##### 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, 2004 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)3290 West Bayshore Road
    
    94303Palo Alto, California
    
    (Zip Code)(Address of principal executive offices)
 Registrants telephone number, including area code: (650) 843-2800 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 whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes x No o As of October 29, 2004, there were 35,611,904 shares of the Registrants
common stock at $0.001 par value outstanding.




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CONNETICS CORPORATION TABLE OF CONTENTS PagePART I FINANCIAL INFORMATIONItem 1. Financial Statements
    
    
    3Condensed Consolidated Balance Sheets at September 30, 2004 and December 31, 2003
    
    
    3Condensed Consolidated Statements of Operations for the Three and Nine Months ended September 30, 2004 and 2003
    
    
    4Condensed Consolidated Statements of Cash Flows for the Nine Months ended September 30, 2004 and 2003
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    20Item 4. Controls and Procedures
    
    
    20PART II OTHER INFORMATION
    
    
    21Item 2.Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    21Item 6. Exhibits
    
    
    21Signatures
    
    
    22Exhibits
    
    
    23EXHIBIT 10.1EXHIBIT 10.2EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2EXHIBIT 99.1
  2




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PART I. FINANCIAL INFORMATION 
 Item 1. Financial Statements CONNETICS CORPORATION 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited) September 30,
    
    December 31,2004
    
    2003ASSETSCurrent assets:Cash and cash equivalents
    
    $
    25,159
    
    
    $
    17,946Marketable securities
    
    
    51,827
    
    
    
    96,716Restricted cash  current
    
    
    1,000
    
    
    
    304Accounts receivable, net of allowances
    
    
    2,120
    
    
    
    2,594Inventory
    
    
    4,695
    
    
    
    1,035Prepaid and other current assets
    
    
    6,909
    
    
    
    3,779Total current assets
    
    
    91,710
    
    
    
    122,374Property and equipment, net
    
    
    8,540
    
    
    
    5,628Restricted cash  long term
    
    
    2,963
    
    
    
    Debt issuance costs, deposits and other assets
    
    
    4,455
    
    
    
    5,418Goodwill
    
    
    6,271
    
    
    
    6,271Other intangible assets, net
    
    
    125,787
    
    
    
    6,206Total assets
    
    $
    239,726
    
    
    $
    145,897LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    15,844
    
    
    $
    3,884Assumed liabilities related to acquisition of product rights
    
    
    4,075
    
    
    
    Accrued payroll and related expenses
    
    
    5,094
    
    
    
    3,792Accrued clinical trial costs
    
    
    590
    
    
    
    857Other accrued liabilities
    
    
    4,403
    
    
    
    1,594Total current liabilities
    
    
    30,006
    
    
    
    10,127Convertible senior notes
    
    
    90,000
    
    
    
    90,000Other non-current liabilities
    
    
    36
    
    
    
    16Commitments and contingenciesStockholders equity:Preferred stock
    
    
    
    
    
    
    Common stock
    
    
    35
    
    
    
    32Additional paid-in capital
    
    
    235,791
    
    
    
    174,080Deferred stock compensation
    
    
    (17
    )
    
    
    (31
    )Accumulated deficit
    
    
    (117,163
    )
    
    
    (130,188
    )Accumulated other comprehensive income
    
    
    1,038
    
    
    
    1,861Total stockholders equity
    
    
    119,684
    
    
    
    45,754Total liabilities and stockholders equity
    
    $
    239,726
    
    
    $
    145,897
 See accompanying notes to condensed consolidated financial statements. 3




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CONNETICS CORPORATION 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited) Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Revenues:Product
    
    $
    36,999
    
    
    $
    17,652
    
    
    $
    98,564
    
    
    $
    47,491Royalty and contract
    
    
    345
    
    
    
    2,060
    
    
    
    2,015
    
    
    
    7,502Total revenues
    
    
    37,344
    
    
    
    19,712
    
    
    
    100,579
    
    
    
    54,993Operating costs and expenses:Cost of product revenues
    
    
    3,067
    
    
    
    1,388
    
    
    
    8,213
    
    
    
    3,645Amortization of intangible assets
    
    
    3,399
    
    
    
    208
    
    
    
    8,071
    
    
    
    611Research and development
    
    
    6,180
    
    
    
    6,212
    
    
    
    15,717
    
    
    
    23,448Selling, general and administrative
    
    
    16,986
    
    
    
    9,954
    
    
    
    49,746
    
    
    
    31,447Acquired in-process research and development and milestone expense
    
    
    3,500
    
    
    
    
    
    
    
    3,500
    
    
    
    Total operating costs and expenses
    
    
    33,132
    
    
    
    17,762
    
    
    
    85,247
    
    
    
    59,151Income (loss) from operations
    
    
    4,212
    
    
    
    1,950
    
    
    
    15,332
    
    
    
    (4,158
    )Interest income
    
    
    303
    
    
    
    330
    
    
    
    803
    
    
    
    624Interest expense
    
    
    (706
    )
    
    
    (699
    )
    
    
    (2,087
    )
    
    
    (930
    )Other income, net
    
    
    30
    
    
    
    48
    
    
    
    11
    
    
    
    134Income (loss) before income taxes
    
    
    3,839
    
    
    
    1,629
    
    
    
    14,059
    
    
    
    (4,330
    )Provision for income taxes
    
    
    (144
    )
    
    
    (13
    )
    
    
    (1,034
    )
    
    
    (1,291
    )Net income (loss)
    
    $
    3,695
    
    
    $
    1,616
    
    
    $
    13,025
    
    
    $
    (5,621
    )Net income (loss) per share:Basic
    
    $
    0.10
    
    
    $
    0.05
    
    
    $
    0.37
    
    
    $
    (0.18
    )Diluted
    
    $
    0.10
    
    
    $
    0.05
    
    
    $
    0.35
    
    
    $
    (0.18
    )Shares used to calculate net income (loss) per share:Basic
    
    
    35,510
    
    
    
    31,648
    
    
    
    34,794
    
    
    
    31,485Diluted
    
    
    38,064
    
    
    
    33,607
    
    
    
    37,179
    
    
    
    31,485
 See accompanying notes to condensed consolidated financial statements. 4




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CONNETICS CORPORATION 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited) Nine Months EndedSeptember 30,2004
    
    2003Cash flows from operating activities:Net income (loss)
    
    $
    13,025
    
    
    $
    (5,621
    )Adjustments to reconcile net income (loss) to net cash from operating activities:Depreciation
    
    
    1,082
    
    
    
    1,058Amortization of intangible assets
    
    
    8,071
    
    
    
    611Amortization of convertible debt offering costs
    
    
    552
    
    
    
    237Allowance for rebates, returns and chargebacks
    
    
    8,666
    
    
    
    2,350Stock compensation expense
    
    
    13
    
    
    
    13Changes in assets and liabilities:Accounts receivable
    
    
    (8,250
    )
    
    
    (3,272
    )Other assets
    
    
    (2,293
    )
    
