##### 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 June 30, 2006
 Commission file number: 0-27406
 CONNETICS CORPORATION
 (Exact name of registrant as specified in its charter)
 Delaware
    
    94-3173928(State or other jurisdiction of
    
    (IRS Employerincorporation or organization)
    
    Identification Number)
 3160 Porter DrivePalo Alto, California
    
    94304(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number, including area code: (650) 843-2800
 þ o
  o þ o
 o þ




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##### 



CONNETICS CORPORATION
 TABLE OF CONTENTS
 PagePART I FINANCIAL INFORMATIONItem 1.
    
    Financial Statements
    
    
    3Unaudited Condensed Consolidated Balance Sheets at June 30, 2006 and December 31, 2005
    
    
    3Unaudited Condensed Consolidated Statements of Operations for the Three and Six Months ended June 30, 2006 and 2005 (as restated)
    
    
    4Unaudited Condensed Consolidated Statements of Cash Flows for the Six Months ended June 30, 2006 and 2005 (as restated)
    
    
    5Notes to Unaudited Condensed Consolidated Financial Statements
    
    
    6Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    21Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    29Item 4.
    
    Controls and Procedures
    
    
    29PART II OTHER INFORMATIONItem 1A
    
    Risk Factors
    
    
    31Item 2.
    
    Purchases of Equity Securities by the Issuer
    
    
    32Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    32Item 5.
    
    Other Information
    
    
    33Item 6.
    
    Exhibits
    
    
    34Signatures
    
    
    35ExhibitsEXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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PART I. FINANCIAL INFORMATION
 
 Item 1. Financial Statements
 CONNETICS CORPORATION
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (In thousands)
 (Unaudited)
 June 30,
    
    
    December 31,2006
    
    
    2005ASSETSCurrent assets:Cash and cash equivalents
    
    $
    49,817
    
    
    $
    29,988Marketable securities
    
    
    192,700
    
    
    
    241,108Restricted cash  current
    
    
    1,000
    
    
    
    1,000Accounts receivable, net of cash discounts and
allowances
    
    
    22,821
    
    
    
    11,100Inventory
    
    
    8,228
    
    
    
    7,485Other current assets
    
    
    21,933
    
    
    
    21,938Total current assets
    
    
    296,499
    
    
    
    312,619Long-term investments
    
    
    13,176
    
    
    
    Property and equipment, net
    
    
    14,303
    
    
    
    14,438Restricted cash  long term
    
    
    3,059
    
    
    
    3,059Goodwill
    
    
    6,271
    
    
    
    6,271Other intangibles, net
    
    
    113,272
    
    
    
    108,789Other assets
    
    
    12,042
    
    
    
    12,313$
    458,622
    
    
    $
    457,489LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    17,215
    
    
    $
    16,609Product-related liabilities
    
    
    33,092
    
    
    
    35,371Other accrued liabilities
    
    
    14,674
    
    
    
    15,075Total current liabilities
    
    
    64,981
    
    
    
    67,055Convertible senior notes
    
    
    290,000
    
    
    
    290,000Other non-current liabilities
    
    
    650
    
    
    
    517Commitments and contingenciesStockholders Equity:Common stock
    
    
    34
    
    
    
    37Treasury stock
    
    
    (62,603
    )
    
    
    (60,447
    )Additional paid-in-capital
    
    
    254,484
    
    
    
    247,880Accumulated deficit
    
    
    (89,128
    )
    
    
    (88,080
    )Accumulated other comprehensive income
    
    
    204
    
    
    
    527Total stockholders equity
    
    
    102,991
    
    
    
    99,917Total liabilities and stockholders equity
    
    $
    458,622
    
    
    $
    457,489
 See accompanying notes to condensed consolidated financial statements.
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CONNETICS CORPORATION
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (In thousands, except per share amounts)
 (Unaudited)
 Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2005
    
    
    
    
    
    
    20052006
    
    
    (restated)
    
    
    2006
    
    
    (restated)Net revenues:Product
    
    $
    43,620
    
    
    $
    45,338
    
    
    $
    90,569
    
    
    $
    85,543Royalty and contract
    
    
    222
    
    
    
    130
    
    
    
    406
    
    
    
    311Total net revenues
    
    
    43,842
    
    
    
    45,468
    
    
    
    90,975
    
    
    
