##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-Q
 QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 SECURITIES EXCHANGE ACT OF 1934
 For the Quarterly Period Ended September 30, 2006
 Commission file number: 0-27406
 CONNETICS CORPORATION
 (Exact name of registrant as specified in its charter)
 Delaware
    
    94-3173928(State or other jurisdiction of
    
    (IRS Employerincorporation or organization)
    
    Identification Number)3160 Porter DrivePalo Alto, California
    
    94304(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number, including area code: (650) 843-2800
 þ o
  o þ o
 o þ




---



##### Table of Contents



CONNETICS CORPORATION
 TABLE OF CONTENTS
 PagePART I FINANCIAL INFORMATIONItem 1. Financial Statements
    
    3Unaudited Condensed Consolidated Balance Sheets at September 30, 2006 and December 31, 2005
    
    3Unaudited Condensed Consolidated Statements of Operations for the Three and Nine Months ended September 30, 2006 and 2005 (as restated)
    
    4Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months ended September 30, 2006 and 2005 (as restated)
    
    5Notes to Unaudited Condensed Consolidated Financial Statements
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    24Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    35Item 4. Controls and Procedures
    
    35PART II OTHER INFORMATIONItem 1. Legal Proceedings
    
    39Item 1A. Risk Factors
    
    40Item 2. Purchases of Equity Securities by the Issuer
    
    41Item 5. Other Information
    
    41Item 6. Exhibits
    
    43Signatures
    
    44EXHIBIT 10.1EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.1
 2




---



##### Table of Contents



PART I. FINANCIAL INFORMATION
 
 Item 1. Financial Statements
 CONNETICS CORPORATION
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (In thousands)
(Unaudited)
 September 30,
    
    
    December 31,2006
    
    
    2005ASSETSCurrent assets:Cash and cash equivalents
    
    $
    42,338
    
    
    $
    29,988Marketable securities
    
    
    187,154
    
    
    
    241,108Restricted cash  current
    
    
    1,421
    
    
    
    1,000Accounts receivable, net of cash discounts and allowances
    
    
    10,132
    
    
    
    11,100Inventory
    
    
    9,476
    
    
    
    7,485Other current assets
    
    
    22,682
    
    
    
    21,938Total current assets
    
    
    273,203
    
    
    
    312,619Long-term investments
    
    
    12,274
    
    
    
    Property and equipment, net
    
    
    14,874
    
    
    
    14,438Restricted cash  long term
    
    
    2,533
    
    
    
    3,059Goodwill
    
    
    6,271
    
    
    
    6,271Other intangibles, net
    
    
    109,213
    
    
    
    108,789Other assets
    
    
    9,413
    
    
    
    12,313$
    427,781
    
    
    $
    457,489LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    17,046
    
    
    $
    16,609Product-related liabilities
    
    
    28,109
    
    
    
    35,371Other accrued liabilities
    
    
    13,845
    
    
    
    15,075Total current liabilities
    
    
    59,000
    
    
    
    67,055Convertible senior notes
    
    
    290,000
    
    
    
    290,000Other non-current liabilities
    
    
    590
    
    
    
    517Commitments and contingenciesStockholders Equity:Common stock
    
    
    35
    
    
    
    37Treasury stock
    
    
    (62,603
    )
    
    
    (60,447
    )Additional paid-in-capital
    
    
    256,060
    
    
    
    247,880Accumulated deficit
    
    
    (116,130
    )
    
    
    (88,080
    )Accumulated other comprehensive income
    
    
    829
    
    
    
    527Total stockholders equity
    
    
    78,191
    
    
    
    99,917Total liabilities and stockholders equity
    
    $
    427,781
    
    
    $
    457,489
 See accompanying notes to condensed consolidated financial statements.
 3




---



##### Table of Contents



CONNETICS CORPORATION
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (In thousands, except per share amounts)
(Unaudited)
 Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2005
    
    
    
    
    
    
    20052006
    
    
    (restated)
    
    
    2006
    
    
    (restated)Net revenues:Product
    
    $
    18,836
    
    
    $
    50,788
    
    
    $
    109,405
    
    
    $
    136,331Royalty and contract
    
    
    849
    
    
    
    158
    
    
    
    1,255
    
    
    
    469Total net revenues
    
    
    19,685
    
    
    
    50,946
    
    
    
    110,660
    
    
    
    136,800Operating costs and expenses:Cost of product revenues (excluding amortization of acquired
product rights)
    
    
    1,668
    
    
    
    4,183
    
    
    
    9,226
    
    
    
    12,931Amortization of intangible assets
    
    
    4,059
    
    
    
    3,399
    
    
    
    12,114
    
    
    
    10,198Research and development
    
    
    10,035
    
    
    
    8,381
    
    
    
    26,237
    
    
    
    23,236Selling, general and administrative
    
    
    31,578
    
    
    
    23,703
    
    
    
    92,980
    
    
    
    76,868Total operating costs and expenses
    
    
    47,340
    
    
    
    39,666
    
    
    
    140,557
    
    
    
    123,233Income (loss) from operations
    
    
    (27,655
    )
    
    
    11,280
    
    
    
    (29,897
    )
    
    
    13,567Interest and other income (expense):Interest income
    
    
    3,046
    
    
    
    2,130
    
    
    
    8,046
    
    
    
