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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934


For the Fiscal Year Ended December 31, 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. o

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 $354,126,000 as of March 3, 2003, based upon
the closing sale price on the Nasdaq National Market reported for that date.
The calculation excludes shares of common stock held by each officer and
director and by each person who owns 5% or more of the outstanding common stock
in that such persons may be deemed to be affiliates. This determination of
affiliate status is not necessarily a conclusive determination for other
purposes.

There were 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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TABLE OF CONTENTS



|                                                                      |                                                                                                         |                                                  |  |  |  |  |  | 
|--------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------- | ------------------------------------------------ |  |  |  |  |  | 
|PART I                                                               
|                                                                      | Item 1. Business                                                                                       
|                                                                      |                                                                                                         | 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                           
|                                                                      | Item 2. Properties                                                                                     
|                                                                      | Item 3. Legal Proceedings                                                                              
|                                                                      | Item 4. Submission of Matters to a Vote of Security Holders                                            
|PART II                                                              
|                                                                      | Item 5. Market for the Companys Common Equity and Related Stockholder Matters                         
|                                                                      | Item 6. Selected Financial Data                                                                        
|                                                                      | Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations          
|                                                                      | Item 7A. Quantitative and Qualitative Disclosures About Market Risk                                    
|                                                                      | Item 8. Financial Statements and Supplementary Data                                                    
|                                                                      | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure           
|PART III                                                             
|                                                                      | Item 10. Our Directors and Executive Officers                                                          
|                                                                      | Item 11. Executive Compensation                                                                        
|                                                                      | Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
|                                                                      | Item 13. Certain Relationships and Related Transactions                                                
|                                                                      | Item 14. Controls and Procedures                                                                       
|PART IV                                                              
|                                                                      | Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K                               
|SIGNATURES                                                           
|CERTIFICATION BY CHIEF EXECUTIVE OFFICER                             
|CERTIFICATION BY CHIEF FINANCIAL OFFICER                             
|REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS                    
|CONNETICS CORPORATION CONSOLIDATED BALANCE SHEETS                    
|CONNETICS CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS          
|CONNETICS CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
|CONNETICS CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS          
|Connetics Corporation Index to Exhibits Item 15(c)                   
|EXHIBIT 10.12                                                        
|EXHIBIT 21                                                           
|EXHIBIT 23.1                                                         
|EXHIBIT 99.1                                                         
|EXHIBIT 99.2                                                         



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Table of Contents

|                                                                                                        |                                                  |  |  |  |  |  |      |    | 
|------------------------------------------------------------------------------------------------------- | ------------------------------------------------ |  |  |  |  |  | ---- | -- | 
|                                                                                                        |                                                  |  |  |  |  |  | Page
|Forward-Looking Information                                                                             |                                                  |  |  |  |  |  | 1    |   
|PART I                                                                                                  |                                                  |  |  |  |  |  |      |   
|Item 1. Business                                                                                        |                                                  |  |  |  |  |  | 1    |   
|                                                                                                        | The Company                                      |  |  |  |  |  |      | 1  | 
|                                                                                                        | Our Strategy                                     |  |  |  |  |  |      | 2  | 
|                                                                                                        | Our Products                                     |  |  |  |  |  |      | 3  | 
|                                                                                                        | Product Candidates and Clinical Trials           |  |  |  |  |  |      | 4  | 
|                                                                                                        | Royalty-Bearing Products and Licensed Technology |  |  |  |  |  |      | 5  | 
|                                                                                                        | Sales and Marketing                              |  |  |  |  |  |      | 6  | 
|                                                                                                        | Competition                                      |  |  |  |  |  |      | 6  | 
|                                                                                                        | Customers                                        |  |  |  |  |  |      | 7  | 
|                                                                                                        | Research and Development and Product Pipeline    |  |  |  |  |  |      | 7  | 
|                                                                                                        | Patents and Proprietary Rights                   |  |  |  |  |  |      | 8  | 
|                                                                                                        | Trademarks                                       |  |  |  |  |  |      | 9  | 
|                                                                                                        | Manufacturing                                    |  |  |  |  |  |      | 9  | 
|                                                                                                        | Warehousing and Distribution                     |  |  |  |  |  |      | 9  | 
|                                                                                                        | Government Regulation                            |  |  |  |  |  |      | 9  | 
|                                                                                                        | Marketing to Healthcare Professionals            |  |  |  |  |  |      | 12 | 
|                                                                                                        | Marketing Exclusivity                            |  |  |  |  |  |      | 12 | 
|                                                                                                        | Third Party Reimbursement                        |  |  |  |  |  |      | 12 | 
|                                                                                                        | Relaxin Development Program                      |  |  |  |  |  |      | 13 | 
|                                                                                                        | Environmental Regulation                         |  |  |  |  |  |      | 14 | 
|                                                                                                        | Employees                                        |  |  |  |  |  |      | 14 | 
|                                                                                                        | Factors Affecting Our Business and Prospects     |  |  |  |  |  |      | 14 | 
|                                                                                                        | Available Information                            |  |  |  |  |  |      | 22 | 
|                                                                                                        | Executive Officers of the Company                |  |  |  |  |  |      | 23 | 
|Item 2. Properties                                                                                      |                                                  |  |  |  |  |  | 24   |   
|Item 3. Legal Proceedings                                                                               |                                                  |  |  |  |  |  | 24   |   
|Item 4. Submission of Matters to a Vote of Security Holders                                             |                                                  |  |  |  |  |  | 25   |   
|PART II                                                                                                 |                                                  |  |  |  |  |  |      |   
|Item 5. Market for the Companys Common Equity and Related Stockholder
Matters                          |                                                  |  |  |  |  |  | 25   |   
|Item 6. Selected Financial Data                                                                         |                                                  |  |  |  |  |  | 26   |   
|Item 7. Managements Discussion and Analysis of Financial Condition
and Results of Operations           |                                                  |  |  |  |  |  | 28   |   
|Item 7A. Quantitative and Qualitative Disclosures About Market Risk                                     |                                                  |  |  |  |  |  | 38   |   
|Item 8. Financial Statements and Supplementary Data                                                     |                                                  |  |  |  |  |  | 38   |   
|Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure            |                                                  |  |  |  |  |  | 38   |   
|PART III                                                                                                |                                                  |  |  |  |  |  |      |   
|Item 10. Our Directors and Executive Officers                                                           |                                                  |  |  |  |  |  | 39   |   
|Item 11. Executive Compensation                                                                         |                                                  |  |  |  |  |  | 39   |   
|Item 12. Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters |                                                  |  |  |  |  |  | 39   |   
|Item 13. Certain Relationships and Related Transactions                                                 |                                                  |  |  |  |  |  | 39   |   
|Item 14. Controls and Procedures                                                                        |                                                  |  |  |  |  |  | 39   |   
|PART IV                                                                                                 |                                                  |  |  |  |  |  |      |   
|Item 15. Exhibits, Financial Statement Schedules and Reports on Form
8-K                                |                                                  |  |  |  |  |  | 40   |   
|Signatures                                                                                              |                                                  |  |  |  |  |  |      |   
|Certifications of Chief Executive Officer and Chief Financial Officer                                   |                                                  |  |  |  |  |  |      |   
|Consolidated Financial Statements and Report of Independent Auditors                                    |                                                  |  |  |  |  |  |      |   
|Index to Exhibits                                                                                       |                                                  |  |  |  |  |  |      |   





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Forward-Looking Information

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

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

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




PART I




Item 1.Business

THE COMPANY

References in this Report to Connetics, the Company, we, our and
us refer to Connetics Corporation, a Delaware corporation, and its
consolidated subsidiaries. Unless the context specifically requires 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.

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

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

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

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

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.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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| |  |  | 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.

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

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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 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.

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




ROYALTY-BEARING PRODUCTS AND LICENSED TECHNOLOGY

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

Before April 2001, Connetics Australia (under the name Soltec) had entered
into a number of other agreements for the foam technology. Connetics Australia
licensed the technology to betamethasone valerate foam to Celltech plc in
Europe, and Celltech has licensed the worldwide rights to their patent on the
steroid foam technology to us through Connetics Australia. We pay Celltech
royalties on all sales worldwide of foam formulations containing steroids.
Celltech markets their product as Bettamousse® (the product equivalent of
Luxíq), and pays us royalties on those sales. We have license agreements with
Bayer (in the U.S.) and Pfizer and Mipharm (internationally) for the use of
pyrethrin foam for head lice. That product is marketed in the U.S. as RID®, as
Banlice® in Australia, and as Milice® in Italy. We receive royalties on sales
of those products. In 2002, on a consolidated basis, we received $307,000 in
royalties for foam-based technology. We have development agreements with other
companies to develop the foam for specific indications.

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

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

Liquipatch.We have agreements with several companies to develop
Liquipatch for various indications. In June 2001, we entered into a global
licensing agreement with Novartis Consumer Health SA for the Liquipatch
drug-delivery system for use in topical antifungal applications. The agreement
followed successful pilot development work and gives Novartis the exclusive,
worldwide right to use the Liquipatch technology in the topical antifungal
field. In March 2002, Novartis paid $580,000 to exercise its then-existing
option to expand the license agreement. Novartis will be responsible for all
development costs, and will be obligated to pay license fees, milestone
payments and royalties on future product sales. We have development agreements
with other companies to develop Liquipatch for specific indications.

