule should be considered in conjunction with our
consolidated financial statements. No applicable amounts were
recorded in 1999. All other schedules have been omitted because
the required information is either not applicable, not
sufficiently material to require submission of the schedule, or
is included in the consolidated financial statements or the
notes to the consolidated financial statements.

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SCHEDULE II  VALUATION AND
QUALIFYING ACCOUNTS

|                           |      |                  |   |                   |  |              |   |                |  |  |   |            |   |  |   |           | 
|-------------------------- | ---- | ---------------- | - | ----------------- |  | ------------ | - | -------------- |  |  | - | ---------- | - |  | - | --------- | 
|Allowance for Doubtful     |      |                  |   | Additions Charged |  |              |   |               
|Accounts, Returns, Rebates |      | Balance at Start |   | to Expense Net of |  |              |   | Balance at End
|and Chargebacks            |      | of Period        |   | Reversals         |  | Utilizations |   | of Period     
|                           |      |                  |   |                   |  |              |   |               
|Year Ended December 31,    |      |                  |   |                   |  |              |   |                |  |  |   |            |   |  |   |          
|                           | 2001 |                  | $ | 1,372,448         |  |              | $ | 2,060,732      |  |  | $ | (2,180,552 | ) |  | $ | 1,252,628 | 
|                           | 2000 |                  | $ | 776,835           |  |              | $ | 1,372,226      |  |  | $ | (776,613   | ) |  | $ | 1,372,448 | 
|                           | 1999 |                  | $ | 456,841           |  |              | $ | 507,248        |  |  | $ | (187,254   | ) |  | $ | 776,835   | 

3. The Exhibits filed as a part of this
Report are listed in the Index to Exhibits.

(b) Reports on Form 8-K. No
reports on Form 8-K were filed during the fourth quarter of
2001.

(c) Exhibits. See Index to Exhibits.

(d) Financial Statement Schedules.
See Item 14(a)(2), above.

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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.



| |                       
| | ----------------------
| | CONNETICS CORPORATION 
| | a Delaware corporation



| |     |                    
| | --- | -------------------
| | By: | /s/ JOHN L. HIGGINS

| |                                  
| | ---------------------------------
| |                                  
| | John L. Higgins                  
| | Chief Financial Officer          
| | Executive Vice President, Finance
| | and Corporate Development        

Date: March      ,
2002

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

|                                             |  |                                                                                        |  |               
|-------------------------------------------- |  | -------------------------------------------------------------------------------------- |  | --------------
|Signature                                    |  | Title                                                                                  |  | Date          
|                                             |  |                                                                                        |  |               
|Principal Executive Officer:                 |  |                                                                                       
|                                            
|/s/ THOMAS G. WIGGANSThomas G. Wiggans       |  | President, Chief Executive
	Officer and Director                                       |  | March   , 2002
|                                            
|Principal Financial and Accounting
	Officer: |  |                                                                                       
|                                            
|/s/ JOHN L. HIGGINSJohn L. Higgins           |  | Chief Financial Officer;
	Executive Vice President,
	Finance and Corporate Development |  | March   , 2002
|                                            
|Directors:                                   |  |                                                                                       
|                                            
|/s/ ALEXANDER E. BARKASAlexander E. Barkas   |  | Director                                                                               |  | March   , 2002
|                                            
|/s/ EUGENE A. BAUEREugene A. Bauer           |  | Director                                                                               |  | March   , 2002
|                                            
|/s/ JOHN C. KANEJohn C. Kane                 |  | Director                                                                               |  | March   , 2002
|                                            
|/s/ THOMAS D. KILEYThomas D. Kiley           |  | Director                                                                               |  | March   , 2002
|                                            
|/s/ GLENN A. OCLASSENGlenn A. Oclassen       |  | Director                                                                               |  | March   , 2002
|                                            
|/s/ LEON E. PANETTALeon E. Panetta           |  | Director                                                                               |  | March   , 2002
|                                            
|/s/ G. KIRK RAABG. Kirk Raab                 |  | Chairman of the Board, Director                                                        |  | March   , 2002

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CONNETICS CORPORATION

FORM 10-K

INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS

The following Consolidated Financial Statements
and Report of Independent Auditors are filed as part of this
Report:

|                                                                                                                    |  |      |     | 
|------------------------------------------------------------------------------------------------------------------- |  | ---- | --- | 
|                                                                                                                    |  | Page
|                                                                                                                    |  |     
|Report of Ernst & Young LLP, Independent
	Auditors                                                                  |  |      | F-2 | 
|Consolidated Balance Sheets as of
	December 31, 2001 and 2000                                                       |  |      | F-3 | 
|Consolidated Statements of Operations for each of
	the three years in the period ended December 31, 2001            |  |      | F-4 | 
|Consolidated Statements of Stockholders
	Equity for each of the three years in the period ended
	December 31, 2001 |  |      | F-5 | 
|Consolidated Statements of Cash Flows for each of
	the three years in the period ended December 31, 2001            |  |      | F-6 | 
|Notes to Consolidated Financial Statements                                                                          |  |      | F-7 | 

F-1



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##### Table of Contents



REPORT OF ERNST & YOUNG LLP, INDEPENDENT
AUDITORS

Board of Directors and Stockholders

Connetics Corporation


We have audited the accompanying consolidated
balance sheets of Connetics Corporation as of December 31,
2001 and 2000, and the related consolidated statements of
operations, stockholders equity, and cash flows for each
of the three years in the period ended December 31, 2001.
Our audits also included the financial statement schedule listed
in the Index at Item 14(a). These financial statements and
schedule are the responsibility of the Companys
management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.

We conducted our audits in accordance with
auditing standards generally accepted in the United States.
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
consolidated financial position of Connetics Corporation at
December 31, 2001 and 2000, and the consolidated results of
its operations and its cash flows for each of the three years in
the period ended December 31, 2001, in conformity with
accounting principles generally accepted in the United States.
Also, in our opinion, the related financial statement schedule,
when considered in relation to the basic financial statements
taken as a whole, presents fairly in all material respects the
information set forth therein.

As discussed in Note 1 to the consolidated
financial statements, in 2000 the Company changed its method of
accounting for nonrefundable license fee revenue.



| |                      
| | ---------------------
| | /s/ ERNST & YOUNG LLP

Palo Alto, California

January 28, 2002


except for the Note titled Subsequent Event


as to which the date is March 26, 2002


F-2



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CONNETICS CORPORATION






CONSOLIDATED BALANCE SHEETS


|                                         |                                                                                                                                          |                                            |        |          |        |   |        |         |        | 
|---------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------ | -------- | ------ | - | ------ | ------- | ------ | 
|                                         |                                                                                                                                          |                                           
|                                         |                                                                                                                                          | December 31,                              
|                                         |                                                                                                                                          |                                           
|                                         |                                                                                                                                          | 2001                                       |        | 2000    
|                                         |                                                                                                                                          |                                            |        |         
|                                         |                                                                                                                                          |                                           
|                                         |                                                                                                                                          | (In thousands, except                     
|                                         |                                                                                                                                          | share and per share                       
|                                         |                                                                                                                                          | amounts)                                  
|ASSETS                                  
|Current assets:                          |                                                                                                                                          |                                            |        |          |        |   |        |        
|                                         | Cash and cash equivalents                                                                                                                |                                            | $      | 3,603    |        |   | $      | 58,314  |       
|                                         | Short-term investments                                                                                                                   |                                            |        | 42,734   |        |   |        | 21,607  |       
|                                         | Accounts receivable, net                                                                                                                 |                                            |        | 5,392    |        |   |        | 2,749   |       
|                                         | Restricted cash                                                                                                                          |                                            |        | 1,539    |        |   |        | 263     |       
|                                         | Other current assets                                                                                                                     |                                            |        | 1,204    |        |   |        | 545     |       
|                                         |                                                                                                                                          |                                            |        |          |        |   |        |        
|                                         |                                                                                                                                          | Total current assets                       |        |          | 54,472 |   |        |         | 83,478 | 
|Property and equipment, net              |                                                                                                                                          |                                            | 3,167  |          |        |   | 1,807  |        
|Restricted cash                          |                                                                                                                                          |                                            | 600    |          |        |   |       |        
|Deposits and other assets                |                                                                                                                                          |                                            | 332    |          |        |   | 428    |        
|Goodwill, net                            |                                                                                                                                          |                                            | 6,132  |          |        |   |       |        
|Other intangible assets, net             |                                                                                                                                          |                                            | 7,624  |          |        |   |       |        
|                                         |                                                                                                                                          |                                            |        |          |        |   |        |        
|Total assets                             |                                                                                                                                          | $                                          | 72,327 |          |        | $ | 85,713 |        
|                                         |                                                                                                                                          |                                            |        |          |        |   |        |        
|                                        
|LIABILITIES AND STOCKHOLDERS
	EQUITY   
|Current liabilities:                     |                                                                                                                                          |                                            |        |          |        |   |        |        
|                                         | Accounts payable                                                                                                                         |                                            | $      | 3,636    |        |   | $      | 5,115   |       
|                                         | Other accrued liabilities                                                                                                                |                                            |        | 1,507    |        |   |        | 2,715   |       
|                                         | Current portion of deferred revenue                                                                                                      |                                            |        | 832      |        |   |        | 132     |       
|                                         | Accrued process development expenses                                                                                                     |                                            |        | 1,209    |        |   |        | 1,389   |       
|                                         | Accrued payroll and related expenses                                                                                                     |                                            |        | 2,599    |        |   |        | 1,797   |       
|                                         | Current portion of long term debt and capital
	lease obligations                                                                         |                                            |        |         |        |   |        | 787     |       
|                                         | Other current liabilities                                                                                                                |                                            |        | 663      |        |   |        | 513     |       
|                                         |                                                                                                                                          |                                            |        |          |        |   |        |        
|                                         |                                                                                                                                          | Total current liabilities                  |        |          | 10,446 |   |        |         | 12,448 | 
|Deferred revenue, net of current portion |                                                                                                                                          |                                            | 527    |          |        |   | 659    |        
|Commitments and contingencies            |                                                                                                                                          |                                            |        |          |        |   |        |        
|Stockholders equity:                    |                                                                                                                                          |                                            |        |          |        |   |        |        
|                                         | Preferred stock, $0.001 par value:                                                                                                       |                                            |        |          |        |   |        |         |       
|                                         | 5,000,000 shares authorized; none issued or
	outstanding                                                                                 |                                            |        |         |        |   |        |        |       
|                                         | Common stock, $0.001 par value; 50,000,000 shares
	authorized; shares issued and outstanding: 30,256,965 in 2001
	and 29,684,854 in 2000 |                                            |        | 29       |        |   |        | 29      |       
|                                         | Additional paid-in capital                                                                                                               |                                            |        | 164,271  |        |   |        | 159,213 |       
|                                         | Deferred compensation                                                                                                                    |                                            |        | (69      | )      |   |        | (21     | )     
|                                         | Accumulated deficit                                                                                                                      |                                            |        | (109,498 | )      |   |        | (92,756 | )     
|                                         | Accumulated other comprehensive income                                                                                                   |                                            |        | 6,621    |        |   |        | 6,141   |       
|                                         |                                                                                                                                          |                                            |        |          |        |   |        |        
|                                         |                                                                                                                                          | Total stockholders equity                 |        |          | 61,354 |   |        |         | 72,606 | 
|                                         |                                                                                                                                          |                                            |        |          |        |   |        |        
|                                         |                                                                                                                                          | Total liabilities and stockholders equity |        | $        | 72,327 |   |        | $       | 85,713 | 
|                                         |                                                                                                                                          |                                            |        |          |        |   |        |        

See accompanying Notes to Consolidated Financial
Statements.

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CONNETICS CORPORATION

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                     |                                                                                            |                                 |         |         |        |      |         |        |        |  |         |         |        |  
|------------------------------------ | ------------------------------------------------------------------------------------------ | ------------------------------- | ------- | ------- | ------ | ---- | ------- | ------ | ------ |  | ------- | ------- | ------ | -
|                                     |                                                                                            |                                
|                                     |                                                                                            | Years Ended December 31,       
|                                     |                                                                                            |                                
|                                     |                                                                                            | 2001                            |         | 2000    |        | 1999
|                                     |                                                                                            |                                 |         |         |        |     
|                                     |                                                                                            |                                
|                                     |                                                                                            | (In thousands, except per share
|                                     |                                                                                            | amounts)                       
|Revenues:                            |                                                                                            |                                 |         |         |        |      |         |        |        |  |         |        
|                                     | Product                                                                                    |                                 | $       | 30,923  |        |      | $       | 20,095 |        |  | $       | 16,595  |       
|                                     | Royalty                                                                                    |                                 |         | 1,097   |        |      |         |       |        |  |         |        |       
|                                     | License, contract and other                                                                |                                 |         | 2,044   |        |      |         | 20,679 |        |  |         | 10,311  |       
|                                     |                                                                                            |                                 |         |         |        |      |         |        |        |  |         |        
|                                     |                                                                                            | Total revenues                  |         |         | 34,064 |      |         |        | 40,774 |  |         |         | 26,906 |  
|Operating costs and expenses:        |                                                                                            |                                 |         |         |        |      |         |        |        |  |         |        
|                                     | Cost of product revenues                                                                   |                                 |         | 3,123   |        |      |         | 3,868  |        |  |         | 5,229   |       
|                                     | Research and development                                                                   |                                 |         | 19,156  |        |      |         | 21,875 |        |  |         | 21,309  |       
|                                     | Selling, general and administrative                                                        |                                 |         | 36,062  |        |      |         | 26,673 |        |  |         | 20,834  |       
|                                     | Acquired in-process research and development                                               |                                 |         | 1,080   |        |      |         |       |        |  |         | 1,000   |       
|                                     | Loss on program termination                                                                |                                 |         | 1,142   |        |      |         |       |        |  |         |        |       
|                                     | License amortization                                                                       |                                 |         |        |        |      |         |       |        |  |         | 6,160   |       
|                                     |                                                                                            |                                 |         |         |        |      |         |        |        |  |         |        
|                                     | Total operating costs and expenses                                                         |                                 |         | 60,563  |        |      |         | 52,416 |        |  |         | 54,532  |       
|                                     |                                                                                            |                                 |         |         |        |      |         |        |        |  |         |        
|Loss from operations                 |                                                                                            |                                 | (26,499 | )       |        |      | (11,642 | )      |        |  | (27,626 | )      
|Interest and other income (expense): |                                                                                            |                                 |         |         |        |      |         |        |        |  |         |        
|                                     | Interest income                                                                            |                                 |         | 2,543   |        |      |         | 2,108  |        |  |         | 1,068   |       
|                                     | Gain on sale of investment                                                                 |                                 |         | 122     |        |      |         | 42,967 |        |  |         |        |       
|                                     | Gain on sale of Ridaura product line                                                       |                                 |         | 8,002   |        |      |         |       |        |  |         |        |       
|                                     | Interest expense                                                                           |                                 |         | (46     | )      |      |         | (235   | )      |  |         | (868    | )     
|                                     | Other income (expense), net                                                                |                                 |         | (519    | )      |      |         |       |        |  |         | 143     |       
|                                     |                                                                                            |                                 |         |         |        |      |         |        |        |  |         |        
|                                     | Income (loss) before income taxes and
	cumulative effect of change in accounting principle |                                 |         | (16,397 | )      |      |         | 33,198 |        |  |         | (27,283 | )     
|                                     |                                                                                            |                                 |         |         |        |      |         |        |        |  |         |        
|                                     | Income tax provision                                                                       |                                 |         | (345    | )      |      |         | (1,010 | )      |  |         |        |       
|                                     |                                                                                            |                                 |         |         |        |      |         |        |        |  |         |        
|                                     | Income (loss) before cumulative effect of
	change in accounting principle                  |                                 |         | (16,742 | )      |      |         | 32,188 |        |  |         | (27,283 | )     
|                                     | Cumulative effect of change in accounting
	principle, net of tax                           |                                 |         |        |        |      |         | (5,192 | )      |  |         |        |       
|                                     |                                                                                            |                                 |         |         |        |      |         |        |        |  |         |        
|                                     | Net income (loss)                                                                          |                                 | $       | (16,742 | )      |      | $       | 26,996 |        |  | $       | (27,283 | )     
|                                     |                                                                                            |                                 |         |         |        |      |         |        |        |  |         |        
|Basic Earnings Per Share            |                                                                                            |                                 |         |         |        |      |         |        |        |  |         |        
|                                     | Income (loss) per share before cumulative
	effect of change in accounting principle        |                                 | $       | (0.56   | )      |      | $       | 1.13   |        |  | $       | (1.21   | )     
|                                     | Cumulative effect of change in accounting
	principle, net of tax                           |                                 |         |        |        |      |         | (0.18  | )      |  |         |        |       
|                                     | Net income (loss) per share                                                                |                                 | $       | (0.56   | )      |      | $       | 0.95   |        |  | $       | (1.21   | )     
|Diluted Earnings Per
	Share         |                                                                                            |                                 |         |         |        |      |         |        |        |  |         |        
|                                     | Income (loss) per share before cumulative
	effect of change in accounting principle        |                                 | $       | (0.56   | )      |      | $       | 1.07   |        |  | $       | (1.21   | )     
|                                     | Cumulative effect of change in accounting
	principle, net of tax                           |                                 |         |        |        |      |         | (0.17  | )      |  |         |        |       
|                                     | Net income (loss) per share                                                                |                                 | $       | (0.56   | )      |      | $       | 0.90   |        |  | $       | (1.21   | )     
|                                     | Shares used to compute basic net income
	(loss) per share                                  |                                 |         | 29,861  |        |      |         | 28,447 |        |  |         | 22,619  |       
|                                     | Shares used to compute diluted net income
	(loss) per share                                |                                 |         | 29,861  |        |      |         | 30,086 |        |  |         | 22,619  |       
|                                     | Pro forma amounts assuming the accounting change
	was applied retroactively:               |                                 |         |         |        |      |         |        |        |  |         |         |       
|                                     | Net income (loss)                                                                          |                                 |         | (16,742 | )      |      |         | 32,188 |        |  |         | (30,968 | )     
|                                     | Net income (loss) per share                                                                |                                 |         |         |        |      |         |        |        |  |         |         |       
|                                     |                                                                                            | Basic                           |         | $       | (0.56  | )    |         | $      | 1.13   |  |         | $       | (1.37  | )
|                                     |                                                                                            | Diluted                         |         | $       | (0.56  | )    |         | $      | 1.07   |  |         | $       | (1.37  | )
|                                     |                                                                                            |                                 |         |         |        |      |         |        |        |  |         |        

See accompanying Notes to Consolidated Financial
Statements.

