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UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549


Form 10-K/A

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


SECURITIES EXCHANGE ACT OF 1934


For the Fiscal Year Ended December 31,
2002

Commission file number: 0-27406

CONNETICS CORPORATION

(Exact name of registrant as specified in its
charter)


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

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

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

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

Common Stock, $0.001 par value per
share


Preferred Share Purchase Rights


Indicate by check mark whether the registrant
(1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports) and
(2) has been subject to such filing requirements for the
past
90 days. YES x     NO o

Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be
contained to the best of registrants knowledge, in
definitive proxy or information statements incorporated by
reference in Part III of this Form 10-K or any
amendment to this
Form 10-K. 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
$250,191,000 as of June 28, 2002, 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 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 31,398,567 shares of
registrants common stock issued and outstanding as of
March 3, 2003.

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 14, 2003.



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|                                                     |                                                                                                         |  |  |  |  |  |  | 
|---------------------------------------------------- | ------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|Explanatory Note                                    
|Forward-Looking Information                         
|Item 1. Business                                    
|                                                     | THE COMPANY                                                                                            
|                                                     | OUR STRATEGY                                                                                           
|                                                     | OUR PRODUCTS                                                                                           
|                                                     | PRODUCT CANDIDATES AND CLINICAL TRIALS                                                                 
|                                                     | ROYALTY-BEARING PRODUCTS AND LICENSED TECHNOLOGY                                                       
|                                                     | SALES AND MARKETING                                                                                    
|                                                     | COMPETITION                                                                                            
|                                                     | CUSTOMERS                                                                                              
|                                                     | RESEARCH AND DEVELOPMENT AND PRODUCT PIPELINE                                                          
|                                                     | PATENTS AND PROPRIETARY RIGHTS                                                                         
|                                                     | TRADEMARKS                                                                                             
|                                                     | MANUFACTURING                                                                                          
|                                                     | WAREHOUSING AND DISTRIBUTION                                                                           
|                                                     | GOVERNMENT REGULATION                                                                                  
|                                                     | MARKETING TO HEALTHCARE PROFESSIONALS                                                                  
|                                                     | MARKETING EXCLUSIVITY                                                                                  
|                                                     | THIRD PARTY REIMBURSEMENT                                                                              
|                                                     | RELAXIN DEVELOPMENT PROGRAM                                                                            
|                                                     | ENVIRONMENTAL REGULATION                                                                               
|                                                     | EMPLOYEES                                                                                              
|                                                     | FACTORS AFFECTING OUR BUSINESS AND PROSPECTS                                                           
|                                                     | AVAILABLE INFORMATION                                                                                  
|                                                     | EXECUTIVE OFFICERS OF THE COMPANY                                                                      
|                                                     | Item 2. Properties                                                                                     
|                                                     | Item 3. Legal Proceedings                                                                              
|                                                     | Item 4. Submission of Matters to a Vote of Security Holders                                            
|PART II                                             
|                                                     | Item 5. Market for the Companys Common Equity and Related Stockholder Matters                         
|                                                     | Item 6. Selected Financial Data                                                                        
|                                                     | Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations          
|                                                     | Item 7A. Quantitative and Qualitative Disclosures About Market Risk                                    
|                                                     | Item 8. Financial Statements and Supplementary Data                                                    
|                                                     | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure           
|PART III                                            
|                                                     | Item 10. Our Directors and Executive Officers                                                          
|                                                     | Item 11. Executive Compensation                                                                        
|                                                     | Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
|                                                     | Item 13. Certain Relationships and Related Transactions                                                
|                                                     | Item 14. Controls and Procedures                                                                       
|PART IV                                             
|                                                     | Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K                               
|CERTIFICATION BY CHIEF EXECUTIVE OFFICER            
|REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS   
|Connetics Corporation Index to Exhibits [Item 15(c)]
|EXHIBIT 23.1                                        
|EXHIBIT 99.1                                        
|EXHIBIT 99.2                                        



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Table of Contents

|                                                                                                      |                                                  |      |    |    | 
|----------------------------------------------------------------------------------------------------- | ------------------------------------------------ | ---- | -- | -- | 
|                                                                                                      |                                                  | Page
|                                                                                                      |                                                  |     
|Explanatory Note                                                                                      |                                                  |      | 1  |   
|Forward-Looking Information                                                                           |                                                  |      | 1  |   
|PART I                                                                                               
|Item 1. Business                                                                                      |                                                  |      | 1  |   
|                                                                                                      | The Company                                      |      |    | 1  | 
|                                                                                                      | Our Strategy                                     |      |    | 3  | 
|                                                                                                      | Our Products                                     |      |    | 3  | 
|                                                                                                      | Product Candidates and Clinical Trials           |      |    | 4  | 
|                                                                                                      | Royalty-Bearing Products and Licensed Technology |      |    | 5  | 
|                                                                                                      | Sales and Marketing                              |      |    | 6  | 
|                                                                                                      | Competition                                      |      |    | 7  | 
|                                                                                                      | Customers                                        |      |    | 8  | 
|                                                                                                      | Research and Development and Product Pipeline    |      |    | 8  | 
|                                                                                                      | Patents and Proprietary Rights                   |      |    | 9  | 
|                                                                                                      | Trademarks                                       |      |    | 9  | 
|                                                                                                      | Manufacturing                                    |      |    | 9  | 
|                                                                                                      | Warehousing and Distribution                     |      |    | 10 | 
|                                                                                                      | Government Regulation                            |      |    | 10 | 
|                                                                                                      | Marketing to Healthcare Professionals            |      |    | 13 | 
|                                                                                                      | Marketing Exclusivity                            |      |    | 13 | 
|                                                                                                      | Third Party Reimbursement                        |      |    | 13 | 
|                                                                                                      | Relaxin Development Program                      |      |    | 14 | 
|                                                                                                      | Environmental Regulation                         |      |    | 15 | 
|                                                                                                      | Employees                                        |      |    | 15 | 
|                                                                                                      | Factors Affecting Our Business and Prospects     |      |    | 15 | 
|                                                                                                      | Available Information                            |      |    | 23 | 
|                                                                                                      | Executive Officers of the Company                |      |    | 24 | 
|Item 2. Properties                                                                                    |                                                  |      | 25 |   
|Item 3. Legal Proceedings                                                                             |                                                  |      | 26 |   
|Item 4. Submission of Matters to a Vote
    of Security Holders                                       |                                                  |      | 26 |   
|PART II                                                                                              
|Item 5. Market for the Companys
    Common Equity and Related Stockholder Matters                    |                                                  |      | 26 |   
|Item 6. Selected Financial Data                                                                       |                                                  |      | 27 |   
|Item 7. Managements Discussion and
    Analysis of Financial Condition and Results of
    Operations |                                                  |      | 29 |   
|Item 7A. Quantitative and Qualitative
    Disclosures About Market Risk                               |                                                  |      | 40 |   
|Item 8. Financial Statements and
    Supplementary Data                                               |                                                  |      | 40 |   
|Item 9. Changes in and Disagreements with
    Accountants on Accounting and Financial Disclosure      |                                                  |      | 40 |   



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|                                                                                                                |  |      |       | 
|--------------------------------------------------------------------------------------------------------------- |  | ---- | ----- | 
|                                                                                                                |  | Page
|                                                                                                                |  |     
|PART III                                                                                                       
|Item 10. Our Directors and Executive
    Officers                                                               |  |      | 41    | 
|Item 11. Executive Compensation                                                                                 |  |      | 41    | 
|Item 12. Security Ownership of Certain
    Beneficial Owners and Management and Related Stockholder
    Matters |  |      | 41    | 
|Item 13. Certain Relationships and
    Related Transactions                                                     |  |      | 41    | 
|Item 14. Controls and
    Procedures                                                                            |  |      | 41    | 
|PART IV                                                                                                        
|Item 15. Exhibits, Financial Statement
    Schedules and Reports on Form 8-K                                    |  |      | 42    | 
|Signatures                                                                                                      |  |      | 44    | 
|Certifications of Chief Executive Officer and
    Chief Financial Officer                                       |  |      | 45-46 | 
|Consolidated Financial Statements and Report of
    Independent Auditors                                        |  |      | F-1   | 
|Index to Exhibits                                                                                               |  |      |       | 



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Explanatory Note

We are filing an amendment to our Annual Report
on Form 10-K for the year ended December 31, 2002, as
filed on March 6, 2003, to make the following changes:
(1) revise the aggregate market value of the companys
voting common stock to reflect the market value held by
non-affiliates at June 28, 2002, as reported on the cover
of this Form 10-K, instead of March 3, 2003 as
originally filed; (2) update Item 1, Business, to
reflect updated information about market exclusivity for the
Companys product OLUX on page 13; (3) revise
Item 10 to correct the cross references to sections in our
Proxy Statement; (4) make certain conforming changes in
Item 7 under the heading Recent Accounting
Pronouncements; and (5) correct certain typographical
errors.




Forward-Looking Information

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

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

Although we believe that our plans, intentions
and expectations reflected in these forward-looking statements
are reasonable, we may not achieve these plans, intentions or
expectations. Forward-looking statements in this Report include,
but are not limited to, those relating to the commercialization
of our currently marketed products, the progress of our product
development programs, developments with respect to clinical
trials and the regulatory approval process, developments related
to acquisitions and development of drug candidates, 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

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otherwise, we includes Connetics
Australia Pty Ltd. Our principal executive offices are located
at 3290 West Bayshore Road, Palo Alto, California 94303. Our
telephone number is (650) 843-2800. Connetics®,
Luxíq®, and OLUX® are registered trademarks, and
Extina, Actiza, Liquipatch, Solux and
the seven interlocking Cs design are
trademarks, of Connetics. All other trademarks or service marks
appearing in this Report are the property of their respective
companies. We disclaim any proprietary interest in the marks and
names of others.


Connetics is a specialty pharmaceutical company
focusing exclusively on the treatment of dermatological
conditions. We currently market two pharmaceutical products,
OLUX® Foam (clobetasol propionate), 0.05%, and
Luxíq® Foam (betamethasone valerate), 0.12%. 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
two 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.

We established the Connetics Center for Skin
Biology with a goal of connecting the scientific understanding
of skin disease with better treatment options. The Center was
created to bring together dermatologists and pharmacologists
from across the country to interact with our researchers to
explore how topical drugs interact with and penetrate the skin.
The purpose of the Center is to learn how 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 will assist in the
continued development of innovative topical dermatology products
through rigorous scientific evaluation of products and product
candidates. We believe this novel approach to drug development
will enable us to bring even more effective and novel treatments
to our product platform and the dermatology market.

Our products, OLUX and Luxíq, compete in the
topical steroid market. According to NDC Health, in 2002, the
value of the retail topical steroid market for mid-potency and
high and super-high potency steroids was $831 million.
Luxíq competes in the mid-potency steroid market and OLUX
competes in the high-and super-high potency steroid market.

Dermatological diseases often persist for an
extended period of time and are treated with a variety of
clinically proven drugs that are delivered in a variety of
formulations, including solutions, creams, gels and ointments.
These existing delivery systems often inadequately address a
patients needs for efficacy and cosmetic elegance, and the
failure to address those needs may decrease patient compliance.
We believe that the proprietary foam delivery system unique to
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, 80% of
patients said that they preferred the foam to other topical
delivery vehicles.

We acquired our wholly-owned subsidiary,
Connetics Australia Pty Ltd. (formerly Soltec Research Pty Ltd.)
in 2001. The acquisition, for which we paid approximately U.S.
$16.9 million, was intended to provide us with powerful
product innovation and development capabilities and to fuel an
extensive new product pipeline as well as contributing revenue
and profits to our financial results. We have leveraged our
broad range of drug delivery technologies by entering into
license agreements with many well-known dermatology companies
around the world. Those license agreements for marketed products
bear royalties payable to us. In connection with the
acquisition, we gained worldwide rights to a number of unique
topical delivery systems, including several distinctive aerosol
foams including water-, ethanol- and petrolatum- based foams.
Consolidating the rights to these technologies enables us to
populate our own product development portfolio, as well as
pursue business development agreements with other pharmaceutical
companies for over-the-counter and foreign markets.

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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 Near-Term 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
    permits us to effectively reach the majority of the treating
    dermatologists. In 2002, we introduced sample-size versions of
    both our products. In December 2002, we received approval from
    the FDA to market OLUX for the treatment of non-scalp psoriasis,
    specifically the short-term topical treatment of mild to
    moderate plaque- type psoriasis of non-scalp regions excluding
    the face and intertriginous areas.                                                                                                                                                                                                                                                                                                                           
|
| |  | 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|
| |  | Broadening Our Product Portfolio Through
    Development, License or Acquisition.We believe that we can leverage our
    dermatology-dedicated sales force by marketing additional
    products to the dermatology market. In 2002, we acquired the
    rights to Velac®, a first-in-class combination of 1%
    clindamycin and 0.025% tretinoin for the treatment of acne. Also
    in 2002, we in-licensed the rights to access the clinical,
    regulatory and manufacturing records of a currently approved and
    marketed dermatological product. Connetics intends to
    reformulate and market the product using its proprietary foam
    delivery vehicle. Details regarding the product and the target
    market were not disclosed. We are evaluating the licensing or
    acquisition of additional product candidates. We may also
    acquire additional technologies or businesses that we believe
    will enhance our research and development capabilities.
|
| |  | Selective Collaborations.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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            




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.

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 moderate to severe scalp psoriasis
significantly more patients (74%) treated with OLUX achieved
90-100% clearance (Investigators Global Assessment) within
two weeks as compared with patients treated with placebo (10%;
p<0.001). In a more rigorous assessment of efficacy from the
Phase III clinical trial, treatment success was achieved in
63% of OLUX -treated patients compared to 57% of patients
treated with clobetasol solution.

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In December 2002, the FDA approved our
supplemental New Drug Application, or sNDA, to market OLUX for a
non-scalp indication. The sNDA was based on results from a
279-patient, placebo-controlled, randomized, double-blind,
Phase III clinical trial of OLUX for the treatment of
mild-to-moderate non-scalp psoriasis. During the study, patients
treated with OLUX experienced a statistically significant
improvement in clearance of disease (p<0.0001) over patients
in the placebo group after treatment twice a day for 14 days.
Patients were evaluated using the Physicians Static Global
Assessment score as the primary endpoint, and patients
global assessment and erythema, scaling, plaque thickness, and
pruritus baselines as secondary endpoints. In non-scalp
psoriasis significantly more patients (68%) treated with OLUX
achieved a Physicians Static Global Assessment score of 0
or 1 within two weeks as compared with patients treated with
placebo (21%; p<0.001). In a more rigorous assessment of
efficacy, treatment success was achieved in 28% of OLUX-treated
patients vs. 3% of patients treated with placebo. Treatment
success was scored on a severity scale from 0 to 5, and was
defined as a Physicians Static Global Assessment score of
0 or 1, plus a plaque thickness score of 0, an erythema score of
0 or 1, and a scaling score of 0 or 1 at endpoint. There was no
statistical difference in the reported adverse events between
the OLUX and placebo groups. The most common adverse events
reported were application site reactions (burning and dryness).

A separate study conducted at Stanford University
School of Medicine, presented at the Annual Hawaii Dermatology
Seminar in January 2002, 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 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 solution for some
patients. This study supports our belief that improved patient
compliance with the foam will yield better treatment results
than the same active ingredient in other formulations.

Mipharm S.p.A., which holds a license to market
OLUX in Italy, filed a Marketing Authorization Application, or
MAA, in April 2002 for OLUX with the Medicines Control Agency,
or MCA, in the United Kingdom. It is our intention to submit the
MAA to all additional concerned member states in the European
Union after the MCA grants authorization, using a process called
the Mutual Recognition process. We are seeking commercial
partners outside 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 began selling Luxíq commercially in the United States in
April 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 lotion.




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.

At the end of 2002, we had three product
candidates in Phase III clinical trials. We are in
Phase III clinical trials with Extina, a foam
formulation of a 2% concentration of the antifungal drug
ketoconazole, for the treatment of seborrheic dermatitis. The
Extina clinical program consists of a pivotal trial and two small

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supplemental clinical studies required by the
FDA. In the pivotal trial, which completed enrollment in late
January 2003, patients were treated for four weeks in a
double-blind, placebo- and active-controlled protocol. Subject
to a successful outcome, we intend to submit a New Drug
Application, or NDA, to the FDA for Extina in mid-2003. We
believe Extina will compete primarily in the topical antifungal
market, representing approximately $484 million in
U.S. prescriptions in 2002. Prescriptions for all
antifungals in the U.S. in 2002 were approximately
$693 million.


We are in Phase III clinical trials with
Actiza, a formulation of 1% clindamycin in our proprietary
foam delivery system, for the treatment of acne. The Actiza
clinical program consists of a pivotal trial, a pilot trial, and
two small supplemental clinical studies required by the FDA. In
the pivotal trial, patients will be treated for 12 weeks in
a double-blind, placebo- and active-controlled protocol. Subject
to a successful outcome, we intend to submit an NDA to the FDA
for Actiza in late 2003. We believe Actiza will compete
primarily in the topical antibiotic market, representing
approximately $594 million in U.S. prescriptions in 2002.
Prescriptions for the entire U.S. acne market in 2002 were
approximately $1.5 billion not including oral antibiotics.

In December, 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, and two
small supplemental clinical studies required by the FDA. The two
pivotal trials will enroll approximately 2,000 patients.
Assuming successful clinical development, we anticipate that we
will submit an NDA to the FDA for Velac in 2004 and be able to
launch Velac in mid-2005. We believe Velac will compete with
topical retinoids as well as topical antibiotics, representing
approximately $977 million in U.S. prescriptions in
2002. Prescriptions for the entire U.S. acne market in 2002
were approximately $1.5 billion not including oral
antibiotics.

In February 2003, we began a promotional giveaway
to dermatologists of Solux, a sunscreen formulated in our
proprietary foam delivery system. The goal of the program is to
introduce the foam delivery vehicle to a broad physician
audience.

In addition to the product candidates described
above, we are also developing the foam technology for other
disease indications. Our most promising preclinical candidates
include a petrolatum-based foam as line extensions for OLUX and
Luxíq, and other formulation candidates in early stages of
development. We are exploring various product formulations for
Liquipatch as well.




ROYALTY-BEARING PRODUCTS AND LICENSED
TECHNOLOGY

Foam Technology.In
December 2001, we entered into an agreement granting Pharmacia
Corporation exclusive global rights, excluding Japan, to our
proprietary foam drug delivery technology for use with
Pharmacias Rogaine® hair loss treatment. The license
with Pharmacia will expand the reach of the foam vehicle to the
non-prescription (over-the-counter) pharmaceutical market. Under
the agreement, Pharmacia paid us an initial licensing fee, and
agreed to pay us when it achieves specified milestones, plus a
royalty on product sales. We have recognized $1.0 million
under the agreement through December 31, 2002. Pharmacia
will be responsible for most product development activities and
costs.

Before April 2001, Connetics Australia (under the
name Soltec) had entered into a number of other agreements for
the foam technology. Connetics Australia licensed the technology
to betamethasone valerate foam to Celltech plc in Europe, and
Celltech has licensed the worldwide rights to their patent on
the steroid foam technology to us through Connetics Australia.
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
pays us royalties on those sales. 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 2002, on a
consolidated basis, we received $307,000 in royalties for
foam-based technology. We have development agreements with other
companies to develop the foam for specific indications.

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We have licensed to Mipharm commercial rights for
Italy to OLUX, and we will receive milestone payments and
royalties on future product sales. In April 2002, Mipharm began
the process to obtain marketing authorization in Europe, by
filing a Marketing Authorization Application with the Medicines
Control Agency in the United Kingdom. Under the Mutual
Recognition process in Europe, after the MCA approves the MAA,
we will be able to submit the MAA to all other European Union
concerned member states for approval to sell OLUX. We retained
marketing and manufacturing rights for the rest of Europe and
are seeking commercial partners outside of Mipharms
territory.

Aerosol Spray.Connetics Australia has licensed to a major international
company the rights to a super-concentrated aerosol spray that is
marketed in the U.S. and internationally. We receive royalties
on sales of the product. In 2002, on a consolidated basis, we
received $2.4 million in royalties in connection with this
agreement.

Liquipatch.We have
agreements with several companies to develop Liquipatch
for various indications. 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
will be responsible for all development costs, and will be
obligated to pay license fees, milestone payments and royalties
on future product sales. We have development agreements with
other companies to develop Liquipatch for specific indications.

Actimmune®.In
1995, we acquired from Genentech, Inc. the exclusive development
and marketing rights to interferon gamma for dermatological and
other indications in the U.S., Japan, and Canada. Interferon
gamma is one of a family of proteins involved in the regulation
of the immune system and has been shown to reduce the frequency
and severity of certain infections. In April 2000, we assigned
our remaining rights and obligations under the license with
Genentech and the corresponding supply agreement to InterMune
Pharmaceuticals, Inc. (now InterMune, Inc.), to develop
Actimmune for various infections and fungal diseases. In
exchange, 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 $172,000 in royalty revenue related to
Actimmune sales in 2002. 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.

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. The decision to divest the
product was consistent with our decision to focus exclusively on
dermatology. 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 no royalties in
2002. Prometheus agreed to assume, effective as of the closing
date of the transaction, our obligations under existing
agreements with Pharmascience, Inc. and SmithKline Beecham
Corporation (now known as GlaxoSmithKline).




SALES AND MARKETING

We have an experienced, highly productive sales
and marketing organization, which is 100% dedicated to
dermatology. As of March 3, 2003, we had 76 employees
in our sales and marketing organization, including 60 field
sales directors and representatives.

Our marketing efforts are focused on assessing
and meeting the needs of dermatologists, residents, dermatology
nurses, and physicians assistants. Our sales
representatives focus on cultivating relationships of trust and
confidence with the physicians they call on. Of the 7,500 U.S.
dermatologists our sales force called on in 2002, we focused our
efforts on the approximately 5,000 dermatologists who are
responsible for approximately 90% of all prescriptions written
by dermatologists in the United States. To achieve our marketing
objectives, we use a variety of advertising, promotional
material (including journal advertising,

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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 http://www.connetics.comincludes fundamental information about the company as well
as descriptions of ongoing research, development and clinical
work. Our product websites, at http://www.olux.comand
http://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
the Stanford University Medical School, and a dermatology fellow
at the University of California  San Francisco. We
are working to provide an innovative surgery-tracking program
for dermatology residents. We also provide corporate sponsorship
to various dermatology groups, including the National Psoriasis
Foundation, the Dermatology Foundation, the Skin Disease
Education Foundation, and the Foundation for Research &
Education in Dermatology. In 2002, we sponsored 15 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 product
development and substantial technological change. We also face
competition from other manufacturers of prescription
pharmaceuticals for our dermatology products as well as other
products that we may develop and market in the future. Many of
our competitors are large, well-established pharmaceutical,
chemical, cosmetic or health care companies with considerably
greater financial, marketing, sales and technical resources than
those available to us. Additionally, many of our present and
potential competitors have research and development capabilities
that may allow such competitors to develop new or improved
products that may compete with our product lines. Our products
could be rendered obsolete or made uneconomical by the
development of new products to treat the conditions addressed by
our products, technological advances affecting the cost of
production, or marketing or pricing actions by one or more of
our competitors. Each of our products competes for a share of
the existing market with numerous products that have become
standard treatments recommended or prescribed by dermatologists.

