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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, 2003 Commission File Number 0-27406 CONNETICS CORPORATION (Exact name of registrant as specified in its charter)
 Delaware
    
    94-3173928(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)
 3290 West Bayshore RoadPalo Alto, California
    
    94303(Address of principal executive offices)
    
    (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 x   NOo 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. x Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act
Rule 12b-2). YES x   NO o The aggregate market value of the voting stock held by non-affiliates of the
registrant was approximately
$371,000,000 as of June 30, 2003, based upon the shares outstanding and 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 known by the registrant to beneficially own 5% or more of
the outstanding common stock as of that date, 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 35,202,167 shares of registrants common stock issued and
outstanding as of March 9, 2004. 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 7, 2004.




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Table of Contents

PageForward-Looking Statements
    
    
    1PART IItem 1. Business
    
    
    1The Company
    
    
    1Our Strategy
    
    
    3Our Products
    
    
    4Product Candidates and Clinical Trials
    
    
    5Recent Developments  Acquisition of U.S. Rights to Soriatane
    
    
    6Royalty-Bearing Products and Licensed Technology
    
    
    7Sales and Marketing
    
    
    9Competition
    
    
    9Customers
    
    
    10Research and Development and Product Pipeline
    
    
    10Patents and Proprietary Rights
    
    
    11Trademarks
    
    
    12Manufacturing
    
    
    12Warehousing and Distribution
    
    
    12Government Regulation
    
    
    13Marketing to Healthcare Professionals
    
    
    16Marketing Exclusivity
    
    
    17Termination of Relaxin Development Program
    
    
    17Environmental Regulation
    
    
    17Employees
    
    
    18Factors Affecting Our Business and Prospects
    
    
    18Available Information
    
    
    30Executive Officers of the Company
    
    
    31Item 2. Properties
    
    
    32Item 3. Legal Proceedings
    
    
    33Item 4. Submission of Matters to a Vote of Security Holders
    
    
    33PART IIItem 5. Market for the Companys Common Equity, Related Stockholder Matters and
Issuer Purchases of Equity Securities
    
    
    33Item 6. Selected Financial Data
    
    
    34Item 7. Managements Discussion and Analysis of Financial Condition and Results of
Operations
    
    
    36Item 7A. Quantitative and Qualitative Disclosures About Market Risk
    
    
    51Item 8. Financial Statements and Supplementary Data
    
    
    51Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure
    
    
    52Item 9A. Controls and Procedures
    
    
    52PART IIIItem 10. Our Directors and Executive Officers
    
    
    52Item 11. Executive Compensation
    
    
    53Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters
    
    
    53Item 13. Certain Relationships and Related Transactions
    
    
    54Item 14. Principal Accountant Fees and Services
    
    
    54PART IVItem 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K
    
    
    54Signatures
    
    
    56Consolidated Financial Statements and Report of Independent Auditors
    
    
    F-1Index to ExhibitsEXHIBIT 10.41EXHIBIT 14.1EXHIBIT 14.2EXHIBIT 23.1EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2






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Forward-Looking Statements 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 of 1933, and Section 21E of the
Securities Exchange Act of 1934. Forward-looking statements give our current
expectations or forecasts of future events. 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. You can identify forward-looking 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. 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 developments relating to 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. In particular, this
Report sets forth important factors that could cause actual results to differ
materially from our forward-looking statements. 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, now 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. Unless the context specifically requires otherwise,
we includes Connetics Australia Pty Ltd. Connetics was incorporated in
Delaware in February 1993, and our principal executive offices are located at
3290 West Bayshore Road, Palo Alto, California 94303. Our telephone number is
(650) 843-2800. Connetics®, Luxíq®, OLUX® and Extina® are registered
trademarks, and VersaFoam, Actiza, Liquipatch, and the seven interlocking
Cs design are trademarks, of Connetics. Velac® is a registered trademark of
Yamanouchi Europe B.V. Soriatane® is a registered trademark of Hoffmann-La
Roche Inc., and was assigned to us effective March 4, 2004. All other
trademarks or service marks appearing in this Report are the property 1




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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, OLUX® Foam (clobetasol propionate), 0.05%, and Luxíq®
Foam (betamethasone valerate), 0.12%. On March 4, 2004, we acquired exclusive
U.S. rights to Soriatane®-brand acitretin, as described below under Recent
Developments  Acquisition of U.S. Rights to Soriatane. Our commercial business is focused on the dermatology
marketplace, which is characterized by a large patient population that is
served by a relatively small number of treating physicians. Our dermatology
products have clinically proven therapeutic advantages for the treatment of
dermatoses in a novel formulation, and we are providing quality customer
service to dermatologists through our experienced sales and marketing
professionals. Except for 2000, we have lost money every year since inception.
During each of the last five years, our operating cash flows were insufficient
to cover our fixed charges. Dermatological diseases often persist for an extended period of time and
are treated with a variety of clinically proven drugs that are delivered in a
variety of formulations, including solutions, creams, gels and ointments.
These delivery systems often inadequately address a patients needs for
efficacy, ease of use and cosmetic elegance, and the failure to address those
needs may decrease patient compliance. We believe that VersaFoam, the
proprietary foam delivery system used in OLUX and Luxíq, has significant
advantages over conventional therapies for dermatoses. The foam formulation
liquefies when applied to the skin, and enables the active therapeutic agent to
penetrate rapidly. 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, more than 80% of patients said that they preferred the foam to other
topical delivery vehicles. Our products, OLUX and Luxíq, compete in the topical steroid market.
According to NDC Health, in 2003, the value of the retail topical steroid
market for mid-potency and high and super-high potency steroids was $854
million. Luxíq competes in the mid-potency steroid market and OLUX competes in
the high- and super-high potency steroid market. We have two New Drug Applications, or NDAs, under review by the Food and
Drug Administration, or FDA, and one product candidate in Phase III clinical
trials. We submitted an NDA to the FDA for Actiza Foam for the treatment of
acne in December 2003. Actiza is a formulation of 1% clindamycin in our
proprietary foam delivery system. Following discussions with the FDA about
whether a user fee was due, we submitted an NDA for Extina® Foam in January
2004. Extina, a potential new treatment for seborrheic dermatitis, is an
investigational new drug formulation of 2% ketoconazole formulated using our
proprietary platform foam delivery vehicle. We recently completed enrollment
in two Phase III clinical trials for Velac® Gel, a combination of 1%
clindamycin and 0.025% tretinoin for the treatment of acne, which is the first
such combination in its class. We continue to develop and formulate new product candidates by leveraging
the abilities of our wholly-owned subsidiary, Connetics Australia Pty Ltd., and
the Connetics Center for Skin Biology. We own worldwide rights to a number of
unique topical delivery systems, including several distinctive aerosol foams.
We have leveraged our broad range of drug delivery technologies by entering
into license agreements with many well-known pharmaceutical companies around
the world. Those license agreements for marketed products bear royalties
payable to us. The Center for Skin Biology, which is a segment of our product
development group staffed by Connetics employees, was created in 2001 to
explore ways to optimize drug penetration, distribution, and efficiency at the
targeted treatment site on the skin, and to assess novel formulations and new
delivery technologies. The Center assists in the continued development of
innovative topical dermatology products through rigorous scientific evaluation
of products and product candidates. The Center presents us with the
opportunity to bring together 2




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dermatologists and pharmacologists from across the country to interact
with our researchers to explore how topical drugs interact with and penetrate
the skin. 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. We did not incur any costs to establish the Center. 
 OUR STRATEGY Our principal business objective is to be a leading specialty
pharmaceutical company focused on providing innovative treatments in the field
of dermatologic disease. To achieve this 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. We have
described our development paradigm as a 4:2:1 model. We strive in any given
year to have four product candidates in product formulation, two product
candidates in late-stage clinical trials, and one product or new indication
launched commercially. We fuel our product pipeline by a combination of
internally developing product candidates and in-licensing novel products that
fit with our broader strategy. Key elements of our business and
commercialization strategy include the following:  
    
    Maximizing Commercial Opportunities for OLUX and Luxíq.We have a
focused sales force dedicated to establishing OLUX and Luxíq as the
standard of care. Our commercial strategy is to call on those medical
professionals in dermatology who are most likely to write prescriptions
for our products. We are able to effectively reach approximately 99%
of our target audience. Effective March 4, 2004, we also own exclusive
U.S. rights to Soriatane-brand acitretin. We anticipate that we will begin
promoting Soriatane to dermatologists in May 2004, after our sales
force is fully trained on the new product.  
    
    Advancing the Development of Novel Dermatology Drugs.We plan to
continue to leverage our investment in Connetics Australia and the
Center for Skin Biology to enhance our ability to develop novel
products and drug delivery technologies for the dermatology market. We
concluded clinical trials in 2003 and subsequently submitted NDAs with
the FDA for two new product candidates: Extina (ketoconazole 2%) Foam
and Actiza (clindamycin 1%) Foam. We also completed enrollment of two
clinical trials to support an NDA for a third product candidate, Velac
(1% clindamycin, 0.025% tretinoin) Gel. We anticipate that, if results
of the Velac trial are positive, we will be in a position to file an
NDA for that product in the third quarter of 2004.  
    
    Broadening Our Product Portfolio Through Development, License or
Acquisition.We believe that we can leverage our dermatology-dedicated
product development and commercial activities by acquiring or licensing
additional products for the dermatology market. We are evaluating the
licensing or acquisition of additional product candidates. We may also
acquire additional technologies or business that we believe will
enhance our research and development capabilities. On March 4, 2004,
we acquired exclusive U.S. rights to Soriatane-brand acitretin from
Hoffmann-La Roche Inc., or Roche.  
    
    Selective Collaborations that Leverage Our Technology.As we
expand certain aspects of our development pipeline and delivery
technologies, we intend to partner with pharmaceutical or biotech
companies to gain access to additional marketing expertise, such as
over-the-counter or non-U.S. markets. Our approach to partnership will
be on a selective basis, seeking to maintain the highest possible value
of our product candidates. For instance, we have licensed our
technologies to Novartis for Lamisil® and Pfizer for Rogaine®. 3




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OUR PRODUCTS OLUX Foam OLUX is a foam formulation of clobetasol propionate, one of the most
widely prescribed super high-potency topical steroids. OLUX has been proven to
deliver rapid and effective results for scalp and non-scalp psoriasis. In
fact, according to Physician Global Assessments, significantly more patients
were completely clear or almost clear after two weeks of treatment. Topical
steroids are used to treat a range of dermatoses, for which approximately 24
million steroid prescriptions are written annually. In 2003, OLUX and Luxíq
comprised 7.3% of the branded prescriptions in these combined topical steroid
markets, corresponding to 17% of the retail annual branded sales for 2003.
While the topical steroid market is highly fragmented, we believe that OLUX is
the number one branded super-high potency topical steroid prescribed by U.S.
dermatologists. 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 December 2002, the FDA approved
our supplemental New Drug Application, or sNDA, to market OLUX for the
treatment of mild to moderate non-scalp psoriasis. A study conducted at Stanford University School of Medicine compared the
safety and 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, or PASI, and the Dermatology Life Quality Index. The trial
showed 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
lotion 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 other formulations. Mipharm S.p.A., which holds a license to market OLUX in Italy, filed a
Marketing Authorization Application, or MAA, in 2002 for OLUX with the
Medicines and Healthcare Products Regulatory Agency, known as MHRA, in the
United Kingdom. The MHRA granted marketing authorization for OLUX in June
2003. The approval grants the right to market and launch OLUX in the U.K.
 Following MHRA approval, updated MAAs were submitted to each of the EU
Concerned Member States, using a process called the mutual recognition process,
or MRP. The MRP was completed in December 2003 with all Concerned Member
States granting approval for OLUX except France. National licenses are
expected to be issued in the first half of 2004. We will receive milestone
payments and royalties from Mipharm on future product sales in the Italian
territory. We retain marketing and distribution rights for the rest of Europe
and are seeking commercial partners outside the territory licensed to Mipharm.
We have signed a letter of intent with a third party for rights to market OLUX
in all of Europe excluding the U.K. and the territory licensed to Mipharm. 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. We have been selling Luxíq commercially in the United States since
1999. In a clinical trial, a majority of patients were judged to be almost
clear or completely clear (90-100%) of scalp psoriasis at the end of treatment
as judged by Investigators Global Assessment of response. Luxíq also
significantly reduced scaling, erythema, and plaque thickness, as compared with
betamethasone valerate 4




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lotion. While the topical steroid market is highly fragmented, we believe
that Luxíq is the number one branded mid-potency topical steroid prescribed by
U.S. dermatologists. Soriatane On March 4, 2004, we acquired exclusive U.S. rights to Soriatane-brand
acitretin, as described below under Recent Developments  Acquisition of U.S. Rights to Soriatane. 
 PRODUCT CANDIDATES AND CLINICAL TRIALS Our product candidates require extensive clinical evaluation and clearance
by the FDA before we can sell them commercially. Our 4:2:1 development model
anticipates that we will conduct simultaneous studies on several products at a
given time. However, we regularly re-evaluate our product development efforts.
On the basis of these re-evaluations, 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. Extina® Foam In April 2003, we announced summary results from our Phase III clinical
trial with Extina, a foam formulation of a 2% concentration of the antifungal
drug ketoconazole for the treatment of seborrheic dermatitis. Ketoconazole is
used to treat a variety of fungal infections, including seborrheic dermatitis.
Seborrheic dermatitis is a chronic, recurrent skin condition that affects 3-5%
of the U.S. population. It usually involves the scalp, but also can affect the
skin on other parts of the body, including the face and chest. The symptoms of
seborrheic dermatitis include itching, redness and scaling. In 2003 an
estimated 1.1 million patients sought physician treatment for seborrheic
dermatitis. In 2003, the total U.S. market for prescription antifungal
products was approximately $720 million. We believe Extina will compete
primarily in the topical antifungal market, representing approximately $485
million in U.S. prescriptions in 2002. The Extina clinical program consisted of a pivotal trial and two smaller
supplemental clinical studies required by the FDA. In the pivotal trial, 619
patients were treated for four weeks in a double-blind, placebo- and
active-controlled protocol. As designed, the trial results demonstrated that
Extina was not inferior to Nizoral® (ketoconazole) 2% cream as measured by the
primary endpoint of Investigators Static Global Assessment, or ISGA. The
trial was also designed to compare Extina to placebo foam per the ISGA. The
result, although in favor of Extina, did not achieve statistical significance.
On all other endpoints, statistical significance was achieved; therefore, we
believe that the totality of the data demonstrated that Extina was clinically
superior to placebo foam. In July 2003, we submitted an NDA to the FDA for
Extina. The FDA initially informed us that a user fee was required for the
Extina NDA on the basis that the FDA believed it contained a new indication for
use, but in December 2003 the FDA agreed that no user fee was required. The
FDA did not, however, accept the NDA retroactive to the original filing date,
and in January 2004 we re-submitted the NDA for Extina. Actiza Foam On September 30, 2003, we announced the positive outcome of a Phase III
clinical trial evaluating Actiza, an investigational new drug formulation of 1%
clindamycin delivered in our proprietary VersaFoam delivery system, as a
potential new topical treatment for acne. The Actiza clinical program
consisted of a pivotal trial, a pilot trial, and two smaller supplemental
clinical studies required by the FDA. We filed an NDA for Actiza in December
2003. 5




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The Phase III trial was a 12-week, double-blinded, active- and
placebo-controlled trial that included 1,026 patients at 18 centers across the
U.S. The trial was designed to demonstrate that Actiza was not inferior to
Clindagel® (clindamycin phosphate 1% topical gel) as measured by the primary
endpoints of ISGA and percent reduction in lesion counts (total, inflammatory
and non-inflammatory) from baseline to Week 12 (end of treatment). Success was
defined as achieving non-inferiority to Clindagel for two out of three lesion
counts and for ISGA. The trial results met or exceeded all of these
requirements with a high level of statistical confidence. Additionally, Actiza
was superior to placebo for all primary endpoints. Adverse events with Actiza
were mild to moderate in nature and were related primarily to burning at the
application site. According to the National Institute of Arthritis, Musculoskeletal and Skin
Disorders, in the U.S. an estimated 17 million people are affected by acne, and
an estimated 5.1 million people visited a physician for treatment during the 12
months ended July 2003. Prescriptions for the entire U.S. acne market in 2003
were approximately $1.7 billion not including oral antibiotics, making it the
largest segment of the dermatology market. In the U.S., acne products
containing clindamycin generated approximately $376 million in revenue in 2003,
making this active ingredient one of the most widely prescribed for acne. We
believe Actiza will compete primarily in the topical antibiotic market,
representing approximately $516 million in U.S. prescriptions in 2003. Velac® Gel In December 2002, we initiated the Phase III program for Velac gel, a
first-in-class combination of 1% clindamycin and 0.025% tretinoin for the
treatment of acne. The Velac clinical program consists of two pivotal trials
designed to demonstrate superiority to the individual drug products, and two
smaller supplemental clinical studies required by the FDA. We completed
enrollment of both pivotal trials in late 2003, enrolling over 2,200 patients.
Assuming a successful clinical outcome, we anticipate that we will submit an
NDA to the FDA for Velac in the third quarter of 2004 and be in a position to
launch Velac commercially in mid-2005. We believe Velac will compete with
topical retinoids as well as topical antibiotics, representing approximately
$947 million in U.S. prescriptions in 2003. Prescriptions for the entire U.S.
acne market in 2003 were approximately $1.7 billion not including oral
antibiotics. Other Pipeline Formulations In addition to the product candidates described above, we are also
developing the foam technology for other disease indications. As part of our
4:2:1 development model, we strive to have four product candidates in product
formulation at any given time, so that we have some flexibility in determining
which two to move into human clinical trials. Our most promising preclinical
candidates include an emollient foam line extension for OLUX and an emollient
foam of desonide, a low potency steroid, as well as other formulation
candidates in early stages of development. We are exploring various product
formulations for Liquipatch as well, which is described in more detail below
under Royalty-Bearing Products and Licensed Technology  Liquipatch. 
 RECENT DEVELOPMENTS  ACQUISITION OF U.S. RIGHTS TO SORIATANE On February 9, 2004, we announced that we had entered into a binding
purchase agreement with Roche to acquire exclusive U.S. rights to
Soriatane-brand acitretin, an approved oral medicine for the treatment of
severe psoriasis in adults. The transaction closed on March 4, 2004. Under
the terms of the purchase agreement, we paid Roche a total of $123 million in
cash at the closing. We also agreed to assume certain liabilities in
connection with returns, rebates and chargebacks, and we are obligated to buy
Roches existing inventory within thirty days after the closing of the
acquisition. 6




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Soriatane is a convenient once a day oral retinoid approved in the U.S.
for the treatment of severe psoriasis in adults. Approximately 4.5 million
people in the U.S. suffer from psoriasis; of these, approximately one million
seek treatment. Most cases are treated with topical steroids, while the more
severe cases are treated with oral or injectable treatments. The product is
currently manufactured and marketed by Roche. It is approved for the treatment
of severe psoriasis, and has been studied in plaque, guttate, erythrodermic,
palmar-plantar and pustular psoriasis. Soriatane is the only treatment
approved for both initial and maintenance psoriasis therapy. It is supplied as
10 mg and 25 mg capsules. Roche received FDA approval for Soriatane in 1997
and its patent protection ended in 1999, although there are currently no
generic competitors in the marketplace. We believe Soriatane is currently the
only oral retinoid being marketed for psoriasis in the United States. Roches
U.S. net sales of Soriatane were approximately $41 million in 2003, $36 million
in 2002 and $37 million in 2001. Clinical efficacy studies showed that 76% of patients taking Soriatane
showed statistically significant improvement in as little as eight weeks. At
six months, 40% of patients experienced complete or almost complete clearing of
their psoriasis; at 12 months, patients continued to experience statistically
significant improvement in symptoms. In published literature, patients treated
with Soriatane had PASI 50 scores (percentage of patients with at least 50%
improvement in PASI score) of 85% and PASI 75 scores of 52%, both at 12 weeks.
Additionally 59% of patients treated for 12 weeks were relapse free from
psoriasis at six months post treatment, and at 12 months Soriatane patients had
PASI scores of 78%. Since Soriatane is neither immunosuppressive nor
cytotoxic, it can be used without the risk of reducing a patients resistance
to common infections. In women of childbearing potential, Soriatane should be reserved for
non-pregnant patients who have not responded to other therapies or whose
clinical condition makes other treatments inappropriate, because the drug may
cause serious birth defects. Women who are pregnant or might become pregnant
during therapy or within three years after stopping therapy should not take
Soriatane. Less frequent but potentially serious adverse events that have been
reported include liver toxicity, pancreatitis and increased intracranial
pressure, as well as bone spurs, alteration in lipid levels, possible
cardiovascular effects and eye problems. 
 ROYALTY-BEARING PRODUCTS AND LICENSED TECHNOLOGY Foam Technology.We are party to an agreement with Pfizer, Inc. (formerly
Pharmacia Corporation) pursuant to which we granted Pfizer exclusive global
rights, excluding Japan, to our proprietary foam drug delivery technology for
use with Pfizers Rogaine® hair loss treatment. The license with Pfizer will
expand the reach of the foam vehicle to the non-prescription (over-the-counter)
pharmaceutical market. Under the agreement, Pfizer paid us an initial
licensing fee, and agreed to pay us when it achieves specified milestones, plus
a royalty on product sales. We recognized $1.0 million under the agreement
during 2002 related to license fees and milestone payments. During 2003 we
recognized $86,000 in license fees related to development costs. Pfizer will
be responsible for most product development activities and costs. Unless
terminated earlier, the agreement with Pfizer will terminate on the first date
on which all of Pfizers obligations to pay royalties has expired or been
terminated. In general, in each country (excluding Japan) where the
manufacture, importation, distribution, marketing, sale or use of the product
would infringe any of our issued patents covered by the agreement, Pfizers
obligation to pay patent royalties with respect to that country will expire
automatically on the expiration or revocation of the last of our patents to
expire (or to be revoked) in that country. No patents have yet been issued
covering this technology. Before April 2001, Connetics Australia (under the name Soltec Research Pty
Ltd., or Soltec) had entered into a number of other agreements for the foam
technology. Connetics Australia licensed the technology of betamethasone
valerate foam to Celltech plc in Europe, and Celltech has licensed the 7




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worldwide rights to their patent on the steroid foam technology to us
through Connetics Australia. In 2003, we bought the rights to the U.S. patent
from Celltech. We pay Celltech royalties on all sales worldwide of foam
formulations containing steroids. Celltech markets their product as
Bettamousse® (the product equivalent of Luxíq), and Celltech paid us royalties
for their sales through April 2003. We have 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. In February 2004, we entered into an agreement with Mipharm to
license ketoconazole foam to them in exchange for an initial fee of $90,000,
plus future milestone and royalty payments. In 2003, on a consolidated basis,
we received $267,000 in royalties for foam-based technology. As discussed under OLUX Foam, above, we have licensed to Mipharm
commercial rights to market and sell OLUX in Italy, and we will receive
milestone payments and royalties on future product sales. We have received
$50,000 under the agreement through December 31, 2003. Based on the minimum
royalty provisions in the agreement, and assuming the agreement stays in force
through 2021, the aggregate potential minimum royalties under the contract are
$975,000. Unless terminated earlier, the agreement with Mipharm will terminate
on the later of September 2021 and the last expiration date of the patents

covering the aerosol mousse technology, which is currently 2015. Aerosol Spray. We have licensed to S.C. Johnson & Son, Inc. 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 2003, on a
consolidated basis, we received $7.0 million in royalties in connection with
this agreement, which included a one-time royalty payment of $2.9 million. On
January 5, 2004, we reached an agreement with S.C. Johnson to terminate the
license agreement, and we will cease recognizing royalties in connection with
the agreement after the first quarter of 2004. Liquipatch.We have agreements with Novartis to develop Liquipatch for
various indications. 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. In June
2001, we entered into a global licensing agreement with Novartis Consumer
Health SA for the Liquipatch drug-delivery system for use in topical antifungal
applications. The agreement followed successful pilot development work and
gives Novartis the exclusive, worldwide right to use the Liquipatch technology
in the topical antifungal field. In March 2002, Novartis paid $580,000 to
exercise its then-existing option to expand the license agreement. Novartis
has paid an aggregate of $641,000 under the contract as of December 31, 2003.
The total potential licensing and milestone fees range from $75,000 to $375,000
for the life of the contract. Unless terminated earlier, the agreement may be
terminated by either party after the expiration of one or more claims within a
patent covered by the agreement with respect to the relevant country (which
claim has not been declared to be invalid or unenforceable by a court of
competent jurisdiction) or after eight years anniversary of the first market
introduction of the product in countries without such a claim. The expiration
date of the last patent to expire is currently 2017. Novartis will be
responsible for all development costs, and will be obligated to pay royalties
on future product sales. Actimmune®.We have an agreement with InterMune, Inc. pursuant to which
InterMune pays us royalties for sales of Actimmune® (gamma interferon). In
connection with the agreement, InterMune paid us approximately $6.1 million, of
which $942,000 was paid to us in March 2001 and the balance was paid in 2000.
We recorded $358,000 and $172,000 in royalty revenue related to Actimmune sales
in 2003 and 2002, respectively. In August 2002, we entered into an agreement
with InterMune to terminate our exclusive option for certain rights in the
dermatology field in exchange for a payment of $350,000. We recognized the
full amount of this revenue in 2002. 8