    
    (2,581
    )Inventory
    
    
    (3,626
    )
    
    
    98Accounts payable
    
    
    11,989
    
    
    
    (5,132
    )Accrued and other current liabilities
    
    
    3,360
    
    
    
    224Deferred revenue
    
    
    (11
    )
    
    
    (729
    )Net cash from operating activities
    
    
    32,578
    
    
    
    (12,744
    )Cash flows from investing activities:Purchases of marketable securities
    
    
    (46,608
    )
    
    
    (95,947
    )Sales and maturities of marketable securities
    
    
    90,926
    
    
    
    60,958Purchases of property and equipment
    
    
    (4,096
    )
    
    
    (607
    )Acquisition of patent and product rights
    
    
    (123,529
    )
    
    
    (200
    )Net cash from investing activities
    
    
    (83,307
    )
    
    
    (35,796
    )Cash flows from financing activities:Restricted cash
    
    
    (3,659
    )
    
    
    312Proceeds from issuance of convertible senior notes, net of issuance costs
    
    
    
    
    
    
    86,407Proceeds from issuance of common stock, net of issuance costs
    
    
    56,901
    
    
    
    Proceeds from exercise of stock options and employee stock purchase plan, net
of repurchases of unvested shares
    
    
    4,813
    
    
    
    3,030Net cash from financing activities
    
    
    58,055
    
    
    
    89,749Effect of foreign currency exchange rate changes on cash and cash equivalents
    
    
    (113
    )
    
    
    133Net change in cash and cash equivalents
    
    
    7,213
    
    
    
    41,342Cash and cash equivalents at beginning of period
    
    
    17,946
    
    
    
    8,624Cash and cash equivalents at end of period
    
    $
    25,159
    
    
    $
    49,966
 See accompanying notes to condensed consolidated financial statements. 5




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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Note 1. Basis of Presentation and Policies We have prepared the accompanying unaudited condensed consolidated
financial statements of Connetics Corporation (Connetics) in accordance with
accounting principles generally accepted in the United States for interim
financial information and pursuant to the instructions to Form 10-Q and Article
10 of Regulation S-X. Accordingly, the financial statements do not include all
of the information and footnotes required by generally accepted accounting
principles for complete financial statements. We believe that we have included
all adjustments, consisting of normal recurring adjustments, considered
necessary for a fair presentation. We reclassify as necessary certain prior
year balances to conform to the current year presentation. Operating results for the three and nine months ended September 30, 2004
are not necessarily indicative of the results that may be expected for the year
ending December 31, 2004. For a better understanding of Connetics and its
financial statements, we recommend reading these unaudited condensed
consolidated financial statements and notes in conjunction with the audited
consolidated financial statements and notes to those financial statements for
the year ended December 31, 2003, which are included in our Annual Report on
Form 10-K as filed with the Securities and Exchange Commission. Principles of Consolidation The accompanying condensed consolidated financial statements include the
accounts of Connetics, as well as its subsidiaries, Connetics Holdings Pty Ltd.
and Connetics Australia Pty Ltd. We have eliminated all intercompany accounts
and transactions in consolidation. Use of Estimates To prepare financial statements in conformity with accounting principles
generally accepted in the United States, management must make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Future events could cause our actual results to differ. We evaluate our estimates on an on-going basis. In particular, we
regularly evaluate estimates related to recoverability of accounts receivable
and inventory, revenue reserves, assumed liabilities related to acquired
product rights and accrued liabilities for clinical trial activities. We base
our estimates on historical experience and on various other specific
assumptions that we believe to be reasonable under the circumstances. Those
estimates and assumptions form the basis for making judgments about the
carrying value of assets and liabilities that are not readily apparent from
other sources. Revenue Recognition Product Revenues.We recognize revenue from product sales when there is
persuasive evidence that an arrangement exists, when title has passed, the
price is fixed or determinable, and we are reasonably assured of collecting the
resulting receivable. We recognize product revenues net of estimated allowances
for discounts, returns, rebates, and chargebacks. We are obligated to accept
from customers the return of pharmaceuticals that have reached their expiration
date. We authorize returns for damaged products and exchanges for expired
products in accordance with our return goods policy and procedures, and we
establish reserves for such amounts at the time of sale. To date we have not
experienced significant returns of damaged or expired product. We include
product shipping and handling costs in the cost of product revenues. Royalty Revenues.We collect royalties from our third-party licensees
based on their sales. We recognize royalties either in the quarter in which we
receive the royalty payment from the licensee or in which we can reasonably
estimate the royalty, which is typically one quarter following the related sale
by the licensee. Contract Revenues.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 date we receive the payments or the date when collection is
assured, whichever is earlier. 6




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If, at the time an agreement is executed, there remains significant risk
due to the incomplete state of the products development, we recognize revenue
from non-refundable upfront license fees ratably over the period in which we
have continuing development obligations. We recognize revenue associated with
substantial at risk performance milestones, as defined in the respective
agreements, based upon the achievement of the milestones. We recognize revenue
under R&D cost reimbursement contracts as the related costs are incurred. When
we receive advance payments in excess of amounts earned, we classify them as
deferred revenue until they are earned. Cash Equivalents and Marketable Securities Cash and cash equivalents consist of cash on deposit with banks, money
market and other debt 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 are included in marketable securities. We classify
marketable securities as available for sale at the time of purchase and we
carry them at fair value. We report unrealized gains and losses on marketable
securities as a component of other comprehensive income (loss) in stockholders
equity. We use the specific identification method to determine the cost of
securities sold. Cash, cash equivalents and marketable securities are financial instruments
that potentially subject us to concentration of risk to the extent we record
them on our balance sheet. We believe we have established guidelines for
investing our excess cash in a way that will maintain safety and liquidity with
respect to diversification and maturities. We invest our excess cash in debt
instruments of the U.S. Government and its agencies, and high-quality corporate
issuers. By policy, we 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. Restricted Cash Restricted cash reflects certificates of deposit used to secure letter of
credit arrangements. Restricted cash  current includes deposits of $1,000,000
that support our annual insurance renewal and restricted cash  long term
includes deposits of $2,963,000 that support two office facility leases and two
vehicle fleet services leases. 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. We
record foreign currency translation adjustments in other comprehensive income
(loss). Net gains and losses that result from foreign exchange transactions are
included in the condensed consolidated statements of operations and were
immaterial for all periods presented. Income Taxes We account for income taxes using the asset and liability method. Under
this method, we recognize deferred tax assets and liabilities for the future
tax consequences attributable to differences between (1) the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases, and (2) operating loss and tax credit carryforwards. We
measure deferred tax assets and liabilities using enacted tax rates that are
expected to apply to taxable income in the years in which we anticipate those
temporary differences will be recovered or settled. When the timing of the
realization is uncertain, we establish a valuation allowance for the net
deferred tax assets. Historically our income tax provision related primarily to
the operations of our Australian subsidiary. In 2004, however, the income tax
provision is primarily related to the domestic corporation due to our expected
full-year profitability and a reduction in profitability at our Australian
subsidiary in 2004. Property and Equipment We state property and equipment at cost less accumulated depreciation. We
calculate depreciation using the straight-line method over the estimated useful
lives of the assets, generally three to five years. We are depreciating
equipment we have purchased on behalf of our contract manufacturer using the
units of production method based on contractual minimum quantities to be
produced over the term of the agreement. We amortize leasehold improvements
over the shorter of the estimated useful lives of the assets or the lease term. 7