Actimmune®.In 1995, we acquired from Genentech, Inc. the exclusive
development and marketing rights to interferon gamma for dermatological and
other indications in the U.S., Japan, and Canada. Interferon gamma is one of a
family of proteins involved in the regulation of the immune system and has been
shown to reduce the frequency and severity of certain infections. In April
2000, we assigned our remaining rights and obligations under the license with
Genentech and the corresponding supply agreement to InterMune Pharmaceuticals,
Inc. (now InterMune, Inc.), to develop Actimmune for various infections and
fungal diseases. In exchange, InterMune paid us approximately $6.1 million, of
which $942,000 was paid to us in March 2001 and the balance was paid in 2000.
We recorded $172,000 in royalty revenue related to Actimmune sales in 2002. In
August 2002, we entered into an

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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, 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.

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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 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

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humans with products that offer significant improvements over existing
products. A secondary strategy is to evaluate the acquisition of products from
other companies.

We have developed several additional aerosol foams similar to our foam
delivery system for OLUX and Luxíq, including water-, ethanol- and
petrolatum-based foams. We have also developed Liquipatch, a multi-polymer
gel-matrix delivery system that applies to the skin like a normal gel and dries
to form a very thin, invisible, water-resistant film. This film enables a
controlled release of the active agent, which we believe will provide a longer
treatment period. We anticipate developing one or more new products in the
aerosol foam or Liquipatch formulations, by incorporating leading dermatologic
agents in formulations that are tailored to treat specific diseases or
different areas of the body.

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




PATENTS AND PROPRIETARY RIGHTS

Our success will depend in part on our ability and our licensors ability
to obtain and retain patent protection for our products and processes, to
preserve our trade secrets, and to operate without infringing the proprietary
rights of third parties. We are pursuing several U. S. and international
patent applications, although we cannot be sure that any of these patents will
ever be issued. We also have acquired rights from the assignment of rights to
patents and patent applications from certain of our consultants and officers.
These patents and patent applications may be subject to claims of rights by
third parties. If there are conflicting claims to the same patent or patent
application, we may not prevail and, even if we do have some rights in a patent
or application, those rights may not be sufficient for the marketing and
distribution of products covered by the patent or application.

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

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

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



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

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

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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. 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.

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

Clinical trials are normally done in phases and generally take two to five
years, but may take longer, to complete. Phase I trials generally involve
administration of a product to a small number of patients to determine safety,
tolerance and the metabolic and pharmacologic actions of the agent in humans
and the side effects associated with increasing doses. Phase II trials
generally involve administration of a product to a larger group of patients
with a particular disease to obtain evidence of the agents effectiveness
against the targeted disease, to further explore risk and side effect issues,
and to confirm preliminary data regarding optimal dosage ranges. Phase III
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

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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 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.

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We also make our products available to authorized users of the Federal
Supply Schedule, of FSS, of the General Services Administration under an FSS
contract negotiated by the Department of Veterans Affairs. The Veterans Health
Care Act of 1992, or VHCA, imposes a requirement that the prices a company such
as Connetics charges the Veterans Administration, the Department of Defense,
the Coast Guard, and the PHS be discounted by a minimum of 24% off the average
manufacturer price charged to non-federal customers. Our computation of the
average price to non-federal customers is used in establishing the FSS price
for these four purchasers. The government maintains the right to audit the
accuracy of our computations. Among the remedies available to the government
for failure to accurately calculate FSS pricing and the average manufacturer
price charged to non-federal customers is recoupment of any overpayments made
by FSS purchasers as a result of errors in computations that affect the FSS
price.

The Medicaid rebate statute and the VHCA also provide that, in addition to
penalties that may be applicable under other federal statutes, civil monetary
penalties may be assessed for knowingly providing false information in
connection with the pricing and reporting requirements under the laws. The
amount that may be assessed is up to $100,000 for each item of false
information. We have provided additional information about the risks
associated with participation in the Medicaid and similar programs, under
Factors Affecting Our Business and Prospects  Our sales depend on payment and
reimbursement from third party payors, and if they reduce or refuse payment or
reimbursement, the use and sales of our products will suffer, we may not
increase our market share, and our revenues and profitability will suffer and
The growth of managed care organizations and other third-party reimbursement
policies may have an adverse effect on our pricing policies and our margins
below.




MARKETING TO HEALTHCARE PROFESSIONALS

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. The exclusivity prevents other parties from submitting or
getting approval for any application before the exclusive period expires. The
FDA determines whether a drug is eligible for exclusivity on a case-by-case
basis. The FDA may grant three-year exclusivity provided that the application
included at least one new clinical investigation other than bioavailability
studies, the investigation was conducted or sponsored by the drug company, and
the reports of the clinical investigation were essential to the approval of the
application. 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.

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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 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

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

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




ENVIRONMENTAL REGULATION

Our research and development activities involve the controlled use of
hazardous and biohazardous materials, chemicals such as solvents and active
pharmaceutical agents, compressed gases, and certain radioactive materials,
such as hydrogen-3, carbon-14, and phosphorous-33. We are subject to federal,
state and local laws and regulations governing the use, storage, handling and
disposal of such materials and certain waste products. Although we believe
that our safety procedures for handling and disposing of such materials comply
with the standards prescribed by state, federal, and local laws and
regulations, we cannot completely eliminate the risk of accidental
contamination or injury from these materials.

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




EMPLOYEES

As of March 3, 2003, we had 190 full-time employees. Of the full-time
employees, 76 were engaged in sales and marketing, 79 were in research and
development and 35 were in general and administrative positions. We believe
our relations with our employees are good.




FACTORS AFFECTING OUR BUSINESS AND PROSPECTS

There are many factors that affect our business and results of operations,
some of which are beyond our control. The following describes some of the
important factors that may cause the actual results of our operations in future
periods to differ materially from the results currently expected or desired,
and so materially affect our future developments and performance. This list of
factors that may affect future performance and the accuracy of forward-looking
statements is illustrative, but not exhaustive. Accordingly, you should
evaluate all forward-looking statements with the understanding of their
inherent uncertainty. Due to the foregoing factors, we believe that
quarter-to-quarter comparisons of our results of operations are not a good
indication of our future performance.

Risks Related To Our Business

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

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



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

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

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

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

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

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

Except for fiscal year 2000, we have lost money every year since our
inception. We had net losses of $27.3 million in 1999, $16.0 million in 2000
(after excluding a one-time gain of $43.0 million on sales of stock we held in
InterMune, and the associated income tax), $16.7 million in 2001, and $16.6
million for the year ended December 31, 2002. Our accumulated deficit was
$126.1 million at December 31, 2002. We may incur additional losses during the
next few years. If we do not eventually achieve and maintain profitability,
our stock price may decline.

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

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



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

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

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

We believe that the protection of our intellectual property, including
patents and trademarks, is an important factor in product recognition,
maintaining goodwill, and maintaining or increasing market share. If we do not
adequately protect our rights in our trademarks from infringement, any goodwill
which has been developed in those marks could be lost or impaired. If the
marks we use are found to infringe upon the trademark of another company, we
could be forced to stop using those marks, and as a result we could lose all
the goodwill which has been developed in those marks and could be liable for
damaged caused by an infringement.

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Our commercial success depends in part on our ability and the ability of
our licensors to obtain and maintain patent protection on technologies, to
preserve trade secrets, and to operate without infringing the proprietary
rights of others.

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

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

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

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

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

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

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

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

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

Risks Related To Our Products

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

Manufacturing facilities are subject to ongoing periodic inspection by the
FDA and corresponding state agencies, including unannounced inspections, and
must be licensed before they can be used in commercial manufacturing of our
products. If DPT, AccraPac or Miza cannot provide us with our product
requirements in a timely and cost-effective manner, or if the product they are
able to supply cannot meet commercial requirements for shelf life, our sales of
marketed products could be reduced and we could suffer delays in the progress
of clinical trials for products under development. In addition, any commercial
dispute with any of our suppliers could result in delays in the manufacture of
product, and affect our ability to commercialize our products. We cannot be
certain that manufacturing sources will continue to be available or that we can
continue to out-source the manufacturing of our products on reasonable or
acceptable terms. Any loss of a manufacturer or any difficulties that could
arise in the manufacturing process could significantly affect our inventories
and supply of products available for sale. If we are unable to supply
sufficient amounts of our products on a timely basis, our market share could
decrease and, correspondingly, our profitability could decrease.

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

All of our contractors must comply with the applicable FDA cGMP
regulations, which include quality control and quality assurance requirements
as well as the corresponding maintenance of records and documentation. If our
contract manufacturers do not comply with the applicable cGMP regulations and
other FDA regulatory requirements, our sales of marketed products could be
reduced and we could suffer delays in the progress of clinical trials for
products under development. We do not have control over our third-party
manufacturers compliance with these regulations and standards. Our business
interruption insurance, which covers the loss of income for up to $10.0
million, may not completely mitigate the harm to our business from the
interruption of the manufacturing of products caused by certain events, as the
loss of a manufacturer could still have a negative effect on our sales, margins
and market share, as well as our overall business and financial results.

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

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

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

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

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

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



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

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

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

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



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

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

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

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

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

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

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



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

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

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

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

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

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

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

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

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

We rely on the services of a single company to distribute our products to our
customers.

All of our product distribution activities are handled by SPS. SPS stores
and distributes our products from a warehouse in Tennessee. Any delay or
interruption in the process or in payment could result in a delay delivering
product to our customers, which could have a material effect on our business.