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Ridaura®.In April 2001, we sold all of our rights and interests in
Ridaura® (auranofin) to Prometheus Laboratories, Inc. Ridaura is a
prescription pharmaceutical product for the treatment of rheumatoid arthritis.
Under the terms of the agreement with Prometheus, 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 per calendar year through
March 2006. We received $133,000 and $0 in royalties in 2003 and 2002,
respectively. 
 SALES AND MARKETING We have an experienced, highly productive sales and marketing
organization, which is dedicated to dermatology. As of March 1, 2004, we had
96 employees in our sales and marketing organization, including 79 field sales
directors and representatives. Since a relatively small number of physicians
write the majority of prescriptions, we believe that the size of our sales
force is appropriate to reach our target physicians. Our marketing efforts are focused on assessing and meeting the needs of
dermatologists, residents, dermatology nurses, and physicians assistants. Our
sales representatives strive to cultivate relationships of trust and confidence
with the healthcare professionals they call on. The nearly 9,800 U.S.
dermatologists and dermatology medical professionals our sales force called on
in 2003 are responsible for approximately 99% of all topical corticosteroid
prescriptions written by dermatologists in the United States. To achieve our
marketing objectives, we use a variety of advertising, promotional material
(including journal advertising, promotional literature, and rebate coupons),
specialty publications, participation in educational conferences, support of
continuing medical education activities, and advisory board meetings, as well
as product internet sites to convey basic information about our products and
our company. Our corporate website at www.connetics.comincludes fundamental
information about the company as well as descriptions of ongoing research,
development and clinical work. Our product websites, at www.olux.comand
www.luxiq.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. In addition to traditional marketing approaches and field sales
relationships with dermatologists, we sponsor several programs that support the
dermatology field. We currently provide funding to sponsor one dermatology
resident at Stanford University Medical School and dermatology fellows at the
Harvard Medical School and Johns Hopkins Medical Center. We also provide
corporate sponsorship to various dermatology groups, including the American
Academy of Dermatology, the National Psoriasis Foundation, the Dermatology
Foundation, the Skin Disease Education Foundation, and the Foundation for
Research & Education in Dermatology. In 2003, we sponsored 20 children to
attend Camp Wonder, a summer camp sponsored by the Childrens Skin Disease
Foundation for children suffering from serious and fatal skin diseases. 
 COMPETITION The specialty pharmaceutical industry is characterized by intense market
competition, extensive and rapid product development and substantial
technological change. Competition is intense among manufacturers of
prescription pharmaceuticals, such as our products. The principal means of
competition used to market our products include quality, service, price,
intellectual property, and product performance. Each of our products competes for a share of the existing market with
numerous products that have become standard treatments recommended or
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compete with a number of corticosteroid brands in the super-, high- and
mid-potency categories for the treatment of inflammatory skin conditions, as
well as with generic products. 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®, which are marketed by GlaxoSmithKline; DermaSmoothe FS®, marketed by
Hill Dermaceuticals; Capex and Clobex, marketed by Galderma; and Psorcon®,
marketed by Dermik Laboratories, Inc. The FDA has approved two systemic
biologic drugs for the treatment of severe psoriasis: Amevive, marketed by
Biogen; and Raptiva, marketed by Genentech, Inc. These biologics will compete
with the market for Soriatane. In addition, both OLUX and Luxíq 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, marketing,
sales, 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, and 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. Moreover, 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 We sell product directly to wholesale distributors and, since January
2003, to a national retail pharmacy chain. Patients have their prescriptions
filled by pharmacies that buy the drug from the wholesalers. Accordingly, the
number of prescriptions written for our products only indirectly affects our
product revenues. Our customers include the nations leading wholesale
pharmaceutical distributors, such as McKesson HBOC, Inc., Cardinal Health,
Inc., and AmerisourceBergen Corporation, and one national retail pharmacy
chain, Walgreens. 
 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 $30.1
million in 2003, $25.8 million in 2002, and $19.2 million in 2001. Our goal is
to discover, develop and bring to market innovative products that address unmet
healthcare needs. 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
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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 product
candidates that we believe have large 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. We have developed several additional aerosol foams similar to our foam
delivery system for OLUX and Luxíq, including water-, ethanol- and
petrolatum-based foams. We have also developed Liquipatch, 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. 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 into
agreements with academic or university-based researchers to conduct various
studies for us. 
 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 are pursuing a number of 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 by assignment 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 to allow us to market and
distribute products covered by the patent or application. The U.S. and worldwide issued patents and pending applications we are
developing and pursuing in our intellectual property portfolio relate to novel
drug delivery vehicles for the topical administration of active pharmaceutical
ingredients, for use in both human and veterinary applications. We own or are
exclusively licensed under pending applications and/or issued patents worldwide
relating to OLUX and Luxíq, and other products in the earlier stages of
research. Of the 20 U.S. or worldwide issued patents relating to our
technologies, one relates to corticosteroid foam formulations, one relates to a
foam formulation for the treatment of head lice, nine relate to an
antibacterial foam formulation, one relates to ketoconazole foam, three relate
to emollient foams, and five relate to Liquipatch. Of the additional 19 issued
patents related to the technologies developed by Connetics Australia, three
relate to the aerosol technology licensed to S. C. Johnson, one relates to an
acne treatment and 15 relate to an ectoparasiticidal formulation which has
veterinary applications. We also have an exclusive license under two patents
covering stable retinoid compositions. The patents discussed above expire
between 2004 and 2019. 11




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The delivery technology that is the basis for OLUX and Luxíq is covered by
a U.S. patent on methods of treating various skin diseases using a foam
pharmaceutical composition comprising a corticosteroid active substance, a
propellant and a buffering agent. That patent will expire in 2015. The
Liquipatch technology is covered by one U.S. patent, which will expire in 2016. 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 and brand recognition. We own eight U.S. and 10 non-U.S. registered
trademarks, and several trademark applications and common law trademarks
related to our dermatology business. 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 do not operate manufacturing or distribution facilities for any of our
products. Instead, we contract with third parties to manufacture our products
for us. Our
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. Currently, DPT Laboratories,
Ltd., or DPT, and Accra Pac Group,
Inc. manufacture commercial supplies of OLUX and Luxíq, as well as physician
samples of those products for us. DPT also manufactures clinical supplies for
our various clinical trial programs. In March 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. The aerosol line was
completed in September 2002 and approved for commercial manufacture in February
2003. 
 WAREHOUSING AND DISTRIBUTION Currently, all of our product distribution activities are handled by
Cardinal Health Specialty Pharmaceutical Services, or SPS. SPS is a division
of Cardinal Health, which was our largest customer in 12




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2003. For more information about our customers, see Customersabove,
and Note 2 of Notes to Consolidated Financial Statements.SPS stores and
distributes products to our customers from a warehouse in Tennessee. When SPS
receives a purchase order, it processes the order into a computerized
distribution database. Generally, our customers orders are shipped from SPS
within 24 hours after their order is received. Once the order has shipped, SPS
generates and mails out invoices on our behalf. Any delay or interruption in
the distribution process or in payment by our customers could have a material
effect on our business. 
 GOVERNMENT REGULATION Generally  Product Development.The pharmaceutical industry is 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 prescription 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
sponsor of these studies submits the results to the FDA 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 product candidates. 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 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 III
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often more locations and clinical investigators than the earlier trials.
At least one such trial is required for FDA approval to market a drug. 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. The Food, Drug and Cosmetic Act includes provisions for accelerating the
FDA approval process under certain circumstances. For example, we used the
so-called 505(b)(2) application process for OLUX, Luxíq, Extina and Actiza,
which permitted us in each case to satisfy the requirements for a full 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 applicant,
together with the studies generated on our products. While the FDA evaluation
used the same standards of approval as an NDA, 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. The 505(b)(2) process will not be available for all of our
other product candidates, and as a result the FDA process may be longer for our
future product candidates than it has been for our products to date. 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. 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 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 cGMP 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. Post-Approval Regulation.The FDA continues to review marketed products
even after granting regulatory clearances, and if previously unknown problems
are discovered or if we fail to comply with the applicable regulatory
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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
SPS 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. In April 2003, the Office of Inspector General, or OIG,
of the U.S. Department of Health and Human Services released guidance that
outlines several considerations for pharmaceutical manufacturers to be aware of
in the context of marketing and promotion of products reimbursable by the
federal health care programs. The federal anti-kickback statute places constraints on business
activities in the health care sector that are common business activities in
other industries, including sales, marketing, discounting, and purchase
relations. Practices that may be common or longstanding in other businesses
are not necessarily acceptable or lawful when soliciting federal health care
program business. Specifically, anti-kickback laws make it illegal for a
prescription drug manufacturer to solicit or to offer or pay anything of value
for patient referrals, or in return for purchasing, leasing, ordering, or
arranging for or recommending the purchase, lease or ordering of, any item or
service that is reimbursable in whole or part by a federal health care program,
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). Medicaid and State Rebate Programs.We participate in the Federal
Medicaid rebate program established by the Omnibus Budget Reconciliation Act of
1990, as well as several state supplemental rebate programs. Under the
Medicaid rebate program, we pay a rebate to each state Medicaid program for our
products that are 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
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Health and Human Services Centers for Medicare and Medicaid Services of
our current average manufacturer price and best price for each of our products.
As part of our revenue recognition policy, we provide reserves on this
potential exposure at the time of product shipment. Federal law also requires that any company that participates in the
Medicaid program must extend 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. We also make our products available to authorized users of the Federal
Supply Schedule, of 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 Medicaid rebate statute and the VHCA also provide that, in addition to
penalties that may be applicable under other federal statutes, civil monetary
penalties may be assessed for knowingly providing false information in
connection with the pricing and reporting requirements under the laws. The
amount that may be assessed is up to $100,000 for each item of false
information. We have provided additional information about the risks
associated with participation in the Medicaid and similar programs, under
Factors Affecting Our Business and Prospects  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 and
 The growth of managed care organizations and other third-party reimbursement
policies may have an adverse effect on our pricing policies and our margins
below. 
 MARKETING TO HEALTHCARE PROFESSIONALS The pharmaceutical industry is regulated by a number of agencies which
have issued guidelines on, among other matters, how pharmaceutical
manufacturers interact with doctors and other healthcare professionals. In
April 2003, the OIG issued its Compliance Program Guidance for Pharmaceutical
Manufacturers, and the OIG has announced that the compliance program guidance
is a major initiative in its effort to engage the health care community in
preventing and reducing fraud and abuse in federal health care programs. The
stated purpose of the compliance program guidance is to encourage the use of
internal controls to efficiently monitor adherence to applicable statutes,
regulations and program requirements. The program guidance sets forth seven
elements that the OIG says are widely recognized as fundamental to an effective
compliance program. Officially, the guidance is voluntary and does not
represent binding standards for pharmaceutical manufacturers, but in practical
effect, the compliance program guidance sets forth the essential elements of an
effective compliance program, some of which represent significant restrictions
on how pharmaceutical companies can interact with the medical community. We intend for our relationships with doctors to benefit patients and to
enhance the practice of medicine, and at the same time represent the interests
of our stockholders in maintaining and growing our 16




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company. We have adopted internal policies that emphasize to our
employees that all interactions with healthcare professionals should be focused
on informing them about FDA-approved uses of our products, providing scientific
and educational information consistent with FDA regulations and guidances, or
supporting medical research and education. We believe that effective marketing
of our products is necessary to ensure that patients have access to the
products they need, and that the products are correctly used for maximum
patient benefit. Our marketing and sales organization is critical to achieving
these goals, because they foster relationships that enable us to inform
healthcare professionals about the benefits and risks of our products, provide
scientific and educational information, support medical research and education,
and obtain feedback and advice about our products through consultation with
medical experts. 
 MARKETING EXCLUSIVITY The FDA has the power to grant pharmaceutical companies new drug product
exclusivity for a drug, independent of any orphan drug or patent term
exclusivity accorded to that drug. This marketing exclusivity 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 until
December 20, 2005, for the short-term topical treatment of mild to moderate
plaque-type psoriasis of non-scalp regions. The exclusivity prevents other
parties from submitting or getting approval for any comparable 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. At the time
we submitted the sNDA for the expanded label for OLUX, we requested exclusivity
for the new indication. The FDA has not advised us of its position on that
issue. 
 TERMINATION OF RELAXIN DEVELOPMENT PROGRAM In October 2000, we announced that our pivotal trial for a recombinant
form of a natural human hormone called relaxin was unsuccessful in reaching the
primary endpoint of that trial. There were, however, statistically
significant responses with respect to secondary parameters measured in that
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 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. In June 2003, we sold all of
our rights and interest in the development of recombinant human relaxin to BAS
Medical, Inc., or BAS Medical. In exchange, BAS Medical paid us $100,000 in an
upfront assignment fee that we recognized as license revenue in the third
quarter of 2003. BAS Medical will pay an additional $900,000 if it achieves
various milestones, and will pay royalties on future product sales. In
connection with the sale, we also assigned to BAS Medical all of our rights in
intellectual property relating to relaxin, and our rights and obligations under
outstanding contracts to develop relaxin. Specifically, we assigned to BAS
Medical all of our rights under outstanding agreements with Genentech, Inc.,
the Howard Florey Institute, Mario Bigazzi, M.D., Paladin Labs, Inc., and F.H.
Faulding & Co. As a result of this agreement we recognized $661,000 of
previously deferred revenue associated with the relaxin license agreements
during the third quarter of 2003. 
 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, and carbon-14. We are subject to federal, state and 17




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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
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 laws 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, 2004, we had 215 full-time employees, including 16 in
Connetics Australia. Of the full-time employees, 96 were engaged in sales and
marketing, 81 were in research and development and 38 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 section describes 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, and so materially affect our future developments and performance.
This list of factors is illustrative, but not exhaustive. Accordingly, you
should evaluate all forward-looking statements with the understanding of their
inherent uncertainty. 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 business faces significant risks. In addition to the other
information contained in this prospectus and the documents incorporated by
reference in this prospectus, you should carefully consider the following risks
before purchasing our securities. Our operating results may fluctuate. This fluctuation could cause financial
results to be below expectations and the market prices of our securities to
decline. Our operating results may fluctuate from period to period for a number of
reasons, some of which are beyond our control. Even a relatively small revenue
shortfall may cause a periods results to be below our expectations or
projections, which in turn may cause the market price of our securities to drop
significantly and the value of your investment to decline in value. If we do not obtain the capital necessary to fund our operations, we will be
unable to develop or market our products. Although we are currently generating positive cash flows from operations,
in the future our product revenues could decline or we might be unable to raise
additional funds when we need them. In that case, we may not have sufficient
funds to 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.
Any additional equity financing 18




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may be dilutive to our stockholders and debt financing, if available, may
involve restrictive covenants, which may limit our operating flexibility with
respect to certain business matters. 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, $15.0 million in 2000
(after excluding a one-time gain of $43.0 million on sales of stock we held in
InterMune, Inc. and the associated income tax), $16.7 million in 2001, $16.6
million in 2002, and $4.1 million in 2003. Our accumulated deficit was $130.2
million at December 31, 2003. We may incur additional losses in the future.
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 revenues 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:  
    
    we may be contractually bound to terms that, in the
future, are not commercially favorable to us,
    
    royalties generated from licensing arrangements may be
insignificant or may fluctuate from period to period, and
    
    a loss of royalties could have a disproportionately
large impact on operating income in periods where the
operating income is a small profit. If any of these events occur, we may not be able to successfully develop our
products. Our reported earnings per share may be more volatile because of the conversion
provisions of our convertible senior notes or the exercise of outstanding stock
options and warrants. In May 2003 we sold convertible senior notes, due in 2008, in the
principal amount of $90 million. The noteholders may convert the notes into
shares of our common stock at any time before the notes mature, at a conversion
rate of 46.705 shares per $1,000 principal amount of notes, subject to
adjustment in certain circumstances. Also, at December 31, 2003 we had 5.9
million shares reserved for issuance upon exercise of outstanding stock options
and warrants. Should any noteholders convert the notes, or if our option and
warrant holders exercise their options and warrants, our basic earnings per
share would be expected to decrease as a result of the inclusion of the
underlying shares in the basic earnings per share calculation. 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. We believe that the protection of our intellectual property, including
patents and trademarks, is an important factor in product recognition,
maintaining goodwill, and maintaining or increasing market share. If we do not
adequately protect our rights in our trademarks from infringement, any goodwill
that has been developed in those marks could be lost or impaired. If the marks
we use are found to infringe upon the trademark of another company, we could be
forced to stop using those marks, and as a result we could lose all the
goodwill that has been developed in those marks and could be liable for damages
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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. 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 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. 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. Our business could
suffer materially if a third party were to be awarded a judgment adverse to us
in any patent interference, litigation or other proceeding arising in
connection with these patent applications. 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. 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, are 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. 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
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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. Although we maintain general liability insurance in the amount of
$10 million aggregate and workers compensation coverage in the amount of $1
million per incident, our insurance may not provide adequate coverage against
potential claims or losses related to our use of hazardous materials, and we
cannot be certain that our current coverage will continue to be available on
reasonable terms, if at all. We may be unable to effectively integrate Soriatane into our existing business
and our marketing efforts for Soriatane may not be successful. We will not be able to achieve the benefits of the acquisition of
Soriatane unless we are able to integrate that product with our existing
products. Moreover, the integration of this program requires substantial
attention from management and any diversion of managements attention away from
our existing business could adversely impact our operations. In anticipation
of our commercial re-launch of Soriatane in the U.S., we are expending
significant resources. We will begin to train our sales force to sell
Soriatane in the second quarter of 2004, and we may not see any increase in
commercial sales of Soriatane as compared to historical results until after our
sales force is trained to market Soriatane, if at all. If we engage in future acquisitions, we will incur a variety of costs, and we
may not be able to realize the anticipated benefits. From time to time, we discuss with third parties potential acquisitions of
products, technologies and businesses. Acquisitions may require us to make
considerable cash outlays and can entail the need for us to issue equity
securities, incur debt and contingent liabilities, incur amortization expenses
related to intangible assets, and can result in the impairment of goodwill,
which could harm our profitability. In addition, acquisitions involve a number
of risks, including:  
    
    difficulties in and costs associated with the
assimilation of the operations, technologies, personnel and
products of the acquired companies,
    
    assumption of known or unknown liabilities or other
unanticipated events or circumstances, and
    
    risks of entering markets in which we have limited or
no experience. Any of these risks could harm our ability to achieve levels of
profitability of acquired operations or to realize other anticipated benefits
of an acquisition. Our future product revenues could be reduced by imports from countries where
our products are available at lower prices. While our products are not generally available for sale outside the United
States, OLUX has been approved for sale in Europe. Also, Roche will continue
to market Soriatane outside of the United States. There have been cases in
which pharmaceutical products were sold at steeply discounted prices in markets
outside the United States and then re-imported to the United States where they
could be resold at prices higher than the original discounted price, but lower
than the prices commercially available in the United States. If this happens
with our products our revenues would be adversely affected. In addition, in the European Union, we are required to permit cross border
sales. This allows buyers in countries where government-approved prices for
our products are relatively high to purchase 21




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our products legally from countries where they must be sold at lower
prices. Such cross-border sales could adversely affect our revenues. Our indebtedness and debt service obligations may adversely affect our cash
flow. In May 2003 we issued $90 million of convertible senior notes in a private
offering. We will pay interest on the notes at a rate of 2.25% per year. In
2003, we recorded $1.2 million in interest on the notes. Assuming none of the
notes are redeemed or converted, we will record interest on the notes in the
amounts of $2.0 million per year from 2004 through 2007, and $843,750 for 2008.
Whether we are able to make payments on the notes will depend on our ability
to generate sufficient cash. During each of the last five years, our operating
cash flows were insufficient to cover our fixed charges. Our ability to
generate sufficient cash flow will depend on increasing sales of our products,
collection of receivables and the results of our research and development
efforts and other factors, including general economic, financial, competitive,
legislative and regulatory conditions, some of which are beyond our control. If we incur new indebtedness, the related risks that we now face could
intensify. Whether we are able to make required payments on the notes and to
satisfy any other future debt obligations will depend on our future operating
performance and our ability to obtain additional debt or equity financing. Risks Related to Our Products Future manufacturing difficulties could delay future revenues from our product
sales. Manufacturing facilities are subject to ongoing periodic inspection by the
FDA and corresponding state agencies and must be licensed before they can be
used in commercial manufacturing of our products. In general, our
contract manufacturers purchase principle raw materials and supplies
in the open market. If our contract
manufacturers cannot provide us with our product requirements in a timely and
cost-effective manner, or if the product they supply does not meet commercial
requirements for shelf life, our sales of marketed products could be reduced.
The active ingredient for our product OLUX is currently supplied by a single
source, although we are in the process of qualifying an additional source. We
will continue to buy Soriatane finished product and active pharmaceutical
ingredient from Roche, and it will take us several months to qualify alternate
sources for Soriatane. Substantially all other raw materials are
available from a number of sources, and the loss of any one source of
supply would not have a material adverse effect on our company,
although delays in the availability of some raw materials could cause
delays in our commercial production. Any commercial dispute with any of our 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 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 our
contract manufacturers do not comply with the applicable cGMP regulations and
other FDA regulatory requirements, the availability of marketed products for
sale 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.
Our business interruption insurance, which covers the loss of income for up to
$14.6 million at our 22




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California and Australia locations, and lower amounts for each of our
contract manufacturers, may not completely mitigate the harm to our business
from the interruption of the manufacturing of products. 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 and future revenues may be delayed. 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 affecting
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. The FDA 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. If we fail to comply with applicable regulatory requirements, we
could be subject to, among other things, 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,
    
    submitting products for inspection and, if any
inspection reveals that the product is not in compliance,
prohibiting the sale of all products from the same lot,
    
    suspending manufacturing,
    
    recalling products, and
    
    withdrawing marketing approval. 23




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Even before any formal regulatory action, we could voluntarily decide to
cease distribution and sale or recall any of our products if concerns about
safety or effectiveness develop. To market our products in countries outside of the United States, we and
our partners must obtain 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 if we were to receive correspondence from the FDA alleging these
practices we might be required to:  
    
    incur substantial expenses, including fines,
penalties, legal fees and costs to comply with the FDAs
requirements,
    
    change our methods of marketing and selling products,
    
    take FDA-mandated corrective action, which could
include placing advertisements or sending letters to
physicians rescinding previous advertisements or promotion,
and
    
    disrupt the distribution of products and stop sales
until we are in compliance with the FDAs position. We may spend a significant amount of money to obtain FDA and other regulatory
approvals, which may never be granted. Failure to obtain such regulatory
approvals could adversely affect our prospects for future revenue growth. 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. To obtain approval, we must show in preclinical and clinical trials that
our products are safe and effective. The FDA approval processes require
substantial time and effort, the FDA continues to modify product development
guidelines, and 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. 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. Moreover, the 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. 24




