##### 



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 March 31, 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
incorporation or organization)
    
    (IRS Employer
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




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##### 



CONNETICS CORPORATION
 TABLE OF CONTENTS
 PagePART I FINANCIAL INFORMATIONExplanatory
Note

    
    
    3Item 1.
    
    Financial Statements
    
    
    4Unaudited Condensed Consolidated Balance Sheets at March 31, 2006 and December 31, 2005
    
    
    4Unaudited Condensed Consolidated Statements of Operations for the Three Months ended
March 31, 2006 and 2005 (restated)
    
    
    5Unaudited Condensed Consolidated Statements of Cash Flows for the Three Months ended
March 31, 2006 and 2005 (restated)
    
    
    6Notes to Unaudited Condensed Consolidated Financial Statements
    
    
    7Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    20Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    26Item 4.
    
    Controls and Procedures
    
    
    26PART II OTHER INFORMATIONItem 1A
    
    Risk Factors
    
    
    29Item 2.
    
    Purchases of Equity Securities by the Issuer
    
    
    31Item 5.
    
    Other Information
    
    
    31Item 6.
    
    Exhibits
    
    
    33Signatures
    
    
    
    
    34Exhibits
    
    
    
    
    35
 2




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##### 



EXPLANATORY NOTE
  3




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##### 



PART I. FINANCIAL INFORMATION
 
 Item 1. Financial Statements
 CONNETICS CORPORATION
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited)
 March 31,
    
    
    December 31,2006
    
    
    2005ASSETSCurrent assets:Cash and cash equivalents
    
    $
    36,189
    
    
    $
    29,988Marketable securities
    
    
    187,878
    
    
    
    241,108Restricted cash  current
    
    
    1,000
    
    
    
    1,000Accounts receivable, net of cash discounts and allowances
    
    
    30,369
    
    
    
    11,100Other current assets
    
    
    29,607
    
    
    
    29,423Total current assets
    
    
    285,043
    
    
    
    312,619Long-term investments
    
    
    20,131
    
    
    
    Property and equipment, net
    
    
    14,296
    
    
    
    14,438Restricted
cash  long-term
    
    
    3,059
    
    
    
    3,059Other assets, goodwill and other intangible assets, net
    
    
    135,482
    
    
    
    127,373Total assets
    
    $
    458,011
    
    
    $
    457,489LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    16,706
    
    
    $
    16,609Product-related accruals
    
    
    35,418
    
    
    
    35,371Other accrued liabilities
    
    
    12,169
    
    
    
    15,075Total current liabilities
    
    
    64,293
    
    
    
    67,055Convertible senior notes
    
    
    290,000
    
    
    
    290,000Other non-current liabilities
    
    
    572
    
    
    
    517Commitments and contingenciesStockholders equity:Common stock
    
    
    34
    
    
    
    37Treasury stock
    
    
    (62,603
    )
    
    
    (60,447
    )Additional paid-in capital
    
    
    252,178
    
    
    
    247,880Accumulated deficit
    
    
    (86,967
    )
    
    
    (88,080
    )Accumulated other comprehensive income
    
    
    504
    
    
    
    527Total stockholders equity
    
    
    103,146
    
    
    
    99,917Total liabilities and stockholders equity
    
    $
    458,011
    
    
    $
    457,489
 See accompanying notes to condensed consolidated financial statements.
 4




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##### 



CONNETICS CORPORATION
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)
 Three Months EndedMarch 31,20052006
    
    
    (restated)Net revenues:Product
    
    $
    46,949
    
    
    $
    40,205Royalty and contract
    
    
    184
    
    
    
    181Total revenues
    
    
    47,133
    
    
    
    40,386Operating costs and expenses:Cost of product revenues (excluding amortization of acquired product rights)
    
    
    3,919
    
    
    
    3,766Amortization of intangible assets
    
    
    3,902
    
    
    
    3,399Research and development
    
    
    8,182
    
    
    
    5,898Selling, general and administrative
    
    
    30,365
    
    
    
    27,809Total operating costs and expenses
    
    
    46,368
    
    
    
    40,872Income (loss) from operations
    
    
    765
    
    
    
    (486
    )Interest income
    
    
    2,242
    
    
    
    477Interest expense
    
    
    (1,865
    )
    
    
    (771
    )Other income (expense), net
    
    
    52
    
    
    
    (59
    )Income (loss) before income taxes
    
    
    1,194
    
    
    
    (839
    )Income tax provision
    
    
    81
    
    
    
    105Net income (loss)
    