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

Our products commercial success is dependent, in part, on whether
third-party reimbursement is available for the use of our products by
hospitals, clinics, doctors and patients. Third-party payors include state and
federal governments, under programs such as Medicare and Medicaid, managed care
organizations, private insurance plans and health maintenance organizations.
Over 70% of the U.S. population now participates in some version of managed
care. Because of the size of the patient population covered by managed care
organizations, it is important to our business that we market our products to
them and to the pharmacy benefit managers that serve many of these
organizations. Payment or reimbursement of only a portion of the cost of our
prescription products could make our products less attractive, from a net-cost
perspective, to patients, suppliers and prescribing physicians. Managed care
organizations and other third-party payors try to negotiate the pricing of
medical services and products to control their costs. Managed care
organizations and pharmacy benefit managers typically develop formularies to
reduce their cost for medications. Formularies can be based on the prices and
therapeutic benefits of the available products. Due to their lower costs,
generics are often favored. The breadth of the products covered by formularies
varies considerably from one managed care organization to another, and many
formularies include alternative and competitive products for treatment of
particular medical conditions. Exclusion of a product from a formulary can
lead to its sharply reduced usage in the managed care organization patient
population. If our products are not

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included within an adequate number of formularies or adequate
reimbursement levels are not provided, or if those policies increasingly favor
generic products, our market share and gross margins could be negatively
affected, as could our overall business and financial condition.

In 2002, we expanded our contracts with managed care organizations in an
effort to increase the inclusion of our products on formularies and reduce the
co-payments required to be made by the ultimate consumer. To the extent that
our products are purchased by patients through a managed care group with which
we have a contract, our average selling price is lower than it would be for a
non-contracted managed care group. We take reserves for the estimated amounts
of rebates we will pay to managed care organizations each quarter. Any
increase in returns and any increased usage of our products through Medicaid or
managed care programs will affect the amount of rebates that we owe.

Risks Related To Our Industry

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

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

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

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

The growth of managed care organizations and other third-party reimbursement
policies may have an adverse effect on our pricing policies and our margins.

If managed care organizations or other third-party payors do not provide
adequate reimbursement levels for our products, or if those reimbursement
policies predominantly favor the use of generic products, our sales could
decline and our business could be seriously harmed. Managed care initiatives
to control costs have influenced primary-care physicians to refer fewer
patients to specialists such as dermatologists. Further reductions in these
referrals could have a material adverse effect on the size of our potential
market as well as our business, financial condition and results of operation.

Furthermore, federal and state regulations govern or influence the
reimbursement to health care providers of fees in connection with medical
treatment of certain patients. In the U.S., there have been, and we expect
there will continue to be, a number of state and federal proposals that could
limit the amount that state or federal

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

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

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

Risks Related To Our Stock

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

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

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

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




AVAILABLE INFORMATION

We file electronically with the Securities and Exchange Commission our
annual reports on Form 10-K, quarterly reports on Form 10-Q, and current
reports on Form 8-K, pursuant to Section 13(a) or 15(d) of the

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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 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 of 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                     
|Jay 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 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.

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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 served as Vice President of Human Resources from December
1999 to December 2002, and as Director of Human Resources from 1996 through
November 1999. She worked at COR Therapeutics from 1990 to 1996 in the
positions of Manager of Research Administration, Manager of Human Resources,
and Senior Manager of Human Resources. Ms. Gardiner also worked at Genelabs as
Manager of Research Administration from 1988 to 1990, at Genentech in 1987, and
in various hospital administration positions from 1984 to 1987. Ms. Gardiner
received her B.A. from UC Santa Barbara and her M.P.A. in Health Sciences from
the University of San Francisco.

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

Matthew Foehrjoined Connetics in 1999, and has served as Senior Vice
President, Technical Operations, since January 2003. He served as Vice
President, Manufacturing, from November 2001 through December 2002, and in
various director-and manager-level manufacturing positions from July 1999 to
November 2001. Before joining Connetics, Mr. Foehr worked for over five years
at LXR Biotechnology, Inc., most recently serving as Associate Director,
Manufacturing and Process Development. Before joining LXR, Mr. Foehr worked
for Berlex Biosciences in the Department of Process Development and
Biochemistry/Biophysics. Mr. Foehr received his B.S. in biology from Santa
Clara University.




Item 2. Properties

As of March 1, 2003, we lease 52,468 square feet of laboratory and office
space at 3290 and 3400 West Bayshore Road in Palo Alto, California. We lease
this space under two lease agreements that will both expire in March 2005. We
are subleasing 10,188 square feet of laboratory and office space at 3400 West
Bayshore Road in Palo Alto, California to a third party. Our subsidiary,
Connetics Australia Pty Ltd., owns certain land and real property consisting of
laboratory and office space at 8 Macro Court, Rowville, Victoria, Australia.
In addition, we contracted with DPT Laboratories, Ltd. to construct a 12,000
square foot aerosol filling line in San Antonio, Texas, and we make rental
payments to DPT for the space in their facility that the aerosol line occupies.
We believe that our existing facilities are adequate to meet our requirements
for the near term and that additional space will be available on commercially
reasonable terms if needed.




Item 3. Legal Proceedings

We are not a party to any material legal proceedings.

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

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




PART II




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

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

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

On March 3, 2003, we had approximately 167 stockholders of record of our
common stock.

We have never declared or paid cash dividends on our common stock. We
currently intend to retain all available funds for use in our business, and do
not anticipate paying any cash dividends in the foreseeable future.

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

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Item 6. Selected Financial Data

The selected consolidated financial data that appears below and on the
following page has been derived from our audited consolidated financial
statements. This historical data should be read in conjunction with our
Consolidated Financial Statements and the related Notes to Consolidated
Financial Statements contained in this Report, and with the Managements
Discussion and Analysis of Financial Condition and Results of Operations in
Item 7 of this Report. The selected consolidated statement of operations data
for each of the three years in the period ended December 31, 2002, and the
selected consolidated balance sheet data as of December 31, 2002 and 2001, are
derived from and qualified by reference to the audited consolidated financial
statements included elsewhere in this Report. The selected consolidated
statement of operations data for the years ended December 31, 1999 and 1998,
and the selected consolidated balance sheet data as of December 31, 2000, 1999
and 1998, are derived from audited financial statements not included in this
Report.

Connetics Corporation
Selected Consolidated Financial Data(in thousands, except per share amounts)

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

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



| | (1) |  | In May 2002, we entered into an agreement with Yamanouchi Europe,
B.V. to license Velac gel. In connection with this agreement we paid
Yamanouchi an initial $2.0 million licensing fee in the second quarter
of 2002 and accrued another $2.0 million in the fourth quarter of 2002
upon the initiation of the Phase III trial for Velac.                                                                                                                                                
| | --- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | (2) |  | In the second quarter of 2001
we recorded a $6.0 million charge representing estimated costs
accrued in connection with the reduction in workforce and the wind
down of relaxin development contracts. In the fourth quarter of 2001
we reversed $4.9 million of this charge due to the settlement of
potential amounts owed. In the second quarter of 2002 we recorded an
additional charge of $312,000, representing the final payment due
under an agreement with Boehringer Ingelheim.
|
| | (3) |  | In the fourth quarter of 2000, we recorded a $43.0 million gain on the sale
of securities.                                                                                                                                                                                                                                                                                                                                                                                                
|
| | (4) |  | In April 2001 we sold our rights to Ridaura including inventory to
Prometheus Laboratories, Inc. for $9.0 million in cash plus a royalty
on annual sales in excess of $4.0 million for the next five years. We
recognized a gain of $8.0 million in connection with the sale of
Ridaura.                                                                                                                                                                                                  
|
| | (5) |  | Effective January 1, 2000, we changed our method of accounting for
non-refundable license fees in accordance with Staff Accounting
Bulletin 101, Revenue Recognition in Financial Statements. Please
refer to Note 2 of the Notes to Consolidated Financial Statements.                                                                                                                                                                                                                 

27



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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.

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 | 
|                              

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

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

The agreement with Pharmacia granted Pharmacia exclusive global rights,
excluding Japan, to our proprietary foam drug-delivery technology for use in
Pharmacias Rogaine hair loss treatment. We recognized $1.0 million under the
Pharmacia agreement in 2002. The agreement with Novartis expanded the existing
global license to Novartis consumer health to cover Liquipatch drug-delivery
system for use in topical antifungal applications. Novartis will continue to
be responsible for all product development cost, and pay us license fees,
milestone payments and royalties on future product sales. We recognized
$580,000 of revenue related to this agreement in the quarter ended March 31,
2002.

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

We anticipate that product revenue will increase in 2003 due to continued
sales growth of OLUX and Luxíq. We also anticipate that license and contract
revenue will decrease, as several revenue streams from 2002 will not recur in
2003, while royalty revenue is expected to remain about the same in 2003.
Beyond 2003, we expect license revenue to fluctuate significantly depending on
whether we enter into additional collaborations, when and whether we or our
partners achieve milestones under existing agreements, and the timing of any
new business opportunities that we may identify.