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Inventory Inventory consists primarily of finished goods. We state inventory at the
lower of cost (determined on a first-in first-out method) or market. While
we do not directly manufacture any of our products, we do incur
internal manufacturing support and quality assurance costs. Before January 1,
2004, inventory and cost of goods sold only captured third party product
manufacturing costs, depreciation on Connetics-owned equipment at our
third-party manufacturers, product freight and distribution costs from the
third party that handles all of our product distribution activities, and
royalties. Effective January 1, 2004, we began including in our
finished goods inventory and samples inventory costs certain manufacturing support
and quality assurance costs which had previously been classified as research
and development expense. Those activities include overseeing third party
manufacturing, process development, quality assurance and quality control
activities. Capitalizing these costs in inventory and samples inventory in the
three and nine months ended September 30, 2004 had the effect of increasing net
income (net of tax effect) by $465,000 and $1.9 million, or approximately $0.01
and $0.05 per diluted share, respectively. We have determined that the effect
of this change in accounting would not have had a material impact on our
financial statements in any prior quarterly or annual period. For the three months ended September 30, 2004, we allocated $1.2 million
of costs which in previous periods would have been included in R&D expense as
follows: (1) we charged $307,000 to cost of goods sold, (2) we charged $454,000
to sales expense, (3) we added $645,000 to the value of commercial inventory,
and (4) we reduced by $161,000 the value of samples inventory. For the nine months ended September 30, 2004, we allocated $3.3 million of
costs which in previous periods would have been included in R&D expense as
follows: (1) we charged $432,000 to cost of goods sold, (2) we charged $824,000
to sales expense, (3) we added $1.7 million to the value of commercial
inventory, and (4) we added $317,000 to the value of samples inventory. Goodwill, Other 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.
Under Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and
Other Intangible Assets, effective January 1, 2002, we are not 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 are amortized over their useful lives,
generally ten years. SFAS 142 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, 2004, which did not result in an impairment
charge. We will perform this test on October 1 of each year or more frequently
if indicators of potential impairment exist. We periodically perform reviews to determine if the carrying value of
long-term assets, other than goodwill (purchased intangibles, property and
equipment), are impaired. The reviews look for the existence of facts or
circumstances, either internal or external, which indicate that the carrying
value of the asset cannot be recovered. Our reviews have indicated no such
impairment to date. If in the future we determine that impairment indicators
exist, we would use undiscounted cash flows to initially determine whether we
should recognize any impairment. If necessary, we would perform a 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, we would calculate the fair value
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 assumptions and projections
at the time. 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, we do not recognize any compensation in our
financial statements in connection with stock options granted to employees when
those options have exercise prices equal to or greater than fair market value
of our common stock. We also 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. 8




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For options granted to non-employees, we have determined compensation
expense in accordance with SFAS No. 123 Accounting for Stock-Based
Compensation, as amended, and Emerging Issues Task Force No. 96-18,
Accounting for Equity Instruments That Are Issued to Other Than Employees for
Acquiring, or in Conjunction with Selling Goods or Services. By those
criteria, we quantify compensation expense 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 they vest. Although SFAS 123 allows us to continue to follow the APB 25 guidelines,
we are required to disclose pro formanet income (loss) and basic and diluted
income (loss) per share as if we had applied the fair value based method to all
awards. Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,(in thousands except per share amounts):
    
    2004
    
    2003
    
    2004
    
    2003Net income (loss), as reported
    
    $
    3,695
    
    
    $
    1,616
    
    
    $
    13,025
    
    
    $
    (5,621
    )Add: Stock-based employee compensation
expense, included in reported net income (loss), net of related tax effect
    
    
    5
    
    
    
    4
    
    
    
    13
    
    
    
    13Deduct: Total stock-based employee
compensation expense determined under
the fair value method for all awards,
net of related tax effect
    
    
    (2,743
    )
    
    
    (2,072
    )
    
    
    (8,044
    )
    
    
    (5,838
    )Pro forma net income (loss)
    
    $
    957
    
    
    $
    (452
    )
    
    $
    4,994
    
    
    $
    (11,446
    )Net income (loss) per share:Basic income (loss)  as reported
    
    $
    0.10
    
    
    $
    0.05
    
    
    $
    0.37
    
    
    $
    (0.18
    )Diluted income (loss)  as reported
    
    $
    0.10
    
    
    $
    0.05
    
    
    $
    0.35
    
    
    $
    (0.18
    )Basic income (loss)  pro forma
    
    $
    0.03
    
    
    $
    (0.01
    )
    
    $
    0.14
    
    
    $
    (0.36
    )Diluted income (loss)  pro forma
    
    $
    0.03
    
    
    $
    (0.01
    )
    
    $
    0.13
    
    
    $
    (0.36
    )
 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 Option PlansThree Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Expected stock volatility
    
    
    55.8
    %
    
    
    59.2
    %
    
    
    56.3
    %
    
    
    61.6
    %Risk-free interest rate
    
    
    2.9
    %
    
    
    2.2
    %
    
    
    2.8
    %
    
    
    4.3
    %Expected life (in years)
    
    
    3.4
    
    
    
    2.6
    
    
    
    3.4
    
    
    
    3.3Expected dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %
 Stock Purchase Plan
    
    Stock Purchase PlanThree Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Expected stock volatility
    
    
    47.6
    %
    
    
    59.9
    %
    
    
    44.4
    %
    
    
    61.7
    %Risk-free interest rate
    
    
    3.1
    %
    
    
    4.5
    %
    
    
    2.6
    %
    
    
    4.7
    %Expected life (in years)
    
    
    1.6
    
    
    
    1.5
    
    
    
    1.5
    
    
    
    1.4Expected dividend yield
    
    
    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. This model also requires us to make highly
subjective assumptions, including the expected volatility of our stock. 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, we do not believe that the existing
models necessarily provide a reliable single measure of the fair value of our
options. The effects on pro formadisclosures of applying SFAS 123 are not likely
to be representative of the effects on reported results of future periods. Note 2. Net Income (Loss) Per Share We compute basic net income (loss) per share by dividing net income (loss)
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 potential shares of common stock outstanding during the period. For the
three months and nine months ended September 30, 2004 and the three months
ended September 30, 2003, we included all dilutive stock options and warrants
in the calculation of diluted net income per share. For 9