    4,452Interest expense
    
    
    (3,215
    )
    
    
    (2,008
    )
    
    
    (6,945
    )
    
    
    (4,639
    )Other income (expense), net
    
    
    179
    
    
    
    38
    
    
    
    213
    
    
    
    (25
    )Income (loss) before income taxes
    
    
    (27,645
    )
    
    
    11,440
    
    
    
    (28,583
    )
    
    
    13,355Income tax provision (benefit)
    
    
    (274
    )
    
    
    470
    
    
    
    (533
    )
    
    
    728Net income (loss)
    
    $
    (27,371
    )
    
    $
    10,970
    
    
    $
    (28,050
    )
    
    $
    12,627Net income (loss) per share:Basic
    
    $
    (0.81
    )
    
    $
    0.31
    
    
    $
    (0.83
    )
    
    $
    0.36Diluted
    
    $
    (0.81
    )
    
    $
    0.29
    
    
    $
    (0.83
    )
    
    $
    0.34Shares used to compute basic and diluted net income (loss) per share:Basic
    
    
    33,836
    
    
    
    35,075
    
    
    
    33,741
    
    
    
    35,197Diluted
    
    
    33,836
    
    
    
    40,812
    
    
    
    33,741
    
    
    
    37,462
 See accompanying notes to condensed consolidated financial statements.
 4




---



##### Table of Contents



CONNETICS CORPORATION
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (In thousands)
(Unaudited)
 Nine Months EndedSeptember 30,20052006
    
    
(restated)Cash flows from operating activities:Net income (loss)
    
    $
    (28,050
    )
    
    $
    12,627Adjustments to reconcile net income (loss) to net cash from operating activities:Depreciation
    
    
    1,891
    
    
    
    1,260Amortization of intangible assets
    
    
    12,114
    
    
    
    10,199Amortization of convertible senior notes offering costs
    
    
    1,076
    
    
    
    911Allowance for cash discounts and doubtful accounts
    
    
    (62
    )
    
    
    28Stock compensation expense
    
    
    3,756
    
    
    
    13Changes in assets and liabilities:Accounts receivable
    
    
    1,030
    
    
    
    2,038Other assets
    
    
    1,091
    
    
    
    (5,705
    )Inventory
    
    
    (1,936
    )
    
    
    (336
    )Accounts payable
    
    
    574
    
    
    
    1,622Product-related accruals
    
    
    (7,262
    )
    
    
    11,428Other current liabilities
    
    
    (924
    )
    
    
    2,088Other non-current liabilities
    
    
    (233
    )
    
    
    126Net cash (used in) provided by operating activities
    
    
    (16,935
    )
    
    
    36,299Cash flows from investing activities:Purchases of marketable securities
    
    
    (108,152
    )
    
    
    (300,033
    )Sales and maturities of marketable securities
    
    
    150,175
    
    
    
    114,772Transfer to restricted cash
    
    
    105
    
    
    
    (96
    )Purchases of property and equipment
    
    
    (2,496
    )
    
    
    (3,873
    )Acquisition of sales force
    
    
    (12,537
    )
    
    
    Net cash provided by (used in) investing activities
    
    
    27,095
    
    
    
    (189,230
    )Cash flows from financing activities:Proceeds from issuance of convertible senior notes, net of issuance costs
    
    
    
    
    
    
    192,625Repurchases of common stock
    
    
    (2,156
    )
    
    
    (35,000
    )Proceeds from exercise of stock options and employee stock purchase plan, net
of repurchases of unvested shares
    
    
    4,422
    
    
    
    7,135Net cash provided by financing activities
    
    
    2,266
    
    
    
    164,760Effect of foreign currency exchange rate changes on cash and cash equivalents
    
    
    (76
    )
    
    
    (72
    )Net change in cash and cash equivalents
    
    
    12,350
    
    
    
    11,757Cash and cash equivalents at beginning of period
    
    
    29,988
    
    
    
    18,261Cash and cash equivalents at end of period
    
    $
    42,338
    
    
    $
    30,018
 See accompanying notes to condensed consolidated financial statements.
 5




---



##### Table of Contents



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 Recent Transaction
  1. Basis of Presentation
 Interim Financial Information
   Principles of Consolidation
  Use of Estimates
   6




---



##### Table of Contents



Restatement of Prior Period Information
  Adjustment to Quarterly Financial Statements
 . Interim Financial Reporting in thousands except per share amounts
 Three Months Ended June 30, 2006
    
    
    Six Months Ended June 30, 2006(unaudited)
    
    
    (unaudited)As
    
    
    
    
    
    
    
    
    
    
    AsPreviously
    
    
    Inventory
    
    
    As
    
    
    Previously
    
    
    Inventory
    
    
    AsReported
    
    
    Adjustment
    
    
    Restated
    
    
    Reported
    
    
    Adjustment
    
    
    RestatedNet revenues:Product revenues
    
    
    43,620
    
    
    
    
    
    
    
    43,620
    
    
    
    90,569
    
    
    
    
    
    
    
    90,569Royalty and contract
    
    
    222
    
    
    
    
    
    
    
    222
    
    
    
    406
    
    
    
    
    
    
    
    406Total net revenues
    
    
    43,842
    
    
    
    
    
    
    
    43,842
    
    
    
    90,975
    
    
    
    
    