F-4



---



##### Table of Contents



CONNETICS CORPORATION






CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY


|                                                                                                       |                                |                |        |        |  |            |    |            |  |              |         |             |  |               |     |               |  |   |      |   |  |   |          |         |   |   |       |     |  |   |         |         |  
|------------------------------------------------------------------------------------------------------ | ------------------------------ | -------------- | ------ | ------ |  | ---------- | -- | ---------- |  | ------------ | ------- | ----------- |  | ------------- | --- | ------------- |  | - | ---- | - |  | - | -------- | ------- | - | - | ----- | --- |  | - | ------- | ------- | -
|                                                                                                       |                                | Number of      |        |        |  |            |    |            |  |              |         |             |  | Accumulated   |     |              
|                                                                                                       |                                | Common         |        | Common |  | Additional |    |            |  |              |         |             |  | Other         |     | Total        
|                                                                                                       |                                | Shares         |        | Stock  |  | Paid-in    |    | Notes      |  | Deferred     |         | Accumulated |  | Comprehensive |     | Stockholders
|                                                                                                       |                                | Outstanding    |        | Amount |  | Capital    |    | Receivable |  | Compensation |         | Deficit     |  | Income        |     | Equity       
|                                                                                                       |                                |                |        |        |  |            |    |            |  |              |         |             |  |               |     |              
|                                                                                                       |                                |               
|                                                                                                       |                                | (In thousands)
|Balance at December 31, 1998                                                                           |                                |                | 20,577 |        |  | $          | 20 |            |  | $            | 105,265 |             |  | $             | (65 | )             |  | $ | (302 | ) |  | $ | (92,469  | )       |   | $ | 3     |     |  | $ | 12,452  |        
|Common stock issued under stock option and
	purchase plans                                             |                                |                | 542    |        |  |            |    |            |  |              | 916     |             |  |               |    |               |  |   |     |   |  |   |         |         |   |   |      |     |  |   | 916     |        
|Issuance of common stock pursuant to license
	agreements                                               |                                |                | 672    |        |  |            | 1  |            |  |              | 5,119   |             |  |               |    |               |  |   |     |   |  |   |         |         |   |   |      |     |  |   | 5,120   |        
|Issuance of common stock pursuant to secondary
	offering, net                                          |                                |                | 4,920  |        |  |            | 5  |            |  |              | 21,928  |             |  |               |    |               |  |   |     |   |  |   |         |         |   |   |      |     |  |   | 21,933  |        
|Issuance of common stock and amendment to
	guaranteed market value of common stock issued to Genentech |                                |                | 229    |        |  |            |    |            |  |              |        |             |  |               |    |               |  |   |     |   |  |   |         |         |   |   |      |     |  |   |        |        
|Repayment of notes receivable                                                                          |                                |                | (36    | )      |  |            |    |            |  |              | (315    | )           |  |               | 65  |               |  |   |     |   |  |   |         |         |   |   |      |     |  |   | (250    | )      
|Deferred compensation, net                                                                             |                                |                |       |        |  |            |    |            |  |              | 1,024   |             |  |               |    |               |  |   | 263  |   |  |   |         |         |   |   |      |     |  |   | 1,287   |        
|Comprehensive loss:                                                                                    |                                |                |        |        |  |            |    |            |  |              |         |             |  |               |     |               |  |   |      |   |  |   |          |         |   |   |       |     |  |   |         |        
|                                                                                                       | Net loss                       |                |        |       |  |            |    |           |  |              |         |            |  |               |     |              |  |   |      |  |  |   |          | (27,283 | ) |   |       |    |  |   |         | (27,283 | )
|                                                                                                       | Unrealized gain on investments |                |        |       |  |            |    |           |  |              |         |            |  |               |     |              |  |   |      |  |  |   |          |        |   |   |       | 113 |  |   |         | 113     |  
|                                                                                                       |                                |                |        |        |  |            |    |            |  |              |         |             |  |               |     |               |  |   |      |   |  |   |          |         |   |   |       |     |  |   |         |        
|                                                                                                       | Total comprehensive loss       |                |        |        |  |            |    |            |  |              |         |             |  |               |     |               |  |   |      |   |  |   |          |         |   |   |       |     |  |   |         | (27,170 | )
|                                                                                                       |                                |                |        |        |  |            |    |            |  |              |         |             |  |               |     |               |  |   |      |   |  |   |          |         |   |   |       |     |  |   |         |        
|Balance at December 31, 1999                                                                           |                                |                | 26,904 |        |  |            | 26 |            |  |              | 133,937 |             |  |               |    |               |  |   | (39  | ) |  |   | (119,752 | )       |   |   | 116   |     |  |   | 14,288  |        
|Common stock issued under stock option and
	purchase plans                                             |                                |                | 561    |        |  |            | 1  |            |  |              | 2,297   |             |  |               |    |               |  |   |     |   |  |   |         |         |   |   |      |     |  |   | 2,298   |        
|Issuance of common stock pursuant to license
	agreements                                               |                                |                | 90     |        |  |            |   |            |  |              | 561     |             |  |               |    |               |  |   |     |   |  |   |         |         |   |   |      |     |  |   | 561     |        
|Issuance of common stock pursuant to private
	placement                                                |                                |                | 2,010  |        |  |            | 2  |            |  |              | 19,978  |             |  |               |    |               |  |   |     |   |  |   |         |         |   |   |      |     |  |   | 19,980  |        
|Issuance of common stock pursuant to equity line                                                       |                                |                | 100    |        |  |            |   |            |  |              | 814     |             |  |               |    |               |  |   |     |   |  |   |         |         |   |   |      |     |  |   | 814     |        
|Exercise of warrants                                                                                   |                                |                | 20     |        |  |            |   |            |  |              | 247     |             |  |               |    |               |  |   |     |   |  |   |         |         |   |   |      |     |  |   | 247     |        
|Stock compensation expense                                                                             |                                |                |       |        |  |            |   |            |  |              | 1,092   |             |  |               |    |               |  |   |     |   |  |   |         |         |   |   |      |     |  |   | 1,092   |        
|Tax benefit realized from stock option exercises                                                       |                                |                |       |        |  |            |   |            |  |              | 287     |             |  |               |    |               |  |   |     |   |  |   |         |         |   |   |      |     |  |   | 287     |        
|Deferred compensation, net                                                                             |                                |                |       |        |  |            |   |            |  |              |        |             |  |               |    |               |  |   | 18   |   |  |   |         |         |   |   |      |     |  |   | 18      |        
|Comprehensive income:                                                                                  |                                |                |        |        |  |            |    |            |  |              |         |             |  |               |     |               |  |   |      |   |  |   |          |         |   |   |       |     |  |   |         |        
|Net income                                                                                             |                                |                |       |        |  |            |   |            |  |              |        |             |  |               |    |               |  |   |     |   |  |   | 26,996   |         |   |   |      |     |  |   | 26,996  |        
|Unrealized gain on investments                                                                         |                                |                |       |        |  |            |   |            |  |              |        |             |  |               |    |               |  |   |     |   |  |   |         |         |   |   | 6,025 |     |  |   | 6,025   |        
|                                                                                                       |                                |                |        |        |  |            |    |            |  |              |         |             |  |               |     |               |  |   |      |   |  |   |          |         |   |   |       |     |  |   |         |        
|                                                                                                       | Total comprehensive income     |                |        |        |  |            |    |            |  |              |         |             |  |               |     |               |  |   |      |   |  |   |          |         |   |   |       |     |  |   |         | 33,021  |  
|                                                                                                       |                                |                |        |        |  |            |    |            |  |              |         |             |  |               |     |               |  |   |      |   |  |   |          |         |   |   |       |     |  |   |         |        
|Balance at December 31, 2000                                                                           |                                |                | 29,685 |        |  |            | 29 |            |  |              | 159,213 |             |  |               |    |               |  |   | (21  | ) |  |   | (92,756  | )       |   |   | 6,141 |     |  |   | 72,606  |        
|Common stock issued under stock option and
	purchase plans                                             |                                |                | 519    |        |  |            |   |            |  |              | 2,070   |             |  |               |    |               |  |   |     |   |  |   |         |         |   |   |      |     |  |   | 2,070   |        
|Issuance of common stock pursuant to license
	agreements                                               |                                |                | 1      |        |  |            |   |            |  |              | 12      |             |  |               |    |               |  |   |     |   |  |   |         |         |   |   |      |     |  |   | 12      |        
|Exercise of warrants                                                                                   |                                |                | 52     |        |  |            |   |            |  |              | 392     |             |  |               |    |               |  |   |     |   |  |   |         |         |   |   |      |     |  |   | 392     |        
|Stock compensation expense                                                                             |                                |                |       |        |  |            |   |            |  |              | 2,584   |             |  |               |    |               |  |   | (48  | ) |  |   |         |         |   |   |      |     |  |   | 2,536   |        
|Comprehensive income:                                                                                  |                                |                |        |        |  |            |    |            |  |              |         |             |  |               |     |               |  |   |      |   |  |   |          |         |   |   |       |     |  |   |         |        
|Net loss                                                                                               |                                |                |       |        |  |            |   |            |  |              |        |             |  |               |    |               |  |   |     |   |  |   | (16,742  | )       |   |   |      |     |  |   | (16,742 | )      
|Unrealized gain on investments                                                                         |                                |                |       |        |  |            |   |            |  |              |        |             |  |               |    |               |  |   |     |   |  |   |         |         |   |   | 503   |     |  |   | 503     |        
|Foreign currency translation adjustment                                                                |                                |                |       |        |  |            |   |            |  |              |        |             |  |               |    |               |  |   |     |   |  |   |         |         |   |   | (23   | )   |  |   | (23     | )      
|                                                                                                       |                                |                |        |        |  |            |    |            |  |              |         |             |  |               |     |               |  |   |      |   |  |   |          |         |   |   |       |     |  |   |         |        
|Total comprehensive loss                                                                               |                                |                |        |        |  |            |    |            |  |              |         |             |  |               |     |               |  |   |      |   |  |   |          |         |   |   |       |     |  |   | (16,262 | )      
|                                                                                                       |                                |                |        |        |  |            |    |            |  |              |         |             |  |               |     |               |  |   |      |   |  |   |          |         |   |   |       |     |  |   |         |        
|Balance at December 31, 2001                                                                           |                                |                | 30,257 |        |  | $          | 29 |            |  | $            | 164,271 |             |  | $             |    |               |  | $ | (69  | ) |  | $ | (109,498 | )       |   | $ | 6,621 |     |  | $ | 61,354  |        
|                                                                                                       |                                |                |        |        |  |            |    |            |  |              |         |             |  |               |     |               |  |   |      |   |  |   |          |         |   |   |       |     |  |   |         |        

See accompanying Notes to Consolidated Financial
Statements.

F-5



---



##### Table of Contents



CONNETICS CORPORATION

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                                      |                                                                                    |                                                |   |         |        |      |   |         |         |   |   |         |        |  
|--------------------------------------------------------------------- | ---------------------------------------------------------------------------------- | ---------------------------------------------- | - | ------- | ------ | ---- | - | ------- | ------- | - | - | ------- | ------ | -
|                                                                      |                                                                                    |                                               
|                                                                      |                                                                                    | Years Ended December 31,                      
|                                                                      |                                                                                    |                                               
|                                                                      |                                                                                    | 2001                                           |   | 2000    |        | 1999
|                                                                      |                                                                                    |                                                |   |         |        |     
|                                                                      |                                                                                    |                                               
|                                                                      |                                                                                    | (In thousands)                                
|Cash flows from operating
	activities:                                |                                                                                    |                                                |   |         |        |      |   |         |         |   |   |        
|                                                                      | Net income (loss)                                                                  |                                                | $ | (16,742 | )      |      | $ | 26,996  |         |   | $ | (27,283 | )     
|                                                                      | Adjustments to reconcile net loss to net cash
	used in operating activities:       |                                                |   |         |        |      |   |         |         |   |   |         |       
|                                                                      |                                                                                    | Depreciation                                   |   |         | 953    |      |   |         | 764     |   |   |         | 505    |  
|                                                                      |                                                                                    | Amortization of goodwill and intangible assets |   |         | 1,057  |      |   |         |        |   |   |         | 6,160  |  
|                                                                      |                                                                                    | Gain on sale of investment                     |   |         | (122   | )    |   |         | (42,967 | ) |   |         |       |  
|                                                                      |                                                                                    | Gain on sale of Ridaura product line           |   |         | (8,002 | )    |   |         |        |   |   |         |       |  
|                                                                      |                                                                                    | Stock compensation expense                     |   |         | 2,536  |      |   |         | 1,110   |   |   |         | 1,287  |  
|                                                                      |                                                                                    | In-process research and development            |   |         | 1,080  |      |   |         |        |   |   |         |       |  
|                                                                      |                                                                                    | Loss on foreign exchange forward contract      |   |         | 555    |      |   |         |        |   |   |         |       |  
|                                                                      |                                                                                    | Stock issued pursuant to license agreement     |   |         | 12     |      |   |         |        |   |   |         |       |  
|                                                                      | Changes in assets and liabilities:                                                 |                                                |   |         |        |      |   |         |         |   |   |         |       
|                                                                      |                                                                                    | Accounts receivable, net                       |   |         | (1,091 | )    |   |         | (1,141  | ) |   |         | (1,123 | )
|                                                                      |                                                                                    | Other assets                                   |   |         | (588   | )    |   |         | 25      |   |   |         | (255   | )
|                                                                      |                                                                                    | Accounts payable                               |   |         | (1,645 | )    |   |         | 220     |   |   |         | 3,759  |  
|                                                                      |                                                                                    | Accrued and other current liabilities          |   |         | (3,166 | )    |   |         | (1,139  | ) |   |         | 2,829  |  
|                                                                      |                                                                                    | Deferred revenue                               |   |         | 568    |      |   |         | 791     |   |   |         |       |  
|                                                                      |                                                                                    |                                                |   |         |        |      |   |         |         |   |   |        
|                                                                      | Net cash used in operating activities                                              |                                                |   | (24,595 | )      |      |   | (15,341 | )       |   |   | (14,121 | )     
|                                                                      |                                                                                    |                                                |   |         |        |      |   |         |         |   |   |        
|Cash flows from investing
	activities:                                |                                                                                    |                                                |   |         |        |      |   |         |         |   |   |        
|                                                                      | Purchases of short-term investments                                                |                                                | $ | (56,371 | )      |      | $ | (23,148 | )       |   | $ | (12,852 | )     
|                                                                      | Sales and maturities of short-term investments                                     |                                                |   | 35,870  |        |      |   | 68,372  |         |   |   | 3,438   |       
|                                                                      | Purchases of property and equipment                                                |                                                |   | (1,758  | )      |      |   | (1,066  | )       |   |   | (882    | )     
|                                                                      | Proceeds from sale of Ridaura product line                                         |                                                |   | 8,979   |        |      |   |        |         |   |   |        |       
|                                                                      | Acquisition of business, net of cash acquired                                      |                                                |   | (16,611 | )      |      |   |        |         |   |   |        |       
|                                                                      |                                                                                    |                                                |   |         |        |      |   |         |         |   |   |        
|                                                                      | Net cash provided by (used in) investing
	activities                               |                                                |   | (29,891 | )      |      |   | 44,158  |         |   |   | (10,296 | )     
|                                                                      |                                                                                    |                                                |   |         |        |      |   |         |         |   |   |        
|Cash flows from financing
	activities:                                |                                                                                    |                                                |   |         |        |      |   |         |         |   |   |        
|                                                                      | Restricted cash                                                                    |                                                |   | (1,876  | )      |      |   | (263    | )       |   |   |        |       
|                                                                      | Payments of debt                                                                   |                                                |   | (750    | )      |      |   | (1,000  | )       |   |   | (2,250  | )     
|                                                                      | Payment of notes payable                                                           |                                                |   |        |        |      |   | (1,553  | )       |   |   | (6,300  | )     
|                                                                      | Payments on obligations under capital leases                                       |                                                |   | (37     | )      |      |   | (47     | )       |   |   | (531    | )     
|                                                                      | Proceeds from issuance of common stock, net                                        |                                                |   | 2,462   |        |      |   | 23,900  |         |   |   | 27,250  |       
|                                                                      |                                                                                    |                                                |   |         |        |      |   |         |         |   |   |        
|                                                                      | Net cash provided by (used in) financing
	activities                               |                                                |   | (201    | )      |      |   | 21,037  |         |   |   | 18,169  |       
|                                                                      | Effect of foreign currency exchange rates on cash
	and cash equivalents            |                                                |   | (24     | )      |      |   |        |         |   |   |        |       
|                                                                      |                                                                                    |                                                |   |         |        |      |   |         |         |   |   |        
|                                                                      | Net change in cash and cash equivalents                                            |                                                |   | (54,711 | )      |      |   | 49,854  |         |   |   | (6,248  | )     
|                                                                      | Cash and cash equivalents at beginning of year                                     |                                                |   | 58,314  |        |      |   | 8,460   |         |   |   | 14,708  |       
|                                                                      |                                                                                    |                                                |   |         |        |      |   |         |         |   |   |        
|                                                                      | Cash and cash equivalents at end of year                                           |                                                | $ | 3,603   |        |      | $ | 58,314  |         |   | $ | 8,460   |       
|                                                                      |                                                                                    |                                                |   |         |        |      |   |         |         |   |   |        
|Supplementary information:                                            |                                                                                    |                                                |   |         |        |      |   |         |         |   |   |        
|                                                                      | Interest paid                                                                      |                                                | $ | 46      |        |      | $ | 235     |         |   | $ | 864     |       
|Supplemental schedule of noncash investing and
	financing activities: |                                                                                    |                                                |   |         |        |      |   |         |         |   |   |        
|                                                                      | Conversion of notes payable into common stock                                      |                                                | $ |        |        |      | $ |        |         |   | $ | 719     |       
|                                                                      | Deferred compensation related to stock options,
	purchase rights and purchase plan |                                                | $ |        |        |      | $ |        |         |   | $ | 747     |       
|                                                                      |                                                                                    |                                                |   |         |        |      |   |         |         |   |   |        

See accompanying Notes to Consolidated Financial
Statements.