Cost of Product Revenues

Our cost of product revenues includes the third party costs of
manufacturing OLUX, Luxíq, Ridaura (until April 2001), and Actimmune (until
April 2000), royalty payments based on a percentage of our product revenues and
product freight and distribution costs from SPS, the third party that handles
all of our product distribution activities. We recorded cost of product
revenues of $4.2 million in 2002 compared to $3.1 million in 2001 and $3.9
million in 2000. The increase in total cost of product revenues in 2002 was
the result of an increase in sales volumes. On a percentage basis, cost of
product revenues decreased to 8.8% in 2002 from 10.1% in 2001. When we
acquired Connetics Australia, we began to eliminate all intercompany
transactions in consolidation, which included our royalty expense and Connetics
Australias related royalty income. The decrease in cost of product revenues
from 2001 to 2002 on a percentage basis was primarily due to the elimination of
intercompany royalties, partially offset by an increase in the cost
per unit of our products. The decrease in cost of product revenues
from 2000 to 2001 was primarily due to the elimination of
intercompany royalties, as well as a change in product mix as a
result of discontinuing sales of Ridaura, which had higher
manufacturing costs than our other products. We sold the rights to
Ridaura to Prometheus in April 2001.

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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,
|
| |  |  | $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.       

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

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:

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| |  |  | $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,
|
| |  |  | 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.

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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.

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

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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.

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
CapitalWorking 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

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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.

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

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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 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. 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. The provisions
of SFAS 148 are effective for fiscal years ending after December 15, 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.

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,
| | - |  | ------------------------------------------------------------

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




Item 7A.Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk.Our holdings of financial instruments comprise a mix
of securities that may include U.S. corporate debt, U.S. government debt, and
commercial paper. All such instruments are classified as securities available
for sale. The average time to maturity of our investments is 87 days. Generally, we do not invest in portfolio equity securities or
commodities or use financial derivatives for trading purposes. Our market risk
exposure consists principally of exposure to reductions in interest rates. The
table below presents the principal amounts and weighted average interest rates
by year of maturity for our investment portfolio as of December 31, 2002 (in
thousands):

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

Foreign Currency Exchange Risk.Certain payments by third parties to
Connetics Australia are made in local currency or Australian dollars, and
payments by Connetics Australia to Celltech in the U.K. are made in
Australian dollars. Any fluctuations in the currencies of our
licensees or licensors against the Australian or the U.S. dollar will
cause our royalty revenues and expenses to fluctuate as well. We currently do not
hedge our exposure to changes in foreign currency exchange rates. Interest
income from our investments is sensitive to changes in the general level of
U.S. interest rates, particularly since the majority of our investments are in
short-term instruments. Due to the nature of our short-term investments, we
have concluded that we face minimal material market risk exposure.




Item 8.Financial Statements and Supplementary Data

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




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

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

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PART III




Item 10.   Our Directors and Executive Officers

Information regarding our Board of Directors is incorporated by reference
to the sections entitled Election of Directors, Further Information
Concerning the Board of Directors, and Additional Information in our Proxy
Statement (2003 Proxy Statement) to be filed with the Securities and Exchange
Commission relating to our annual meeting of stockholders to be held May 14,
2003. Information regarding our executive officers is included in Part I of
this Report in the section entitled Business  Executive Officers of the
Company.




Item 11.   Executive Compensation

Information regarding executive compensation is incorporated by reference
to the information set forth under the caption Executive Compensation and
Related Information in our 2003 Proxy Statement.




|         |  |                                                                                               
|-------- |  | ----------------------------------------------------------------------------------------------
|Item 12. |  | Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters

Information regarding the beneficial ownership of our common stock by
certain beneficial owners and by our directors and management is incorporated
into this item by reference to the information set forth under the captions
Stock Ownership and Executive Compensation and Related Information in our
2003 Proxy Statement.




Item 13.   Certain Relationships and Related Transactions

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




Item 14.   Controls and Procedures

Our management, under the supervision and with the participation of our
Chief Executive Officer and Chief Financial Officer, performed an evaluation of
the effectiveness of the design and operation of Connetics disclosure controls
and procedures. This evaluation was performed within 90 days before the filing
date of this quarterly report. Our disclosure controls and procedures are
designed with the objective of ensuring that information required to be
disclosed in our reports filed under the Securities Exchange Act of 1934 is
recorded, processed, summarized and reported within the time periods specified
in the SECs rules and forms. Based on their evaluation, the CEO and CFO
concluded that the companys disclosure controls and procedures were effective
in timely alerting them to material information required to be included in our
periodic SEC reports. There have been no significant changes in Connetics
internal controls or in other factors that could significantly affect internal
controls since their evaluation.

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PART IV




Item 15.   Exhibits, Financial Statement Schedules and Reports on Form 8-K



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

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

2.     Financial Statement Schedules

The following additional consolidated financial statement schedule should
be considered in conjunction with our consolidated financial statements. All
other schedules have been omitted because the required information is either
not applicable, not sufficiently material to require submission of the
schedule, or is included in the consolidated financial statements or the notes
to the consolidated financial statements.

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

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

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

| | (i)   |  | We filed a Current Report on Form 8-K dated December
23, 2002, with the Securities and Exchange Commission on
December 23, 2002, under Item 5, Other Events, and Item 7,
Financial Statements and Exhibits.
| | ----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | (ii)  |  | We filed a Current Report on Form 8-K dated November
30, 2002, with the Securities and Exchange Commission on
December 2, 2002, under Item 5, Other Events.                                                
|
| | (iii) |  | We filed a Current Report on Form 8-K dated November
19, 2002, with the Securities and Exchange Commission on
November 20, 2002, under Item 5, Other Events and Item 7,
Financial Statements and Exhibits. 
|
| | (iv)  |  | We filed a Current Report on Form 8-K dated October
25, 2002, with the Securities and Exchange Commission on
October 28, 2002, under Item 5, Other Events and Item 7,
Financial Statements and Exhibits.   

(c)          Exhibits.See Index to Exhibits.

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

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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. HigginsChief Financial Officer
Executive Vice President, Finance
and Corporate Development

Date: March 5, 2003

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

|                                             |  |                                                                                      |  |              
|-------------------------------------------- |  | ------------------------------------------------------------------------------------ |  | -------------
|Signature                                    |  | Title                                                                                |  | Date         
|                                             |  |                                                                                      |  |              
|Principal Executive Officer:                 |  |                                                                                      |  |              
|                                             |  |                                                                                      |  |              
|/s/ Thomas G. Wiggans

Thomas G. Wiggans     |  | President, Chief Executive
Officer and Director                                      |  | March 5, 2003
|                                             |  |                                                                                      |  |              
|Principal Financial and Accounting Officer:  |  |                                                                                      |  |              
|                                             |  |                                                                                      |  |              
|/s/ John L. Higgins

John L. Higgins         |  | Chief Financial Officer;
Executive Vice President,
Finance and Corporate Development |  | March 5, 2003
|                                             |  |                                                                                      |  |              
|Directors:                                   |  |                                                                                      |  |              
|                                             |  |                                                                                      |  |              
|/s/ Alexander E. Barkas

Alexander E. Barkas |  | Director                                                                             |  | March 5, 2003
|                                             |  |                                                                                      |  |              
|/s/ Eugene A. Bauer

Eugene A. Bauer         |  | Director                                                                             |  | March 5, 2003
|                                             |  |                                                                                      |  |              
|/s/ R. Andrew Eckert

R. Andrew Eckert       |  | Director                                                                             |  | March 5, 2003
|                                             |  |                                                                                      |  |              
|/s/ John C. Kane

John C. Kane               |  | Director                                                                             |  | March 5, 2003
|                                             |  |                                                                                      |  |              
|/s/ Thomas D. Kiley

Thomas D. Kiley         |  | Director                                                                             |  | March 5, 2003
|                                             |  |                                                                                      |  |              
|/s/ Glenn A. Oclassen

Glenn A. Oclassen     |  | Director                                                                             |  | March 5, 2003
|                                             |  |                                                                                      |  |              
|/s/ Leon E. Panetta

Leon E. Panetta         |  | Director                                                                             |  | March 5, 2003
|                                             |  |                                                                                      |  |              
|/s/ G. Kirk Raab

G. Kirk Raab               |  | Chairman of the Board, Director                                                      |  | March 5, 2003

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CERTIFICATION BY CHIEF EXECUTIVE OFFICER

I, Thomas G. Wiggans, certify that:

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

2.     Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;

3.     Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;

4.     The registrants other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:



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

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



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

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

Date: March 5, 2003

/s/ Thomas G. Wiggans
Thomas G. Wiggans
President and Chief Executive Officer

42



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##### Table of Contents






CERTIFICATION BY CHIEF FINANCIAL OFFICER

I, John L. Higgins, certify that:

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

2.     Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;

3.     Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;

4.     The registrants other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:



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

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



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

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

Date: March 5, 2003

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

43



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##### Table of Contents



CONNETICS CORPORATION
FORM 10-K
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

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

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

F-1



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##### Table of Contents






REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

Board of Directors and Stockholders
Connetics Corporation

We have audited the accompanying consolidated balance sheets of Connetics
Corporation as of December 31, 2002 and 2001, and the related consolidated
statements of operations, stockholders equity, and cash flows for each of the
three years in the period ended December 31, 2002. Our audits also included
the financial statement schedule listed in the Index at Item 15(a). These
financial statements and schedule are the responsibility of the Companys
management. Our responsibility is to express an opinion on these financial
statements and schedule based on our audits.

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

In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Connetics
Corporation at December 31, 2002 and 2001, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
December 31, 2002, in conformity with accounting principles generally accepted
in the United States. Also, in our opinion, the related financial statement
schedule, when considered in relation to the basic financial statements taken
as a whole, presents fairly in all material respects the information set forth
therein.