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Any factor adversely affecting the prescription volume related to our products
could harm our business, financial condition and results of operations. We derive all of our prescription volume from Luxíq and OLUX and,
effective March 4, 2004, from Soriatane. Accordingly, any factor adversely
affecting our sales related to these products, individually or collectively,
could harm our business, financial condition and results of operations. Both
Luxíq and OLUX are subject to generic competition, and each of them could be
rendered obsolete or uneconomical by regulatory or competitive changes.
Product sales could also be adversely affected by other factors, including:  
    
    manufacturing or supply interruptions;
    
    the development of new competitive pharmaceuticals and
technological advances to treat the conditions addressed by our core
branded products;
    
    marketing or pricing actions by one or more of our competitors;
    
    regulatory action by the FDA and other government regulatory agencies;
    
    changes in the prescribing or procedural practices of
dermatologists, pediatricians and / or podiatrists;
    
    changes in the reimbursement or substitution policies of
third-party payors or retail pharmacies; and
    
    product liability claims. We depend on a limited number of customers, and if we lose any of them, our
business could be harmed. Our customers include the nations leading wholesale pharmaceutical
distributors, such as McKesson HBOC, Inc., Cardinal Health, Inc., and
AmerisourceBergen Corporation, and one national retail pharmacy. During 2003,
Cardinal Health, McKesson, AmerisourceBergen, and Walgreens accounted for 36%,
30%, 15% and 11%, respectively, of our net 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. Orders for our products may increase or decrease depending on the
inventory levels held by our major customers.
Significant increases and decreases in orders from our major customers could
cause our operating results to vary significantly from quarter to quarter. Retail availability of our products is greatly affected by inventory
levels held by our customers. We monitor wholesaler inventory of our products
using a combination of methods, including tracking prescriptions filled at the
pharmacy level to determine inventory amounts sold from the wholesalers to
their customers. However, our estimates of wholesaler inventories may differ
significantly from actual inventory levels. Significant differences between
actual and estimated inventory levels may result in excessive inventory
production, inadequate supplies of products in distribution channels,
insufficient or excess product available at the retail level, and unexpected
increases or decreases in orders from our major customers. Forward-buying by
wholesalers, for example, may result in significant and unexpected changes in
customer orders from quarter to quarter. These changes may cause our revenues 25




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to fluctuate significantly from quarter to quarter, and in some cases may
cause our operating results for a particular quarter to be below our
expectations or projections. If our financial results are below expectations
for a particular period, the market price of our securities may drop
significantly. We rely on third parties to conduct clinical trials for our product candidates,
and those third parties may not perform satisfactorily. If those third parties
do not perform satisfactorily, it may significantly delay commercialization of
our products, increase expenditures and negatively affect our prospects for
future revenue growth. We rely on third parties to independently conduct clinical studies for our
product candidates. 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. Our continued growth depends on our ability to develop new products, and if we
are unable to develop new products, our expenses may exceed our revenues
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,
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. 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 and,
regardless of whether they are ever released to the market, the expense of such
processes will have already been incurred. 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 we do not integrate these products or product lines
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 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. We rely on the services of a single company to distribute our products to our
customers. A delay or interruption in the distribution of our products could
negatively impact our business. 26




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Cardinal Health Specialty Pharmaceutical Services, or SPS, handles all of
our product distribution activities. SPS stores and distributes our products
from a warehouse in Tennessee. Any delay or interruption in the process or in
payment could result in a delay delivering product to our customers, which
could have a material effect on our business. Our revenues 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 operating results and business success depend, in part, on whether
adequate 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, managed care
organizations, private insurance plans and health maintenance organizations.
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. If only a portion of the cost of our prescription products is
paid for or reimbursed, our products could be less attractive, from a net-cost
perspective, to patients, suppliers and prescribing physicians. 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 on formularies. 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. 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 a product is excluded from a formulary,
its usage may be sharply reduced in the managed care organization patient
population. 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. To the extent that patients buy our products through a managed care group
with which we have a contract, our average selling price is lower than it would
be for a non-contracted managed care group. We take reserves for the estimated
amounts of rebates we will pay to managed care organizations each quarter. Any
increase in returns and any increased usage of our products through Medicaid or
managed care programs will affect the amount of rebates that we owe. Risks Related to Our Industry We face intense competition, which may limit our commercial opportunities and
limit our ability to generate revenues. 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. 27




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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. Luxíq and OLUX 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 coverage 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. The growth of managed care organizations and other third-party reimbursement
policies and state regulatory agencies may have an adverse effect on our
pricing policies and our margins. Managed care initiatives to control costs have influenced primary-care
physicians to refer fewer patients to specialists such as dermatologists.
Further reductions in these referrals could have a material adverse effect on
the size of our potential market as well as our business, financial condition
and results of operation. Federal and state regulations govern or influence the reimbursement to
health care providers of fees in connection with medical treatment of certain
patients. 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.
Continued significant changes in the health care system could have a material
adverse effect on our business. Decisions by state regulatory agencies,
including state pharmacy boards, and/or retail pharmacies may require
substitution of generic for branded products, may prefer competitors products
over our own, and may impair our pricing and thereby constrain our market share
and growth. In addition, we believe the increasing emphasis on managed care in
the U.S. 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. We cannot predict whether reimbursement for
our products or product candidates will be available or in what amounts, 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. 28




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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. 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. Effective March 4, 2004, we also own exclusive U.S.
rights to Soriatane, which is a product known to cause serious birth defects and
other serious side effects. Although as of March 4, 2004 we maintain product
liability insurance in the amount of $14 million aggregate, our insurance may
not provide adequate coverage against potential product liability claims or
losses. In particular, we anticipate that insurers may be less willing to
extend product liability insurance for Soriatane, and that insurance will only
be available at higher premiums and with higher deductibles than our other
products have required. 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 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 holdings of these investors. Such volatility could result
in securities class action litigation. Any litigation would likely result in
substantial costs, and divert our managements attention and resources. 29




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The following table sets forth the high and low closing sale prices of our
common stock on the Nasdaq National Market for 2002 and 2003: Period
    
    High
    
    Low2003
    
    $
    19.27
    
    
    $
    12.302002
    
    $
    14.55
    
    
    $
    7.92
 The trading price of our common stock could be subject to significant
fluctuations, which may adversely affect the price at which you can sell our
common stock. The trading price of our common stock has been volatile, and the trading
price for the common stock may be volatile in the future. Factors such as
announcements of fluctuations in our or our competitors operating results,
changes in our prospects and general market conditions for specialty
pharmaceutical or biotechnology stocks could have a significant impact on the
future trading prices of our common stock. In particular, the trading price of
the common stock of many specialty pharmaceutical companies, including us, has
experienced extreme price and volume fluctuations, and those fluctuations have
at times been unrelated to the operating performance of the companies whose
stocks were affected. Some of the factors that may cause volatility in the
price of our securities include:  
    
    clinical trial results and regulatory developments,
    
    quarterly variations in results,
    
    business and product market cycles,
    
    fluctuations in customer requirements,
    
    the availability and utilization of manufacturing capacity,
    
    the timing of new product introductions,
    
    the ability to develop and implement new technologies, and
    
    the timing and amounts of royalties paid to us by third parties. The price of our securities may also be affected by the estimates and
projections of the investment community, general economic and market
conditions, and the cost of operations in our product markets. These factors,
either individually or in the aggregate, could result in significant variations
in price of our securities and may have an adverse effect on the trading prices
of our common stock. 
 AVAILABLE INFORMATION We file electronically with the Securities and Exchange Commission our
annual reports on Form 10-K, quarterly reports on Form 10-Q, and current
reports on Form 8-K, pursuant to Section 13(a) or 15(d) of the Securities
Exchange Act of 1934. You may obtain a free copy of our annual reports on Form
10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and
amendments to those reports on the day of filing with the SEC on our website on
the World Wide Web at http://www.connetics.com, by contacting our Investor
Relations Department by calling 650-843-2800, or by sending an e-mail message
to ir@connetics.com. 30




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##### Table of Contents



EXECUTIVE OFFICERS OF THE COMPANY The following table shows information about our executive officers as of
March 5, 2004: Name
    
    Age
    
    PositionThomas G. Wiggans
    
    
    52
    
    
    President, Chief Executive Officer and DirectorKatrina J. Church
    
    
    42
    
    
    Exec. Vice President, Legal Affairs; General Counsel
and SecretaryMatthew W. Foehr
    
    
    31
    
    
    Sr. Vice President, Technical OperationsJohn L. Higgins
    
    
    33
    
    
    Chief Financial Officer; Executive Vice President, Finance
and Corporate DevelopmentLincoln Krochmal, M.D.
    
    
    57
    
    
    Exec. Vice President, Research and Product DevelopmentMichael Miller
    
    
    46
    
    
    Sr. Vice President, Sales and Marketing
and Chief Commercial OfficerRebecca Sunshine
    
    
    41
    
    
    Sr. Vice President, Human Resources and Organizational
DynamicsC. Gregory Vontz
    
    
    43
    
    
    Chief Operating Officer; Executive Vice President
 Thomas 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 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 also a director of Abgenix Corporation, and of two private
biotechnology companies. Mr. Wiggans received his B.S. in Pharmacy from the
University of Kansas and his M.B.A. from Southern Methodist University. Katrina Churchjoined Connetics in 1998, and has served as Executive Vice
President, Legal Affairs since January 2002 and as Secretary since September
1998. She served as Senior Vice President, Legal Affairs and General Counsel
from January 2000 through December 2001, and as Vice President, Legal Affairs
and Corporate Counsel from June 1998 through December 1999. 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. Matthew Foehrjoined Connetics in 1999, and has served as Senior Vice
President, Technical Operations, since January 2003. He served as Vice
President, Manufacturing, from November 2001 through December 2002, and in
various director-and manager-level manufacturing positions from July 1999 to
November 2001. Before joining Connetics, Mr. Foehr worked for over five years
at LXR Biotechnology, Inc., most recently serving as Associate Director,
Manufacturing and Process Development. Before joining LXR, Mr. Foehr worked
for Berlex Biosciences in the Department of Process Development and
Biochemistry/Biophysics. Mr. Foehr received his B.S. in Biology from Santa
Clara University. John Higginsjoined Connetics as Chief Financial Officer in 1997, and has
served as Executive Vice President, Finance and Administration and Corporate
Development since January 2002. He served as Executive Vice President, Finance
and Administration, from January 2000 to December 2001, and as 31




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Vice President, Finance and Administration from September 1997 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 currently serves as a director of a
private company. He received his A.B. from Colgate University. Lincoln Krochmal, M.D.joined Connetics in October 2003 as Executive Vice
President, Research and Product Development. Before joining Connetics, Dr.
Krochmal spent 10 years with Unilever PLC, most recently as Senior Vice
President, Home & Personal Care Research & Development Worldwide. Before
Unilever, Dr. Krochmal was with Bristol-Myers Squibb for 10 years, initially
joining the dermatological division, Westwood Pharmaceuticals, in 1983. He
held various positions at Westwood and in the Pharmaceutical Research Institute
including Vice President, Dermatology R&D and Vice President, Worldwide Medical
Development. Following completion of his specialty training in dermatology at
the University of Missouri Medical Center and before joining industry, Dr
Krochmal was in private practice for seven years. Dr. Krochmal is board
certified in Dermatology and received his Doctor of Medicine degree from the
Medical College of Wisconsin and his B.S. in Medical Sciences from the
University of Wisconsin. He is the author of 16 scientific publications, a
Fellow of the American Academy of Dermatology, a Diplomat of the American Board
of Dermatology, and a member of the International Society of Dermatology and
the Dermatology Foundation. Michael Millerjoined Connetics in February 2003 as Senior Vice President
of Sales and Marketing and Chief Commercial Officer. Mr. Miller most recently
served as Vice President of Commercial Operations at Cellegy Pharmaceuticals.
Before Cellegy, Mr. Miller spent four years with ALZA Corporation, most
recently as Vice President of the Urology Business Unit, three years with
VIVUS, Inc. as Marketing Director, and 14 years with Syntex/Roche in marketing
and sales management. Mr. Miller received his B.S. in Finance from University
of San Francisco and his MBA in Information Systems from San Francisco State
University. Rebecca Sunshinejoined Connetics in 1996, and has served as Senior Vice
President Human Resources and Organizational Dynamics since January 2002. Ms.
Sunshine served as Vice President of Human Resources from December 1999 to
December 2002, and as Director of Human Resources from 1996 through November
1999. 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 Human Resources. Ms. Sunshine 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. Sunshine received her
B.A. from UC Santa Barbara and her M.P.A. in Health Services from the
University of San Francisco. Gregory Vontzjoined Connetics as Executive Vice President, Chief
Commercial Officer in December 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. 
 Item 2. Properties As of March 1, 2004, we leased 52,468 square feet of laboratory and office
space at 3290 and 3400 West Bayshore Road in Palo Alto, California. We lease
this space under two lease agreements, one of which expires in March 2005 and
one of which expires in April 2005. We are subleasing 10,112 square feet of
laboratory and office space at 3400 West Bayshore Road in Palo Alto, California
to a third 32




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party. Our subsidiary, Connetics Australia Pty Ltd., owns certain land
and real property consisting of laboratory and office space at 8 Macro Court,
Rowville, Victoria, Australia. In addition, we contracted with DPT
Laboratories, Ltd. to construct a 12,000 square foot aerosol filling line in
San Antonio, Texas, and we make rental payments to DPT for the space in their
facility that the aerosol line occupies. On January 21, 2004, we signed a
letter of intent with Incyte Corporation and The Board of Trustees of the
Leland Stanford Junior University to sublease approximately 96,025 square feet
of laboratory and office space in Palo Alto, California. The final sublease is
subject to approval by the Boards of Directors of Incyte and Connetics. We
anticipate that we would move in late 2004 or early 2005, at which time we
would allow the existing leases to expire, or possibly sublease the remaining
time available on our leases for the West Bayshore properties. We believe that
our existing facilities are adequate to meet our requirements for the
foreseeable future. 
 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 2003. 
 PART II 
 Item 5. Market for the Companys Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 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
    
    Low2002First Quarter
    
    $
    14.55
    
    
    $
    8.75Second Quarter
    
    
    13.44
    
    
    
    10.57Third Quarter
    
    
    12.35
    
    
    
    7.92Fourth Quarter
    
    
    12.98
    
    
    
    9.352003First Quarter
    
    $
    16.75
    
    
    $
    12.30Second Quarter
    
    
    18.18
    
    
    
    14.70Third Quarter
    
    
    18.74
    
    
    
    14.24Fourth Quarter
    
    
    19.27
    
    
    
    16.00
 On March 3, 2004, we had approximately 181 stockholders of record of our common
stock. We have never declared or paid cash dividends on our common stock. 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. 33




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Item 6. Selected Financial Data The selected consolidated financial data that appears below and 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, 2003, and the
selected consolidated balance sheet data as of December 31, 2003 and 2002, 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, 2000 and 1999,
and the selected consolidated balance sheet data as of December 31, 2001, 2000
and 1999, are derived from audited financial statements not included in this
Report. Connetics Corporation
Selected Consolidated Financial Data(in thousands, except per share amounts) Years Ended December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999Consolidated Statement of Operations Data:Revenues:Product
    
    $
    66,606
    
    
    $
    47,573
    
    
    $
    30,923
    
    
    $
    20,095
    
    
    $
    16,595Royalty (1)
    
    
    7,788
    
    
    
    2,926
    
    
    
    1,097
    
    
    
    
    
    
    
    Contract and other
    
    
    937
    
    
    
    2,264
    
    
    
    2,044
    
    
    
    20,679
    
    
    
    10,311Total revenues
    
    
    75,331
    
    
    
    52,763
    
    
    
    34,064
    
    
    
    40,774
    
    
    
    26,906Operating costs and expenses:Cost of product revenues
    
    
    5,129
    
    
    
    4,190
    
    
    
    3,123
    
    
    
    3,868
    
    
    
    5,229License amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,160Research and development
    
    
    30,109
    
    
    
    25,821
    
    
    
    19,156
    
    
    
    21,875
    
    
    
    21,309Selling, general and administrative
    
    
    42,600
    
    
    
    37,624
    
    
    
    36,062
    
    
    
    26,673
    
    
    
    20,834Acquired in-process research and development
and milestone payments (2)
    
    
    
    
    
    
    4,350
    
    
    
    1,080
    
    
    
    
    
    
    
    1,000Loss on program termination (3)
    
    
    
    
    
    
    312
    
    
    
    1,142
    
    
    
    
    
    
    
    Total operating costs and expenses
    
    
    77,838
    
    
    
    72,297
    
    
    
    60,563
    
    
    
    52,416
    
    
    
    54,532Loss from operations
    
    
    (2,507
    )
    
    
    (19,534
    )
    
    
    (26,499
    )
    
    
    (11,642
    )
    
    
    (27,626
    )Gain on sale of investment (4)
    
    
    
    
    
    
    2,086
    
    
    
    122
    
    
    
    42,967
    
    
    
    Gain on sale of Ridaura product line (5)
    
    
    
    
    
    
    
    
    
    
    8,002
    
    
    
    
    
    
    
    Interest income (expense), net
    
    
    (426
    )
    
    
    1,039
    
    
    
    1,978
    
    
    
    1,873
    
    
    
    343Income (loss) before income taxes and cumulative
effect of a change in accounting principle
    
    
    (2,933
    )
    
    
    (16,409
    )
    
    
    (16,397
    )
    
    
    33,198
    
    
    
    (27,283
    )Income tax provision
    
    
    1,167
    
    
    
    181
    
    
    
    345
    
    
    
    1,010
    
    
    
    Income (loss) before cumulative effect of
change in
accounting principle
    
    
    (4,100
    )
    
    
    (16,590
    )
    
    
    (16,742
    )
    
    
    32,188
    
    
    
    (27,283
    )Cumulative
effect of change in accounting
principle,
net of tax (6)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,192
    )
    
    
    Net income (loss)
    
    $
    (4,100
    )
    
    $
    (16,590
    )
    
    $
    (16,742
    )
    
    $
    26,996
    
    
    $
    (27,283
    )
 34




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Years Ended December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999Basic Earnings Per Share -Income (loss) per share before cumulative effect
of change in accounting principle
    
    $
    (0.13
    )
    
    $
    (0.54
    )
    
    $
    (0.56
    )
    
    $
    1.13
    
    
    $
    (1.21
    )Cumulative effect of change in accounting
principle, net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (0.18
    )
    
    
    Net income (loss) per share
    
    $
    (0.13
    )
    
    $
    (0.54
    )
    
    $
    (0.56
    )
    
    $
    0.95
    
    
    $
    (1.21
    )Diluted Earnings Per Share Income (loss) per share before cumulative
effect of
change in accounting principle
    
    $
    (0.13
    )
    
    $
    (0.54
    )
    
    $
    (0.56
    )
    
    $
    1.07
    
    
    $
    (1.21
    )Cumulative effect of change in accounting
principle, net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (0.17
    )
    
    
    Net income (loss) per share
    
    $
    (0.13
    )
    
    $
    (0.54
    )
    
    $
    (0.56
    )
    
    $
    0.90
    
    
    $
    (1.21
    )Shares used to calculate basic net earnings
(loss) per share
    
    
    31,559
    
    
    
    30,757
    
    
    
    29,861
    
    
    
    28,447
    
    
    
    22,619Shares used to calculate diluted net earnings
(loss) per share
    
    
    31,559
    
    
    
    30,757
    
    
    
    29,861
    
    
    
    30,086
    
    
    
    22,619Pro forma amounts assuming the accounting change
was applied retroactively:Net income (loss)
    
    $
    (4,100
    )
    
    $
    (16,590
    )
    
    $
    (16,742
    )
    
    $
    32,188
    
    
    $
    (30,968
    )Earnings per share:Basic
    
    $
    (0.13
    )
    
    $
    (0.54
    )
    
    $
    (0.56
    )
    
    $
    1.13
    
    
    $
    (1.37
    )Diluted
    
    $
    (0.13
    )
    
    $
    (0.54
    )
    
    $
    (0.56
    )
    
    $
    1.07
    
    
    $
    (1.37
    )Consolidated Balance Sheet Data:Cash, cash equivalents, marketable securities
and restricted cash
    
    $
    114,966
    
    
    $
    33,788
    
    
    $
    48,476
    
    
    $
    80,184
    
    
    $
    26,299Working capital
    
    
    112,247
    
    
    
    25,185
    
    
    
    44,026
    
    
    
    71,030
    
    
    
    13,401Total assets
    
    
    145,897
    
    
    
    59,553
    
    
    
    72,327
    
    
    
    85,713
    
    
    
    30,410Total stockholders equity
    
    
    45,754
    
    
    
    44,743
    
    
    
    61,354
    
    
    
    72,606
    
    
    
    14,288
  (1)
    
    In the second quarter of 2003, we received a one-time royalty payment
by a third party in the amount of $2.9 million in connection with our
aerosol spray technology.  (2)
    
    In May 2002, we entered into an agreement with Yamanouchi Europe,
B.V. to license Velac gel. In connection with this agreement we paid
Yamanouchi an initial $2.0 million licensing fee in the second quarter
of 2002 and accrued another $2.0 million in the fourth quarter of 2002
when we initiated the Phase III trial for Velac.  (3)
    
    In 2001 we recorded a net charge of $1.1 million representing costs
accrued in connection with the reduction in workforce and the wind
down of relaxin development contracts.  (4)
    
    In the fourth quarter of 2000, we recorded a $43.0 million gain on
the sale of securities.  (5)
    
    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 through March 2006. We
recognized a gain of $8.0 million in connection with the sale of
Ridaura.  (6)
    
    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 2 of the Notes to Consolidated Financial Statements. 35




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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 to Consolidated Financial
Statements filed with this Report. BUSINESS OVERVIEW Our commercial business is focused on the dermatology marketplace, which
is characterized by a large patient population that is served by a relatively
small, and therefore more accessible, group of treating physicians. We
currently market two pharmaceutical products, OLUX and Luxíq. Both products
have clinically proven therapeutic advantages and we are providing quality
customer service to physicians through our experienced sales and marketing
professionals. Effective March 4, 2004, we own exclusive U.S. rights to a
third product, Soriatane, which is discussed below in Subsequent Events. In addition to revenue from product sales, we receive royalties on sales
of RID®, Actimmune® and Ridaura® in the U.S., and internationally on sales of
Banlice®, Milice®, Bettamousse®, and, through 2003, on a super-concentrated
aerosol spray licensed worldwide. We have licenses with Novartis and with
Pfizer, which have the potential to bear royalties in the future depending on
approval of their products for sale. To enable us to focus on our core sales and marketing activities, we
selectively outsource certain non-sales and non-marketing functions, such as
manufacturing, warehousing and distribution. As we expand our activities in
these areas, we expect to invest additional financial resources in managing
those outsourced functions. We assess our product sales using a market share analysis that takes into
account prescriptions written for the total U.S. steroid market, the ratio of
prescriptions written for OLUX and Luxíq to the whole market, and the ratio of
prescriptions for our products to prescriptions for specific brands that we
believe are being actively positioned against our products. We sell product
directly to wholesale distributors and to one national retail pharmacy chain,
however, whereas patients have their prescriptions filled by pharmacies that
buy the drug from the wholesalers. Accordingly, the number of prescriptions
written for our products only indirectly affects our product revenues. Consistent with pharmaceutical industry patterns, approximately 92% of our
product revenues are derived from four major customers. While we attempt to
estimate inventory levels of our products at our major wholesale customers
using historical prescription information and historical purchase patterns,
this process is inherently imprecise. Wholesale customers rarely provide us
with information on complete inventory levels at regional distribution centers,
or within their national distribution systems. We rely entirely on our
wholesale and retail pharmacy customers to effect the distribution allocation
of our products. We can give no assurances that these customers will
adequately manage their local and regional inventories to avoid spot outages.
Based on historically consistent purchasing patterns of our major wholesale
customers, we believe our estimates of trade inventory levels of our products
are reasonable. We further believe that inventories of our products among
wholesale customers, taken as a whole, are similar to those of other specialty
pharmaceutical companies, and that our trade practices, which periodically
involve volume discounts and early payment discounts, are typical of the
industry. We monitor wholesaler inventory using a combination of techniques,
including evaluating how much inventory is sold through to the wholesalers
customers, which we do by tracking the prescriptions filled for our products at
the pharmacy level. This is an inexact science, and requires us to monitor and
assess the desirable level of wholesaler inventory, industry average wholesaler
inventory, seasonal 36