OLUX and Luxíq compete with a number of
corticosteroid brands in the super-, high- and mid-potency
categories for the treatment of inflammatory skin conditions.
Competing brands include Halog® and Ultravate®,
marketed by Bristol-Myers Squibb Company; Elocon® and
Diprolene®, marketed by Schering-Plough Corporation;
Locoid®, marketed by Ferndale Labs; Temovate® and
Cutivate®, which are marketed by GlaxoSmithKline as of late
2002; DermaSmoothe FS®, marketed by Hill Dermaceuticals;
and Psorcon®, marketed by Dermik Laboratories, Inc. In
February 2003, Biogen announced that the FDA had approved its
systemic drug, Amevive, for the treatment of psoriasis. 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, technical and human resources than we do. In
addition, many of these competitors have more collective
experience than we do in undertaking preclinical testing and
human clinical trials of new pharmaceutical products and
obtaining regulatory approvals for therapeutic products.
Accordingly, our competitors may succeed in obtaining FDA
approval for products more rapidly or successfully than we do.

We intend to compete on the basis of the quality
and efficacy of our products and unique drug delivery vehicles,
combined with the effectiveness of our marketing and sales
efforts. Competing successfully will depend on our continued
ability to attract and retain skilled and experienced personnel,
to identify, secure the

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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. 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 major drug chains. During
2002, Cardinal Health, McKesson, and AmerisourceBergen accounted
for 43%, 26%, and 23%, respectively, of our gross product
revenues. The distribution network for pharmaceutical products
is subject to increasing consolidation. As a result, a few large
wholesale distributors control a significant share of the
market. In addition, the number of independent drug stores and
small chains has decreased as retail consolidation has occurred.
Further consolidation among, or any financial difficulties of,
distributors or retailers could result in the combination or
elimination of warehouses, which may result in reductions in
purchases of our products, returns of our products, or cause a
reduction in the inventory levels of distributors and retailers,
any of which could have a material adverse impact on our
business. If we lose any of these customer accounts, or if our
relationship with them were to deteriorate, our business could
also be materially and adversely affected.




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 $25.8 million in 2002,
$19.2 million in 2001, and $21.9 million in 2000. 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 most value from our development portfolio, we are focusing
on later-stage development. This approach helps to minimize the
risk and time requirements for us to get a product on the
market. Our strategy involves targeting 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

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

We own or are exclusively licensed under pending
applications and/or issued patents worldwide relating to OLUX
and Luxíq, recombinant human relaxin, and other products in
the earlier stages of research. We own over 20 patents related
to the technologies developed by Connetics Australia, expiring
between 2003 and 2018, and we have several pending applications.

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. The Liquipatch technology is
covered by one U.S. patent.

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




MANUFACTURING

We do not operate manufacturing or distribution
facilities for any of our products. Instead, we contract with
third parties to manufacture our products for us. 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, Miza Pharmaceuticals and Accra Pac Group, Inc.
manufacture commercial supplies of OLUX and Luxíq, as well
as physician samples of those products for us.

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DPT also manufactures clinical supplies for our
various clinical trial programs. On March 12, 2002, we
entered into agreements with DPT to construct an aerosol filling
line at DPTs plant in Texas and to manufacture and fill
our commercial aerosol products. The aerosol line was completed
in September 2002, and effective February 21, 2003, is
approved for the manufacture of OLUX in the United States. We
anticipate that DPT will be approved to manufacture Luxíq
commercially in the spring of 2003.





WAREHOUSING AND DISTRIBUTION

Currently, all of our product distribution
activities are handled by Cardinal Health Specialty
Pharmaceutical Services (formerly CORD Logistics, Inc.).
Cardinal Health Specialty Pharmaceutical Services, or SPS, is a
division of Cardinal Health, which was our largest customer in
2002. 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

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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 trials involve more patients, and often
more locations and clinical investigators than the earlier
trials. At least one such trial is required for FDA approval to
market a drug.


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 both OLUX and Luxíq,
which permitted us 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 those product
candidates than it was for OLUX and Luxíq.

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
requirements, the FDA may restrict the marketing of a product or
impose the 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

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

We participate in the 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 based on our submission to the United States
Department of Health and Human Services Centers for Medicare and
Medicaid Services of our current average manufacturer price and
best price for each of our products. 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.

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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

A number of guidelines were issued in 2002
relating to how pharmaceutical manufacturers interact with
doctors and other healthcare professionals. 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
company. We have adopted internal policies that emphasize to our
employees that all interactions with healthcare professionals
should be focused on informing them about our products,
providing scientific and educational information, or supporting
medical research and education. Recent draft guidance issued by
the Office of Inspector General of Health and Human Services
recommends significant restrictions on how pharmaceutical
companies can interact with the medical community. 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. We intend to closely follow developments in this field,
and to continue to assess the impact that any new regulations
might have on our business.




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 May 26, 2003 for
scalp dermatoses, and 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.




THIRD PARTY REIMBURSEMENT

Our operating results will depend in part on
whether adequate reimbursement is available for our products
from third-party payors, such as government entities, private
health insurers and managed care organizations.

Medicare, Medicaid, health maintenance
organizations and other third-party payors may not authorize or
otherwise budget such reimbursement. Because of the size of the
patient population covered by managed care organizations,
marketing of prescription drugs to them and the pharmacy benefit
managers that serve many of these organizations is important to
our business. Managed care organizations and other third-party
payors try

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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. Due to their lower costs,
generic products are often favored on such 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. The exclusion of
a product from a formulary can sharply reduce usage of that
product in the managed care organizations patient
population. 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 managed care
organizations or other third-party payors do not provide
adequate reimbursement levels for our products, or if those
reimbursement policies predominantly favor the use of generic
products, our sales could decline and our business could be
seriously harmed.


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




RELAXIN DEVELOPMENT PROGRAM

Overview

In addition to our commercial business, we own
the development and commercialization rights to a recombinant
form of a natural human hormone called relaxin. Relaxin reduces
the hardening, or fibrosis, of skin and organ tissue, dilates
existing blood vessels and stimulates new blood vessel growth.
Relaxin circulates in the blood and has a broad spectrum of
biological activities.

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

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

Relaxin Alliances

Canadian and Australian
Licenses.In July 1999, we
entered into a collaboration and exclusive license agreement
with Paladin Labs, Inc. for the development and
commercialization of relaxin in Canada. In April 2000, we
entered into a collaboration and exclusive license agreement
with Faulding for the development and commercialization of
relaxin in Australia. Although we have discontinued our
development efforts for relaxin for scleroderma, Paladin and
Faulding have indicated that they will continue the
collaboration for other indications. Under the terms of the
agreements, Paladin and Faulding would owe additional milestone
payments for the approval of non-scleroderma indications for
relaxin in Canada and Australia, respectively. Paladin is
responsible for all development and commercialization activities
in Canada, and is obligated to pay royalties on all sales of
relaxin in Canada. Faulding is responsible for all development
and commercialization

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activities in Australia, and will pay royalties
on all sales of relaxin in Australia. In October 2001, Faulding
was acquired by Mayne Group Limited, Australias largest
private health care provider.


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




ENVIRONMENTAL REGULATION

Our research and development activities involve
the controlled use of hazardous and biohazardous materials,
chemicals such as solvents and active pharmaceutical agents,
compressed gases, and certain radioactive materials, such as
hydrogen-3, carbon-14, and phosphorous-33. We are subject to
federal, state and local laws and regulations governing the use,
storage, handling and disposal of such materials and certain
waste products. Although we believe that our safety procedures
for handling and disposing of such materials comply 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 3, 2003, we had 190 full-time
employees. Of the full-time employees, 76 were engaged in sales
and marketing, 79 were in research and development and 35 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 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 that may affect future
performance and the accuracy of forward-looking statements is
illustrative, but not exhaustive. Accordingly, you should
evaluate all forward-looking statements with the understanding
of their inherent uncertainty. Due to the foregoing factors, we
believe that quarter-to-quarter comparisons of our results of
operations are not a good indication of our future performance.

Risks Related To Our Business

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

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



| |   |                                             
| | - | --------------------------------------------
| |  | lower than expected demand for our products,

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| |   |                                                                                            
| | - | -------------------------------------------------------------------------------------------
| |  | changes in the governments or private
    payors reimbursement policies for our products,
|
| |  | changes in wholesale buying patterns,                                                      
|
| |  | increases in returns of our product, or rebates
    paid for our products,                 
|
| |  | increased competition from new or existing
    products, or                                
|
| |  | changes in our product pricing strategies.                                                 

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

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

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

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, $16.0 million in 2000 (after
excluding a one-time gain of $43.0 million on sales of
stock we held in InterMune, and the associated income tax),
$16.7 million in 2001, and $16.6 million for the year
ended December 31, 2002. Our accumulated deficit was
$126.1 million at December 31, 2002. We may incur
additional losses during the next few years. If we do not
eventually achieve and maintain profitability, our stock price
may decline.

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

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



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

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

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

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 which 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 which has been developed in those marks and
could be liable for damaged caused by an infringement.

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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
from the assignment of rights to patents and patent applications
from certain of our consultants and officers. These patents and
patent applications may be subject to claims of rights by third
parties. If there are conflicting claims to the same patent or
patent application, we may not prevail and, even if we do have
some rights in a patent or application, those rights may not be
sufficient for the marketing and distribution of products
covered by the patent or application.

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

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

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

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

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

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

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

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

Risks Related To Our Products

Future manufacturing difficulties could delay
future revenues from product sales of OLUX and
Luxíq.

Manufacturing facilities are subject to ongoing
periodic inspection by the FDA and corresponding state agencies,
including unannounced inspections, and must be licensed before
they can be used in commercial manufacturing of our products. If
DPT, AccraPac or Miza cannot provide us with our product
requirements in a timely and cost-effective manner, or if the
product they are able to supply cannot meet commercial
requirements for shelf life, our sales of marketed products
could be reduced and we could suffer delays in the progress of
clinical trials for products under development. In addition, any
commercial dispute with any of 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, our sales of marketed
products could be reduced and we could suffer delays in the
progress of clinical trials for products under development. We
do not have control over our third-party manufacturers
compliance with these regulations and standards. Our business
interruption insurance, which covers the loss of income for up
to $10.0 million, may not completely mitigate the harm to
our business from the interruption of the manufacturing of
products caused by certain events, as the loss of a manufacturer
could still have a negative effect on our sales, margins and
market share, as well as our overall business and financial
results.

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

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

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

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

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

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



| |   |                                                                                                                                                                                
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | testing and surveillance to monitor the product
    and its continued compliance with regulatory requirements,                                                                 
|
| |  | submitting products for inspection and, if any
    inspection reveals that the product is not in compliance, the
    prohibition of the sale of all products from the same lot,
|
| |  | suspending manufacturing,                                                                                                                                                      
|
| |  | recalling products, and                                                                                                                                                        
|
| |  | withdrawing marketing approval.                                                                                                                                                

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

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

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



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

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

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

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

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

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

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



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

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

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

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

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

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

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

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

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

All of our product distribution activities are
handled by SPS. 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 sales depend on payment and reimbursement
from third party payors, and if they reduce or refuse payment or
reimbursement, the use and sales of our products will suffer, we
may not increase our market share, and our revenues and
profitability will suffer.

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

In 2002, we expanded our contracts with managed
care organizations in an effort to increase the inclusion of our
products on formularies and reduce the co-payments required to
be made by the ultimate consumer. To the extent that our
products are purchased by patients through a managed care group
with which we have a

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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 our ability to become
profitable.

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

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

Our products compete with generic
pharmaceuticals, which claim to offer equivalent benefit at a
lower cost. In some cases, insurers and other health care
payment organizations encourage the use of these less expensive
generic brands through their prescription benefits 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 may have an adverse
effect on our pricing policies and our margins.

If managed care organizations or other
third-party payors do not provide adequate reimbursement levels
for our products, or if those reimbursement policies
predominantly favor the use of generic products, our sales could
decline and our business could be seriously harmed. 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.

Furthermore, 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. 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

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product will be reimbursed. We cannot predict the
availability or amount of reimbursement for our products or
product candidates, and current reimbursement policies for
existing products may change at any time. Changes in
reimbursement policies or health care cost containment
initiatives that limit or restrict reimbursement for our
products may cause our revenues to decline.


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

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

Risks Related To Our Stock

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

The market prices for securities of specialty
pharmaceutical companies like Connetics have been and are likely
to continue to be highly volatile. As a result, investors in
these companies often buy at very high prices only to see the
price drop substantially a short time later, resulting in an
extreme drop in value in the stock holdings of these investors.
In the past two fiscal years, the price of our common stock has
ranged from a low of $4.06 per share to a high of $14.55 per
share. In addition, the volatility could result in securities
class action litigation. Any litigation would likely result in
substantial costs, and divert our managements attention
and resources.

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

Our certificate of incorporation authorizes our
board of directors to issue undesignated preferred stock and to
determine the rights, preferences, privileges and restrictions
of the preferred stock without further vote or action by our
stockholders. The issuance of preferred stock could make it more
difficult for third parties to acquire a majority of our
outstanding voting stock. We also have a stockholder rights
plan, which entitles existing stockholders to rights, including
the right to purchase shares of preferred stock, in the event of
an acquisition of 15% or more of our outstanding common stock,
or an unsolicited tender offer for such shares. We have also
entered into change in control agreements with our
directors, officers, and key employees. Those change in control
agreements provide for severance payments to be made in the
event of a change in control of the company. Provisions of
Delaware law, our rights plan, our charter documents, and other
arrangements, including a provision eliminating the ability of
stockholders to take actions by written consent, could delay or
make difficult the removal of our current management or a
merger, tender offer or proxy contest involving us. Further, our
stock option and purchase plans generally provide for the
assumption of such plans or substitution of an equivalent option
of a successor corporation or, alternatively, at the discretion
of the board of directors, exercise of some or all of the option
stock, including non-vested shares, or acceleration of vesting
of shares issued pursuant to stock grants, upon a change of
control or similar event.




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 From 8-K and
amendments to those reports on the day of filing

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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.





EXECUTIVE OFFICERS OF THE COMPANY

The following table shows information about our
executive officers as of March 3, 2003:

|                  |  |     |    |          |  |                                                                                         
|----------------- |  | --- | -- | -------- |  | ----------------------------------------------------------------------------------------
|                 
|                 
|Name              |  | Age |    | Position
|                 
|                 
|Thomas G. Wiggans |  |     | 51 |          |  | President, Chief Executive Officer and Director                                         
|C. Gregory Vontz  |  |     | 42 |          |  | Chief Operating Officer; Executive Vice President                                       
|John L. Higgins   |  |     | 32 |          |  | Chief Financial Officer; Executive Vice
    President, Finance and Corporate Development
|Katrina J. Church |  |     | 41 |          |  | Exec. Vice President, Legal Affairs; General
    Counsel and Secretary                  
|Michael Miller    |  |     | 45 |          |  | Sr. Vice President, Sales and Marketing and Chief
    Commercial Officer                
|Robert G. Lederer |  |     | 58 |          |  | Sr. Vice President, Strategic Account Management                                        
|Rebecca Gardiner  |  |     | 40 |          |  | Sr. Vice President, Human Resources and
    Organizational Dynamics                     
|Joseph Finster    |  |     | 38 |          |  | Sr. Vice President, Marketing                                                           
|Matthew W. Foehr  |  |     | 30 |          |  | Sr. Vice President, Technical Operations                                                
|                 

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
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.

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

John 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 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.

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

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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.


Michael Milleraccepted a position with Connetics
effective February 4, 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 BS in Finance from
University of San Francisco and his MBA in Information Systems
from San Francisco State University.

Robert Ledererjoined Connetics in 1998 and has
served as Senior Vice President, Strategic Account Management
since January 2003. Prior to that he served as Senior Vice
President, Commercial Operations from January 1999 to December
2002, and as Senior Vice President, Marketing and Sales from
July 1998 to December 1998. Before joining Connetics,
Mr. Lederer spent 15 years with Serono Laboratories,
most recently as the Executive Vice President for Business
Operations. Before joining Serono, Mr. Lederer held sales
and management positions with Becton Dickinson and Genovese
Drugs. Mr. Lederer serves as a board member for an
infertility patient advocacy organization, a not-for-profit
organization. He also serves on the Board of Advisors for a
small start-up company. Mr. Lederer received his B.A. from
St. Johns University in New York.

Rebecca Gardinerjoined Connetics in 1996 and has
served as Senior Vice President Human Resources and
Organizational Dynamics since January 2002. Ms. Gardiner
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. Gardiner also worked at Genelabs as Manager
of Research Administration from 1988 to 1990, at Genentech in
1987, and in various hospital administration positions from 1984
to 1987. Ms. Gardiner received her B.A. from UC Santa
Barbara and her M.P.A. in Health Sciences from the University of
San Francisco.

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

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.




Item 2. Properties

As of March 1, 2003, we lease
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 that will both
expire in March 2005. We are subleasing 10,188 square feet
of laboratory and office space at 3400 West Bayshore Road
in Palo Alto, California to a third 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

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occupies. We believe that our existing facilities
are adequate to meet our requirements for the near term and that
additional space will be available on commercially reasonable
terms if needed.





Item 3. Legal Proceedings

We are not a party to any material legal
proceedings.




Item 4. Submission of Matters to a Vote
of Security Holders

No matters were submitted to a vote of security
holders during the fourth quarter of 2002.




PART II




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

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

|     |                |      |   |       |  |  |   |       | 
|---- | -------------- | ---- | - | ----- |  |  | - | ----- | 
|    
|    
|     |                |      |   |      
|     |                | High |   | Low  
|    
|    
|2001 |                |      |   |       |  |  |   |      
|     | First Quarter  |      | $ | 7.81  |  |  | $ | 4.38  | 
|     | Second Quarter |      |   | 7.69  |  |  |   | 4.06  | 
|     | Third Quarter  |      |   | 7.80  |  |  |   | 5.65  | 
|     | Fourth Quarter |      |   | 13.95 |  |  |   | 6.46  | 
|2002 |                |      |   |       |  |  |   |      
|     | First Quarter  |      | $ | 14.55 |  |  | $ | 8.75  | 
|     | Second Quarter |      |   | 13.44 |  |  |   | 10.57 | 
|     | Third Quarter  |      |   | 12.35 |  |  |   | 7.92  | 
|     | Fourth Quarter |      |   | 12.98 |  |  |   | 9.35  | 
|    

On March 3, 2003, we had approximately 167
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.

Information regarding our compensation plans
under which equity securities are authorized for issuance is
incorporated into this Report by reference to the information
set forth under the caption Executive Compensation and
Related Information in our 2003 Proxy Statement.

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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, 2002, and the selected consolidated balance
sheet data as of December 31, 2002 and 2001, 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, 1999 and 1998, and the selected
consolidated balance sheet data as of December 31, 2000,
1999 and 1998, 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,                       
|                              |                                                                                                 |                                                
|                              |                                                                                                 | 2002                                            |                                    | 2001    |        | 2000    |   | 1999    |        | 1998   
|                             
|                             
|Statement of Operations Data: |                                                                                                 |                                                 |                                    |         |        |         |   |         |        |         |   |        |        |         |   |         |        |         |   |        
|                              | Revenues:                                                                                       |                                                 |                                    |         |        |         |   |         |        |         |   |        |        |         |   |         |        |         |   |         |       
|                              |                                                                                                 | Product                                         |                                    | $       | 47,573 |         |   | $       | 30,923 |         |   | $      | 20,095 |         |   | $       | 16,595 |         |   | $       | 7,473  |        
|                              |                                                                                                 | Royalty                                         |                                    |         | 2,926  |         |   |         | 1,097  |         |   |        |       |         |   |         |       |         |   |         |       |        
|                              |                                                                                                 | Contract and other                              |                                    |         | 2,264  |         |   |         | 2,044  |         |   |        | 20,679 |         |   |         | 10,311 |         |   |         | 1,648  |        
|                             
|                              |                                                                                                 |                                                 | Total revenues                     |         |        | 52,763  |   |         |        | 34,064  |   |        |        | 40,774  |   |         |        | 26,906  |   |         |        | 9,121   |  
|                              | Operating costs and expenses:                                                                   |                                                 |                                    |         |        |         |   |         |        |         |   |        |        |         |   |         |        |         |   |         |       
|                              |                                                                                                 | Cost of product revenues                        |                                    |         | 4,190  |         |   |         | 3,123  |         |   |        | 3,868  |         |   |         | 5,229  |         |   |         | 1,374  |        
|                              |                                                                                                 | License amortization                            |                                    |         |       |         |   |         |       |         |   |        |       |         |   |         | 6,160  |         |   |         | 6,720  |        
|                              |                                                                                                 | Research and development                        |                                    |         | 25,821 |         |   |         | 19,156 |         |   |        | 21,875 |         |   |         | 21,309 |         |   |         | 11,446 |        
|                              |                                                                                                 | Selling, general and administrative             |                                    |         | 37,624 |         |   |         | 36,062 |         |   |        | 26,673 |         |   |         | 20,834 |         |   |         | 11,680 |        
|                              |                                                                                                 | Acquired in-process research and development(1) |                                    |         | 4,350  |         |   |         | 1,080  |         |   |        |       |         |   |         | 1,000  |         |   |         | 4,000  |        
|                              |                                                                                                 | Loss on program termination(2)                  |                                    |         | 312    |         |   |         | 1,142  |         |   |        |       |         |   |         |       |         |   |         |       |        
|                             
|                              |                                                                                                 |                                                 | Total operating costs and expenses |         |        | 72,297  |   |         |        | 60,563  |   |        |        | 52,416  |   |         |        | 54,532  |   |         |        | 35,220  |  
|                              |                                                                                                 |                                                 | Loss from operations               |         |        | (19,534 | ) |         |        | (26,499 | ) |        |        | (11,642 | ) |         |        | (27,626 | ) |         |        | (26,099 | )
|                              | Gain on sale of investment(3)                                                                   |                                                 |                                    | 2,086   |        |         |   | 122     |        |         |   | 42,967 |        |         |   |        |        |         |   |        |       
|                              | Gain on sale of Ridaura product line(4)                                                         |                                                 |                                    |        |        |         |   | 8,002   |        |         |   |       |        |         |   |        |        |         |   |        |       
|                              | Interest income (expense), net                                                                  |                                                 |                                    | 1,039   |        |         |   | 1,978   |        |         |   | 1,873  |        |         |   | 343     |        |         |   | (496    | )     
|                             
|                              | Income (loss) before income taxes and
    cumulative effect of a change in accounting principle |                                                 |                                    | (16,409 | )      |         |   | (16,397 | )      |         |   | 33,198 |        |         |   | (27,283 | )      |         |   | (26,595 | )     
|                              | Income tax provision                                                                            |                                                 |                                    | (181    | )      |         |   | (345    | )      |         |   | (1,010 | )      |         |   |        |        |         |   |        |       
|                             
|                              | Income (loss) before cumulative effect of
    change in accounting principle                    |                                                 |                                    | (16,590 | )      |         |   | (16,742 | )      |         |   | 32,188 |        |         |   | (27,283 | )      |         |   | (26,595 | )     
|                              | Cumulative effect of change in accounting
    principle, net of tax(5)                          |                                                 |                                    |        |        |         |   |        |        |         |   | (5,192 | )      |         |   |        |        |         |   |        |       
|                             
|                              | Net income (loss)                                                                               |                                                 | $                                  | (16,590 | )      |         | $ | (16,742 | )      |         | $ | 26,996 |        |         | $ | (27,283 | )      |         | $ | (26,595 | )     
|                             