    $
    1,113
    
    
    $
    (944
    )Net income (loss) per share:Basic
    
    $
    0.03
    
    
    $
    (0.03
    )Diluted
    
    $
    0.03
    
    
    $
    (0.03
    )Shares used to compute basic and diluted net income (loss) per share:Basic
    
    
    33,646
    
    
    
    35,699Diluted
    
    
    34,953
    
    
    
    35,699
 See accompanying notes to condensed consolidated financial statements.
 5




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##### 



CONNETICS CORPORATION
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 Three Months EndedMarch 31,20052006
    
    
    (restated)Cash flows from operating activities:Net income (loss)
    
    $
    1,113
    
    
    $
    (944
    )Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:Depreciation
    
    
    567
    
    
    
    346Amortization of intangible assets
    
    
    3,900
    
    
    
    3,399Amortization of convertible debt issuance costs
    
    
    358
    
    
    
    196Allowance for cash discounts and allowances
    
    
    313
    
    
    
    (875
    )Stock compensation expense
    
    
    1,407
    
    
    
    4Changes in assets and liabilities:Accounts receivable
    
    
    (19,582
    )
    
    
    (2,316
    )Other assets
    
    
    63
    
    
    
    (3,163
    )Accounts payable
    
    
    242
    
    
    
    460Product-related accruals
    
    
    48
    
    
    
    5,277Other accrued liabilities
    
    
    (2,903
    )
    
    
    (67
    )Other non-current liabilities
    
    
    55
    
    
    
    26Net cash provided by (used in) operating activities
    
    
    (14,419
    )
    
    
    2,343Cash flows from investing activities:Purchases of marketable securities
    
    
    (25,050
    )
    
    
    (15,980
    )Sales and maturities of marketable securities
    
    
    58,034
    
    
    
    17,655Purchases of property and equipment
    
    
    (496
    )
    
    
    (1,369
    )Transfer to restricted cash
    
    
    
    
    
    
    (146
    )Acquisition of sales force
    
    
    (12,537
    )
    
    
    Net cash provided by investing activities
    
    
    19,951
    
    
    
    160Cash flows from financing activities:Proceeds from issuance of convertible senior notes, net of issuance costs
    
    
    
    
    
    
    194,000Repurchase of common stock
    
    
    (2,156
    )
    
    
    (35,000
    )Proceeds from exercise of stock options and employee stock purchase plan
    
    
    2,888
    
    
    
    1,755Net cash provided by financing activities
    
    
    732
    
    
    
    160,755Effect of foreign currency exchange rate changes on cash and cash equivalents
    
    
    (63
    )
    
    
    (39
    )Net change in cash and cash equivalents
    
    
    6,201
    
    
    
    163,219Cash and cash equivalents at beginning of period
    
    
    29,988
    
    
    
    18,261Cash and cash equivalents at end of period
    
    $
    36,189
    
    
    $
    181,480
 See accompanying notes to condensed consolidated financial statements.
 6




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##### 



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 1. Basis of Presentation
 Interim Financial Information
   Restatement of Prior Period Information
  2. Significant Accounting Policies
 Principles of Consolidation
  Use of Estimates
   7




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##### 



Revenue Recognition
   Gross-to-Net Sales Adjustment
  Returns
   8




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##### 



Managed Care Rebates
   Medicaid Rebates
   Chargebacks
  9




---



##### 



Cash
Discounts
  Other Adjustments
  Use of Information from External Sources
   Use of Estimates in Reserves
  10




---



##### 



Royalty Revenues
  Contract Revenues
   Stock-Based Compensation
    3. Net Income (Loss) Per Share
  11




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##### 



Three Months EndedMarch 31,2005(in thousands except per share amounts)
    
    2006
    
    
    (restated)Net income (loss), as reported
    
    $
    1,113
    
    
    $
    (944
    )Basic weighted-average shares outstanding:
    
    
    33,646
    
    
    
    35,699Dilutive stock options and unvested shares
subject to repurchase
    
    
    1,307
    
    
    
    Diluted weighted-average shares outstanding:
    
    
    34,953
    
    
    
    35,699Net income (loss) per share:Basic
    
    $
    0.03
    
    
    $
    (0.03
    )Diluted
    
    $
    0.03
    
    
    $
    (0.03
    )
 in thousands
 Three Months EndedMarch 31,2006
    
    2005Options
    
    
    3,471
    
    
    
    255Convertible debt
    
    
    4,203
    
    
    
    4,203Total
    
    
    7,674
    
    
    
    4,458
  4. Stock-Based Compensation
   12




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##### 



Three MonthsEnded(in thousands except per share amounts)
    