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##### Table of Contents



demand, and other factors. We estimate prescription demand for our products
primarily by analyzing third-party syndicated data sources that track
prescriptions written by health care providers and dispensed by licensed
pharmacies. These third-party data sources are extrapolations from information
provided only by certain pharmacies, and are estimates of historical demand
levels, so our estimates are subject to inherent limitation of estimates that
rely on third-party data. We observe trends from these data, and, coupled with
certain proprietary information, prepare demand forecasts that are the basis
for purchase orders for finished inventory from our third party manufacturers.
Our forecasts may fail to accurately anticipate ultimate customer demand for
products. Wholesaler buying patterns and wholesaler inventory levels may not
reflect underlying prescriber demand. Conversely, underlying prescriber demand
my not accurately predict our reported net sales in a given period. If we
overestimate demand, we may have excessive inventory production; if we
underestimate demand, we may not have an adequate supply of our products in
channels of distribution. We periodically offer promotions to wholesale and chain drugstore
customers to encourage dispensing of our products, consistent with a health
care providers prescription. Because our products compete in markets which
offer multiple alternative drugs, it is important for us to ensure the licensed
health care providers dispensing instructions are fulfilled with our branded
products and are not substituted with a generic product or another therapeutic
alternative product which may be contrary to the licensed health care
providers recommended prescribed Connetics brand. We believe that a critical
component of our brand protection program is maintenance of full product
availability at drugstore and wholesale customers. Such availability strongly
reduces the probability of local and regional product substitutions, shortages
and backorders, which could result in lost sales. We expect to continue
providing favorable terms to wholesale and retail drug chain customers as may
be necessary to ensure the fullest possible distribution of our branded
products within the pharmaceutical chain of commerce. We cannot control or greatly influence the purchasing patterns of
wholesale and retail drug chain customers. These are highly sophisticated
customers that purchase our products in a manner consistent with their industry
practices and perceived business interests. Our sales are subject to the
purchase requirements of our major customers, which, presumably, are based upon
their projected demand levels. Purchases by any given customer, during any
given financial period, may be above or below actual prescription volumes of
one or more of our products during the same financial period, resulting in
increases or decreases in product inventory existing in the distribution
channel, which are managed presumably in accordance with such customers
business practices. 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,
    
    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. 37




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CERTAIN EVENTS IN 2003 During 2003, we had three product candidates in Phase III clinical trials:
Extina, a foam formulation of a 2% concentration of the antifungal drug
ketoconazole, for the treatment of seborrheic dermatitis; Actiza, a foam
formulation of 1% clindamycin for the treatment of acne; and Velac Gel, a
first-in-class combination of 1% clindamycin and 0.025% tretinoin for the
treatment of acne. Extina and Actiza are delivered in our proprietary foam
delivery system. In April 2003, we announced the outcome of a Phase III clinical trial
evaluating Extina. The four-week, double-blinded active- and
placebo-controlled trial included 619 patients at 25 centers. As designed, the
trial results successfully demonstrated that Extina was not inferior to
Nizoral® (ketoconazole) 2% Cream as measured by the primary endpoint of ISGA.
The trial was also designed to compare Extina to placebo foam per the ISGA.
The result, although in favor of Extina, did not achieve statistical
significance. On all other endpoints, statistical significance was achieved;
therefore, we believe that the totality of the data demonstrated that Extina
was clinically superior to placebo foam. In July 2003, we submitted an NDA to
the FDA for Extina. The FDA initially informed us that a user fee was required
for the Extina NDA, but in December 2003 the FDA agreed that no user fee was
required. The FDA did not, however, accept the NDA retroactive to the original
filing date, and in January 2004 we re-submitted the NDA for Extina. In May 2003 we issued $90 million of convertible senior notes in a private
placement exempt from registration under the Securities Act of 1933. The notes
bear an interest rate of 2.25% per year and have a five-year term. The notes
are convertible into shares of our common stock at a conversion rate of 46.705
shares per $1,000 principal amount of notes, subject to adjustment in certain
circumstances. The conversion rate is equivalent to a conversion price of
approximately $21.41 per share, which represents a 35% premium over the closing
price of our common stock on the date the offering was announced. We are using
the proceeds from the offering to augment our cash reserves for general
corporate purposes, including the acquisition of Soriatane, capital
expenditures and working capital. On July 15, 2003, we assigned our rights to recombinant human relaxin to
BAS Medical, a private, development-stage company focused on the development
and marketing of novel medical treatments. As part of the transaction, we may
receive up to $1.0 million in licensing and milestone fees, plus royalties on
future product sales. We received a $100,000 upfront assignment fee when the
agreement was executed that we recognized as license revenue in the third
quarter of 2003. We will receive the remaining $900,000 if BAS Medical
achieves various milestones. BAS Medical assumed rights to develop and
commercialize relaxin for all indications of use. All of our obligations under
existing contracts related to relaxin were also transferred to BAS Medical as
part of this transaction, and as a result in 2003 we recognized $661,000 in
deferred revenue relating to previous relaxin license agreements. On September 30, 2003, we announced the positive outcome of the Phase III
clinical trial evaluating Actiza. The 12-week, double-blinded, active- and
placebo-controlled trial included 1,026 patients at 18 centers across the U.S.
The trial was designed to demonstrate that Actiza was not inferior to
Clindagel® (clindamycin phosphate 1% topical gel) as measured by the primary
endpoints of ISGA and in percent reduction in lesion counts (total,
inflammatory and non-inflammatory) from baseline to Week 12 (end of treatment).
Success was defined as achieving non-inferiority to Clindagel for two out of
three lesion counts and for ISGA. The trial results met or exceeded all of
these requirements. Additionally, Actiza was statistically superior to placebo
for all primary endpoints. Adverse events with Actiza were mild to moderate in
nature and were related primarily to burning at the application site. On
December 24, 2003 we filed an NDA with the FDA for Actiza. 38




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SUBSEQUENT EVENTS On January 5, 2004, we reached an agreement with S.C. Johnson to terminate
an existing license agreement pursuant to which we licensed to S.C. Johnson the
rights to a concentrated aerosol spray that is marketed in the U.S. and
internationally. On a consolidated basis, in 2003, we received $7.0 million in
royalties in connection with this agreement, which included a one-time royalty
payment of $2.9 million. In connection with the termination of the agreement,
we will cease recognizing royalties after the first quarter of 2004, and S.C.
Johnson will have a fully-paid up license to the technology. On February 9, 2004, we announced that we had entered into a binding
purchase agreement with Roche to acquire exclusive U.S. rights to
Soriatane-brand acitretin, an approved oral medicine for the treatment of
severe psoriasis in adults. The transaction closed on March 4, 2004. Under
the terms of the purchase agreement, we paid Roche a total of $123 million in
cash at the closing to acquire Soriatane. We also agreed to assume certain
liabilities in connection with returns, rebates and chargebacks, and we are
obligated to buy Roches existing inventory within thirty days after the
closing of the acquisition. On February 6, 2004, in connection with the Soriatane acquisition, we
entered into a $30 million credit facility provided by Goldman, Sachs Credit
Partners L.P. We formally terminated the credit facility on February 25, 2004,
without incurring any indebtedness under the facility. On February 13, 2004, we completed a private placement of 3.0 million
shares of our common stock to accredited institutional investors at a price of
$20.25 per share, for net proceeds of approximately $57.1
million without giving effect to certain offering costs. We used a
portion of the net proceeds to pay for the acquisition of exclusive
U.S. rights to Soriatane, and we intend to use the
balance for general corporate purposes, including working capital. CRITICAL ACCOUNTING POLICIES AND ESTIMATES 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 and
estimates 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  Reserves for Discounts, Returns, Rebates and Chargebacks. We recognize product revenue net of allowances for estimated discounts,
returns, rebates and chargebacks. We allow a discount for prompt payment, and
we estimate other allowances based primarily on our past 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), current arrangements with managed
care organizations, the economic value of the rebates being offered and other
factors. In the past, actual discounts, returns, rebates and chargebacks have
not generally exceeded our reserves. However, actual returns, rebates and
chargebacks in the future period are inherently uncertain. Our revenue
reserves are approximately 14% of our gross product revenues. 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. If we changed our
assumptions and estimates, our revenue reserves would change, which would
impact the net revenue we report. 39




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We are obligated to accept from customers the return of pharmaceuticals
that have reached their expiration date. As a practice, we avoid shipping
product that has less than ten months dating. We monitor inventories in the
distributor channel to help us assess the rate of return. We establish and maintain reserves for amounts payable by us to managed
care organizations and state Medicaid programs. Generally, we pay managed care
organizations and state Medicaid programs a rebate on the prescriptions filled
that are covered by the respective programs. We determine the reserve amount
at the time of sale based on our best estimate of the expected prescription
fill rate to managed care and state Medicaid patients, adjusted to reflect
historical experience and known changes in the factors that impact such
reserves. Revenue Recognition  Contract Revenue We record contract revenue for research and development as it is earned
based on the performance requirements of the contract. We recognize royalty
revenue 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. 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 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. Goodwill, Purchased
Intangibles and Other Long-Lived Assets - Impairment
Assessments We make judgments about the recoverability 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. To judge the fair value of
long-lived assets, we make various assumptions about the value of the business
that the asset relates to and typically estimate future cash flows to be
generated by the asset or, in the case of goodwill, the enterprise. 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 2in our Notes to Consolidated Financial Statements. 40




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RESULTS OF OPERATIONS Revenues Our revenues consist of revenues from the sale of products, royalty
revenues, and contract revenues generated from agreements with third parties.
We recognize product revenue net of allowances for estimated returns, rebates
and chargebacks. Typically, increases in product revenue are a result of a
combination of increased sales volume and increased sales prices of our
products. Years Ended December 31,2003
    
    2002
    
    2001(In thousands)
    
    $
    
    % Change
    
    $
    
    % Change
    
    $Product:OLUX
    
    $
    47,538
    
    
    
    47.0
    %
    
    $
    32,339
    
    
    
    115.7
    %
    
    $
    14,996Luxíq
    
    
    18,857
    
    
    
    25.4
    %
    
    
    15,042
    
    
    
    8.6
    %
    
    
    13,848Ridaura
    
    
    
    
    
    
    N/A
    
    
    
    
    
    
    
    (100
    %)
    
    
    2,015Other
    
    
    211
    
    
    
    9.9
    %
    
    
    192
    
    
    
    200
    %
    
    
    64Total product revenues
    
    
    66,606
    
    
    
    40.0
    %
    
    
    47,573
    
    
    
    53.8
    %
    
    
    30,923Royalty:Royalty
    
    
    7,788
    
    
    
    166.2
    %
    
    
    2,926
    
    
    
    166.7
    %
    
    
    1,097License and contract:Relaxin related contract revenue
    
    
    827
    
    
    
    531.3
    %
    
    
    131
    
    
    
    (85.2
    %)
    
    
    888Pfizer (formerly Pharmacia)
    
    
    86
    
    
    
    (91.5
    %)
    
    
    1,006
    
    
    
    N/A
    
    
    
    Novartis
    
    
    
    
    
    
    (100
    %)
    
    
    580
    
    
    
    N/A
    
    
    
    InterMune
    
    
    
    
    
    
    (100
    %)
    
    
    350
    
    
    
    (54.6
    %)
    
    
    771Celltech
    
    
    
    
    
    
    (100
    %)
    
    
    60
    
    
    
    100
    %
    
    
    Other contracts
    
    
    24
    
    
    
    (82.5
    %)

    
    
    137
    
    
    
    (64.4
    %)
    
    
    385Total license, contract
and royalty revenues
    
    
    8,725
    
    
    
    68.1
    %
    
    
    5,190
    
    
    
    65.2
    %
    
    
    3,141Total revenues
    
    $
    75,331
    
    
    
    42.8
    %
    
    $
    52,763
    
    
    
    54.9
    %
    
    $
    34,064
 Our net product revenues were $66.6 million in 2003 compared to $47.6
million in 2002 and $30.9 million in 2001. Increased sales volumes for OLUX
and Luxíq in 2003 accounted for 64% of this increase in our 2003 net product
revenues and increases in pricing accounted for the remaining 36% of this
increase in the net product revenues. Total net product revenues increased in 2002 compared to 2001. Combined
increased sales volumes for OLUX and Luxíq accounted for a 50% increase in our
2002 net product revenues (not including revenues from Ridaura) compared to
2001. Higher sales prices accounted for the remainder of the increases in net
revenues of those products in 2002 compared to 2001. The increase in product
revenues was partially offset by increases in our revenue reserves and a
decrease in Ridaura revenue after the sale of that product in April 2001. We recognized $8.7 million of royalty, license and contract revenues in
2003, compared to $5.2 million in 2002 and $3.1 million in 2001. Royalty,
license and contract revenue was higher for 2003 compared to 2002 primarily
because we received a one-time royalty payment of $2.9 million from S.C.
Johnson. We received royalties in connection with the S.C. Johnson license
agreement in the amount of $2.4 million in 2002 and $7.0 million in 2003, which
included a one-time royalty payment of $2.9 million. On January 5, 2004, we
reached an agreement to terminate the license agreement with S.C. Johnson. We
will cease recognizing royalties under this agreement after the first quarter
of 2004, which will have a significant impact on our royalty revenue for 2004.
Also affecting the increase in 2003, we recognized $761,000 of relaxin-related
revenue associated with the execution of the agreement with BAS 41




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Medical in July 2003. Of the relaxin-related revenue, $661,000
represented previously deferred revenue associated with relaxin license
agreements with other parties that was fully recognized upon the execution of
the BAS Medical agreement. These increases were partially offset by decreases
in contract revenue from other third parties related to one-time contract
payments made in 2002. We expect no further relaxin-related revenue. The increase in license revenue in 2002 from 2001 was partially due to
revenue recognized in association with an agreement we entered into in December
2001 with Pfizer and an expanded license agreement with Novartis. We have an
agreement with Pfizer pursuant to which Pfizer has exclusive global rights,
excluding Japan, to our proprietary foam drug-delivery technology for use in
Rogaine® hair loss treatment. We recognized $1.0 million under the Pfizer
agreement in 2002. The agreement with Novartis expanded the existing global
license to Novartis consumer health to cover Liquipatch drug-delivery system
for use in topical antifungal applications. Novartis will continue to be
responsible for all product development cost, and pay us license fees,
milestone payments and royalties on future product sales. We recognized
$580,000 of revenue related to this agreement in 2002. We have an agreement with InterMune pursuant to which InterMune pays us
royalties for sales of Actimmune® (gamma interferon). In connection with the
agreement, InterMune paid us approximately $942,000 in 2001, which was offset
by related product rebates and chargebacks of $171,000. We recorded $358,000
and $172,000 in royalty revenue related to Actimmune sales in 2003 and 2002,
respectively. In August 2002, we entered into an agreement with InterMune to
terminate our exclusive option for certain rights in the dermatology field in
exchange for a payment of $350,000. We recognized the full amount of this
revenue in 2002. We anticipate that product revenue will increase in 2004 due to continued
sales growth of OLUX and Luxíq as well as the addition of over nine months of
revenue related to Soriatane product sales. In 2004, we anticipate that
license and contract revenue and royalty revenue will decrease, as several
revenue sources in 2003 will not recur in 2004, in particular, the royalties
from S.C. Johnson. Beyond 2004, 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 the timing of any new business opportunities that we may
identify. Cost of Product Revenues Years Ended December 31,2003
    
    2002
    
    2001As a % of Net
    
    
    
    
    
    As a % of Net
    
    
    
    
    
    As a % of NetProduct
    
    
    
    
    
    Product
    
    
    
    
    
    Product(In thousands)
    
    $
    
    Revenues
    
    $
    
    Revenues
    
    $
    
    RevenuesCost of product revenues
    
    $
    5,129
    
    
    
    7.7
    %
    
    $
    4,190
    
    
    
    8.8
    %
    
    $
    3,123
    
    
    
    10.1
    %
 Our cost of product revenues includes the third party costs of
manufacturing OLUX, Luxíq, Ridaura (until April 2001), depreciation costs
associated with Connetics-owned equipment located at the DPT facility in Texas,
royalty payments based on a percentage of our product revenues, and product
freight and distribution costs from SPS, the third party that handles all of
our product distribution activities. The total increase in the cost of product
revenues for 2003 compared to 2002 is primarily attributable to the increase in
sales volume of our products, as well as the establishment of a $262,000
reserve recorded during 2003 related to minimum purchase commitments under our
manufacture and supply agreement with DPT. If the effects of the $262,000
reserve from the 2003 year-to-date are excluded, we experienced a slight
improvement in our gross product margin due to the combined effects 42




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of the price increases for OLUX and Luxíq, effective in the fourth quarter
2002 and the second quarter 2003, and slightly lower cost of manufacturing our
products. The increase in total cost of product revenues in 2002 as compared to 2001
was the result of an increase in sales volumes. On a product basis, cost of
product revenues decreased to 8.8% in 2002 from 10.1% in 2001. When we
acquired Connetics Australia, we began to eliminate all intercompany
transactions in consolidation, which included our royalty expense and Connetics
Australias related royalty income. Our cost of product revenues decreased
from 2001 to 2002 on a percentage basis primarily because we eliminated
intercompany royalties of $1.7 million. That decrease was partially offset by
an average increase in the cost per unit of our products of approximately 8%. Research and Development Years Ended December 31,2003
    
    2002
    
    2001(In thousands)
    
    $
    
    % Change
    
    $
    
    % Change
    
    $Research and
development
expenses
    
    $
    30,109
    
    
    
    16.6
    %
    
    $
    25,821
    
    
    
    34.8
    %
    
    $
    19,156
 Research and development expenses include costs of personnel to support
our research and development activities, costs of preclinical studies, costs of
conducting our clinical trials, such as clinical investigator fees, monitoring
costs, data management and drug supply costs, external research programs, and
an allocation of facilities costs, salaries and benefits, and overhead costs
such as rent, supplies and utilities. In 2003 and 2002, our research and development expenses primarily
consisted of: Years Ended December 31,Category
    
    2003
    
    2002Preclinical and clinical research in the development of
new dermatology products
    
    $13.0 million
    
    $7.4 millionQuality assurance and quality control in the maintenance
and enhancement of existing dermatology products
    
    $5.2 million
    
    $5.1 millionOptimization of manufacturing and process development for
existing dermatology products
    
    $2.8 million
    
    $3.9 millionManufacturing, process development and optimization of
dermatology products under development
    
    $2.1 million
    
    $2.7 millionQuality assurance and quality control in the development
of new dermatology products
    
    $2.0 million
    
    $1.9 millionBasic research and formulation of new dermatology products
    
    $1.3 million
    
    $1.3 millionRegulatory review of new and existing dermatology products
    
    $1.6 million
    
    $1.1 million
 In 2001, our research and development expenses primarily consisted of new
dermatology product efforts ($6.1 million), relaxin development efforts prior
to the May 2001 decision to reduce investment in the program ($4.9 million),
development efforts to expand the usage of existing dermatology products ($7.6
million), and costs to integrate Connetics Australia into our research and
development efforts from April 2001 ($0.6 million). We are conducting research on a number of potential therapeutic products
for new indications that are in various phases of clinical and pre-clinical
development. Pharmaceutical research and 43




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development programs, by their nature, require a substantial amount of
financial and human resources and the FDA may not approve our product
candidates for marketing. The costs to develop all of our potential drugs
through all clinical phases would cost substantially more than the funds
currently available to us. 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. We caution that many of our development
efforts could experience delays, setbacks and failures, with no assurance that
any of our clinical research will reach the stage of an NDA or that the NDA
will be approved. The following table sets forth the status of, and costs attributable to,
our product candidates currently in clinical trials as well as other current
research and development programs. The actual timing of completion of phases
of research could differ materially from the estimates provided in the table.
For a discussion of the risks and uncertainties associated with the timing of
completing a product development phase, see the discussion of clinical risks
set forth in Factors Affecting Our Business and Prospects.Clinical
development is inherently uncertain and expense levels may fluctuate
unexpectedly because we cannot accurately predict the timing and level of such
expenses. EstimatedCompletion of
    
    Accumulated Program-relatedPhase of
    
    Phase III
    
    Research and DevelopmentDescription/Indication
    
    Development
    
    Clinical Trials
    
    Expenses through 2003Extina. Foam
formulation of
ketoconazole for the
treatment of
seborrheic
dermatitis.
    
    NDA filed
    
    Completed
    
    $9.2 millionActiza. Foam
formulation of
clindamycin for the
treatment of acne.
    
    NDA filed
    
    Completed
    
    $8.6 millionVelac. Gel
formulation of
clindamycin and
tretinoin for the
treatment of acne
(excluding license
and milestone
payments to
Yamanouchi).
    
    Phase III
    
    mid-2004
    
    $11.4 millionPre-clinical research
and development for
multiple
dermatological
indications.
    
    Pre-clinical
    
    
    N/A
    
    
    $1.2 million
 In general, we expect research and development expenses to remain
consistent in 2004 due to ongoing research and clinical trials. Consistent
with our 4:2:1 development model, we have multiple product candidates in
product formulation, at least two in late-stage clinical trials, and we expect
to launch at least one new product or indication commercially in 2004.
Pharmaceutical products that we develop internally can take several years to
research, develop and bring to market in the United States. We cannot reliably
estimate the overall completion dates or total costs to complete our major
research and development programs. The clinical development portion of these
programs can span several years and any estimation of completion dates or costs
to complete would be highly speculative and subjective due to the numerous
risks and uncertainties associated with developing pharmaceutical products.
The FDA defines the steps required to develop a drug in the U.S. Clinical
development typically involves three phases of study, 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 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. 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and  We
may spend a significant amount of money to obtain FDA and other regulatory
approvals, which may never be grantedand  Our 44




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continued growth depends on our ability to develop new products, and if we
are unable to develop new products, our expenses may exceed our revenues
without any return on the investment. Selling, General and Administrative Expenses Selling, general and administrative expenses include expenses and costs
associated with finance, legal, insurance, marketing, sales, and other
administrative matters. Years Ended December 31,2003
    
    2002
    
    2001(In thousands)
    
    $
    
    % Change
    
    $
    
    % Change
    
    $Selling, general
and administrative
expenses
    
    $
    42,600
    
    
    
    13.2
    %
    
    $
    37,624
    
    
    
    4.3
    %
    
    $
    36,062
 Selling, general and administrative expenses increased in 2003 over 2002
primarily due to:  
    
    higher labor and benefit expenses due to increased headcount
($2.3 million increase),
    
    higher expenses related to product sampling and sales
promotion programs ($1.8 million increase),
    
    higher cost of outside service and other fees primarily
related to warehousing, distribution and production of sales and
marketing materials ($600,000 increase),
    
    increased business development activities ($250,000 increase), and
    
    higher outside legal expenses incurred ($185,000 increase). Those increases were partially offset by a $662,000 decrease in various
marketing activities such as tradeshows, honorariums, and medical education. Selling, general and administrative expenses increased in 2002 over 2001
primarily due to:  
    
    the introduction of product samples ($1.3 million increase),
    
    higher labor and benefit expenses due to increased head count
as well as having a full year of expanded sales force compared to
eight months in 2001 ($2.7 million increase), and
    
    an increase compared to 2001 in depreciation expenses related
to equipment purchased to support increased headcount of $392,000. Those increases were partially offset by $2.6 million in non-cash stock
compensation expense in 2001 that did not recur in 2002. We expect selling, general and administrative expenses to be slightly
higher in 2004 than in 2003 because we will have a full year of expenses
related to increased headcount in the sales and marketing departments. We also
anticipate increased marketing spending related to the commencement of
marketing efforts in anticipation of approvals for Extina and Actiza. In
connection with the Soriatane acquisition, we also anticipate increased
marketing, sales, finance, legal and other administrative costs in connection
with launching the product. 45




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##### Table of Contents



Acquired In-Process Research and Development and Milestone Payments In May 2002, we entered into an agreement with Yamanouchi Europe B.V. to
license Velac Gel (a first in class combination of 1% clindamycin, and 0.025%
tretinoin). We have licensed exclusive rights to develop and commercialize the
product in the U.S. and Canada, and have licensed non-exclusive rights in
Mexico. Under the terms of the agreement, we paid Yamanouchi an initial $2.0
million licensing fee, which we recorded as acquired in-process research and
development expense in 2002, because the product remains in clinical
development and has no alternative future use. In the fourth quarter of 2002,
we initiated a Phase III trial for Velac. Under the terms of the agreement, we
recorded an additional $2.0 million of acquired in-process research and
development expense related to this milestone. In April 2001, we acquired Connetics Australia (then known as 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 acquired
in-process research and development, based on a third party valuation, and the
balance to the tangible assets of Connetics Australia, existing developed
technology and goodwill. Acquired in-process research and development
consisted of several projects, which involved the use of novel technologies to
improve the delivery of drugs. The projects were and still are in various
stages of development and are subject to substantial risks, and did not have
alternative future uses. The value of the in-process research and development
was determined using a discounted cash flow analysis with a 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. Loss on Program Termination (relaxin) In 2001 we recorded a net charge of $1.1 million representing costs
accrued in connection with the reduction in workforce and the wind down of
relaxin development contracts. Interest and other income (expense), net Years Ended December 31,2003
    