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|                                                                                |                                                                                        |                          |       |         |       |      |       |         |       |      |      |        |      |   |       |         |       |   |       |         |       |  
|------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------- | ------------------------ | ----- | ------- | ----- | ---- | ----- | ------- | ----- | ---- | ---- | ------ | ---- | - | ----- | ------- | ----- | - | ----- | ------- | ----- | -
|                                                                               
|                                                                               
|                                                                                |                                                                                        |                         
|                                                                                |                                                                                        | Years Ended December 31,
|                                                                                |                                                                                        |                         
|                                                                                |                                                                                        | 2002                     |       | 2001    |       | 2000 |       | 1999    |       | 1998
|                                                                               
|                                                                               
|Basic Earnings Per Share                                                       |                                                                                        |                          |       |         |       |      |       |         |       |      |      |        |      |   |       |         |       |   |       |        
|                                                                                | Income (loss) per share before cumulative effect
    of change in accounting principle |                          | $     | (0.54   | )     |      | $     | (0.56   | )     |      | $    | 1.13   |      |   | $     | (1.21   | )     |   | $     | (1.61   | )    
|                                                                                | Cumulative effect of change in accounting
    principle, net of tax                    |                          |       |        |       |      |       |        |       |      |      | (0.18  | )    |   |       |        |       |   |       |        |      
|Net income (loss) per share                                                     |                                                                                        | $                        | (0.54 | )       |       | $    | (0.56 | )       |       | $    | 0.95 |        |      | $ | (1.21 | )       |       | $ | (1.61 | )      
|Diluted Earnings Per
    Share                                                 |                                                                                        |                          |       |         |       |      |       |         |       |      |      |        |      |   |       |         |       |   |       |        
|                                                                                | Income (loss) per share before cumulative
    effect of change in accounting principle |                          | $     | (0.54   | )     |      | $     | (0.56   | )     |      | $    | 1.07   |      |   | $     | (1.21   | )     |   | $     | (1.61   | )    
|                                                                                | Cumulative effect of change in accounting
    principle, net of tax                    |                          |       |        |       |      |       |        |       |      |      | (0.17  | )    |   |       |        |       |   |       |        |      
|Net income (loss) per share                                                     |                                                                                        | $                        | (0.54 | )       |       | $    | (0.56 | )       |       | $    | 0.90 |        |      | $ | (1.21 | )       |       | $ | (1.61 | )      
|                                                                                | Shares used to calculate basic net earnings
    (loss) per share                       |                          |       | 30,757  |       |      |       | 29,861  |       |      |      | 28,447 |      |   |       | 22,619  |       |   |       | 16,533  |      
|                                                                                | Shares used to calculate diluted net earnings
    (loss) per share                     |                          |       | 30,757  |       |      |       | 29,861  |       |      |      | 30,086 |      |   |       | 22,619  |       |   |       | 16,533  |      
|Pro forma amounts assuming the accounting
    change was applied retroactively: |                                                                                        |                          |       |         |       |      |       |         |       |      |      |        |      |   |       |         |       |   |       |        
|                                                                                | Net income (loss)                                                                      |                          | $     | (16,590 | )     |      | $     | (16,742 | )     |      | $    | 32,188 |      |   | $     | (30,968 | )     |   | $     | (28,102 | )    
|                                                                                | Earnings per share                                                                     |                          |       |         |       |      |       |         |       |      |      |        |      |   |       |         |       |   |       |         |      
|                                                                                |                                                                                        | Basic                    |       | $       | (0.54 | )    |       | $       | (0.56 | )    |      | $      | 1.13 |   |       | $       | (1.37 | ) |       | $       | (1.70 | )
|                                                                                |                                                                                        | Diluted                  |       | $       | (0.54 | )    |       | $       | (0.56 | )    |      | $      | 1.07 |   |       | $       | (1.37 | ) |       | $       | (1.70 | )
|                                                                               
|Balance Sheet Data:                                                             |                                                                                        |                          |       |         |       |      |       |         |       |      |      |        |      |   |       |         |       |   |       |        
|                                                                                | Cash, cash equivalents short-term investments and
    restricted cash                  |                          | $     | 33,788  |       |      | $     | 48,476  |       |      | $    | 80,184 |      |   | $     | 26,299  |       |   | $     | 23,020  |      
|                                                                                | Working capital                                                                        |                          |       | 25,185  |       |      |       | 44,026  |       |      |      | 71,030 |      |   |       | 13,401  |       |   |       | 12,464  |      
|                                                                                | Total assets                                                                           |                          |       | 59,553  |       |      |       | 72,327  |       |      |      | 85,713 |      |   |       | 30,410  |       |   |       | 31,394  |      
|                                                                                | Total stockholders equity                                                             |                          |       | 44,743  |       |      |       | 61,354  |       |      |      | 72,606 |      |   |       | 14,288  |       |   |       | 12,452  |      
|                                                                               



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | 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 upon the
    initiation of the Phase III trial for Velac.                                                                                                                                                            
|   
|(2) | In the second quarter of 2001 we recorded a
    $6.0 million charge representing estimated costs accrued in
    connection with the reduction in workforce and the wind down of
    relaxin development contracts. In the fourth quarter of 2001 we
    reversed $4.9 million of this charge due to the settlement
    of potential amounts owed. In the second quarter of 2002 we
    recorded an additional charge of $312,000, representing the
    final payment due under an agreement with Boehringer
    Ingelheim.
|   
|(3) | In the fourth quarter of 2000, we recorded a
    $43.0 million gain on the sale of securities.                                                                                                                                                                                                                                                                                                                                                                                                                            
|   
|(4) | In April 2001 we sold our rights to Ridaura
    including inventory to Prometheus Laboratories, Inc. for
    $9.0 million in cash plus a royalty on annual sales in
    excess of $4.0 million for the next five years. We
    recognized a gain of $8.0 million in connection with the
    sale of Ridaura.                                                                                                                                                                                                              
|   
|(5) | 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.                                                                                                                                                                                                                             

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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.

OVERVIEW

Our commercial business is focused on the
dermatology marketplace, which is characterized by a large
patient population that is served by relatively small, and
therefore more accessible, groups of treating physicians. We
currently market two pharmaceutical products, 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. In December 2002, we received approval from the
FDA to sell OLUX for the treatment of non-scalp psoriasis.

In addition to revenue from product sales, we
receive royalties on sales of RID and Actimmune in the U.S., and
internationally on sales of Banlice, Milice, Bettamousse, and on
a super-concentrated aerosol spray licensed worldwide. We are
also entitled to receive royalties on future sales of Ridaura.
We have licenses with Novartis and with Pharmacia, which have
the potential to bear royalties in the future depending on
approval of their products for sale.

In April 2001, we completed the acquisition of
Connetics Australia for approximately $16.9 million. We
accounted for this transaction using the purchase method and
allocated $1.1 million of the purchase price to in-process
research and development, based on an independent valuation, and
the balance to the tangible assets of Connetics Australia,
existing technology and goodwill. In April 2001 we sold our
rights to Ridaura, including inventory, to Prometheus for
$9.0 million in cash plus a royalty on annual sales in
excess of $4.0 million for five years, resulting in a gain
of $8.0 million in 2001.

In addition to our commercial business, we own
the rights to a recombinant form of a natural hormone called
relaxin. On May 23, 2001, we announced our decision to
reduce our investment in the development of relaxin and to
search for licensing opportunities or other strategic
alternatives for the product. We eliminated 27 employee
positions related to relaxin. In 2001, we recorded a
$1.1 million charge representing estimated costs accrued in
connection with the reduction in workforce and the wind down of
relaxin development contracts. In the second quarter of 2002, we
recorded an additional charge of $312,000 representing the final
payment due under the agreement with Boehringer Ingelheim.

CRITICAL ACCOUNTING POLICIES

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

Revenue Recognition.We record contract revenue for
research and development as it is earned based on the
performance requirements of the contract. We recognize 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. Commencing
January 1, 2000, we recognize revenue from non-refundable
upfront license fees ratably over the period in which we have
continuing development obligations when, at the time the
agreement is executed, there remains significant risk due to the
incomplete state of the products development. Revenue
associated with substantial at risk performance
milestones, as defined in the respective agreements, is
recognized based upon the achievement of the milestones. We
recognize revenue under R&D cost reimbursement contracts as
the related costs are incurred.

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Returns, Rebates and Chargebacks Reserves.We recognize product revenue net of
allowances for estimated returns, rebates and chargebacks. We
are obligated to accept from customers the return of
pharmaceuticals that have reached their expiration date. As part
of our revenue recognition policy, we estimate future product
returns, rebates and chargeback payments. These estimates
determine our revenue reserves. We make these estimates based
primarily on our past return, rebate and chargeback experience.
We also consider the volume and price mix of products in the
retail channel, trends in distributor inventory, economic trends
that might impact patient demand for our products (including
competitive environment), the economic value of the rebates
being offered and other factors. In the past, actual returns,
rebates and chargebacks have not generally exceeded our
reserves. However, actual returns, rebates and chargebacks in
the future period are inherently uncertain. Any changes in our
Medicaid liability, any increase in returns, as well as
increased usage of our products through managed care programs,
will affect the amount of rebates that we owe. If we changed our
assumptions and estimates, our revenue reserves would change,
which would impact the net revenue we report. In addition, if
actual returns, rebates and chargebacks are significantly
greater than the reserves we have established, the actual
results would decrease our reported revenue. Conversely, if
actual returns, rebates and chargebacks are significantly less
than our reserves, this would increase our reported revenue.

Goodwill, Purchased Intangibles and Other
Long-Lived Assets Impairment Assessments.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 2 in our Notes to Consolidated
Financial Statements.

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RESULTS OF OPERATIONS

Revenues

|                               |                            |                                              |   |        |        |      |   |        |        |  |   |        |        | 
|------------------------------ | -------------------------- | -------------------------------------------- | - | ------ | ------ | ---- | - | ------ | ------ |  | - | ------ | ------ | 
|                              
|                              
|                               |                            |                                             
|                               |                            | Years Ended December 31,                    
|                               |                            |                                             
|(In thousands)                 |                            | 2002                                         |   | 2001   |        | 2000
|                              
|                              
|Product:                       |                            |                                              |   |        |        |      |   |        |        |  |   |       
|                               | OLUX                       |                                              | $ | 32,339 |        |      | $ | 14,996 |        |  | $ | 1,211  |       
|                               | Luxíq                      |                                              |   | 15,042 |        |      |   | 13,848 |        |  |   | 10,973 |       
|                               | Ridaura                    |                                              |   |       |        |      |   | 2,015  |        |  |   | 6,013  |       
|                               | Other                      |                                              |   | 192    |        |      |   | 64     |        |  |   | 1,898  |       
|                              
|                               |                            | Total product revenues                       |   |        | 47,573 |      |   |        | 30,923 |  |   |        | 20,095 | 
|License, contract and royalty: |                            |                                              |   |        |        |      |   |        |        |  |   |       
|                               | Royalty                    |                                              |   | 2,926  |        |      |   | 1,097  |        |  |   |       |       
|                               | Pharmacia                  |                                              |   | 1,006  |        |      |   |       |        |  |   |       |       
|                               | Novartis                   |                                              |   | 580    |        |      |   |       |        |  |   |       |       
|                               | InterMune                  |                                              |   | 350    |        |      |   | 771    |        |  |   | 6,768  |       
|                               | Celltech (formerly Medeva) |                                              |   | 60     |        |      |   | 756    |        |  |   | 11,500 |       
|                               | Other contracts            |                                              |   | 268    |        |      |   | 517    |        |  |   | 2,411  |       
|                              
|                               |                            | Total license, contract and royalty revenues |   |        | 5,190  |      |   |        | 3,141  |  |   |        | 20,679 | 
|                              
|                               |                            | Total revenues                               |   | $      | 52,763 |      |   | $      | 34,064 |  |   | $      | 40,774 | 
|                              

Our product revenues were $47.6 million in
2002 compared to $30.9 million in 2001 and
$20.1 million in 2000. We recognize product revenue net of
allowances for estimated returns, rebates and chargebacks. The
increase in total product revenue in 2002 was due to continued
sales growth of OLUX and Luxíq. This increase was the
result of volume and price increases, partially offset by
increases in our revenue allowances. The increase in total
product revenue in 2001 over 2000 was due to sales growth of
Luxíq, and to our first full year of sales of OLUX, which
we launched in November 2000. We also recognized product revenue
on sales of Ridaura until the April 2001 sale of that product
line to Prometheus. Effective April 1, 2000, in connection
with our agreement with InterMune, we sold our remaining
Actimmune product rights. When we acquired Connetics Australia
in April 2001, we began to recognize product revenue on some
over-the-counter products they sell and royalty revenue in
association with royalty bearing contracts to which Connetics
Australia is a party.

License, contract, royalty and other revenues
were $5.2 million in 2002 compared to $3.1 million in
2001 and $20.7 million in 2000. The increase in royalty
revenue from 2001 to 2002 was primarily related to increased
sales of an aerosol spray product that we have licensed to a
third party. 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 Pharmacia
Corporation and an expanded license agreement with Novartis.

The agreement with Pharmacia granted Pharmacia
exclusive global rights, excluding Japan, to our proprietary
foam drug-delivery technology for use in Pharmacias
Rogaine hair loss treatment. We recognized $1.0 million
under the Pharmacia 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
the quarter ended March 31, 2002.

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The decrease in license revenue in 2001 from 2000
was in part due to our decision in May 2001 to reduce our
investment in the development of relaxin. Through the end of
2002, we had not entered into any new licensing opportunities or
other strategic alternatives for relaxin. Effective
April 1, 2000 we assigned to InterMune our remaining rights
and obligations under a license with Genentech for Actimmune and
the corresponding supply agreement. In exchange, InterMune paid
us approximately $5.2 million in 2000. InterMune paid an
additional $942,000 by the end of March 2001, which was offset
by related product rebates and chargebacks of $171,000. 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 an up-front, non-refundable
payment of $350,000. We recognized the full amount of this
revenue in 2002.

We anticipate that product revenue will increase
in 2003 due to continued sales growth of OLUX and Luxíq. We
also anticipate that license and contract revenue will decrease,
as several revenue streams from 2002 will not recur in 2003,
while royalty revenue is expected to remain about the same in
2003. Beyond 2003, 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

Our cost of product revenues includes the third
party costs of manufacturing OLUX, Luxíq, Ridaura (until
April 2001), and Actimmune (until April 2000), royalty payments
based on a percentage of our product revenues and product
freight and distribution costs from SPS, the third party that
handles all of our product distribution activities. We recorded
cost of product revenues of $4.2 million in 2002 compared
to $3.1 million in 2001 and $3.9 million in 2000. The
increase in total cost of product revenues in 2002 was the
result of an increase in sales volumes. On a percentage 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. The decrease in cost of product revenues
from 2001 to 2002 on a percentage basis was primarily due to the
elimination of intercompany royalties, partially offset by an
increase in the cost per unit of our products. The decrease in
cost of product revenues from 2000 to 2001 was primarily due to
the elimination of intercompany royalties, as well as a change
in product mix as a result of discontinuing sales of Ridaura,
which had higher manufacturing costs than our other products. We
sold the rights to Ridaura to Prometheus in April 2001. We
anticipate a slight increase in the cost of product revenues in
2003, on a per unit basis as we shift the production of our
products to domestic suppliers.

Research and Development

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. Research and development expenses increased in 2002
to $25.8 million, compared to $19.2 million in 2001
and $21.9 million in 2000.

In 2002, our research and development expenses
primarily consisted of:



| |   |                                                                                                                       
| | - | ----------------------------------------------------------------------------------------------------------------------
| |  | $7.4 million on preclinical and clinical
    research in the development of new dermatology products,                 
|
| |  | $5.1 million on quality assurance and
    quality control in the enhancement of existing dermatology
    products,    
|
| |  | $3.9 million on the optimization of
    manufacturing and process development for existing dermatology
    products,  
|
| |  | $2.7 million on manufacturing, process
    development and optimization of dermatology products under
    development,

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| |   |                                                                                                          
| | - | ---------------------------------------------------------------------------------------------------------
| |  | $1.9 million on quality assurance and
    quality control in the development of new dermatology products,
|
| |  | $1.3 million on basic research and
    formulation of new dermatology products, and                      
|
| |  | $1.1 million on the regulatory review of new
    and existing dermatology products.                      

In 2001, our research and development expenses
primarily consisted of:



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

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



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

We are currently 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 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 current research and clinical
development programs. The actual timing of completion of those
phases 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

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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.


|                                                                                                                                               |  |                      |  |                         |           |              |  |   |             | 
|---------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------- |  | ----------------------- | --------- | ------------ |  | - | ----------- | 
|                                                                                                                                              
|                                                                                                                                              
|                                                                                                                                               |  | Research and        
|                                                                                                                                               |  | Estimated            |  | Development Expenses   
|Description/Indication                                                                                                                         |  | Phase of Development |  | Completion of Phase III |           | through 2002
|                                                                                                                                              
|                                                                                                                                              
|Extina. Foam formulation of ketoconazole for the
    treatment of seborrheic dermatitis                                                        |  | Phase III            |  |                         | mid-2003  |              |  | $ | 6.7 million | 
|Actiza. Foam formulation of clindamycin for the
    treatment of acne                                                                          |  | Phase III            |  |                         | late 2003 |              |  | $ | 4.6 million | 
|Velac. Gel formulation of clindamycin and
    tretinoin for the treatment of acne (excluding license and
    milestone payments to Yamanouchi) |  | Phase III            |  |                         | mid-2004  |              |  | $ | 2.5 million | 
|Pre-clinical research and development for
    multiple dermatological indications                                                              |  | Pre-clinical         |  |                         | N/A       |              |  | $ | 0.5 million | 
|                                                                                                                                              

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

Selling, General and Administrative
Expenses

Selling, general and administrative expenses were
$37.6 million in 2002, $36.1 million in 2001, and
$26.7 million in 2000. The increase in 2002 over 2001 was
primarily due to:



| |   |                                                                                                                                                                                                                                  
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | $1.3 million increase compared to 2001
    related to the introduction of product samples,                                                                                                                                       
|
| |  | $2.7 million increase compared to 2001 in
    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, and                         
|
| |  | an increase compared to 2001 in depreciation
    expenses related to equipment purchased to support increased
    headcount, as well as a full year of depreciation related to
    equipment supporting the expanded sales force,

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| |   |                                                                                                                
| | - | ---------------------------------------------------------------------------------------------------------------
| |  | partially offset by $2.6 million in non-cash
    stock compensation expense in 2001 that did not recur in 2002.

The increase in 2001 over 2000 was primarily due
to:



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

We expect selling, general and administrative
expenses to remain consistent or be slightly higher in 2003 due
to the commencement of marketing efforts relating to the
anticipated outcome of clinical trials for antifungal foam and
anti-acne foam.

Acquired In-Process Research and
Development

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
during the quarter ended June 30, 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 completed the acquisition of
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
an independent 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 by an independent valuation expert 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 the second quarter of 2001 we recorded a
$6.0 million charge representing estimated costs accrued in
connection with the reduction in workforce and the wind down of
relaxin development contracts. In the fourth quarter of 2001 we
reversed $4.9 million of this charge due to the settlement
of potential amounts owed. In the second quarter of 2002 we
recorded an additional charge of $312,000, representing the
final payment due under an agreement with Boehringer Ingelheim.
For additional information, see Note 10 in our Notes to
Consolidated Financial Statements for a discussion of the
relationship with Boehringer Ingelheim.

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Interest and other income (expense),
net

Interest income was $823,000 for 2002, compared
to $2.5 million for 2001 and $2.1 million for 2000.
The decrease in interest income in 2002 from 2001 was the result
of lower cash and investment balances, combined with a decrease
in market interest rates on investments. The increase in
interest income in 2001 over 2000 arose from the high cash and
investment balance which arose from the sale of InterMune shares
in December 2000.

Interest expense was $11,000 in 2002, compared to
$46,000 in 2001 and $235,000 in 2000. Interest expense in 2002
was primarily related to a financing arrangement associated with
our corporate insurance policies. There were no capital leases
outstanding during 2002. The decrease in interest expense in
2001 over 2000 resulted from lower interest expense associated
with lower balances outstanding for obligations under capital
leases, and long term debt.

Other income (expense) was a net income of
$227,000 in 2002 compared to a net expense of $519,000 in 2001
and zero in 2000. The net other income in 2002 was directly
related to the rents received from two sublease arrangements.
The net other expense in 2001 was primarily due to a $555,000
net loss on a foreign exchange forward contract partially offset
by rents received from a sublease arrangement. The contract was
entered into in relation to a business combination and does not
qualify as a hedge under SFAS 133. The purpose of the
contract was to lock in the purchase price paid for Connetics
Australia. The foreign exchange forward contract was terminated
on the closing date of the acquisition of Connetics Australia.

Income Taxes

Income tax expense was $181,000 in 2002 compared
to $345,000 in 2001 and $1.0 million in 2000. Income tax
expense for 2002 reflects $798,000 of foreign tax provision
recorded by Connetics Australia, substantially offset by 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. The income tax
provision for 2000 consisted of alternative minimum tax paid as
a result of a $43.0 million gain from the sale of
securities. For a more complete description of our income tax
position, refer to Note 13 in our Notes to Consolidated
Financial Statements.

Change in Accounting
Principle

Effective January 1, 2000, we changed our
method of accounting for nonrefundable up-front license fees to
recognize such fees over the expected research and development
period. The $5.2 million cumulative effect of the change in
accounting principle, calculated as of January 1, 2000, was
reported as a charge in the year ended December 31, 2000.
The cumulative effect was initially recorded as deferred revenue
and is being recognized as revenue over the research and
development period of the agreements. During the year ended
December 31, 2000, the impact of this change in accounting
method (excluding the cumulative effect itself) increased net
income by $4.4 million or $0.15 per share. This increase
consists of $4.9 million revenue deferred in the cumulative
effect that was recognized as income in 2000 under the new
accounting method, offset by the impact of deferring upfront
fees received in 2000. During 2000, approximately
$4.1 million of revenue deferred as a component of the
cumulative effect charge was fully recognized in the fourth
quarter when two of our collaboration partners terminated their
agreements with us as a result of the failure of relaxin to meet
the primary endpoint in a Phase III trial, and we were
released from further obligations. Revenue for both 2002 and
2001 includes $132,000 of revenue previously recognized and
included in the cumulative effect adjustment. The unamortized
balance of deferred revenue at December 31, 2002, of
approximately $527,000 is expected to be recognized as revenue
of approximately $132,000 per year during the years ending 2003
through 2006. The pro formaamounts presented in the
statement of operations were calculated assuming the accounting
change had been in effect for prior periods, and was made
retroactive to prior periods.