    85,854Operating costs and expenses:Cost of product revenues (excluding amortization of
acquired product rights)
    
    
    4,007
    
    
    
    4,982
    
    
    
    7,926
    
    
    
    8,748Amortization of intangible assets
    
    
    4,153
    
    
    
    3,400
    
    
    
    8,055
    
    
    
    6,799Research and development
    
    
    8,020
    
    
    
    8,957
    
    
    
    16,202
    
    
    
    14,855Selling, general and administrative
    
    
    31,037
    
    
    
    25,356
    
    
    
    61,402
    
    
    
    53,165Total operating costs and expenses
    
    
    47,217
    
    
    
    42,695
    
    
    
    93,585
    
    
    
    83,567Income (loss) from operations
    
    
    (3,375
    )
    
    
    2,773
    
    
    
    (2,610
    )
    
    
    2,287Interest and other income (expense):Interest income
    
    
    2,758
    
    
    
    1,845
    
    
    
    5,000
    
    
    
    2,322Interest expense
    
    
    (1,865
    )
    
    
    (1,860
    )
    
    
    (3,730
    )
    
    
    (2,631
    )Other income (expense), net
    
    
    (19
    )
    
    
    (4
    )
    
    
    33
    
    
    
    (63
    )Income (loss) before income taxes
    
    
    (2,501
    )
    
    
    2,754
    
    
    
    (1,307
    )
    
    
    1,915Income tax provision (benefit)
    
    
    (340
    )
    
    
    153
    
    
    
    (259
    )
    
    
    258Net income (loss)
    
    $
    (2,161
    )
    
    $
    2,601
    
    
    $
    (1,048
    )
    
    $
    1,657Net income (loss) per share:Basic
    
    $
    (0.06
    )
    
    $
    0.07
    
    
    $
    (0.03
    )
    
    $
    0.05Diluted
    
    $
    (0.06
    )
    
    $
    0.07
    
    
    $
    (0.03
    )
    
    $
    0.04Shares used to compute basic and diluted net income (loss) per share:Basic
    
    
    33,740
    
    
    
    34,825
    
    
    
    33,693
    
    
    
    35,259Diluted
    
    
    33,740
    
    
    
    37,093
    
    
    
    33,693
    
    
    
    37,785
 See accompanying notes to condensed consolidated financial statements.
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CONNETICS CORPORATION
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (In thousands)
 (Unaudited)
 Six Months EndedJune 30,20052006
    
    
    (restated)Cash flows from operating activities:Net income
    
    $
    (1,048
    )
    
    $
    1,657Adjustments to reconcile net income to net cash from operating activities:Depreciation
    
    
    1,201
    
    
    
    772Amortization of intangible assets
    
    
    8,055
    
    
    
    6,799Amortization of convertible senior notes offering costs
    
    
    717
    
    
    
    550Allowance for cash discounts and doubtful accounts
    
    
    181
    
    
    
    (49
    )Stock compensation expense
    
    
    2,565
    
    
    
    9Changes in assets and liabilities:Accounts receivable
    
    
    (11,902
    )
    
    
    1,224Other assets
    
    
    (344
    )
    
    
    (3,821
    )Inventory
    
    
    (711
    )
    
    
    (2,375
    )Accounts payable
    
    
    735
    
    
    
    984Product-related accruals
    
    
    (2,279
    )
    
    
    12,249Accrued and other current liabilities
    
    
    (399
    )
    
    
    1,710Other non-current liabilities
    
    
    133
    
    
    
    51Net cash
(used in) provided by operating activities
    
    
    (3,096
    )
    
    
    19,760Cash flows from investing activities:Purchases of marketable securities
    
    
    (60,744
    )
    
    
    (238,682
    )Sales and maturities of marketable securities
    
    
    95,600
    
    
    
    54,981Transfer to restricted cash
    
    
    
    
    
    
    (96
    )Purchases of property and equipment
    
    
    (1,201
    )
    
    
    (3,088
    )Acquisition of sales force
    
    
    (12,537
    )
    
    
    Net cash
provided by (used in) investing activities
    
    
    21,118
    
    
    
    (186,885
    )Cash flows from financing activities:Proceeds from issuance of convertible senior notes, net of issuance costs
    
    
    
    
    
    
    193,625Repurchases of common stock
    
    
    (2,156
    )
    
