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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, 2003

Commission file number: 0-27406

CONNETICS CORPORATION

(Exact name of registrant as specified in its charter)


Delaware(State or other jurisdiction of
incorporation or organization)
    
    94-3173928(IRS Employer
Identification Number)3290 West Bayshore Road
Palo Alto, California(Address of principal executive offices)
    
    94303(Zip Code)


Registrants telephone number, including area code: (650) 843-2800

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 [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]

As of
November 10, 2003, 31,818,143 shares of the Registrants
common stock at $0.001 par value, were outstanding.



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TABLE OF CONTENTS



|                              |                                                                                               |                                       |  |  |  |  |  | 
|----------------------------- | --------------------------------------------------------------------------------------------- | ------------------------------------- |  |  |  |  |  | 
|PART I. FINANCIAL INFORMATION
|                              | Item 1. Financial Statements                                                                 
|                              |                                                                                               | CONDENSED CONSOLIDATED BALANCE SHEETS
|                              | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS                                              
|                              | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS                                              
|                              | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                                         
|                              | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                              | Item 3. Quantitative and Qualitative Disclosures About Market Risk                           
|                              | Item 4. Controls and Procedures                                                              
|PART II. OTHER INFORMATION   
|                              | Item 6. Exhibits and Reports on Form 8-K                                                     
|INDEX TO EXHIBITS            
|EXHIBIT 31.1                 
|EXHIBIT 31.2                 
|EXHIBIT 32.1                 
|EXHIBIT 32.2                 



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CONNETICS CORPORATION

TABLE OF CONTENTS

PagePART I FINANCIAL INFORMATIONItem 1.
    
    Condensed Consolidated Financial Statements
    
    
    1Condensed Consolidated Balance Sheets at September 30, 2003 and December 31, 2002
    
    
    1Condensed Consolidated Statements of Operations for the Three and
Nine Months ended September 30, 2003 and 2002
    
    
    2Condensed Consolidated Statements of Cash Flows for the Nine
Months ended September 30, 2003 and 2002
    
    
    3Notes to Condensed Consolidated Financial Statements
    
    
    4Item 2.
    
    Managements Discussion and Analysis of Financial Condition and
Results of Operations
    
    
    11Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    17Item 4.
    
    Controls and Procedures
    
    
    17PART II OTHER INFORMATIONItem 6.
    

Exhibits
and Reports on Form 8-K
    
    
    18(a) Exhibits
    
    
    18(b) Reports
on Form 8-K
    
    
    18SignaturesExhibits






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PART I. FINANCIAL INFORMATION




Item 1.Financial Statements

CONNETICS CORPORATION




CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)
(Unaudited)


September 30,
    
    December 31,2003
    
    2002ASSETSCurrent assets:Cash and cash equivalents
    
    $
    49,966
    
    
    $
    8,624Marketable securities  current
    
    
    49,335
    
    
    
    24,440Restricted cash
    
    
    411
    
    
    
    424Accounts receivable, net of allowances
    
    
    5,242
    
    
    
    4,308Prepaid and other current assets
    
    
    3,491
    
    
    
    1,803Total current assets
    
    
    108,445
    
    
    
    39,599Property and equipment, net
    
    
    5,556
    
    
    
    5,860Marketable securities  non-current
    
    
    9,736
    
    
    
    Restricted cash
    
    
    
    
    
    
    300Debt issuance costs, deposits and other assets
    
    
    5,029
    
    
    
    848Goodwill, net
    
    
    6,271
    
    
    
    6,271Other intangible assets, net
    
    
    6,414
    
    
    
    6,675Total assets
    
    $
    141,451
    
    
    $
    59,553LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    2,842
    
    
    $
    7,760Accrued clinical trial costs
    
    
    1,319
    
    
    
    1,223Accrued payroll and related expenses
    
    
    3,241
    
    
    
    2,942Accrued process development expenses
    
    
    28
    
    
    
    633Other accrued liabilities
    
    
    2,057
    
    
    
    1,493Current portion of deferred revenue
    
    
    29
    
    
    
    363Total current liabilities
    
    
    9,516
    
    
    
    14,414Deferred revenue, net of current portion
    
    
    
    
    
    
    396Convertible senior notes
    
    
    90,000
    
    
    
    Stockholders equity:Preferred stock
    
    
    
    
    
    
    Common stock
    
    
    32
    
    
    
    31Additional paid-in capital
    
    
    172,797
    
    
    
    169,769Deferred compensation
    
    
    (35
    )
    
    
    (48
    )Accumulated deficit
    
    
    (131,709
    )
    
    
    (126,088
    )Accumulated other comprehensive income
    
    
    850
    
    
    
