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UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549


Form 10-K/A

(Amendment No. 2)


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                                                                             
|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 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
|OVERVIEW                                                                                     
|CRITICAL ACCOUNTING POLICIES                                                                 
|RESULTS OF OPERATIONS                                                                        
|LIQUIDITY AND CAPITAL RESOURCES                                                              
|RECENT ACCOUNTING PRONOUNCEMENTS                                                             
|OUR BUSINESS STRATEGY MAY CAUSE FLUCTUATING OPERATING RESULTS                                
|SIGNATURES                                                                                   
|Index to Exhibits                                                                            
|EXHIBIT 10.51                                                                                
|EXHIBIT 31.1                                                                                 
|EXHIBIT 31.2                                                                                 
|EXHIBIT 32.1                                                                                 
|EXHIBIT 32.2                                                                                 



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Explanatory Note

We are filing this Amendment No. 2 (Amendment No. 2) to our Annual
Report on Form 10-K/A for the year ended December 31, 2002, as filed with the
Securities and Exchange Commission on April 1, 2003 (the Original Form
10-K/A), to reflect certain revisions in Item 1 of Part I, Item 7 of Part II
and to add Exhibit 10.51. This Amendment No. 2 speaks as of the date of the
Original Form 10-K/A, except for the certifications, which speak as of their
respective dates and the filing date of this Amendment No. 2. This Amendment
No. 2 does not reflect events occurring after the filing of the Original Form
10-K/A, nor does it modify or update the disclosure in the Original Form 10-K/A
except as specifically set forth herein.




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. Except for 2000, we have lost money every year since
inception. During each of the last five years, our operating cash
flows were insufficient to cover our fixed charges.

We established the Connetics Center for Skin
Biology in 2001 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. We did not incur
any costs in establishing the Center, which consists of employees of
Connetics.

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, which includes
license fees and milestone payments, through December 31, 2002. Pharmacia will
be responsible for most product development activities and costs. Unless
terminated earlier, the agreement with Pharmacia will terminate on the first
date on which all of Pharmacias obligations to pay royalties has expired or
been terminated. In general, in each country (excluding Japan) where the
manufacture, importation, distribution, marketing, sale or use of the product
would infringe any of our issued patents covered by the agreement, Pharmacias
obligation to pay patent royalties with respect to that country will expire
automatically on the expiration or revocation of the last of our patents to
expire (or to be revoked) in that country. No patents have yet been issued
covering this technology.

Before April 2001, Connetics Australia (under the
name Soltec) 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. We had received $50,000 under the agreement through December 31, 2002. Based
on the minimum royalty provisions in the agreement, and assuming the agreement
stays in force through 2021, the aggregate potential minimum royalties under
the contract are $975,000. Unless terminated earlier, the agreement with
Mipharm will terminate on the later of September 2021 and the
last expiration date of the patents covering the aerosol mousse
technology, which is currently 2015. 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 S.C. Johnson & Son, Inc. the rights to a super-concentrated aerosol spray that is
marketed in the U.S. and internationally. We receive royalties
on sales of the product. In 2002, on a consolidated basis, we
received $2.4 million in royalties in connection with this
agreement. Unless terminated earlier, the agreement terminates on the
last expiration date of the patents covered by the agreement. The
expiration date of the last patent to expire is currently 2013.

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 has
paid an aggregate of $641,000 under the contract as of December 31, 2002. The total potential licensing and milestone fees range from $75,000
to $375,000 for the life of the contract. Unless terminated earlier, the
agreement may be terminated by either party after the expiration of one or more
claims within a patent covered by the agreement with respect to the relevant
country (which claim has not been declared to be invalid or unenforceable by a
court of competent jurisdiction) or after eight years anniversary of the first
market introduction of the product in countries without such a claim. The
expiration date of the last patent to expire is currently 2017. Novartis
will be responsible for all development costs, and will be
obligated to pay 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. Of the 16 U.S. or
worldwide patents relating to our technologies, two relate to Banlice, twelve
relate to Hexifoam, one relates to ketoconazole foam, and one relates to
Liquipatch. Of the 23 patents related to the technologies developed by
Connetics Australia, five relate to an aerosol technology which we have
licensed to a third party, one relates to acne treatment and 17 relate to
ectoparasiticidal, which has veterinary applications. The patents discussed
above expire between 2003 and 2018.

The delivery technology that is the basis for
OLUX and Luxíq is covered by a U.S. patent on methods of
treating various skin diseases using a foam pharmaceutical
composition comprising a corticosteroid active substance, a
propellant and a buffering agent. That patent will expire in 2015. The Liquipatch technology is
covered by one U.S. patent, which will expire in 2016.

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



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

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




TRADEMARKS

We believe that trademark protection is an
important part of establishing product and brand recognition. We
own 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. This fluctuation could cause financial
results to be below expectations and the market price of our securities to
decline.

Our operating results may fluctuate from period to period for a number of
reasons, some of which are beyond our control. Even a relatively small revenue
shortfall may cause a periods results to be below our expectations or
projections, which in turn may cause the market price of our securities to drop
significantly and the value of your investment to decline in value.

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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.
Any additional equity financing may be dilutive to our stockholders
and debt financing, if available, may involve restrictive covenants,
which may limit our operating flexibility with respect to certain
business matters.