F-6



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##### Table of Contents



CONNETICS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

December 31, 2001


1.     Organization
and Summary of Significant Accounting Policies



| |             
| | ------------
| | Organization

Connetics Corporation was incorporated in the
State of Delaware on February 8, 1993. Since our inception
we have principally been involved in the development of
therapeutics for a variety of human diseases and disorders.
Since our inception, we have completed numerous financings,
secured operating facilities, and entered a variety of business
development opportunities. In 2001, we announced our decision to
focus our resources on expanding our dermatology business.

In March 1999, we received marketing clearance
from the U.S. Food and Drug Administration, or FDA, to sell
Luxíq and in April 1999, we launched Luxíq. In May
2000, OLUX was approved and in November 2000 we began selling
the product. These products are approved for the treatment of
corticosteroid-responsive scalp dermatoses. We cannot assure you
that any of our other potential products will be successfully
developed, receive the necessary regulatory approvals or be
successfully commercialized. Accordingly, our ability to
continue our development and commercialization activities is
dependent upon the ability of our management to obtain
substantial additional financing.

In the course of our development activities, we
have sustained continuing operating losses and expect such
losses to continue for at least the next few years. Our future
capital uses and requirements depend on numerous factors,
including the level of product revenues, the possible
acquisition of new products and technologies, the development of
commercialization activities, the progress of our research and
development programs, the progress of clinical testing, the time
and costs involved in obtaining regulatory approvals, the cost
of filing, prosecuting, and enforcing patent claims and other
intellectual property rights, competing technological and market
developments, and our ability to establish collaborative
arrangements. Therefore, our uses of capital and our
requirements may increase in future periods. As a result, we may
require additional funds before we are able to sustain
profitability and we may attempt to raise additional funds
through equity or debt financings, collaborative arrangements
with corporate partners or from other sources.

We currently have no commitments for any
additional financings, and we cannot assure you that additional
funding will be available to finance our ongoing operations when
needed or, if available, that the terms for obtaining such funds
will be favorable or will not result in dilution to the our
stockholders. If we are not able to obtain sufficient funds, we
could be required to delay, scale back or eliminate some or all
of our research and development programs, to limit the marketing
of our products or to license to third parties the rights to
commercialize products or technologies that we would otherwise
seek to develop and market ourselves.



| |                            
| | ---------------------------
| | Principles of Consolidation

The consolidated financial statements include the
accounts of Connetics and its two subsidiaries, Soltec Research
Pty. Ltd. (Soltec) since April 20, 2001, the day following
the acquisition (see Note 4), and InterMune
Pharmaceuticals, Inc. (now InterMune, Inc.), through
April 28, 1999, when InterMune became an independent
company (see Note 12).At that date our investment in
InterMune was diluted from 100% to 9% and we began accounting
for our investment using the cost method. All significant
intercompany accounts and transactions have been eliminated in
consolidation.



| |                 
| | ----------------
| | Use of Estimates

The preparation of financial statements in
conformity with accounting principles generally accepted in the
United States requires management to make estimates and
assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ
from those estimates.

F-7



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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                    
| | -------------------
| | Revenue Recognition

Product Sales.We
recognize revenue from product sales when there is persuasive
evidence that an arrangement exists, when title has passed, the
price is fixed and determinable, and collection of the resulting
receivable is reasonably assured. We recognize product revenue
net of allowances for estimated returns, rebates and
chargebacks. We are obligated to accept from customers the
return of pharmaceuticals that have reached their expiration
date. To date we have not experienced significant returns of
expired product. Product shipping and handling costs are
included in cost of product revenues.

Royalty Revenue.Royalties from licensees are based on
third-party sales. We recognize royalties in the quarter in
which the royalty payment is either received from the licensee
or may be reasonably estimated, which is typically one quarter
following the related sale by the licensee.

Royalty expenses directly related to product
sales are classified in cost of product revenues. Royalty
expenses totaled $0.7 million in 2001, $2.1 million in
2000, and $2.6 million in 1999. The reduction in royalty
expenses in 2001 compared to 2000 was due to the effects of the
Soltec acquisition. Royalty expenses related to agreements with
Soltec are now eliminated in consolidation.

Contract Revenue.We
record contract revenue for research and development, or
R&D, as it is earned based on the performance requirements
of the contract. We recognize non-refundable contract fees for
which no further performance obligations exist, and for which
Connetics has no continuing involvement, on the earlier of when
the payments are received or when collection is assured.

We recognize revenue from non-refundable upfront
license fees ratably over the period in which we have continuing
development obligations when, at the time the agreement is
executed, there remains significant risk due to the incomplete
state of the products development. Revenue associated with
substantial at risk performance milestones, as
defined in the respective agreements, is recognized based upon
the achievement of the milestones. We recognize revenue under
R&D cost reimbursement contracts as the related costs are
incurred. Advance payments that we receive in excess of amounts
earned are classified as deferred revenue until they are earned.

Prior to 2000, we previously recognized
non-refundable license fees received in connection with
collaborative agreements as revenue when we received the fees,
when the technology had been transferred, and when all
significant contractual obligations of Connetics relating to the
fees had been fulfilled. Effective January 1, 2000, we
changed our method of accounting for non-refundable license fees
to recognize such fees over the expected research and
development period. We believe the change in accounting
principle is preferable based on guidance in SEC Staff
Accounting Bulletin (SAB) No. 101,
Revenue Recognition in Financial Statements.

The $5.2 million cumulative effect of the
change in accounting principle, calculated as of January 1,
2000, was reported as a charge in the year ended
December 31, 2000. The cumulative effect was initially
recorded as deferred revenue and is being recognized as revenue
over the research and development period of the agreements.
During the year ended December 31, 2000, the impact of this
change in accounting method (excluding the cumulative effect
itself) increased net income by $4.4 million or $0.15 per
share. This increase consists of $4.9 million revenue
deferred in the cumulative effect that was recognized as income
in 2000 under the new accounting method, offset by the impact of
deferring upfront fees received in 2000. During 2000,
approximately $4.1 million of revenue deferred as a
component of the cumulative effect charge was fully recognized
in the fourth quarter when two of our collaboration partners
terminated their agreements with us as a result of the failure
of relaxin to meet the primary endpoint in a Phase III trial,
and Connetics was released from further obligations. Revenue for
2001 includes $132,000 of revenue previously recognized and
included in the cumulative effect adjustment. The unamortized
balance of deferred revenue at December 31, 2001 of
approximately $659,000 is expected to be recognized as revenue
of approximately $132,000 per year during the years ending 2002
through 2006. The pro forma amounts presented in the
consolidated statement of

F-8



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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

operations were calculated assuming the
accounting change had been in effect for prior periods, and was
made retroactive to prior periods.



| |                                             
| | --------------------------------------------
| | Cash Equivalents and Short-term
	Investments

Cash and cash equivalents consist of cash on
deposit with banks and money market instruments with original
maturities of 90 days or less at the date of purchase.
Investments with maturities beyond three months at the date of
acquisition and that mature within one year from the balance
sheet date are considered to be short-term investments.
Short-term investments are classified as available-for-sale at
the time of purchase and are carried at fair value, with
unrealized gains and losses reported as a separate component of
stockholders equity. The cost of securities sold is based
on the specific identification method.

Cash equivalents and investments are financial
instruments that potentially subject us to concentration of risk
to the extent recorded on the balance sheet. We believe we have
established guidelines for investment of our excess cash
relative to diversification and maturities that maintain safety
and liquidity. We invest our excess cash in debt instruments of
the U.S. Government and its agencies and high-quality corporate
issuers, and, by policy, restrict our exposure to any single
corporate issuer by imposing concentration limits. To minimize
the exposure due to adverse shifts in interest rates, we
maintain investments at an average maturity of generally less
than one year.



| |                 
| | ----------------
| | Foreign Currency

Soltecs functional currency is the
Australian dollar. We translate Soltecs local currency
balance sheet into U.S. dollars using the exchange rates in
effect at the balance sheet date; for revenue and expense
accounts we use a weighted average exchange rate during the
period. Foreign currency translation adjustments are recorded in
comprehensive income (loss). Net gains & losses resulting
from foreign exchange transactions are included in the
consolidated statement of operations and were immaterial for the
year ended December 31, 2001.



| |                                          
| | -----------------------------------------
| | Goodwill and Purchased Intangible
	Assets

Goodwill and purchased intangibles are amortized
on a straight-line basis over their estimated useful life of
10-year lives. See also the Recent Accounting
Pronouncements section below.



| |                       
| | ----------------------
| | Property and Equipment

Property and equipment are stated at cost less
accumulated depreciation. Depreciation is determined using the
straight-line method over the estimated useful lives of the
assets, generally three to five years. Leasehold improvements
and assets acquired under capital lease arrangements are
amortized over the shorter of the estimated useful lives of the
assets or the lease term.

F-9



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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                                 
| | --------------------------------
| | Impairment of Long Lived
	Assets

We periodically perform reviews to determine if
the carrying value of long-term assets (goodwill, purchased
intangibles, property and equipment) is impaired. The reviews
look for the existence of facts of circumstances, either
internal or external, which indicate that the carrying value of
the asset cannot be recovered. No such impairment has been
indicated to date. If in the future, management determines the
existence of impairment indicators, we would use undiscounted
cash flows to initially determine whether impairment should be
recognized. If necessary, we would perform subsequent
calculation to measure the amount of impairment loss based on
the excess of the carrying value over the fair value of the
impaired assets. If quoted market prices for the assets are not
available, the fair value would be calculated using the present
value of estimated expected future cash flows or other
appropriate valuation methodologies. The cash flow calculation
would be based on managements best estimates, using
appropriate assumption and projections at the time. See also the
Recent Accounting Pronouncements section below.



| |                                     
| | ------------------------------------
| | Fair Value of Financial
	Instruments

The fair value of our cash equivalents and
investments is based on quoted market prices. The fair value of
capital lease obligations and long-term debt is based on current
interest rates available to us for debt instruments with similar
terms, degrees of risk, and remaining maturities. The carrying
amount of cash equivalents, short-term investments, and capital
lease obligations are considered to be representative of their
respective fair values at December 31, 2001 and 2000.



| |                         
| | ------------------------
| | Research and Development

Research and development expenses include
salaries and benefits, laboratory supplies, external research
programs, clinical studies and allocated overhead costs such as
rent, supplies and utilities. All such costs are charged to
research and development expense as incurred.



| |            
| | -----------
| | Inventories

Inventories consist primarily of finished goods
and supplies and are valued at the lower of cost or market. In
general, cost is determined on the basis of average cost. All
such amounts are included in other current assets in the
Consolidated Balance Sheets.



| |                       
| | ----------------------
| | Certain Concentrations

Financial instruments that potentially subject us
to concentration of credit risk consist principally of
investments in debt securities and trade receivables. Management
believes the financial risks associated with these financial
instruments are minimal. We maintain our cash, cash equivalents
and investments with high-quality financial institutions. We do
not require collateral on accounts receivable.

We contract with independent sources to
manufacture our products. We currently rely on one manufacturer
to produce our products. If this manufacturer is unable to
fulfill our supply requirements, our future results could be
negatively impacted. We sell our products to wholesalers in the
United States.

For the year ended December 31, 2001, four
customers represented 29%, 26%, 18% and 12% of total product
sales, respectively and four customers represented 33%, 29%, 16%
and 14% of outstanding trade receivable, respectively. For the
year ended December 31, 2000, four customers represented
32%, 27%, 15% and 11% of total product sales respectively, and
three customers represented 45%, 26% and 10% of outstanding
trade receivable respectively. For the year ended
December 31, 1999, three customers represented 29%, 28% and
18% of total product sales respectively, and four customers
represented 41%, 18%, 14% and 11% of outstanding trade
receivables, respectively.

F-10



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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                            
| | ---------------------------
| | Comprehensive Income (Loss)

Comprehensive income (loss) represents net
income (loss), unrealized gains (losses) on our
available-for-sale securities, and foreign currency translation
adjustment, all net of taxes. Accumulated other comprehensive
income included $6.6 million of unrealized gains on
investments and $23,000 of foreign currency translation
adjustments as of December 31, 2001 and $6.1 million
of unrealized gains on investments and zero foreign currency
translation adjustments as of December 31, 2000.
Comprehensive income (loss) has been disclosed in the
Consolidated Statement of Stockholders Equity.



| |             
| | ------------
| | Income Taxes

Income taxes are accounted for under the asset
and liability method. Under this method, deferred tax assets and
liabilities are recognized for the future tax consequences
attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their
respective tax bases, and operating loss and tax credit
carryforwards. Deferred tax assets and liabilities are measured
using enacted tax rates expected to apply to taxable income in
the years in which those temporary differences are expected to
be recovered or settled. A valuation for net deferred tax assets
is established when realization is uncertain.



| |            
| | -----------
| | Advertising

We expense advertising costs as we incur them.
Advertising costs were $968,000 in 2001, $292,000 in 2000, and
$293,000 in 1999.



| |                         
| | ------------------------
| | Stock-Based Compensation

We use the intrinsic-value method of accounting
for stock-based awards granted to employees, as allowed under
Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees
(APB 25) and related interpretations.
Accordingly, no compensation expense is recognized in our
financial statements in connection with stock options granted to
employees with exercise prices not less than fair value. Also,
we do not record any compensation expense in connection with our
Employee Stock Purchase Plan as long as the purchase price is
not less than 85% of the fair market value at the beginning or
end of each offering period, whichever is lower.

We have determined compensation expense for
options granted to non-employees in accordance with SFAS 123 and
Emerging Issues Task Force No. 96-18, as the fair value of
the consideration received or the fair value of the equity
instruments issued, whichever is more reliably measured. We
periodically re-measure the compensation expense for options
granted to non-employees as the underlying options vest.



| |                            
| | ---------------------------
| | Net Income (Loss) Per Share

We compute basic net income (loss) per
common share by dividing net income (loss) applicable to
common stockholders by the weighted average number of common
shares outstanding during the period. We compute diluted net
income (loss) per share using the weighted average of all
common and diluted equivalent stock options and warrants
outstanding during the period. We excluded all stock option and
warrants from the calculation of diluted loss per common share
for the years ended December 31, 2001 and 1999 because
these securities were anti-dilutive during those years.