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

/s/ ERNST & YOUNG LLP

Palo Alto, California
January 24, 2003

F-2



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##### Table of Contents






CONNETICS CORPORATION
CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share amounts)


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

See accompanying Notes to Consolidated Financial Statements.

F-3



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##### Table of Contents






CONNETICS CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)


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

See accompanying Notes to Consolidated Financial Statements.

F-4



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##### Table of Contents






CONNETICS CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY

(In thousands)


|                                                                         |                            |  |             |  |        |   |            |  |              |   |             |  |               |   |               |   |       |   |          |   |             |   |        |   |  |   |         |        | 
|------------------------------------------------------------------------ | -------------------------- |  | ----------- |  | ------ | - | ---------- |  | ------------ | - | ----------- |  | ------------- | - | ------------- | - | ----- | - | -------- | - | ----------- | - | ------ | - |  | - | ------- | ------ | 
|                                                                        
|                                                                         |                            |  | Number of   |  |        |   |            |  |              |   |             |  |               |   |               |   |       |   |          |   | Accumulated |   |        |   | 
|                                                                         |                            |  | Common      |  | Common |   | Additional |  |              |   |             |  |               |   |               |   | Other |   | Total   
|                                                                         |                            |  | Shares      |  | Stock  |   | Paid-in    |  | Deferred     |   | Accumulated |  | Comprehensive |   | Stockholders'
|                                                                         |                            |  | Outstanding |  | Amount |   | Capital    |  | Compensation |   | Deficit     |  | Income        |   | Equity       
|                                                                        
|Balance at December 31, 1999                                             |                            |  | 26,904      |  |        | $ | 27         |  |              | $ | 133,936     |  |               | $ | (39           | ) |       | $ | (119,752 | ) |             | $ | 116    |   |  | $ | 14,288  |       
|Common stock issued under
stock option and purchase plans                |                            |  | 561         |  |        |   | 1          |  |              |   | 2,297       |  |               |   |              |   |       |   |         |   |             |   |       |   |  |   | 2,298   |       
|Issuance of common stock
pursuant to license agreements                  |                            |  | 90          |  |        |   |           |  |              |   | 561         |  |               |   |              |   |       |   |         |   |             |   |       |   |  |   | 561     |       
|Issuance of common stock
pursuant to private placement                   |                            |  | 2,010       |  |        |   | 2          |  |              |   | 19,978      |  |               |   |              |   |       |   |         |   |             |   |       |   |  |   | 19,980  |       
|Issuance of common stock
pursuant to equity line                         |                            |  | 100         |  |        |   |           |  |              |   | 814         |  |               |   |              |   |       |   |         |   |             |   |       |   |  |   | 814     |       
|Exercise of warrants                                                     |                            |  | 20          |  |        |   |           |  |              |   | 247         |  |               |   |              |   |       |   |         |   |             |   |       |   |  |   | 247     |       
|Stock compensation expense                                               |                            |  |            |  |        |   |           |  |              |   | 1,092       |  |               |   |              |   |       |   |         |   |             |   |       |   |  |   | 1,092   |       
|Tax benefit realized from
stock option exercises                         |                            |  |            |  |        |   |           |  |              |   | 287         |  |               |   |              |   |       |   |         |   |             |   |       |   |  |   | 287     |       
|Deferred compensation, net                                               |                            |  |            |  |        |   |           |  |              |   |            |  |               |   | 18            |   |       |   |         |   |             |   |       |   |  |   | 18      |       
|Comprehensive income:                                                    |                            |  |             |  |        |   |            |  |              |   |             |  |               |   |               |   |       |   |          |   |             |   |        |   |  |   |         |       
|Net income                                                               |                            |  |            |  |        |   |           |  |              |   |            |  |               |   |              |   |       |   | 26,996   |   |             |   |       |   |  |   | 26,996  |       
|Unrealized gain on investments                                           |                            |  |            |  |        |   |           |  |              |   |            |  |               |   |              |   |       |   |         |   |             |   | 6,025  |   |  |   | 6,025   |       
|                                                                         |                            |  |             |  |        |   |            |  |              |   |             |  |               |   |               |   |       |   |          |   |             |   |        |   |  |   |         |       
|                                                                         | Total comprehensive income |  |             |  |        |   |            |  |              |   |             |  |               |   |               |   |       |   |          |   |             |   |        |   |  |   |         | 33,021 | 
|                                                                        
|Balance at December 31, 2000                                             |                            |  | 29,685      |  |        |   | 30         |  |              |   | 159,212     |  |               |   | (21           | ) |       |   | (92,756  | ) |             |   | 6,141  |   |  |   | 72,606  |       
|Common stock issued under
stock option and purchase plans                |                            |  | 519         |  |        |   |           |  |              |   | 2,070       |  |               |   |              |   |       |   |         |   |             |   |       |   |  |   | 2,070   |       
|Issuance of common stock
pursuant to license agreements                  |                            |  | 1           |  |        |   |           |  |              |   | 12          |  |               |   |              |   |       |   |         |   |             |   |       |   |  |   | 12      |       
|Exercise of warrants                                                     |                            |  | 52          |  |        |   |           |  |              |   | 392         |  |               |   |              |   |       |   |         |   |             |   |       |   |  |   | 392     |       
|Stock compensation expense                                               |                            |  |            |  |        |   |           |  |              |   | 2,584       |  |               |   | (48           | ) |       |   |         |   |             |   |       |   |  |   | 2,536   |       
|Comprehensive loss:                                                      |                            |  |             |  |        |   |            |  |              |   |             |  |               |   |               |   |       |   |          |   |             |   |        |   |  |   |         |       
|Net loss                                                                 |                            |  |            |  |        |   |           |  |              |   |            |  |               |   |              |   |       |   | (16,742  | ) |             |   |       |   |  |   | (16,742 | )     
|Unrealized gain on investments                                           |                            |  |            |  |        |   |           |  |              |   |            |  |               |   |              |   |       |   |         |   |             |   | 503    |   |  |   | 503     |       
|Foreign currency translation
adjustment                                  |                            |  |            |  |        |   |           |  |              |   |            |  |               |   |              |   |       |   |         |   |             |   | (23    | ) |  |   | (23     | )     
|                                                                         |                            |  |             |  |        |   |            |  |              |   |             |  |               |   |               |   |       |   |          |   |             |   |        |   |  |   |         |       
|Total comprehensive loss                                                 |                            |  |             |  |        |   |            |  |              |   |             |  |               |   |               |   |       |   |          |   |             |   |        |   |  |   | (16,262 | )     
|                                                                        
|Balance at December 31, 2001                                             |                            |  | 30,257      |  |        |   | 30         |  |              |   | 164,270     |  |               |   | (69           | ) |       |   | (109,498 | ) |             |   | 6,621  |   |  |   | 61,354  |       
|Common stock issued under
stock option and purchase plans                |                            |  | 659         |  |        |   | 1          |  |              |   | 3,449       |  |               |   |              |   |       |   |         |   |             |   |       |   |  |   | 3,450   |       
|Issuance of common stock
pursuant to license agreements                  |                            |  | 1           |  |        |   |           |  |              |   | 12          |  |               |   |              |   |       |   |         |   |             |   |       |   |  |   | 12      |       
|Exercise of warrants                                                     |                            |  | 263         |  |        |   |           |  |              |   | 1,683       |  |               |   |              |   |       |   |         |   |             |   |       |   |  |   | 1,683   |       
|Stock compensation expense                                               |                            |  |            |  |        |   |           |  |              |   | 355         |  |               |   | 21            |   |       |   |         |   |             |   |       |   |  |   | 376     |       
|Comprehensive loss:                                                      |                            |  |             |  |        |   |            |  |              |   |             |  |               |   |               |   |       |   |          |   |             |   |        |   |  |   |         |       
|Net loss                                                                 |                            |  |            |  |        |   |           |  |              |   |            |  |               |   |              |   |       |   | (16,590  | ) |             |   |       |   |  |   | (16,590 | )     
|Reclassification adjustment for
realized gain on sale of equity
security |                            |  |            |  |        |   |           |  |              |   |            |  |               |   |              |   |       |   |         |   |             |   | (2,086 | ) |  |   | (2,086  | )     
|Unrealized loss on investments                                           |                            |  |            |  |        |   |           |  |              |   |            |  |               |   |              |   |       |   |         |   |             |   | (3,532 | ) |  |   | (3,532  | )     
|Foreign currency translation
adjustment                                  |                            |  |            |  |        |   |           |  |              |   |            |  |               |   |              |   |       |   |         |   |             |   | 76     |   |  |   | 76      |       
|                                                                         |                            |  |             |  |        |   |            |  |              |   |             |  |               |   |               |   |       |   |          |   |             |   |        |   |  |   |         |       
|Total comprehensive loss                                                 |                            |  |             |  |        |   |            |  |              |   |             |  |               |   |               |   |       |   |          |   |             |   |        |   |  |   | (22,132 | )     
|                                                                        
|Balance at December 31, 2002                                             |                            |  | 31,180      |  |        | $ | 31         |  |              | $ | 169,769     |  |               | $ | (48           | ) |       | $ | (126,088 | ) |             | $ | 1,079  |   |  | $ | 44,743  |       
|                                                                        

See accompanying Notes to Consolidated Financial Statements.