    
    (35,000
    )Proceeds from exercise of stock options and employee stock purchase plan,
net of repurchases of unvested shares
    
    
    4,036
    
    
    
    4,860Net cash provided by financing activities
    
    
    1,880
    
    
    
    163,485Effect of foreign currency exchange rate changes on cash and cash equivalents
    
    
    (73
    )
    
    
    (59
    )Net change in cash and cash equivalents
    
    
    19,829
    
    
    
    (3,699
    )Cash and cash equivalents at beginning of period
    
    
    29,988
    
    
    
    18,261Cash and cash equivalents at end of period
    
    $
    49,817
    
    
    $
    14,562
 See accompanying notes to condensed consolidated financial statements.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 1. Basis of Presentation
 Interim Financial Information
   Principles of Consolidation
  Use of Estimates
   Restatement of Prior Period Information
  6




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Recent Accounting Pronouncements
  2. Significant Accounting Policies
 Revenue Recognition
   Gross-to-Net Sales Adjustment
  Returns
  7




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Managed Care Rebates
   Medicaid Rebates
   8




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Chargebacks
   Cash Discounts
  Other Adjustments
  9




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Use of Information from External Sources
   Use of Estimates in Reserves
  Royalty Revenues
  Contract Revenues
   10




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Stock-Based Compensation
    3. Net Income (Loss) Per Share
   Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2005
    
    
    
    
    
    
    2005(in thousands, except per share amounts)
    
    2006
    
    
    (restated)
    
    
    2006
    
    
    (restated)Net income (loss), as reported
    
    $
    (2,161
    )
    
    $
    2,601
    
    
    $
    (1,048
    )
    
    $
    1,657Weighted average shares outstanding
    
    
    34,299
    
    
    
    34,825
    
    
    
    34,145
    
    
    
    35,259Weighted-average restricted shares
subject to repurchase
    
    
    (559
    )
    
    
    
    
    
    
    (452
    )
    
    
    Basic weighted-average shares outstanding
    
    
    33,740
    
    
    
    34,825
    
    
    
    33,693
    
    
    
    35,259Dilutive stock options and restricted shares
subject to repurchase
    
    
    
    
    
    
    2,268
    
    
    
    
    
    
    
    2,526Diluted weighted-average shares outstanding
    
    
    33,740
    
    
    
    37,093
    
    
    
    33,693
    
    
    
    37,785Net income (loss) per share:Basic
    
    $
    (0.06
    )
    
    $
    0.07
    
    
    $
    (0.03
    )
    
    $
    0.05Diluted
    
    $
    (0.06
    )
    
    $
    0.07
    
    
    $
    (0.03
    )
    
    $
    0.04
 11




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in thousands
 Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Options
    
    
    4,732
    
    
    
    1,480
    
    
    
    4,933
    
    
    
    1,247Restricted Stock
    
    
    64
    
    
    
    
    
    
    
    597
    
    
    
    Convertible debt
    
    
    4,203
    
    
    
    4,203
    
    
    
    4,203
    
    
    
    4,203Total
    
    
    8,999
    
    
    
    5,683
    
    
    
    9,733
    
    
    
    5,450
  4. Stock-Based Compensation
   12




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Three Months
    
    
    Six MonthsEnded
    
    
    EndedJune 30,
    
    
    June 30,(in thousands, except per share amounts)
    
    2006
    
    
    2006Cost of product revenues
    
    $
    
    
    
    $
    Research and development
    
    
    315
    
    
    
    560Selling, general and administrative
    
    
    863
    
    
    
    2,025Stock-based compensation expense before income tax provision
    
    
    1,178
    
    
    
    2,585Income tax provision
    
    
    
    
    
    
    Total stock-based compensation expense after income tax provision
    
    $
    1,178
    
    
    $
    2,585Stock-based compensation expense per share:Basic and diluted
    
    $
    0.03
    
    
    $
    0.08Weighted average shares outstanding:Basic and diluted
    
    
    33,740
    
    
    
    33,693
   pro forma
  13




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Three Months
    
    
    Six MonthsEnded
    
    
    EndedJune 30,
    
    
    June 30,2005
    
    
    2005(in thousands, except per share amounts)
    
    (restated)
    
    
    (restated)Net income, as reported
    
    $
    2,601
    
    
    $
    1,657Add: Stock-based
compensation
expense, net of
related tax effects
    
    
    5
    
    
    