F-11



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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following table sets forth the computation of
basic and diluted earnings per share (in thousands except per
share amounts):

|                                    |                                               |                                                           |       |         |        |      |      |        |        |   |       |         |        | 
|----------------------------------- | --------------------------------------------- | --------------------------------------------------------- | ----- | ------- | ------ | ---- | ---- | ------ | ------ | - | ----- | ------- | ------ | 
|                                    |                                               |                                                          
|                                    |                                               | Years Ended December 31,                                 
|                                    |                                               |                                                          
|                                    |                                               | 2001                                                      |       | 2000    |        | 1999
|                                    |                                               |                                                           |       |         |        |     
|Numerator:                          |                                               |                                                           |       |         |        |      |      |        |        |   |       |        
|                                    | Net income (loss)                             |                                                           | $     | (16,742 | )      |      | $    | 26,996 |        |   | $     | (27,283 | )     
|                                    |                                               |                                                           |       |         |        |      |      |        |        |   |       |        
|                                    | Denominator for basic earnings per
	share    |                                                           |       |         |        |      |      |        |        |   |       |         |       
|                                    |                                               | Weighted-average shares                                   |       |         | 29,861 |      |      |        | 28,447 |   |       |         | 22,619 | 
|Effect of Dilutive Securities:      |                                               |                                                           |       |         |        |      |      |        |        |   |       |        
|                                    | Stock Options                                 |                                                           |       |        |        |      |      | 1,276  |        |   |       |        |       
|                                    | Warrants                                      |                                                           |       |        |        |      |      | 363    |        |   |       |        |       
|                                    |                                               |                                                           |       |         |        |      |      |        |        |   |       |        
|                                    | Denominator for diluted earnings per
	share  |                                                           |       |         |        |      |      |        |        |   |       |         |       
|                                    |                                               | Adjusted weighted-average shares and assumed
	Conversions |       |         | 29,861 |      |      |        | 30,086 |   |       |         | 22,619 | 
|                                    |                                               |                                                           |       |         |        |      |      |        |        |   |       |        
|Basic net income (loss) per share   |                                               | $                                                         | (0.56 | )       |        | $    | 0.95 |        |        | $ | (1.21 | )      
|Diluted net income (loss) per share |                                               | $                                                         | (0.56 | )       |        | $    | 0.90 |        |        | $ | (1.21 | )      



| |                                                                    
| | -------------------------------------------------------------------
| | Disclosure About Segments of an Enterprise
	and Related Information

Statement of Financial Accounting Standards
(SFAS) No. 131, Disclosures About
Segments of an Enterprise and Related Information,
requires us to identify the segment or segments we operate in.
We have determined that we operate in one segment, the
development and commercialization of pharmaceuticals as we
report revenue, profit and loss information on an aggregate
basis to our chief operating decision maker. For the years ended
December 31, 2001 and 2000, approximately 95% and 65%,
respectively, of our revenues were derived from customers in the
United States.

Revenues by product are as follows (in
thousands):

|          |  |                          |        |      |  |      |        |  |  |   |        | 
|--------- |  | ------------------------ | ------ | ---- |  | ---- | ------ |  |  | - | ------ | 
|          |  |                         
|          |  | Years Ended December 31,
|          |  |                         
|          |  | 2001                     |        | 2000 |  | 1999
|          |  |                          |        |      |  |     
|OLUX      |  | $                        | 14,996 |      |  | $    | 1,211  |  |  | $ |       | 
|Luxíq     |  |                          | 13,848 |      |  |      | 10,973 |  |  |   | 6,025  | 
|Ridaura   |  |                          | 2,015  |      |  |      | 6,013  |  |  |   | 5,737  | 
|Actimmune |  |                          |       |      |  |      | 1,898  |  |  |   | 4,833  | 
|Other     |  |                          | 64     |      |  |      |       |  |  |   |       | 
|          |  |                          |        |      |  |      |        |  |  |   |        | 
|          |  | $                        | 30,923 |      |  | $    | 20,095 |  |  | $ | 16,595 | 
|          |  |                          |        |      |  |      |        |  |  |   |        | 

We do not have a material amount of long-lived
assets outside of the United States.



| |                    
| | -------------------
| | Comparative Amounts

We have reclassified certain prior year balances
to conform to the current years presentation.



| |                                  
| | ---------------------------------
| | Recent Accounting
	Pronouncements

SFAS 141.In July
2001, the FASB issued SFAS No. 141, Business
Combinations (SFAS 141), which requires
all business combinations initiated after June 30, 2001 to
be accounted for using the purchase method of accounting. As a
result, use of the pooling-of-interests method is prohibited for
business

F-12



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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

combinations initiated after that date.
SFAS 141 also establishes criteria for separate recognition
of intangible assets acquired in a business combination. We
adopted SFAS 141 effective July 1, 2001. The adoption of
SFAS 141 had no impact on our financial position or results
of operations.

SFAS 142.In July
2001, the FASB issued SFAS No. 142, Goodwill and
Other Intangible Assets (SFAS 142), which
addresses the financial accounting and reporting for acquired
goodwill and other intangible assets. Under SFAS 142,
effective January 1, 2002, we are no longer required to
amortize goodwill and intangible assets with indefinite lives,
but will be required to periodically review these assets for
impairment. Intangible assets determined to have definitive
lives will continue to be amortized over their useful lives. We
adopted SFAS 142 effective January 1, 2002, and
reclassified amounts to goodwill that were previously allocated
to assembled workforce. Upon adoption, we ceased the
amortization of goodwill currently representing expense of
$0.7 million per year. Although we have not completed the
transactional impairment test, we currently do not expect the
results of such test to have a material effect on our financial
position or results of operations.

SFAS 144.In October
2001, the FASB issued SFAS No. 144, Accounting for
the Impairment or Disposal of Long-Lived Assets
(SFAS 144), which establishes a single
accounting model for the impairment or disposal of long-lived
assets, including discontinued operations. SFAS 144
supercedes SFAS 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed
Of. SFAS 144 requires that long-lived assets to be
disposed of by sale be measured at the lower of carrying amount
or fair value less cost to sell, whether reported in continuing
operations or in discontinued operations. SFAS 144 excludes
from the definition of long-lived assets goodwill and other
intangibles that are not amortized in accordance with
SFAS 142. SFAS 144 also expands the reporting of
discontinued operations to include components of an entity that
have been or will be disposed of rather than limiting such
discontinuance to a segment of a business. SFAS 144 is
effective for years ending after December 15, 2001. We
adopted SFAS 144 effective January 1, 2002, and it did
not have a significant impact on our financial position or
results of operations.

2.     Cash
Equivalents and Short-term Investments

The following tables summarize our
available-for-sale investments (in thousands):

|                                           |                              |                   |        |            |  |            |       |            |  |   |     |     |   |   |        |        | 
|------------------------------------------ | ---------------------------- | ----------------- | ------ | ---------- |  | ---------- | ----- | ---------- |  | - | --- | --- | - | - | ------ | ------ | 
|                                           |                              |                  
|                                           |                              | December 31, 2001
|                                           |                              |                  
|                                           |                              |                   |        | Gross      |  | Gross      |       |           
|                                           |                              | Amortized         |        | Unrealized |  | Unrealized |       | Estimated 
|                                           |                              | Cost              |        | Gains      |  | Loss       |       | Fair Value
|                                           |                              |                   |        |            |  |            |       |           
|Corporate debt                             |                              | $                 | 29,863 |            |  | $          | 85    |            |  | $ | (6  | )   |   | $ | 29,942 |       
|Commercial paper                           |                              |                   | 5,625  |            |  |            |      |            |  |   |    |     |   |   | 5,625  |       
|Equity securities                          |                              |                   | 602    |            |  |            | 6,643 |            |  |   | (78 | )   |   |   | 7,167  |       
|Money market funds                         |                              |                   | 665    |            |  |            |      |            |  |   |    |     |   |   | 665    |       
|                                           |                              |                   |        |            |  |            |       |            |  |   |     |     |   |   |        |       
|                                           | Total                        |                   |        | 36,755     |  |            |       | 6,728      |  |   |     | (84 | ) |   |        | 43,399 | 
|Less amount classified as cash equivalents |                              |                   | (665   | )          |  |            |      |            |  |   |    |     |   |   | (665   | )     
|                                           |                              |                   |        |            |  |            |       |            |  |   |     |     |   |   |        |       
|                                           | Total short-term investments |                   | $      | 36,090     |  |            | $     | 6,728      |  |   | $   | (84 | ) |   | $      | 42,734 | 
|                                           |                              |                   |        |            |  |            |       |            |  |   |     |     |   |   |        |       

F-13



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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

|                                           |                              |                   |        |            |  |            |       |            |  |   |    |    |   |   |        |        | 
|------------------------------------------ | ---------------------------- | ----------------- | ------ | ---------- |  | ---------- | ----- | ---------- |  | - | -- | -- | - | - | ------ | ------ | 
|                                           |                              |                  
|                                           |                              | December 31, 2000
|                                           |                              |                  
|                                           |                              |                   |        | Gross      |  | Gross      |       |           
|                                           |                              | Amortized         |        | Unrealized |  | Unrealized |       | Estimated 
|                                           |                              | Cost              |        | Gains      |  | Loss       |       | Fair Value
|                                           |                              |                   |        |            |  |            |       |           
|Corporate debt                             |                              | $                 | 13,146 |            |  | $          | 2     |            |  | $ |   |    |   | $ | 13,148 |       
|Commercial paper                           |                              |                   | 1,690  |            |  |            |      |            |  |   | (1 | )  |   |   | 1,689  |       
|Equity securities                          |                              |                   | 630    |            |  |            | 6,140 |            |  |   |   |    |   |   | 6,770  |       
|Money market funds                         |                              |                   | 423    |            |  |            |      |            |  |   |   |    |   |   | 423    |       
|                                           |                              |                   |        |            |  |            |       |            |  |   |    |    |   |   |        |       
|                                           | Total                        |                   |        | 15,889     |  |            |       | 6,142      |  |   |    | (1 | ) |   |        | 22,030 | 
|Less amount classified as cash equivalents |                              |                   | (423   | )          |  |            |      |            |  |   |   |    |   |   | (423   | )     
|                                           |                              |                   |        |            |  |            |       |            |  |   |    |    |   |   |        |       
|                                           | Total short-term investments |                   | $      | 15,466     |  |            | $     | 6,142      |  |   | $  | (1 | ) |   | $      | 21,607 | 
|                                           |                              |                   |        |            |  |            |       |            |  |   |    |    |   |   |        |       

The gross realized gains on sales of
available-for-sale investments totaled $413,000 in 2001,
$43.1 million in 2000, and $588,000 in 1999, and gross
realized losses for the same periods totaled $166,000, $82,000,
and $31,000, respectively. The average maturity of our
available-for-sale debt securities is less than one year.

3.     Property and
Equipment

Property and equipment consists of the following
(in thousands):

|                                               |  |              |        |      |  |   |        |  
|---------------------------------------------- |  | ------------ | ------ | ---- |  | - | ------ | -
|                                               |  |             
|                                               |  | December 31,
|                                               |  |             
|                                               |  | 2001         |        | 2000
|                                               |  |              |        |     
|Laboratory equipment                           |  | $            | 3,277  |      |  | $ | 2,915  |  
|Computer equipment                             |  |              | 1,672  |      |  |   | 1,034  |  
|Furniture and fixtures                         |  |              | 968    |      |  |   | 772    |  
|Leasehold improvements                         |  |              | 1,319  |      |  |   | 760    |  
|Land and building                              |  |              | 446    |      |  |   |       |  
|                                               |  |              |        |      |  |   |        |  
|                                               |  |              | 7,682  |      |  |   | 5,481  |  
|Less accumulated depreciation and amortization |  |              | (4,515 | )    |  |   | (3,674 | )
|                                               |  |              |        |      |  |   |        |  
|Property and equipment, net                    |  | $            | 3,167  |      |  | $ | 1,807  |  
|                                               |  |              |        |      |  |   |        |  

Property and equipment includes assets under
capitalized leases of approximately $1.0 million at
December 31, 2000. Accumulated amortization related to
leased assets was $1.0 million at December 31, 2000.
There were no new capitalized leases for the years ended
December 31, 2001 or 2000.

4.     Acquisition of
Soltec Research Pty. Ltd.

In April 2001, we acquired Soltec, and on a
consolidated basis we now own the intellectual property that we
licensed from Soltec prior to the acquisition. Our two marketed
dermatology products and current product development programs
are based on technology developed by Soltec. Soltec has been
developing innovative delivery systems for new dermatology
products for over 10 years, and has leveraged its broad
range of drug delivery technologies by entering into license
agreements with dermatology companies around the world. Those
license agreements bear royalties payable to Soltec for
currently marketed products, as well as potential future
royalties for products under development. We accounted for the
acquisition using the purchase method of accounting and
accordingly, the purchase price was allocated to the assets
acquired and liabilities assumed based on their estimated fair
values on the acquisition date. Since April 20, 2001,
Soltecs results of operations have been included in our
consolidated statements of operations.

F-14



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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

We purchased all of the shares of Soltecs
capital stock for cash of $16.9 million plus transaction costs
of approximately $250,000. The purchase price was allocated to:
existing technology of $6.8 million, goodwill of $6.6
million, tangible net assets assumed of $1.3 million,
patents and core technology of $1.2 million, acquired
in-process research and development of $1.1 million, and
assembled workforce of $150,000. We determined the fair value of
the intangible assets based upon an independent valuation using
a combination of methods, including an income approach for the
in-process research and development and existing technology, a
cost approach for the assembled workforce and the royalty
savings approach for the patents and core technology.

We computed the value of the acquired in-process
technology using a discounted cash flow analysis with a discount
rate of 20% on the anticipated income stream and the expected
completion stage of the related product revenues. The acquired
in-process research and development programs are in early stages
of development, have not reached technological feasibility, and
have no foreseeable alternative future uses. The value of the
existing technology was computed using a discounted cash flow
analysis with a discount rate of 15%. The discounted cash flow
analysis was based on managements forecast of future
revenues, cost of revenues and operating expenses related to the
products and technologies purchased from Soltec. Amortization of
the acquired intangibles and goodwill associated with this
acquisition totaled $1.0 million for the year ended
December 31, 2001.

These projects may not meet either technological
or commercial success. The products under development have no
foreseeable alternative future uses. The estimates we used in
valuing in-process research and development were based on
assumptions we believe to be reasonable, but they are inherently
uncertain and unpredictable. Our assumptions may be incomplete
or inaccurate, and unanticipated events and circumstances may
occur. Accordingly, actual results may vary from the results
projected for purposes of determining the fair value of the
acquired in-process research and development.

F-15



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CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following pro forma data summarizes the
results of operations for the periods indicated as if Soltec had
been completed as of the beginning of the periods presented. The
pro forma data give effect to actual operating results prior to
the acquisition and exclude the charge for acquired in-process
research and development. No effect has been given to cost
reductions or operating synergies in this presentation. These
pro forma amounts do not purport to be indicative of the results
that would have actually been obtained if the acquisition had
occurred as of the beginning of the periods presented or that
may be obtained in the future.

|                                                                 |                                                                                     |                          |        |         |   |   |        |        |  
|---------------------------------------------------------------- | ----------------------------------------------------------------------------------- | ------------------------ | ------ | ------- | - | - | ------ | ------ | -
|                                                                 |                                                                                     |                         
|                                                                 |                                                                                     | Years Ended December 31,
|                                                                 |                                                                                     |                         
|                                                                 |                                                                                     | 2001                     |        | 2000   
|                                                                 |                                                                                     |                          |        |        
|                                                                 |                                                                                     |                         
|                                                                 |                                                                                     | (Unaudited)             
|Pro forma revenue                                                |                                                                                     | $                        | 35,555 |         |   | $ | 43,747 |       
|                                                                 | Pro forma income (loss) before cumulative
	effect of change in accounting principle |                          |        | (14,495 | ) |   |        | 34,418 |  
|Cumulative effect of change in accounting
	principle, net of tax |                                                                                     |                          |       |         |   |   | (5,192 | )     
|                                                                 |                                                                                     |                          |        |         |   |   |        |       
|                                                                 | Pro forma net income (loss)                                                         |                          | $      | (14,495 | ) |   | $      | 29,226 |  
|                                                                 |                                                                                     |                          |        |         |   |   |        |       
|Basic pro forma earnings per share:                              |                                                                                     |                          |        |         |   |   |        |       
|                                                                 | Pro forma income (loss) before cumulative
	effect of change in accounting principle |                          | $      | (0.49   | ) |   | $      | 1.21   |  
|                                                                 | Cumulative effect of change in accounting
	principle, net of tax                    |                          |        |        |   |   |        | (0.18  | )
|                                                                 | Pro forma net income (loss) per share                                               |                          |        | (0.49   | ) |   |        | 1.03   |  
|Diluted Pro Forma Earnings Per Share:                            |                                                                                     |                          |        |         |   |   |        |       
|                                                                 | Pro forma (income) loss before cumulative
	effect of change in accounting principle |                          |        | (0.49   | ) |   |        | 1.14   |  
|                                                                 | Cumulative effect of change in accounting
	principle, net of tax                    |                          |        |        |   |   |        | (0.17  | )
|                                                                 | Pro forma net (income) loss per share                                               |                          | $      | (0.49   | ) |   | $      | 0.97   |  

5.     Research and
License Agreements



| |                            
| | ---------------------------
| | Pharmacia License Agreement

At the end of December 2001, we entered into an
agreement granting Pharmacia Corporation exclusive global
rights, excluding Japan, to our proprietary foam drug-delivery
technology for use with Pharmacias Rogaine® hair loss
treatment. Under the agreement, Pharmacia paid Connetics an
undisclosed initial licensing fee, milestone payments and a
royalty on product sales. Pharmacia will be responsible for most
product development activities and costs, and we have agreed to
provide certain pre-clinical development support. As of
December 31, 2001, we have deferred the upfront license and
development fees received and will recognize the amounts ratably
over the development period.



| |                          
| | -------------------------
| | Soltec License Agreements