    
    
    90,975Operating costs and expenses:Cost of product revenues
(excluding amortization of
acquired product rights)
    
    
    4,007
    
    
    
    (368
    )
    
    
    3,639
    
    
    
    7,926
    
    
    
    (368
    )
    
    
    7,558Amortization of intangible assets
    
    
    4,153
    
    
    
    
    
    
    
    4,153
    
    
    
    8,055
    
    
    
    
    
    
    
    8,055Research and Development
    
    
    8,020
    
    
    
    
    
    
    
    8,020
    
    
    
    16,202
    
    
    
    
    
    
    
    16,202Selling, general and
administrative
    
    
    31,037
    
    
    
    
    
    
    
    31,037
    
    
    
    61,402
    
    
    
    
    
    
    
    61,402Total operating costs
and expenses
    
    
    47,217
    
    
    
    (368
    )
    
    
    46,849
    
    
    
    93,585
    
    
    
    (368
    )
    
    
    93,217Income (loss) from operations
    
    
    (3,375
    )
    
    
    368
    
    
    
    (3,007
    )
    
    
    (2,610
    )
    
    
    368
    
    
    
    (2,242
    )Interest and other income (expense):Interest income
    
    
    2,758
    
    
    
    
    
    
    
    2,758
    
    
    
    5,000
    
    
    
    
    
    
    
    5,000Interest expense
    
    
    (1,865
    )
    
    
    
    
    
    
    (1,865
    )
    
    
    (3,730
    )
    
    
    
    
    
    
    (3,730
    )Other income (expense), net
    
    
    (19
    )
    
    
    
    
    
    
    (19
    )
    
    
    33
    
    
    
    
    
    
    
    33Income (loss) before income taxes
    
    
    (2,501
    )
    
    
    368
    
    
    
    (2,133
    )
    
    
    (1,307
    )
    
    
    368
    
    
    
    (939
    )Income tax provision (benefit)
    
    
    (340
    )
    
    
    
    
    
    
    (340
    )
    
    
    (259
    )
    
    
    
    
    
    
    (259
    )Net income (loss)
    
    $
    (2,161
    )
    
    $
    368
    
    
    $
    (1,793
    )
    
    $
    (1,048
    )
    
    $
    368
    
    
    $
    (680
    )Net income (loss) per share:Basic
    
    $
    (0.06
    )
    
    
    
    
    
    $
    (0.05
    )
    
    $
    (0.03
    )
    
    
    
    
    
    $
    (0.02
    )Diluted
    
    $
    (0.06
    )
    
    
    
    
    
    $
    (0.05
    )
    
    $
    (0.03
    )
    
    
    
    
    
    $
    (0.02
    )Shares used to compute basic and diluted
net income (loss) per share:Basic
    
    
    33,740
    
    
    
    
    
    
    
    33,740
    
    
    
    33,693
    
    
    
    
    
    
    
    33,693Diluted
    
    
    33,740
    
    
    
    
    
    
    
    33,740
    
    
    
    33,693
    
    
    
    
    
    
    
    33,693
 7




---



##### Table of Contents



Recent Accounting Pronouncements
 Accounting for Uncertainty in Income Taxes Accounting for Income Taxes
 Fair Value Measurements
 2. Significant Accounting Policies
 Revenue Recognition
   8




---



##### Table of Contents



Gross-to-Net Sales Adjustment
  Returns
    9




---



##### Table of Contents



Managed Care Rebates
   Medicaid Rebates
    10




---



##### Table of Contents



Chargebacks
   Cash Discounts
  Other Adjustments
   11




---



##### Table of Contents



product-related accruals
 Use of Information from External Sources
   Use of Estimates in Reserves
  12




---



##### Table of Contents



Royalty Revenues
  Contract Revenues
   Stock-Based Compensation
 Share-Based Payment Accounting for Stock-Based Compensation
   3. Net Income (Loss) Per Share
  13




---



##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2005
    
    
    
    
    
    
    2005(in thousands, except per share amounts)
    
    2006
    
    
    (restated)
    
    
    2006
    
    
    (restated)Net income (loss), as reported
    
    $
    (27,371
    )
    
    $
    10,970
    
    
    $
    (28,050
    )
    
    $
    12,627Add: interest on convertible note, net of tax effect
    
    
    
    
    
    
    669
    
    
    
    
    
    
    
    Net income (loss), diluted
    
    $
    (27,371
    )
    
    $
    11,639
    
    
    $
    (28,050
    )
    
    $
    12,627Weighted average shares outstanding
    
    
    34,436
    
    
    
    35,075
    
    
    
    34,243
    
    
    
    35,197Weighted-average restricted shares subject to repurchase
    
    
    (600
    )
    
    
    
    
    
    
    (502
    )
    
    
    Basic weighted-average shares outstanding
    
    
    33,836
    
    
    
    35,075
    
    
    
    33,741
    
    
    
    35,197Dilutive stock options
    
    
    
    
    
    
    1,534
    
    
    
    
    
    
    
    2,265Convertible debt
    
    
    
    
    
    
    4,203
    
    
    
    
    
    
    
    Diluted weighted-average shares outstanding
    
    
    33,836
    
    
    
    40,812
    
    
    
    33,741
    
    
    
    37,462Net income (loss) per share:Basic
    
    $
    (0.81
    )
    