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the nine months ended September 30, 2003, we excluded all stock options
and warrants in the calculation of diluted net loss per share because these
securities were anti-dilutive during this period. We excluded convertible debt
in the calculation of diluted net income per share as it was anti-dilutive for
all periods. The following table shows a reconciliation of the numerator and
denominator used in diluted net income (loss) per share computations (in
thousands): Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Numerator:Net income (loss)
    
    $
    3,695
    
    
    $
    1,616
    
    
    $
    13,025
    
    
    $
    (5,621
    )Denominator:Weighted-average shares outstanding used for basic net income
(loss) per share
    
    
    35,510
    
    
    
    31,648
    
    
    
    34,794
    
    
    
    31,485Effect of dilutive securities:Stock options
    
    
    2,525
    
    
    
    1,905
    
    
    
    2,350
    
    
    
    Warrants
    
    
    29
    
    
    
    54
    
    
    
    35
    
    
    
    Weighted-average shares used for diluted net income (loss) per share
    
    
    38,064
    
    
    
    33,607
    
    
    
    37,179
    
    
    
    31,485
 Note 3. Comprehensive Income (Loss) The components of comprehensive income (loss) are as follows (in
thousands): Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net income (loss)
    
    $
    3,695
    
    
    $
    1,616
    
    
    $
    13,025
    
    
    $
    (5,621
    )Foreign currency translation adjustment
    
    
    109
    
    
    
    59
    
    
    
    (252
    )
    
    
    128Change in unrealized gain (loss) on
securities, net of reclassification
adjustments for realized gain (loss)
    
    
    (140
    )
    
    
    175
    
    
    
    (571
    )
    
    
    (357
    )Comprehensive income (loss)
    
    $
    3,664
    
    
    $
    1,850
    
    
    $
    12,202
    
    
    $
    (5,850
    )
 Accumulated other comprehensive loss included $289,000 of net unrealized
gains on investments and $749,000 of foreign currency translation adjustments
as of September 30, 2004, and $861,000 of unrealized gains on investments and
$1.0 million of foreign currency translation adjustments as of December 31,
2003. Note 4. Goodwill and Purchased Intangible Assets There were no changes in the carrying amount of goodwill during the nine
months ended September 30, 2004. The components of our other intangible assets
at September 30, 2004, are as follows (in thousands): Gross Carrying
    
    AccumulatedAmount
    
    Amortization
    
    NetAcquired product rights
    
    $
    127,652
    
    
    $
    (7,447
    )
    
    $
    120,205Existing technology
    
    
    6,810
    
    
    
    (2,355
    )
    
    
    4,455Patents
    
    
    1,590
    
    
    
    (463
    )
    
    
    1,127Total
    
    $
    136,052
    
    
    $
    (10,265
    )
    
    $
    125,787
 Amortization expense for our other intangible assets was $3.4 million for
the three months ended September 30, 2004 and
$8.1 million for the nine months ended September 30, 2004. For the same
reporting periods in 2003, amortization expense was $208,000 and $611,000,
respectively. 10




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The expected future amortization expense of our other purchased intangible
assets is as follows (in thousands): Amortization ExpenseRemaining three months in 2004
    
    $
    3,399For the year ending December 31, 2005
    
    
    13,598For the year ending December 31, 2006
    
    
    13,598For the year ending December 31, 2007
    
    
    13,598For the year ending December 31, 2008
    
    
    13,598For the year ending December 31, 2009
    
    
    13,598Thereafter
    
    
    54,398$
    125,787
 Note 5. Guaranties and Indemnifications 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 No. 45). FIN No. 45 requires that
upon issuance of a guarantee, the guarantor must recognize a liability for the
fair value of the obligations it assumes under that guarantee. We enter into indemnification provisions under our agreements with other
companies in the ordinary course of our business, typically with business
partners, contractors, clinical sites, insurers, and customers. Under these
provisions we generally indemnify and hold harmless the indemnified party for
losses suffered or incurred by the indemnified party as a result of our
activities. These indemnification provisions generally survive termination of
the underlying agreement. In some cases, the maximum potential amount of future
payments Connetics could be required to make under these indemnification
provisions is unlimited. The estimated fair value of the indemnity obligations
of these agreements is minimal. Accordingly, we have no liabilities recorded
for these agreements as of September 30, 2004. We have not incurred any costs
to defend lawsuits or settle claims related to these indemnification
arrangements. Note 6. In-License Agreement In August 2004, we submitted a New Drug Application (NDA) for Velac® (1%
clindamycin and 0.025% tretinoin) Gel with the Food and Drug Administration
(FDA) and, in October 2004, we received notification that the FDA accepted the
NDA for filing as of August 23, 2004. For the three months ended September 30,
2004, we recorded a $3.5 million fee payable to the licensor upon the filing of
the NDA. Because the product was not yet approved and had no alternative future
use, we recorded the fee as acquired in-process research and development and
milestone expense. Under the terms of the license agreement entered into in
2002 with Yamanouchi Europe B.V., we hold exclusive rights to develop and
commercialize the product in the U.S. and Canada and non-exclusive rights in
Mexico. Note 7. Equity Issuance On February 13, 2004, we completed a private placement of 3.0 million
shares of our common stock to accredited institutional investors at a price of
$20.25 per share, for net proceeds of approximately $56.9 million. We used a
portion of the net proceeds to pay for the acquisition of the exclusive U.S.
rights to Soriatane®, and we are using the balance for general corporate
purposes, including working capital. Note 8. Soriatane® Product Line Acquisition and Distribution Agreement On February 6, 2004, we entered into a binding agreement with Roche to
acquire exclusive U.S. rights to Soriatane-brand acitretin, an approved oral
therapy for the treatment of severe psoriasis in adults. The transaction closed
on March 4, 2004, and we have recognized revenue, net of applicable reserves,
for all sales of the product from that date. Under the terms of the purchase
agreement, we paid Roche a total of $123.0 million in cash at the closing to
acquire Soriatane. We also assumed certain liabilities in connection with
returns, rebates and chargebacks associated with prior sales of Soriatane by
Roche totaling $4.1 million, and purchased Roches existing inventory of
Soriatane at a cost of approximately $1.5 million. In addition, we incurred
transaction costs, originally estimated at approximately $500,000 and finalized
at $529,000, during the second quarter of 2004. Including the cash paid to
acquire the rights, liabilities assumed, and transactions costs, the total
value of the acquired product rights for accounting purposes is $127.7 million.
We are amortizing this amount over the ten-year estimated useful life of the
Soriatane asset. 11