    2002
    
    2001(In thousands)
    
    $
    
    % Change
    
    $
    
    % Change
    
    $Interest and other income
(expense), netInterest income
    
    $
    972
    
    
    
    18.1
    %
    
    $
    823
    
    
    
    (67.6
    %)
    
    $
    2,543Gain on sale of investment
    
    
    
    
    
    
    (100
    %)
    
    
    2,086
    
    
    
    1,609.8
    %
    
    
    122Gain on sale of Ridaura product line
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (100
    %)
    
    
    8,002Interest expense
    
    
    (1,632
    )
    
    
    14,736.4
    %
    
    
    (11
    )
    
    
    (76.1
    %)
    
    
    (46
    )Other income (expense), net
    
    
    234
    
    
    
    3.1
    %
    
    
    227
    
    
    
    (143.7
    %)
    
    
    (519
    )
 Interest Income.Interest income increased during 2003 because we had
higher cash and investment balances in connection with the money we raised by
issuing $90 million of convertible senior notes in May 2003, partially offset
by lower market interest rates on investments. Interest income 46




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decreased in 2002 from 2001 because we had lower cash and investment
balances, combined with a decrease in market interest rates on investments. Interest Expense.Interest expense increased during 2003 compared to 2002
as a direct result of the interest expense associated with the convertible
senior notes issued in the second quarter of 2003. Interest expense in 2002
was primarily related to a financing arrangement associated with our corporate
insurance policies. Income Taxes Years Ended December 31,2003
    
    2002
    
    2001(In thousands)
    
    $
    
    % Change
    
    $
    
    % Change
    
    $Income tax provision
    
    $
    (1,167
    )
    
    
    544.8
    %
    
    $
    (181
    )
    
    
    (47.5
    %)
    
    $
    (345
    )
 We
pay income tax in Australia and withholding tax in the U.S. in
connection with the activities conducted by Connetics Australia. The income
tax expense for 2003 includes $1.3 million of foreign tax provision offset by
$330,000 of foreign tax credit claimed in Australia for the U.S. withholding
tax paid in the same amount. Income tax expense for 2002 reflects $798,000 of
foreign tax provision recorded by Connetics Australia, offset by $331,000 of
foreign tax credit claimed for U.S. withholding tax paid during the year in the
same amount and a U.S. tax benefit of $617,000. The U.S. tax benefit arose
principally because of the provisions of the Job Creation and Worker Assistance
Act of 2002 enacted on March 9, 2002, which allows taxpayers to carry back net
operating losses generated in 2001 and 2002 to offset alternative minimum tax
previously paid. Income tax expense in 2001 arose from the taxable operating
results of Connetics Australia. For a more complete description of our income
tax position, refer to Note 14 in our Notes to Consolidated
Financial Statements. LIQUIDITY AND CAPITAL RESOURCES December 31,2003
    
    2002(In thousands)
    
    $
    
    % Change
    
    $Cash, cash equivalents and
marketable securities
    
    $
    114,662
    
    
    
    246.8
    %
    
    $
    33,064
 Sources
and Use of Cash. We have financed our operations to date
primarily through proceeds from equity and debt financings, sale of
investments, collaborative arrangements with corporate partners, bank loans,
and product revenues. We hold our cash balances in a variety of
interest-bearing instruments including high-grade corporate bonds, commercial
paper, U.S. Government agencies papers, asset and mortgage based securities,
and money market accounts. Years Ended December 31,(In thousands)
    
    2003
    
    2002
    
    2001Cash flows from operating activities
    
    $
    (8,511
    )
    
    $
    (12,505
    )
    
    $
    (24,595
    )Cash flows from investing activities
    
    $
    (73,602
    )
    
    $
    10,855
    
    
    $
    (29,891
    )Cash flows from financing activities
    
    $
    91,048
    
    
    $
    6,548
    
    
    $
    (201
    )
 Cash Used in Operating Activities.We used cash in our operating
activities in each of 2003, 2002, and 2001. In 2003, our net loss of $4.1
million was affected by non-cash charges of $2.7 million of 47




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depreciation and amortization, and increased reserves of $3.0 million
related to product discounts, returns, rebates and chargebacks. Our use of
cash primarily reflected an increase in accounts receivable of approximately
$1.2 million related to the timing of sales and collection of outstanding

amounts, an increase in other assets of $3.8 million primarily related to
various prepaid activities, and a decrease in accounts payable and other
accrued and current liabilities of $4.3 million primarily related to the timing
of payments and activities related to product development and other business
activity. In 2002, our use of cash included non-cash charges of $2.1 million of
depreciation and amortization expense, a $2.1 million gain on the sale of
investments, and $1.2 million in increased reserves related to discounts,
returns, rebates and chargebacks. Our use of cash was partially offset by a
$70,000 increase in accounts receivable primarily related to the timing of
sales and collection of outstanding amounts, an increase in other assets of
$931,000 primarily related to various prepaid activities, and an increase in
accounts payable of approximately $4.1 million related to increased development
costs. In 2001, our use of cash included 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, acquired in-process research and
development charge of $1.1 million related to the Connetics Australia
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 the Ridaura
product line. Cash Flows from Investing Activities.We received cash from investing
activities in 2002, and used cash in investing activities in 2003 and 2001. In
2003, we used cash in investing activities primarily as the result of a
significant net increase in purchasing of marketable securities following the
convertible debt financing. We had only moderate increases in operating
expenses in twelve months ended December 31, 2003 compared to the same period
in 2002, but our property and equipment expenditures decreased by $2.9 million
in 2003 compared to 2002. The decrease is primarily because we had
expenditures in 2002 that were not repeated in 2003, including $2.5 million
related to the construction of an aerosol filling line at DPTs plant in Texas,
which occurred in 2002. In 2001, our principal uses of cash for investing
activities were net purchases of marketable securities and the acquisition of
Connetics Australia, which were partially offset by proceeds from the sale of
the Ridaura product line. Cash Flows from Financing Activities.Financing activities provided $91.0
million in cash during 2003 and $6.5 million in cash during 2002. In 2001, we
used $201,000 in financing activities. The increase in 2003 primarily
represents $86.3 million of net proceeds we received from the issuance of
convertible senior notes. We recognized $4.3 million in net proceeds from the
issuance of common stock pursuant to the exercise of warrants and stock options
during 2003 compared to the 2002 proceeds of $5.1 million from the sale of
common stock. During 2002, $1.4 million of previously restricted certificates
of deposits related to our controlled disbursements account, security deposit
in connection with an operating lease arrangement, and collateral on certain
officers personal bank loans were released. For the same period in 2003,
$420,000 of previously restricted certificates of deposit were released: one
related to a security deposit on our facility and the other related to
collateral on certain officers personal bank loans. Working Capital.Our working capital increased by $87.0 million to $112.2
million at December 31, 2003 from $25.2 million at December 31, 2002, primarily
due to the convertible debt financing which we completed in the second quarter
of 2003. Working capital decreased to $25.2 million at December 31, 2002 from
$44.0 million at December 31, 2001, primarily because in 2002 we used cash in
operations and for the acquisition of acquired in-process development. Working
capital at December 31, 2003 includes cash, cash equivalents and marketable securities of $114.7
million. Giving effect to the net proceeds of the private placement that
closed on February 13, 2004, and the use of cash to purchase
exclusive U.S. rights to Soriatane and existing Soriatane inventory from Roche, our 48




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adjusted cash, cash equivalents and marketable securities as of December
31, 2003 would be approximately $47.2 million without giving effect to certain
transaction costs and assumed liabilities (including reserves for
discounts, returns, rebates and chargebacks) related to the acquisition and to the private placement. Contractual Obligations and Commercial Commitments.As of December 31,
2003, we had the following contractual obligations and commitments: Payments Due by PeriodLess than
    
    
    
    
    
    
    
    
    
    More ThanContractual Obligations
    
    Total
    
    1 year
    
    1  3 years
    
    3  5 years
    
    5 yearsLong-Term Debt Obligations (1)
    
    $
    99.0 million
    
    
    $
    2.0 million
    
    
    $
    4.1 million
    
    
    $
    92.9 million
    
    
    
    Operating Lease Obligations (2)
    
        
4.0 million
    
    
    $
 2.5 million
    
    
    $
1.2 million
    
    
    $
0.1 million
    
    
    $
0.2 millionPurchase Obligations (3)
    
        
8.2 million
    
    
    $
0.5 million
    
    
    $
1.5 million
    
    
    $
1.7 million
    
    
    $
4.5 millionOther Long-Term Liabilities
Reflected on the Registrants
Balance Sheet under GAAP
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total Contractual Cash Obligations
    
    $
111.2 million
    
    
    $
5.0 million
    
    
    $
6.8 million
    
    
    $
94.7 million
    
    
    $
4.7 million
  (1)
    
    On May 28, 2003, we issued $90 million of 2.25% convertible
senior notes due May 30, 2008 in a private offering. The notes
are unsecured and rank equal to all of our future unsecured and
unsubordinated debts. The notes are convertible at any time at
the option of note holders into shares of our common stock at a
conversion rate of 46.705 shares for each $1,000 principal
amount of notes, subject to adjustment in certain circumstances,
which is equivalent to a conversion price of approximately
$21.41 per share. The amounts reflected above include annual
interest payments of approximately $2.0 million per year,
assuming that the notes are not redeemed or converted before
maturity.(2)
    
    We lease laboratory and office facilities under
noncancelable operating leases, which expire through 2005.
Under our agreement with DPT, we are also obligated to pay
approximately $56,000 per year in rent for the pro rataportion
of DPTs facility allocated to the aerosol line. Under the DPT
agreement, we will pay rent for the term of the agreement or as
long as we own the associated assets, whichever is longer. We
also lease various automobiles and office equipment under
similar leases, expiring through 2007. These obligations are to
be partially offset by $313,000 to be received from subleasing
arrangements with third parties.(3)
    
    In March 2002 we entered into a manufacturing and supply
agreement with DPT that requires minimum purchase commitments,
beginning six months after the opening of the commercial
production line and continuing for 10 years. Also in 2002 we
entered into a license agreement that requires minimum royalty
payments beginning in 2005 and continuing for fifteen years,
unless the agreement is terminated earlier by either party. We believe our existing cash, cash equivalents and marketable securities,
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. The amount of
our future product revenues is uncertain, as product sales can be impacted by
patent risks and competition from new products, and 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. The amount of capital we
require for operations in the future depends on numerous factors, including the
level of product revenues, the 49




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extent of commercialization activities, the
scope and progress of our clinical research and development programs, the time
and costs involved in obtaining regulatory approvals, the cost of filing,
prosecuting, and enforcing patent claims and other intellectual property
rights, and competing technological and market developments. If we need funds
in the future to in-license or acquire additional marketed or late-stage
development products, a portion of the funds may come from our existing cash,
which will result in fewer resources available to our current products and
clinical programs. To take action on business development opportunities we may
identify in the future, we may need to use some of our available cash, or raise
additional cash by liquidating some of our investment portfolio and/or raising
additional funds through equity or debt financings. On February 13, 2004, we
completed a private placement of 3.0
million shares of our common stock to accredited institutional investors at a price of $20.25 per share. We intend
to use the net cash after giving effect to the Soriatane acquisition for
general corporate purposes, including working capital. 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. OFF BALANCE SHEET ARRANGEMENTS We do not have any off-balance sheet arrangements (as that term is defined
in Item 303 of Regulation S-K) that are reasonably likely to have a current or
future material effect on our financial condition, revenue or expenses, results
of operations, liquidity, capital expenditures or capital resources. RECENT ACCOUNTING PRONOUNCEMENTS EITF 00-21. In November 2002, the Emerging Issues Task Force, or EITF, of
the Financial Accounting Standards Board, or FASB, issued EITF 00-21, Revenue
Arrangements with Multiple Deliverables, which addresses certain aspects of
the accounting for arrangements that involve the delivery or performance of
multiple products, services, and/or rights to use assets. EITF 00-21 requires
us to divide revenue arrangements with multiple deliverables into separate
units of accounting if the deliverables meet certain criteria, including
whether the fair value of the delivered items can be determined and whether
there is evidence of fair value of the undelivered items. EITF 00-21 also
requires us to allocate the consideration among the separate units of
accounting based on their fair values, and to consider applicable revenue
recognition criteria separately for each of the separate units of accounting.
EITF 00-21 is effective for revenue arrangements we enter into after June 30,
2003. There was no impact on our financial statements from the adoption of
EITF 00-21. FIN 46.In January 2003, the FASB issued Interpretation 46,
Consolidation of Variable Interest Entities (FIN 46). FIN 46 requires that
companies that control another entity through interests other than voting
interests should consolidate the controlled entity. FIN 46, as amended,
applies to variable interest entities created after January 31, 2003, and to
variable interest entities in which an enterprise obtains an interest after
that date. The consolidation requirements apply to older entities in the first
fiscal year or interim period beginning after March 15, 2004. Certain
disclosure requirements apply to all financial statements issued after January
31, 2003, regardless of when the variable interest entity was established. The
adoption of FIN 46 is not expected to have a significant impact on our
financial position or results of operations. 50




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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,
municipal debt, and asset and mortgage backed securities. 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
reductions in interest 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 marketable securities, we have concluded that we face minimal
material market risk exposure. The table below presents the principal amounts and weighted average
interest rates by year of maturity for our investment portfolio as of December
31, 2003 (dollar amounts in thousands): There-
    
    
    
    
    
    Fair2004
    
    2005
    
    2006
    
    2007
    
    2008
    
    after
    
    Total
    
    ValueAssets:Available-for-sale
securities
    
    $
    50,054
    
    
    $
    15,965
    
    
    $
    3,800
    
    
    $
    850
    
    
    $
    300
    
    
    $
    22,646
    
    
    $
    93,615
    
    
    $
    95,545Weighted average
annual interest rate
    
    
    4.4
    %
    
    
    4.9
    %
    
    
    2.9
    %
    
    
    1.2
    %
    
    
    1.2
    %
    
    
    1.3
    %
    
    
    
    
    
    
    Liabilities:2.25% Convertible
Senior Notes Due
2008
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    90,000
    
    
    
    
    
    
    $
    90,000
    
    
    $
    96,912Average interest rate
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2.25
    %
    
    
    
    
    
    
    
    
    
    
    
 Included in the table above are principal and fair value amounts of $20.1
million as of December 31, 2003, related to auction rate securities. Although
these securities have long final maturities (from 14 to 37 years), we consider
them to be short-term investments because liquidity is provided through the
short-term (7 to 90 days) interest rate reset mechanism. These securities are
allocated between maturity groupings based on their final maturities. The
table above also includes principal amounts of $7.7 million and fair value
amounts of $7.8 million related to asset-backed and mortgage-backed securities
that are allocated between maturity groupings based on their final maturities. Foreign Currency Exchange Risk.Certain payments by third parties to
Connetics Australia are made in local currency or Australian dollars, and
payments by Connetics Australia to Celltech in the U.K. are made in Australian
dollars. Any fluctuations in the currencies of our licensees or licensors
against the Australian or the U.S. dollar will cause our royalty revenues and
expenses to fluctuate as well. We currently do not hedge our exposure to
changes in foreign currency exchange rates. 
 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 15(a) for
an Index to Consolidated Financial Statements. 51




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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. Item 9A. Controls and Procedures Thomas G. Wiggans, our Chief Executive Officer, and John L. Higgins, our
Chief Financial Officer, have evaluated the effectiveness of Connetics
disclosure controls and procedures as of December 31, 2003. Our disclosure
controls and procedures are designed with the objective of ensuring that
information required to be disclosed in our reports filed under the Securities
Exchange Act of 1934 is recorded, processed, summarized and reported within the
time periods specified in the SECs rules and forms. Based on their
evaluation, each of them concluded that our disclosure controls and procedures
were effective to ensure that the material information required to be disclosed
by Connetics in our periodic SEC reports is recorded, processed, summarized and
reported within the time periods specified in the rules and forms of the SEC.
There have been no changes in our internal control over financial reporting
during the period covered by this Report that have materially affected or are
reasonably likely to materially affect, our internal control over financial
reporting. 
 PART III Item 10. Our Directors and Executive Officers (a) Information
regarding our Board of Directors is incorporated by  reference to the sections entitled Election of Directors,  Stock Ownership,
 Corporate Governance, and Report of the Audit Committee in our Proxy
Statement (2004 Proxy Statement) to be filed with the Securities and Exchange
Commission relating to our annual meeting of stockholders to be held May 7,
2004. (b) Information regarding our executive officers is included in Part I of
this Report in the section entitled Business  Executive Officers of the
Company, and is incorporated by reference to the section entitled Stock
Ownership in our 2004 Proxy Statement. (c) Information regarding the identity of the audit committee members and
the audit committee financial expert is incorporated by reference to the
section entitled Report of the Audit Committee in our 2004 Proxy Statement. (d) Information with respect to our policy regarding nominations by
stockholders for the Board is incorporated by reference to the section entitled
Corporate Governance in our 2004 Proxy Statement. (e) The information found in our 2004 Proxy Statement under the heading
Stock Ownership  Section 16 (a) Beneficial Ownership Reporting Compliance
is incorporated by reference. (f) The Board has adopted a code of professional conduct that applies to
all employees, and a supplemental code of professional conduct that applies to
our CEO, senior financial officers, and the Board of Directors. These codes of
conduct are posted on the Corporate Governance section of our website at
http://governance.connetics.com. We intend to disclose any amendments to, or
waivers from, our codes of conduct on our website. 52




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##### Table of Contents



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 2004 Proxy Statement. Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters Information regarding the beneficial ownership of our common stock by
certain beneficial owners and by our directors and management, is incorporated
by reference to the information set forth under the caption Stock Ownership
in our 2004 Proxy Statement. Equity Compensation Plan Information.The following table sets forth
information as of December 31, 2003 with respect to all of our compensation
plans under which equity securities are authorized for issuance. (a)
    
    (b)
    
    (c)Number of securities remainingNumber of securities to be
    
    
    
    
    
    available for future issuanceissued upon exercise of
    
    Weighted average exercise
    
    under equity compensationoutstanding options, warrants
    
    price of outstanding options,
    
    plans (excluding securitiesPlan Category
    
    and rights
    
    warrants and rights
    
    reflected in column (a))Equity compensation plans approved by security holders (1)
    
    
    5,435,997
    (2)
    
    $
    8.42 (2
    ) (3)
    
    
    1,089,513
    (4)Equity compensation plans not approved by security holders (5)
    
    
    609,437
    
    
    $
    7.25
    
    
    
    145,386Total
    
    
    6,045,434
    
    
    $
    8.30
    
    
    
    1,234,899
  (1)
    
    Consists of the 1994 Stock Plan, the 1995 Employee
Stock Purchase Plan, or ESPP, the 1995 Directors Stock
Option Plan, the Stock Plan (2000), and the 2002 Employee
Stock Plan. No shares are available to grant under the 1994
Stock Plan, and the 325,000 shares available to grant under
the Directors Plan are not available to Connetics employees.(2)
    
    Excludes purchase rights accruing under the ESPP which
have a stockholder approved reserve of 335,700 shares.(3)
    
    Weighted average exercise price of outstanding
options; excludes shares issued to date under the ESPP.(4)
    
    Includes shares available for future issuance under
the ESPP. As of March 1, 2004, an aggregate of 216,320
 shares were available for issuance under the ESPP.(5)
    
    Consists of the 1998 Supplemental Stock Plan, the 2000
Non-Officer Stock Plan, the International Stock Incentive
Plan, and certain non-plan stock options and common stock
warrants. These are discussed in more detail in Note 13 of
Notes to Consolidated Financial Statements. Each of the
non-stockholder approved plans provides for options to be
granted only to non-officer employees of Connetics, and the
options granted under the plans are nonstatutory stock
options. 53




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##### Table of Contents



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 2004 Proxy Statement. 
 Item 14. Principal Accountant Fees and Services The information required by this item is incorporated by reference to the
section entitled Audit and Other Fees of our 2004 Proxy Statement. 
 PART IV 
 Item 15. 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: PageReport of Ernst & Young LLP, Independent Auditors
    
    
    F-2Consolidated Balance Sheets as of December 31, 2003 and 2002
    
    
    F-3Consolidated Statements of Operations for each of the three years in
the period ended December 31, 2003
    
    
    F-4Consolidated Statements of Stockholders Equity for each of the three
years in the period ended December 31, 2003
    
    
    F-5Consolidated Statements of Cash Flows for each of the three years in
the period ended December 31, 2003
    
    
    F-6Notes 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. 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. 54




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##### Table of Contents



Schedule II  Valuation and Qualifying Accounts Allowance for doubtful
    
    
    
    
    
    Additionsaccounts, discounts,
    
    Balance at
    
    Charged to
    
    
    
    
    
    Balance atreturns, rebates and
    
    start of
    
    Expense/Revenue
    
    
    
    
    
    endchargebacks
    
    period
    
    net of reversals
    
    Utilizations
    
    of periodYear ended December 31,2003
    
    $
    2,041,507
    
    
    $
    10,909,819
    
    
    $
    (7,918,349
    )
    
    $
    5,032,9772002
    
    $
    975,318
    
    
    $
    5,353,368
    
    
    $
    (4,287,179
    )
    
    $
    2,041,5072001
    
    $
    1,458,734
    
    
    $
    2,120,208
    
    
    $
    (2,603,624
    )
    
    $
    975,318
  3.
    
    The Exhibits filed as a part of this Report are listed in the
Index to Exhibits.  (b)
    
    Reports onForm 8-K.We filed or furnished the following Current Reports
on Form 8-K during the quarter ended December 31, 2003. Current Reports
furnished under Item 12, Results of Operations and Financial Condition,
are not deemed to be filed for purposes of Section 18 of the Securities
Exchange Act of 1934.  (i)
    
    Current Report on Form 8-K dated December 22, 2003, filed
with the Securities and Exchange Commission on December 24, 2003,
under Item 5, Other Events, and Item 7, Financial Statements and
Exhibits.(ii)
    
    Current Report on Form 8-K dated December 10, 2003, filed
with the Securities and Exchange Commission on December 11, 2003,
under Item 5, Other Events, and Item 7, Financial Statements and
Exhibits.(iii)
    
    Current Report on Form 8-K dated November 21, 2003, filed
with the Securities and Exchange Commission on November 24, 2003,
under Item 5, Other Events.(iv)
    
    Current Report on Form 8-K dated October 21, 2003, furnished
to the Securities and Exchange Commission on October 21, 2003, under
Item 7, Financial Statements & Exhibits and Item 12, Results of
Operations and Financial Condition.(v)
    
    Current Report on Form 8-K dated September 30, 2003, filed
with the Securities and Exchange Commission on October 1, 2003,
under Item 5, Other Events, and Item 7, Financial Statements and
Exhibits.  (c)
    
    Exhibits.See Index to Exhibits.  (d)
    
    Financial Statement Schedules.See Item15(a)(2), above. 55




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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 Corporationa Delaware corporationBy:
    
    /s/ John L. HigginsJohn L. HigginsChief Financial OfficerExecutive Vice President, Financeand Corporate Development
 Date: March 11, 2004 Each person whose signature appears below constitutes and appoints Katrina
J. Church and John L. Higgins, jointly and severally, his or her attorneys-in-fact and
agents, each with the power of substitution, for him or her and in his or her name, place or
stead, in any and all capacities, to sign any and all amendments to this Annual
Report on Form 10-K, and to file the same, with exhibits and other documents in
connection therewith, with the Securities and Exchange Commission, granting to
each attorney-in-fact and agent, full power and authority to do and perform
each and every act and thing requisite and necessary to be done in and about
the premises, as fully as he or she might or could do in person, and ratifying
and confirming all that the attorneys-in-fact and agents, or his or her substitute or
substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated. Signature
    

Title
    

DatePrincipal Executive Officer:/s/ Thomas G. Wiggans
    
    President, Chief ExecutiveOfficer and Director
    
    March 11, 2004Thomas G. WiggansPrincipal Financial and Accounting Officer:/s/ John L. Higgins
    
    Chief Financial Officer;Executive Vice President,John L. Higgins
    
    Finance and Corporate Development
    
    March 11, 2004
 56




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##### Table of Contents



Signature
    

Title
    

DateDirectors:/s/ Alexander E. BarkasDirector
    
    March 11, 2004Alexander E. Barkas/s/ Eugene A. BauerDirector
    
    March 11, 2004Eugene A. Bauer/s/ R. Andrew EckertDirector
    
    March 11, 2004R. Andrew Eckert/s/ Denise M. GilbertDirector
    
    March 11, 2004Denise M. Gilbert/s/ John C. KaneDirector
    
    March 11, 2004John C. Kane/s/ Thomas D. KileyDirector
    
    March 11, 2004Thomas D. Kiley/s/ Leon E. PanettaDirector
    
    March 11, 2004Leon E. Panetta/s/ G. Kirk RaabChairman of the Board
    
    March 11, 2004G. Kirk Raab


57



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##### Table of Contents



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:

PageReport of Ernst & Young LLP, Independent Auditors
    
    F-2Consolidated Balance Sheets as of December 31, 2003
and 2002
    
    F-3Consolidated Statements of Operations for each the three years in
the period ended December 31, 2003
    
    F-4Consolidated Statements of Stockholders Equity for each of the three
years in the period ended December 31, 2003
    
    F-5Consolidated Statements of Cash Flows for each of the three years in
the period ended December 31, 2003
    
    F-6Notes to Consolidated Financial Statements
    
    F-7


F-1





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REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

Board of Directors and StockholdersConnetics Corporation

We have audited the accompanying consolidated balance sheets of Connetics
Corporation as of December 31, 2003 and 2002, and the related consolidated
statements of operations, stockholders equity, and cash flows for each of the
three years in the period ended December 31, 2003. Our audits also included
the financial statement schedule listed in the Index at Item 15(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, 2003 and 2002, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
December 31, 2003, 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.