Before we acquired Soltec, we had entered into a
series of license agreements with Soltec. Those license
agreements are still in effect, although royalty payments to
Soltec are now eliminated in consolidation. In December 1999, we
entered into a comprehensive licensing agreement with Soltec for
exclusive rights to certain applications of a broad range of
unique topical delivery technologies, including aerosol foam
formulations and Soltecs patented Liquipatch technology.
We paid Soltec a $500,000 license fee upon signing of agreement
and issued 80,154 shares of our common stock in January 2000
valued at $500,000. That stock

F-16



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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

was assigned to F.H. Faulding & Co.
Ltd. in 2001, in connection with our acquisition of Soltec. We
charged the $1.0 million to research and development
expense.



| |                            
| | ---------------------------
| | Genentech License Agreement

In December 1995, we entered into a license
agreement with Genentech, Inc. to acquire exclusive development
and marketing rights to interferon gamma in the United States
for dermatologic indications. In May 1998, we amended and
restated this agreement and entered into a new license agreement
that granted us an exclusive license under certain patent rights
and know-how to Actimmune (interferon gamma). Under the terms of
the agreement, we issued Genentech 380,048 shares of our common
stock valued at $2.0 million at the time of closing with a
guaranteed value of $4.0 million at the second closing
date, originally set as December 28, 1998. Based on that
provision, in December 1999 we issued an additional 228,882
shares of common stock to Genentech to bring the value of the
consideration to $4.0 million. We formed a subsidiary,
InterMune Pharmaceuticals, Inc. (now InterMune, Inc.), to
develop Actimmune. In April 1999, InterMune became an
independent company, and in March 2000, InterMune became a
public company. Effective April 1, 2000 we assigned to
InterMune our remaining rights and obligations under the license
with Genentech and the corresponding supply agreement. For
more detail on the sale of rights to InterMune, please refer to
Note 12.



| |                             
| | ----------------------------
| | Licenses for Foam Technology

Before April 2001, Soltec had entered into a
number of other agreements for the foam technology. Soltec
licensed the technology to betamethasone valerate foam to
Celltech plc in Europe, and Celltech has licensed the worldwide
rights to their patent on the technology to Soltec. Soltec pays
Celltech royalties on all sales worldwide of foam formulations
containing steroids. Celltech markets their product as
BettamousseTM (the product equivalent of Luxíq).
Soltec has license agreements with Bayer (in the U.S.) and
Pfizer and Mipharm (internationally) for the use of pyrethrin
foam for head lice. That product is marketed in the U.S. as
RID®, as Banlice® in Australia, and as Milice in
Italy. We receive royalties on sales of those products. Soltec
has entered into development agreements with other companies to
develop the foam for specific indications.



| |                                    
| | -----------------------------------
| | Licenses for Liquipatch
	Technology

Soltec has entered into agreements with several
companies to develop Liquipatch for various indications. On
June 26, 2001, we announced that Soltec had entered into a
global licensing agreement with a major, international
healthcare company for Liquipatch. The agreement followed
successful pilot development work and gives the licensee the
exclusive, worldwide right to use the Liquipatch technology in a
particular field in dermatology, particularly for the delivery
of a topical over-the-counter product. The licensee will be
responsible for all development costs, and will be obligated to
pay license fees, milestone payments and royalties on future
product sales. Soltec has entered into development agreements
with other companies to develop Liquipatch for specific
indications.



| |                          
| | -------------------------
| | License for Aerosol Spray

Soltec has licensed to a major international
company the rights to a super-concentrated aerosol spray that is
marketed in the U.S. and internationally. We receive royalties
on sales of the product. In 2001, on a consolidated basis, we
received $0.8 million in royalties in connection with this
agreement.

6.     Divestiture of
Ridaura

In April 2001, we sold the rights to our product
Ridaura including inventory and identified liabilities to
Prometheus Laboratories Inc. for $900,000 in cash plus a royalty
on annual sales in excess of $4.0 million for the next
five years. Ridaura is a prescription pharmaceutical
product for the treatment of rheumatoid

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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

arthritis. We accrued approximately
$978,000 million for transaction related costs and
contractual liabilities incurred as of the date of the sale.
After recognizing the above amounts, we recorded a gain of
$8.0 million on this transaction during the second quarter
of 2001. Prometheus assumed our obligations under a Supply
Agreement to supply Ridaura in Canada to Pharmascience, Inc.

We first acquired the U.S. and Canada rights to
Ridaura in December 1996 from SmithKline (now GlaxoSmithKline)
(as amended in 1997 and 1998, referred to as the SKB Agreement).
We determined the useful life of the acquired asset to be three
years and had fully amortized the acquired asset as of
December 31, 1999. We recorded amortization expense of
$6.2 million in 1999. Accumulated amortization was zero in
2001 and 2000, and $20.6 million at December 31, 1999.
We were required to pay interest on the principal amount
outstanding from January 5, 1999 through April 1,
2000. We paid GlaxoSmithKline $6.7 million in principal and
interest in 1999, and $1.6 million in principal and
interest in 2000. At December 31, 2000, there were no
amounts outstanding under the SKB agreement.

7.     Relaxin
Program and Agreements

In October 2000, we announced that our pivotal
clinical trial of relaxin had failed to show statistical
significance with respect to the primary endpoint of the trial.
Based on the result of the pivotal trial, and following an
extensive evaluation of other potential uses for relaxin, in May
2001, we announced our decision to pursue a license partner or
other strategic alternative for our relaxin program. As a
result, we have reduced our investment in the development of
relaxin in favor of focusing our resources on expanding our
dermatology business. During the second quarter of 2001, we
eliminated 27 employee positions related to relaxin. We
recognized a one-time charge of approximately $1.1 million
in 2001, which represents $451,000 accrued in connection with
the reduction in workforce as well as $691,000 for the wind down
of relaxin development contracts. Of the amounts accrued in
2001, $456,000 remains accrued as of December 31, 2001.

Genentech.Pursuant
to an agreement with Genentech, we have licensed the worldwide
exclusive right to make, use and sell certain products arising
from recombinant human relaxin in indications other than
reproductive indications. In April 1999, in connection with the
agreement, we issued 95,815 shares to Genentech with a fair
market value of $709,000. We will also pay Genentech royalties
on sales of products arising from relaxin, if any.

Boehringer
Ingelheim.Boehringer Ingelheim, or
BIA, manufactured relaxin for us for clinical uses under a
long-term contract. In July 2000, in anticipation of successful
results in our relaxin clinical trial for scleroderma, we
submitted a purchase order to BIA for product to be used for
commercial supply at a price to be negotiated. Throughout 2001
we were in discussions with BIA regarding whether any additional
monies are owed under the contract in view of the failure of the
clinical trial. In July 2001, following our May 2001
announcement about downsizing the relaxin program, BIA notified
us that BIA believed we were in breach of the relaxin
manufacturing agreement and that BIA intended to terminate the
agreement and seek remedies if we did not remedy the alleged
breach. In December 2001, we reached an amicable settlement with
BIA. We mutually agreed to terminate the agreement, BIA agreed
to provide certain reports still owing to Connetics at the time,
and Connetics agreed to pay BIA a total of
1,103,000, or
approximately $990,000, as settlement of all remaining matters.
Of the amount owed, we paid
250,000 or
approximately $222,000 in 2001, and the balance is due in three
installments in 2002.

Medeva PLC.Prior to
our decision to discontinue the relaxin program in May 2001, we
had entered into a series of development, commercialization and
supply agreements for relaxin. In January 1999, we entered into
such an agreement with Medeva PLC (now Celltech Group PLC) of
the United Kingdom for certain therapeutic indications
pertaining to relaxin in Europe. Under the terms of the
agreement, Celltech paid a total of $20.0 million
representing a $4.0 million contract fee, a
$4.0 million equity investment, and a $5.0 million
milestone payment, plus reimbursement of 50% of our product
development costs in the U.S. during the term of the agreement.
In October 2000, following the announcement of the results of our

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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Phase III clinical trial for scleroderma,
Celltech notified us that they were terminating the agreement in
accordance with its terms. As of December 31, 2000, we had
no further development obligations under the agreement; all
rights reverted to us in April 2001 and as a result, we recorded
all previously deferred revenue as revenue in 2001.

Paladin Labs, Inc.In July 1999, we entered into a collaboration and exclusive
license agreement with Paladin for the development and
commercialization of relaxin in Canada. Although we have
discontinued our development efforts for relaxin for
scleroderma, Paladin has indicated that it will continue the
collaboration for other indications. Under the terms of the
agreement, we received an initial sum of $800,000, which
includes payments for development fees and an equity investment.
Paladin would owe additional milestone payments for the approval
of indications other than scleroderma for relaxin in Canada.
Paladin is responsible for all development and commercialization
activities in Canada, and is obligated to pay royalties on all
sales of relaxin in Canada. For the year ended December 31,
2001 we recorded $53,000 in contract revenue under this
agreement.. For the year ended December 31, 2000, we
recorded $703,000 in contract revenue under this agreement. For
the year ended December 31, 1999, we recorded $400,000 in
contract revenue under this agreement.

F.H. Faulding & Co.,
Ltd.In April 2000, we entered into a
collaboration and exclusive license agreement with Faulding for
the development and commercialization of relaxin in Australia.
Under the terms of the agreement, Faulding paid $510,000 for the
initial license of relaxin for the treatment of scleroderma.
Although we have discontinued our development efforts for
relaxin for scleroderma, Faulding has indicated that it will
continue the collaboration for other indications. Under the
agreement, Faulding would owe additional milestone payments for
the approval of non-scleroderma indications for relaxin in
Australia. Faulding is responsible for all development and
commercialization activities in Australia, and will pay
royalties on all sales of relaxin in Australia. In October 2001,
Faulding was acquired by Mayne Group Limited, Australias
largest private health care provider. For the year ended
December 31, 2001 we recorded $79,000 in contract revenue
under this agreement. For the year ended December 31, 2000
we recorded $39,000 in contract revenue under this agreement.

Suntory
Pharmaceuticals.In April 1998, we
entered into a development, commercialization and supply
agreement with Suntory Pharmaceuticals (Suntory), a division of
Suntory Limited of Osaka, Japan, for relaxin for the treatment
of scleroderma. Under the terms of the agreement, Suntory paid
us a total of $2.5 million in non-refundable license and
development fees. In October 2000, following the announcement of
the results of our Phase III clinical trial for
scleroderma, Suntory notified us that they were terminating the
agreement in accordance with its terms.

8.     Financing
Arrangements



| |               
| | --------------
| | Long-Term Debt

In 1998, we entered into a term Loan and Security
Agreement (the Term Loan) with a bank (the Lender), under which
we borrowed $4.0 million. In October 1999, we made a
$2.25 million payment to reduce the principal loan balance
down to $1.75 million. We paid an additional
$1.0 million against the principal balance in 2000 and the
remaining $750,000 principal balance in 2001. In conjunction
with the Term Loan, we granted the Lender a first priority
security interest in our presently existing intellectual
property collateral, as defined in the loan documents. There was
no principal or interest balance owing on the Term Loan at
December 31, 2001.



| |                                           
| | ------------------------------------------
| | Structured Equity Line Flexible
	Financing

In January 1997, we entered into a three year
Structured Equity Line Flexible Financing Agreement (the Equity
Line) with Kepler Capital LLC (Kepler), which became available
to us beginning December 1, 1997.

F-19



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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The agreement expired on December 1, 2000.
The equity line agreement allowed us to access up to
$25 million through sales of our common stock. In addition,
under the terms of the agreement we were required to sell
$500,000 of our common stock from time to time if the price per
share exceeded $10.00 and certain volume conditions were met.
Over the term of the equity line agreement we received a total
of $792,000 in net proceeds, and issued 100,000 shares of common
stock, plus warrants to purchase up to 384,511 shares of our
common stock. See Note 10.

9.     Commitments



| |                 
| | ----------------
| | Operating Leases

We lease three facilities under non-cancelable
operating leases, the last of which expires in April 2005. We
also lease office equipment and automobiles under various
operating leases that will expire on various dates through 2004.
The future minimum rental payments under the non-cancelable
operating leases as of December 31, 2001 are as follows
(in thousands):

|                          |  |   |       | 
|------------------------- |  | - | ----- | 
|                          |  |  
|                         
|Years Ending December 31:
|                         
|2002                      |  | $ | 2,181 | 
|2003                      |  |   | 1,711 | 
|2004                      |  |   | 1,271 | 
|2005                      |  |   | 316   | 
|                          |  |   |       | 
|                          |  | $ | 5,479 | 
|                          |  |   |       | 

We recognize facilities rent expense on a
straight-line basis over the term of each lease. Facilities rent
expense under operating leases was approximately $1,161,000 for
the year ended December 31, 2001 (net of sublease income of
$160,000), $938,000 in 2000, and $882,000 in 1999. The operating
lease obligations are to be partially offset by $570,000 to be
received from a subleasing arrangement with a third party:
$526,000 in 2002 and $44,000 in 2003. The sublease agreement
expires on January 31, 2003.



| |      
| | -----
| | Other

The Company has a purchase commitment for
approximately $1.5 million with Miza for the manufacture
and supply of OLUX and Luxíq in the upcoming year. See
Note 14 for a discussion of additional commitments.

F-20



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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

10.     Stockholders
Equity



| |         
| | --------
| | Warrants

We have outstanding warrants to purchase up to
391,752 shares of our common stock, at various prices and with
varying expiration dates. The following table summarizes our
outstanding warrants as of December 31, 2001; additional
details follow the table.

|                                                              |       |           |         |          |  |             |               |            |  |  |             |  |  |  |             |  | 
|------------------------------------------------------------- | ----- | --------- | ------- | -------- |  | ----------- | ------------- | ---------- |  |  | ----------- |  |  |  | ----------- |  | 
|                                                              |       | Number of |         | Exercise |  |             |               |           
|Activity                                                      |       | Warrants  |         | Price    |  | Year Issued |               | Expiration
|                                                              |       |           |         |          |  |             |               |           
|Issuance of Series B preferred stock                          |       |           | 15,329  |          |  | $           | 4.89          |            |  |  | 1995        |  |  |  | 2002        | 
|Loan and security agreement                                   |       |           | 68,574  |          |  | $           | 5.78          |            |  |  | 1995        |  |  |  | 2002        | 
|Consulting services                                           |       |           | 6,000   |          |  | $           | 6.00          |            |  |  | 1998        |  |  |  | 2003        | 
|Consulting services                                           |       |           | 15,000  |          |  | $           | 6.063         |            |  |  | 1999        |  |  |  | 2004        | 
|Structured Equity Line Flexible Financing
	Agreement (Note 8) |       |           | 191,422 |          |  | $           | 8.125         |            |  |  | 1997        |  |  |  | 2002        | 
|Commitment Fee pursuant to equity line Agreement              |       |           | 75,427  |          |  | $           | 4.40 - $6.875 |            |  |  | 1998 - 2000 |  |  |  | 2003 - 2005 | 
|Issuance pursuant to license agreement                        |       |           | 20,000  |          |  | $           | 5.31          |            |  |  | 2000        |  |  |  | 2010        | 
|                                                              |       |           |         |          |  |             |               |            |  |  |             |  |  |  |             | 
|                                                              | Total |           |         | 391,752  |  |             |               |            |  |  |             |  |  |  |             |  | 
|                                                              |       |           |         |          |  |             |               |            |  |  |             |  |  |  |             | 

In July 1999, we issued a warrant to a third
party to purchase 15,000 shares of common stock as partial
compensation for financial advice pertaining to investor and
media relations. We valued the warrant using the Black-Scholes
method and recorded $66,000 as selling, general and
administrative expense. As of December 31, 2001, none of
these warrants had been exercised.

In January 1997, in connection with the Equity
Line (see Note 8), we issued Kepler a warrant to purchase
250,000 shares at a purchase price of $8.25. As a commitment fee
in connection with the Equity Line, we issued warrants to
purchase 25,000 shares in December 1998 at a purchase
price of $4.40, warrants to purchase 25,000 shares in
December 1999 at a purchase price of $6.875, and warrants
to purchase 25,427 shares in December 2000 at a
purchase price of $5.3625. Pursuant to certain anti-dilution
provisions in the Equity Line, that warrant now represents
253,922 shares at a purchase price of $8.1225. In January 2000,
Kepler exercised its right to require us to draw down against
the Equity Line in exchange for our common stock, and we issued
58,438 shares to Kepler at a purchase price of $8.556 in
February 2000, and 41,562 shares to Kepler at a purchase price
of $3.375 in June 2000. Altogether in connection with the equity
line, we have issued 384,511 warrants, of which 55,162 were
expired at Dec. 31, 2001, and 62,500 had been exercised.
Kepler has assigned certain of its rights under the warrants to
AFO Capital Advisors LLC and Andrew Kaplan. The fair value of
these warrants has been charged against additional paid-in
capital as a stock offering cost.

In October 2000, we issued a warrant to purchase
20,000 shares of our common stock at an exercise price of $5.31.
The warrant was fully vested and immediately exercisable when
issued in connection with a license to certain intellectual
property. We valued the warrant using the Black-Scholes method
and recorded $82,000, as selling, general and administrative
expense. As of December 31, 2001, none of these warrants
had been exercised.



| |                      
| | ---------------------
| | Dividend Restrictions

Our loan agreement with a bank lender prohibits
us from declaring or paying a dividend without the banks
prior written consent.