    9Deduct: Total
stock-based
employee
compensation
expense determined
under the fair
value method for
all awards, net of
related tax effects
    
    
    (4,330
    )
    
    
    (8,278
    )Pro forma net loss
    
    $
    (1,724
    )
    
    $
    (6,612
    )Net income (loss) per share:Basic, as reported
    
    $
    0.07
    
    
    $
    0.05Diluted, as reported
    
    $
    0.07
    
    
    $
    0.04Basic, pro forma
    
    $
    (0.05
    )
    
    $
    (0.19
    )Diluted, pro forma
    
    $
    (0.05
    )
    
    $
    (0.19
    )
    Stock Option Plans
    
    Stock Option PlansThree Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2006
    
    2005
    
    2006
    
    2005Expected stock volatility
    
    
    51.5
    %
    
    
    46.3
    %
    
    
    51.2
    %
    
    
    47.1
    %Risk-free interest rate
    
    
    5.0
    %
    
    
    3.9
    %
    
    
    4.7
    %
    
    
    3.6
    %Expected life (in years)
    
    
    4.5
    
    
    
    4.0
    
    
    
    4.1
    
    
    
    4.0Expected dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %
 Stock Purchase PlanThree Months
    
    Six MonthsEnded
    
    EndedJune 30,
    
    June 30,2005
    
    2005Expected stock volatility
    
    
    54.5
    %
    
    
    50.2
    %Risk-free interest rate
    
    
    1.8
    %
    
    
    1.7
    %Expected life (in years)
    
    
    1.3
    
    
    
    1.4Expected dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
 14




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Employee Stock Plans
  15




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2000 Stock Plan.
 Non-Officer Stock Option Plans.
 International Stock Incentive Plan.
 Inducement Stock Option Grants.
 Summary of All Option Plans and Non-Plan Grants.
 Options OutstandingShares
    
    
    
    
    
    
    WeightedAvailable
    
    
    Number
    
    
    Averagefor
    
    
    of
    
    
    ExerciseGrant
    
    
    Shares
    
    
    PriceBalance, December 31, 2004
    
    
    372,082
    
    
    
    6,837,909
    
    
    $
    12.64Additional shares authorized
    
    
    1,675,356
    
    
    
    
    
    
    
    Options granted
    
    
    (1,730,887
    )
    
    
    1,730,887
    
    
    
    22.05Options exercised
    
    
    
    
    
    
    (713,747
    )
    
    
    8.93Options canceled, expired or forfeited
    
    
    474,797
    
    
    
    (474,797
    )
    
    
    18.90Balance, December 31, 2005
    
    
    791,348
    
    
    
    7,380,252
    
    
    $
    14.80Additional shares authorized
    
    
    1,277,543
    
    
    
    
    
    
    
    Options granted
    
    
    (753,130
    )
    
    
    753,130
    
    
    
    15.12Restricted shares granted
    
    
    (596,620
    )
    
    
    
    
    
    
    Options exercised
    
    
    
    
    
    
    (349,805
    )
    
    
    9.68Options cancelled, expired or forfeited (1)
    
    
    302,583
    
    
    
    (352,079
    )
    
    
    18.68Options cancelled due to an expired plan (2)
    
    
    (70,000
    )
    
    
    
    
    
    
    Balance, June 30, 2006
    
    
    951,724
    
    
    
    7,431,498
    
    
    $
    14.91
 
 (1)
    
    During the six months ended June 30, 2006 we had 49,000 cancelled, expired or forfeited
options related to stock option plans that expired before January 1, 2006. As these
options expire or are forfeited they are not added back to the pool of options available
for grant.(2)
    
    On January 1, 2006 our 1995 Directors Plan expired, with the result that 70,000
options expired that had never been granted. 16




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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
    
    
    530,944
    
    
    
    3.99
    
    
    
    4.46
    
    
    
    530,944
    
    
    
    4.46$ 5.85  $8.75
    
    
    1,089,356
    
    
    
    3.14
    
    
    
    7.57
    
    
    
    1,059,668
    
    
    
    7.56$ 8.76  $11.67
    
    
    255,315
    
    
    
    5.35
    
    
    
    10.57
    
    
    
    244,862
    
    
    
    10.54$11.68  $14.59
    
    
    1,765,610
    
    
    
    6.40
    
    
    
    12.30
    
    
    