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CONNETICS CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)


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

See accompanying Notes to Consolidated Financial Statements.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002

1. Organization and Development of the Company

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

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

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

2. Summary of Significant Accounting Policies

Principles of Consolidation

In April 2001, we established a holding company (Connetics Holdings Pty
Ltd.) to acquire Soltec Research Pty Ltd., or Soltec. In October 2002, we
changed Soltecs name to Connetics Australia Pty Ltd. The accompanying
consolidated financial statements include the accounts of Connetics, Connetics
Holdings, and Connetics Australia since April 20, 2001, the day following the
acquisition. All significant intercompany accounts and transactions have been
eliminated in consolidation. We have reclassified certain prior year balances
to conform to the current years presentation.

Use of Estimates

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

Revenue Recognition

Product Sales.We recognize revenue from product sales when there is
persuasive evidence that an arrangement exists, when title has passed, the
price is fixed and determinable, and collection of the resulting receivable is
reasonably assured. We recognize product revenue net of estimated allowances
for discounts, rebates, returns and chargebacks. We are obligated to accept
from customers the return of pharmaceuticals that have reached

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their expiration
date. We authorize returns for damaged products and exchanges for expired
products in accordance with our return goods policy and procedures, and we establish reserves for
such amounts at the time of sale. To date we have not experienced significant
returns of damaged or expired product. Product shipping and handling costs are
included in cost of product revenues.

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

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

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

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

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

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

Cash Equivalents and Short-term Investments

Cash and cash equivalents consist of cash on deposit with banks and money
market instruments with original maturities of 90 days or less at the date of
purchase. Investments with maturities beyond three months at the date of
acquisition and that mature within one year from the balance sheet date are
considered to be short-term investments. Short-term investments are classified
as available-for-sale at the time of purchase and are carried at

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fair value,
and we report unrealized gains and losses as a separate component of
stockholders equity. The cost of securities sold is based on the specific
identification method.

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

Foreign Currency

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

Property and Equipment

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

Goodwill, Purchased Intangibles and Impairment of Long Lived Assets

We record goodwill in a business combination when the purchase price of
the net tangible and intangible assets we acquire exceeds their fair value. In
July 2001 the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible
Assets. Under SFAS 142, effective January 1, 2002, we are no longer required
to amortize goodwill and intangible assets with indefinite lives, but are
required to periodically review these assets for impairment. Intangible assets
determined to have definite lives will continue to be amortized over their
useful lives. We adopted SFAS 142 effective January 1, 2002 and reclassified
amounts to goodwill that were previously allocated to assembled workforce.
When we adopted SFAS 142, we ceased amortizing goodwill previously representing
an expense of approximately $700,000 per year. In conjunction with the
implementation of SFAS 142 we performed an impairment test of goodwill as of
January 1, 2002, which did not result in an impairment charge at transition.
SFAS 142 also requires that we test goodwill for impairment on an annual basis
or more frequently if indicators of potential impairment exist. We performed
the annual test as of October 1, 2002, which also did not result in an
impairment charge. We will perform this annual test on October 1 of future
years or more frequently if indicators of potential impairment exist. We will
continue to amortize other intangible assets that meet the criteria for
separate recognition from goodwill over their useful lives of ten years.

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

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Fair Value of Financial Instruments

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

Research and Development

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

Inventories

Inventories consist primarily of finished goods and supplies held at the
manufacturers facilities and are valued at the lower of actual cost or market.
All such amounts are included in other current assets in the Consolidated
Balance Sheets.

Certain Concentrations

Financial instruments that potentially subject us to concentration of
credit risk consist principally of investments in debt securities and trade
receivables. Management believes the financial risks associated with these
financial instruments are minimal. We maintain our cash, cash equivalents and
investments with high-quality financial institutions. We perform credit
evaluations of our customers financial condition and limit the amount of
credit extended when necessary, but generally we do not require collateral on
accounts receivable.

We contract with independent sources to manufacture our products. We
currently rely on two vendors to manufacture our products and we are in the
process of qualifying one additional vendor for this purpose. If these
manufacturers are unable to fulfill our supply requirements, our future results
could be negatively impacted. We sell our products to wholesalers in the
United States.

Our product revenues and trade accounts receivable are concentrated with a
few customers. The following tables detail those concentrations in gross
product sales and trade accounts receivable that are greater than 10% of the
relative total, for each of the years ended December 31, 2002, 2001 and 2000.
Note that Cardinal Health acquired Bindley Western in 2001, and Amerisource
acquired Bergen Brunswig in 2001.

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

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

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Comprehensive Income (Loss)

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

Income Taxes

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

Advertising

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

Stock-Based Compensation

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

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

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

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

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

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

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

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

Net Income (Loss) Per Share

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

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

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

Disclosure about Segments of an Enterprise and Related Information

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

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Revenues by product are as follows (in thousands):

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

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

Recent Accounting Pronouncements

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

SFAS 148. In December 2002, the FASB issued SFAS No. 148, Accounting for
Stock-Based Compensation  Transition and Disclosure. This statement amends
SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative
methods of transition for an entity that changes to the fair value method of
accounting for stock-based employee compensation. In addition, SFAS 148 amends
the disclosure provisions of SFAS 123 and 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.
We use the intrinsic-value method of accounting for stock-based awards granted
to employees, as allowed under Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB 25) and related
interpretations. We adopted the disclosure provisions of SFAS 148 on December
31, 2002.

FIN 45. In November 2002, the FASB issued Interpretation No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others (FIN
45). FIN 45 requires that
upon issuance of a guarantee, the guarantor must recognize a liability for the
fair value of the obligation it assumes under that guarantee. FIN 45 is
effective on a prospective basis to guarantees issued or modified after
December 31, 2002. The disclosure requirements of FIN 45 are effective for
financial statements of interim or annual periods ending after December 15,
2002. We do not expect the adoption of FIN 45 to have a significant impact on
our financial statements.

FIN 46. In January 2003,
the FASB issued Interpretation 46, Consolidation of
Variable Interest Entities (FIN 46).
FIN 46 requires that companies that control another entity
through interests other than voting interests should consolidate the
controlled entity. FIN 46 applies to variable interest entities
created after January 31, 2003, and to variable interest
entities in which an enterprise obtains an interest after that date.
The consolidation requirements apply to older entities in the first
fiscal year or interim period beginning after June 15, 2003.
Certain disclosure requirements apply to all financial statements
issued after January 31, 2003, regardless of when the variable
interest entity was established. The adoption of FIN 46 is not
expected to have a significant impact on our financial position or
results of operations.

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3. Cash Equivalents and Short-term Investments

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

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

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

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

4. Property and Equipment

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

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

5.     Acquisition of Connetics Australia (formerly Soltec Research Pty Ltd.)

In April 2001, we acquired Soltec Research Pty Ltd. We changed Soltecs
name to Connetics Australia Pty Ltd. in 2002. On a consolidated basis we now
own the intellectual property that we licensed from Connetics

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##### Table of Contents



Australia prior
to the acquisition. Our two marketed dermatology products and current product
development programs are based on technology developed by Connetics Australia.
Connetics Australia has leveraged its broad range of drug delivery technologies
by entering into license agreements with dermatology companies around the
world. Those license agreements bear royalties payable to Connetics Australia
for currently marketed products, as well as potential future royalties for
products under development. We accounted for the acquisition using the
purchase method of accounting, and accordingly the purchase price was allocated
to the assets acquired and liabilities assumed based on their estimated fair
values on the acquisition date.

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

We computed the value of the acquired in-process technology using a
discounted cash flow analysis with a discount rate of 20% on the anticipated
income stream and the expected completion stage of the related product
revenues. The acquired in-process research and development programs are in
early stages of development, have not reached technological feasibility, and
have no foreseeable alternative future uses. We computed the value of the
existing technology using a discounted cash flow analysis with a discount rate
of 15%. The discounted cash flow analysis was based on managements forecast
of future revenues, cost of revenues and operating expenses related to the
products and technologies purchased from Connetics Australia. Amortization of
the acquired intangibles associated with this acquisition totaled $805,000 for
the year ended December 31, 2002.

The estimates we used in valuing in-process research and development were
based on assumptions we believe to be reasonable, but they are inherently
uncertain and unpredictable. Our assumptions may be incomplete or inaccurate,
and unanticipated events and circumstances may occur. Accordingly, actual
results may vary from the results projected for purposes of determining the
fair value of the acquired in-process research and development.

6. Goodwill and Other Intangible Assets

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

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

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

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

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

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##### Table of Contents



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

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

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

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

7. In-License Agreements

Yamanouchi License Agreement

In May 2002, we entered into an agreement with Yamanouchi Europe B.V. to
license Velac® gel (a first in class combination of 1% clindamycin, and 0.025%
tretinoin). We have licensed exclusive rights to develop and commercialize the
product in the U.S. and Canada, and have licensed non-exclusive rights in
Mexico. Under the terms of the agreement, we paid Yamanouchi an initial $2.0
million licensing fee, which we recorded as acquired in-process research and
development expense during the quarter ended June 30, 2002, because the product
remains in clinical development and has no alternative future use. In the
fourth quarter of 2002, we initiated a Phase III trial for Velac. Under the
terms of the agreement, we recorded an additional $2.0 million in-process
research and development expense related to this milestone.