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LIQUIDITY AND CAPITAL RESOURCES

Sources and Use of
Cash.We have financed our operations
to date primarily through proceeds from equity financings, sale
of investments, collaborative arrangements with corporate
partners, bank loans, and product revenues. At December 31,
2002, cash, cash equivalents and short-term investments totaled
$33.1 million, compared to $46.3 million at
December 31, 2001 and $79.9 million at
December 31, 2000. Accounts receivable, net, totaled
$4.3 million at December 31, 2002, compared to
$5.4 million at December 31, 2001. Our cash balances
are held in a variety of interest-bearing instruments including
high-grade corporate bonds, commercial paper and money market
accounts.

Cash Flows from Operating
Activities.Cash used in operations
was $12.5 million for 2002 compared to $24.6 million
for 2001 and $15.3 million in 2000. Net loss of
$16.6 million for 2002 was affected by non-cash charges of
$2.1 million of depreciation and amortization expense and a
$2.1 million gain on the sale of investments. Cash usage
was partially offset by a decrease in accounts receivable of
approximately $1.1 million related to timing of sales and
collection of outstanding amounts, and an increase in accounts
payable of approximately $4.1 million related to increased
development costs.

Net loss of $16.7 million for 2001 was
affected by 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. The primary reason for the decrease in operating cash
flows in 2001 was that we had a $122,000 gain on the sale of
InterMune stock in 2001 compared to a $43.0 million gain in
2000 and an unfavorable change in working capital accounts in
2001 of approximately $5.9 million.

Net income of $27.0 million for 2000 was
affected by the gain on sale of InterMune stock of
$43.0 million, partially offset by non-cash charges of
$764,000 of depreciation and amortization expense and
$1.0 million non-cash compensation expense.

Cash Flows from Investing Activities.Investing activities provided
$10.9 million in cash during 2002 compared to cash used in
investing activities of $29.9 million in cash during 2001
and $44.2 million provided by investing activities in 2000.
The principal source of cash from investing activities in 2002
was net sales of short-term investments, which was partially
offset by the use of cash to construct an aerosol filling line
at DPTs plant in Texas. The principal uses of cash for
investing activities in 2001 were net purchases of short-term
investments 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 $6.5 million in cash during 2002 compared to cash
used in financing activities of $200,000 in 2001 and to cash
provided by financing activities of $21.0 million in 2000.
The principal sources of cash from financing activities in 2002
were proceeds from the sale of common stock of $5.1 million
pursuant to the exercise of warrants and stock options and the
$1.4 million reduction of restricted cash in connection
with the requirements of an operating lease arrangement and
collateral on various officer loans.

Working Capital.Working capital decreased to
$25.2 million at December 31, 2002 from
$44.0 million at December 31, 2001. Our working
capital primarily decreased as we used cash in operations and
for the purchase of acquired in-process research and
development. Working capital decreased to $44.0 million at
December 31, 2001 from $71.0 million at
December 31, 2000. Our working capital primarily decreased
as we used cash in operations and acquired Connetics Australia.
The decrease was partially offset by the sale of the Ridaura
product line.

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Contractual Obligations and Commercial
Commitments.As of December 31,
2002, we had the following contractual obligations and
commitments:

|                                   |  |                        |              |         |  |             |             |             |  |          |             |  |  |   |             |  |  |   |             | 
|---------------------------------- |  | ---------------------- | ------------ | ------- |  | ----------- | ----------- | ----------- |  | -------- | ----------- |  |  | - | ----------- |  |  | - | ----------- | 
|                                  
|                                  
|                                   |  |                       
|                                   |  | Payments Due by Period
|                                   |  |                       
|                                   |  |                       
|Contractual Obligations            |  | Total                  |              | <1 year |  | 1  3 years |             | 4  5 years |  | >5 years
|                                  
|                                  
|Operating Leases (1)               |  | $                      | 5.5 million  |         |  | $           | 2.4 million |             |  | $        | 2.7 million |  |  | $ | 0.1 million |  |  | $ | 0.3 million | 
|Financing Arrangement (2)          |  | $                      | 0.1 million  |         |  | $           | 0.1 million |             |  | $        |            |  |  | $ |            |  |  | $ |            | 
|Contractual Commitments (3)        |  | $                      | 8.4 million  |         |  | $           | 0.2 million |             |  | $        | 1.2 million |  |  | $ | 1.7 million |  |  | $ | 5.3 million | 
|Total Contractual Cash Obligations |  | $                      | 14.0 million |         |  | $           | 2.7 million |             |  | $        | 3.9 million |  |  | $ | 1.8 million |  |  | $ | 5.6 million | 
|                                  



| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | We lease laboratory and office facilities under
    noncancelable operating leases, which expire through 2005. In
    March 2002 we entered into an agreement with DPT to construct an
    aerosol filling line at DPTs plant in Texas. Under the
    agreement we are obligated to pay approximately $56,000 per year
    in rent, for an indefinite period of time, for the pro rata
    portion of DPTs facility allocated to the aerosol line. We
    also lease various automobiles and office equipment under
    similar leases, expiring through 2006. These obligations are to
    be partially offset by $458,000 to be received from subleasing
    arrangements with third parties.
|
| | (2) | In 2002 we entered into short term financing
    arrangements related to our corporate insurance policies. All
    remaining amounts related to these financing arrangements will
    be paid in 2003 and have been included in Other Accrued
    Liabilities on the Consolidated Balance Sheet.                                                                                                                                                                                                                                                                                                                                                                                                 
|
| | (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.                                                                                                                                                                                                                                                                                                

As of December 31, 2002, we had no
off-balance sheet financing arrangements or commitments other
than those disclosed in the table above.

Restricted Cash and Cash Equivalents.As of December 31, 2002, $724,000
of our total cash and cash equivalents balance was restricted
cash, held in various certificates of deposit, for specific
purposes: $111,000 relates to collateral on a personal bank loan
to one of our officers, and $613,000 relates to a deposit
required in connection with a noncancelable operating lease.

We believe our existing cash, cash equivalents
and short-term investments, cash generated from product sales
and collaborative arrangements with corporate partners, will be
sufficient to fund our operating expenses, debt obligations and
capital requirements through at least the next 12 months.
Future revenues from sales are uncertain as we are subject to
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. Our future capital uses and
requirements will depend on numerous factors, including the
progress of our research and development programs, the progress
of clinical testing, the time and costs involved in obtaining
regulatory approvals, the cost of filing, prosecuting, and
enforcing patent claims and other intellectual property rights,
competing technological and market developments, the level of
product revenues, and the possible acquisition of new products
and technologies. A key element of our strategy is to in-license
or acquire additional marketed or late-stage development
products. A portion of the funds needed to acquire, develop and
market any new products may come from our existing cash, which
will result in fewer resources available to our current products
and clinical programs. We are currently evaluating a number of
business development opportunities, including the possibility of
acquiring or in-licensing other products. If we successfully
reach agreements with third parties, these transactions may
require us to use some of our available cash, or to raise
additional cash by

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liquidating some of our investment portfolio
and/or raising additional funds through equity or debt
financings in connection with the transaction.


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

RECENT ACCOUNTING PRONOUNCEMENTS

SFAS 146.In
July 2002, the FASB issued Statement of Financial Accounting
Standards No. 146, Accounting for Costs Associated
with Exit and Disposal Activities (SFAS 146). This
statement revises the accounting for exit and disposal
activities under Emerging Issues Task Force Issue No. 94-3,
Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity.
Specifically, SFAS 146 requires that companies record the
costs to exit an activity or dispose of long-lived assets when
those costs are incurred. SFAS 146 requires that the
measurement of the liability be at fair value. The provisions of
SFAS 146 are effective prospectively for exit or disposal
activities initiated after December 31, 2002. Upon the
adoption of SFAS 146, previously issued financial
statements shall not be restated. We will assess the impact of
adoption of SFAS 146 based on the nature of transactions
ongoing at the adoption date.

SFAS 148.In
December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure. This
statement amends SFAS No. 123, Accounting for
Stock-Based Compensation, to provide alternative methods
of transition for an entity that changes to the fair value
method of accounting for stock-based employee compensation. In
addition, SFAS 148 amends the disclosure provisions of
SFAS 123 and Accounting Principles Board (APB) Opinion
No. 28, Interim Financial Reporting to require
expanded and more prominent disclosure of the effects of an
entitys accounting policy with respect to stock-based
employee compensation. The provisions of SFAS 148 are
effective for fiscal years ending after December 15, 2002.
SFAS 148 does not amend SFAS 123 to require companies
to account for employee stock options using the fair value
method. However, the disclosure provisions of SFAS 148 are
applicable to all companies with stock-based employee
compensation, regardless of whether they account for the
compensation using the fair value method of SFAS 123 or the
intrinsic value method of APB Opinion No. 25,
Accounting for Stock Issued to Employees
(APB 25). We use the intrinsic value method of accounting
for stock-based awards granted to employees, as allowed under
APB 25 and related interpretations. We adopted the
disclosure provisions of SFAS 148 on December 31,
2002. See Stock-Based Compensation in Note 2
of our Notes to Consolidated Financial Statements for
disclosures required by SFAS 148.

FIN 45.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 45). FIN 45 requires that upon
issuance of a guarantee, the guarantor must recognize a
liability for the fair value of the obligation it assumes under
that guarantee. FIN 45 is effective on a prospective basis
to guarantees issued or modified after December 31, 2002.
The disclosure requirements of FIN 45 are effective for
financial statements of interim or annual periods ending after
December 15, 2002. Our adoption of FIN 45 did not have
a material effect on our financial position or results of
operations.

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 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 June 15, 2003. 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.

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##### Table of Contents



OUR BUSINESS STRATEGY MAY CAUSE FLUCTUATING
OPERATING RESULTS

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



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




Item 7A. Quantitative and
Qualitative Disclosures About Market Risk

Interest Rate
Risk.Our holdings of financial
instruments comprise a mix of securities that may include
U.S. corporate debt, U.S. government debt, and
commercial paper. All such instruments are classified as
securities available for sale. The average time to maturity of
our investments is 87 days. 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. The table below presents the principal amounts and
weighted average interest rates by year of maturity for our
investment portfolio as of December 31, 2002 (in
thousands):

|                                      |  |      |        |      |  |       |   |            |  |   |        |  |  |   |        | 
|------------------------------------- |  | ---- | ------ | ---- |  | ----- | - | ---------- |  | - | ------ |  |  | - | ------ | 
|                                     
|                                     
|                                      |  | 2003 |        | 2004 |  | Total |   | Fair Value
|                                     
|                                     
|Available-for-sale securities         |  | $    | 22,700 |      |  |       |  |            |  | $ | 22,700 |  |  | $ | 23,155 | 
|Weighted average annual interest rate |  |      | 3.96%  |      |  |       |  |            |  |   |        |  |  |   |        | 
|                                     

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. Interest income from our investments is
sensitive to changes in the general level of U.S. interest
rates, particularly since the majority of our investments are in
short-term instruments. Due to the nature of our short-term
investments, we have concluded that we face minimal material
market risk exposure.




Item 8. Financial Statements and
Supplementary Data

Our consolidated financial statements and related
financial information are filed as a separate section to this
Report. Please refer to Item 15(a) for an Index to
Consolidated Financial Statements.




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

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

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##### Table of Contents






PART III




Item 10. Our Directors and
Executive Officers

Information regarding our Board of Directors is
incorporated by reference to the sections entitled
Election of Directors, Stock Ownership,
Corporate Governance, and Report of the Audit
Committee in our Proxy Statement (2003 Proxy
Statement) to be filed with the Securities and Exchange
Commission relating to our annual meeting of stockholders to be
held May 14, 2003. 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 2003 Proxy
Statement.




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 2003 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 captions Stock
Ownership and Executive Compensation and Related
Information in our 2003 Proxy Statement.




Item 13. Certain Relationships
and Related Transactions

Information regarding certain relationships and
related transactions is incorporated by reference to the
information set forth under the caption Certain
Relationships and Related Transactions in our
2003 Proxy Statement.




Item 14. Controls and
Procedures

Our management, under the supervision and with
the participation of our Chief Executive Officer and Chief
Financial Officer, performed an evaluation of the effectiveness
of the design and operation of Connetics disclosure
controls and procedures. This evaluation was performed within
90 days before the filing date of this quarterly report.
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, the CEO and CFO concluded that the
companys disclosure controls and procedures were effective
in timely alerting them to material information required to be
included in our periodic SEC reports. There have been no
significant changes in Connetics internal controls or in
other factors that could significantly affect internal controls
since their evaluation.

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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:

|                                                                                                                          |  |      |     | 
|------------------------------------------------------------------------------------------------------------------------- |  | ---- | --- | 
|                                                                                                                         
|                                                                                                                         
|                                                                                                                          |  | Page
|                                                                                                                         
|                                                                                                                         
|Report of Ernst & Young LLP, Independent
    Auditors                                                                     |  |      | F-2 | 
|Consolidated Balance Sheets as of
    December 31, 2002 and 2001                                                          |  |      | F-3 | 
|Consolidated Statements of Operations for each of
    the three years in the period ended December 31, 2002               |  |      | F-4 | 
|Consolidated Statements of Stockholders
    Equity for each of the three years in the period ended
    December 31, 2002 |  |      | F-5 | 
|Consolidated Statements of Cash Flows for each of
    the three years in the period ended December 31, 2002               |  |      | F-6 | 
|Notes to Consolidated Financial Statements                                                                                |  |      | F-7 | 
|                                                                                                                         

2.       Financial
Statement Schedules

The following additional consolidated financial
statement schedule should be considered in conjunction with our
consolidated financial statements. 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.

Schedule II 
Valuation and Qualifying Accounts

|                           |      |            |   |                  |  |              |   |            |  |  |   |            |   |  |   |           | 
|-------------------------- | ---- | ---------- | - | ---------------- |  | ------------ | - | ---------- |  |  | - | ---------- | - |  | - | --------- | 
|                          
|                          
|                           |      | Additions  |   |                 
|Allowance for doubtful     |      | Balance at |   | Charged to       |  |              |   | Balance at
|accounts, returns, rebates |      | start of   |   | Expense/Revenue  |  |              |   | end       
|and chargebacks            |      | period     |   | net of reversals |  | Utilizations |   | of period 
|                          
|                          
|Year ended December 31,    |      |            |   |                  |  |              |   |            |  |  |   |            |   |  |   |          
|                           | 2002 |            | $ | 1,252,628        |  |              | $ | 4,397,606  |  |  | $ | (3,491,166 | ) |  | $ | 2,159,068 | 
|                           | 2001 |            | $ | 1,372,448        |  |              | $ | 2,060,732  |  |  | $ | (2,180,552 | ) |  | $ | 1,252,628 | 
|                           | 2000 |            | $ | 776,835          |  |              | $ | 1,372,226  |  |  | $ | (776,613   | ) |  | $ | 1,372,448 | 
|                          

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



|    |                                                                                                                               
|--- | ------------------------------------------------------------------------------------------------------------------------------
|(b) | Reports on
    Form 8-K.We filed the following
    Current Reports on Form 8-K during the quarter ended
    December 31, 2002:



| |       |                                                                                                                                                                                                                        
| | ----- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (i)   | We filed a Current Report on Form 8-K dated
    December 23, 2002, with the Securities and Exchange
    Commission on December 23, 2002, under Item 5, Other
    Events, and Item 7, Financial Statements and Exhibits.
|
| | (ii)  | We filed a Current Report on Form 8-K dated
    November 30, 2002, with the Securities and Exchange
    Commission on December 2, 2002, under Item 5, Other
    Events.                                                
|
| | (iii) | We filed a Current Report on Form 8-K dated
    November 19, 2002, with the Securities and Exchange
    Commission on November 20, 2002, under Item 5, Other
    Events and Item 7, Financial Statements and Exhibits. 

42



---



##### Table of Contents





| |      |                                                                                                                                                                                                                     
| | ---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (iv) | We filed a Current Report on Form 8-K dated
    October 25, 2002, with the Securities and Exchange
    Commission on October 28, 2002, under Item 5, Other
    Events and Item 7, Financial Statements and Exhibits.

(c)       Exhibits.See Index to Exhibits.

(d)       Financial
Statement Schedules.See
Item 15(a)(2), above.

43



---



##### Table of Contents



SIGNATURES

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



| |                       
| | ----------------------
| | Connetics Corporation 
| | a Delaware corporation



| |     |                                                                                       
| | --- | --------------------------------------------------------------------------------------
| | By: | /s/ JOHN L. HIGGINS 
     ______________________________________ 
     John L. Higgins

| |                                  
| | ---------------------------------
| | Chief Financial Officer          
| | Executive Vice President, Finance
| | and Corporate Development        

Date: March 31, 2003

44



---



##### Table of Contents






CERTIFICATION BY CHIEF EXECUTIVE OFFICER

I, Thomas G. Wiggans, certify that:



|   |                                                                                                                                                                                                                                                                                                                                             
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|1. | I have reviewed this annual report on
    Form 10-K/A of Connetics Corporation;                                                                                                                                                                                                                                                             
|  
|2. | Based on my knowledge, this annual report does
    not contain any untrue statement of a material fact or omit to
    state a material fact necessary to make the statements made, in
    light of the circumstances under which such statements were
    made, not misleading with respect to the period covered by this
    annual report;
|  
|3. | Based on my knowledge, the financial statements,
    and other financial information included in this annual report,
    fairly present in all material respects the financial condition,
    results of operations and cash flows of the registrant as of,
    and for, the periods presented in this annual report;                       
|  
|4. | The registrants other certifying officers
    and I are responsible for establishing and maintaining
    disclosure controls and procedures (as defined in Exchange Act
    Rules 13a-14 and 15d-14) for the registrant and have:                                                                                                          



| |    |                                                                                                                                                                                                                                                                                                             
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) | designed such disclosure controls and procedures
    to ensure that material information relating to the registrant,
    including its consolidated subsidiaries, is made known to us by
    others within those entities, particularly during the period in
    which this annual report is being prepared;
|
| | b) | evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) | presented in this annual report our conclusions
    about the effectiveness of the disclosure controls and
    procedures based on our evaluation as of the Evaluation Date;                                                                                                                                



|   |                                                                                                                                                                                                                                                                
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|5. | The registrants other certifying officers
    and I have disclosed, based on our most recent evaluation, to
    the registrants auditors and the audit committee of
    registrants board of directors (or persons performing the
    equivalent functions):



| |    |                                                                                                                                                                                                                                                                                                                   
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) | all significant deficiencies in the design or
    operation of internal controls which could adversely affect the
    registrants ability to record, process, summarize and
    report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) | any fraud, whether or not material, that involves
    management or other employees who have a significant role in the
    registrants internal controls; and                                                                                                                                                    



|   |                                                                                                                                                                                                                                                                                                                                                                                                        
|-- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|6. | The registrants other certifying officers
    and I have indicated in this annual report whether there were
    significant changes in internal controls or in other factors
    that could significantly affect internal controls subsequent to
    the date of our most recent evaluation, including any corrective
    actions with regard to significant deficiencies and material
    weaknesses.

Date: March 31, 2003



|                                      | 
|------------------------------------- | 
|/s/ THOMAS G. WIGGANS                 | 
|                                      | 
|                                     
|Thomas G. Wiggans                     | 
|President and Chief Executive Officer | 

45



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##### Table of Contents



CERTIFICATION BY CHIEF FINANCIAL OFFICER

I, John L. Higgins, certify that:

1.       I
have reviewed this annual report on Form 10-K/A of
Connetics Corporation;



|   |                                                                                                                                                                                                                                                                                                                                             
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|2. | Based on my knowledge, this annual report does
    not contain any untrue statement of a material fact or omit to
    state a material fact necessary to make the statements made, in
    light of the circumstances under which such statements were
    made, not misleading with respect to the period covered by this
    annual report;
|  
|3. | Based on my knowledge, the financial statements,
    and other financial information included in this annual report,
    fairly present in all material respects the financial condition,
    results of operations and cash flows of the registrant as of,
    and for, the periods presented in this annual report;                       
|  
|4. | The registrants other certifying officers
    and I are responsible for establishing and maintaining
    disclosure controls and procedures (as defined in Exchange Act
    Rules 13a-14 and 15d-14) for the registrant and have:                                                                                                          



| |    |                                                                                                                                                                                                                                                                                                             
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) | designed such disclosure controls and procedures
    to ensure that material information relating to the registrant,
    including its consolidated subsidiaries, is made known to us by
    others within those entities, particularly during the period in
    which this annual report is being prepared;
|
| | b) | evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) | presented in this annual report our conclusions
    about the effectiveness of the disclosure controls and
    procedures based on our evaluation as of the Evaluation Date;                                                                                                                                



|   |                                                                                                                                                                                                                                                                
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|5. | The registrants other certifying officers
    and I have disclosed, based on our most recent evaluation, to
    the registrants auditors and the audit committee of
    registrants board of directors (or persons performing the
    equivalent functions):



| |    |                                                                                                                                                                                                                                                                                                                   
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) | all significant deficiencies in the design or
    operation of internal controls which could adversely affect the
    registrants ability to record, process, summarize and
    report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) | any fraud, whether or not material, that involves
    management or other employees who have a significant role in the
    registrants internal controls; and                                                                                                                                                    



|   |                                                                                                                                                                                                                                                                                                                                                                                                        
|-- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|6. | The registrants other certifying officers
    and I have indicated in this annual report whether there were
    significant changes in internal controls or in other factors
    that could significantly affect internal controls subsequent to
    the date of our most recent evaluation, including any corrective
    actions with regard to significant deficiencies and material
    weaknesses.

Date: March 31, 2003



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

46



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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:

|                                                                                                                          |  |      |     | 
|------------------------------------------------------------------------------------------------------------------------- |  | ---- | --- | 
|                                                                                                                         
|                                                                                                                         
|                                                                                                                          |  | Page
|                                                                                                                         
|                                                                                                                         
|Report of Ernst & Young LLP, Independent
    Auditors                                                                     |  |      | F-2 | 
|Consolidated Balance Sheets as of
    December 31, 2002 and 2001                                                          |  |      | F-3 | 
|Consolidated Statements of Operations for each of
    the three years in the period ended December 31, 2002               |  |      | F-4 | 
|Consolidated Statements of Stockholders
    Equity for each of the three years in the period ended
    December 31, 2002 |  |      | F-5 | 
|Consolidated Statements of Cash Flows for each of
    the three years in the period ended December 31, 2002               |  |      | F-6 | 
|Notes to Consolidated Financial Statements                                                                                |  |      | F-7 | 
|                                                                                                                         

F-1



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##### Table of Contents






REPORT OF ERNST & YOUNG LLP, INDEPENDENT
AUDITORS

Board of Directors and Stockholders

Connetics Corporation


We have audited the accompanying consolidated
balance sheets of Connetics Corporation as of December 31,
2002 and 2001, and the related consolidated statements of
operations, stockholders equity, and cash flows for each
of the three years in the period ended December 31, 2002.
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, 2002 and 2001, and the consolidated results of
its operations and its cash flows for each of the three years in
the period ended December 31, 2002, in conformity with
accounting principles generally accepted in the United States.
Also, in our opinion, the related financial statement schedule,
when considered in relation to the basic financial statements
taken as a whole, presents fairly in all material respects the
information set forth therein.