    $
    0.31
    
    
    $
    (0.83
    )
    
    $
    0.36Diluted
    
    $
    (0.81
    )
    
    $
    0.29
    
    
    $
    (0.83
    )
    
    $
    0.34
 in thousands
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2006
    
    2005
    
    2006
    
    2005Options
    
    
    6,219
    
    
    
    3,053
    
    
    
    4,833
    
    
    
    1,456Restricted stock
    
    
    615
    
    
    
    
    
    
    
    615
    
    
    
    Convertible debt
    
    
    4,203
    
    
    
    
    
    
    
    4,203
    
    
    
    4,203Total
    
    
    10,441
    
    
    
    3,053
    
    
    
    9,651
    
    
    
    5,659
  4. Stock-Based Compensation
  14




---



##### Table of Contents



Three Months
    
    
    Nine MonthsEnded
    
    
    EndedSeptember 30,
    
    
    September 30,(in thousands, except per share amounts)
    
    2006
    
    
    2006Cost of product revenues
    
    $
    
    
    
    $
    Research and development
    
    
    307
    
    
    
    867Selling, general and administrative
    
    
    964
    
    
    
    2,989Stock-based compensation expense before income tax provision
    
    
    1,271
    
    
    
    3,856Income tax provision
    
    
    
    
    
    
    Total stock-based compensation expense after income tax provision
    
    $
    1,271
    
    
    $
    3,856Stock-based compensation expense per share:Basic and diluted
    
    $
    0.04
    
    
    $
    0.11Weighted average shares outstanding:Basic and diluted
    
    
    33,836
    
    
    
    33,741
   pro forma
 15




---



##### Table of Contents



Three Months
    
    
    Nine MonthsEnded
    
    
    EndedSeptember 30,
    
    
    September 30,2005
    
    
    2005(in thousands, except per share amounts)
    
    (restated)
    
    
    (restated)Net income, as reported
    
    $
    10,970
    
    
    $
    12,627Add: interest on convertible note, net of tax effect
    
    
    669
    
    
    
    Net income, diluted
    
    $
    11,639
    
    
    $
    12,627Add: Stock-based compensation expense, net of related tax effects
    
    
    5
    
    
    
    13Deduct: Total stock-based employee compensation expense
determined under the fair value method for all awards, net of
related tax effects
    
    
    (4,010
    )
    
    
    (12,288
    )Pro forma net income
    
    $
    7,634
    
    
    $
    352Net income per share:Basic, as reported
    
    $
    0.31
    
    
    $
    0.36Diluted, as reported
    
    $
    0.29
    
    
    $
    0.34Basic, pro forma
    
    $
    0.20
    
    
    $
    0.01Diluted, pro forma
    
    $
    0.19
    
    
    $
    0.01
    Stock Option Plans

    
    Stock Option PlansThree Months Ended

    
    Nine Months EndedSeptember 30,

    
    September 30,2006
    
    2005
    
    2006
    
    2005Expected stock volatility
    
    
    53.7
    %
    
    
    47.1
    %
    
    
    51.9
    %
    
    
    47.1
    %Risk-free interest rate
    
    
    4.7
    %
    
    
    3.9
    %
    
    
    4.7
    %
    
    
    3.6
    %Expected life (in years)
    
    
    4.5
    
    
    
    4.0
    
    
    
    4.2
    
    
    
    4.0Expected dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %
 Stock Purchase PlanThree Months
    
    Nine MonthsEnded
    
    EndedSeptember 30,
    
    September 30,2005
    
    2005Expected stock volatility
    
    
    55.9
    %
    
    
    52.1
    %Risk-free interest rate
    
    
    1.5
    %
    
    
    1.6
    %Expected life (in years)
    
    
    1.4
    
    
    
    1.4Expected dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
  16




---



##### Table of Contents



Stock Plans
  17




---



##### Table of Contents



2000 Stock Plan.
 Non-Officer Stock Option Plans.
 International Stock Incentive Plan.
 Inducement Stock Option Grants.
 Summary of All Option Plans and Non-Plan Grants.
 Options OutstandingShares
    
    
    
    
    
    
    WeightedAvailable
    
    
    Number
    
    
    Averagefor
    
    
    of
    
    
    ExerciseGrant
    
    
    Shares
    
    
    PriceBalance, December 31, 2004
    
    
    372,082
    
    
    
    6,837,909
    
    
    $
    12.64Additional shares authorized
    
    
    1,675,356
    
    
    
    
    
    
    
    Options granted
    
    
    (1,730,887
    )
    
    
    1,730,887
    
    
    
    22.05Options exercised
    
    
    
    
    
    
    (713,747
    )
    
    
    8.93Options canceled, expired or forfeited
    
    
    474,797
    
    
    
    (474,797
    )
    
    
    18.90Balance, December 31, 2005
    
    
    791,348
    
    
    
    7,380,252
    
    
    $
    14.80Additional shares authorized
    
    
    1,277,543
    
    
    
    
    
    
    
    Options granted
    
    
    (1,008,068
    )
    
    
    1,008,068
    
    
    
    13.85Restricted shares granted
    
    
    (615,120
    )
    
    
    
    
    
    
    Options exercised
    
    
    
    
    
    
    (424,032
    )
    
    
    8.90Options canceled, expired or forfeited (1)
    