Connetics Australia License Agreements

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

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---



##### Table of Contents



8. Royalty-Bearing Agreements

Pharmacia License Agreement

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

Other Licenses for Foam Technology

We have entered into a number of agreements for the foam technology. We
have licensed the technology to betamethasone valerate foam to Celltech Group
plc in Europe, and Celltech has licensed the worldwide rights to their patent
on the technology to us. We pay Celltech royalties on all sales worldwide of
foam formulations containing steroids. Celltech markets their product as
Bettamousse (the product equivalent of Luxíq). We also have license
agreements with Bayer (in the U.S.) and Pfizer and Mipharm (internationally)
for the use of pyrethrin foam for head lice. That product is marketed in the
U.S. as RID®, as Banlice® in Australia, and as Milice® in Italy. We receive
royalties on sales of those products. In 2002, on a consolidated basis, we
received $305,000 in royalties for foam-based technology. We have also entered
into development agreements with other companies to develop the foam for
specific indications.

Licenses for Liquipatch Technology

In June 2001, we entered into a global licensing agreement with Novartis
Consumer Health SA for the Liquipatch drug-delivery system for use in topical
antifungal applications. The agreement gives Novartis the exclusive, worldwide
rights to use the Liquipatch technology in the topical antifungal field. In
March 2002, Novartis paid us $580,000 to exercise its then-existing option to
expand the license agreement. Novartis will be
responsible for all development costs, and will be obligated to pay
license fees, milestone payments and royalties on future product sales.

License for Aerosol Spray

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

InterMune

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

9. Divestiture of Ridaura

In April 2001, we sold the rights to our product Ridaura including
inventory and identified liabilities to

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Prometheus Laboratories Inc. for $9.0
million in cash plus a royalty on annual sales in excess of $4.0 million
through March 2006. Ridaura is a prescription pharmaceutical product for the
treatment of rheumatoid arthritis. We accrued approximately $978,000 for
transaction related costs and contractual liabilities incurred as of the date
of the sale. After recognizing the above amounts, we recorded a gain of $8.0
million on this transaction in 2001. Prometheus assumed our obligations under
a Supply Agreement to supply Ridaura in Canada to Pharmascience, Inc. We have
received no royalties to date on sales of Ridaura.

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

10. Relaxin Program and Agreements

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

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

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

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

F.H. Faulding & Co., Ltd.In April 2000, we entered into a collaboration
and exclusive license agreement with Faulding for the development and
commercialization of relaxin in Australia. Although we have discontinued our
development efforts for relaxin for scleroderma, Faulding has indicated that it
will continue the collaboration for other indications. Under the terms of the
agreement, Faulding paid $510,000 for the initial license of relaxin for the
treatment of scleroderma. Faulding would owe additional milestone payments for
the approval of non-scleroderma indications for relaxin in Australia. Faulding
is responsible for all development and commercialization activities in

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Australia, and is obligated to pay royalties on all sales of relaxin in
Australia. We recorded contract revenue under this agreement of $79,000 in
2002, $79,000 in 2001, and $39,000 in 2000.

11. Commitments

We lease three facilities under non-cancelable operating leases, the last
of which expires in April 2005. One of the operating leases requires an
irrevocable standby letter of credit that is secured by a certificate of
deposit with our bank. The amount of the letter of credit includes an
automatic annual reduction feature and expires on December 31, 2003. At
December 31, 2002, the restricted cash related to this letter of credit
amounted to $612,000; at December 31, 2001, the restricted cash related to this
letter of credit amounted to $925,000. The amounts are included in the
restricted cash balances on the Consolidated Balance Sheets. We also lease
office equipment and automobiles under various operating leases that will
expire on various dates through 2006.

In 2002 we entered into short term financing arrangements related to our
corporate insurance policies. The remaining amount of $89,000 related to these
financing arrangements will be paid in 2003 and has been included in Other
Accrued Liabilities on the Consolidated Balance Sheet.

In March 2002 we entered into a manufacturing and supply agreement with
DPT that requires minimum purchase commitments, beginning six months after the
opening of the commercial production line and continuing for 10 years. Also in
2002 we entered into a license agreement that requires minimum royalty payments
beginning in 2005 and continuing for fifteen years.

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

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

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

12. Stockholders Equity

Warrants

We have outstanding warrants to purchase up to 90,427 shares of our common
stock, at various prices and with varying expiration dates.

In July 1999, we issued a warrant to a third party to purchase 15,000
shares of common stock as partial compensation for financial advice pertaining
to investor and media relations. The warrant has an exercise price of $6.063
and expires in 2004. We valued the warrant using the Black-Scholes method and
recorded $66,000 as selling, general and administrative expense. As of
December 31, 2002, none of these warrants had been exercised.

As a commitment fee in connection with an equity line arrangement, we
issued warrants to purchase 25,000 shares in December 1998 at a purchase price
of $4.40, warrants to purchase 25,000 shares in December 1999 at a

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purchase
price of $6.875, and warrants to purchase 25,427 shares in December 2000 at a
purchase price of $5.3625. The warrants expire between 2003 and 2005. The
fair value of these warrants has been charged against additional paid-in
capital as a stock offering cost.

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

1995 Director Stock Option Plan

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

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

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

Employee Stock Plans

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

1994 Stock Plan

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

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2000 Stock Plan

Our 2000 Stock Plan (the 2000 Plan) was approved by the Board and our
stockholders in 1999. The 2000 Plan became available on January 1, 2000, and
was initially funded with 808,512 shares. On the first day of each new
calendar year during the term of the 2000 Plan, the number of shares available
will be increased (with no further action needed by the Board or the
stockholders) by a number of shares equal to the lesser of three percent (3%)
of the number of shares of common stock outstanding on the last preceding
business day, or an amount determined by the Board. In 2002, the increase in
authorized shares was 909,312 shares. As of December 31, 2002, a total of
2,447,829 common shares are reserved for issuance under the 2000 Plan.

Non-Officer Stock Option Plans

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

International Stock Incentive Plan

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

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

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

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

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

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

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

1995 Employee Stock Purchase Plan

The Board adopted the 1995 Employee Stock Purchase Plan (the Purchase
Plan) in December 1995, and amended the Purchase Plan in February and November
2000 and December 2002. We have reserved 1,255,010 shares of common stock for
issuance under the Purchase Plan. The Purchase Plan has an evergreen feature
pursuant to which, on November 30 of each year, the number of shares available
is increased automatically by a number of shares equal to the lesser of one
half of one percent (0.5%) of the number of shares of common stock outstanding
on that date, or an amount determined by the Board of Directors. The
Compensation Committee of the Board
administers the Purchase Plan. Employees (including officers and employee
directors) of Connetics are eligible to participate if they are employed for at
least 20 hours per week and more than 5 months per year. The Purchase Plan
permits eligible employees to purchase common stock through payroll deductions,
which may not exceed 15% of an employees compensation, at a price equal to the
lower of 85% of the fair market value of our common stock at the beginning or
end of the offering period. We issued 191,010 shares under the plan in 2002.
At December 31, 2002, we had 335,700 shares reserved for future issuance.

Common Shares Reserved for Future Issuance

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

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

Stockholder Rights Plan

We adopted a stockholder rights plan (the Rights Plan) in May 1997, as
amended and restated in November 2001. The Rights Plan entitles existing
stockholders to purchase from Connetics one preferred share purchase right,

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or Right, for each share of common stock they own. If the Rights become
exercisable, each Right entitles the holder to buy one one-thousandth of a
share of Series B Participating Preferred stock for $80.00. The Rights attach
to and trade only together with our common stock and do not have voting rights.
Rights Certificates will be issued and the Rights will become exercisable on
the Distribution Date, which is defined as the earlier of the tenth business
day (or such later date as may be determined by our Board of Directors) after a
person or group of affiliated or associated persons (Acquiring Person) (a)
has acquired, or obtained the right to acquire, beneficial ownership of 15% or
more of the common shares then outstanding or (b) announces a tender or
exchange offer, the consummation of which would result in ownership by a person
or group of 15% or more of our then outstanding common shares. Unless the
Rights are earlier redeemed, if an Acquiring Person obtains 15% or more of our
then outstanding common shares, then any Rights held by the Acquiring Person
are void, and each other holder of a Right which has not been exercised will
have the right to receive, upon exercise, common shares having a value equal to
two times the purchase price. The Rights are redeemable for $0.001 per Right
at the direction of our Board. The purchase price payable, the number of
Rights, and the number of Series B Participating Preferred Stock or common
shares or other securities or property issuable upon exercise of the Rights are
subject to adjustment from time to time in connection with the dilutive
issuances by Connetics as set forth in the Rights Plan. At December 31, 2002,
a total of 90,000 shares were designated as Series B Participating Preferred
Stock and no shares were issued and outstanding.

13. Income Taxes

The provision for income taxes consists of the following:

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

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

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

Pretax income from foreign operations was approximately $2.2 million in 2002
and $1.2 million in 2001.

Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets for financial reporting purposes and the
amounts used for income tax purposes. Significant components of our deferred
tax assets for federal and state income taxes as of December 31 are as follows
(in thousands):

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##### Table of Contents



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

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

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

The annual utilization of the federal and state net operating loss and tax
credit carryforwards is limited for tax purposes under the Internal Revenue
Code of 1986. The annual limitation may result in the expiration of net
operating losses and credits before we are able to utilize them.

Tax benefits associated with employee stock options provide a deferred
benefit of approximately $2.0 million, which has been offset by the valuation
allowance. The deferred tax benefit associated with the employee stock options
will be credited to additional paid-in capital when realized.