As discussed in Note 2 to the consolidated
financial statements, in 2000 the Company changed its method of
accounting for nonrefundable license fee revenue.

/s/ ERNST & YOUNG LLP

Palo Alto, California

January 24, 2003


F-2



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##### Table of Contents



CONNETICS CORPORATION

CONSOLIDATED BALANCE SHEETS


(In thousands, except share and per share
amounts)


|                                           |                                                                                                                                                |                            |                           |          |        |        |        |          |        |        | 
|------------------------------------------ | ---------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | ------------------------- | -------- | ------ | ------ | ------ | -------- | ------ | ------ | 
|                                          
|                                          
|                                           |                                                                                                                                                |                           
|                                           |                                                                                                                                                | December 31,              
|                                           |                                                                                                                                                |                           
|                                           |                                                                                                                                                | 2002                       |                           | 2001    
|                                          
|                                          
|Assets                                     |                                                                                                                                                |                            |                           |          |        |        |        |         
|Current assets:                            |                                                                                                                                                |                            |                           |          |        |        |        |         
|                                           | Cash and cash equivalents                                                                                                                      |                            | $                         | 8,624    |        |        | $      | 3,603    |       
|                                           | Short-term investments                                                                                                                         |                            |                           | 24,440   |        |        |        | 42,734   |       
|                                           | Accounts receivable, net of allowances of $2,042
    in 2002 and $975 in 2001                                                                  |                            |                           | 4,308    |        |        |        | 5,392    |       
|                                           | Restricted cash                                                                                                                                |                            |                           | 424      |        |        |        | 1,539    |       
|                                           | Prepaid and other current assets                                                                                                               |                            |                           | 1,803    |        |        |        | 1,204    |       
|                                          
|                                           |                                                                                                                                                |                            | Total current assets      |          |        | 39,599 |        |          |        | 54,472 | 
|Property and equipment, net                |                                                                                                                                                |                            | 5,860                     |          |        |        | 3,167  |         
|Restricted cash                            |                                                                                                                                                |                            | 300                       |          |        |        | 600    |         
|Deposits and other assets                  |                                                                                                                                                |                            | 848                       |          |        |        | 332    |         
|Goodwill, net                              |                                                                                                                                                |                            | 6,271                     |          |        |        | 6,132  |         
|Other intangible assets, net               |                                                                                                                                                |                            | 6,675                     |          |        |        | 7,624  |         
|                                          
|Total assets                               |                                                                                                                                                | $                          | 59,553                    |          |        | $      | 72,327 |         
|                                          
|Liabilities and Stockholders
    Equity   |                                                                                                                                                |                            |                           |          |        |        |        |         
|Current liabilities:                       |                                                                                                                                                |                            |                           |          |        |        |        |         
|                                           | Accounts payable                                                                                                                               |                            | $                         | 7,760    |        |        | $      | 3,636    |       
|                                           | Accrued clinical trial costs                                                                                                                   |                            |                           | 1,223    |        |        |        | 40       |       
|                                           | Other accrued liabilities                                                                                                                      |                            |                           | 1,493    |        |        |        | 2,130    |       
|                                           | Current portion of deferred revenue                                                                                                            |                            |                           | 363      |        |        |        | 832      |       
|                                           | Accrued process development expenses                                                                                                           |                            |                           | 633      |        |        |        | 1,209    |       
|                                           | Accrued payroll and related expenses                                                                                                           |                            |                           | 2,942    |        |        |        | 2,599    |       
|                                          
|                                           |                                                                                                                                                |                            | Total current liabilities |          |        | 14,414 |        |          |        | 10,446 | 
|Deferred revenue, net of current portion   |                                                                                                                                                |                            | 396                       |          |        |        | 527    |         
|Commitments and contingencies              |                                                                                                                                                |                            |                           |          |        |        |        |         
|Stockholders equity:                      |                                                                                                                                                |                            |                           |          |        |        |        |         
|                                           | Preferred stock, $0.001 par value:
    5,000,000 shares authorized; none issued or outstanding                                                 |                            |                           |         |        |        |        |         |       
|                                           | Common stock, $0.001 par value;
    50,000,000 shares authorized; shares issued and outstanding:
    31,180,436 in 2002 and 30,256,965 in 2001 |                            |                           | 31       |        |        |        | 30       |       
|                                           | Additional paid-in capital                                                                                                                     |                            |                           | 169,769  |        |        |        | 164,270  |       
|                                           | Deferred compensation                                                                                                                          |                            |                           | (48      | )      |        |        | (69      | )     
|                                           | Accumulated deficit                                                                                                                            |                            |                           | (126,088 | )      |        |        | (109,498 | )     
|                                           | Accumulated other comprehensive income                                                                                                         |                            |                           | 1,079    |        |        |        | 6,621    |       
|                                          
|                                           |                                                                                                                                                | Total stockholders equity |                           |          | 44,743 |        |        |          | 61,354 |       
|                                          
|Total liabilities and stockholders equity |                                                                                                                                                | $                          | 59,553                    |          |        | $      | 72,327 |         
|                                          

See accompanying Notes to Consolidated
Financial Statements.


F-3



---



##### Table of Contents



CONNETICS CORPORATION

CONSOLIDATED STATEMENTS OF
OPERATIONS


(In thousands, except per share
amounts)


|                                     |                                                                                               |                                    |                |         |         |        |         |         |         |        |         |        |        |        | 
|------------------------------------ | --------------------------------------------------------------------------------------------- | ---------------------------------- | -------------- | ------- | ------- | ------ | ------- | ------- | ------- | ------ | ------- | ------ | ------ | ------ | 
|                                    
|                                    
|                                     |                                                                                               |                                   
|                                     |                                                                                               | Years Ended December 31,          
|                                     |                                                                                               |                                   
|                                     |                                                                                               | 2002                               |                | 2001    |         | 2000  
|                                    
|                                    
|Revenues:                            |                                                                                               |                                    |                |         |         |        |         |         |         |        |         |       
|                                     | Product                                                                                       |                                    | $              | 47,573  |         |        | $       | 30,923  |         |        | $       | 20,095 |       
|                                     | Royalty                                                                                       |                                    |                | 2,926   |         |        |         | 1,097   |         |        |         |       |       
|                                     | License, contract and other                                                                   |                                    |                | 2,264   |         |        |         | 2,044   |         |        |         | 20,679 |       
|                                    
|                                     |                                                                                               |                                    | Total revenues |         |         | 52,763 |         |         |         | 34,064 |         |        |        | 40,774 | 
|Operating costs and expenses:        |                                                                                               |                                    |                |         |         |        |         |         |         |        |         |       
|                                     | Cost of product revenues                                                                      |                                    |                | 4,190   |         |        |         | 3,123   |         |        |         | 3,868  |       
|                                     | Research and development                                                                      |                                    |                | 25,821  |         |        |         | 19,156  |         |        |         | 21,875 |       
|                                     | Selling, general and administrative                                                           |                                    |                | 37,624  |         |        |         | 36,062  |         |        |         | 26,673 |       
|                                     | Acquired in-process research and development                                                  |                                    |                | 4,350   |         |        |         | 1,080   |         |        |         |       |       
|                                     | Loss on program termination                                                                   |                                    |                | 312     |         |        |         | 1,142   |         |        |         |       |       
|                                    
|                                     |                                                                                               | Total operating costs and expenses |                |         | 72,297  |        |         |         | 60,563  |        |         |        | 52,416 |       
|                                    
|Loss from operations                 |                                                                                               |                                    | (19,534        | )       |         |        | (26,499 | )       |         |        | (11,642 | )     
|Interest and other income (expense): |                                                                                               |                                    |                |         |         |        |         |         |         |        |         |       
|                                     | Interest income                                                                               |                                    |                | 823     |         |        |         | 2,543   |         |        |         | 2,108  |       
|                                     | Gain on sale of investment                                                                    |                                    |                | 2,086   |         |        |         | 122     |         |        |         | 42,967 |       
|                                     | Gain on sale of Ridaura product line                                                          |                                    |                |        |         |        |         | 8,002   |         |        |         |       |       
|                                     | Interest expense                                                                              |                                    |                | (11     | )       |        |         | (46     | )       |        |         | (235   | )     
|                                     | Other income (expense), net                                                                   |                                    |                | 227     |         |        |         | (519    | )       |        |         |       |       
|                                    
|                                     | Income (loss) before income taxes and
    cumulative effect of change in accounting principle |                                    |                | (16,409 | )       |        |         | (16,397 | )       |        |         | 33,198 |       
|                                    
|                                     | Income tax provision                                                                          |                                    |                | (181    | )       |        |         | (345    | )       |        |         | (1,010 | )     
|                                    
|                                     | Income (loss) before cumulative effect of
    change in accounting principle                  |                                    |                | (16,590 | )       |        |         | (16,742 | )       |        |         | 32,188 |       
|                                     | Cumulative effect of change in accounting
    principle, net of tax                           |                                    |                |        |         |        |         |        |         |        |         | (5,192 | )     
|                                    
|                                     | Net income (loss)                                                                             |                                    | $              | (16,590 | )       |        | $       | (16,742 | )       |        | $       | 26,996 |       
|                                    
|Basic Earnings Per Share            |                                                                                               |                                    |                |         |         |        |         |         |         |        |         |       
|                                    
|                                     | Income (loss) per share before cumulative
    effect of change in accounting principle        |                                    | $              | (0.54   | )       |        | $       | (0.56   | )       |        | $       | 1.13   |       
|                                    
|                                     | Cumulative effect of change in accounting
    principle, net of tax                           |                                    |                |        |         |        |         |        |         |        |         | (0.18  | )     
|                                    
|                                     | Net income (loss) per share                                                                   |                                    | $              | (0.54   | )       |        | $       | (0.56   | )       |        | $       | 0.95   |       
|                                    
|Diluted Earnings Per
    Share      |                                                                                               |                                    |                |         |         |        |         |         |         |        |         |       
|                                     | Income (loss) per share before cumulative
    effect of change in accounting principle        |                                    | $              | (0.54   | )       |        | $       | (0.56   | )       |        | $       | 1.07   |       
|                                     | Cumulative effect of change in accounting
    principle, net of tax                           |                                    |                |        |         |        |         |        |         |        |         | (0.17  | )     
|                                     | Net income (loss) per share                                                                   |                                    | $              | (0.54   | )       |        | $       | (0.56   | )       |        | $       | 0.90   |       
|                                     | Shares used to compute basic net income
    (loss) per share                                  |                                    |                | 30,757  |         |        |         | 29,861  |         |        |         | 28,447 |       
|                                     | Shares used to compute diluted net income
    (loss) per share                                |                                    |                | 30,757  |         |        |         | 29,861  |         |        |         | 30,086 |       
|                                     | Pro forma amounts assuming the accounting change
    was applied retroactively:               |                                    |                |         |         |        |         |         |         |        |         |        |       
|                                     |                                                                                               | Net income (loss)                  |                |         | (16,590 | )      |         |         | (16,742 | )      |         |        | 32,188 |       
|                                     |                                                                                               | Net income (loss) per share        |                | $       | (0.54   | )      |         | $       | (0.56   | )      |         | $      | 1.13   |       
|                                     |                                                                                               |                                    | Basic Diluted  |         | $       | (0.54  | )       |         | $       | (0.56  | )       |        | $      | 1.07   | 
|                                    

See accompanying Notes to Consolidated
Financial Statements.

F-4



---



##### Table of Contents



CONNETICS CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY


(In thousands)


|                                                                             |  |             |        |        |  |             |    |              |  |             |         |               |  |               |     |   |  |   |          |   |  |   |        |   |  |   |         |  
|---------------------------------------------------------------------------- |  | ----------- | ------ | ------ |  | ----------- | -- | ------------ |  | ----------- | ------- | ------------- |  | ------------- | --- | - |  | - | -------- | - |  | - | ------ | - |  | - | ------- | -
|                                                                            
|                                                                            
|                                                                             |  | Number of   |        |        |  | Accumulated |    |             
|                                                                             |  | Common      |        | Common |  | Additional  |    |              |  | Other       |         | Total        
|                                                                             |  | Shares      |        | Stock  |  | Paid-in     |    | Deferred     |  | Accumulated |         | Comprehensive |  | Stockholders
|                                                                             |  | Outstanding |        | Amount |  | Capital     |    | Compensation |  | Deficit     |         | Income        |  | Equity       
|                                                                            
|                                                                            
|Balance at December 31, 1999                                                 |  |             | 26,904 |        |  | $           | 27 |              |  | $           | 133,936 |               |  | $             | (39 | ) |  | $ | (119,752 | ) |  | $ | 116    |   |  | $ | 14,288  |  
|Common stock issued under stock option and
    purchase plans                |  |             | 561    |        |  |             | 1  |              |  |             | 2,297   |               |  |               |    |   |  |   |         |   |  |   |       |   |  |   | 2,298   |  
|Issuance of common stock pursuant to license
    agreements                  |  |             | 90     |        |  |             |   |              |  |             | 561     |               |  |               |    |   |  |   |         |   |  |   |       |   |  |   | 561     |  
|Issuance of common stock pursuant to private
    placement                   |  |             | 2,010  |        |  |             | 2  |              |  |             | 19,978  |               |  |               |    |   |  |   |         |   |  |   |       |   |  |   | 19,980  |  
|Issuance of common stock pursuant to equity line                             |  |             | 100    |        |  |             |   |              |  |             | 814     |               |  |               |    |   |  |   |         |   |  |   |       |   |  |   | 814     |  
|Exercise of warrants                                                         |  |             | 20     |        |  |             |   |              |  |             | 247     |               |  |               |    |   |  |   |         |   |  |   |       |   |  |   | 247     |  
|Stock compensation expense                                                   |  |             |       |        |  |             |   |              |  |             | 1,092   |               |  |               |    |   |  |   |         |   |  |   |       |   |  |   | 1,092   |  
|Tax benefit realized from stock option exercises                             |  |             |       |        |  |             |   |              |  |             | 287     |               |  |               |    |   |  |   |         |   |  |   |       |   |  |   | 287     |  
|Deferred compensation, net                                                   |  |             |       |        |  |             |   |              |  |             |        |               |  |               | 18  |   |  |   |         |   |  |   |       |   |  |   | 18      |  
|Comprehensive income:                                                        |  |             |        |        |  |             |    |              |  |             |         |               |  |               |     |   |  |   |          |   |  |   |        |   |  |   |         |  
|Net income                                                                   |  |             |       |        |  |             |   |              |  |             |        |               |  |               |    |   |  |   | 26,996   |   |  |   |       |   |  |   | 26,996  |  
|Unrealized gain on investments                                               |  |             |       |        |  |             |   |              |  |             |        |               |  |               |    |   |  |   |         |   |  |   | 6,025  |   |  |   | 6,025   |  
|                                                                             |  |             |        |        |  |             |    |              |  |             |         |               |  |               |     |   |  |   |          |   |  |   |        |   |  |   |         |  
|Total comprehensive income                                                   |  |             |        |        |  |             |    |              |  |             |         |               |  |               |     |   |  |   |          |   |  |   |        |   |  |   | 33,021  |  
|                                                                            
|Balance at December 31, 2000                                                 |  |             | 29,685 |        |  |             | 30 |              |  |             | 159,212 |               |  |               | (21 | ) |  |   | (92,756  | ) |  |   | 6,141  |   |  |   | 72,606  |  
|Common stock issued under stock option and
    purchase plans                |  |             | 519    |        |  |             |   |              |  |             | 2,070   |               |  |               |    |   |  |   |         |   |  |   |       |   |  |   | 2,070   |  
|Issuance of common stock pursuant to license
    agreements                  |  |             | 1      |        |  |             |   |              |  |             | 12      |               |  |               |    |   |  |   |         |   |  |   |       |   |  |   | 12      |  
|Exercise of warrants                                                         |  |             | 52     |        |  |             |   |              |  |             | 392     |               |  |               |    |   |  |   |         |   |  |   |       |   |  |   | 392     |  
|Stock compensation expense                                                   |  |             |       |        |  |             |   |              |  |             | 2,584   |               |  |               | (48 | ) |  |   |         |   |  |   |       |   |  |   | 2,536   |  
|Comprehensive loss:                                                          |  |             |        |        |  |             |    |              |  |             |         |               |  |               |     |   |  |   |          |   |  |   |        |   |  |   |         |  
|Net loss                                                                     |  |             |       |        |  |             |   |              |  |             |        |               |  |               |    |   |  |   | (16,742  | ) |  |   |       |   |  |   | (16,742 | )
|Unrealized gain on investments                                               |  |             |       |        |  |             |   |              |  |             |        |               |  |               |    |   |  |   |         |   |  |   | 503    |   |  |   | 503     |  
|Foreign currency translation adjustment                                      |  |             |       |        |  |             |   |              |  |             |        |               |  |               |    |   |  |   |         |   |  |   | (23    | ) |  |   | (23     | )
|                                                                             |  |             |        |        |  |             |    |              |  |             |         |               |  |               |     |   |  |   |          |   |  |   |        |   |  |   |         |  
|Total comprehensive loss                                                     |  |             |        |        |  |             |    |              |  |             |         |               |  |               |     |   |  |   |          |   |  |   |        |   |  |   | (16,262 | )
|                                                                            
|Balance at December 31, 2001                                                 |  |             | 30,257 |        |  |             | 30 |              |  |             | 164,270 |               |  |               | (69 | ) |  |   | (109,498 | ) |  |   | 6,621  |   |  |   | 61,354  |  
|Common stock issued under stock option and
    purchase plans                |  |             | 659    |        |  |             | 1  |              |  |             | 3,449   |               |  |               |    |   |  |   |         |   |  |   |       |   |  |   | 3,450   |  
|Issuance of common stock pursuant to license
    agreements                  |  |             | 1      |        |  |             |   |              |  |             | 12      |               |  |               |    |   |  |   |         |   |  |   |       |   |  |   | 12      |  
|Exercise of warrants                                                         |  |             | 263    |        |  |             |   |              |  |             | 1,683   |               |  |               |    |   |  |   |         |   |  |   |       |   |  |   | 1,683   |  
|Stock compensation expense                                                   |  |             |       |        |  |             |   |              |  |             | 355     |               |  |               | 21  |   |  |   |         |   |  |   |       |   |  |   | 376     |  
|Comprehensive 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     |   |  |   | 76      |  
|                                                                             |  |             |        |        |  |             |    |              |  |             |         |               |  |               |     |   |  |   |          |   |  |   |        |   |  |   |         |  
|Total comprehensive loss                                                     |  |             |        |        |  |             |    |              |  |             |         |               |  |               |     |   |  |   |          |   |  |   |        |   |  |   | (22,132 | )
|                                                                            
|Balance at December 31, 2002                                                 |  |             | 31,180 |        |  | $           | 31 |              |  | $           | 169,769 |               |  | $             | (48 | ) |  | $ | (126,088 | ) |  | $ | 1,079  |   |  | $ | 44,743  |  
|                                                                            

See accompanying Notes to Consolidated
Financial Statements.

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CONNETICS CORPORATION

CONSOLIDATED STATEMENTS OF CASH
FLOWS


(In thousands)


|                                          |                                                                                 |                                                             |   |         |        |      |   |         |        |   |   |         |         |  
|----------------------------------------- | ------------------------------------------------------------------------------- | ----------------------------------------------------------- | - | ------- | ------ | ---- | - | ------- | ------ | - | - | ------- | ------- | -
|                                         
|                                         
|                                          |                                                                                 |                                                            
|                                          |                                                                                 | Years Ended December 31,                                   
|                                          |                                                                                 |                                                            
|                                          |                                                                                 | 2002                                                        |   | 2001    |        | 2000
|                                         
|                                         
|Cash flows from operating
    activities: |                                                                                 |                                                             |   |         |        |      |   |         |        |   |   |        
|                                          | Net income (loss)                                                               |                                                             | $ | (16,590 | )      |      | $ | (16,742 | )      |   | $ | 26,996  |        
|                                          | Adjustments to reconcile net loss to net cash
    used in operating activities: |                                                             |   |         |        |      |   |         |        |   |   |         |        
|                                          |                                                                                 | Depreciation                                                |   |         | 1,285  |      |   |         | 953    |   |   |         | 764     |  
|                                          |                                                                                 | Amortization of goodwill and intangible assets              |   |         | 810    |      |   |         | 1,057  |   |   |         |        |  
|                                          |                                                                                 | Gain on sale of investment                                  |   |         | (2,086 | )    |   |         | (122   | ) |   |         | (42,967 | )
|                                          |                                                                                 | Gain on sale of Ridaura product line                        |   |         |       |      |   |         | (8,002 | ) |   |         |        |  
|                                          |                                                                                 | Stock compensation expense                                  |   |         | 376    |      |   |         | 2,536  |   |   |         | 1,110   |  
|                                          |                                                                                 | Non-cash charge for in-process research and
    development |   |         |       |      |   |         | 1,080  |   |   |         |        |  
|                                          |                                                                                 | Loss on foreign exchange forward contract                   |   |         |       |      |   |         | 555    |   |   |         |        |  
|                                          |                                                                                 | Stock issued pursuant to license agreement                  |   |         | 12     |      |   |         | 12     |   |   |         |        |  
|                                          | Changes in assets and liabilities:                                              |                                                             |   |         |        |      |   |         |        |   |   |         |        
|                                          |                                                                                 | Accounts receivable, net                                    |   |         | 1,103  |      |   |         | (1,091 | ) |   |         | (1,141  | )
|                                          |                                                                                 | Other assets                                                |   |         | (931   | )    |   |         | (588   | ) |   |         | 25      |  
|                                          |                                                                                 | Accounts payable                                            |   |         | 4,119  |      |   |         | (1,645 | ) |   |         | 220     |  
|                                          |                                                                                 | Accrued and other current liabilities                       |   |         | (3     | )    |   |         | (3,166 | ) |   |         | (1,139  | )
|                                          |                                                                                 | Deferred revenue                                            |   |         | (600   | )    |   |         | 568    |   |   |         | 791     |  
|                                         
|                                          | Net cash used in operating activities                                           |                                                             |   | (12,505 | )      |      |   | (24,595 | )      |   |   | (15,341 | )      
|                                         
|Cash flows from investing
    activities: |                                                                                 |                                                             |   |         |        |      |   |         |        |   |   |        
|                                          | Purchases of short-term investments                                             |                                                             | $ | (32,573 | )      |      | $ | (56,371 | )      |   | $ | (23,148 | )      
|                                          | Sales and maturities of short-term investments                                  |                                                             |   | 47,335  |        |      |   | 35,870  |        |   |   | 68,372  |        
|                                          | Purchases of property and equipment                                             |                                                             |   | (3,907  | )      |      |   | (1,758  | )      |   |   | (1,066  | )      
|                                          | Proceeds from sale of Ridaura product line                                      |                                                             |   |        |        |      |   | 8,979   |        |   |   |        |        
|                                          | Acquisition of business, net of cash acquired                                   |                                                             |   |        |        |      |   | (16,611 | )      |   |   |        |        
|                                         
|                                          | Net cash provided by (used in) investing
    activities                         |                                                             |   | 10,855  |        |      |   | (29,891 | )      |   |   | 44,158  |        
|                                         
|Cash flows from financing
    activities: |                                                                                 |                                                             |   |         |        |      |   |         |        |   |   |        
|                                          | Restricted cash                                                                 |                                                             |   | 1,415   |        |      |   | (1,876  | )      |   |   | (263    | )      
|                                          | Payments of debt                                                                |                                                             |   |        |        |      |   | (750    | )      |   |   | (1,000  | )      
|                                          | Payment of notes payable                                                        |                                                             |   |        |        |      |   |        |        |   |   | (1,553  | )      
|                                          | Payments on obligations under capital leases                                    |                                                             |   |        |        |      |   | (37     | )      |   |   | (47     | )      
|                                          | Proceeds from issuance of common stock, net                                     |                                                             |   | 5,133   |        |      |   | 2,462   |        |   |   | 23,900  |        
|                                         
|                                          | Net cash provided by (used in) financing
    activities                         |                                                             |   | 6,548   |        |      |   | (201    | )      |   |   | 21,037  |        
|                                          | Effect of foreign currency exchange rates on cash
    and cash equivalents      |                                                             |   | 123     |        |      |   | (24     | )      |   |   |        |        
|                                         
|                                          | Net change in cash and cash equivalents                                         |                                                             |   | 5,021   |        |      |   | (54,711 | )      |   |   | 49,854  |        
|                                          | Cash and cash equivalents at beginning of year                                  |                                                             |   | 3,603   |        |      |   | 58,314  |        |   |   | 8,460   |        
|                                         
|                                          | Cash and cash equivalents at end of year                                        |                                                             | $ | 8,624   |        |      | $ | 3,603   |        |   | $ | 58,314  |        
|                                         
|Supplementary information:                |                                                                                 |                                                             |   |         |        |      |   |         |        |   |   |        
|                                          | Interest paid                                                                   |                                                             | $ | 11      |        |      | $ | 46      |        |   | $ | 235     |        
|                                          | Income taxes paid                                                               |                                                             |   | 654     |        |      |   | 698     |        |   |   | 2       |        
|                                         

See accompanying Notes to Consolidated
Financial Statements.