    1,419,857
    
    
    
    12.19$14.60  $17.51
    
    
    935,880
    
    
    
    8.97
    
    
    
    15.81
    
    
    
    197,642
    
    
    
    16.41$17.52  $20.43
    
    
    1,329,247
    
    
    
    7.61
    
    
    
    18.28
    
    
    
    1,235,003
    
    
    
    18.32$20.44  $23.34
    
    
    282,646
    
    
    
    8.24
    
    
    
    21.88
    
    
    
    282,646
    
    
    
    21.88$23.35  $26.26
    
    
    977,500
    
    
    
    8.27
    
    
    
    23.77
    
    
    
    977,500
    
    
    
    23.77$26.27  $29.18
    
    
    265,000
    
    
    
    8.35
    
    
    
    27.32
    
    
    
    265,000
    
    
    
    27.32$ 0.00  $29.18
    
    
    7,431,498
    
    
    
    6.64
    
    
    
    14.91
    
    
    
    6,213,122
    
    
    
    14.94
  5. Comprehensive Income
 (in thousands)
 Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2005
    
    
    
    
    
    
    20052006
    
    
    (restated)
    
    
    2006
    
    
    (restated)Net income
    
    $
    (2,161
    )
    
    $
    2,601
    
    
    $
    (1,048
    )
    
    $
    1,657Foreign currency translation adjustment
    
    
    (39
    )
    
    
    48
    
    
    
    54
    
    
    
    (174
    )Change in unrealized gain (loss) on
securities
    
    
    (261
    )
    
    
    (1
    )
    
    
    (377
    )
    
    
    (83
    )Comprehensive income (loss)
    
    $
    (2,461
    )
    
    $
    2,648
    
    
    $
    (1,371
    )
    
    $
    1,400
  17




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6. Inventory
  (in thousands)
 June 30,
    
    
    December 31,2006
    
    
    2005Raw materials
    
    $
    3,655
    
    
    $
    1,649Finished goods
    
    
    4,573
    
    
    
    5,836Total inventory
    
    $
    8,228
    
    
    $
    7,485
 other assets
 7. PediaMed Sales Organization Acquisition
  8. Goodwill and Other Intangible Assets
 (in
thousands)
 June 30, 2006
    
    
    December 31, 2005Useful Life
    
    
    Gross Carrying
    
    
    Accumulated
    
    
    
    
    
    
    Gross Carrying
    
    
    Accumulatedin Years
    
    
    Amount
    
    
    Amortization
    
    
    Net
    
    
    Amount
    
    
    Amortization
    
    
    NetAcquired product rights
    
    
    10
    
    
    $
    127,652
    
    
    
    (29,785
    )
    
    
    97,867
    
    
    $
    127,652
    
    
    $
    (23,403
    )
    
    $
    104,249Existing technology
    
    
    10
    
    
    
    6,810
    
    
    
    (3,547
    )
    
    
    3,263
    
    
    
    6,810
    
    
    
    (3,206
    )
    
    
    3,604Patents
    
    
    10-13
    
    
    
    1,661
    
    
    
    (800
    )
    
    
    861
    
    
    
    1,661
    
    
    
    (725
    )
    
    
    936Assembled workforce
    
    
    5
    
    
    
    12,248
    
    
    
    (1,021
    )
    
    
    11,227
    
    
    
    
    
    
    
    
    
    
    
    Other PediaMed assets
    
    
    0.5
    
    
    
    289
    
    
    
    (235
    )
    
    
    54
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    
    
    
    
    $
    148,660
    
    
    $
    (35,388
    )
    
    $
    113,272
    
    
    $
    136,123
    
    
    $
    (27,334
    )
    
    $
    108,789
 18




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##### Table of Contents



(in
thousands)
 AmortizationExpenseRemaining six months in 2006
    
    $
    8,070For 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
    
    $
    113,272
 9. Guaranties and Indemnifications
  10. Co-Promotion Agreement
  11. Stock Repurchase Program
  12. SEC Investigation
 19




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##### Table of Contents







13. Subsequent Events






20



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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 /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 for
the year ended December 31, 2005, as amended. Our historical operating results are not necessarily
indicative of the results to be expected in any future period.
 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.
 ®
 21




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® ® tm
    22




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##### Table of Contents



Critical Accounting Policies and Estimates
  Stock-Based Compensation
    Results of Operations
 Net Revenues
 (in thousands)
 Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Gross product revenues
    