F-21



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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                                 
| | --------------------------------
| | 1995 Director Stock Option
	Plan

The Board adopted the 1995 Director Stock Option
Plan (the Directors Plan) in December 1995, and amended
the Plan in 1999 and 2001. A total of 600,000 shares of
common stock have been reserved for issuance under the
Directors Plan. The Directors Plan provides for the
grant of non-statutory stock options to non-employee directors
of Connetics.

The Directors Plan, as amended, provides
that each person who first becomes a non-employee director shall
be granted a non-statutory stock option to purchase
30,000 shares of common stock (the First Option) on the
date on which he or she first becomes a non-employee director.
Thereafter, on the date of each annual meeting of our
stockholders, each non-employee director is granted an
additional option to purchase 10,000 shares of common stock
(a Subsequent Option) if he or she has served on the Board for
at least six months as of the annual meeting date. Effective
upon re-election at the 2002 Annual Meeting, the amount of the
Subsequent Option is increased to 15,000 shares of common
stock.

Under the Directors Plan, the First Option
is exercisable in installments as to 25% of the total number of
shares subject to the First Option on each of the first, second,
third and fourth anniversaries of the date of grant of the First
Option; each Subsequent Option becomes exercisable in full on
the first anniversary of the date of grant of that Subsequent
Option. The exercise price of all stock options granted under
the Directors Plan is equal to the fair market value of a
share of our common stock on the date of grant of the option.
Options granted under the Directors Plan have a term of
ten years.



| |                     
| | --------------------
| | Employee Stock Plans

We have six plans pursuant to which we have
granted stock options to the employees and consultants. In
general, all of the plans authorize the grant of stock options
vesting at a rate to be set by the Board or the Compensation
Committee. Stock options under all of our employee stock plans
become exercisable at a rate of 25% per year for a period of
four (4) years from date of grant. The plans require that
the options be exercisable at a rate no less than 20% per year.
The exercise price of stock options under the employee stock
plan generally meets the following criteria: exercise price of
incentive stock options must be at least 100% of the fair market
value on the grant date, exercise price of non-statutory stock
options must be at least 85% of the fair market value on the
grant date, and exercise price of options granted to 10% (or
greater) stockholders must be at least 110% of the fair market
value on the grant date. The 2000 and 2002 Non-Officer Plans and
the International Plan do not permit the grant of incentive
stock options. Stock options under all of our employee stock
plans have a term of ten years from date of grant.



| |                
| | ---------------
| | 1994 Stock Plan

Our 1994 Stock Plan, as amended (the 1994 Stock
Plan) authorizes our Board of Directors to grant incentive stock
options, non-statutory stock options, and stock purchase rights
for up to 3,100,000 shares of common stock. The 1994 Stock
Plan was terminated on December 31, 1999, and the Board is
no longer authorized to grant options under that plan.



| |                
| | ---------------
| | 2000 Stock Plan

Our 2000 Stock Plan (the 2000 Plan) was approved
by the Board and our stockholders in 1999. The 2000 Plan became
available on January 1, 2000, and was initially funded with
808,512 shares, which equals three percent (3%) of
shares outstanding on December 31, 1999. On the first day
of each new calendar year during the term of the 2000 Plan, the
number of shares available will be increased (with no further
action needed by the Board or the stockholders) by a number of
shares equal to the lesser of three percent of the number of
shares of common stock outstanding on the last preceding
business day, or an amount determined by the Board. In 2001, the
increase in authorized shares was 892,149.

F-22



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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                                
| | -------------------------------
| | Non-Officer Stock Option
	Plans

Our 1998 Supplemental Stock Plan (the
Supplemental Plan) was funded with 500,000 shares. The
Supplemental Plan was terminated effective May 19, 1999,
and the Board is no longer authorized to grant options under
that plan. In February 2000, the Board approved a new 2000
Non-Officer Stock Plan. The plan was funded with
500,000 shares. No additional shares will be added to this
plan, although shares can be granted if they become available
through cancellation. In December 2001, the Board approved a
2002 Non-Officer Stock Option Plan, which became immediately
available. The plan was funded with 500,000 shares. At
December 31, 2001, no shares had been granted under this
plan. Each of the Supplemental Plan and the 2000 and 2002
Non-officer Stock Option Plans provide for options to be granted
only to non-officer employees of Connetics, and the options
granted under the plan are nonstatutory stock options.



| |                                    
| | -----------------------------------
| | International Stock Incentive
	Plan

In May 2001, the Board approved an International
Stock Incentive Plan, which provided for the grant of Connetics
stock options to employees of Connetics or its
subsidiaries where the employees are based outside of the United
States. The plan was funded with 250,000 shares. The
options granted under the plan are nonstatutory stock options.

The following table summarizes information
concerning stock options outstanding under all of our stock
option plans and certain grants of options outside of our plans:

|                           |                              |                  |         |                     |   |                  |           |           |   |   |      |      | 
|-------------------------- | ---------------------------- | ---------------- | ------- | ------------------- | - | ---------------- | --------- | --------- | - | - | ---- | ---- | 
|                           |                              |                  |         |                    
|                           |                              |                  |         | Outstanding Options
|                           |                              |                  |         |                    
|                           |                              | Shares Available |         | Number              |   | Weighted Average
|                           |                              | for Grant        |         | of Shares           |   | Exercise Price  
|                           |                              |                  |         |                     |   |                 
|Balance, December 31, 1998 |                              |                  | 606,978 |                     |   |                  | 2,332,380 |           |   | $ | 4.22 |     
|                           |                              |                  |         |                     |   |                  |           |           |   |   |      |     
|                           | Additional shares authorized |                  |         | 499,250             |   |                  |           |          |   |   |      |     | 
|                           | Options granted              |                  |         | (1,160,608          | ) |                  |           | 1,160,608 |   |   | $    | 6.18 | 
|                           | Options exercised            |                  |         |                    |   |                  |           | (316,993  | ) |   | $    | 2.38 | 
|                           | Options canceled             |                  |         | 274,380             |   |                  |           | (302,130  | ) |   | $    | 5.81 | 
|                           |                              |                  |         |                     |   |                  |           |           |   |   |      |     
|Balance, December 31, 1999 |                              |                  | 220,000 |                     |   |                  | 2,873,865 |           |   | $ | 5.05 |     
|                           |                              |                  |         |                     |   |                  |           |           |   |   |      |     
|                           | Additional shares authorized |                  |         | 1,308,512           |   |                  |           |          |   |   |      |     | 
|                           | Options granted              |                  |         | (1,389,195          | ) |                  |           | 1,389,195 |   |   | $    | 7.85 | 
|                           | Options exercised            |                  |         |                     |   |                  |           | (416,387  | ) |   | $    | 4.22 | 
|                           | Options canceled             |                  |         | 180,406             |   |                  |           | (300,673  | ) |   | $    | 7.33 | 
|                           |                              |                  |         |                     |   |                  |           |           |   |   |      |     
|Balance, December 31, 2000 |                              |                  | 319,723 |                     |   |                  | 3,546,000 |           |   | $ | 6.06 |     
|                           |                              |                  |         |                     |   |                  |           |           |   |   |      |     
|                           | Additional shares authorized |                  |         | 1,842,149           |   |                  |           |          |   |   |      |     | 
|                           | Options granted              |                  |         | (1,432,838          | ) |                  |           | 1,432,838 |   |   | $    | 5.89 | 
|                           | Options exercised            |                  |         |                    |   |                  |           | (352,026  | ) |   | $    | 3.92 | 
|                           | Options canceled             |                  |         | 252,812             |   |                  |           | (405,256  | ) |   | $    | 6.87 | 
|                           |                              |                  |         |                     |   |                  |           |           |   |   |      |     
|Balance, December 31, 2001 |                              |                  | 981,846 |                     |   |                  | 4,221,556 |           |   | $ | 6.10 |     
|                           |                              |                  |         |                     |   |                  |           |           |   |   |      |     

Options canceled under terminated plans are no
longer available for grant.

F-23



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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following table summarizes information
concerning outstanding and exercisable options at
December 31, 2001:

|                         |  |                     |           |                     |  |                  |      |           |  |                  |       |  |  |  |           |  |  |   |       | 
|------------------------ |  | ------------------- | --------- | ------------------- |  | ---------------- | ---- | --------- |  | ---------------- | ----- |  |  |  | --------- |  |  | - | ----- | 
|                         |  |                     |           |                     |  |                 
|                         |  | Options Outstanding |           |                    
|                         |  |                     |           | Options Exercisable
|                         |  |                     |           | Weighted Average    |  |                  |      |          
|                         |  | Number              |           | Remaining Life      |  | Weighted Average |      | Number    |  | Weighted Average
|Range Of Exercise Prices |  | of Shares           |           | (in years)          |  | Exercise Price   |      | of Shares |  | Exercise Price  
|                         |  |                     |           |                     |  |                  |      |           |  |                 
|$0.44 - $ 4.56           |  |                     | 1,378,371 |                     |  |                  | 7.27 |           |  | $                | 3.74  |  |  |  | 818,638   |  |  | $ | 3.32  | 
|$4.56 - $ 6.38           |  |                     | 1,091,593 |                     |  |                  | 8.65 |           |  | $                | 5.47  |  |  |  | 470,066   |  |  | $ | 5.55  | 
|$6.50 - $ 8.75           |  |                     | 1,403,800 |                     |  |                  | 7.57 |           |  | $                | 7.65  |  |  |  | 755,260   |  |  | $ | 7.56  | 
|$9.50 - $18.00           |  |                     | 347,792   |                     |  |                  | 8.21 |           |  | $                | 11.21 |  |  |  | 242,938   |  |  | $ | 10.91 | 
|                         |  |                     |           |                     |  |                  |      |           |  |                  |       |  |  |  |           |  |  |   |       | 
|$0.44 - $18.00           |  |                     | 4,221,556 |                     |  |                  | 7.80 |           |  | $                | 6.10  |  |  |  | 2,286,902 |  |  | $ | 5.98  | 
|                         |  |                     |           |                     |  |                  |      |           |  |                  |       |  |  |  |           |  |  |   |       | 

We recorded stock compensation expense of
$322,000 for the year ended December 31, 2001, zero in
2000, and $747,000 in 1999, related to shares issued pursuant to
stock purchase rights and options granted in 1996 and 1995. This
deferred stock compensation expense was amortized over the
related vesting period.



| |                                   
| | ----------------------------------
| | 1995 Employee Stock Purchase
	Plan

The Board adopted the 1995 Employee Stock
Purchase Plan (the Purchase Plan) in December 1995, and amended
the Purchase Plan in February 2000 and November 2000. We have
reserved 948,591 shares of common stock for issuance under the
Purchase Plan. The Purchase Plan has an evergreen feature
pursuant to which, on November 30 of each year, the number
of shares available is increased automatically by a number of
shares equal to the lesser of one half of one percent (0.5%) of
the number of shares of common stock outstanding on that date,
or an amount determined by the Board of Directors. The
Compensation Committee of the Board administers the Purchase
Plan. Employees (including officers and employee directors) of
Connetics are eligible to participate if they are employed by us
or any U.S. subsidiary of Connetics for at least 20 hours per
week and more than 5 months per year. The Purchase Plan
permits eligible employees to purchase common stock through
payroll deductions, which may not exceed 15% of an
employees compensation, at a price equal to the lower of
85% of the fair market value of our common stock at the
beginning or end of the offering period. We issued 165,966
shares under the plan in 2001. At December 31, 2001, we had
370,988 shares reserved for future issuance. For the year ended
December 31, 1999, we recorded $221,000 in stock
compensation expense relating to this plan; we did not record
any stock compensation expense for the years ended
December 31, 2000 and 2001.

F-24



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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                                            
| | -------------------------------------------
| | Common Shares Reserved for Future
	Issuance

We have reserved shares of common stock for
issuance as follows:

|                                   |       |              |           |           |  |  |           |           | 
|---------------------------------- | ----- | ------------ | --------- | --------- |  |  | --------- | --------- | 
|                                   |       |             
|                                   |       | December 31,
|                                   |       |             
|                                   |       | 2001         |           | 2000     
|                                   |       |              |           |          
|1994 Stock Plan                    |       |              | 1,584,690 |           |  |  | 1,964,089 |          
|1995 Employee Stock Purchase Plan  |       |              | 370,988   |           |  |  | 386,257   |          
|1995 Directors Stock Option Plan   |       |              | 570,000   |           |  |  | 377,500   |          
|1998 Supplemental Stock Plan       |       |              | 120,466   |           |  |  | 192,683   |          
|2000 Stock Plan                    |       |              | 1,662,172 |           |  |  | 472,179   |          
|2000 Non-Officer Stock Plan        |       |              | 482,082   |           |  |  | 500,000   |          
|International Stock Incentive Plan |       |              | 250,000   |           |  |  |          |          
|2002 Non-Officer Stock Plan        |       |              | 500,000   |           |  |  |          |          
|Non-plan stock options             |       |              | 33,992    |           |  |  | 33,992    |          
|Common stock warrants              |       |              | 391,752   |           |  |  | 1,415,492 |          
|                                   |       |              |           |           |  |  |           |          
|                                   | Total |              |           | 5,966,142 |  |  |           | 5,342,192 | 
|                                   |       |              |           |           |  |  |           |          



| |                                         
| | ----------------------------------------
| | Accounting for Stock-Based
	Compensation

In accordance with the provisions of
SFAS 123, we apply APB Opinion No. 25 and related
interpretations in accounting for our stock option plans and,
accordingly, do not recognize compensation cost for options
granted with exercise prices not less than fair value on the
date of grant. If we had elected to recognize compensation cost
based on the fair value of the options at the date of grant and
stock purchases under the Purchase Plan as prescribed by
SFAS 123, our net loss and net loss per share numbers would
have been changed to the pro forma amounts indicated in
the table below (in thousands except per share amounts):

|                             |             |                          |   |         |   |      |   |        |  |  |   |         |  
|---------------------------- | ----------- | ------------------------ | - | ------- | - | ---- | - | ------ |  |  | - | ------- | -
|                             |             |                         
|                             |             | Years Ended December 31,
|                             |             |                         
|                             |             | 2001                     |   | 2000    |   | 1999
|                             |             |                          |   |         |   |     
|Net income (loss):           |             |                          |   |         |   |      |   |        |  |  |   |        
|                             | as reported |                          | $ | (16,742 | ) |      | $ | 26,996 |  |  | $ | (27,283 | )
|                             | pro forma   |                          | $ | (19,921 | ) |      | $ | 22,596 |  |  | $ | (29,473 | )
|Net income (loss) per share: |             |                          |   |         |   |      |   |        |  |  |   |        
|                             | as reported |                          | $ | (0.56   | ) |      | $ | 0.95   |  |  | $ | (1.21   | )
|                             | pro forma   |                          | $ | (0.67   | ) |      | $ | 0.79   |  |  | $ | (1.30   | )

For purposes of this analysis, we estimate the
fair value of each option grant on the date of grant using the
Black-Scholes option-pricing model with the following weighted
average assumptions:

|                                |  |                    |      |                     |  |      |      |      |  |      |      |      |  |  |      |   |  |  |      |   |  |  |      |  
|------------------------------- |  | ------------------ | ---- | ------------------- |  | ---- | ---- | ---- |  | ---- | ---- | ---- |  |  | ---- | - |  |  | ---- | - |  |  | ---- | -
|                                |  |                    |      |                    
|                                |  | Stock Option Plans |      | Stock Purchase Plan
|                                |  |                    |      |                    
|                                |  | 2001               |      | 2000                |  | 1999 |      | 2001 |  | 2000 |      | 1999
|                                |  |                    |      |                     |  |      |      |      |  |      |      |     
|Expected stock price volatility |  |                    | 70.0 | %                   |  |      | 100  | %    |  |      | 76.0 | %    |  |  | 94.0 | % |  |  | 100  | % |  |  | 76.0 | %
|Risk-free interest rate         |  |                    | 5.35 | %                   |  |      | 6.00 | %    |  |      | 5.71 | %    |  |  | 5.92 | % |  |  | 5.80 | % |  |  | 5.70 | %
|Expected life (in years)        |  |                    | 3.57 |                     |  |      | 3.89 |      |  |      | 3.7  |      |  |  | 1.81 |   |  |  | 1.71 |   |  |  | 0.5  |  
|Expected dividend yield         |  |                    | 0.0  | %                   |  |      | 0.0  | %    |  |      | 0.0  | %    |  |  | 0.0  | % |  |  | 0.0  | % |  |  | 0.0  | %

The Black-Scholes option valuation model was
developed for use in estimating the fair value of traded options
that have no vesting restrictions and are fully transferable. In
addition, option valuation models require the input of highly
subjective assumptions, including the expected stock price
volatility. Because our stock

F-25



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##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

options have characteristics significantly
different from those of traded options, and because changes in
the subjective input assumptions can materially affect the fair
value estimate, our management does not believe that the
existing models necessarily provide a reliable single measure of
the fair value of its options. The weighted average fair value
of options granted was $3.02 in 2001, $5.37 in 2000, and $3.84
in 1999.