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##### Table of Contents



In July 2004, we entered into a multi-year consent with Roche to sell
Soriatane to a U.S.-based distributor that exports branded pharmaceutical
products to select international markets. Product sold to this distributor is
not permitted to be resold in the U.S. Under the terms of the agreement, we
will pay a royalty to Roche on Soriatane sales made during the term of the
agreement to this distributor. Note 9. UCB Co-Promotion Agreement In the first quarter of 2004, we entered into an agreement with UCB
Pharma, a subsidiary of UCB Group, pursuant to which we authorized UCB Pharma
to promote OLUX® and Luxíq® to a segment of U.S. primary care physicians
(PCPs). In July 2004, UCB Pharma acquired Celltech plc, and in connection with
the other post-acquisition changes, UCB notified us that it intended to
discontinue the co-promotion agreement effective March 31, 2005. UCB will
continue to promote OLUX and Luxíq until then. Through the end of the promotion
period, UCBs focus will be on the approximately 10% of PCPs who are active
prescribers of dermatology products, including OLUX and Luxíq. The purpose of
the co-promotion agreement is to build value for the OLUX and Luxíq brands with
the additional benefit of ensuring appropriate use of OLUX and Luxíq with the
current PCP users. We estimate that, prior to entering into the agreement with
UCB Pharma, PCPs wrote approximately 15% of prescriptions for OLUX and Luxíq,
even though we promote primarily to dermatologists. We will record 100% of the revenue from sales generated by promotional
efforts of UCB and pay UCB a portion of revenue as a promotion expense. UCB
bears the marketing costs for promoting the products (including product
samples, marketing materials, etc.). We will not have any financial obligation
to UCB on prescriptions generated by PCPs after March 31, 2005. Note 10. Commitments In June 2004, we signed a series of lease agreements with Incyte
Corporation and The Board of Trustees of the Leland Stanford Junior University
to lease approximately 96,000 square feet of space in Palo Alto, California. We
anticipate that we will move from our current facilities in late 2004 or early
2005. Our commitments, including those disclosed in the Annual Report on Form
10-K for the year ended December 31, 2003, consist primarily of operating lease
agreements for our facilities as well as a minimum purchase commitment under
one of our contract manufacturing agreements. As a result of this new leasing arrangement, our operating lease
obligations will increase as follows (in thousands): Increase in operating leaseobligationsFor the year ending December 31, 2005
    
    $
    2,975For the year ending December 31, 2006
    
    
    1,325For the year ending December 31, 2007
    
    
    1,325For the year ending December 31, 2008
    
    
    1,325For the year ending December 31, 2009
    
    
    1,325Thereafter
    
    
    8,009$
    16,284
 In August 2004, we signed an Amended and Restated Manufacturing and Supply
Agreement with DPT Laboratories, Ltd. that reduced our minimum purchase
obligation by $1.3 million over the term of the agreement that extends until
2011. 12




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##### 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 on Form 10-K for the year ended December 31,
2003, 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 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 in this Report under the caption
Factors That May Affect Future Results, Financial Condition and the Market
Price of Securities and under the caption Factors Affecting Our Business and
Prospects in our 2003 Annual Report on Form 10-K. Our historical operating
results are not necessarily indicative of the results to be expected in any
future period. Overview We are a specialty pharmaceutical company that develops and commercializes
products for 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 three
pharmaceutical products, OLUX® (clobetasol propionate), Luxíq® (betamethasone
valerate), and Soriatane® (acitretin). Our products have clinically proven
therapeutic advantages and we provide quality customer service to physicians
through our experienced sales and marketing professionals. On March 4, 2004, we completed the acquisition of the exclusive U.S.
rights to Roches Soriatane, an approved oral therapy for the treatment of
severe psoriasis in adults. Including the purchase price of $123.0 million,
assumed liabilities of $4.1 million and transaction costs of $529,000, we
recorded an intangible asset of approximately $127.7 million related to this
acquisition, which we are amortizing over an estimated useful life of 10 years.
In July 2004, we entered into a multi-year consent with Roche to sell Soriatane
to a U.S.-based distributor that exports branded pharmaceutical products to
select international markets. Product sold to this distributor is not permitted
to be resold in the U.S. Under the terms of the agreement, we will pay a
royalty to Roche on Soriatane sales made during the term of the agreement to
this distributor. In the first quarter of 2004, we entered into an agreement with UCB
Pharma, a subsidiary of UCB Group, pursuant to which we authorized UCB Pharma
to promote OLUX and Luxíq to a segment of U.S. primary care physicians (PCPs).
In July 2004, UCB Pharma acquired Celltech plc, and in connection with the
other post-acquisition changes, UCB notified us that it intended to discontinue
the co-promotion agreement effective March 31, 2005. UCB will continue to
promote OLUX and Luxiq until then. Through the end of the promotion period,
UCBs focus will be on the approximately 10% of PCPs who are active
prescribers of dermatology products, including OLUX and Luxíq. The purpose of
the co-promotion agreement is to build value for the OLUX and Luxíq brands with
the additional benefit of ensuring appropriate use of OLUX and Luxíq with the
current PCP users. We estimate that, before we entered into the agreement with
UCB Pharma, PCPs wrote approximately 15% of prescriptions for OLUX and Luxíq,
even though we have promoted primarily to dermatologists. We will record 100%
of the revenue from sales generated by promotional efforts of UCB and pay UCB a
portion of revenue as a promotion expense. UCB bears the marketing costs for
promoting the products (including product samples, marketing materials, etc.).
We will not have any financial obligation to UCB on prescriptions generated by
PCPs after March 31, 2005. In August 2004, we submitted a New Drug Application (NDA) for Velac® (1%
clindamycin and 0.025% tretinoin) Gel with the Food and Drug Administration
(FDA) and, in October 2004, we received notification that the FDA accepted the
NDA for filing as of August 23, 2004. For the three months ended September 30,
2004, we recorded a $3.5 million fee due to the licensor upon the filing of the
NDA. Because the product was not yet approved and had no alternative future
use, we recorded the fee as acquired in-process research and development and
milestone expense. Under the terms of the license agreement we entered into in
2002 with Yamanouchi Europe B.V., we hold exclusive rights to develop and
commercialize the product in the U.S. and Canada and non-exclusive rights in
Mexico. 13




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##### Table of Contents



In September 2004, we signed a license agreement granting Pierre Fabre
Dermatologie exclusive commercial rights to OLUX for Europe, excluding Italy
where the product is licensed to Mipharm S.p.A. The license agreement with
Pierre Fabre also grants marketing rights for certain countries in South
America and Africa. The product will be marketed by Pierre Fabre under
different trade names. Under the terms of the license, we will receive an
upfront license payment, milestone payments and royalties on product sales.
Pierre Fabre will be responsible for costs associated with product
manufacturing, sales, marketing, and distribution in its licensed territories.
As part of the agreement, we also negotiated a right-of-first-refusal in the
U.S. to an early-stage, innovative dermatology product currently under
development by Pierre Fabre. Pierre Fabre anticipates an initial launch of OLUX
in select European countries in mid-2005. In October 2004, we received approval from the Food and Drug
Administration for Evoclin (clindamycin) Foam, 1% for the treatment of acne
vulgaris. Evoclin is delivered in our proprietary VersaFoam® vehicle and will
be available in the fourth quarter of 2004 in 50g and 100g trade unit sizes. Critical Accounting Policies There have been no material changes to our critical accounting policies,
which are included in our Annual Report on Form 10-K for the year ended
December 31, 2003. Results of Operations Revenues Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,(In thousands)
    