    March 31, 2006Cost of product revenues
    
    $
    Research and development
    
    
    245Selling, general and administrative
    
    
    1,162Stock-based compensation expense before income
tax provision
    
    
    1,407Income tax provision
    
    
    Total stock-based compensation expense after
income tax provision
    
    $
    1,407Stock-based compensation expense per share:Basic
    
    $
    0.04Diluted
    
    $
    0.04Weighted average shares outstanding:Basic
    
    
    33,646Diluted
    
    
    34,953
   pro forma
  Three Months EndedMarch 31, 2005(in thousands except per share amounts):
    
    (restated)Net loss, as reported
    
    $
    (944
    )Add: Stock-based compensation expense, net of related tax effects
    
    
    4Deduct: Total stock-based employee compensation expense
determined under the fair value method for all awards, net of
related tax effects
    
    
    (3,948
    )Pro forma net loss
    
    $
    (4,888
    )Net loss per share:Basic and diluted loss  as reported
    
    $
    (0.03
    )Basic and diluted loss  pro forma
    
    $
    (0.14
    )Weighted average shares outstanding:Basic and dilutive common shares
    
    
    35,699
 13




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##### 



Stock Option Plans
    
    Stock Purchase PlansThree Months Ended
    
    Three Months EndedMarch 31,
    
    March 31,2006
    
    2005
    
    2005Expected stock volatility
    
    
    51.1
    %
    
    
    47.3
    %
    
    
    45.9
    %Risk-free interest rate
    
    
    4.6
    %
    
    
    3.5
    %
    
    
    1.6
    %Expected life (in years)
    
    
    4.0
    
    
    
    4.0
    
    
    
    1.4Expected dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %
    14




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##### 



Employee Stock Plans
  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.
 15




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##### 



Outstanding OptionsWeightedShares
    
    
    
    
    
    
    AverageAvailable for
    
    
    Number 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
    
    
    474,797
    
    
    
    (474,797
    )
    
    
    18.90Balance, December 31, 2005
    
    
    791,348
    
    
    
    7,380,252
    
    
    $
    14.80Additional shares authorized
    
    
    1,277,543
    
    
    
    
    
    
    
    Options granted
    
    
    (612,800
    )
    
    
    612,800
    
    
    
    15.49Options exercised
    
    
    
    
    
    
    (298,563
    )
    
    
    9.94Options canceled
    
    
    184,401
    
    
    
    (184,401
    )
    
    
    18.58Options canceled due to expiration of option plan
    
    
    (34,896
    )
    
    
    
    
    
    
    18.58Balance, March 31, 2006
    
    
    1,605,596
    
    
    
    7,510,088
    
    
    $
    14.96Exercisable, December 31, 2005
    
    
    
    
    
    
    6,525,829
    
    
    $
    14.69Exercisable, March 31, 2006
    
    
    
    
    
    
    6,228,269
    
    
    $
    14.80
   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
    
    
    547,867
    
    
    
    4.24
    
    
    $
    4.47
    
    
    
    547,867
    
    
    $
    4.47$5.85  $8.75
    
    
    1,108,165
    
    
    
    3.38
    
    
    
    7.56
    
    
    
    1,074,956
    
    
    
    7.54$8.76  $11.67
    
    
    255,670
    
    
    
    5.73
    
    
    
    10.57
    
    
    
    241,445
    
    
    
    10.54$11.68  $14.59
    
    
    1,723,088
    
    
    
    6.42
    
    
    
    12.31
    
    
    
    1,399,225
    
    
    
    12.19$14.60  $17.51
    
    
    922,988
    
    
    
    8.79
    
    
    
    15.87
    
    
    
    206,709
    
    
    
    16.44$17.52  $20.43
    
    
    1,385,914
    
    
    
    7.55
    
    
    
    18.28
    
    
    
    1,281,671
    
    
    
    18.32$20.44  $23.34
    
    
    288,896
    
    
    
    8.37
    
    
    
    21.87
    
    
    
    288,896
    
    
    
    21.87$23.35  $26.26
    
    
    1,011,000
    
    
    
    8.30
    
    
    
    23.78
    
    
    
    1,011,000
    
    
    
    23.78$26.27  $29.18
    
    
    266,500
    
    
    
    8.55
    
    
    
    27.32
    
    
    
    176,500
    
    
    
    26.97$0.00  $29.18
    
    
    7,510,088
    
    
    
    6.69
    
    
    $
    14.96
    
    
    
    6,228,269
    
    
    $
    14.80
  5. Comprehensive Income
 (in thousands)
 Three Months EndedMarch 31,20052006
    