    
    456,076
    
    
    
    (456,076
    )
    
    
    18.19Options canceled due to an expired plan (2)
    
    
    (70,000
    )
    
    
    
    
    
    
    Balance, September 30, 2006
    
    
    831,779
    
    
    
    7,508,212
    
    
    $
    14.80
 
 (1)
    
    During the nine months ended September 30, 2006 we had 49,000 canceled, expired or
forfeited 18




---



##### Table of Contents



options related to stock option plans that expired before January 1, 2006. As these
options expire or are forfeited they are not added back to the pool of options available for
grant.(2)
    
    On January 1, 2006 our 1995 Directors Plan expired, with the result that 70,000
options expired that had never been granted.   Options Outstanding
    
    Options ExercisableWeightedAverage
    
    Weighted
    
    
    
    
    
    WeightedRange
    
    
    
    
    
    Remaining
    
    Average
    
    
    
    
    
    Averageof
    
    Number of
    
    Life (in
    
    Exercise
    
    Number of
    
    ExerciseExercise Prices
    
    Shares
    
    years
    
    Price
    
    Shares
    
    Price$ 0.00  $5.84
    
    
    488,005
    
    
    
    3.30
    
    
    $
    4.48
    
    
    
    488,005
    
    
    $
    4.48$ 5.85  $8.75
    
    
    1,062,756
    
    
    
    2.90
    
    
    
    7.61
    
    
    
    1,026,256
    
    
    
    7.60$ 8.76  $11.67
    
    
    488,419
    
    
    
    7.40
    
    
    
    10.34
    
    
    
    246,688
    
    
    
    10.53$11.68  $14.59
    
    
    1,757,109
    
    
    
    5.65
    
    
    
    12.29
    
    
    
    1,468,325
    
    
    
    12.20$14.60  $17.51
    
    
    898,468
    
    
    
    8.62
    
    
    
    15.82
    
    
    
    241,032
    
    
    
    16.30$17.52  $20.43
    
    
    1,320,559
    
    
    
    6.81
    
    
    
    18.28
    
    
    
    1,237,098
    
    
    
    18.32$20.44  $23.34
    
    
    282,146
    
    
    
    7.72
    
    
    
    21.88
    
    
    
    282,146
    
    
    
    21.88$23.35  $26.26
    
    
    950,500
    
    
    
    7.68
    
    
    
    23.76
    
    
    
    950,500
    
    
    
    23.76$26.27  $29.18
    
    
    260,250
    
    
    
    7.77
    
    
    
    27.32
    
    
    
    260,250
    
    
    
    27.32$ 0.00  $29.18
    
    
    7,508,212
    
    
    
    6.19
    
    
    
    14.80
    
    
    
    6,200,300
    
    
    
    14.99
  5. Comprehensive Income
 (in thousands)
 Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2005
    
    
    
    
    
    
    20052006
    
    
    (restated)
    
    
    2006
    
    
    (restated)Net income (loss)
    
    $
    (27,371
    )
    
    $
    10,970
    
    
    $
    (28,050
    )
    
    $
    12,627Foreign currency translation adjustment
    
    
    (95
    )
    
    
    (9
    )
    
    
    (41
    )
    
    
    (92
    )Change in unrealized gain (loss) on securities
    
    
    720
    
    
    
    (362
    )
    
    
    343
    
    
    
    (536
    )Comprehensive income (loss)
    
    $
    (26,746
    )
    
    $
    10,599
    
    
    $
    (27,748
    )
    
    $
    11,999
  6. Inventory
  19




---



##### Table of Contents



(in thousands)
 September 30,
    
    
    December 31,2006
    
    
    2005Raw materials
    
    $
    4,054
    
    
    $
    1,649Finished goods
    
    
    5,422
    
    
    
    5,836Total inventory
    
    $
    9,476
    
    
    $
    7,485
 other assets
 7. PediaMed Sales Organization Acquisition
  8. Goodwill and Other Intangible Assets
 (in
thousands)
 September 30, 2006
    
    
    December 31, 2005Useful Life
    
    
    Gross Carrying
    
    
    Accumulated
    
    
    
    
    
    
    Gross Carrying
    
    
    Accumulatedin Years
    
    
    Amount
    
    
    Amortization
    
    
    Net
    
    
    Amount
    
    
    Amortization
    
    
    NetAcquired product rights
    
    
    10
    
    
    $
    127,652
    
    
    $
    (32,977
    )
    
    $
    94,675
    
    
    $
    127,652
    
    
    $
    (23,403
    )
    
    $
    104,249Existing technology
    
    
    10
    
    
    
    6,810
    
    
    
    (3,717
    )
    
    
    3,093
    
    
    
    6,810
    
    
    
    (3,206
    )
    
    
    3,604Patents
    
    
    10-13
    
    
    
    1,661
    
    
    
    (838
    )
    
    
    823
    
    
    
    1,661
    
    
    
    (725
    )
    
    
    936Assembled workforce
    
    
    5
    
    
    
    12,248
    
    
    
    (1,626
    )
    
    
    10,622
    
    
    
    
    
    
    
    
    
    
    
    Other PediaMed assets
    
    
    0.5
    
    
    
    289
    
    
    
    (289
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    
    
    
    
    $
    148,660
    
    
    $
    (39,447
    )
    