    (In thousands)2004
    
    2003
    
    2004
    
    2003Product revenues:OLUX
    
    $
    15,962
    
    
    $
    12,941
    
    
    $
    45,555
    
    
    $
    33,820Luxíq
    
    
    6,281
    
    
    
    4,693
    
    
    
    17,366
    
    
    
    13,572Soriatane
    
    
    14,724
    
    
    
    
    
    
    
    35,518
    
    
    
    Other
    
    
    32
    
    
    
    18
    
    
    
    125
    
    
    
    99Total product revenues
    
    
    36,999
    
    
    
    17,652
    
    
    
    98,564
    
    
    
    47,491Royalty and contract revenues:Royalty
    
    
    58
    
    
    
    1,256
    
    
    
    1,583
    
    
    
    6,576Contract
    
    
    287
    
    
    
    804
    
    
    
    432
    
    
    
    926Total royalty and contract revenues
    
    
    345
    
    
    
    2,060
    
    
    
    2,015
    
    
    
    7,502Total revenues
    
    $
    37,344
    
    
    $
    19,712
    
    
    $
    100,579
    
    
    $
    54,993
 Our product revenues were $37.0 million for the three months ended
September 30, 2004, and $98.6 million for the nine months ended September 30,
2004, compared to $17.7 million and $47.5 million, respectively, for the three
and nine months ended September 30, 2003. In general, increases in our product
revenues reflect the introduction of Soriatane into our product line in March
2004, and, to a lesser extent, increases in sales volumes and sales prices for
existing products. Specifically, total product revenues increased by 110% in
the three months ended September 30, 2004, and by 108% in the nine months ended
September 30, 2004, as compared to the same periods in the prior year. Of the
110% increase in product revenues in the three months ended September 30, 2004,
84% is attributable to the introduction of Soriatane to our product portfolio,
12% is attributable to increases in sales volumes, and 14% is attributable to
higher sales prices for our OLUX and Luxíq product lines. Of the 108% increase
in product revenues in the nine months ended September 30, 2004, 75% is
attributable to the introduction of Soriatane to our product portfolio, 15% is
attributable to increases in sales volumes, and 18% is attributable to higher
sales prices for our OLUX and Luxíq product lines. During the three months
ended September 30, 2004, we recorded an increase in revenue of $544,000
related to the reduction of certain revenue reserves recorded on the initial
sales of Soriatane through June 30, 2004. We reduced the reserves to reflect
the timing and expected terms of new and anticipated managed care contracts. Royalty and contract revenues were $345,000 for the three months ended
September 30, 2004, and $2.0 million for the nine months ended September 30,
2004, compared to $2.1 million and $7.5 million, respectively, for the three
and nine months ended September 30, 2003. Royalty and contract revenues
decreased primarily because we agreed with S.C. Johnson to terminate a royalty
agreement related to a concentrated aerosol spray as of the first quarter of
2004. As a direct consequence, we did not receive any 14




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royalties in the third quarter of 2004, but we received $1.1 million in
royalties in the same quarter last year, and revenues for the nine months ended
September 30, 2004 decreased $4.8 million compared to the same period last
year. Cost of Product Revenues Currently, DPT Laboratories, Ltd. and AccraPac Group, Inc. manufacture
commercial supplies of OLUX and Luxíq, and they will also manufacture Evoclin.
Roche manufactures commercial supplies of Soriatane. Cardinal Health Specialty
Pharmaceutical Services handles all of our product distribution activities. Our
cost of product revenues includes the third party costs of manufacturing OLUX
and Luxíq, the cost of Soriatane inventory acquired from Roche, depreciation
costs associated with Connetics-owned equipment located at the DPT facility in
Texas, allocation of overhead, royalty payments based on a percentage of our
product revenues, and product freight and distribution costs from Cardinal
Health SPS. We recorded costs of product revenues of $3.1 million for the three
months ended September 30, 2004, and $8.2 million for the nine months ended
September 30, 2004, compared to $1.4 million and $3.6 million for the
comparable periods in 2003. The increase in the cost of product revenues in
2004 is primarily attributable to the introduction of Soriatane to our product
portfolio in 2004 as well as an increase in sales volume of our OLUX and Luxíq
products. While we do not directly manufacture any of our products, we do have
internal manufacturing support and quality assurance costs. Before January 1,
2004, inventory and cost of goods sold only captured third party product
manufacturing costs, depreciation on Connetics-owned equipment at our
third-party manufacturers, product freight and distribution costs from the
third party that handles all of our product distribution activities, and
royalties. Effective January 1, 2004, we began including certain manufacturing
support and quality assurance costs in the cost of finished goods inventory and
samples inventory which had previously been classified as research and
development expense. Those activities include overseeing third party
manufacturing, process development, quality assurance and quality control
activities. We have determined that the effect of this change in accounting
would not have had a material impact on our financial statements in any prior
quarterly or annual period. For the three months ended September 30, 2004, we allocated $1.2 million
of costs which in previous periods would have been included in R&D expense as
follows: (1) we charged $307,000 to cost of goods sold, (2) we charged $454,000
to sales expense, (3) we added $645,000 to the value of commercial inventory,
and (4) we reduced by $161,000 the value of samples inventory. For the nine months ended September 30, 2004, we allocated $3.3 million of
costs which in previous periods would have been included in R&D expense as
follows: (1) we charged $432,000 to cost of goods sold, (2) we charged $824,000
to sales expense, (3) we added $1.7 million to the value of commercial
inventory, and (4) we added $317,000 to the value of samples inventory. 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, and external research programs, and  
    
    an allocation of facilities costs, salaries and benefits, and
overhead costs such as rent, supplies and utilities. In the three months ended September 30, 2004 we incurred costs associated
with continued research for a marketed product as well as start up costs
associated with trials for three other product candidates. During the third
quarter of 2003, we incurred costs associated with concurrent trials in Velac
which were in varying stages of completion. Research and development expenses were $6.2 million for each of the
three-month periods ended September 30, 2004 and September 30, 2003. Expenses
for the three months ended September 30, 2004 compared to the same period in
2003 reflect reductions of $1.2 million due to a change in classification from
research and development costs to cost of goods sold, inventory, and selling
expense, as explained above under Cost of Product Revenues, and $1.1 million
related to clinical trials activities underway in 2003. The decreases were
offset by $573,000 recorded for the fee for filing the New Drug Application
with the FDA, $214,000 in FDA user fees for a new product, and the one-time
reversal in 2003 of a previously recorded liability of $575,000 for clinical
trial materials which we concluded were not owed. 15