/s/ ERNST & YOUNG LLP

Palo Alto, California
January 23, 2004,
except for Note 18 as to which
the date is March 4, 2004

F-2





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##### Table of Contents



CONNETICS CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share amounts) December 31,2003
    
    2002AssetsCurrent assets:Cash and cash equivalents
    
    $
    17,946
    
    
    $
    8,624Marketable securities
    
    
    96,716
    
    
    
    24,440Restricted cash  current
    
    
    304
    
    
    
    424Accounts receivable, net of allowances of $5,033 in
2003 and $2,042 in 2002
    
    
    2,594
    
    
    
    4,308Prepaid expenses and other current assets
    
    
    4,814
    
    
    
    1,803Total current assets
    
    
    122,374
    
    
    
    39,599Property and equipment, net
    
    
    5,628
    
    
    
    5,860Restricted cash long term
    
    
    
    
    
    
    300Debt issuance costs, deposits and other assets
    
    
    5,418
    
    
    
    848Goodwill, net
    
    
    6,271
    
    
    
    6,271Other intangible assets, net
    
    
    6,206
    
    
    
    6,675Total assets
    
    $
    145,897
    
    
    $
    59,553Liabilities and Stockholders EquityCurrent liabilities:Accounts payable
    
    $
    3,884
    
    
    $
    7,760Accrued payroll and related expenses
    
    
    3,792
    
    
    
    2,942Accrued clinical trial costs
    
    
    857
    
    
    
    1,223Current portion of deferred revenue
    
    
    19
    
    
    
    363Other accrued liabilities
    
    
    1,575
    
    
    
    2,126Total current liabilities
    
    
    10,127
    
    
    
    14,414Convertible senior notes
    
    
    90,000
    
    
    
    Deferred revenue, net of current portion
    
    
    
    
    
    
    396Other non-current liabilities
    
    
    16
    
    
    
    Commitments and contingenciesStockholders 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: 31,885,404 in 2003 and 31,180,436 in 2002
    
    
    32
    
    
    
    31Additional paid-in capital
    
    
    174,080
    
    
    
    169,769Deferred stock compensation
    
    
    (31
    )
    
    
    (48
    )Accumulated deficit
    
    
    (130,188
    )
    
    
    (126,088
    )Accumulated other comprehensive income
    
    
    1,861
    
    
    
    1,079Total stockholders equity
    
    
    45,754
    
    
    
    44,743Total liabilities and stockholders equity
    
    $
    145,897
    
    
    $
    59,553
 See accompanying Notes to Consolidated Financial Statements. F-3




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CONNETICS CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts) Years Ended December 31,2003
    
    2002
    
    2001Revenues:Product
    
    $
    66,606
    
    
    $
    47,573
    
    
    $
    30,923Royalty
    
    
    7,788
    
    
    
    2,926
    
    
    
    1,097License, contract and other
    
    
    937
    
    
    
    2,264
    
    
    
    2,044Total revenues
    
    
    75,331
    
    
    
    52,763
    
    
    
    34,064Operating costs and expenses:Cost of product revenues
    
    
    5,129
    
    
    
    4,190
    
    
    
    3,123Research and development
    
    
    30,109
    
    
    
    25,821
    
    
    
    19,156Selling, general and administrative
    
    
    42,600
    
    
    
    37,624
    
    
    
    36,062Acquired in-process research and
development and milestone payments
    
    
    
    
    
    
    4,350
    
    
    
    1,080Loss on program termination
    
    
    
    
    
    
    312
    
    
    
    1,142Total operating costs and expenses
    
    
    77,838
    
    
    
    72,297
    
    
    
    60,563Loss from operations
    
    
    (2,507
    )
    
    
    (19,534
    )
    
    
    (26,499
    )Interest and other income (expense):Interest income
    
    
    972
    
    
    
    823
    
    
    
    2,543Gain on sale of investment
    
    
    
    
    
    
    2,086
    
    
    
    122Gain on sale of Ridaura product line
    
    
    
    
    
    
    
    
    
    
    8,002Interest expense
    
    
    (1,632
    )
    
    
    (11
    )
    
    
    (46
    )Other income (expense), net
    
    
    234
    
    
    
    227
    
    
    
    (519
    )Loss before income taxes
    
    
    (2,933
    )
    
    
    (16,409
    )
    
    
    (16,397
    )Income tax provision
    
    
    1,167
    
    
    
    181
    
    
    
    345Net loss
    
    $
    (4,100
    )
    
    $
    (16,590
    )
    
    $
    (16,742
    )Basic and diluted loss per share Net loss per share
    
    $
    (0.13
    )
    
    $
    (0.54
    )
    
    $
    (0.56
    )Shares used to compute basic and
diluted net loss per share
    
    
    31,559
    
    
    
    30,757
    
    
    
    29,861
 See accompanying Notes to Consolidated Financial Statements. F-4




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CONNETICS CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
(In thousands) Number of
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    AccumulatedCommon
    
    Common
    
    Additional
    
    Deferred
    
    
    
    
    
    Other
    
    TotalShares
    
    Stock
    
    Paid-in
    
    Stock
    
    Accumulated
    
    Comprehensive
    
    StockholdersOutstanding
    
    Amount
    
    Capital
    
    Compensation
    
    Deficit
    
    Income
    
    EquityBalance at December 31, 2000
    
    
    29,685
    
    
    $
    30
    
    
    $
    159,212
    
    
    $
    (21
    )
    
    $
    (92,756
    )
    
    $
    6,141
    
    
    $
    72,606Common stock issued under
stock option and purchase
plans
    
    
    519
    
    
    
    
    
    
    
    2,070
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,070Issuance of common stock
pursuant to license
agreements
    
    
    1
    
    
    
    
    
    
    
    12
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    12Exercise of warrants
    
    
    52
    
    
    
    
    
    
    
    392
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    392Stock compensation expense
    
    
    
    
    
    
    
    
    
    
    2,584
    
    
    
    (48
    )
    
    
    
    
    
    
    
    
    
    
    2,536Comprehensive loss:Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (16,742
    )
    
    
    
    
    
    
    (16,742
    )Unrealized gain on investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    503
    
    
    
    503Foreign currency translation
adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (23
    )
    
    
    (23
    )Total comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (16,262
    )Balance at December 31, 2001
    
    
    30,257
    
    
    
    30
    
    
    
    164,270
    
    
    
    (69
    )
    
    
    (109,498
    )
    
    
    6,621
    
    
    
    61,354Common stock issued under
stock option and purchase
plans
    
    
    659
    
    
    
    1
    
    
    
    3,449
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,450Issuance of common stock
pursuant to license
agreements
    
    
    1
    
    
    
    
    
    
    
    12
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    12Exercise of warrants
    
    
    263
    
    
    
    
    
    
    
    1,683
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,683Stock compensation expense
    
    
    
    
    
    
    
    
    
    
    355
    
    
    
    21
    
    
    
    
    
    
    
    
    
    
    
    376Comprehensive loss:Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (16,590
    )
    
    
    
    
    
    
    (16,590
    )Reclassification adjustment
for realized gain on sale of
equity security
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,086
    )
    
    
    (2,086
    )Unrealized loss on investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,532
    )
    
    
    (3,532
    )Foreign currency translation
adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    76
    
    
    
    76Total comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (22,132
    )Balance at December 31, 2002
    
    
    31,180
    
    
    
    31
    
    
    
    169,769
    
    
    
    (48
    )
    
    
    (126,088
    )
    
    
    1,079
    
    
    
    44,743Common stock issued under
stock option and purchase
plans
    
    
    674
    
    
    
    1
    
    
    
    4,158
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,159Exercise of warrants
    
    
    31
    
    
    
    
    
    
    
    153
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    153Stock compensation expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    17
    
    
    
    
    
    
    
    
    
    
    
    17Comprehensive loss:Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,100
    )
    
    
    
    
    
    
    (4,100
    )Unrealized loss on investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (167
    )
    
    
    (167
    )Foreign currency translation
adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    949
    
    
    
    949Total comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,318
    )Balance at December 31, 2003
    
    
    31,885
    
    
    $
    32
    
    
    $
    174,080
    
    
    $
    (31
    )
    
    $
    (130,188
    )
    
    $
    1,861
    
    
    $
    45,754
 See accompanying Notes to Consolidated Financial Statements. F-5




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CONNETICS CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands) Years Ended December 31,2003
    
    2002
    
    2001Cash flows from operating activities:Net loss
    
    $
    (4,100
    )
    
    $
    (16,590
    )
    
    $
    (16,742
    )Adjustments to reconcile net loss to net cash
used in operating activities:Depreciation
    
    
    1,422
    
    
    
    1,285
    
    
    
    953Amortization of goodwill, intangible assets and debt issuance costs
    
    
    1,249
    
    
    
    810
    
    
    
    1,057Allowance for discounts, returns, rebates and chargebacks
    
    
    2,994
    
    
    
    1,173
    
    
    
    (516
    )Gain on sale of investment
    
    
    
    
    
    
    (2,086
    )
    
    
    (122
    )Gain on sale of Ridaura product line
    
    
    
    
    
    
    
    
    
    
    (8,002
    )Stock compensation expense
    
    
    17
    
    
    
    388
    
    
    
    2,548Non-cash charge for acquired in-process research and development
    
    
    
    
    
    
    
    
    
    
    1,080Loss on foreign exchange forward contract
    
    
    
    
    
    
    
    
    
    
    555Changes in assets and liabilities:Accounts receivable
    
    
    (1,236
    )
    
    
    (70
    )
    
    
    (575
    )Other assets
    
    
    (3,773
    )
    
    
    (931
    )
    
    
    (588
    )Accounts payable
    
    
    (4,199
    )
    
    
    4,119
    
    
    
    (1,645
    )Accrued and other current liabilities
    
    
    (146
    )
    
    
    (3
    )
    
    
    (3,166
    )Deferred revenue
    
    
    (739
    )
    
    
    (600
    )
    
    
    568Net cash used in operating activities
    
    
    (8,511
    )
    
    
    (12,505
    )
    
    
    (24,595
    )Cash flows from investing activities:Purchases of marketable securities
    
    
    (135,352
    )
    
    
    (32,573
    )
    
    
    (56,371
    )Sales and maturities of marketable securities
    
    
    62,909
    
    
    
    47,335
    
    
    
    35,870Purchases of property and equipment
    
    
    (959
    )
    
    
    (3,907
    )
    
    
    (1,758
    )Proceeds from sale of Ridaura product line
    
    
    
    
    
    
    
    
    
    
    8,979Acquisition of patent
    
    
    (200
    )
    
    
    
    
    
    
    Acquisition of business, net of cash acquired
    
    
    
    
    
    
    
    
    
    
    (16,611
    )Net cash provided by (used in) investing activities
    
    
    (73,602
    )
    
    
    10,855
    
    
    
    (29,891
    )Cash flows from financing activities:Restricted cash
    
    
    420
    
    
    
    1,415
    
    
    
    (1,876
    )Proceeds from issuance of convertible senior notes, net of
issuance costs
    
    
    86,316
    
    
    
    
    
    
    
    Proceeds from issuance of common stock
    
    
    4,312
    
    
    
    5,133
    
    
    
    2,462Payments of debt and capital leases
    
    
    
    
    
    
    
    
    
    
    (787
    )Net cash provided by (used in) financing activities
    
    
    91,048
    
    
    
    6,548
    
    
    
    (201
    )Effect of foreign currency exchange rates on cash and cash
equivalents
    
    
    387
    
    
    
    123
    
    
    
    (24
    )Net change in cash and cash equivalents
    
    
    9,322
    
    
    
    5,021
    
    
    
    (54,711
    )Cash and cash equivalents at beginning of year
    
    
    8,624
    
    
    
    3,603
    
    
    
    58,314Cash and cash equivalents at end of year
    
    $
    17,946
    
    
    $
    8,624
    
    
    $
    3,603Supplementary information:Interest paid
    
    $
    1,028
    
    
    $
    11
    
    
    $
    46Income taxes paid
    
    
    1,541
    
    
    
    654
    
    
    
    698
 See accompanying Notes to Consolidated Financial Statements. F-6




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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003 Note 1. Organization and Development of the Company Connetics Corporation, or Connetics, was incorporated in the State of
Delaware on February 8, 1993. Connetics is a specialty pharmaceutical company
focusing exclusively on the treatment of dermatological conditions. We
currently market two pharmaceutical products in the United States, OLUX® Foam
(clobetasol propionate), 0.05%, and Luxíq® Foam (betamethasone valerate),
0.12%. Effective March 4, 2004, we also own exclusive U.S. rights to a third
product, Soriatane (see Note 18). We also have several product candidates
under development. Our commercial business is focused on the dermatology
marketplace, which is characterized by a large patient population that is
served by a relatively small number of treating physicians. 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 increase sales of
our existing products and obtain substantial additional financing. In the course of our development activities, we have sustained continuing
operating losses, and our uses of capital and our requirements may increase in
future periods. As a result, we may require additional funds until such time
that we are able to sustain profitability, if ever, and we may attempt to raise
additional funds through equity or debt financings (see Note 18), 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 our stockholders. Note 2. Summary of Significant Accounting Policies Principles of Consolidation In April 2001, we established a holding company (Connetics Holdings Pty
Ltd.) to acquire Soltec Research Pty Ltd., or Soltec. In October 2002, we
changed Soltecs name to Connetics Australia Pty Ltd. The accompanying
consolidated financial statements include the accounts of Connetics, Connetics
Holdings, and Connetics Australia since April 20, 2001, the day following the
acquisition. All significant intercompany accounts and transactions have been
eliminated in consolidation. We have reclassified certain prior year balances
to conform to the current years presentation. Use of Estimates To prepare financial statements in conformity with accounting principles
generally accepted in the United States, management must make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates based
upon future events. We evaluate our estimates on an on-going basis. In particular, we
regularly evaluate estimates related to recoverability of accounts receivable
and inventory, revenue recognition and accrued liabilities for clinical trial
activities. We base our estimates on historical experience and on various
other specific assumptions that we believe to be reasonable under the
circumstances. Those estimates and assumptions form the basis for making
judgments about the carrying value of assets and liabilities that are not
readily apparent from other sources. F-7




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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 estimated allowances
for discounts, returns, rebates and chargebacks. We are obligated to accept
from customers the return of pharmaceuticals that have reached their expiration
date. We authorize returns for damaged products and exchanges for expired
products in accordance with our return goods policy and procedures, and we
establish reserves for such amounts at the time of sale. To date we have not
experienced significant returns of damaged or 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. 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. If, at the time an agreement is executed, there remains significant risk
due to the incomplete state of the products development, we recognize revenue
from non-refundable upfront license fees ratably over the period in which we
have continuing development obligations. We recognize revenue associated with
substantial at risk performance milestones, as defined in the respective
agreements, 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. Cash Equivalents and Marketable Securities Cash and cash equivalents consist of cash on deposit with banks and money
market and other debt 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 are included in marketable securities. Marketable
securities are classified as available for sale at the time of purchase and are
carried at fair value, and we report unrealized gains and losses as a component
of other comprehensive income (loss) in stockholders equity. We determine the
cost of securities sold using 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 Connetics Australias functional currency is the Australian dollar. We
translate Connetics Australias local currency balance sheet into U.S. dollars
using the exchange rates in effect at the balance F-8




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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 and losses resulting from
foreign exchange transactions are included in the consolidated statement of
operations and were immaterial for all years presented. Income Taxes We account for income taxes using the asset and liability method. Under
this method, we recognize deferred tax assets and liabilities for the future
tax consequences attributable to differences between (1) the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases, and (2) operating loss and tax credit carryforwards. We
measure deferred tax assets and liabilities using enacted tax rates that are
expected to apply to taxable income in the years in which we anticipate those
temporary differences will be recovered or settled. We establish a valuation
for the net deferred tax assets when realization is uncertain. Our income tax
provision relates primarily to the operations of our Australian subsidiary. Property and Equipment Property and equipment are stated at cost less accumulated depreciation
and amortization. We calculate depreciation using the straight-line method
over the estimated useful lives of the assets, generally three to five years.
Equipment we have purchased on behalf of our contract manufacturer is being
depreciated using the units of production method based on contractual minimum
quantities to be produced over the term of the agreement. We amortize
leasehold improvements and assets acquired under capital lease arrangements
over the shorter of the estimated useful lives of the assets or the lease term. Goodwill, Purchased Intangibles and Impairment of Long Lived Assets We record goodwill in a business combination when the purchase price of
the net tangible and identifiable intangible assets we acquire exceeds their
fair value. In July 2001 the Financial Accounting Standards Board (FASB)
issued Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill
and Other Intangible Assets. Under SFAS 142, effective January 1, 2002, we
are not required to amortize goodwill and intangible assets with indefinite
lives, but are required to periodically review these assets for impairment.
Intangible assets determined to have definite 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. When we
adopted SFAS 142, we ceased amortizing goodwill previously representing an
expense of approximately $700,000 per year. In conjunction with the
implementation of SFAS 142 we performed an impairment test of goodwill as of
January 1, 2002, which did not result in an impairment charge at transition.
SFAS 142 also requires that we test goodwill for impairment on an annual basis
or more frequently if indicators of potential impairment exist. We performed
the annual test as of October 1, 2003, which also did not result in an
impairment charge. We will perform this annual test on October 1 of future
years or more frequently if indicators of potential impairment exist. We will
continue to amortize other intangible assets that meet the criteria for
separate recognition from goodwill over their useful lives of ten years. We periodically perform reviews to determine if the carrying value of
long-term assets, other than goodwill (purchased intangibles, property and
equipment), is impaired. The reviews look for the existence of facts or
circumstances, either internal or external, which indicate that the carrying
value of the asset cannot be recovered. Our reviews have indicated no such
impairment to date. If in the future we F-9




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determine that impairment indicators exist, we would use undiscounted cash
flows to initially determine whether we should recognize any impairment. If
necessary, we would perform a 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, we would calculate the fair value 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. Fair Value of Financial Instruments The fair value of our cash equivalents and marketable securities is based
on quoted market prices. The carrying amount of cash equivalents and
marketable securities are equal to their respective fair values at December 31,
2003 and 2002. Other financial instruments, including accounts receivable, accounts
payable and accrued liabilities, are carried at cost, which we believe
approximates fair value because of the short-term maturity of these
instruments. The fair value of our convertible subordinated debt was $96.9
million at December 31, 2003, which we determined using available market
information. Research and Development Research and development expenses include related 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 held at the manufacturers
facilities and are valued at the lower of actual cost or market. 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 perform credit
evaluations of our customers financial condition and limit the amount of
credit extended when necessary, but generally we do not require collateral on
accounts receivable. We contract with independent sources to manufacture our products. We
currently rely on two vendors to manufacture our products and we are in the
process of qualifying one additional vendor for this purpose. If these
manufacturers are unable to fulfill our supply requirements, our future results
could be negatively impacted. We sell our products to wholesalers in the
United States. Our products are promoted to dermatologists, but they are sold primarily
to wholesalers and retail chain drug stores, and our product revenues and trade
accounts receivable are concentrated with a few customers. The following
tables detail those concentrations in gross product sales and trade accounts
receivable that are greater than 10% of the relative total, for each of the
years ended December 31, 2003, 2002 and 2001. F-10




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Percentage of Product RevenuesYears Ended December 31,Customer
    
    2003
    
    2002
    
    2001Cardinal Health
    
    
    36
    %
    
    
    43
    %
    
    
    44
    %McKesson
    
    
    30
    %
    
    
    26
    %
    
    
    29
    %AmerisourceBergen
    
    
    15
    %
    
    
    23
    %
    
    
    16
    %Walgreens
    
    
    11
    %
    
    
    
    
    
    
    
 Percentage of Outstanding TradeAccounts Receivableas of December 31,Customer
    
    2003
    
    2002
    
    2001Cardinal Health
    
    
    36
    %
    
    
    54
    %
    
    
    45
    %McKesson
    
    
    28
    %
    
    
    6
    %
    
    
    33
    %AmerisourceBergen
    
    
    17
    %
    
    
    37
    %
    
    
    16
    %
 Comprehensive Income (Loss) Comprehensive income (loss) represents net loss, unrealized gains (losses)
on our available-for-sale securities, and foreign currency translation
adjustments, all net of taxes. Accumulated other comprehensive income included
$859,000 of net unrealized gains on investments and $1.0 million of foreign
currency translation adjustments as of December 31, 2003; and $1.0 million of
net unrealized gains on investments and $53,000 of foreign currency translation
adjustments as of December 31, 2002. Comprehensive income (loss) has been
disclosed in the Consolidated Statement of Stockholders Equity. Advertising We expense advertising costs as we incur them. Advertising costs were
$380,000 in 2003, $362,000 in 2002, and $1,025,000 in 2001. Stock-Based Compensation We grant stock options for a fixed number of shares to employees with an
exercise price equal to the fair value of the shares at the date of grant. 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, we do not recognize any stock-based employee
compensation in our financial statements when those options have exercise
prices equal to or greater than fair market value. We also 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 Statement of Financial Accounting Standards
(SFAS) No. 123, Accounting for Stock-Based Compensation, as amended, and
Emerging Issues Task Force No. 96-18 (EITF 96-18), Accounting for Equity
Instruments That Are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services, 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. The following table illustrates the effect on net loss and loss per share
if we had applied the fair F-11




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value recognition provisions of SFAS 123 to options granted under our
stock option plans and our ESPP. Because the estimated value is determined as
of the date of grant, the actual value ultimately realized by the employee may
be significantly different. Years Ended December 31,(in thousands except per share amounts):
    
    2003
    
    2002
    
    2001Net loss, as reported
    
    $
    (4,100
    )
    
    $
    (16,590
    )
    
    $
    (16,742
    )Add: stock-based compensation expense,
included in reported net loss
    
    
    17
    
    
    
    21
    
    
    
    322Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all awards,
net of related tax effects
    
    
    (9,834
    )
    
    
    (4,535
    )
    
    
    (3,836
    )Pro forma net loss
    
    $
    (13,917
    )
    
    $
    (21,104
    )
    
    $
    (20,256
    )Net loss per share:Basic and diluted  as reported
    
    $
    (0.13
    )
    
    $
    (0.54
    )
    
    $
    (0.56
    )Basic and diluted pro forma
    
    $
    (0.44
    )
    
    $
    (0.69
    )
    
    $
    (0.68
    )
 For purposes of this analysis, we estimate the fair value of each option
on the date of grant using the Black-Scholes option-pricing model. The
weighted average assumptions used in the model were as follows: Stock Option Plans
    