    $
    53,369
    
    
    $
    62,380
    
    
    $
    112,868
    
    
    $
    115,171Product returns
    
    
    (2,971
    )
    
    
    (5,219
    )
    
    
    (7,586
    )
    
    
    (8,966
    )Managed care and Medicaid rebates
    
    
    (1,421
    )
    
    
    (6,168
    )
    
    
    (6,171
    )
    
    
    (11,578
    )Chargebacks
    
    
    (1,375
    )
    
    
    (1,990
    )
    
    
    (3,069
    )
    
    
    (3,887
    )Cash discounts and other
    
    
    (3,982
    )
    
    
    (3,665
    )
    
    
    (5,473
    )
    
    
    (5,197
    )Net product revenues
    
    $
    43,620
    
    
    $
    45,338
    
    
    $
    90,569
    
    
    $
    85,543
 23




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##### Table of Contents



(in
thousands)
 Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Net product revenues:Soriatane
    
    $
    16,281
    
    
    $
    17,743
    
    
    $
    34,456
    
    
    $
    34,107OLUX Foam
    
    
    12,236
    
    
    
    14,413
    
    
    
    27,045
    
    
    
    29,397Evoclin Foam
    
    
    9,326
    
    
    
    6,958
    
    
    
    17,204
    
    
    
    9,998Luxiq Foam
    
    
    5,705
    
    
    
    6,224
    
    
    
    11,777
    
    
    
    11,945Other
    
    
    72
    
    
    
    
    
    
    
    87
    
    
    
    96Total net product revenues
    
    
    43,620
    
    
    
    45,338
    
    
    
    90,569
    
    
    
    85,543Royalty and contract revenues:Royalty
    
    
    222
    
    
    
    130
    
    
    
    406
    
    
    
    228Contract
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    83Total royalty and
contract revenues
    
    
    222
    
    
    
    130
    
    
    
    406
    
    
    
    311Total revenues
    
    $
    43,842
    
    
    $
    45,468
    
    
    $
    90,975
    
    
    $
    85,854
     24




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##### Table of Contents



Product
    
    June 30, 2006
    
    March 31, 2006
    
    December 31, 2005Soriatane
    
    
    3.2
    
    
    
    3.9
    
    
    
    4.2OLUX Foam
    
    
    3.6
    
    
    
    3.9
    
    
    
    4.6Evoclin Foam
    
    
    3.7
    
    
    
    4.0
    
    
    
    4.3Luxíq Foam
    
    
    4.0
    
    
    
    4.4
    
    
    
    5.4Weighted average for all products
    
    
    3.6
    
    
    
    4.0
    
    
    
    4.6
    Cost of Product Revenues
   Amortization of Intangible Assets
  25




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##### Table of Contents



Research and Development
   TM
 Selling, General and Administrative Expenses
    Stock-based Compensation
  pro forma
  26




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##### Table of Contents



Interest and other income (expense), net
   Provision (Benefit) for Income Taxes
  Liquidity and Capital Resources
 Working Capital
   Fluctuation in Current Assets
    
    Explanation$11.7 million increase 
accounts receivable, net of cash
discounts and allowances
    
    Increase is primarily a result of the timing of shipments
and cash receipts in June 2006 versus December 2005.$28.6 million decrease  cash,
cash equivalents and marketable
securities
    
    $12.5 million of the decrease is the result of the
acquisition of the PediaMed sales organization.
Furthermore, at June 30, 2006 $13.2 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 dates.
 Fluctuation in Current Liabilities
    
    Explanation$2.3 million decrease
product-related accrued liabilities
    
    Decrease is driven by a $2.9 million release of Medicaid
rebate reserves in the three months ended June 30, 2006
related to Medicare Part D programs as described above.
 27




---



##### Table of Contents



Capital Expenditures
   Capital Resources
     Contractual Obligations and Commercial Commitments
  Recent Accounting Pronouncements
  28




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##### Table of Contents








Item 3. Quantitative and Qualitative Disclosures About Market Risk







Item 4. Controls and Procedures


Disclosure Controls and Procedures
   Managements Report on Internal Control Over Financial Reporting
   29