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For the nine months ended September 30, 2004 and 2003, research and
development expenses were $15.7 million and $23.4 million, respectively. The
decrease represents a reduction of $7.0 million of costs related to clinical
trials activities underway in 2003 as well as a $3.3 million change in
classification from research and development costs to cost of goods sold,
inventory, and selling expense as explained above under Cost of Product
Revenue. Selling, General and Administrative Expenses Selling, general and administrative expenses were $17.0 million for the
three months ended September 30, 2004, compared to $10.0 million for the
comparable period in 2003. For the three months ended September 30, 2004 the
overall increase in expenses, compared with the same period in 2003 was
primarily related to a $2.6 million increase in direct and indirect sales
promotion capabilities, an increase of approximately $1.5 million in increased
marketing and sales activities such as tradeshows, sales meetings, product
samples, advertising and market research and, a $1.2 million increase in
employee-related costs due to increased headcount in the marketing and general
and administrative departments. Selling, general and administrative expenses were $49.7 million for the
nine months ended September 30, 2004, compared to $31.4 million for the
comparable period in 2003. For the nine months ended September 30, 2004 the
overall increase in expenses, compared with the same period in 2003 was
primarily related to an increase of approximately $5.9 million for marketing
and sales activities such as trade shows, sales meetings, product samples,
advertising and market research, a $5.7 million increase in direct and indirect
sales promotion capabilities, and a $2.6 million increase in employee-related
costs due to increased headcount in the marketing and general and
administrative departments. Interest and other income (expense), net Interest income was $303,000 for the three months ended September 30,
2004, and $803,000 for the nine months ended September 30, 2004, compared to
$330,000 and $624,000 for the three and nine months ended September 30, 2003,
respectively. The increase in interest income during 2004 was the result of
higher average cash and investment balances in connection with the cash we
received by issuing $90.0 million of convertible senior notes in May 2003, as
well as the $56.9 million net receipts from a private placement of common stock
in February 2004, partially offset by lower market interest rates on
investments. Interest expense was $706,000 for the three months ended September 30,
2004, and $2.1 million for the nine months ended September 30, 2004, compared
to $699,000 and $930,000, respectively, for the three and nine months ended
September 30, 2003. The increase in interest expense during 2004 was directly
related to the interest expense associated with the convertible senior notes
issued in the second quarter of 2003. Income Taxes We recognized income tax expense of $144,000 for the three months ended
September 30, 2004, and $1.0 million for the nine months ended September 30,
2004. We recorded tax provisions for domestic income taxes primarily
related to the alternative minimum tax because we have had
three profitable quarters and anticipate that we will be profitable for the
full year of 2004. Specifically, for the three months ended September 30, 2004,
we recorded a domestic tax provision of $352,000, and for the nine months ended
September 30, 2004, we recorded a domestic tax provision of $924,000. We also
recorded a foreign tax provision related to our Australian operations for the
nine months ended September 30, 2004 of $110,000, including a benefit for the
three months ended September 30, 2004 of $208,000. By comparison, we recognized
income tax expense of $13,000 and $1.3 million, respectively, in the three and
nine months ended September 30, 2003 related to our Australian operations. Liquidity and Capital Resources Sources and Use of Cash.We have financed our operations to date primarily
through proceeds from equity and debt financings, collaborative arrangements
with corporate partners, bank loans, and product revenues. At September 30,
2004, cash, cash equivalents and marketable securities totaled $77.0 million
compared to $114.7 million at December 31, 2003. Our cash balances are held in
a variety of interest-bearing instruments including high-grade obligations,
commercial paper, obligations of the U.S. Government and state and local
agencies, and money market accounts. Cash from operating activities.Cash provided by operations for the nine
months ended September 30, 2004 was $32.6 million compared to $12.7 million of
cash used for the nine months ended September 30, 2003. Operating activities
changed to become a net 16




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provider of cash in the nine months ended September 30, 2004 from a net
user for the same period in 2003 primarily because we had net income in 2004
compared to the net loss in 2003, non-cash depreciation and amortization
charges were higher in 2004, and accounts payable increased more during 2004
than during the same period in 2003 primarily due to the timing of payments and
other business activities. For the nine months ended September 30, 2004, the
cash provided was comprised primarily of the following:  
    
    net income of $13.0 million,  
    
    non-cash charges of $9.7 million for depreciation and amortization expense,  
    
    increased reserves of $8.7 million primarily related to product
returns, chargebacks, rebates and coupon programs , and  
    
    an increase in accounts payable and other accrued and current
liabilities of $15.3 million primarily due to the timing of payments
and other business activities. The cash provided was partially offset by cash used during the same period,
primarily for the following:  
    
    an increase in gross accounts receivable of approximately $8.3
million primarily attributable to receivables related to the Soriatane
product line; the balance of the change in accounts receivable was
related to the timing of sales on OLUX and Luxíq, and collection of
outstanding amounts,  
    
    an increase in inventory of $3.6 million to support increased
sales volume, and  
    
    an increase in other assets of $2.3 million related to various
prepaid activities including payments in connection with our UCB
co-promotion agreement, insurance, and sales and marketing activities. Cash from investing activities.We used $83.3 million cash in investing
activities for the nine months ended September 30, 2004, compared to $35.8
million for the nine months ended September 30, 2003. We used more cash in
investing activities in 2004 primarily in connection with the 2004 acquisition
of the Soriatane product line for $123.5 million, partially offset by $44.3
million from net sales and maturities of marketable securities necessary to
fund the acquisition. Cash from financing activities.Financing activities provided $58.1
million for the nine months ended September 30, 2004 compared to $89.7 million
for the nine months ended September 30, 2003. The primary difference is that in
May 2003 we generated net cash proceeds of $86.4 million by issuing convertible
senior notes whereas in 2004 we generated net cash proceeds of
$56.9 million from a private placement of our common stock. Working Capital.Working capital decreased by $50.5 million to $61.7
million at September 30, 2004 from $112.2 million at December 31, 2003,
primarily because we used cash to fund the acquisition of exclusive U.S. rights
to Soriatane and related inventory in March 2004 and we assumed approximately
$4.1 million in liabilities associated with the Soriatane acquisition. The
amounts related to the acquisition were partially offset by net proceeds of
$56.9 million from a private placement of our common stock in February 2004. Contractual Obligations and Commercial Commitments.Our commitments,
including those disclosed in the Annual Report on Form 10-K for the year ended
December 31, 2003, consist primarily of operating lease agreements for our
facilities as well as minimum purchase commitments under one of our contract
manufacturing agreements. In June 2004, we signed a series of lease agreements with Incyte
Corporation and The Board of Trustees of the Leland Stanford Junior University
to lease approximately 96,000 square feet of space in Palo Alto, California. We
anticipate that we will move from our current facilities in late 2004 or early
2005. As a result of this new leasing arrangement, our operating lease
obligations will increase as follows (in thousands): Increase in operating leaseobligationsFor the year ending December 31, 2005
    