    $
    109,213
    
    
    $
    136,123
    
    
    $
    (27,334
    )
    
    $
    108,789
 20




---



##### Table of Contents



(in
thousands)
 AmortizationExpenseRemaining three months in 2006
    
    $
    4,011For the year ending December 31, 2007
    
    
    16,049For the year ending December 31, 2008
    
    
    16,049For the year ending December 31, 2009
    
    
    16,049For the year ending December 31, 2010
    
    
    16,049For the year ending December 31, 2011
    
    
    13,232Thereafter
    
    
    27,774Total
    
    $
    109,213
 9. Guaranties and Indemnifications
  10. Co-Promotion Agreement
  11. Stock Repurchase Program
  21




---



##### Table of Contents



12. SEC Investigation
  13. Subsequent Events  Proposed Merger with Stiefel Laboratories, Inc.
   
    
    each issued and outstanding share of the Companys common stock (including shares of
restricted common stock whose vesting will accelerate upon the closing of the merger,
as discussed below), will be converted into a right to receive $17.50 in cash, without
interest;
    
    all of the Companys outstanding stock options and shares of restricted stock, to
the extent not vested, will accelerate in full; and
    
    each outstanding stock option will be terminated and converted into a right to
receive a cash payment equal to the product of (i) the amount, if any, that $17.50
exceeds the exercise price per share of such option, multiplied by (ii) the number of
shares underlying such option.
 22




---



##### Table of Contents



23




---



##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
 This discussion and analysis should be read in conjunction with the MD&A included in our
Annual Report, as amended, on Form 10-K /A for the year ended December 31, 2005 and with the
unaudited condensed consolidated financial statements and notes to financial statements included in
this Report. 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
may 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 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. Some of the factors that, in our view, could cause actual results to
differ are discussed under the caption Risk Factors in our 2005 Annual Report, as amended, on
Form 10-K/A for the year ended December 31, 2005, as amended. Our historical operating results are
not necessarily indicative of the results to be expected in any future period.
 Proposed Merger With Stiefel
   
    
    each issued and outstanding share of the Companys common stock (including shares of
restricted common stock whose vesting will accelerate upon the closing of the merger,
as discussed below), will be converted into a right to receive $17.50 in cash, without
interest;
    
    all of the Companys outstanding stock options and shares of restricted stock, to
the extent not vested, will accelerate in full; and
    
    each outstanding stock option will be terminated and converted into a right to
receive a cash payment equal to the product of (i) the amount, if any, that $17.50
exceeds the exercise price per share of such option, multiplied by (ii) the number of
shares underlying such option.
  24




---



##### Table of Contents







Restatement of Consolidated Financial Statements




Overview






§
    
    OLUX (clobetasol propionate) Foam, 0.05%, a super high-potency topical steroid
prescribed for the treatment of steroid responsive dermatological diseases of the scalp
and mild to moderate plaque-type psoriasis of non-scalp regions excluding the face and
intertriginous areas;§
    
    Luxíq (betamethasone valerate) Foam, 0.12%, a mid-potency topical steroid prescribed
for scalp dermatoses such as psoriasis, eczema and seborrheic dermatitis;§
    
    Soriatane (acitretin), an oral medicine for the treatment of severe psoriasis; and§
    
    Evoclin (clindamycin phosphate) Foam, 1%, a topical treatment for acne vulgaris.§
    
    Verdeso (desonide) Foam, 0.05%, a low-potency topical steroid and is the first
approved product formulated in Connetics proprietary VersaFoam(R)-EF emulsion
formulation foam vehicle for the treatment of mild-to-moderate atopic dermatitis.




tm) 25




---



##### Table of Contents



Critical Accounting Policies and Estimates
  27




---



##### Table of Contents



Revenue Recognition
  Stock-Based Compensation
 Share-Based Payment Accounting for
Stock-Based Compensation
   27




---



##### Table of Contents



Results of Operations
 Net Revenues
 (in thousands)
 Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Gross product revenues
    
    $
    21,968
    
    
    $
    58,848
    
    
    $
    134,836
    
    
    $
    174,019Product returns
    
    
    (1,708
    )
    
    
    965
    
    
    
    (9,294
    )
    
    
    (8,001
    )Managed care and Medicaid rebates
    
    
    (798
    )
    
    
    (5,484
    )
    
    
    (6,969
    )
    
    
    (17,062
    )Chargebacks
    
    
    (764
    )
    
    
    (1,889
    )
    
    
    (3,833
    )
    
    
    (5,776
    )Cash discounts and other
    
    
    138
    
    
    
    (1,652
    )
    
    
    (5,335
    )
    
    
    (6,849
    )Net product revenues
    
    $
    18,836
    
    
    $
    50,788
    
    
    $
    109,405
    
    
    $
    136,331
 (in
thousands)
 Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Net product revenues:Soriatane
    
    $
    10,411
    
    
    $
    20,804
    
    
    $
    44,867
    
    
    $
    54,911OLUX Foam
    
    
    4,317
    
    
    
    15,879
    
    
    
    31,362
    
    
    
    45,276Evoclin Foam
    
    
    2,255
    
    
    
    7,519
    
    
    
    19,459
    
    
    
    17,517Luxiq Foam
    
    
    1,843
    
    
    
    6,541
    
    
    
    13,620
    
    
    