    
    (restated)Net income (loss)
    
    $
    1,113
    
    
    $
    (944
    )Foreign currency translation adjustment
    
    
    93
    
    
    
    (82
    )Change in unrealized gain (loss) on securities
    
    
    (116
    )
    
    
    (222
    )Comprehensive income (loss)
    
    $
    1,090
    
    
    $
    (1,248
    )
  16




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##### 



6. Inventory
 Other Current Assets
 (in thousands)
 March 31,
    
    
    December 31,2006
    
    
    2005Raw materials
    
    $
    2,517
    
    
    $
    1,649Finished goods
    
    
    4,920
    
    
    
    5,836Total inventory
    
    $
    7,437
    
    
    $
    7,485
 debt issuance, deposits and other assets
 7. Goodwill and Other Intangible Assets
 (in thousands)
 March 31, 2006
    
    
    December 31, 2005Useful Life
    
    Gross Carrying
    
    
    Accumulated
    
    
    
    
    
    
    Gross Carrying
    
    
    Accumulatedin Years
    
    Amount
    
    
    Amortization
    
    
    Net
    
    
    Amount
    
    
    Amortization
    
    
    NetAcquired product rights
    
    10
    
    $
    127,652
    
    
    $
    (26,594
    )
    
    $
    101,058
    
    
    $
    127,652
    
    
    $
    (23,403
    )
    
    $
    104,249Existing technology
    
    10
    
    
    6,810
    
    
    
    (3,377
    )
    
    
    3,433
    
    
    
    6,810
    
    
    
    (3,206
    )
    
    
    3,604Patents
    
    10-13
    
    
    1,661
    
    
    
    (762
    )
    
    
    899
    
    
    
    1,661
    
    
    
    (725
    )
    
    
    936Assembled workforce
    
    5
    
    
    12,248
    
    
    
    (408
    )
    
    
    11,840
    
    
    
    
    
    
    
    
    
    
    
    Other PediaMed assets
    
    0.5
    
    
    289
    
    
    
    (93
    )
    
    
    196
    
    
    
    
    
    
    
    
    
    
    
    Goodwill
    
    Indefinite
    
    
    6,271
    
    
    
    
    
    
    
    6,271
    
    
    
    6,271
    
    
    
    
    
    
    
    6,271Total
    
    
    
    $
    154,931
    
    
    $
    (31,234
    )
    
    $
    123,697
    
    
    $
    142,394
    
    
    $
    (27,334
    )
    
    $
    115,060
  (in
thousands)
 AmortizationExpenseRemaining nine months in 2006
    
    $
    12,224For 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
    
    $
    117,426
 17




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##### 



8. PediaMed Sales Organization Acquisition
  9. Guaranties and Indemnifications
  10. Co-Promotion Agreement
  11. Stock Repurchase Program
  18




---



##### 



12. Subsequent Events
 SEC Investigation
  Notices
of Default Under Senior Convertible Notes
    NASDAQ Notice
  19




---



##### 



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 on Form 10-K /A for the year ended December 31, 2005,as amended, 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 on Form 10-K/A .
Our historical operating results are not necessarily indicative of the results to be expected in
any future period.
 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.
  20




---



##### 



tm tm
 tm
  ®
 ® ®
 Critical Accounting Policies and Estimates
  Stock-Based Compensation
   21




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##### 



Results of Operations
 Net Revenues
  Three Months EndedMarch 31,(In thousands)2006
    
    
    2005Gross product revenues
    
    $
    59,499
    
    
    $
    52,791Product returns
    
    
    (4,615
    )
    
    
    (3,747
    )Managed care and Medicaid rebates
    
    
    (4,750
    )
    
    
    (5,410
    )Chargebacks
    
    
    (1,694
    )
    
    
    (1,897
    )Cash discounts and other
    
    
    (1,491
    )
    
    
    (1,532
    )Net product revenues
    
    
    46,949
    
    
    
    40,205
  Three Months EndedMarch 31,(In thousands)2006
    
    
    2005Net product revenues:Soriatane
    
    $
    18,175
    
    
    $
    16,364OLUX Foam
    
    
    14,809
    
    
    
    14,984Evoclin Foam
    
    
    7,878
    
    
    
    3,040Luxíq Foam
    
    
    6,072
    
    
    
    5,721Other
    
    
    15
    
    
    
    96Total net product revenues
    
    
    46,949
    
    
    
    40,205Royalty and contract:Royalty
    
    
    184
    
    
    
    98Contract
    
    
    
    
    
    
    83Total royalty and contract revenues
    
    
    184
    
    
    