    $
    2,975For the year ending December 31, 2006
    
    
    1,325For the year ending December 31, 2007
    
    
    1,325For the year ending December 31, 2008
    
    
    1,325For the year ending December 31, 2009
    
    
    1,325Thereafter
    
    
    8,009$
    16,284
 17




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In August 2004, we signed an Amended and Restated Manufacturing and Supply
Agreement with DPT Laboratories, Ltd. that reduced our minimum purchase
obligation by $1.3 million over the term of the agreement that extends until
2011. We have an agreement to purchase health information services that requires
minimum purchase commitments during the years of 2004 to 2007 of $1.1 million,
$1.2 million, $983,000, and $983,000, respectively. The agreement includes a
provision allowing us to terminate the contract early for a one-time payment of
$1.2 million in 2004 that decreases annually to $293,000 in 2007. Restricted Cash and Cash Equivalents.In the three months ended September
30, 2004, we entered into four letter of credit arrangements that are secured
by certificates of deposit. We extended two letters of credit in connection
with new office facility leasing arrangements, one for $2,000,000 for a lease
that will begin in late 2004 or early 2005 and one for $663,000 in anticipation
of entering into a new lease that will begin in late 2005 or early 2006,
pending landlord consent of our agreement with the sublessor. We extended two
other letters of credit, one for $250,000 and one for $50,000, in connection
with separate vehicle fleet services agreements. All four certificates of
deposit are included in non-current restricted cash on the balance sheet. We believe our existing cash, cash equivalents and marketable securities,
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. Our future
capital uses and requirements 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 continually evaluate various 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. Factors that May Affect Future Results, Financial Condition and the Market Price of Securities Please also read Item 1 in our Annual Report onForm 10-Kfor the year ended
December 31, 2003, where we have described our business and the challenges and
risks we may face in the future. There are many factors that affect our business and results of operations,
some of which are beyond our control. In our Annual Report on Form 10-K for the
year ended December 31, 2003 we list 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. Due to these
factors, we believe that quarter-to-quarter comparisons of our results of
operations are not a good indication of our future performance. The factors
discussed in our reports filed with the Securities and Exchange Commission,
including our 2003 Annual Report on Form 10-K, in particular under the caption
Factors Affecting Our Business and Prospects, should be carefully considered
when evaluating our business and prospects. Implementation of Section 404 of the Sarbanes Oxley Act of 2002 Section 404 of the Sarbanes Oxley Act of 2002 requires that we evaluate and
report on our system of internal controls beginning with our fiscal year ending
December 31, 2004. In addition, the independent auditors must report on
managements evaluation of those controls, whether our assessment is fairly
stated, and whether the independent auditors believe we maintained effective
internal controls. We are in the process of documenting and testing our system
of internal controls. If we fail to timely complete this assessment, or if our
independent registered public accounting firm cannot timely attest to our
assessment, we could be subject to regulatory sanctions, including potential
delisting from NASDAQ, and a loss of public confidence in our internal
controls. In addition, any failure to implement required new or improved
controls, or difficulties encountered in their implementation, could harm our
operating results or cause us to fail to timely meet our regulatory reporting
obligations. However, at this time, due to the ongoing evaluation and testing
of the companys internal controls, we cannot give any assurances as to whether
these reports might reveal material weaknesses or significant deficiencies with
our internal controls. Additionally, upon the completion of our testing and
documentation, certain deficiencies may be discovered that will require
remediation. This remediation may require implementing additional controls, the
costs of which could have a material adverse effect on our results of
operations. 18




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Our Business Strategy May Cause Fluctuating Operating Results Our operating results and financial condition may fluctuate from quarter
to quarter and year to year depending upon the relative timing of events or
uncertainties that may arise. For example, the following events or occurrences
could cause fluctuations in our financial performance from period to period:  
    
    changes in the levels we spend to develop new product lines,  
    
    changes in the amounts 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, including changes that affect newly developed or newly
acquired products,  
    
    forward-buying patterns by wholesalers that may result in significant quarterly swings in revenue reporting,  
    
    agreements to pay wholesalers in connection with inventory management or distribution services agreements,  
    
    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,  
    
    our responses to price competition, and  
    
    fluctuations in royalties paid by third parties. 19




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Item 3.Quantitative and Qualitative Disclosures About Market Risk There have been no material changes in the reported market risks or
foreign currency exchange risks from those reported under Item 7A, Quantitative
and Qualitative Disclosures About Market Risk in our Annual Report on Form 10-K
for the year ended December 31, 2003. 
 Item 4.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 as of September 30, 2004. 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 our disclosure controls and
procedures were effective in timely alerting them to material information
required to be included in our periodic SEC reports. In addition, our CEO and
CFO concluded that during the quarter ended September 30, 2004, there was no
change in our internal control over financial reporting that materially
affected, or is reasonably likely to materially affect, our internal control
over financial reporting. 20




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PART II. OTHER INFORMATION 
 Item 2.Unregistered Sales of Equity Securities and Use of Proceeds We do not have a plan or program to repurchase shares of our common stock. 
 Item 6.Exhibits. ExhibitNumber
    
    Description10.1*
    
    Amendment to Facilities Contribution Agreement between DPT Laboratories, Ltd. and Connetics Corporation,
dated August 18, 200410.2*
    
    Amended and Restated Manufacturing and Supply Agreement between DPT Laboratories, Ltd. and Connetics
Corporation, dated August 18, 200410.3*
    
    License Agreement between Pierre Fabre Dermatologie and Connetics Corporation, dated September 29, 2004
(incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K dated September 29, 2004 and
filed with the Securities and Exchange Commission on October 4, 2004 (Commission File No. 0-27406))31.1
    
    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 Financial Officer99.1
    
    Industrial Building Lease between West Bayshore Associates and Connetics Corporation, dated September 30, 2004
 * Portions of this exhibit have been omitted and filed separately with the
Commission. Confidential treatment has been requested with respect to the
omitted portions. 21




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SIGNATURE Pursuant to the requirements 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 CorporationBy:
    
    /s/ John L. Higgins
John L. HigginsExecutive Vice President, Finance and
Corporate Development and Chief Financial Officer
(Principal Financial Officer and Principal
Accounting Officer and Duly Authorized Officer
of the Registrant)Date: November 8, 2004
 22




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INDEX TO EXHIBITS ExhibitNumber
    
    Description10.1*
    
    Amendment to Facilities Contribution Agreement between DPT Laboratories, Ltd. and Connetics Corporation,
dated August 18, 200410.2*
    
    Amended and Restated Manufacturing and Supply Agreement between DPT Laboratories, Ltd. and Connetics
Corporation, dated August 18, 200410.3*
    
    License Agreement between Pierre Fabre Dermatologie and Connetics Corporation, dated September 29, 2004
(incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K dated September 29, 2004 and
filed with the Securities and Exchange Commission on October 4, 2004 (Commission File No. 0-27406))31.1
    
    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 Financial Officer99.1
    
    Industrial Building Lease between West Bayshore Associates and Connetics Corporation, dated September 30, 2004
 * Portions of this exhibit have been omitted and filed separately with the
Commission. Confidential treatment has been requested with respect to the
omitted portions. 23