    18,486Other
    
    
    10
    
    
    
    45
    
    
    
    97
    
    
    
    141Total net product revenues
    
    
    18,836
    
    
    
    50,788
    
    
    
    109,405
    
    
    
    136,331Royalty and contract revenues:Royalty
    
    
    475
    
    
    
    158
    
    
    
    881
    
    
    
    386Contract
    
    
    374
    
    
    
    
    
    
    
    374
    
    
    
    83Total royalty and contract revenues
    
    
    849
    
    
    
    158
    
    
    
    1,255
    
    
    
    469Total net revenues
    
    $
    19,685
    
    
    $
    50,946
    
    
    $
    110,660
    
    
    $
    136,800
 product-related accruals
 28




---



##### Table of Contents



September 30,
    
    June 30,
    
    March 31,
    
    December 31,Product
    
    2006
    
    2006
    
    2006
    
    2005Soriatane
    
    
    1.5
    
    
    
    3.2
    
    
    
    3.9
    
    
    
    4.2OLUX Foam
    
    
    1.5
    
    
    
    3.6
    
    
    
    3.9
    
    
    
    4.6Evoclin Foam
    
    
    1.3
    
    
    
    3.7
    
    
    
    4.0
    
    
    
    4.3Luxíq Foam
    
    
    1.6
    
    
    
    4.0
    
    
    
    4.4
    
    
    
    5.4Weighted
average for
all products
    
    
    1.5
    
    
    
    3.6
    
    
    
    4.0
    
    
    
    4.6
   29




---



##### Table of Contents



Cost of Product Revenues
   30




---



##### Table of Contents



.
 Amortization of Intangible Assets
  Research and Development
  research and development
 research and development
 Selling, General and Administrative Expenses
  31




---



##### Table of Contents



Stock-based Compensation
  pro forma
    32




---



##### Table of Contents



Interest and other income (expense), net
   Provision (Benefit) for Income Taxes
  Liquidity and Capital Resources
 Working Capital
   33




---



##### Table of Contents



Fluctuation in Current Assets
    
    Explanation$41.6 million decrease  cash, cash
equivalents and marketable securities
    
    In addition to the items
noted above, at September 30,
2006 $12.3 million of
investments were classified
as long-term assets, whereas,
at December 31, 2005 all of
our investments were
classified as current assets.
 Fluctuation in Current Liabilities
    
    Explanation$7.3 million decrease product-related
accrued liabilities
    
    Decrease is primarily driven
by lower costs related to
fewer units in our
distribution channel
resulting from the reduction
of inventory levels of our
products at our major
wholesalers.
 Capital Expenditures
   Capital Resources
     34




---



##### Table of Contents



Contractual Obligations and Commercial Commitments
  Recent Accounting Pronouncements
   
 Item 3. Quantitative and Qualitative Disclosures About Market Risk
  
 Item 4. Controls and Procedures
 Disclosure Controls and Procedures
  35




---



##### Table of Contents



Managements Report on Internal Control Over Financial Reporting
     36




---



##### Table of Contents



Changes in Internal Control over Financial Reporting
  Remediation of Material Weaknesses
 
 §
    
    modified the methodology used to estimate accruals for rebates and chargebacks to
fully capture the future liability related to product inventory in the distribution
channel and other factors, including anticipated price increases for our products and
estimated future usage of our products by patients enrolled in Medicaid programs and
contracted managed care organizations;§
    
    revised our methodology used to estimate the accrual for product returns to (a)
estimate the return rate on our most recent three years data, resulting in an
estimated rate that is more responsive to current return trends, (b) apply the rate to
production lots, (c) consider the relevant risk of return, and (d) take into account
current price and anticipated price increases;§
    
    assigned an individual with significant industry experience as our Senior Revenue
Manager and increased the involvement of our Vice-President, Finance and Administration
in the estimation process;§
    
    engaged external consultants to assist us in revising our methodologies to ensure
all relevant factors were considered and the computational aspects of the models were
appropriate;§
    
    established formal intradepartmental communication between the finance function and
other departments, including, but not limited to, commercial operations, specifically
personnel involved in our sales operations, managed care and manufacturing activities
involving monthly forecast meetings and a central, shared location on our internal
network for the sharing of information;§
    
    established formal coordination related to assumptions used in our quarterly revenue
reserves including meetings with relevant operational personnel at the start of the
quarterly close and written confirmations of the final assumptions used in our
financial statements from those same operational personnel upon the completion of the
quarterly close;§
    
    developed a checklist used by finance personnel to ensure all quarterly activities
related to revenue reserves are completed on a timeline basis; and§
    
    hired an individual with significant industry experience as our Senior Financial
Analyst to assist in
 37




---



##### Table of Contents



and support our revenue-reserves estimation process; and
  §
    
    development of processes for the periodic regular reconciliation of our inventory
data with third party wholesalers inventory reports; and§
    
    training of all relevant finance and commercial operations personnel regarding the
new revenue-reserves methodologies and the controls and procedures surrounding channel
inventory and product returns;§
    
    hiring of additional finance and commercial personnel with specific, relevant
industry experience to manage the more sophisticated methodologies adopted in
connection with the restatement of our financial statements.
  38