    Stock Purchase Plan2003
    
    2002
    
    2001
    
    2003
    
    2002
    
    2001Expected stock volatility
    
    
    60.62
    %
    
    
    65.28
    %
    
    
    70.0
    %
    
    
    57.50
    %
    
    
    77.26
    %
    
    
    94.0
    %Risk-free interest rate
    
    
    4.06
    %
    
    
    4.63
    %
    
    
    5.35
    %
    
    
    4.40
    %
    
    
    5.61
    %
    
    
    5.92
    %Expected life (in years)
    
    
    3.16
    
    
    
    3.48
    
    
    
    3.57
    
    
    
    1.36
    
    
    
    1.33
    
    
    
    1.81Expected 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. This model also requires us to make highly
subjective assumptions, including the expected volatility of our stock.
Because our stock 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, we do not believe
that the existing models necessarily provide a reliable single measure of the
fair value of our options. The weighted average fair value of options granted,
determined using the Black-Scholes model, was $5.83 in 2003, $5.74 in 2002, and
$3.02 in 2001. The effects on pro formadisclosures of applying SFAS 123 are not likely
to be representative of the effects on reported results of future years. Net Income (Loss) Per Share We compute basic net income (loss) per common share by dividing net income
(loss) 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 options and warrants from
the calculation of diluted loss per common share for the years ended December
31, 2003, 2002, and 2001, because these securities were anti-dilutive in those
years. We excluded convertible debt for the year ended December 31, 2003,
because its effect is also anti-dilutive. F-12




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Warrants, options and convertible debt excluded from the calculation of
diluted loss per share are as follows: Years Ended December 31,2003
    
    2002
    
    2001Warrants
    
    
    59,177
    
    
    
    90,427
    
    
    
    391,752Options
    
    
    5,986,257
    
    
    
    4,883,966
    
    
    
    4,221,556Convertible Debt
    
    
    4,203,450
    
    
    
    
    
    
    
    
 Disclosure about Segments of an Enterprise and Related Information SFAS No. 131, Disclosures About Segments of an Enterprise and Related
Information, requires us to identify the segment or segments we operate in.
Based on the standards set forth in SFAS 131, we operate in one segment: the
development and commercialization of specialty pharmaceuticals in the field of
dermatology. For each of the years ended December 31, 2003 and 2002,
approximately 98% of our total revenues were derived from customers in the
United States. For the year ended December 31, 2001, approximately 96% of our
total revenues were derived from customers in the United States. Revenues by product are as follows (in thousands): Years Ended December 31,2003
    
    2002
    
    2001OLUX
    
    $
    47,538
    
    
    $
    32,339
    
    
    $
    14,996Luxíq
    
    
    18,857
    
    
    
    15,042
    
    
    
    13,848Other
    
    
    211
    
    
    
    192
    
    
    
    2,079$
    66,606
    
    
    $
    47,573
    
    
    $
    30,923
 We do not have a material amount of long-lived assets outside of the
United States. Recent Accounting Pronouncements EITF 00-21. In November 2002, the Emerging Issues Task Force (or EITF) of
the FASB issued EITF 00-21, Revenue Arrangements with Multiple Deliverables,
which addresses certain aspects of the accounting for arrangements that involve
the delivery or performance of multiple products, services, and/or rights to
use assets. EITF 00-21 requires us to divide revenue arrangements with
multiple deliverables into separate units of accounting if the deliverables
meet certain criteria, including whether the fair value of the delivered items
can be determined and whether there is evidence of fair value of the
undelivered items. EITF 00-21 also requires us to allocate the consideration
among the separate units of accounting based on their fair values, and to
consider applicable revenue recognition criteria separately for each of the
separate units of accounting. EITF 00-21 is effective for revenue arrangements
we enter into after June 30, 2003. There was no impact on our financial
statements from the adoption of EITF 00-21. FIN 46.In January 2003, the FASB issued Interpretation 46,
Consolidation of Variable Interest Entities (FIN 46). FIN 46 requires that
companies that control another entity through interests other than voting
interests should consolidate the controlled entity. FIN 46, as amended,
applies to variable interest entities created after January 31, 2003, and to
variable interest entities in which an enterprise obtains an interest after
that date. The consolidation requirements apply to older entities in the first
fiscal year or interim period beginning after March 15, 2004. Certain
disclosure requirements apply to all financial statements issued after January
31, 2003, regardless of when the variable interest entity was F-13




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established. The adoption of FIN 46 is not expected to have a significant
impact on our financial position or results of operations. Note 3. Cash Equivalents and Marketable Securities The following tables summarize our available-for-sale investments (in
thousands): December 31, 2003Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    EstimatedCost
    
    Gains
    
    Losses
    
    Fair ValueCorporate debt
    
    $
    53,165
    
    
    $
    17
    
    
    $
    (41
    )
    
    $
    53,141Government securities
    
    
    35,387
    
    
    
    7
    
    
    
    (11
    )
    
    
    35,383Asset backed securities
    
    
    7,016
    
    
    
    7
    
    
    
    (2
    )
    
    
    7,021Equity securities
    
    
    289
    
    
    
    882
    
    
    
    
    
    
    
    1,171Money market funds
    
    
    12,894
    
    
    
    
    
    
    
    
    
    
    
    12,894Total
    
    
    108,751
    
    
    
    913
    
    
    
    (54
    )
    
    
    109,610Less amount classified as cash
equivalents
    

    
    (12,894
    )
    
    
    
    
    
    
    
    
    
    
    (12,894
    )Total marketable securities
    
    $
    95,857
    
    
    $
    913
    
    
    $
    (54
    )
    
    $
    96,716
 December 31, 2002Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    EstimatedCost
    
    Gains
    
    Losses
    
    Fair ValueCorporate debt
    
    $
    18,137
    
    
    $
    31
    
    
    $
    (1
    )
    
    $
    18,167Commercial paper
    
    
    5,500
    
    
    
    
    
    
    
    
    
    
    
    5,500Equity securities
    
    
    289
    
    
    
    996
    
    
    
    
    
    
    
    1,285Money market funds
    
    
    626
    
    
    
    
    
    
    
    
    
    
    
    626Total
    
    
    24,551
    
    
    
    1,027
    
    
    
    (1
    )
    
    
    25,578Less amount classified as cash
equivalents
    
    
    (1,138
    )
    
    
    
    
    
    
    
    
    
    
    (1,138
    )Total marketable securities
    
    $
    23,414
    
    
    $
    1,027
    
    
    $
    (1
    )
    
    $
    24,440
 The following table summarizes the amortized cost of the estimated fair
value of available-for-sale debt securities at December 31, by contract
maturity (in thousands): 2003
    
    2002Estimated Fair
    
    
    
    
    
    Estimated FairAmortized Cost
    
    Value
    
    Amortized Cost
    
    ValueMature in less than one year
    
    $
    50,550
    
    
    $
    50,971
    
    
    $
    17,335
    
    
    $
    17,655Mature in one to three years
    
    
    20,590
    
    
    
    20,746
    
    
    
    
    
    
    
    Mature in over three years
    
    
    23,797
    
    
    
    23,828
    
    
    
    5,500
    
    
    
    5,500Total
    
    $
    94,937
    
    
    $
    95,545
    
    
    $
    22,835
    
    
    $
    23,155
 The table above also includes amounts related to asset-backed and
mortgage-backed securities that are allocated between maturity groupings based
on their final maturities. The gross realized gains and losses on sales of available-for-sale
investments were immaterial for all periods presented except for 2002 in which
we recognized a gain of $2.1 million related to the sale of an equity security
we had been holding. F-14




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Note 4. Property and Equipment Property and equipment consist of the following (in thousands): December 31,2003
    
    2002Laboratory and manufacturing equipment
    
    $
    5,073
    
    
    $
    4,632Leasehold improvements
    
    
    2,982
    
    
    
    3,023Computer equipment
    
    
    2,250
    
    
    
    1,927Furniture, fixtures and office equipment
    
    
    1,284
    
    
    
    1,258Land, building and building improvements
    
    
    736
    
    
    
    55512,325
    
    
    
    11,395Less accumulated depreciation and amortization
    
    
    (6,697
    )
    
    
    (5,535
    )Property and equipment, net
    
    $
    5,628
    
    
    $
    5,860
 Note 5. Acquisition of Connetics Australia (formerly Soltec Research Pty Ltd.) In April 2001, we acquired Soltec Research Pty Ltd. We changed Soltecs
name to Connetics Australia Pty Ltd. in 2002. On a consolidated basis we now
own the intellectual property that we licensed from Connetics Australia before
the acquisition. Our marketed dermatology products and current product
development programs are based on technology developed by Connetics Australia.
Connetics Australia 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 Connetics Australia
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. We purchased all of the shares of Soltecs capital stock for cash of $16.9
million plus transaction costs of approximately $250,000. We allocated $6.8
million of the purchase price to existing technology, $6.6 million to goodwill,
$1.3 million to tangible net assets assumed, $1.2 million to patents and core
technology, $1.1 million to acquired in-process research and development, and
$150,000 to assembled workforce. 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. We computed the value of the
existing technology 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 Connetics Australia. 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 F-15




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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. Note 6. Goodwill and Other Intangible Assets There was no change in the carrying amount of goodwill for the year ended
December 31, 2003. The components of our other intangible assets at December
31, 2003, are as follows (in thousands): Useful Life in
    
    Gross Carrying
    
    AccumulatedYears
    
    Amount
    
    Amortization
    
    NetExisting technology
    
    10
    
    $
    6,810
    
    
    $
    (1,844
    )
    
    $
    4,966Patents
    
    10-13
    
    
    1,590
    
    
    
    (350
    )
    
    
    1,240Total
    
    
    
    $
    8,400
    
    
    $
    (2,194
    )
    
    $
    6,206
 Amortization expense for our other intangible assets was $819,000 for the
year ended December 31, 2003, $810,000 for the year ended December 31, 2002
and, $590,000 for the year ended December 31, 2001. The expected future amortization expense of our other intangible assets is
as follows (in thousands): Amortization ExpenseFor the year ended December 31, 2004
    
    $
    833For the year ended December 31, 2005
    
    
    833For the year ended December 31, 2006
    
    
    833For the year ended December 31, 2007
    
    
    833For the year ended December 31, 2008
    
    
    833Thereafter
    
    
    2,041Total
    
    $
    6,206
 SFAS 142 does not permit restatement of previously issued financial
statements. The following table provides reconciliation of reported operating
results and per share information, adjusted to exclude goodwill amortization as
though SFAS 142 had been applied. No reconciliation is required for the years
ended December 31, 2002 and 2003. Year EndedDecember 31, 2001Reported net loss
    
    $
    (16,742
    )Add back: goodwill amortization
    
    
    478Net loss excluding goodwill amortization
    
    $
    (16,264
    )Reported basic and diluted loss per share
    
    $
    (0.56
    )Add back: goodwill amortization
    
    
    0.02Basic and diluted loss per share excluding
goodwill amortization
    
    $
    (0.54
    )Shares used to calculate basic and diluted
loss per share
    
    
    29,861
 F-16




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Note 7. Convertible Senior Notes On May 28, 2003, we issued $90 million principal amount of 2.25%
convertible senior notes due May 30, 2008 in a private placement exempt from
registration under the Securities Act of 1933. The notes are senior, unsecured
obligations and rank equal in right of payment with any of our existing and
future unsecured and unsubordinated debt. The notes are convertible into our
shares of common stock at any time at the option of the note holder at a
conversion rate of 46.705 shares of common stock per $1,000 principal
amount of notes, subject to adjustment in certain circumstances, which is
equivalent to a conversion price of approximately $21.41 per share of common
stock. This conversion price is higher than the price of our common stock on
the date the notes were issued. The notes bear interest at a rate of 2.25% per
year, which is payable semi-annually in arrears on May 30 and November 30 of
each year, beginning November 30, 2003. Offering expenses of $3.7 million
related to the issuance of these notes have been included in other assets and
are amortized to interest expense over the contractual term of the notes. As
of December 31, 2003, the fair value of these notes was approximately $96.9
million. The notes cannot be redeemed before May 30, 2005. On or after May 30,
2005 and before May 30, 2007, we may redeem all or a portion of the notes at
our option at a redemption price equal to 100% of the principal amount of the
notes to be redeemed, plus accrued and unpaid interest if the closing price of
our common stock has exceeded 140% of the conversion price then in effect for
at least 20 trading days within a period of 30 consecutive trading days ending
on the trading day before the date of mailing of the redemption notice. We may
redeem all or a portion of the notes at any time on or after May 30, 2007 at a
redemption price equal to 100.45% of the principal amount of the notes to be
redeemed, plus accrued and unpaid interest. Holders of the notes may require
us to repurchase all or a portion of their notes upon a change in control, as
defined in the indenture governing the notes, at 100% of the principal amount
of the notes to be repurchased, plus accrued and unpaid interest. Fees and other costs incurred in connection with the issuance of the notes
are being amortized into interest expense on a straight-line basis over the
five-year term of the notes. Accumulated amortization amounted to
approximately $430,000 as of December 31, 2003. Note 8. In-License Agreements Yamanouchi License Agreement In 2002, we entered into an agreement with Yamanouchi Europe B.V. to
license Velac gel (a first in class combination of 1% clindamycin, and 0.025%
tretinoin). We have licensed exclusive rights to develop and commercialize the
product in the U.S. and Canada, and have licensed non-exclusive rights in
Mexico. Under the terms of the agreement, we paid Yamanouchi an initial $2.0
million licensing fee, which we recorded as acquired in-process research and
development expense during the quarter ended June 30, 2002, because the product
remained in clinical development and had no alternative future use. In the
fourth quarter of 2002, we initiated a Phase III trial for Velac. In
connection with this milestone, in accordance with the agreement, we paid and
recorded an additional $2.0 million charge to in-process research and
development expense and milestone payments. Connetics Australia License Agreements Before we acquired Connetics Australia, we had entered into a series of
license agreements with Connetics Australia. Those license agreements are
still in effect, although royalty payments to Connetics Australia are now
eliminated in consolidation. F-17




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##### Table of Contents



Note 9. Royalty-Bearing Agreements Pfizer License Agreement In December 2001, we entered into an agreement granting Pharmacia
Corporation (now Pfizer) exclusive global rights, excluding Japan, to our
proprietary foam drug-delivery technology for use with Pfizers Rogaine® hair
loss treatment. Under the agreement, Pfizer paid us an initial licensing fee,
and agreed to pay us additional amounts when it achieves specified milestones,
plus a royalty on product sales. We recognized $1.0 million under the
agreement related to license fees, milestone payments and contract revenue
through December 31, 2002. Our obligation to incur development expenses in
connection with the agreement ended in 2002. We provided additional
development support to Pfizer at their request in 2003, and in that connection
we recognized $86,000 in fees. Other Licenses for Foam Technology We have entered into a number of agreements for our foam drug delivery
technology. We have licensed the technology to betamethasone valerate foam to
Celltech Group plc in Europe, and Celltech has licensed the worldwide rights to
their patent on the technology to us. We pay Celltech royalties on all sales
worldwide of foam formulations containing steroids. Celltech markets their
product as Bettamousse (the product equivalent of Luxíq). We also have 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. In 2003, we received $267,000 in royalties for foam-based technology,
compared to $305,000 in 2002 and $265,000 in 2001. We have also entered into
development agreements with other companies to develop the foam for specific
indications. Licenses for Liquipatch Technology In June 2001, we entered into a global licensing agreement with Novartis
Consumer Health SA for the Liquipatch drug-delivery system for use in topical
antifungal applications. The agreement gives Novartis the exclusive, worldwide
rights to use the Liquipatch technology in the topical antifungal field. In
March 2002, Novartis paid us $580,000 to exercise its then-existing option to
expand the license agreement. Novartis will be responsible for all development
costs, and will be obligated to pay license fees, milestone payments and
royalties on future product sales. S.C. Johnson License Agreement We have licensed to S.C. Johnson & Son, Inc. 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 2003, we
received $7.0 million in royalties in connection with this agreement, which
included a one-time royalty payment of $2.9 million. On January 5, 2004, we
reached an agreement with S.C. Johnson to terminate the license agreement. We
will receive an additional $1.2 million under the agreement in 2004, after
which S.C. Johnson will have a fully-paid up, royalty-free license to the
technology. InterMune We have an agreement with InterMune, Inc. pursuant to which we receive
royalties for sales of Actimmune. As of December 31, 2003 we owned 50,000
shares of common stock of InterMune. In F-18




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addition, we have retained the product rights to Actimmune for certain
potential dermatological applications. We received royalties on Actimmune
sales of $358,000 in 2003, $172,000 in 2002, and zero in 2001. We recorded
gains on the sale of InterMune stock of zero in 2003, $2.1 million in 2002, and
$122,000 in 2001. Note 10. Divestiture of Relaxin In May 2001, we announced our decision to pursue a license partner or
other strategic alternative for our recombinant human relaxin program. During
the second quarter of 2001, we eliminated 27 employee positions related to
relaxin. We recognized charges of approximately $1.1 million in 2001 and
$312,000 in 2002 related to this decision, which represented $451,000 for the
reduction in workforce and $1.0 million for the wind down of relaxin
development contracts. On July 15, 2003, we assigned our rights to recombinant human relaxin to
BAS Medical, Inc. (BAS Medical), a private, development-stage company focused
on the development and marketing of novel medical treatments. As part of the
transaction, we may receive up to $1.0 million in licensing and milestone fees,
plus royalties on future product sales. Upon the execution of the definitive
agreement, we received a $100,000 upfront assignment fee that we recognized as
license revenue in the third quarter of 2003. We will receive the remaining
$900,000 if BAS Medical achieves various milestones. BAS Medical assumed the
rights to develop and commercialize relaxin for all indications of use. All of
our obligations under existing contracts related to relaxin, including those
with Paladin Labs, Inc., and F.H. Faulding & Co. Ltd., were also transferred to
BAS Medical as part of this transaction, and as a result, in the third quarter
of 2003, we recognized $661,000 in deferred revenue relating to previous
relaxin license agreements. Note 11. Divestiture of Ridaura In April 2001, we sold the rights to our product Ridaura including
inventory and identified liabilities to Prometheus Laboratories Inc. for $9.0
million in cash plus a royalty on annual sales in excess of $4.0 million
through March 2006. Ridaura is a prescription pharmaceutical product for the
treatment of rheumatoid arthritis. We accrued approximately $978,000 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 in 2001. Prometheus assumed our obligations under
a Supply Agreement to supply Ridaura in Canada. We recognized $133,000 in 2003
for royalties on sales of Ridaura, which is all of the royalties received to
date. Note 12. Commitments We lease two facilities under non-cancelable operating leases, the last of
which expires in April 2005. One of the operating leases requires an
irrevocable standby letter of credit that is secured by a certificate of
deposit with our bank. The amount of the letter of credit includes an
automatic annual reduction feature and expires on January 1, 2004. At December
31, 2003, the restricted cash related to this letter of credit amounted to
$304,000; at December 31, 2002, the restricted cash related to this letter of
credit amounted to $612,000; and at December 31, 2001, the restricted cash
related to this letter of credit amounted to $925,000. The amounts are
included in the restricted cash balances on the Consolidated Balance Sheets.
We also lease office equipment and automobiles under various operating leases
that will expire on various dates through 2006. In March 2002 we entered into a manufacturing and supply agreement with
DPT that requires F-19




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minimum purchase commitments, beginning in August 2003 and continuing for
10 years. Also in 2002 we entered into a license agreement that requires
minimum royalty payments beginning in 2005 and continuing for 15 years, unless
the agreement is terminated earlier at the discretion of either party. The future minimum rental payments under non-cancelable operating leases
and contractual commitments as of December 31, 2003 are as follows (in
thousands): Years ending
    
    Operating
    
    ContractualDecember 31:
    
    Leases
    
    Commitments
    
    Total2004
    
    $
    2,173
    
    
    $
    450
    
    
    $
    2,6232005
    
    
    894
    
    
    
    700
    
    
    
    1,5942006
    
    
    257
    
    
    
    850
    
    
    
    1,1072007
    
    
    73
    
    
    
    850
    
    
    
    9232008
    
    
    56
    
    
    
    850
    
    
    
    906Thereafter
    
    
    222
    
    
    
    4,475
    
    
    
    4,697$
    3,675
    
    
    $
    8,175
    
    
    $
    11,850
 We recognize facilities rent expense on a straight-line basis over the
term of each lease. Facilities rent expense under operating leases was
approximately $1.4 million for the year ended December 31, 2003 (net of
sublease income of $490,000); $1.5 million for the year ended December 31, 2002
(net of sublease income of $742,000), and $1.2 million for the year ended
December 31, 2001 (net of sublease income of $160,000). The operating lease
obligations set forth above for 2004 are shown net of $313,000 to be received
as a result of a subleasing arrangement with a third party that expires on
October 31, 2004. Note 13. Stockholders Equity Warrants We have outstanding warrants to purchase up to 59,177 shares of our common
stock, at various prices and with varying expiration dates. 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. The warrant has an exercise price of $6.063
and expires in 2004. As of December 31, 2003, none of these warrants had been
exercised. In connection with an equity line arrangement, we issued warrants for the
following: (a) 25,000 shares in December 1999 at a purchase price of $6.875,
of which 18,750 were outstanding as of December 31, 2003, and which expire in
December 2004, (b) 25,427 shares in December 2000 at a purchase price of
$5.3625, all of which were outstanding as of December 31, 2003, and which
expire in December 2005. We have a commitment to a third party to issue a warrant to purchase
30,000 shares of our common stock when and if relaxin is approved for a
commercial indication. As of December 31, 2003, that warrant had not been
issued. Although we sold the relaxin program to BAS Medical in 2003, the
warrant obligation was not transferred. We have not reserved any shares for
issuance of common stock pursuant to this commitment. F-20




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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, 2001 and 2003. A total
of 850,000 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 is 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 15,000 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. 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
employees, directors, 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. Generally, 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 plans 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 Non-Officer Plan, the
2002 Employee Stock Plan 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.Options granted under our 1994 Stock Plan, as amended
(the 1994 Stock Plan) include incentive stock options and non-statutory stock
options. 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. 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 (3%)
of the number of shares of common stock outstanding on the last preceding
business day, or an amount determined by the Board. In 2003, the increase in
authorized shares was 937,016 shares. Non-Officer Stock Option Plans.Our 1998 Supplemental Plan (the
Supplemental Plan) was terminated in 1999, and the Board is no longer
authorized to grant options under that plan. The 2000 Non-Officer Stock Plan
was funded with 500,000 shares. No additional shares will be added to this
plan, F-21




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##### Table of Contents



although shares can be granted if they become available through
cancellation. The 2002 Employee Stock Plan was initially funded with 500,000
shares. In 2003, the 2002 Employee Stock Plan was amended to increase the
shares available for issuance by 750,000 shares, for a total of 1,250,000
shares, and to permit the issuance of options under the plan to officers of
Connetics who are not executive officers within the meaning of Section 16 of
the Securities Exchange Act of 1934. Our stockholders approved those
amendments in 2003. Each of the Supplemental Plan and the 2000 Non-officer
Stock Option Plan provide for options to be granted only to non-officer
employees of Connetics, and the options granted under all three plans are
nonstatutory stock options. International Stock Incentive Plan.In 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. Summary of All Option Plans.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. Options canceled under
terminated plans are no longer available for grant. Outstanding OptionsWeightedShares
    
    
    
    
    
    AverageAvailable for
    
    Number
    
    ExerciseGrant
    
    of Shares
    
    PriceBalance, December 31, 2000
    
    
    319,723
    
    
    
    3,546,000
    
    
    $
    6.06Additional shares authorized
    
    
    1,842,149
    
    
    
    
    
    
    
    Options granted
    
    
    (1,432,838
    )
    
    
    1,432,838
    
    
    
    5.89Options exercised
    
    
    
    
    
    
    (352,026
    )
    
    
    3.92Options canceled
    
    
    252,812
    
    
    
    (405,256
    )
    
    
    6.87Balance, December 31, 2001
    
    
    981,846
    
    
    
    4,221,556
    
    
    
    6.10Additional shares authorized
    
    
    909,312
    
    
    
    
    
    
    
    Options granted
    
    
    (1,400,378
    )
    
    
    1,400,378
    
    
    
    11.71Options exercised
    
    
    
    
    