    181Total revenues
    
    $
    47,133
    
    
    $
    40,386
  Use of Information from External
Sources
 Product
    
    March 31, 2006
    
    December 31, 2005Soriatane
    
    
    3.9
    
    
    
    4.2OLUX Foam
    
    
    3.9
    
    
    
    4.6Evoclin Foam
    
    
    4.1
    
    
    
    4.3Luxíq Foam
    
    
    4.4
    
    
    
    5.4Weighted average for all products
    
    
    4.0
    
    
    
    4.6
 22




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##### 



Cost of Product Revenues
   Amortization of Intangible Assets
  Research and Development
  23




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##### 



TM
 Selling, General and Administrative Expenses
   Stock-based Compensation
     Interest and other income (expense), net
   24




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##### 



Provision for Income Taxes
  Liquidity and Capital Resources
 Working Capital
   Fluctuation in Current Assets
    
    Explanation$19.3 million increase
 accounts receivable,
net
    
    Increase is primarily a result of the timing of
shipments and cash receipts in March 2006
versus December 2005.$53.2 million decrease  marketable
securities
    
    At March 31, 2006 $20.1
million of investments
were classified as
long-term assets, whereas,
at December 31, 2005 all
of our investments were
classified as current
assets. We classify our
investments based on their
maturity date.
 
 Fluctuation in Current Liabilities
    
    Explanation$2.9 million decrease accrued and other
current liabilities
    
    Decrease is a result of
timing of payments made in
the quarter ended March
31, 2006 versus December
2005.
 Capital Expenditures
   Capital Resources
  25




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##### 



Contractual Obligations and Commercial Commitments
  
 Item 3. Quantitative and Qualitative Disclosures About Market Risk
  
 Item 4. Controls and Procedures
 Disclosure Controls and Procedures
   26




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##### 



Managements Report on Internal Control Over Financial Reporting
   Changes in Internal Control over Financial Reporting
  27




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##### 



Remediation of Material Weaknesses
 
 
    
    we 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;
    
    with respect to the accrual for product returns, we revised our methodology (a) to
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) to apply the rate to production lots,
(c) to consider the relevant risk of return, and (d) to take into account current price and
anticipated price increases;
    
    we designated an individual with significant industry experience as our Senior Revenue
Manager with specific responsibility for managing our
revenue-reserves estimation process, and increased the involvement of
our Vice President, Finance and Administration in
the estimation process; and
    
    we engaged external consultants to assist us in revising our methodologies to ensure we considered all
relevant factors and that the computational aspects of the models were
appropriate.
  
    
    significantly increase the level of involvement and intradepartmental communication in a
way that will foster improved shared information between our finance
department and other
departments, including, but not limited to, commercial operations, specifically personnel
involved in our sales operations, managed care and manufacturing activities;
    
    train all relevant finance and commercial operations personnel regarding the new
revenue-reserves methodologies and the controls and procedures surrounding channel inventory
and product returns;
    
    develop formal policies regarding the preparation and maintenance of contemporaneous
documentation supporting orders, demand forecasts, inventory, and information necessary for
the calculation of revenue reserves;
    
    perform periodic regular reconciliations of our inventory data with third party
wholesalers inventory reports; and
    
    hire 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.
  28




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##### 



PART II. OTHER INFORMATION
 
 Item 1A. Risk Factors
 Please also read Item 1 in our Annual Report on Form 10-K for the year ended December 31,
2005,as amended, 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 restatement of our financial statements for the five
years ended December 31, 2005, as further discussed in our
Annual Report on Form 10-K/A filed July 24, 2006, and the
related delayed filing of our Quarterly Report on Form 10-Q
for the three months ended March 31, 2006,
    
    our pending SEC investigation,
    
    quarterly variations in results,
    
    any decision by NASDAQ Global Market to delist our common stock,
    
    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.
 29




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##### 



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.
    30




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##### 



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
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23,500,000Total
    
    
    143,104
    
    
    $
    15.02
    
    
    
    143,104
    
    
    $
    23,500,000
 
 Item 5. Other Information
 Long Term Incentive Plan
  31




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##### 



SEC Investigation
  NASDAQ Notice
  Unresolved Staff Comments
   32




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##### 



Item 6. Exhibits
 ExhibitNumber
    
    Description31.1
    
    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. 33




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##### 



SIGNATURE
  Connetics CorporationBy:
    
    /s/ John L. HigginsJohn L. HigginsChief Financial Officer
Executive Vice President, Finance
and Corporate Development
  34




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##### 



INDEX TO EXHIBITS
 ExhibitNumber
    
    Description31.1
    
    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. 35