---



##### Table of Contents



PART II. OTHER INFORMATION
 
 Item 1. Legal Proceedings
 SEC Investigation
  Plumbers & Pipefitters Local #562 Pension Fund vs.
Connetics Corporation, Thomas G. Wiggans, C.
Gregory Vontz, and Alexander J. Yaroshinsky (N.D. Cal. Case No. 06-5691 PJH).
 Almar T. Widiger Living Trust vs. Connetics Corporation, Thomas G. Wiggans, C. Gregory Vontz,
and Alexander J. Yaroshinsky (N.D. Cal. Case No. 06-06250 VRW).
 vs. Connetics Corporation, Thomas G. Wiggans, C. Gregory Vontz, and Alexander
J. Yaroshinsky (S.D. N.Y. Case No. 06-CV-11496).
 Bruce Gallant vs. Connetics Corporation, Thomas G. Wiggans, C. Gregory Vontz, and Alexander J.
Yaroshinsky (S.D. N.Y. Case No. 06-CV-12875).
 39




---



##### Table of Contents



Rosenberg v. Wiggans et al.  (Santa Clara County Case No.
1-06-CV-071778, and Spiegal v. Wiggans et al.  (Santa Clara County Case No. 1-06-CV-071776
 
 Item 1A. Risk Factors
 Please also read Item 1 in our Annual Report on Form 10-K/A for the year ended December 31,
2005 where we have described our business and the challenges and risks we may face in the future.
  Our Business Strategy May Cause Fluctuating Operating Results
  
    
    the pending SEC investigation,
    
    quarterly variations in results,
    
    the timing of new product introductions,
    
    clinical trial results and regulatory developments,
    
    competition, including both branded and generic,
    
    business and product market cycles,
    
    fluctuations in customer requirements,
    
    the availability and utilization of manufacturing capacity,
    
    the timing and amounts of royalties paid to us by third parties, and
    
    issues with the safety or effectiveness of our products.
 40




---



##### Table of Contents



We face additional risks and costs as a result of the delayed filing of our quarterly report
on Form 10-Q for the quarter ended March 31, 2006 and our recent financial restatement.
   
 Item 2. Purchase of Equity Securities by the Issuer
  Total Number of
    
    
    Approximate DollarShares Purchased as
    
    
    Value of SharesPart of Publicly
    
    
    That May Yet BeTotal Number of
    
    
    Average Price Paid
    
    
    Announced Plans or
    
    
    Purchased Under thePeriod
    
    Shares Purchased
    
    
    Per Share
    
    
    Programs
    
    
    Plans or ProgramsJanuary 1  31, 2006
    
    
    
    
    
    $
    
    
    
    
    
    
    
    $
    25,700,000February 1  28, 2006
    
    
    143,104
    
    
    
    15.02
    
    
    
    143,104
    
    
    
    23,500,000March 1  31, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23,500,000April 1  30, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23,500,000May 1  31, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23,500,000June 1  30, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23,500,000July 1  31, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23,500,000August 1  31, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23,500,000September 1  30, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23,500,000Total
    
    
    143,104
    
    
    $
    15.02
    
    
    
    143,104
    
    
    $
    23,500,000
 
 Item 5. Other Information
 Unresolved Staff Comments
  41




---



##### Table of Contents



42




---



##### Table of Contents



Item 6. Exhibits
 ExhibitNumber
    
    Description10.1
    
    Letter of Agreement with Dr. Lincoln Krochmal31.1
    
    Rule 13a-14(a) Certification of the Chief Executive Officer31.2
    
    Rule 13a-14(a) Certification of the Chief Financial Officer32.1 
    
    Section 1350 Certification of the Chief Executive Officer32.2 
    
    Section 1350 Certification of the Chief Executive Officer
 
 *
    
    Portions of this exhibit have been omitted and filed separately with the Commission. Confidential treatment has been requested with respect to the omitted portions.
    
    The certifications attached as Exhibits 32.1 and 32.2 that accompany this quarterly report on
Form 10-Q, are not deemed filed with the Securities and Exchange Commission and are not to be
incorporated by reference into any filing of Connetics Corporation under the Securities Act of
1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or
after the date of this Form 10-Q, irrespective of any general incorporation language contained in
such filing. 43




---



##### Table of Contents



SIGNATURE
  Connetics CorporationBy:
    /s/ John L. HigginsJohn L. HigginsChief Financial Officer

Executive Vice President, Finance
and Corporate Development  44




---



##### Table of Contents



INDEX TO EXHIBITS
 ExhibitNumber
    
    Description10.1
    
    Letter of Agreement with Dr. Lincoln Krochmal31.1
    
    Rule 13a-14(a) Certification of the Chief Executive Officer31.2
    
    Rule 13a-14(a) Certification of the Chief Financial Officer32.1 
    
    Section 1350 Certification of the Chief Executive Officer32.2 
    
    Section 1350 Certification of the Chief Executive Officer
 
 *
    
    Portions of this exhibit have been omitted and filed separately with the Commission.
Confidential treatment has been requested with respect to the omitted portions.
    
    The certifications attached as Exhibits 32.1 and 32.2 that accompany this quarterly report on
Form 10-Q, are not deemed filed with the Securities and Exchange Commission and are not to be
incorporated by reference into any filing of Connetics Corporation under the Securities Act of
1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or
after the date of this Form 10-Q, irrespective of any general incorporation language contained in
such filing.