    
    (469,246
    )
    
    
    5.20Options canceled
    
    
    248,411
    
    
    
    (268,722
    )
    
    
    7.60Balance, December 31, 2002
    
    
    739,191
    
    
    
    4,883,966
    
    
    
    7.72Additional shares authorized
    
    
    1,937,016
    
    
    
    
    
    
    
    Options granted
    
    
    (1,759,888
    )
    
    
    1,759,888
    
    
    
    14.20Options exercised
    
    
    
    
    
    
    (554,274
    )
    
    
    5.69Options canceled
    
    
    102,260
    
    
    
    (103,323
    )
    
    
    9.97Balance, December 31, 2003
    
    
    1,018,579
    
    
    
    5,986,257
    
    
    $
    9.77
 The following table summarizes information concerning outstanding and
exercisable options at December 31, 2003: F-22




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##### Table of Contents



Options Outstanding
    
    Options ExercisableWeightedAverage
    
    Weighted
    
    
    
    
    
    WeightedRange
    
    Number
    
    Remaining
    
    Average
    
    Number
    
    AverageOf
    
    of
    
    Life
    
    Exercise
    
    of
    
    ExerciseExercise Prices
    
    Shares
    
    (in years)
    
    Price
    
    Shares
    
    Price$0.44  -  $6.42
    
    
    1,529,359
    
    
    
    6.1
    
    
    $
    4.55
    
    
    
    1,310,781
    
    
    $
    4.50$6.43  - $10.70
    
    
    1,387,293
    
    
    
    5.9
    
    
    $
    7.99
    
    
    
    1,190,948
    
    
    $
    7.96$10.71 - $11.50
    
    
    263,771
    
    
    
    6.8
    
    
    $
    10.97
    
    
    
    199,959
    
    
    $
    10.96$11.51 - $18.51
    
    
    2,805,834
    
    
    
    8.7
    
    
    $
    13.38
    
    
    
    628,520
    
    
    $
    12.53$0.44  -  $18.51
    
    
    5,986,257
    
    
    
    7.3
    
    
    $
    9.77
    
    
    
    3,330,208
    
    
    $
    7.64
 We recorded stock compensation expense of $17,000 for the year ended
December 31, 2003, $21,000 for the year ended December 31, 2002, and $322,000
for the year ended December 31, 2001. 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 and November 2000 and December 2002. We have
reserved 1,414,525 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 for at
least 20 hours per week and more than five 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 119,380 shares under the plan in 2003. Common Shares Reserved for Future Issuance We have reserved shares of common stock for issuance as follows: December 31,2003
    
    20021994 Stock Plan
    
    
    980,617
    
    
    
    1,310,7981995 Employee Stock Purchase Plan
    
    
    216,320
    
    
    
    335,7001995 Directors Stock Option Plan
    
    
    815,000
    
    
    
    570,0001998 Supplemental Stock Plan
    
    
    52,383
    
    
    
    70,6832000 Stock Plan
    
    
    3,285,396
    
    
    
    2,447,8292000 Non-Officer Stock Plan
    
    
    367,612
    
    
    
    445,289International Stock Incentive Plan
    
    
    246,155
    
    
    
    249,0622002 Employee Stock Plan
    
    
    1,228,177
    
    
    
    500,000Non-plan stock options
    
    
    29,496
    
    
    
    29,496Common stock warrants
    
    
    59,177
    
    
    
    90,427Convertible senior notes
    
    
    4,203,450
    
    
    
    Total
    
    
    11,483,783
    
    
    
    6,049,284
 F-23




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##### Table of Contents



Stockholder Rights Plan We adopted a stockholder rights plan (the Rights Plan) in May 1997, as
amended and restated in November 2001. The Rights Plan entitles existing
stockholders 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 direction 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, 2003,
a total of 90,000 shares were designated as Series B Participating Preferred
Stock and no shares were issued and outstanding. Note 14. Income Taxes The provision for income taxes consists of the following (in thousands): December 31,2003
    
    2002
    
    2001CurrentForeign
    
    $
    1,017
    
    
    $
    467
    
    
    $
    159Federal
    
    
    330
    
    
    
    (211
    )
    
    
    186State
    
    
    
    
    
    
    (75
    )
    
    
    Total Current
    
    
    1,347
    
    
    
    181
    
    
    
    345DeferredForeign
    
    
    (180
    )
    
    
    
    
    
    
    Federal
    
    
    
    
    
    
    
    
    
    
    State
    
    
    
    
    
    
    
    
    
    
    Total Deferred
    
    
    (180
    )
    
    
    
    
    
    
    Total
    
    $
    1,167
    
    
    $
    181
    
    
    $
    345
 The provision for income taxes differs from the federal statutory rate as
follows (in thousands): F-24




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##### Table of Contents



December 31,2003
    
    2002
    
    2001Provision at U.S. federal statutory rate
    
    $
    (960
    )
    
    $
    (5,600
    )
    
    $
    (5,700
    )Unbenefited losses (utilization of net
operating loss)
    
    
    450
    
    
    
    4,900
    
    
    
    4,000State taxes, net of federal benefit
    
    
    
    
    
    
    (75
    )
    
    
    Non-deductible stock based compensation
    
    
    10
    
    
    
    100
    
    
    
    900Non-deductible amortization
    
    
    270
    
    
    
    300
    
    
    
    500Alternative minimum tax
    
    
    
    
    
    
    (542
    )
    
    
    Foreign taxes
    
    
    837
    
    
    
    467
    
    
    
    159US withholding tax
    
    
    330
    
    
    
    331
    
    
    
    186Meals and entertainment
    
    
    226
    
    
    
    270
    
    
    
    270Other
    
    
    4
    
    
    
    30
    
    
    
    30Total
    
    $
    1,167
    
    
    $
    181
    
    
    $
    345
 Pretax income from foreign operations was approximately $4.0 million in
2003, $2.2 million in 2002 and $1.2 million in 2001. Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets for financial reporting purposes and the
amounts used for income tax purposes. Significant components of our deferred
tax assets for federal, state and foreign income taxes as of December 31 are as
follows (in thousands): December 31,2003
    
    2002Deferred tax assets:Net operating loss carryforward
    
    $
    38,200
    
    
    $
    35,200Research and other credits
    
    
    5,200
    
    
    
    11,500Capitalized research expenses
    
    
    5,200
    
    
    
    5,800Capitalized license and acquired technology
    
    
    2,100
    
    
    
    500Accruals and reserves
    
    
    2,600
    
    
    
    1,800Foreign expenses
    
    
    485
    
    
    
    Other
    
    
    1,100
    
    
    
    Total deferred tax assets
    
    
    54,885
    
    
    
    54,800Valuation allowance
    
    
    (53,600
    )
    
    
    (54,400
    )Net deferred tax assets
    
    
    1,285
    
    
    
    400Deferred tax liabilities:Prepaid expenses
    
    
    (200
    )
    
    
    Unrealized gain on marketable securities
    
    
    (300
    )
    
    
    (400
    )Net deferred tax liabilities
    
    
    (500
    )
    
    
    (400
    )Total net deferred tax assets
    
    $
    785
    
    
    $
    
 Due to a history of operating losses in the U.S. combined with our
uncertainties surrounding the Companys ability to generate future taxable
income, the net U.S. and state deferred tax assets have been fully offset by a
valuation allowance. The valuation allowance decreased by $0.8 million during
the year ended December 31, 2003 and increased by $13.6 million during the year
ended December 31, 2002, and increased by $4.7 million during the year ended
December 31, 2001. Due to a history of earnings in Australia, the foreign
deferred tax assets of $785,000 have not been offset with a valuation
allowance. As of December 31, 2003, we had federal net operating loss carryforwards
of approximately $110.8 million and state net operating loss carryforwards of
approximately $8.1 million. We also had federal and California research and
other tax credit carryforwards of approximately $6.1 million. The federal net
operating loss and credit carryforwards will expire in the years 2008 through
2023, if not utilized. The state net operating loss carryforward will expire
in 2013, if not utilized. State tax credit F-25




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##### Table of Contents



carryforwards may be carried forward indefinitely. The annual utilization of the federal and state net operating loss and tax
credit carryforwards is limited for tax purposes under the Internal Revenue
Code of 1986. The annual limitation may result in the expiration of net
operating losses and credits before we are able to utilize them. Tax benefits associated with employee stock options provide a deferred
benefit of approximately $3.2 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. Note 15. 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 60% of their pretax
salary, subject to IRS limits. Before 2003, the company match of employee
contributions was discretionary, and was authorized by the Board based on a
pool calculated using a formula tied to Connetics annual product sales and
the employees actual contribution. Beginning in 2003, we match all employees
contributions in an amount equal to 25% of each participants deferral
contributions made during the year. Prior to 2003 the company contribution
vested in relation to each employees tenure with Connetics (40% after the
second year and 100% vested after five years with Connetics). In 2003 we
changed the vesting schedule for company contributions to 100% vesting at the
time the contributions are made. Our contributions to the 401(k) plan were
$308,000 for 2003, $238,000 for 2002, and $155,000 for 2001. Note 16. Related Party Transactions In February 2000, the Board authorized a loan to our Chief Executive
Officer in the amount of $250,000, at an interest rate equal to 6.2%. The loan
is to be forgiven at a rate of $50,000 per year plus accrued interest, on each
anniversary of the loan on which our Chief Executive Officer is still employed
by Connetics. As of December 31, 2003, the outstanding balance of this loan,
including accrued interest, was $105,000. Note 17. Guarantees and Indemnifications In November 2002, the FASB issued Interpretation No. 45, Guarantors
Accounting and Disclosure Requirements for Guarantees, including Indirect
Guarantees of Indebtedness of Others(FIN No. 45). FIN No. 45 requires that
upon issuance of a guarantee, the guarantor must recognize a liability for the
fair value of the obligations in assumes under that guarantee. We enter into indemnification provisions under our agreements with other
companies in the ordinary course of our business, typically with business
partners, contractors, clinical sites, insurers and customers. Under these
provisions, we generally indemnify and hold harmless the indemnified party for
losses suffered or incurred by the indemnified party as a result of our
activities. These indemnification provisions generally survive termination of
the underlying agreement. In some cases, the maximum potential amount of
future payments that we could be required to make under these indemnification
provisions is unlimited. The estimated fair value of the indemnity obligations
of these agreements is not material. Accordingly, we have no liabilities
recorded for these agreements as of December 31, 2003. We have not incurred
material costs to defend lawsuits or settle claims related to these
indemnification agreements. F-26




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##### Table of Contents



Note 18. Subsequent Events On February 9, 2004, we announced that we had entered into a binding
purchase agreement with Hoffmann-La Roche Inc. (Roche) to acquire exclusive
U.S. rights to Soriatane®-brand acitretin, an approved oral medicine for the
treatment of severe psoriasis in adults. The transaction closed on March 4,
2004. Under the terms of the purchase agreement, we paid Roche a total of $123
million in cash at the closing to acquire Soriatane. We also agreed to assume
certain liabilities in connection with returns, rebates and chargebacks, and we
are obligated to buy Roches existing inventory within thirty days after the
closing of the acquisition. The majority of the purchase price will be
recorded as an acquired intangible asset that will be amortized to expense in
the future. On February 13, 2004, we completed a private placement of 3.0 million
shares of our common stock to accredited institutional investors at a price of
$20.25 per share, for net proceeds of approximately $57.1
million without giving effect to certain offering costs. We used a
portion of the net proceeds to pay for the acquisition of exclusive
U.S. rights to Soriatane, and intend to use the balance
for general corporate purposes, including working capital. Note 19. Quarterly Financial Data (unaudited) The following tables summarize the quarterly results of operations for the
years ended December 31, 2003 and 2002 (in thousands, except per share
amounts): 2003 QuartersFirst
    
    Second (1)
    
    Third(2)(3)
    
    FourthTotal revenues
    
    $
    15,311
    
    
    $
    19,970
    
    
    $
    19,712
    
    
    $
    20,338Cost of product revenues
    
    
    1,072
    
    
    
    1,185
    
    
    
    1,388
    
    
    
    1,484Operating expenses
    
    
    19,721
    
    
    
    19,411
    
    
    
    16,374
    
    
    
    17,203Operating income (loss)
    
    
    (5,482
    )
    
    
    (626
    )
    
    
    1,950
    
    
    
    1,651Net income (loss)
    
    
    (5,381
    )
    
    
    (1,856
    )
    
    
    1,616
    
    
    
    1,521Basic net income (loss) per share
    
    
    (0.17
    )
    
    
    (0.06
    )
    
    
    0.05
    
    
    
    0.05Diluted net income (loss) per share
    
    
    (0.17
    )
    
    
    (0.06
    )
    
    
    0.05
    
    
    
    0.05Shares used to calculate basic net
income (loss) per share
    
    
    31,286
    
    
    
    31,519
    
    
    
    31,648
    
    
    
    31,781Shares used to calculate fully
diluted net income (loss) per
share
    
    
    31,286
    
    
    
    31,519
    
    
    
    33,607
    
    
    
    33,759
  (1)
    
    In the second quarter of 2003, we received a one-time royalty
payment from S.C. Johnson in the amount of $2.9 million in connection
with the S.C. Johnson license agreement.(2)
    
    In the third quarter of 2003, we recognized $761,000 of relaxin
related revenue associated with the execution of the agreement with
BAS Medical in July 2003. Of the relaxin related revenue $661,000
represented previously deferred revenue associated with relaxin
license agreements with other parties that was fully recognized upon
the execution of the BAS Medical agreement.(3)
    
    Operating expenses decreased in the third quarter of 2003 when
compared to the second quarter of 2003 mainly due to decreased
clinical trial activity of $712,000, decreased manufacturing expenses
of $977,000 primarily related to a one-time reversal of a previously
recorded liability of $576,000 for clinical trial materials, as well
as the timing of various process and product development activities, a
$416,000 decrease in QA/QC expenses due to F-27




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##### Table of Contents



the timing of stability and release testing, and a $605,000 decrease
in product samples and sales promotion expenses related to the timing
of the programs. 2002 QuartersFirst (1)
    
    Second (2)
    
    Third
    
    Fourth(3)(4)Total revenues
    
    $
    11,531
    
    
    $
    12,626
    
    
    $
    13,641
    
    
    $
    14,965Cost of product revenues
    
    
    675
    
    
    
    973
    
    
    
    1,116
    
    
    
    1,426Operating expenses
    
    
    14,621
    
    
    
    18,671
    
    
    
    15,511
    
    
    
    19,304Operating loss
    
    
    (3,765
    )
    
    
    (7,018
    )
    
    
    (2,986
    )
    
    
    (5,765
    )Net loss
    
    
    (3,168
    )
    
    
    (5,321
    )
    
    
    (2,490
    )
    
    
    (5,611
    )Basic and diluted net loss per share
    
    
    (0.10
    )
    
    
    (0.17
    )
    
    
    (0.08
    )
    
    
    (0.18
    )Shares used to calculate basic and
fully diluted net loss per share
    
    
    30,496
    
    
    
    30,608
    
    
    
    30,866
    
    
    
    31,058
  (1)
    
    In March 2002, Novartis Consumer Health exercised its right to expand
an existing license to cover the Liquipatch drug-delivery system for
use in all topical antifungal applications. We recognized $580,000 of
revenue related to this agreement in the quarter ended March 31, 2002.(2)
    
    In May 2002, we entered into an agreement with Yamanouchi Europe B.V.
to license Velac gel. Under the terms of the agreement, we paid
Yamanouchi an initial $2.0 million licensing fee, which we recorded as
acquired in-process research and development expense during the
quarter ended June 30, 2002. In the second quarter of 2002 and in
connection with the wind down of relaxin development contracts, we
recorded a charge of $312,000, representing the final payment due
under a 2001 agreement with Boehringer Ingelheim.(3)
    
    In the fourth quarter of 2002, we initiated a Phase III trial for
Velac. Under the terms of the agreement with Yamanouchi, we recorded
$2.0 million as acquired in-process research and development expense
related to this milestone.(4)
    
    During the fourth quarter of 2002 there was a significant increase in
operating expenses over the prior quarter mainly due to increased
clinical trial activity of $858,000 due to the initiation of several
trials, an increase in QA/QC expenses of $793,000 due to the timing of
stability and release testing, as well as the acquired in-process
research and development expenses of $2.0 million related to the
Yamanouchi agreement. F-28




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##### Table of Contents



Connetics Corporation
Index to Exhibits[Item 15(c)] Exhibit Number
    
    Description3.1*
    
    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*
    
    Certificate of Amendment of the Companys Amended and
Restated Certificate of Incorporation, as filed with
the Delaware Secretary of State on May 15, 1997
(previously filed as Exhibit 3.7 to the Companys
Current Report on Form 8-K dated and filed 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 (previously filed as Exhibit A to Exhibit 1 to
the Companys Form 8-A filed on May 23, 1997).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
(previously filed as Exhibit 3.5 to the Companys
Annual Report on Form 10-K/A for the year ended
December 31, 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 Stock 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)4.3*
    
    Indenture, dated as of May 28, 2003, between Connetics
and J.P. Morgan Trust Company, National Association,
including therein the forms of the notes (previously
filed as Exhibit 4.1 to the Companys Quarterly Report
on Form 10-Q for the quarter ended June 30, 2003)Management and Consulting Agreements10.1*(M)
    
    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 (previously filed as Exhibit
10.4 to the Companys Annual Report on Form 10-K/A for
the year ended December 31, 2001)10.5*(M)
    
    Form of Notice of Stock Option Grant to G. Kirk Raab
dated July 30, 1997 (previously filed as Exhibit 10.5
to the Companys Annual Report on Form 10-K/A for the
year ended December 31, 2001)Index to Exhibits




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##### Table of Contents



Exhibit Number
    
    Description10.6*(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)10.7*(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 31, 1999)10.8*(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 31, 1999)10.9*(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)10.10*(M)
    
    Form of Change in Control Agreement between the Company
and key employees of the Company (previously filed as
Exhibit 10.12 to the Companys Annual Report on Form
10-K/A for the year ended December 31, 2001)10.11*(M)
    
    Consulting Agreement dated January 1, 2002, as amended
effective January 1, 2003, between Connetics and Eugene
Bauer, M.D. (previously filed as Exhibit 10.12 to the
Companys Annual Report on Form 10-K for the year ended
December 31, 2002)Stock Plans and Equity Agreements10.12(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)10.13(M)*
    
    1995 Employee Stock Purchase Plan (as amended through
December 2002), and form of Subscription Agreement
(previously filed as Exhibit 99.1 to the Companys Form
S-8 Registration Statement No. 333-102619)10.14*(M)
    
    1995 Directors Stock Option Plan (as amended through
May 2003), and form of Option Agreement (previously
filed as Exhibit 99.2 to the Companys Current Report
on Form 8-K dated February 9, 2004 and filed with the
Commission on March 8, 2004)10.15*
    
    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
as filed on November 7, 2000)10.16*
    
    Registration Rights Agreement dated January 2, 1997
between Connetics and Kepler Capital LLC (previously
filed as Exhibit 10.43 to the Companys Annual Report
on Form 10-K for the year ended December 31, 1996)10.17*(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)10.18*(M)
    
    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)10.19*
    
    International Stock Incentive Plan (previously filed as
Exhibit 4.1 to the Companys Form S-8 Registration
Statement No. 333-61558)10.20*
    
    2000 Non-Officer Employee Stock Plan (previously filed
as Exhibit 4.3 to the Companys Form S-8 Registration
Statement No. 333-46562)Index to Exhibits




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##### Table of Contents



Exhibit Number
    
    Description10.21*
    
    2002 Non-Officer Employee Stock Plan (as amended
through May 2003) (previously filed as Exhibit 99.1 to
the Companys Current Report on Form 8-K dated February
9, 2004 and filed with the Commission on March 8, 2004)License Agreements10.22*
    
    Soltec License Agreement dated June 14, 1996
(previously filed as Exhibit 10.28 to the Companys
Quarterly Report on Form 10-Q for the quarter ended
June 30, 1996)10.23*
    
    License Agreement dated January 1, 1998 between
Connetics and Soltec Research Pty Limited (previously
filed as Exhibit 10.57 to the Companys Annual Report
on Form 10-K for the year ended December 31, 1997)10.24*
    
    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 Property10.25*
    
    Lease between Connetics and Renault & Handley
Employees Investment Co., dated June 28, 1999
(previously filed as Exhibit 10.39 to the Companys
Annual Report on Form 10-K/A for the year ended
December 31, 2001)10.26*
    
    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)10.27*
    
    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)10.28*
    
    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)10.29*
    
    Sublease agreement between Connetics (sublessor) and
Tolerian, Inc., dated June 20, 2002 (previously filed
as Exhibit 10.1 to the Companys Quarterly Report for
the quarter ended June 30, 2002)Other Agreements10.30*
    
    Registration Rights Agreement, dated as of May 28,
2003, between Connetics and Goldman, Sachs & Co., C.E.
Unterberg, Towbin (a California Limited Partnership),
CIBC World Markets Corp., Thomas Weisel Partners LLC
and U.S. Bancorp Piper Jaffray Inc., as representatives
(previously filed as Exhibit 4.2 to the Companys
Quarterly Report on Form 10-Q for the quarter ended
June 30, 2003)10.31*
    
    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)10.32*
    
    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)10.33*
    
    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)Index to Exhibits




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##### Table of Contents



Exhibit Number
    
    Description10.34*
    
    Facilities Contribution Agreement between Connetics and
DPT Laboratories, Ltd., with retroactive effect to
November 1, 2001 (previously filed as Exhibit 10.55 to
the Companys Annual Report on Form 10-K/A (Amendment
No. 2) for the year ended December 31, 2001)10.35*
    
    Manufacturing and Supply Agreement between Connetics
and DPT Laboratories, Ltd., dated March 12, 2002
(previously filed as Exhibit 10.56 to the Companys
Annual Report on Form 10-K/A (Amendment No. 2) for
the year ended December 31, 2001)10.36*
    
    License and Development Agreement between Connetics and
Pharmacia & Upjohn Company, dated December 21, 2001
(previously filed as Exhibit 99.1 to the Companys
Current Report on Form 8-K/A-2 dated December 21, 2001,
filed with the SEC on July 12, 2002)10.37*
    
    License and Development Agreement between Connetics and
Yamanouchi Europe B.V., dated May 13, 2002 (previously
filed as Exhibit 10.2 to the Companys Quarterly Report
on Form 10-Q for the quarter ended June 30, 2002)10.38*
    
    Distribution Agreement between Connetics and CORD
Logistics, Inc., dated January 1, 2001, as amended
September 1, 2001, September 3, 2003, and September 24,
2003 (previously filed as Exhibit 10.51 to the
Companys Annual Report on Form 10-K/A (Amendment No.
2) for the year ended December 31, 2002)10.39*
    
    Amended and Restated Manufacturing and Supply Agreement
dated April 24, 2003 between Connetics and AccraPac
Group, Inc. (previously filed as Exhibit 10.1 to the
Companys Quarterly Report on Form 10-Q/A (Amendment
No. 1) for the quarter ended March 31, 2003)10.40*
    
    Credit and Guaranty Agreement dated as of February 6,
2004 between Connetics and Goldman Sachs Credit
Partners L.P. (previously filed as Exhibit 99.1 to the
Companys Current Report on Form 8-K dated February 6,
2004, filed with the SEC on February 9, 2004)10.41
    
    Purchase and Sale Agreement dated February 2, 2004
between Connetics and Hoffmann-La Roche Inc.14.1
    
    Code of Professional Conduct for Employees14.2
    
    Code of Professional Conduct for Board of Directors,
Chief Executive and Senior Financial Officers21*
    
    Subsidiaries of the Company (previously filed as
Exhibit 21 to the Companys Annual Report on Form 10-K
for the year ended December 21, 2002)23.1
    
    Consent of Ernst & Young LLP, Independent Auditors31.1
    
    Certification of Chief Executive Officer pursuant to
Rule 13a-14(a) and Section 302 of the Sarbanes-Oxley
Act of 200231.2
    
    Certification of Chief Financial Officer pursuant to
Rule 13a-14(a) and Section 302 of the Sarbanes-Oxley
Act of 200232.1
    
    Certification by Chief Executive Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002, 18
U.S.C. Section 135032.2
    
    Certification by Chief Financial Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002, 18
U.S.C. Section 1350Index to Exhibits




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##### Table of Contents



Key to Exhibit Index 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. Index to Exhibits