---



##### Table of Contents



Changes in Internal Control over Financial Reporting
  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 assigned an individual with significant industry experience as our Senior Revenue
Manager and increased the involvement of our Vice-President, Finance and Administration in
the estimation process; and
    
    we engaged external consultants to assist us in revising our methodologies to ensure all
relevant factors were considered and the computational aspects of the models were
appropriate.
  
    
    significantly increase the level of involvement and intradepartmental communication in a
way that will foster improved shared information between the finance function and other
departments, including, but not limited to, commercial operations, specifically personnel
involved in our sales operations, managed care and manufacturing activities;
    
    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.
 30




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##### Table of Contents



PART II. OTHER INFORMATION
 
 Item 1A. Risk Factors
 Please
also read Item 1 in our Annual Report on Form 10-K/A for the year ended December 31,
2005 where we have described our business and the challenges and risks we may face in
the future.
  Our Business Strategy May Cause Fluctuating Operating Results
  
    
    the pending SEC investigation,
    
    quarterly variations in results,
    
    the timing of new product introductions,
    
    clinical trial results and regulatory developments,
    
    competition, including both branded and generic,
    
    business and product market cycles,
    
    fluctuations in customer requirements,
    
    the availability and utilization of manufacturing capacity,
    
    the timing and amounts of royalties paid to us by third parties, and
    
    issues with the safety or effectiveness of our products.
 31




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##### Table of Contents



We face additional risks and costs as a result of the delayed filing of our quarterly report on
Form 10-Q for the quarter ended March 31, 2006 and our recent financial restatement.
   
 Item 2. Purchase of Equity Securities by the Issuer
  Total Number of
    
    
    Approximate DollarShares Purchased as
    
    
    Value of SharesPart of Publicly
    
    
    That May Yet BeTotal Number of
    
    
    Average Price Paid
    
    
    Announced Plans or
    
    
    Purchased Under thePeriod
    
    Shares Purchased
    
    
    Per Share
    
    
    Programs
    
    
    Plans or ProgramsJanuary 1 - 31, 2006
    
    
    
    
    
    $
    
    
    
    
    
    
    
    $
    25,700,000February 1 - 28, 2006
    
    
    143,104
    
    
    
    15.02
    
    
    
    143,104
    
    
    
    23,500,000March 1 - 31, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23,500,000April 1  30, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23,500,000May 1  31, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23,500,000June 1 - 30, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23,500,000Total
    
    
    143,104
    
    
    $
    15.02
    
    
    
    143,104
    
    
    $
    23,500,000
 
 Item 4. Submission of Matters to a Vote of Security Holders
   Name
    
    For
    
    
    Withheld
    
    

BrokerNon-VotesDavid E. Cohen, M.D.
    
    
    28,780,482
    
    
    
    2,159,301
    

    
    
    R. Andrew Eckert
    
    
    28,943,725
    
    
    
    1,996,058
    

    
    
    Carl B.
Feldbaum
    
    
    28,975,275
    
    
    
    1,964,508
    

    
    
    Denise Gilbert
    
    
    30,811,854
    
    
    
    127,929
    

    
    
    John C. Kane
    
    
    28,977,925
    
    
    
    1,961,858
    

    
    
    Thomas D. Kiley
    
    
    29,576,717
    
    
    
    1,363,066
    

    
    
    Leon E. Panetta
    
    
    30,193,836
    
    
    
    745,947
    

    
    
    G. Kirk Raab
    
    
    28,776,301
    
    
    
    2,163,482
    

    
    
    Thomas G. Wiggans
    
    
    29,532,326
    
    
    
    1,407,457
    

    
    
    Total
    
    
    264,568,441
    
    
    
    13,889,606
    

    
    
    
  For
    
    Against
    
    Abstain
        
    
BrokerNon-Votes30,113,174
    
    
    294,976
    
    
    
    531,632
    
    
    
    
  For
    
    Against
    
    Abstain
    

BrokerNon-Votes30,868,312
    
    
    65,963
    
    
    
    5,507
    
    
    
 32




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##### Table of Contents



Item 5. Other Information
 SEC Investigation
  NASDAQ Notice
  Unresolved Staff Comments
   33




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##### Table of Contents



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. 34




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##### Table of Contents



SIGNATURE
  Connetics CorporationBy:
    
    /s/ John L. HigginsJohn L. HigginsChief Financial OfficerExecutive Vice President, Financeand Corporate Development
  35




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##### Table of Contents



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.