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NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

December 31, 2002


1. Organization and Development of the
Company

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

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

In the course of our development activities, we
have sustained continuing operating losses. Our future capital
uses and requirements depend on numerous factors, including the
level of product revenues, the possible acquisition of new
products and technologies, the development of commercialization
activities, the progress of our research and development
programs, the progress of clinical testing, the time and costs
involved in obtaining regulatory approvals, the cost of filing,
prosecuting, and enforcing patent claims and other intellectual
property rights, competing technological and market
developments, and our ability to establish collaborative
arrangements. Therefore, our uses of capital and our
requirements may increase in future periods. As a result, we may
require additional funds before we are able to sustain
profitability and we may attempt to raise additional funds
through equity or debt financings, collaborative arrangements
with corporate partners or from other sources. We currently have
no commitments for any additional financings, and we cannot
assure you that additional funding will be available to finance
our ongoing operations when needed or, if available, that the
terms for obtaining such funds will be favorable or will not
result in dilution to the our stockholders.

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

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

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,

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rebates, returns 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.

Royalty expenses directly related to product
sales are classified in cost of product revenues. Royalty
expenses totaled $1.3 million in 2002, $1.4 million in
2001, and $2.1 million in 2000. The reduction in royalty
expenses in 2002 and 2001 compared to 2000 was due to the
effects of the Connetics Australia acquisition in April 2001.
Royalty expenses related to agreements with Connetics Australia
are now eliminated in consolidation.

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

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

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

The $5.2 million cumulative effect of the
change in accounting principle, calculated as of January 1,
2000, was reported as a charge in the year ended
December 31, 2000. The cumulative effect was initially
recorded as deferred revenue and is being recognized as revenue
over the research and development period of the agreements.
During the year ended December 31, 2000, the impact of this
change in accounting method (excluding the cumulative effect
itself) increased net income by $4.4 million or $0.15 per
share. This increase consists of $4.9 million revenue
deferred in the cumulative effect that was recognized as income
in 2000 under the new accounting method, offset by the impact of
deferring upfront fees received in 2000. During 2000,
approximately $4.1 million of revenue deferred as a
component of the cumulative effect charge was fully recognized
in the fourth quarter when two of our collaboration partners
terminated their agreements with us as a result of the failure
of relaxin to meet the primary endpoint in a Phase III
trial, and Connetics was released from further obligations.
Revenue for both 2002 and 2001 included $132,000 of revenue
previously recognized and included in the cumulative effect
adjustment. We expect to recognize the unamortized balance of
deferred revenue at December 31, 2002 of approximately
$527,000 as revenue at a rate of approximately $132,000 per year
during the years ending 2003 through 2006. The pro forma
amounts presented in the consolidated statement of operations
were calculated assuming the accounting change had been in
effect for prior periods, and was made retroactive to prior
periods.

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Cash Equivalents and Short-term
Investments

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

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

Foreign Currency

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 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.

Property and Equipment

Property and equipment are stated at cost less
accumulated depreciation. Depreciation is determined using the
straight-line method over the estimated useful lives of the
assets, generally three to five years. Leasehold improvements
are amortized over the shorter of the estimated useful lives of
the assets or the remaining 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 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 no
longer 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, 2002, 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, including goodwill
(purchased intangibles, property and equipment), is impaired.
The reviews look for the existence of facts of circumstances,
either internal or external, which indicate that the carrying
value of the asset cannot be recovered. No such impairment has
been indicated to date. If in the future, management determines
the

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existence of impairment indicators, we would use
undiscounted cash flows to initially determine whether
impairment should be recognized. If necessary, we would perform
subsequent calculation to measure the amount of impairment loss
based on the excess of the carrying value over the fair value of
the impaired assets. If quoted market prices for the assets are
not available, the fair value would be calculated using the
present value of estimated expected future cash flows or other
appropriate valuation methodologies. The cash flow calculation
would be based on managements best estimates, using
appropriate assumption and projections at the time.


Fair Value of Financial Instruments

The fair value of our cash equivalents and
short-term investments is based on quoted market prices. The
carrying amount of cash equivalents and short-term investments
are equal to their respective fair values at December 31,
2002 and 2001.

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
and supplies 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 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,
2002, 2001 and 2000. Note that Cardinal Health acquired Bindley
Western in 2001, and Amerisource acquired Bergen Brunswig in
2001.

|                  |  |                                      |    |      |  |      |    |   |  |  |    |  
|----------------- |  | ------------------------------------ | -- | ---- |  | ---- | -- | - |  |  | -- | -
|                 
|                 
|                  |  |                                     
|                  |  | Percentage of Gross Product Revenues
|                  |  | Years Ended December 31,            
|                  |  |                                     
|Customer          |  | 2002                                 |    | 2001 |  | 2000
|                 
|                 
|Cardinal Health   |  |                                      | 43 | %    |  |      | 44 | % |  |  | 32 | %
|McKesson          |  |                                      | 26 | %    |  |      | 29 | % |  |  | 27 | %
|AmerisourceBergen |  |                                      | 23 | %    |  |      | 16 | % |  |  |   |  
|Bergen Brunswig   |  |                                      |   |      |  |      |   |   |  |  | 15 | %
|Bindley Western   |  |                                      |   |      |  |      |   |   |  |  | 11 | %
|                 

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|                  |  |                                            |    |      |  |      |    |   |  |  |    |  
|----------------- |  | ------------------------------------------ | -- | ---- |  | ---- | -- | - |  |  | -- | -
|                 
|                 
|                  |  |                                           
|                  |  | Percentage of Outstanding Trade Receivable
|                  |  | Years Ended December 31,                  
|                  |  |                                           
|Customer          |  | 2002                                       |    | 2001 |  | 2000
|                 
|                 
|Cardinal Health   |  |                                            | 54 | %    |  |      | 45 | % |  |  | 45 | %
|AmerisourceBergen |  |                                            | 37 | %    |  |      | 16 | % |  |  |   |  
|McKesson          |  |                                            | 6  | %    |  |      | 33 | % |  |  | 26 | %
|Bergen Brunswig   |  |                                            |   |      |  |      |   |   |  |  | 10 | %
|                 

Comprehensive Income (Loss)

Comprehensive income (loss) represents net
income (loss), unrealized gains (losses) on our
available-for-sale securities, and foreign currency translation
adjustment, all net of taxes. Accumulated other comprehensive
income included $1.0 million of net unrealized gains on
investments and $53,000 of foreign currency translation
adjustments as of December 31, 2002 and $6.6 million
of unrealized gains on investments and $23,000 of foreign
currency translation adjustments as of December 31, 2001.
Comprehensive income (loss) has been disclosed in the
Consolidated Statement of Stockholders Equity.

Income Taxes

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

Advertising

We expense advertising costs as we incur them.
Advertising costs were $348,000 in 2002, $968,000 in 2001, and
$292,000 in 2000.

Stock-Based Compensation

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

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

Although SFAS 123 allows us to continue to
follow the present APB 25 guidelines, we are required to
disclose pro formanet income (loss) and basic and
diluted earnings per share as if the fair value based method had
been applied to all awards.

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|                                                                                                                                                    |                       |                          |         |       |   |      |         |       |   |   |        |      | 
|--------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------- | ------------------------ | ------- | ----- | - | ---- | ------- | ----- | - | - | ------ | ---- | 
|                                                                                                                                                   
|                                                                                                                                                   
|                                                                                                                                                    |                       |                         
|                                                                                                                                                    |                       | Years Ended December 31,
|                                                                                                                                                    |                       |                         
|(in thousands except per share amounts):                                                                                                            |                       | 2002                     |         | 2001  |   | 2000
|                                                                                                                                                   
|                                                                                                                                                   
|Net income, as reported                                                                                                                             |                       | $                        | (16,590 | )     |   | $    | (16,742 | )     |   | $ | 26,996 |     
|Deduct: Total stock-based employee compensation
    expense determined under fair value based method for all awards,
    net of related tax effects |                       | $                        | (4,519  | )     |   | $    | (3,179  | )     |   | $ | (4,400 | )   
|                                                                                                                                                   
|Pro forma net income                                                                                                                                |                       | $                        | (21,109 | )     |   | $    | (19,921 | )     |   | $ | 22,596 |     
|                                                                                                                                                   
|Earnings per share:                                                                                                                                 |                       |                          |         |       |   |      |         |       |   |   |        |     
|                                                                                                                                                    | Basic  as reported   |                          | $       | (0.54 | ) |      | $       | (0.56 | ) |   | $      | 0.95 | 
|                                                                                                                                                    | Basic  pro forma     |                          | $       | (0.69 | ) |      | $       | (0.67 | ) |   | $      | 0.79 | 
|                                                                                                                                                    | Diluted  as reported |                          | $       | (0.54 | ) |      | $       | (0.56 | ) |   | $      | 0.90 | 
|                                                                                                                                                    | Diluted  pro forma   |                          | $       | (0.69 | ) |      | $       | (0.67 | ) |   | $      | 0.75 | 
|                                                                                                                                                   

For purposes of this analysis, we estimate the
fair value of each option grant on the date of grant using the
Black-Scholes option-pricing model. The weighted average
assumptions used in the model were as follows:

|                          |  |                    |       |                     |  |      |      |      |  |      |      |      |  |  |       |   |  |  |      |   |  |  |      |  
|------------------------- |  | ------------------ | ----- | ------------------- |  | ---- | ---- | ---- |  | ---- | ---- | ---- |  |  | ----- | - |  |  | ---- | - |  |  | ---- | -
|                         
|                         
|                          |  |                    |       |                    
|                          |  | Stock Option Plans |       | Stock Purchase Plan
|                          |  |                   
|                          |  |                   
|                          |  | 2002               |       | 2001                |  | 2000 |      | 2002 |  | 2001 |      | 2000
|                         
|                         
|Expected stock volatility |  |                    | 65.28 | %                   |  |      | 70.0 | %    |  |      | 100  | %    |  |  | 60.48 | % |  |  | 94.0 | % |  |  | 100  | %
|Risk-free interest rate   |  |                    | 4.625 | %                   |  |      | 5.35 | %    |  |      | 6.00 | %    |  |  | 3.875 | % |  |  | 5.92 | % |  |  | 5.80 | %
|Expected life (in years)  |  |                    | 3.48  |                     |  |      | 3.57 |      |  |      | 3.89 |      |  |  | 0.49  |   |  |  | 1.81 |   |  |  | 1.71 |  
|Expected dividend yield   |  |                    | 0.0   | %                   |  |      | 0.0  | %    |  |      | 0.0  | %    |  |  | 0.0   | % |  |  | 0.0  | % |  |  | 0.0  | %
|                         

The Black-Scholes option valuation model was
developed for use in estimating the fair value of traded options
that have no vesting restrictions and are fully transferable. In
addition, option valuation models require the input of highly
subjective assumptions, including the expected stock price
volatility. Because our stock options have characteristics
significantly different from those of traded options, and
because changes in the subjective input assumptions can
materially affect the fair value estimate, our management does
not believe that the existing models necessarily provide a
reliable single measure of the fair value of its options. The
weighted average fair value of options granted was $5.74 in
2002, $3.02 in 2001, and $5.37 in 2000.

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) applicable to
common stockholders by the weighted average number of common
shares outstanding during the period. We compute diluted net
income (loss) per share using the weighted average of all
common and diluted equivalent stock options and warrants
outstanding during the period. We excluded all stock option and
warrants from the calculation of diluted loss per common share
for the years ended December 31, 2002 and 2001 because
these securities were anti-dilutive during those years.

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

|                                        |                                                                                                                   |                          |       |         |   |      |       |         |   |   |      |        | 
|--------------------------------------- | ----------------------------------------------------------------------------------------------------------------- | ------------------------ | ----- | ------- | - | ---- | ----- | ------- | - | - | ---- | ------ | 
|                                       
|                                       
|                                        |                                                                                                                   |                         
|                                        |                                                                                                                   | Years Ended December 31,
|                                        |                                                                                                                   |                         
|                                        |                                                                                                                   | 2002                     |       | 2001    |   | 2000
|                                       
|                                       
|Numerator:                              |                                                                                                                   |                          |       |         |   |      |       |         |   |   |      |       
|                                        | Net income (loss)                                                                                                 |                          | $     | (16,590 | ) |      | $     | (16,742 | ) |   | $    | 26,996 | 
|                                       
|                                        | Denominator for basic earnings per
    share 
    Weighted-average shares                                        |                          |       | 30,757  |   |      |       | 29,861  |   |   |      | 28,447 | 
|Effect of Dilutive Securities:          |                                                                                                                   |                          |       |         |   |      |       |         |   |   |      |       
|                                        | Stock Options                                                                                                     |                          |       |        |   |      |       |        |   |   |      | 1,276  | 
|                                        | Warrants                                                                                                          |                          |       |        |   |      |       |        |   |   |      | 363    | 
|                                       
|                                        | Denominator for diluted earnings per
    share 
    Adjusted weighted-average shares and assumed
    conversions |                          |       | 30,757  |   |      |       | 29,861  |   |   |      | 30,086 | 
|                                       
|Basic net income (loss) per
    share   |                                                                                                                   | $                        | (0.54 | )       |   | $    | (0.56 | )       |   | $ | 0.95 |       
|Diluted net income (loss) per
    share |                                                                                                                   | $                        | (0.54 | )       |   | $    | (0.56 | )       |   | $ | 0.90 |       
|                                       

Disclosure about Segments of an Enterprise and
Related Information

Statement of Financial Accounting Standards
(SFAS) No. 131, Disclosures About
Segments of an Enterprise and Related Information,
requires us to identify the segment or segments we operate in.
Based on the standards set forth in SFAS 131, we operate in
one segment: the development and commercialization of
pharmaceuticals. For the years ended December 31, 2002 and
2001, approximately 93% and 95%, respectively, of our revenues
were derived from customers in the United States.

Revenues by product are as follows (in
thousands):

|      |  |                          |        |      |  |      |        |  |  |   |        | 
|----- |  | ------------------------ | ------ | ---- |  | ---- | ------ |  |  | - | ------ | 
|     
|     
|      |  |                         
|      |  | Years Ended December 31,
|      |  |                         
|      |  | 2002                     |        | 2001 |  | 2000
|     
|     
|OLUX  |  | $                        | 32,339 |      |  | $    | 14,996 |  |  | $ | 1,211  | 
|Luxíq |  |                          | 15,042 |      |  |      | 13,848 |  |  |   | 10,973 | 
|Other |  |                          | 192    |      |  |      | 2,079  |  |  |   | 7,911  | 
|     
|      |  | $                        | 47,573 |      |  | $    | 30,923 |  |  | $ | 20,095 | 
|     

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

Recent Accounting Pronouncements

SFAS 146.In July
2002, the FASB issued Statement of Financial Accounting
Standards No. 146, Accounting for Costs Associated
with Exit and Disposal Activities (SFAS 146). This
statement revises the accounting for exit and disposal
activities under Emerging Issues Task Force Issue No. 94-3,
Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity.
Specifically, SFAS 146 requires that companies record the costs
to exit an activity or dispose of long-lived assets when those
costs are incurred. SFAS 146 requires that the measurement of
the liability be at fair value. The

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##### Table of Contents



provisions of SFAS 146 are effective
prospectively for exit or disposal activities initiated after
December 31, 2002. Upon the adoption of SFAS 146,
previously issued financial statements shall not be restated. We
will assess the impact of adoption of SFAS 146 based on the
nature of transactions ongoing at the adoption date.


SFAS 148.In
December 2002, the FASB issued SFAS No. 148,
Accounting for Stock-Based Compensation  Transition
and Disclosure. This statement amends SFAS No. 123,
Accounting for Stock-Based Compensation, to provide
alternative methods of transition for an entity that changes to
the fair value method of accounting for stock-based employee
compensation. In addition, SFAS 148 amends the disclosure
provisions of SFAS 123 and Accounting Principles Board
(APB) Opinion No. 28, Interim Financial
Reporting to require expanded and more prominent
disclosure of the effects of an entitys accounting policy
with respect to stock-based employee compensation. The
provisions of SFAS 148 are effective for fiscal years
ending after December 15, 2002. SFAS 148 does not
amend SFAS 123 to require companies to account for employee
stock options using the fair value method. However, the
disclosure provisions of SFAS 148 are applicable to all
companies with stock-based employee compensation, regardless of
whether they account for the compensation using the fair value
method of SFAS 123 or the intrinsic value method of APB
Opinion No. 25, Accounting for Stock Issued to
Employees (APB 25). We use the intrinsic value method
of accounting for stock-based awards granted to employees, as
allowed under APB 25 and related interpretations. We
adopted the disclosure provisions of SFAS 148 on
December 31, 2002.

FIN 45.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 45). FIN 45 requires that upon
issuance of a guarantee, the guarantor must recognize a
liability for the fair value of the obligation it assumes under
that guarantee. FIN 45 is effective on a prospective basis
to guarantees issued or modified after December 31, 2002.
The disclosure requirements of FIN 45 are effective for
financial statements of interim or annual periods ending after
December 15, 2002. We do not expect the adoption of
FIN 45 to have a significant impact on our financial
statements.

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 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 June 15, 2003. 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.

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3. Cash Equivalents and Short-term
Investments

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

|                                           |                              |                   |        |            |  |            |     |            |  |   |    |    |   |   |        |        | 
|------------------------------------------ | ---------------------------- | ----------------- | ------ | ---------- |  | ---------- | --- | ---------- |  | - | -- | -- | - | - | ------ | ------ | 
|                                          
|                                          
|                                           |                              |                  
|                                           |                              | December 31, 2002
|                                           |                              |                  
|                                           |                              |                   |        | Gross      |  | Gross      |     |           
|                                           |                              | Amortized         |        | Unrealized |  | Unrealized |     | Estimated 
|                                           |                              | Cost              |        | Gains      |  | Loss       |     | Fair Value
|                                          
|                                          
|Corporate debt                             |                              | $                 | 18,137 |            |  | $          | 31  |            |  | $ | (1 | )  |   | $ | 18,167 |       
|Commercial paper                           |                              |                   | 5,500  |            |  |            |    |            |  |   |   |    |   |   | 5,500  |       
|Equity securities                          |                              |                   | 289    |            |  |            | 996 |            |  |   |   |    |   |   | 1,285  |       
|Money market funds                         |                              |                   | 626    |            |  |            |    |            |  |   |   |    |   |   | 626    |       
|                                          
|                                           | Total                        |                   |        | 24,551     |  |            |     | 1,027      |  |   |    | (1 | ) |   |        | 25,578 | 
|Less amount classified as cash Equivalents |                              |                   | (1,138 | )          |  |            |    |            |  |   |   |    |   |   | (1,138 | )     
|                                          
|                                           | Total short-term investments |                   | $      | 23,414     |  |            | $   | 1,027      |  |   | $  | (1 | ) |   | $      | 24,440 | 
|                                          

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

The gross realized gains on sales of
available-for-sale investments totaled $2.4 million in
2002, $413,000 in 2001, and $43.1 million in 2000, and
gross realized losses for the same periods totaled $633,000,
$166,000, and $82,000, respectively. The average maturity of our
available-for-sale debt securities is less than one year. We
calculated realized gains and losses based on the specific
identification method.

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##### Table of Contents



4. Property and Equipment

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

|                                               |  |              |        |      |  |   |        |  
|---------------------------------------------- |  | ------------ | ------ | ---- |  | - | ------ | -
|                                              
|                                              
|                                               |  |             
|                                               |  | December 31,
|                                               |  |             
|                                               |  | 2002         |        | 2001
|                                              
|                                              
|Laboratory and manufacturing equipment         |  | $            | 4,632  |      |  | $ | 3,277  |  
|Leasehold improvements                         |  |              | 3,023  |      |  |   | 1,319  |  
|Computer equipment                             |  |              | 1,927  |      |  |   | 1,672  |  
|Furniture, fixtures and office equipment       |  |              | 1,258  |      |  |   | 968    |  
|Land and building                              |  |              | 555    |      |  |   | 446    |  
|                                              
|                                               |  |              | 11,395 |      |  |   | 7,682  |  
|Less accumulated depreciation and amortization |  |              | (5,535 | )    |  |   | (4,515 | )
|                                              
|Property and equipment, net                    |  | $            | 5,860  |      |  | $ | 3,167  |  
|                                              

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
prior to the acquisition. Our two 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 accounted for the
acquisition using the purchase method of accounting.
Accordingly, the purchase price was allocated to the assets
acquired and liabilities assumed based on their estimated fair
values on the acquisition date. 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.
Amortization of the acquired intangibles associated with this
acquisition totaled $805,000 for the year ended
December 31, 2002.