The effects on pro forma disclosures of
applying SFAS 123 are not likely to be representative of
the effects on reported results of future years.



| |                        
| | -----------------------
| | Stockholder Rights Plan

In May 1997, we adopted a stockholder rights plan
(the Rights Plan), which was amended and restated in November
2001. The Rights Plan entitles existing stockholders the right
to purchase from Connetics one preferred share purchase right,
or Right, for each share of common stock they own. If the Rights
become exercisable, each Right entitles the holder to buy one
one-thousandth of a share of Series B Participating
Preferred stock for $80.00. The Rights attach to and trade only
together with our common stock and do not have voting rights.
Rights Certificates will be issued and the Rights will become
exercisable on the Distribution Date, which is
defined as the earlier of the tenth business day (or such later
date as may be determined by our Board of Directors) after a
person or group of affiliated or associated persons
(Acquiring Person) (a) has acquired, or
obtained the right to acquire, beneficial ownership of 15% or
more of the common shares then outstanding or (b) announces
a tender or exchange offer, the consummation of which would
result in ownership by a person or group of 15% or more of our
then outstanding common shares. Unless the Rights are earlier
redeemed, if an Acquiring Person obtains 15% or more of our then
outstanding common shares, then any Rights held by the Acquiring
Person are void, and each other holder of a Right which has not
been exercised will have the right to receive, upon exercise,
common shares having a value equal to two times the purchase
price. The Rights are redeemable for $0.001 per Right at the
discretion of our Board. The purchase price payable, the number
of Rights, and the number of Series B Participating
Preferred Stock or common shares or other securities or property
issuable upon exercise of the Rights are subject to adjustment
from time to time in connection with the dilutive issuances by
Connetics as set forth in the Rights Plan. At December 31,
2001, a total of 90,000 shares were designated as Series B
Participating Preferred Stock and no shares were issued and
outstanding.

11.     Income
Taxes

The provision for income taxes consists of the
following:

|        |         |              |     |      |  |      |       |     |  |   |   |   | 
|------- | ------- | ------------ | --- | ---- |  | ---- | ----- | --- |  | - | - | - | 
|        |         |             
|        |         | December 31,
|        |         |             
|        |         | 2001         |     | 2000 |  | 1999
|        |         |              |     |      |  |     
|Current |         |              |     |      |  |      |       |     |  |   |   |  
|        | Foreign |              | $   | 345  |  |      | $     |    |  |   | $ |  | 
|        | Federal |              |     |     |  |      |       | 614 |  |   |   |  | 
|        | State   |              |     |     |  |      |       | 396 |  |   |   |  | 
|        |         |              |     |      |  |      |       |     |  |   |   |  
|Total   |         | $            | 345 |      |  | $    | 1,010 |     |  | $ |  |  
|        |         |              |     |      |  |      |       |     |  |   |   |  

F-26



---



##### Table of Contents



CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The provision (benefit) for income taxes
differs from the federal statutory rate as follows:

|                                                        |  |              |        |      |  |      |        |   |  |   |        |  
|------------------------------------------------------- |  | ------------ | ------ | ---- |  | ---- | ------ | - |  | - | ------ | -
|                                                        |  |             
|                                                        |  | December 31,
|                                                        |  |             
|                                                        |  | 2001         |        | 2000 |  | 1999
|                                                        |  |              |        |      |  |     
|Provision (benefit) at U.S. federal
	statutory rate     |  | $            | (5,700 | )    |  | $    | 9,500  |   |  | $ | (9,300 | )
|Unbenefited losses (utilization of net operating
	loss) |  |              | 4,000  |      |  |      | (9,500 | ) |  |   | 9,100  |  
|Non-deductible stock based compensation                 |  |              | 900    |      |  |      |       |   |  |   |       |  
|Non-deductible goodwill amortization                    |  |              | 500    |      |  |      |       |   |  |   |       |  
|Foreign taxes                                           |  |              | 345    |      |  |      |       |   |  |   |       |  
|Alternative minimum tax                                 |  |              |       |      |  |      | 614    |   |  |   |       |  
|State taxes, net of federal benefit                     |  |              |       |      |  |      | 330    |   |  |   |       |  
|Other                                                   |  |              | 300    |      |  |      | 66     |   |  |   | 200    |  
|                                                        |  |              |        |      |  |      |        |   |  |   |        |  
|Total                                                   |  | $            | 345    |      |  | $    | 1,010  |   |  | $ |       |  
|                                                        |  |              |        |      |  |      |        |   |  |   |        |  

Pretax income from foreign operations was
approximately $1.2 million in 2001.

Significant components of our deferred tax assets
for federal and state income taxes are as follows (in
thousands):

|                          |                                              |              |         |        |   |   |         |        |  
|------------------------- | -------------------------------------------- | ------------ | ------- | ------ | - | - | ------- | ------ | -
|                          |                                              |             
|                          |                                              | December 31,
|                          |                                              |             
|                          |                                              | 2001         |         | 2000  
|                          |                                              |              |         |       
|Deferred tax assets:      |                                              |              |         |        |   |   |         |       
|                          | Net operating loss carryforward              |              | $       | 30,100 |   |   | $       | 22,600 |  
|                          | Research and tax other credit carry forwards |              |         | 7,600  |   |   |         | 7,200  |  
|                          | Capitalized research expenses                |              |         | 5,200  |   |   |         | 5,000  |  
|                          | Capitalized license and acquired technology  |              |         | 500    |   |   |         | 3,700  |  
|                          |                                              |              |         |        |   |   |         |       
|Total deferred tax assets |                                              |              | 43,400  |        |   |   | 38,500  |       
|Deferred tax liabilities: |                                              |              |         |        |   |   |         |       
|                          | Unrealized gain on marketable securities     |              |         | (2,600 | ) |   |         | (2,400 | )
|                          |                                              |              |         |        |   |   |         |       
|Valuation allowance       |                                              |              | (40,800 | )      |   |   | (36,100 | )     
|                          |                                              |              |         |        |   |   |         |       
|Net deferred tax assets   |                                              | $            |        |        |   | $ |        |       
|                          |                                              |              |         |        |   |   |         |       

Due to our lack of earnings history, the net
deferred tax assets have been fully offset by a valuation
allowance. The valuation allowance increased by
$4.7 million during the year ended December 31, 2001,
decreased by $9.4 million during the year ended
December 31, 2000, and increased by $10.0 million
during the year ended December 31, 1999.

As of December 31, 2001, the Company had
federal net operating loss carryforwards of approximately
$87.4 million. We also had federal and California research
and other tax credit carryforwards of approximately
$7.6 million. The federal net operating loss and credit
carryforwards will expire in the years 2008 through 2021, if not
utilized.

Utilization of the federal and state net
operating loss and tax credit carryforwards may be subject to a
substantial annual limitation due to the change in
ownership provisions of the Internal Revenue Code of 1986.
The annual limitation may result in the expiration of net
operating losses and credits before utilization.

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CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Tax benefits associated with employee stock
options provide a deferred benefit of approximately
$0.7 million, which has been offset by the valuation
allowance. The deferred tax benefit associated with the employee
stock options will be credited to additional paid-in capital
when realized.

12.     InterMune,
Inc.

In 1998, we formed a subsidiary, InterMune
Pharmaceuticals, Inc. (now known as InterMune, Inc.), to develop
Actimmune for serious pulmonary and infectious diseases and
congenital disorders shortly after we in-licensed Actimmune from
Genentech. In April 1999, InterMune became an independent
company through venture capital funding, and a portion of our
original investment in InterMune was returned to us. Effective
April 1, 2000 we assigned to InterMune our remaining rights
and obligations under the license with Genentech and the
corresponding supply agreement. In exchange, InterMune paid us
approximately $5.2 million; an additional $0.9 million
was payable at the end of March 2001. Commencing in the second
quarter of 2000, InterMune acquired all remaining rights to sell
Actimmune. Effective April 1, 2000, our investment in
InterMune was diluted from 100 percent to nine percent and
we began accounting for our investment in InterMune using the
cost method. In March 2000, InterMune became a public company
and has since changed its name to InterMune, Inc. As of
December 31, 2001 we held 149,000 shares of common stock of
InterMune. In addition, we have retained the product rights for
potential dermatological applications. We will receive royalties
on Actimmune sales beginning January 1, 2002. We recorded
gains of $122,000 and $43.0 million on the sale InterMune
stock in the 2001 and 2000, respectively.

13.     Retirement
Savings Plan

We have a retirement savings plan, commonly known
as a 401(k) plan, that allows all full-time employees to
contribute from 1% to 15% of their pretax salary, subject to IRS
limits. Although no company match of employee contributions is
guaranteed, in the past several years the Board has authorized a
company match in the amount of a pool equal to 0.5%
of Connetics annual product sales, allocated in an amount
per employee participating in the plan not to exceed 30% of that
employees contribution. The company contribution vests in
relation to each employees tenure with Connetics (40%
after the second year and 100% vested after five years with
Connetics). Our contributions to the 401(k) plan were $155,000
for 2001, $100,000 for 2000, and $83,000 for 1999.

14.     Subsequent
Event

On March 12, 2002, we entered into an
agreement with DPT Laboratories, Ltd. to construct an aerosol
filling line at DPTs plant on their premises in Texas. The
agreement is retroactive to November 1, 2001, to cover
certain pre-construction payments we made in December 2001. We
are responsible for the costs of the construction and the
related equipment, which is currently expected to be
approximately $2.3 million. After the aerosol line is
completed, Connetics will pay DPT rent for the facility of
$56,000 per year. DPT and Connetics simultaneously entered into
a manufacturing agreement for DPT to manufacture and fill
Connetics commercial aerosol products. We are also party
to a separate research and development agreement for the
manufacture of clinical supplies for our aerosol products and
product candidates.

F-28



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CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

15.     Quarterly
Financial Data (unaudited)

Following is a summary of the quarterly results
of operations for the years ended December 31, 2001 and
2000 (in thousands, except per share amounts):

|                                                                     |          |               |        |           |   |       |         |           |   |   |        |       |   |   |        |       |  
|-------------------------------------------------------------------- | -------- | ------------- | ------ | --------- | - | ----- | ------- | --------- | - | - | ------ | ----- | - | - | ------ | ----- | -
|                                                                     |          |              
|                                                                     |          | 2001 Quarters
|                                                                     |          |              
|                                                                     |          | First         |        | Second(1) |   | Third |         | Fourth(2)
|                                                                     |          |               |        |           |   |       |         |          
|Total revenues                                                       |          | $             | 8,459  |           |   | $     | 7,563   |           |   | $ | 8,198  |       |   | $ | 9,844  |      
|Gross profit on net sales                                            |          |               | 7,354  |           |   |       | 6,960   |           |   |   | 7,497  |       |   |   | 9,130  |      
|Operating loss                                                       |          |               | (4,610 | )         |   |       | (15,416 | )         |   |   | (5,724 | )     |   |   | (749   | )    
|Net loss                                                             |          |               | (4,888 | )         |   |       | (6,135  | )         |   |   | (5,418 | )     |   |   | (301   | )    
|Basic and diluted earnings per share                                 |          |               |        |           |   |       |         |           |   |   |        |       |   |   |        |      
|                                                                     | Net loss |               |        | (0.16     | ) |       |         | (0.21     | ) |   |        | (0.18 | ) |   |        | (0.01 | )
|Shares used to calculate basic and fully diluted
	net loss per share |          |               | 29,705 |           |   |       | 29,777  |           |   |   | 29,920 |       |   |   | 30,041 |      



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | In April 2001, we completed our acquisition of
	Soltec. We recorded a one-time in-process research and
	development charge of $1.1 million related to the Soltec
	acquisition. In April 2001 we sold our rights to Ridaura
	including inventory to Prometheus Laboratories, Inc. for
	$9.0 million in cash plus a royalty on annual sales in
	excess of $4.0 million for the next five years. We
	recognized a gain of $8.0 million in connection with the
	sale of Ridaura. In May 2001, we announced our decision to
	reduce our investment in the development of relaxin and to
	search for licensing opportunities or other strategic
	alternatives for the product. In the second quarter of 2001 we
	recognized a $6.0 million charge representing estimated
	costs to be incurred in connection with the reduction in
	workforce as well as the wind down of relaxin development
	contracts.
|   
|(2) | In the fourth quarter of 2001 we reversed
	$4.8 million of the relaxin reserve we established in the
	second quarter, due to the settlement of potential amounts owed.
	We also recognized a non-cash compensation expense charge of
	$1.0 million in the fourth quarter of 2001.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

F-29



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CONNETICS CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

|                                                                                                        |                                                      |               |        |           |   |          |        |           |  |   |        |       |   |   |        |      | 
|------------------------------------------------------------------------------------------------------- | ---------------------------------------------------- | ------------- | ------ | --------- | - | -------- | ------ | --------- |  | - | ------ | ----- | - | - | ------ | ---- | 
|                                                                                                        |                                                      |              
|                                                                                                        |                                                      | 2000 Quarters
|                                                                                                        |                                                      |              
|                                                                                                        |                                                      | First(3)      |        | Second(4) |   | Third(5) |        | Fourth(6)
|                                                                                                        |                                                      |               |        |           |   |          |        |          
|Total revenues                                                                                          |                                                      | $             | 13,603 |           |   | $        | 10,522 |           |  | $ | 7,087  |       |   | $ | 9,562  |     
|Gross profit on net sales                                                                               |                                                      |               | 11,804 |           |   |          | 10,061 |           |  |   | 6,368  |       |   |   | 8,673  |     
|Operating income (loss)                                                                                 |                                                      |               | 140    |           |   |          | 31     |           |  |   | (6,225 | )     |   |   | (5,588 | )   
|Income (loss) before cumulative effect of
	change in accounting principle                               |                                                      |               | 785    |           |   |          | 567    |           |  |   | (5,600 | )     |   |   | 36,436 |     
|Cumulative effect of change in accounting
	principle                                                    |                                                      |               | (5,192 | )         |   |          |       |           |  |   |       |       |   |   |       |     
|Net income (loss)                                                                                       |                                                      |               | (4,407 | )         |   |          | 567    |           |  |   | (5,600 | )     |   |   | 36,436 |     
|Earnings per share  basic Income
	(loss) before cumulative effect of change in accounting
	principle   |                                                      |               | 0.03   |           |   |          | 0.02   |           |  |   | (0.19  | )     |   |   | 1.23   |     
|                                                                                                        | Cumulative effect of change in accounting
	principle |               |        | (0.19     | ) |          |        |          |  |   |        |      |   |   |        |     | 
|                                                                                                        | Net income (loss)                                    |               |        | (0.16     | ) |          |        | 0.02      |  |   |        | (0.19 | ) |   |        | 1.23 | 
|Earnings per share  diluted Income
	(loss) before cumulative effect of change in accounting
	principle |                                                      |               | 0.03   |           |   |          | 0.02   |           |  |   | (0.19  | )     |   |   | 1.16   |     
|                                                                                                        | Cumulative effect of change in accounting
	principle |               |        | (0.18     | ) |          |        |          |  |   |        |      |   |   |        |     | 
|                                                                                                        | Net income (loss)                                    |               |        | (0.15     | ) |          |        | 0.02      |  |   |        | (0.19 | ) |   |        | 1.16 | 
|Shares used to calculate basic net income
	(loss) per share                                             |                                                      |               | 26,627 |           |   |          | 27,481 |           |  |   | 29,507 |       |   |   | 29,692 |     
|Shares used to calculate fully diluted net income
	(loss) per share                                     |                                                      |               | 28,412 |           |   |          | 28,704 |           |  |   | 29,507 |       |   |   | 31,331 |     



---



|    |                                                                                                                                                                                                                                                                                                                                                                   
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(3) | In the first quarter of 2000, we recorded a net
	charge of $5.2 million ($0.18 per diluted share) for a
	cumulative effect of a change in accounting principle relating
	to the adoption of SAB 101 for the deferral of certain fees
	recognized in prior years. We also recognized $0.2 million
	of deferred revenue in connection with the adoption of
	SAB 101.
|   
|(4) | In accordance with the adoption of SAB 101,
	we restated the results of operations for the second quarter of
	2000. The impact of the restatement was to increase net income
	by $0.2 million or $0.01 per diluted share. The increase
	was related to the amortization of the amount deferred in the
	first quarter.                                             
|   
|(5) | In accordance with the adoption of SAB 101,
	we restated the results of operations for the third quarter of
	2000. The impact of the restatement was to decrease net income
	by $0.3 million or $0.01 per diluted share, comprised of
	the reversal of $0.5 million in fees previously recognized
	during the period, net of $0.2 million of deferred revenue.    
|   
|(6) | In the fourth quarter of 2000, we recognized $4.1
	in revenue from amounts deferred in the first quarter as a
	result of contract cancellations. We also recorded a
	$43.0 million gain on the sale of securities.                                                                                                                                                