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

Except for fiscal year 2000, we have lost money
every year since our inception. We had net losses of
$27.3 million in 1999, $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. Although we maintain general liability insurance in the amount of $12 million
aggregate and workers compensation coverage in the amount of $1 million per
incident, our insurance may not provide adequate coverage against potential
claims or losses related to our use of hazardous materials, and we cannot be
certain that our current coverage will continue to be available on reasonable
terms, if at all.

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. The active ingredient
for our product OLUX is currently  supplied by a single source,
although we are in the process of qualifying an additional source. 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 and future revenues may be delayed.

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

Supply interruptions may occur and our inventory
may not always be adequate. Numerous factors could cause
interruptions in the supply of our finished products including
shortages in raw material required by our manufacturers, changes
in our sources for manufacturing, our failure to timely locate
and obtain replacement manufacturers as needed and conditions
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. Failure to obtain such regulatory approvals could adversely
affect our prospects for future revenue growth.

Successful product development in our industry is
highly uncertain, and the process of obtaining FDA and other
regulatory approvals is lengthy and expensive. Very few research
and development projects produce a commercial product. Product
candidates that appear promising in the early phases of
development may fail to reach the market for a number of
reasons, including that the product candidate did not
demonstrate acceptable clinical trial results even though it
demonstrated positive preclinical trial results, or that the
product candidate was not effective in treating a specified
condition or illness, 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. Failure of those third parties to perform
satisfactorily may significantly delay commercialization of our
products, increase expenditures and negatively affect our prospects
for future revenue growth.

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.

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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 and, regardless of whether they
are ever released to the market, the expense of such processes will
have already been incurred.

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

When we acquire or develop new products and
product lines, we must be able to integrate those products and
product lines into our systems for marketing, sales and
distribution. If 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. A delay or interruption in
the distribution of our products could negatively impact our business.

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.

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 generate revenues.

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

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

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

The growth of managed care organizations and
other third-party reimbursement policies 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. Although we maintain product liability
insurance in the amount of $14 million aggregate, our insurance may not provide adequate
coverage against potential product liability claims or losses.
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.
Such volatility could result in securities
class action litigation. Any litigation would likely result in
substantial costs, and divert our managements attention
and resources. The following table sets forth the high and low closing sale prices of our
common stock on the Nasdaq National Market for 2001 and 2002:

Period
    
    High
    
    Low2002
    
    $
    14.55
    
    
    $
    7.922001
    
    $
    13.95
    
    
    $
    4.06





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.

25



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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. Total net product
revenues increased 54% in 2002 compared to 2001. The increase in net product
revenue in 2002 was due to continued sales growth of OLUX and Luxíq, partially
offset by increases in our revenue allowances and a decrease in Ridaura revenue
after the sale of that product to Prometheus in April 2001. Combined net
revenues of OLUX and Luxíq increased 64% in 2002 compared to 2001. Combined
increased sales volumes for OLUX and Luxíq accounted for a 50% increase in the
net sales of those products in 2002 compared to 2001. Higher sales prices
accounted for the remainder of the increases in net sales of those
products in
2002 compared to 2001.

Total net product revenues increased 54% in 2001 compared to 2000. The
increase in net product revenue in 2001 was due to continued sales growth of
OLUX and Luxíq, partially offset by a decrease in Ridaura revenue after the
sale of that product to Prometheus in April 2001 and a decrease in Actimmune
revenue after the sale of our remaining Actimmune product rights to InterMune,
effective April 1, 2000. Combined net revenues of OLUX and Luxíq increased
137% in 2001 compared to 2000. Combined increased sales volumes for OLUX and
Luxíq accounted for a 96% increase in the net sales of those products in 2001
compared to 2000, in part due to our first full year of sales of OLUX, which we
launched in November 2000. Higher sales prices accounted for the remainder of
the increases in net sales of those products in 2001 compared to 2000. 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 of $1.7 million, partially offset by an
average increase in the cost per unit of our products of
approximately 6%. The decrease in
cost of product revenues from 2000 to 2001 was primarily due to
the elimination of intercompany royalties of $1.6 million, 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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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.                                                                             

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SIGNATURES

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



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



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

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

Date: December 2, 2003

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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




---



##### 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




---



##### 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)                                                                           
|                 | 10 | .51         |  | Distribution Agreement between Connetics and CORD
Logistics, Inc., dated January 1, 2001, as amended
September 1, 2001, September 3, 2003, and
September 24, 2003                                                                                                                                                  
|                 |    | 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)                                                                                                                                                              
|                 | 2  | 3.1*        |  | Consent of Ernst & Young LLP, Independent
Auditors (previously filed
    as Exhibit 23.1 to the Companys Annual Report on
    Form 10-K/A for the year ended December 31, 2002)                                                                                                                                   



Index to Exhibits




---



##### Table of Contents



|        |      |             |  |                                                                                                                           
|------- | ---- | ----------- |  | --------------------------------------------------------------------------------------------------------------------------
|Exhibit |      |            
|Number  |      | Description
|        |      |            
|        | 31.1 |             |  | Certification of Chief Executive Officer pursuant to Rule 13a-14(a)
and Section 302 of the Sarbanes-Oxley Act of 2002     
|        |      |            
|        | 31.2 |             |  | Certification of Chief Financial Officer pursuant to Rule 13a-14(a)
and Section 302 of the Sarbanes-Oxley Act of 2002     
|        |      |            
|        | 32.1 |             |  | Certification of Chief Executive Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350
|        |      |            
|        | 32.2 |             |  | Certification of Chief Financial Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350

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