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##### Table of Contents



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.

6. Goodwill and Other Intangible
Assets

Changes in the carrying amount of goodwill for
the year ended December 31, 2002, is as follows (in
thousands):

|                                                                                 |  |   |       | 
|-------------------------------------------------------------------------------- |  | - | ----- | 
|                                                                                
|                                                                                
|Balance as of December 31, 2001                                                  |  | $ | 6,132 | 
|Reclassification of net intangible
    asset  assembled workforce into goodwill |  |   | 139   | 
|                                                                                
|Balance as of December 31, 2002                                                  |  | $ | 6,271 | 
|                                                                                

The components of our other intangible assets at
December 31, 2002, are as follows (in thousands):

|                    |  |                      |    |             |  |              |       |     |  |   |        |   |  |   |       | 
|------------------- |  | -------------------- | -- | ----------- |  | ------------ | ----- | --- |  | - | ------ | - |  | - | ----- | 
|                   
|                   
|                    |  | Gross Carrying       |    | Accumulated |  |             
|                    |  | Useful Life in Years |    | Amount      |  | Amortization |       | Net
|                   
|                   
|Existing technology |  |                      | 10 |             |  | $            | 6,810 |     |  | $ | (1,163 | ) |  | $ | 5,647 | 
|Patents             |  |                      | 10 |             |  |              | 1,310 |     |  |   | (282   | ) |  |   | 1,028 | 
|                   
|Total               |  |                      |    |             |  | $            | 8,120 |     |  | $ | (1,445 | ) |  | $ | 6,675 | 
|                   

Amortization expense for our other intangible
assets was $810,000 for the year ended December 31, 2002
and, $590,000 for the year ended December 31, 2001. The
second quarter of 2001 was the first quarter during 2001 that we
recognized amortization expense following the acquisition of
Connetics Australia.

The expected future amortization expense of our
other intangible assets is as follows (in thousands):

|                                     |  |                      |       | 
|------------------------------------ |  | -------------------- | ----- | 
|                                    
|                                    
|                                     |  | Amortization Expense
|                                    
|                                    
|For the year ended December 31, 2003 |  | $                    | 805   | 
|For the year ended December 31, 2004 |  | $                    | 805   | 
|For the year ended December 31, 2005 |  | $                    | 805   | 
|For the year ended December 31, 2006 |  | $                    | 805   | 
|For the year ended December 31, 2007 |  | $                    | 805   | 
|Thereafter                           |  | $                    | 2,650 | 
|                                    

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SFAS 142 does not permit restatement of
previously issued financial statements. The following table
provides a reconciliation of reported operating results and per
share information, adjusted to exclude goodwill amortization as
though SFAS 142 had been applied.

|                                                               |                                 |                                                                     |         |      |         |      |         |      |         |   |        |   |        | 
|-------------------------------------------------------------- | ------------------------------- | ------------------------------------------------------------------- | ------- | ---- | ------- | ---- | ------- | ---- | ------- | - | ------ | - | ------ | 
|                                                              
|                                                              
|                                                               |                                 |                                                                    
|                                                               |                                 | Years Ended December 31,                                           
|                                                               |                                 |                                                                    
|                                                               |                                 | 2002                                                                |         | 2001 |         | 2000
|                                                              
|                                                              
|Reported net income (loss)                                     |                                 | $                                                                   | (16,590 | )    |         | $    | (16,742 | )    |         | $ | 26,996 |  
|                                                               | Add back: goodwill amortization |                                                                     |         |     |         |      |         | 478  |         |   |        |  |       
|                                                              
|                                                               |                                 | Net loss excluding goodwill amortization                            |         | $    | (16,590 | )    |         | $    | (16,264 | ) |        | $ | 26,996 | 
|Reported basic earnings (loss) per share                       |                                 | $                                                                   | (0.54   | )    |         | $    | (0.56   | )    |         | $ | 0.95   |  
|                                                               |                                 | Add back: goodwill amortization                                     |         |      |        |      |         |      | 0.02    |   |        |   |       | 
|                                                              
|                                                               |                                 | Basic earnings (loss) per share excluding
    goodwill amortization |         | $    | (0.54   | )    |         | $    | (0.54   | ) |        | $ | 0.95   | 
|Reported diluted loss per share                                |                                 | $                                                                   | (0.54   | )    |         | $    | (0.56   | )    |         | $ | 0.90   |  
|                                                               | Add back: goodwill amortization |                                                                     |         |     |         |      |         | 0.02 |         |   |        |  |       
|                                                              
|Diluted loss per share excluding goodwill
    amortization     |                                 | $                                                                   | (0.54   | )    |         | $    | (0.54   | )    |         | $ | 0.90   |  
|Shares used to calculate basic earnings
    (loss) per share   |                                 |                                                                     | 30,757  |      |         |      | 29,861  |      |         |   | 28,447 |  
|Shares used to calculate diluted earnings
    (loss) per share |                                 |                                                                     | 30,757  |      |         |      | 29,861  |      |         |   | 30,086 |  
|                                                              

7. In-License Agreements

Yamanouchi License Agreement

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 during the quarter ended June 30,
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
in-process research and development expense related to this
milestone.

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. In December 1999, we entered
into a comprehensive licensing agreement with Connetics
Australia for exclusive rights to certain applications of a
broad range of unique topical delivery technologies, including
aerosol foam formulations and Connetics Australias
patented Liquipatch technology. We paid Connetics Australia a
$500,000 license fee upon signing of the agreement and issued
80,154 shares of our common stock in January 2000
valued at $500,000. That stock was assigned to
F.H. Faulding & Co. Ltd. in 2001, in connection
with our acquisition of Connetics Australia. We charged the
$1.0 million to research and development expense.

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8. Royalty-Bearing Agreements

Pharmacia License Agreement

In December 2001, we entered into an agreement
granting Pharmacia Corporation exclusive global rights,
excluding Japan, to our proprietary foam drug-delivery
technology for use with Pharmacias Rogaine® hair loss
treatment. Under the agreement, Pharmacia paid us an initial
licensing fee, and agreed to pay us when it achieves specified
milestones, plus a royalty on product sales. We have recognized
$1.0 million under the agreement through December 31,
2002. Pharmacia will be responsible for most product development
activities and costs. Pharmacia will be responsible for most
product development activities and costs, and we have agreed to
provide certain pre-clinical development support.

Other Licenses for Foam Technology

We have entered into a number of agreements for
the foam 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 2002, on a consolidated basis, we
received $305,000 in royalties for foam-based technology. 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.

License for Aerosol Spray

We have licensed to a major international company
the rights to a super-concentrated aerosol spray that is
marketed in the U.S. and internationally. We receive royalties
on sales of the product. In 2002, on a consolidated basis, we
received $2.4 million in royalties in connection with this
agreement.

InterMune

In 1998, we formed a subsidiary, InterMune
Pharmaceuticals, Inc. (now known as InterMune, Inc.), to develop
Actimmune for serious pulmonary and infectious diseases and
congenital disorders shortly after we in-licensed Actimmune from
Genentech. In April 1999, InterMune became an independent
company, and effective April 1, 2000 we assigned to
InterMune our remaining rights and obligations under the license
with Genentech and the corresponding supply agreement. In
exchange, InterMune paid us approximately $6.1 million.
Effective April 1, 2000, we began accounting for our
investment in InterMune using the cost method when, after
InterMune became a public company, our investment was diluted
from 100% to 9%. As of December 31, 2002 we held 50,000
shares of common stock of InterMune. In addition, we have
retained the product rights for potential dermatological
applications. We received royalties on Actimmune sales of
$172,000 in 2002, and zero in 2001 and 2000. We recorded gains
on the sale of InterMune stock of $2.3 million in 2002,
$122,000 in 2001, and $43.0 million in 2000.

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9. 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 to Pharmascience, Inc. We have received no
royalties to date on sales of Ridaura.

We acquired the U.S. and Canada rights to Ridaura
in December 1996 from SmithKline (now GlaxoSmithKline). We were
required to pay interest on the principal amount outstanding
from January 5, 1999 through April 1, 2000. We paid
GlaxoSmithKline $1.6 million in principal and interest in
2000, and all amounts owing had been repaid as of
December 31, 2000.

10. Relaxin Program and
Agreements

In October 2000, we announced that our pivotal
clinical trial of relaxin had failed to show statistical
significance with respect to the primary endpoint of the trial.
Based on the result of the pivotal trial, and following an
extensive evaluation of other potential uses for relaxin, in May
2001, we announced our decision to pursue a license partner or
other strategic alternative for our relaxin program. As a
result, we have reduced our investment in the development of
relaxin in favor of focusing our resources on expanding our
dermatology business. During the second quarter of 2001, we
eliminated 27 employee positions related to relaxin. We
recognized a one-time charge of approximately $1.1 million
in 2001 and an additional $312,000 in 2002, which represents
$451,000 accrued in connection with the reduction in workforce
as well as $1.0 million for the wind down of relaxin
development contracts. Of the amounts accrued in 2001 and 2002,
$358,000 remains accrued as of December 31, 2002.

Boehringer Ingelheim.Boehringer Ingelheim, or BIA,
manufactured relaxin for us for clinical uses under a long-term
contract. In July 2001, following our May 2001 announcement
about downsizing the relaxin program, BIA notified us that BIA
believed we were in breach of the relaxin manufacturing
agreement and that BIA intended to terminate the agreement and
seek remedies if we did not remedy the alleged breach. In
December 2001, we reached an amicable settlement with BIA. We
mutually agreed to terminate the agreement, BIA agreed to
provide certain reports still owing to Connetics at the time,
and Connetics agreed to pay BIA a total of
1,103,000, or
approximately $990,000, as settlement of all remaining matters.
Of the amount owed, we paid
500,000 or
approximately $442,000 in 2002 and
250,000 or
approximately $222,000 in 2001. We charged the balance due of
$312,000 to expense in 2002 upon delivery of final reports, and
will make that payment in early 2003.

Medeva PLC.In
January 1999, we entered into a development and
commercialization agreement for relaxin with Medeva PLC (now
Celltech Group PLC) for relaxin in Europe. In October 2000,
following the announcement of the results of our Phase III
clinical trial for scleroderma, Celltech notified us that they
were terminating the agreement in accordance with its terms. As
of December 31, 2000, we had no further development
obligations under the agreement; all rights reverted to us in
April 2001. During the year ended December 31, 2001, we
recorded $756,000 previously deferred as revenue in connection
with this agreement.

Paladin Labs, Inc.In July 1999, we entered into a
collaboration and exclusive license agreement with Paladin for
the development and commercialization of relaxin in Canada.
Although we have discontinued our development efforts for
relaxin for scleroderma, Paladin has indicated that it will
continue the collaboration for other indications. Under the
terms of the agreement, we received an initial sum of $800,000,
which includes payments for development fees and an equity
investment. Paladin would owe additional milestone payments for
the approval of non-scleroderma indications for relaxin in
Canada. Paladin is responsible for all development and
commercialization activities in Canada, and is obligated to pay
royalties on all sales of relaxin in Canada. We recorded
contract revenue under this agreement of $53,000 in 2002,
$53,000 in 2001, and $703,000 in 2000.

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F.H. Faulding & Co., Ltd.In April 2000, we entered into a
collaboration and exclusive license agreement with Faulding for
the development and commercialization of relaxin in Australia.
Although we have discontinued our development efforts for
relaxin for scleroderma, Faulding has indicated that it will
continue the collaboration for other indications. Under the
terms of the agreement, Faulding paid $510,000 for the initial
license of relaxin for the treatment of scleroderma. Faulding
would owe additional milestone payments for the approval of
non-scleroderma indications for relaxin in Australia. Faulding
is responsible for all development and commercialization
activities in Australia, and is obligated to pay royalties on
all sales of relaxin in Australia. We recorded contract revenue
under this agreement of $79,000 in 2002, $79,000 in 2001, and
$39,000 in 2000.

11. Commitments

We lease three 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 December 31, 2003.
At December 31, 2002, the restricted cash related to this
letter of credit amounted to $612,000; 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 2002 we entered into short term financing
arrangements related to our corporate insurance policies. The
remaining amount of $89,000 related to these financing
arrangements will be paid in 2003 and has been included in Other
Accrued Liabilities on the Consolidated Balance Sheet.

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.

The future minimum rental payments under
non-cancelable operating leases, financing arrangements and
contractual commitments as of December 31, 2002 are as
follows (in thousands):

|             |  |                  |       |              |  |             |    |       |  |   |       |  |  |   |        | 
|------------ |  | ---------------- | ----- | ------------ |  | ----------- | -- | ----- |  | - | ----- |  |  | - | ------ | 
|            
|            
|Years ended  |  |                  |       | Financing    |  | Contractual |    |      
|December 31: |  | Operating Leases |       | Arrangements |  | Commitments |    | Total
|             |  |                  |       |              |  |             |    |      
|            
|            
|2003         |  | $                | 1,965 |              |  | $           | 89 |       |  | $ | 225   |  |  | $ | 2,279  | 
|2004         |  |                  | 2,130 |              |  |             |   |       |  | $ | 450   |  |  | $ | 2,580  | 
|2005         |  |                  | 584   |              |  |             |   |       |  | $ | 700   |  |  | $ | 1,284  | 
|2006         |  |                  | 56    |              |  |             |   |       |  | $ | 850   |  |  | $ | 906    | 
|2007         |  |                  | 56    |              |  |             |   |       |  | $ | 850   |  |  | $ | 906    | 
|Thereafter   |  |                  | 278   |              |  |             |   |       |  | $ | 5,325 |  |  | $ | 5,603  | 
|            
|             |  | $                | 5,069 |              |  | $           | 89 |       |  | $ | 8,400 |  |  | $ | 13,558 | 
|            

We recognize facilities rent expense on a
straight-line basis over the term of each lease. Facilities rent
expense under operating leases was approximately
$1.5 million for the year ended December 31, 2002 (net
of sublease income of $742,000), $1.2 million for the year
ended December 31, 2001 (net of sublease income of
$160,000), and $938,000 in 2000. The operating lease obligations
set forth above are shown net of $458,000 to be received from a
subleasing arrangement with third parties: $426,000 in 2003 and
$32,000 in 2004. One sublease agreement expires on
January 31, 2003 and a second sublease agreement expires on
January 31, 2004.

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12. Stockholders Equity

Warrants

We have outstanding warrants to purchase up to
90,427 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. We valued the warrant using the Black-Scholes
method and recorded $66,000 as selling, general and
administrative expense. As of December 31, 2002, none of
these warrants had been exercised.

As a commitment fee in connection with an equity
line arrangement, we issued warrants to purchase 25,000 shares
in December 1998 at a purchase price of $4.40, warrants to
purchase 25,000 shares in December 1999 at a purchase price of
$6.875, and warrants to purchase 25,427 shares in December 2000
at a purchase price of $5.3625. The warrants expire between 2003
and 2005. The fair value of these warrants has been charged
against additional paid-in capital as a stock offering cost.

In October 2000, we entered into a license
agreement with a third party to acquire rights to certain
intellectual property related to relaxin. In connection with the
license agreement, we agreed to issue warrants to purchase up to
50,000 shares of our common stock. In October 2000, we issued
one warrant to that party to purchase 20,000 shares at an
exercise price of $5.31. As of December 31, 2002, that
warrant was no longer outstanding. We valued the warrant using
the Black-Scholes method and recorded $82,000 as selling,
general and administrative expense. We agreed to issue a warrant
to purchase the additional 30,000 shares of our common stock
when and if relaxin is approved for a commercial indication. As
of December 31, 2002, that second warrant had not been
issued.

1995 Director Stock Option Plan

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

The Directors Plan, as amended, provides
that each person who first becomes a non-employee director 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 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

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the fair market value on the grant date, exercise
price of non-statutory stock options must be at least 85% of the
fair market value on the grant date, and exercise price of
options granted to 10% (or greater) stockholders must be at
least 110% of the fair market value on the grant date. The 2000
and 2002 Non-Officer Plans and the International Plan do not
permit the grant of incentive stock options. Stock options under
all of our employee stock plans have a term of ten years from
date of grant.


1994 Stock Plan

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

2000 Stock Plan

Our 2000 Stock Plan (the 2000 Plan) was approved
by the Board and our stockholders in 1999. The 2000 Plan became
available on January 1, 2000, and was initially funded with
808,512 shares. 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 2002, the increase in authorized
shares was 909,312 shares. As of December 31, 2002, a total
of 2,447,829 common shares are reserved for issuance under the
2000 Plan.

Non-Officer Stock Option Plans

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

International Stock Incentive Plan

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

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##### Table of Contents



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

|                           |                              |                     |         |            |   |          |           |           |   |   |      |       | 
|-------------------------- | ---------------------------- | ------------------- | ------- | ---------- | - | -------- | --------- | --------- | - | - | ---- | ----- | 
|                          
|                          
|                           |                              |                    
|                           |                              | Outstanding Options
|                           |                              |                    
|                           |                              |                     |         | Weighted  
|                           |                              | Shares              |         |            |   | Average 
|                           |                              | Available for       |         | Number of  |   | Exercise
|                           |                              | Grant               |         | Shares     |   | Price   
|                          
|                          
|Balance, December 31, 1999 |                              |                     | 220,000 |            |   |          | 2,873,865 |           |   | $ | 5.05 |      
|                          
|                           | Additional shares authorized |                     |         | 1,308,512  |   |          |           |          |   |   |      |      | 
|                           | Options granted              |                     |         | (1,389,195 | ) |          |           | 1,389,195 |   |   | $    | 7.85  | 
|                           | Options exercised            |                     |         |           |   |          |           | (416,387  | ) |   | $    | 4.22  | 
|                           | Options canceled             |                     |         | 180,406    |   |          |           | (300,673  | ) |   | $    | 7.33  | 
|                           |                              |                     |         |           
|Balance, December 31, 2000 |                              |                     | 319,723 |            |   |          | 3,546,000 |           |   | $ | 6.06 |      
|                           |                              |                     |         |           
|                           | Additional shares authorized |                     |         | 1,842,149  |   |          |           |          |   |   |      |      | 
|                           | Options granted              |                     |         | (1,432,838 | ) |          |           | 1,432,838 |   |   | $    | 5.89  | 
|                           | Options exercised            |                     |         |           |   |          |           | (352,026  | ) |   | $    | 3.92  | 
|                           | Options canceled             |                     |         | 252,812    |   |          |           | (405,256  | ) |   | $    | 6.87  | 
|                           |                              |                     |         |           
|Balance, December 31, 2001 |                              |                     | 981,846 |            |   |          | 4,221,556 |           |   | $ | 6.10 |      
|                           |                              |                     |         |           
|                           | Additional shares authorized |                     |         | 909,312    |   |          |           |          |   |   |      |      | 
|                           | Options granted              |                     |         | (1,400,378 | ) |          |           | 1,400,378 |   |   | $    | 11.71 | 
|                           | Options exercised            |                     |         |           |   |          |           | (469,246  | ) |   | $    | 5.20  | 
|                           | Options canceled             |                     |         | 248,411    |   |          |           | (268,722  | ) |   | $    | 7.60  | 
|                           |                              |                     |         |           
|Balance, December 31, 2002 |                              |                     | 739,191 |            |   |          | 4,883,966 |           |   | $ | 7.72 |      
|                          

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

The following table summarizes information
concerning outstanding and exercisable options at
December 31, 2002:

|                |  |                     |           |                |  |                     |      |           |  |                |       |  |  |  |           |  |  |   |       | 
|--------------- |  | ------------------- | --------- | -------------- |  | ------------------- | ---- | --------- |  | -------------- | ----- |  |  |  | --------- |  |  | - | ----- | 
|               
|               
|                |  |                     |           |                |  |                    
|                |  | Options Outstanding |           |                |  | Options Exercisable
|                |  |                    
|                |  |                    
|                |  |                     |           | Weighted       |  |                    
|Range           |  |                     |           | Average        |  | Weighted            |      |           |  | Weighted      
|of              |  | Number of           |           | Remaining Life |  | Average             |      | Number of |  | Average       
|Exercise Prices |  | Shares              |           | (in years)     |  | Exercise Price      |      | Shares    |  | Exercise Price
|               
|               
|$ 0.44  $ 4.56 |  |                     | 1,404,070 |                |  |                     | 6.55 |           |  | $              | 3.93  |  |  |  | 1,054,396 |  |  | $ | 3.73  | 
|$ 4.75  $ 7.13 |  |                     | 1,074,172 |                |  |                     | 6.91 |           |  | $              | 6.28  |  |  |  | 796,487   |  |  | $ | 6.32  | 
|$ 7.38  $11.01 |  |                     | 1,230,004 |                |  |                     | 7.36 |           |  | $              | 9.06  |  |  |  | 817,598   |  |  | $ | 8.98  | 
|$11.02  $18.00 |  |                     | 1,175,750 |                |  |                     | 9.09 |           |  | $              | 12.14 |  |  |  | 47,421    |  |  | $ | 14.30 | 
|                |  |                     |           |                |  |                     |      |           |  |                |       |  |  |  |           | 
|$ 0.44  $18.00 |  |                     | 4,883,966 |                |  |                     | 7.45 |           |  | $              | 7.72  |  |  |  | 2,715,902 |  |  | $ | 6.26  | 
|               

We recorded stock compensation expense of $21,000
for the year ended December 31, 2002, $322,000 for the year
ended December 31, 2001, and zero in 2000.

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 1,255,010 shares of common stock for
issuance under the Purchase Plan. The Purchase Plan has an
evergreen

F-24



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##### Table of Contents



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 5 months per year. The Purchase Plan permits eligible
employees to purchase common stock through payroll deductions,
which may not exceed 15% of an employees compensation, at
a price equal to the lower of 85% of the fair market value of
our common stock at the beginning or end of the offering period.
We issued 191,010 shares under the plan in 2002. At
December 31, 2002, we had 335,700 shares reserved for
future issuance.


Common Shares Reserved for Future
Issuance

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

|                                   |  |              |           |      |  |  |           | 
|---------------------------------- |  | ------------ | --------- | ---- |  |  | --------- | 
|                                  
|                                  
|                                   |  |             
|                                   |  | December 31,
|                                   |  |             
|                                   |  |             
|                                   |  | 2002         |           | 2001
|                                  
|                                  
|1994 Stock Plan                    |  |              | 1,310,798 |      |  |  | 1,584,690 | 
|1995 Employee Stock Purchase Plan  |  |              | 335,700   |      |  |  | 370,988   | 
|1995 Directors Stock Option Plan   |  |              | 570,000   |      |  |  | 570,000   | 
|1998 Supplemental Stock Plan       |  |              | 70,683    |      |  |  | 120,466   | 
|2000 Stock Plan                    |  |              | 2,447,829 |      |  |  | 1,662,172 | 
|2000 Non-Officer Stock Plan        |  |              | 445,289   |      |  |  | 482,082   | 
|International Stock Incentive Plan |  |              | 249,062   |      |  |  | 250,000   | 
|2002 Non-Officer Stock Plan        |  |              | 500,000   |      |  |  | 500,000   | 
|Non-plan stock options             |  |              | 29,496    |      |  |  | 33,992    | 
|Common stock warrants              |  |              | 90,427    |      |  |  | 391,752   | 
|                                  
|Total                              |  |              | 6,049,284 |      |  |  | 5,966,142 | 
|                                  

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,
2002, a total of 90,000 shares were designated as Series B
Participating Preferred Stock and no shares were issued and
outstanding.