14. Retirement Savings Plan

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

15. Related Party Transactions

In February 2000, the Board authorized a loan to Mr. Wiggans in the amount
of $250,000, at an interest rate equal to 6.2%. The loan is to be forgiven at
a rate of $50,000 per year plus accrued interest, on each anniversary of the
loan on which Mr. Wiggans is still employed by Connetics. As of December 31,
2002, the total balance outstanding, including accrued interest, was $158,000.

F-24



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##### Table of Contents



16. Quarterly Financial Data (unaudited)

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

|                                                                    |          |   |               |        |            |   |        |        |            |   |        |        |   |   |        |        |  
|------------------------------------------------------------------- | -------- | - | ------------- | ------ | ---------- | - | ------ | ------ | ---------- | - | ------ | ------ | - | - | ------ | ------ | -
|                                                                   
|                                                                    |          |   | 2002 Quarters
|                                                                    |          |   |              
|                                                                    |          |   | First (1)     |        | Second (2) |   | Third  |        | Fourth (3)
|                                                                   
|Total revenues                                                      |          | $ | 11,531        |        |            | $ | 12,626 |        |            | $ | 13,641 |        |   | $ | 14,965 |       
|Cost of product revenues                                            |          |   | 675           |        |            |   | 973    |        |            |   | 1,116  |        |   |   | 1,426  |       
|Operating loss                                                      |          |   | (3,765        | )      |            |   | (7,018 | )      |            |   | (2,986 | )      |   |   | (5,765 | )     
|                                                                    | Net loss |   |               | (3,168 | )          |   |        | (5,321 | )          |   |        | (2,490 | ) |   |        | (5,611 | )
|Basic and diluted earnings per share
Net loss                       |          |   | (0.10         | )      |            |   | (0.17  | )      |            |   | (0.08  | )      |   |   | (0.18  | )     
|Shares used to calculate basic and
fully diluted net loss per share |          |   | 30,496        |        |            |   | 30,608 |        |            |   | 30,866 |        |   |   | 31,058 |       
|                                                                   



|(1) |  | In March 2002, Novartis Consumer Health exercised its right to
expand an existing license to cover the Liquipatch drug-delivery
system for use in all topical antifungal applications. We
recognized $580,000 of revenue related to this agreement in the
quarter ended March 31, 2002.                                                                                                                                                                                                                                              
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) |  | In May 2002, we entered into an agreement with Yamanouchi
Europe B.V. to license Velac gel. Under the terms of the
agreement, we paid Yamanouchi an initial $2.0 million licensing
fee, which we recorded as acquired in-process research and
development expense during the quarter ended June 30, 2002. In the
second quarter of 2002 and in connection with the wind down of
relaxin development contracts, we recorded a charge of $312,000,
representing the final payment due under a 2001 agreement with
Boehringer Ingelheim.
|   
|(3) |  | In the fourth quarter of 2002, we initiated a Phase III trial
for Velac. Under the terms of the agreement with Yamanouchi, we
recorded $2.0 million as acquired in-process research and
development expense related to this milestone.                                                                                                                                                                                                                                                                                               

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



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

F-25



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##### Table of Contents






Connetics Corporation
Index to Exhibits[Item 15(c)]

|                                     |  |                                                                                                                                                                                                                                                                                                                                                         
|------------------------------------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number                       |  | Description                                                                                                                                                                                                                                                                                                                                             
|                                     |  |                                                                                                                                                                                                                                                                                                                                                         
|                                     |  |                                                                                                                                                                                                                                                                                                                                                         
|3.1*                                 |  | Amended and Restated Certificate of Incorporation
(previously filed as an exhibit to the Companys Form
S-1 Registration Statement No. 33-80261)                                                                                                                                                                                                        
|                                     |  |                                                                                                                                                                                                                                                                                                                                                         
|3.2*                                 |  | Amendment to the Companys Amended and Restated
Certificate of Incorporation, as filed with the
Delaware Secretary of State on May 15, 1997 (previously
filed as an exhibit to the Companys Current Report on
Form 8-K dated May 23, 1997)                                                                                                             
|                                     |  |                                                                                                                                                                                                                                                                                                                                                         
|3.3*                                 |  | Certificate of Designation of Rights, Preferences and
Privileges of Series B Participating Preferred Stock,
as filed with the Delaware Secretary of State on May
15, 1997. Reference is made to Exhibit 4.2.                                                                                                                                            
|                                     |  |                                                                                                                                                                                                                                                                                                                                                         
|3.4*                                 |  | Amended and Restated Bylaws (previously filed as
Exhibit 3.2 to the Companys Form 8-A/A filed
November28, 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
November28, 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)                                                                                                                                
|                                     |  |                                                                                                                                                                                                                                                                                                                                                         
|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)                                                                                                                         

Index to Exhibits



---



##### Table of Contents



|                                  |  |                                                                                                                                                                                                                                                                   
|--------------------------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number                    |  | Description                                                                                                                                                                                                                                                       
|                                  |  |                                                                                                                                                                                                                                                                   
|                                  |  |                                                                                                                                                                                                                                                                   
|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.                                                                                                                                        
|                                  |  |                                                                                                                                                                                                                                                                   
|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)                                                                                                                             
|                                  |  |                                                                                                                                                                                                                                                                   
|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)                                                                                                  

Index to Exhibits



---



##### Table of Contents



|               |  |                                                                                                                                                                                                                                                                                 
|-------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                                                                                                                     
|               |  |                                                                                                                                                                                                                                                                                 
|               |  |                                                                                                                                                                                                                                                                                 
|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)                                                    
|               |  |                                                                                                                                                                                                                                                                                 
|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)                                                                               

Index to Exhibits



---



##### Table of Contents



|                 |  |                                                                                                                                                                                                                                                                                                
|---------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number   |  | Description                                                                                                                                                                                                                                                                                    
|                 |  |                                                                                                                                                                                                                                                                                                
|                 |  |                                                                                                                                                                                                                                                                                                
|Other Agreements
|                 |  |                                                                                                                                                                                                                                                                                                
|10.43*          |  | Agreement dated December 9, 1999 between the Company
and Soltec Research Pty Ltd. (previously filed as
Exhibit 10.75 to the Companys Annual Report on Form
10-K for the year ended December 31, 1999)                                                                                         
|                 |  |                                                                                                                                                                                                                                                                                                
|10.44*          |  | Share Sale Agreement dated March 21, 2001 among the
Company, F. H. Faulding & Co. Ltd., Faulding
Healthcare, and Connetics Australia Pty Ltd.
(previously filed as Exhibit 2.1 to the Companys
Current Report on Form 8-K dated March 20, 2001 and
filed with the Commission on April 2, 2001)
|                 |  |                                                                                                                                                                                                                                                                                                
|10.45*          |  | Asset Purchase Agreement dated as of April 9, 2001, by
and between Connetics and Prometheus Laboratories, Inc.
(previously filed as Exhibit 2.1 to the Companys
Current Report on Form 8-K dated April 30, 2001 and
filed with the Commission on May 11, 2001)                                
|                 |  |                                                                                                                                                                                                                                                                                                
|10.46*          |  | Settlement and Release Agreement effective as of
December 13, 2001 between Connetics and Boehringer
Ingelheim Austria GmbH (previously filed as Exhibit
10.54 to the Companys Annual Report on Form 10-K/A for
the year ended December 31, 2001)                                              
|                 |  |                                                                                                                                                                                                                                                                                                
|10.47*          |  | Facilities Contribution Agreement between Connetics and
DPT Laboratories, Ltd., with retroactive effect to
November 1, 2001 (previously filed as Exhibit 10.55 to
the Companys Annual Report on Form 10-K/A (Amendment
No. 2) for the year ended December 31, 2001)                           
|                 |  |                                                                                                                                                                                                                                                                                                
|10.48*          |  | Manufacturing and Supply Agreement between Connetics
and DPT Laboratories, Ltd., dated March 12, 2002
(previously filed as Exhibit 10.56 to the Companys
Annual Report on Form 10  K/A (Amendment No. 2) for
the year ended December 31, 2001)                                               
|                 |  |                                                                                                                                                                                                                                                                                                
|10.49*          |  | License and Development Agreement between Connetics and
Pharmacia & Upjohn Company, dated December 21, 2001
(previously filed as Exhibit 99.1 to the Companys
Current Report on Form 8-K/A-2 dated December 21, 2001,
filed with the SEC on July 12, 2002)                                    
|                 |  |                                                                                                                                                                                                                                                                                                
|10.50*          |  | License and Development Agreement between Connetics and
Yamanouchi Europe B.V., dated May 14, 2002 (previously
filed as Exhibit 10.2 to the Companys Quarterly Report
on Form
10-Q for the quarter ended June 30, 2002)                                                                       
|                 |  |                                                                                                                                                                                                                                                                                                
|21               |  | Subsidiaries of the Company                                                                                                                                                                                                                                                                    
|                 |  |                                                                                                                                                                                                                                                                                                
|23.1             |  | Consent of Ernst & Young LLP, Independent Auditors                                                                                                                                                                                                                                             
|                 |  |                                                                                                                                                                                                                                                                                                
|99.1             |  | Certification by Chief Executive Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                             
|                 |  |                                                                                                                                                                                                                                                                                                
|99.2             |  | Certification by Chief Financial Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                             

Key to Footnotes:

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



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

Index to Exhibits