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CONNETICS CORPORATION






INDEX TO EXHIBITS


[Item 14(c)]


|                                     |  |                                                                                                                                                                                                                                                                                                                                                                 
|------------------------------------ |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit                              |  |                                                                                                                                                                                                                                                                                                                                                                 
|Number                               |  | Description                                                                                                                                                                                                                                                                                                                                                     
|                                     |  |                                                                                                                                                                                                                                                                                                                                                                 
|3.1*                                 |  | Amended and Restated Certificate of Incorporation
	(previously filed as an exhibit to the Companys
	Form S-1 Registration Statement No. 33-80261)                                                                                                                                                                                                              
|3.2*                                 |  | Amendment to the Companys Amended and
	Restated Certificate of Incorporation, as filed with the
	Delaware Secretary of State on May 15, 1997 (previously
	filed as an exhibit to the Companys Current Report on
	Form 8-K dated May 23, 1997)                                                                                                                 
|3.3*                                 |  | Certificate of Designation of Rights, Preferences
	and Privileges of Series B Participating Preferred Stock,
	as filed with the Delaware Secretary of State on May 15,
	1997. Reference is made to Exhibit 4.2.                                                                                                                                                 
|3.4*                                 |  | Amended and Restated Bylaws (previously filed as
	Exhibit 3.2 to the Companys Form 8-A/ A filed
	November 28, 2001)                                                                                                                                                                                                                                            
|3.5                                  |  | Certificate of Elimination of Rights, Preferences
	and Privileges of Connetics Corporation, as filed with the
	Delaware Secretary of State on December 11, 2001                                                                                                                                                                                                 
|4.1*                                 |  | Form of Common Stock Certificate (previously
	filed as Exhibit 4.1 to the Companys Annual Report on
	Form 10-K for the year ended December 31, 1998)                                                                                                                                                                                                           
|4.2*                                 |  | Amended and Restated Preferred Shares Rights
	Agreement, dated as of November 21, 2001, between the
	Company and EquiServe Trust Company, N.A., including the form of
	Rights Certificate and the Summary of Rights attached thereto as
	Exhibits A and B, respectively (previously filed as
	Exhibit 4.1 to the Companys Form 8-A/ A filed
	November 28, 2001)
|Management and Consulting Agreements
|10.1*                                |  | Form of Indemnification Agreement with the
	Companys directors and officers (previously filed as an
	exhibit to the Companys Form S-1 Registration
	Statement No. 33-80261)                                                                                                                                                                                   
|10.2*(M)                             |  | Employment Agreement dated June 9, 1994
	between Connetics and Thomas Wiggans (previously filed as an
	exhibit to the Companys Form S-1 Registration
	Statement No. 33-80261)                                                                                                                                                                                  
|10.3*(M)                             |  | Letter Agreement with G. Kirk Raab dated
	October 1, 1995 (previously filed as an exhibit to the
	Companys Form S-1 Registration Statement
	No. 33-80261)                                                                                                                                                                                                      
|10.4(M)                              |  | Form of Notice of Stock Option Grant to G. Kirk
	Raab dated January 28, 1997                                                                                                                                                                                                                                                                                    
|10.5(M)                              |  | Form of Notice of Stock Option Grant to G. Kirk
	Raab dated July 30, 1997                                                                                                                                                                                                                                                                                       
|10.6*(M)                             |  | Letter of Employment dated July 1, 1998 from
	Connetics to Robert G. Lederer (previously filed as
	Exhibit 10.56 to the Companys Annual Report on
	Form 10-K for the year ended December 31, 1998)                                                                                                                                                             
|10.7*(M)                             |  | Restricted Common Stock Purchase Agreement dated
	November 5, 1998 between the Company and Kirk Raab
	(previously filed as Exhibit 10.59 to the Companys
	Annual Report on Form 10-K for the year ended
	December 31, 1998)                                                                                                                                    
|10.8*(M)                             |  | Restricted Common Stock Purchase Agreement dated
	March 9, 1999 between the Company and Kirk Raab (previously
	filed as Exhibit 10.5 to the Companys Quarterly
	Report on Form 10-Q for the quarter ended March 30,
	1999)                                                                                                                                     
|10.9*(M)                             |  | Restricted Common Stock Purchase Agreement dated
	March 9, 1999 between the Company and Thomas G. Wiggans
	(previously filed as Exhibit 10.6 to the Companys
	Quarterly Report on Form 10-Q for the quarter ended
	March 30, 1999)                                                                                                                             
|10.10*(M)                            |  | Consulting Agreement effective April 1, 2000
	between the Company and Leon Panetta (previously filed as
	Exhibit 10.77 to the Companys Annual Report on
	Form 10-K for the year ended December 31, 2000)                                                                                                                                                       
|10.11*(M)                            |  | Consulting Agreement dated January 10, 2001
	between the Company and Glenn Oclassen (previously filed as
	Exhibit 10.78 to the Companys Annual Report on
	Form 10-K for the year ended December 31, 2000)                                                                                                                                                      

F-31



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|                                  |  |                                                                                                                                                                                                                                                                        
|--------------------------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit                           |  |                                                                                                                                                                                                                                                                        
|Number                            |  | Description                                                                                                                                                                                                                                                            
|                                  |  |                                                                                                                                                                                                                                                                        
|10.12(M)                          |  | Form of Change in Control Agreement between the
	Company and key employees of the Company                                                                                                                                                                              
|10.13(M)                          |  | Consulting Agreement dated January 1, 2002
	between Connetics and Eugene Bauer, M.D.                                                                                                                                                                                   
|Stock Plans and Equity Agreements
|10.14(M)*                         |  | 1994 Stock Plan (as amended through May 1999) and
	form of Option Agreement (previously filed as Exhibit 4.1
	to the Companys Form S-8 Registration Statement
	No. 333-85155)                                                                                         
|10.15(M)*                         |  | 1995 Employee Stock Purchase Plan (as amended
	through May 2000), and form of Subscription Agreement
	(previously filed as Exhibit 4.1 to the Companys
	Form S-8 Registration Statement No. 333-46562)                                                                
|10.16(M)*                         |  | 1995 Directors Stock Option Plan (as
	amended through May 1999), and form of Option Agreement
	(previously filed as Exhibit 4.2 to the Companys
	Form S-8 Registration Statement No. 333-85155)                                                                      
|10.17*                            |  | Structured Equity Line Flexible Financing
	Agreement dated January 2, 1997 between Connetics and
	Kepler Capital LLC (previously filed as Exhibit 10.1 to the
	Companys Form S-3 Registration Statement
	No. 333-45002)                                               
|10.18*                            |  | Registration Rights Agreement dated
	January 2, 1997 between Connetics and Kepler Capital LLC
	(previously filed as an exhibit to the Companys Annual
	Report on Form 10-K for the year ended December 31, 1996)                                                      
|10.19*(M)                         |  | 1998 Supplemental Stock Plan (previously filed as
	Exhibit 10.60 to the Companys Annual Report on
	Form 10-K for the year ended December 31, 1998)                                                                                                                    
|10.20*                            |  | Common Stock Purchase Agreement dated
	July 7, 1999 between Connetics and Paladin Labs Inc.
	(previously filed as Exhibit 10.2 to the Companys
	Quarterly Report on Form 10-Q for the quarter ended
	June 30, 1999)                                                   
|10.21*                            |  | Registration Rights Agreement dated July 7,
	1999 between Connetics and Paladin Labs Inc. (previously filed
	as Exhibit 10.3 to the Companys Quarterly Report on
	Form 10-Q for the quarter ended June 30, 1999)                                                      
|10.22*                            |  | Stock Plan (2000) and form of Option
	Agreement (previously filed as Exhibit 4.4 to the
	Companys Form S-8 Registration Statement
	No. 333-85155)                                                                                                                     
|10.23*                            |  | International Stock Incentive Plan (previously
	filed as Exhibit 4.1 to the Companys Form S-8
	Registration Statement No. 333-61558)                                                                                                                                  
|10.24*                            |  | 2000 Non-Officer Employee Stock Plan (previously
	filed as Exhibit 4.3 to the Companys Form S-8
	Registration Statement No. 333-46562)                                                                                                                                
|10.25*                            |  | 2002 Non-Officer Employee Stock Plan (previously
	filed as Exhibit 4.4 to the Companys Form S-8
	Registration Statement No. 333-82468)                                                                                                                                
|10.26*                            |  | Form of Warrant Agreement attached as
	Exhibit D to Master Bridge Loan Agreement dated
	December 7, 1995 between Connetics and certain investors
	(previously filed as an exhibit to the Companys
	Form S-1 Registration Statement No. 33-80261)                      
|License Agreements               
|10.27*                           |  | License Agreement dated September 27, 1993,
	between Genentech, Inc. and Connetics, Amendment dated
	July 14, 1994, and side letter agreement dated
	November 17, 1994 (previously filed as an exhibit to the
	Companys Form S-1 Registration Statement
	No. 33-80261)
|10.28*                           |  | Agreement on Relaxin Rights in Asia dated
	April 1, 1996 between the Company and Mitsubishi Chemical
	Corporation (previously filed as an exhibit to the
	Companys Quarterly Report on Form 10-Q for the
	quarter ended June 30, 1996)                                
|10.29*                           |  | Soltec License Agreement dated June 14, 1996
	(previously filed as an exhibit to the Companys Quarterly
	Report on Form 10-Q for the quarter ended June 30,
	1996)                                                                                                    

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|                 |  |                                                                                                                                                                                                                                                                                            
|---------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit          |  |                                                                                                                                                                                                                                                                                            
|Number           |  | Description                                                                                                                                                                                                                                                                                
|                 |  |                                                                                                                                                                                                                                                                                            
|10.30*          |  | License Agreement dated January 1, 1998
	between Connetics and Soltec Research Pty Limited (previously
	filed as an exhibit to the Companys Annual Report on Form
	10-K for the year ended December 31, 1997)                                                                             
|10.31*          |  | Agreement on Relaxin dated January 19, 1998
	by and between Connetics and Howard Florey Institute of
	Experimental Physiology and Medicine (previously filed as an
	exhibit to the Companys Annual Report on Form 10-K
	for the year ended December 31, 1997)                             
|10.32*          |  | Second Omnibus Agreement with SmithKline Beecham
	Corporation and related entities dated April 28, 1998
	(previously filed as an exhibit to the Companys Current
	Report on Form 8-K dated April 10, 1998 and filed with
	the Commission on May 6, 1998)                                  
|10.33*          |  | License Agreement dated as of May 5, 1998
	between Connetics and Genentech, Inc. (previously filed as
	Exhibit 10.2 to the Companys Report on Form 10-Q
	for the quarter ended June 30, 1998)                                                                                             
|10.34*           |  | Amendment No. One to License Agreement,
	effective December 28, 1998, between Connetics and
	Genentech (previously filed as Exhibit 10.63 to the
	Companys Annual Report on Form 10-K for the year
	ended December 31, 1998)                                                              
|10.35*           |  | Amendment No. Two to License Agreement,
	effective as of January 15, 1999, between the Company and
	Genentech, Inc. (previously filed as Exhibit 10.3 to the
	Companys Quarterly Report on Form 10-Q for the
	quarter ended March 30, 1999)                                               
|10.36*          |  | Amendment No. Three to License Agreement,
	effective as of April 27, 1999, between the Company and
	Genentech, Inc. (previously filed as Exhibit 10.4 to the
	Companys Quarterly Report on Form 10-Q for the
	quarter ended March 30, 1999)                                               
|10.37*          |  | Relaxin Development, Commercialization and
	License Agreement dated July 7, 1999 between the Company
	and Paladin Labs Inc. (previously filed as Exhibit 10.1 to
	the Companys Quarterly Report on Form 10-Q for the
	quarter ended June 30, 1999)                                        
|10.38*           |  | License Agreement (Ketoconazole) dated
	July 14, 1999 between the Company and Soltec Research Pty
	Ltd. (previously filed as Exhibit 10.4 to the
	Companys Quarterly Report on Form 10-Q for the
	quarter ended June 30, 1999)                                                            
|Real Property   
|10.39            |  | Lease between Connetics and Renault & Handley
	Employees Investment Co., dated June 28, 1999                                                                                                                                                                                              
|10.40*           |  | Industrial Building Lease dated November 20,
	1998, by and between Connetics and West Bayshore Associates, a
	general partnership, et al. (previously filed as
	Exhibit 10.61 to the Companys Annual Report on
	Form 10-K for the year ended December 31, 1998)                           
|10.41*           |  | Industrial Building Lease dated December 16,
	1999, between Connetics and West Bayshore Associates (previously
	filed as Exhibit 10.2 to the Companys Quarterly
	Report on Form 10-Q for the quarter ended
	September 30, 2001)                                                           
|10.42*           |  | Assignment and Assumption of Lease between
	Connetics and Respond.com, dated August 21, 2001 (previously
	filed as Exhibit 10.3 to the Companys Quarterly
	Report on Form 10-Q for the quarter ended
	September 30, 2001)                                                                 
|10.43*           |  | Agreement dated August 21, 2001, between
	Connetics and Respond.com (previously filed as Exhibit 10.4
	to the Companys Quarterly Report on Form 10-Q for the
	quarter ended September 30, 2001)                                                                                           
|10.44*           |  | Sublease Agreements dated August 21, 2001,
	between Connetics and Respond.com, Inc., with respect to 3290
	and 3294 West Bayshore Road, Palo Alto, California (previously
	filed as Exhibit 10.5 to the Companys Quarterly
	Report on Form 10-Q for the quarter ended
	September 30, 2001)
|Other Agreements
|10.45*           |  | Business Loan Agreement, dated July 18,
	1995, among Connetics, Silicon Valley Bank and MMC/ GATX
	Partnership No. 1 (previously filed as an exhibit to the
	Companys Form S-1 Registration Statement
	No. 33-80261)                                                                      

F-33



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##### Table of Contents



|         |  |                                                                                                                                                                                                                                                                                                     
|-------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit  |  |                                                                                                                                                                                                                                                                                                     
|Number   |  | Description                                                                                                                                                                                                                                                                                         
|         |  |                                                                                                                                                                                                                                                                                                     
|10.46*   |  | Loan and Security Agreement dated
	December 21, 1995 by and among Connetics, Silicon Valley
	Bank and MMC/ GATX Partnership No. 1 (previously filed as
	an exhibit to the Companys Form S-1 Registration
	Statement No. 33-80261)                                                                  
|10.47*  |  | Supply Agreement dated as of May 5, 1998
	between Connetics and Genentech, Inc. (previously filed as
	Exhibit 10.3 to the Companys Quarterly Report on
	Form 10-Q for the quarter ended June 30, 1998)                                                                                             
|10.48*   |  | Loan and Security Agreement between Silicon
	Valley Bank and Connetics dated September 24, 1998, as
	modified December 22, 1998 pursuant to a Loan Modification
	Agreement (previously filed as Exhibit 10.58 to the
	Companys Annual Report on Form 10-K for the year
	ended December 31, 1998)   
|10.49    |  | Release of Security Agreement Covering Interest
	in Trademarks, between Silicon Valley Bank and Connetics, dated
	April 3, 2001                                                                                                                                                                     
|10.50*  |  | Agreement dated December 9, 1999 between the
	Company and Soltec Research Pty Ltd. (previously filed as
	Exhibit 10.75 to the Companys Annual Report on
	Form 10-K for the year ended December 31, 1999)                                                                                           
|10.51*  |  | Share Sale Agreement dated March 21, 2001
	among the Company, F. H. Faulding & Co. Ltd., Faulding
	Healthcare, and Connetics Australia Pty Ltd. (previously filed
	as Exhibit 2.1 to the Companys Current Report on
	Form 8-K dated March 20, 2001 and filed with the
	Commission on April 2, 2001)
|10.52*  |  | Amended and Restated Manufacturing and Supply
	Agreement dated September 19, 2001, by and between
	Connetics and Miza Pharmaceuticals (UK) Limited (previously
	filed as Exhibit 10.1 to the Companys Quarterly
	Report on Form 10-Q for the quarter ended
	September 30, 2001)                    
|10.53*  |  | Asset Purchase Agreement dated as of
	April 9, 2001, by and between Connetics and Prometheus
	Laboratories, Inc. (previously filed as Exhibit 2.1 to the
	Companys Current Report on Form 8-K dated
	April 30, 2001 and filed with the Commission on
	May 11, 2001)                                
|10.54(C) |  | Settlement and Release Agreement effective as of
	December 13, 2001 between Connetics and Boehringer
	Ingelheim Austria GmbH                                                                                                                                                                        
|10.55(C) |  | Facilities Contribution Agreement between
	Connetics and DPT Laboratories, Ltd., with retroactive effect to
	November 1, 2001                                                                                                                                                                       
|10.56(C) |  | Manufacturing and Supply Agreement between
	Connetics and DPT Laboratories, Ltd., dated March 12, 2002                                                                                                                                                                                              
|21       |  | Subsidiaries of the Company                                                                                                                                                                                                                                                                         
|23.1     |  | Consent of Ernst & Young LLP, Independent
	Auditors                                                                                                                                                                                                                                                 

Key to Footnotes:

The Commission file number for our Exchange Act
filings referenced above is 0-27406.



|    |                                                                                                                                                                    
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------
|*   | Incorporated by this reference to the previous
	filing, as indicated.                                                                                              
|   
|(M) | This item is a management compensatory plan or
	arrangement required to be listed as an exhibit to this Report
	pursuant to Item 601(b)(10)(iii) of Regulation S-K.



|    |                                                                                                                            
|--- | ---------------------------------------------------------------------------------------------------------------------------
|(C) | We have omitted certain portions of this Exhibit
	and have requested confidential treatment of such portions from
	the SEC.



|  |                                                                                                        
|- | -------------------------------------------------------------------------------------------------------
| | We have requested and the SEC has granted
	confidential treatment for certain portions of this Exhibit.

F-34