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##### Table of Contents



13. Income Taxes

The provision for income taxes consists of the
following:

|        |         |              |     |      |   |      |     |     |  |   |       |     | 
|------- | ------- | ------------ | --- | ---- | - | ---- | --- | --- |  | - | ----- | --- | 
|       
|       
|        |         |             
|        |         | December 31,
|        |         |             
|        |         |             
|        |         | 2002         |     | 2001 |   | 2000
|       
|       
|Current |         |              |     |      |   |      |     |     |  |   |       |    
|        | Foreign |              | $   | 798  |   |      | $   | 345 |  |   | $     |    | 
|        | Federal |              |     | (542 | ) |      |     |    |  |   |       | 614 | 
|        | State   |              |     | (75  | ) |      |     |    |  |   |       | 396 | 
|       
|Total   |         | $            | 181 |      |   | $    | 345 |     |  | $ | 1,010 |    
|       

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

|                                                           |  |              |        |      |  |      |        |   |  |   |        |  
|---------------------------------------------------------- |  | ------------ | ------ | ---- |  | ---- | ------ | - |  | - | ------ | -
|                                                          
|                                                          
|                                                           |  |             
|                                                           |  | December 31,
|                                                           |  |             
|                                                           |  |             
|                                                           |  | 2002         |        | 2001 |  | 2000
|                                                          
|                                                          
|Provision (benefit) at U.S. federal statutory rate         |  | $            | (5,600 | )    |  | $    | (5,700 | ) |  | $ | 9,500  |  
|Unbenefited losses (utilization of net operating
    loss) |  |              | 4,900  |      |  |      | 4,000  |   |  |   | (9,500 | )
|State taxes, net of federal benefit                        |  |              | (75    | )    |  |      |       |   |  |   | 330    |  
|Non-deductible stock based compensation                    |  |              | 100    |      |  |      | 900    |   |  |   |       |  
|Non-deductible amortization                                |  |              | 300    |      |  |      | 500    |   |  |   |       |  
|Alternative minimum tax                                    |  |              | (542   | )    |  |      |       |   |  |   | 614    |  
|Foreign taxes                                              |  |              | 798    |      |  |      | 345    |   |  |   |       |  
|Other                                                      |  |              | 300    |      |  |      | 300    |   |  |   | 66     |  
|                                                          
|Total                                                      |  | $            | 181    |      |  | $    | 345    |   |  | $ | 1,010  |  
|                                                          

Pretax income from foreign operations was
approximately $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

F-26



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components of our deferred tax assets for federal
and state income taxes as of December 31 are as follows
(in thousands):


|                              |                                             |              |         |        |   |   |         |        |  
|----------------------------- | ------------------------------------------- | ------------ | ------- | ------ | - | - | ------- | ------ | -
|                             
|                             
|                              |                                             |             
|                              |                                             | December 31,
|                              |                                             |             
|                              |                                             |             
|                              |                                             | 2002         |         | 2001  
|                             
|                             
|Deferred tax assets:          |                                             |              |         |        |   |   |         |       
|                              | Net operating loss carryforward             |              | $       | 35,200 |   |   | $       | 30,100 |  
|                              | Research and other credits                  |              |         | 11,500 |   |   |         | 7,600  |  
|                              | Capitalized research expenses               |              |         | 5,800  |   |   |         | 5,200  |  
|                              | Capitalized license and acquired technology |              |         | 500    |   |   |         | 500    |  
|                              | Accruals and reserves                       |              |         | 1,800  |   |   |         |       |  
|                             
|Total deferred tax assets     |                                             |              | 54,800  |        |   |   | 43,400  |       
|                             
|Valuation allowance           |                                             |              | (54,400 | )      |   |   | (40,800 | )     
|                             
|Net deferred tax assets       |                                             |              | 400     |        |   |   | 2,600   |       
|                             
|Deferred tax liabilities:     |                                             |              |         |        |   |   |         |       
|                              | Unrealized gain on marketable securities    |              |         | (400   | ) |   |         | (2,600 | )
|                             
|Net deferred tax liabilities  |                                             |              | (400    | )      |   |   | (2,600  | )     
|                             
|Total net deferred tax assets |                                             | $            |        |        |   | $ |        |       
|                             

Due to our lack of earnings history, the net
deferred tax assets have been fully offset by a valuation
allowance. The valuation allowance increased by
$13.6 million during the year ended December 31, 2002
and by $4.7 million during the year ended December 31,
2001, and decreased by $9.4 million during the year ended
December 31, 2000.

As of December 31, 2002, we had federal net
operating loss carryforwards of approximately
$102.5 million and state net operating loss carryforwards
of approximately $5.4 million. We also had federal and
California research and other tax credit carryforwards of
approximately $12.4 million. The federal net operating loss
and credit carryforwards will expire in the years 2008 through
2022, if not utilized.

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
$2.0 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.

14. Retirement Savings Plan

We have a retirement savings plan, commonly known
as a 401(k) plan, that allows all full-time employees to
contribute from 1% to 15% of their pretax salary, subject to IRS
limits. Although no company match of employee contributions is
guaranteed, in the past several years the Board has authorized a
company match in the amount of a pool equal to 0.5%
of Connetics annual product sales, allocated in an amount
per employee participating in the plan not to exceed 30% of that
employees contribution. The company contribution vests in
relation to each employees tenure with Connetics (40%
after the second year and 100% vested after five years with
Connetics). Our contributions to the 401(k) plan were $238,000
for 2002, $155,000 for 2001, and $100,000 for 2000.

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##### Table of Contents



15. Related Party Transactions

In February 2000, the Board authorized a loan to
Mr. Wiggans 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 Mr. Wiggans is still employed by Connetics. As of
December 31, 2002, the total balance outstanding, including
accrued interest, was $158,000.

16. Quarterly Financial Data
(unaudited)

The following tables summarize the quarterly
results of operations for the years ended December 31, 2002
and 2001 (in thousands, except per share amounts):

|                                                                        |          |               |        |           |   |       |        |           |   |   |        |        |   |   |        |        |  
|----------------------------------------------------------------------- | -------- | ------------- | ------ | --------- | - | ----- | ------ | --------- | - | - | ------ | ------ | - | - | ------ | ------ | -
|                                                                       
|                                                                       
|                                                                        |          |              
|                                                                        |          | 2002 Quarters
|                                                                        |          |              
|                                                                        |          |              
|                                                                        |          | First(1)      |        | Second(2) |   | Third |        | Fourth(3)
|                                                                       
|                                                                       
|Total revenues                                                          |          | $             | 11,531 |           |   | $     | 12,626 |           |   | $ | 13,641 |        |   | $ | 14,965 |       
|Cost of product revenues                                                |          |               | 675    |           |   |       | 973    |           |   |   | 1,116  |        |   |   | 1,426  |       
|Operating loss                                                          |          |               | (3,765 | )         |   |       | (7,018 | )         |   |   | (2,986 | )      |   |   | (5,765 | )     
|                                                                        | Net loss |               |        | (3,168    | ) |       |        | (5,321    | ) |   |        | (2,490 | ) |   |        | (5,611 | )
|Basic and diluted earnings per share Net loss                           |          |               | (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.                                                                                                                                                                                                                                                                                                               

|                                                                        |          |               |        |           |   |       |         |           |   |   |        |        |   |   |        |      |  
|----------------------------------------------------------------------- | -------- | ------------- | ------ | --------- | - | ----- | ------- | --------- | - | - | ------ | ------ | - | - | ------ | ---- | -
|                                                                       
|                                                                       
|                                                                        |          |              
|                                                                        |          | 2001 Quarters
|                                                                        |          |              
|                                                                        |          |              
|                                                                        |          | First         |        | Second(1) |   | Third |         | Fourth(2)
|                                                                       
|                                                                       
|Total revenues                                                          |          | $             | 8,459  |           |   | $     | 7,563   |           |   | $ | 8,198  |        |   | $ | 9,844  |     
|Cost of product revenues                                                |          |               | 1,105  |           |   |       | 603     |           |   |   | 700    |        |   |   | 715    |     
|Operating loss                                                          |          |               | (4,610 | )         |   |       | (15,416 | )         |   |   | (5,724 | )      |   |   | (749   | )   
|                                                                        | Net loss |               |        | (4,888    | ) |       |         | (6,135    | ) |   |        | (5,418 | ) |   |        | (301 | )
|Basic and diluted earnings per share Net loss                           |          |               | (0.16  | )         |   |       | (0.21   | )         |   |   | (0.18  | )      |   |   | (0.01  | )   
|Shares used to calculate basic and fully diluted
    net loss per share |          |               | 29,705 |           |   |       | 29,777  |           |   |   | 29,920 |        |   |   | 30,041 |     
|                                                                       



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | In April 2001, we completed our acquisition of
    Connetics Australia. We recorded an acquired in-process research
    and development charge of $1.1 million related to the
    acquisition. In April 2001 we sold our rights to Ridaura
    including inventory to Prometheus Laboratories, Inc. for
    $9.0 million in cash plus a royalty on annual sales in
    excess of $4.0 million for the next five years. We
    recognized a gain of $8.0 million in connection with the
    sale of Ridaura. In May 2001, we announced our decision to
    reduce our investment in the development of relaxin and to
    pursue other strategic alternatives for the product.

F-28



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|    |                                                                                                                                                                                                                                                                                              
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    | In the second quarter of 2001 we recognized a
    $6.0 million charge representing estimated costs to be
    incurred in connection with the reduction in workforce as well
    as the wind down of relaxin development contracts.                                                           
|   
|(2) | In the fourth quarter of 2001 we reversed
    $4.8 million of the relaxin reserve we established in the
    second quarter, due to the settlement of potential amounts owed.
    We also recognized a non-cash compensation expense charge of
    $1.0 million in the fourth quarter of 2001.

F-29



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##### Table of Contents






Connetics Corporation

Index to Exhibits


[Item 15(c)]


|                                     |    |             |  |                                                                                                                                                                                                                                                                                                                                                                                   
|------------------------------------ | -- | ----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit                              |    |            
|Number                               |    | Description
|                                     |    |            
|                                     | 3  | .1*         |  | Amended and Restated Certificate of Incorporation
    (previously filed as an exhibit to the Companys Form
    S-1 Registration Statement No. 33-80261)                                                                                                                                                                                                                          
|                                     | 3  | .2*         |  | Amendment to the Companys Amended and
    Restated Certificate of Incorporation, as filed with the
    Delaware Secretary of State on May 15, 1997 (previously
    filed as an exhibit to the Companys Current Report on
    Form 8-K dated May 23, 1997)                                                                                                                       
|                                     | 3  | .3*         |  | Certificate of Designation of Rights, Preferences
    and Privileges of Series B Participating Preferred Stock,
    as filed with the Delaware Secretary of State on May 15, 1997.
    Reference is made to Exhibit 4.2.                                                                                                                                                          
|                                     | 3  | .4*         |  | Amended and Restated Bylaws (previously filed
    as Exhibit 3.2 to the Companys Form 8-A/ A filed
    November 28, 2001)                                                                                                                                                                                                                                                        
|                                     | 3  | .5*         |  | Certificate of Elimination of Rights, Preferences
    and Privileges of Connetics Corporation, as filed with the
    Delaware Secretary of State on December 11, 2001
    (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 Shares Rights
    Agreement, dated as of November 21, 2001, between the
    Company and EquiServe Trust Company, N.A., including the form of
    Rights Certificate and the Summary of Rights attached thereto as
    Exhibits A and B, respectively (previously filed as
    Exhibit 4.1 to the Companys Form 8-A/ A filed
    November 28, 2001)
|Management and Consulting Agreements
|                                     | 10 | .1*         |  | Form of Indemnification Agreement with the
    Companys directors and officers (previously filed as an
    exhibit to the Companys Form S-1 Registration
    Statement No. 33-80261)                                                                                                                                                                                            
|                                     | 10 | .2*(M)      |  | Employment Agreement dated June 9, 1994
    between Connetics and Thomas Wiggans (previously filed as an
    exhibit to the Companys Form S-1 Registration
    Statement No. 33-80261)                                                                                                                                                                                           
|                                     | 10 | .3*(M)      |  | Letter Agreement with G. Kirk Raab dated
    October 1, 1995 (previously filed as an exhibit to the
    Companys Form S-1 Registration Statement
    No. 33-80261)                                                                                                                                                                                                               
|                                     | 10 | .4*(M)      |  | Form of Notice of Stock Option Grant to
    G. Kirk Raab dated January 28, 1997 (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)                                                                                                                                                                       
|                                     | 10 | .6*(M)      |  | Letter of Employment dated July 1, 1998 from
    Connetics to Robert G. Lederer (previously filed as
    Exhibit 10.56 to the Companys Annual Report on
    Form 10-K for the year ended December 31, 1998)                                                                                                                                                                      
|                                     | 10 | .7*(M)      |  | Restricted Common Stock Purchase Agreement dated
    November 5, 1998 between the Company and Kirk Raab
    (previously filed as Exhibit 10.59 to the Companys
    Annual Report on Form 10-K for the year ended
    December 31, 1998)                                                                                                                                          



Index to Exhibits




---



##### Table of Contents



|                                  |    |             |  |                                                                                                                                                                                                                                                                  
|--------------------------------- | -- | ----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit                           |    |            
|Number                            |    | Description
|                                  |    |            
|                                  | 10 | .8*(M)      |  | Restricted Common Stock Purchase Agreement dated
    March 9, 1999 between the Company and Kirk Raab
    (previously filed as Exhibit 10.5 to the Companys
    Quarterly Report on Form 10-Q for the quarter ended
    March 30, 1999)                          
|                                  | 10 | .9*(M)      |  | Restricted Common Stock Purchase Agreement dated
    March 9, 1999 between the Company and Thomas G. Wiggans
    (previously filed as Exhibit 10.6 to the Companys
    Quarterly Report on Form 10-Q for the quarter ended
    March 30, 1999)                  
|                                  | 10 | .10*(M)     |  | Consulting Agreement effective April 1, 2000
    between the Company and Leon Panetta (previously filed as
    Exhibit 10.77 to the Companys Annual Report on
    Form 10-K for the year ended December 31, 2000)                                               
|                                  | 10 | .11*(M)     |  | 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 | .12*(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 Agreements
|                                  | 10 | .13*(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 | .14*(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 | .15*(M)     |  | 1995 Directors Stock Option Plan (as
    amended through May 1999), and form of Option Agreement
    (previously filed as Exhibit 4.2 to the Companys
    Form S-8 Registration Statement No. 333-85155)                                                       
|                                  | 10 | .16*        |  | 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 | .17*        |  | Registration Rights Agreement dated
    January 2, 1997 between Connetics and Kepler Capital LLC
    (previously filed as an exhibit to the Companys Annual
    Report on Form 10-K for the year ended December 31,
    1996)                                   
|                                  | 10 | .18*(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 | .19*        |  | Common Stock Purchase Agreement dated
    July 7, 1999 between Connetics and Paladin Labs Inc.
    (previously filed as Exhibit 10.2 to the Companys
    Quarterly Report on Form 10-Q for the quarter ended
    June 30, 1999)                                 
|                                  | 10 | .20*        |  | Registration Rights Agreement dated July 7,
    1999 between Connetics and Paladin Labs Inc. (previously
    filed as Exhibit 10.3 to the Companys Quarterly
    Report on Form 10-Q for the quarter ended June 30,
    1999)                                   
|                                  | 10 | .21*        |  | 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 | .22*        |  | International Stock Incentive Plan (previously
    filed as Exhibit 4.1 to the Companys Form S-8
    Registration Statement No. 333-61558)                                                                                                                      
|                                  | 10 | .23*        |  | 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             |    | Description
|                   |    |            
|                   | 10 | .24*        |  | 2002 Non-Officer Employee Stock Plan
    (previously filed as Exhibit 4.4 to the Companys
    Form S-8 Registration Statement No. 333-82468)                                                                                                                                         
|License Agreements
|                   | 10 | .25*       |  | License Agreement dated September 27, 1993,
    between Genentech, Inc. and Connetics, Amendment dated
    July 14, 1994, and side letter agreement dated
    November 17, 1994 (previously filed as an exhibit to the
    Companys Form S-1 Registration Statement
    No. 33-80261)
|                   | 10 | .26*       |  | Agreement on Relaxin Rights in Asia dated
    April 1, 1996 between the Company and Mitsubishi Chemical
    Corporation (previously filed as an exhibit to the
    Companys Quarterly Report on Form 10-Q for the
    quarter ended June 30, 1996)                                   
|                   | 10 | .27*       |  | Soltec License Agreement dated June 14,
    1996(previously filed as an exhibit to the Companys
    Quarterly Report on Form 10-Q for the quarter ended
    June 30, 1996)                                                                                                           
|                   | 10 | .28*       |  | License Agreement dated January 1, 1998
    between Connetics and Soltec Research Pty Limited (previously
    filed as an exhibit to the Companys Annual Report on
    Form 10-K for the year ended December 31, 1997)                                                               
|                   | 10 | .29*       |  | Agreement on Relaxin dated January 19, 1998
    by and between Connetics and Howard Florey Institute of
    Experimental Physiology and Medicine (previously filed as an
    exhibit to the Companys Annual Report on Form 10-K
    for the year ended December 31, 1997)            
|                   | 10 | .30*       |  | License Agreement dated as of May 5, 1998
    between Connetics and Genentech, Inc. (previously filed as
    Exhibit 10.2 to the Companys Report on Form 10-Q
    for the quarter ended June 30, 1998)                                                                               
|                   | 10 | .31*        |  | Amendment No. One to License Agreement,
    effective December 28, 1998, between Connetics and Genentech
    (previously filed as Exhibit 10.63 to the Companys
    Annual Report on Form 10-K for the year ended
    December 31, 1998)                                             
|                   | 10 | .32*        |  | Amendment No. Two to License Agreement,
    effective as of January 15, 1999, between the Company and
    Genentech, Inc. (previously filed as Exhibit 10.3 to the
    Companys Quarterly Report on Form 10-Q for the
    quarter ended March 30, 1999)                              
|                   | 10 | .33*       |  | Amendment No. Three to License Agreement,
    effective as of April 27, 1999, between the Company and
    Genentech, Inc. (previously filed as Exhibit 10.4 to the
    Companys Quarterly Report on Form 10-Q for the
    quarter ended March 30, 1999)                              
|                   | 10 | .34*       |  | Relaxin Development, Commercialization and
    License Agreement dated July 7, 1999 between the Company
    and Paladin Labs Inc. (previously filed as Exhibit 10.1
    to the Companys Quarterly Report on Form 10-Q for the
    quarter ended June 30, 1999)                       
|                   | 10 | .35*       |  | License Agreement (Ketoconazole) dated
    July 14, 1999 between the Company and Soltec Research Pty
    Ltd. (previously filed as Exhibit 10.4 to the
    Companys Quarterly Report on Form 10-Q for the
    quarter ended June 30, 1999)                                           
|Real Property     
|                   | 10 | .36*        |  | 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 | .37*        |  | Industrial Building Lease dated November 20,
    1998, by and between Connetics and West Bayshore Associates, a
    general partnership, et al. (previously filed as
    Exhibit 10.61 to the Companys Annual Report on
    Form 10-K for the year ended December 31, 1998)          
|                   | 10 | .38*        |  | 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)                                          



Index to Exhibits




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##### Table of Contents



|                 |      |             |  |                                                                                                                                                                                                                                                                                                                    
|---------------- | ---- | ----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit          |      |            
|Number           |      | Description
|                 |      |            
|                 | 10   | .39*        |  | 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   | .40*        |  | 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   | .41*        |  | Sublease Agreements dated August 21, 2001,
    between Connetics and Respond.com, with respect to 3290 and 3294
    West Bayshore Road, Palo Alto, California (previously filed
    as Exhibit 10.5 to the Companys Quarterly Report on
    Form 10-Q for the quarter ended September 30, 2001)                   
|                 | 10   | .42*        |  | 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 Agreements
|                 | 10   | .43*       |  | 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   | .44*       |  | 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   | .45*       |  | Asset Purchase Agreement dated as of
    April 9, 2001, by and between Connetics and Prometheus
    Laboratories, Inc. (previously filed as Exhibit 2.1 to
    the Companys Current Report on Form 8-K dated
    April 30, 2001 and filed with the Commission on
    May 11, 2001)                                
|                 | 10   | .46*       |  | Settlement and Release Agreement effective as of
    December 13, 2001 between Connetics and Boehringer
    Ingelheim Austria GmbH (previously filed as
    Exhibit 10.54 to the Companys Annual Report on
    Form 10-K/ A for the year ended December 31, 2001)                                                 
|                 | 10   | .47*       |  | 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   | .48*       |  | 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   | .49*       |  | 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   | .50*       |  | License and Development Agreement between
    Connetics and Yamanouchi Europe B.V., dated May 14, 2002
    (previously filed as Exhibit 10.2 to the Companys
    Quarterly Report on Form 10-Q for the quarter ended
    June 30, 2002)                                                                           
|                 | 21*  |             |  | Subsidiaries of the Company (previously filed
    as Exhibit 21 to the Companys Annual Report on
    Form 10-K for the year ended December 31, 2002)                                                                                                                                                              
|                 | 23.1 |             |  | Consent of Ernst & Young LLP, Independent
    Auditors                                                                                                                                                                                                                                                             



Index to Exhibits




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##### Table of Contents



|        |      |             |  |                                                                                                       
|------- | ---- | ----------- |  | ------------------------------------------------------------------------------------------------------
|Exhibit |      |            
|Number  |      | Description
|        |      |            
|        | 99.1 |             |  | Certification by Chief Executive Officer pursuant
    to Section 906 of the Sarbanes-Oxley Act of 2002
|        | 99.2 |             |  | Certification by Chief Financial Officer pursuant
    to Section 906 of the Sarbanes-Oxley Act of 2002

Key to Footnotes:

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



|  |                                                                         
|- | ------------------------------------------------------------------------
|* | Incorporated by this reference to the previous
    filing, as indicated.



|    |                                                                                                                                                                          
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(M) | This item is a management compensatory plan or
    arrangement required to be listed as an exhibit to this Report
    pursuant to Item 601(b)(10)(iii) of Regulation S-K.
|   
|(C) | We have omitted certain portions of this Exhibit
    and have requested confidential treatment of such portions from
    the SEC.                                        



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



Index to Exhibits