    1,079Total stockholders equity
    
    
    41,935
    
    
    
    44,743Total liabilities and stockholders equity
    
    $
    141,451
    
    
    $
    59,553


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
    
    Nine Months EndedSeptember 30,
    
    September 30,2003
    
    2002
    
    2003
    
    2002Revenues:Product
    
    $
    17,652
    
    
    $
    12,449
    
    
    $
    47,491
    
    
    $
    34,012Royalty
    
    
    1,256
    
    
    
    741
    
    
    
    6,576
    
    
    
    2,156License, contract and other
    
    
    804
    
    
    
    451
    
    
    
    926
    
    
    
    1,630Total revenues
    
    
    19,712
    
    
    
    13,641
    
    
    
    54,993
    
    
    
    37,798Operating costs and expenses:Cost of product revenues
    
    
    1,388
    
    
    
    1,116
    
    
    
    3,645
    
    
    
    2,765Research and development
    
    
    6,212
    
    
    
    7,014
    
    
    
    23,448
    
    
    
    17,667Selling, general and administrative
    
    
    10,162
    
    
    
    8,497
    
    
    
    32,058
    
    
    
    28,823Acquired in-process research and development
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,000Loss on program termination
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    312Total operating costs and expenses
    
    
    17,762
    
    
    
    16,627
    
    
    
    59,151
    
    
    
    51,567Income (loss) from operations
    
    
    1,950
    
    
    
    (2,986
    )
    
    
    (4,158
    )
    
    
    (13,769
    )Interest income
    
    
    330
    
    
    
    165
    
    
    
    624
    
    
    
    661Gain on sale of investment
    
    
    
    
    
    
    516
    
    
    
    
    
    
    
    2,086Interest expense
    
    
    (699
    )
    
    
    (3
    )
    
    
    (930
    )
    
    
    (9
    )Other income (expense), net
    
    
    48
    
    
    
    (54
    )
    
    
    134
    
    
    
    117Income (loss) before income taxes
    
    
    1,629
    
    
    
    (2,362
    )
    
    
    (4,330
    )
    
    
    (10,914
    )Income tax provision
    
    
    (13
    )
    
    
    (128
    )
    
    
    (1,291
    )
    
    
    (65
    )Net income (loss)
    
    $
    1,616
    
    
    $
    (2,490
    )
    
    $
    (5,621
    )
    
    $
    (10,979
    )Net income (loss) per share:Basic
    
    $
    0.05
    
    
    $
    (0.08
    )
    
    $
    (0.18
    )
    
    $
    (0.36
    )Diluted
    
    $
    0.05
    
    
    $
    (0.08
    )
    
    $
    (0.18
    )
    
    $
    (0.36
    )Shares used to calculate net income (loss) per shareBasic
    
    
    31,648
    
    
    
    30,866
    
    
    
    31,485
    
    
    
    30,656Diluted
    
    
    33,607
    
    
    
    30,866
    
    
    
    31,485
    
    
    
    30,656


See accompanying notes to condensed consolidated financial statements.

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CONNETICS CORPORATION




CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)
(Unaudited)


Nine Months EndedSeptember 30,2003
    
    2002Cash flows from operating activities:Net loss
    
    $
    (5,621
    )
    
    $
    (10,979
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation
    
    
    1,058
    
    
    
    932Amortization of intangible assets and debt issuance costs
    
    
    848
    
    
    
    609Allowance for rebates, returns and chargebacks
    
    
    2,350
    
    
    
    832Gain on sale of investment
    
    
    
    
    
    
    (2,086
    )Stock compensation expense
    
    
    13
    
    
    
    158Stock issued pursuant to license agreement
    
    
    
    
    
    
    12Changes in assets and liabilities:Accounts receivable, net
    
    
    (3,272
    )
    
    
    (3,959
    )Other assets
    
    
    (2,483
    )
    
    
    (941
    )Accounts payable
    
    
    (5,132
    )
    
    
    211Accrued and other current liabilities
    
    
    224
    
    
    
    (540
    )Deferred revenue
    
    
    (729
    )
    
    
    (474
    )Net cash used in operating activities
    
    
    (12,744
    )
    
    
    (16,225
    )Cash flows from investing activities:Purchases of short-term investments
    
    
    (86,211
    )
    
    
    (26,151
    )Sales and maturities of short-term investments
    
    
    60,958
    
    
    
    41,595Purchases of non current marketable securities
    
    
    (9,736
    )
    
    
    Purchases of property and equipment
    
    
    (607
    )
    
    
    (3,291
    )Acquisition of patent
    
    
    (200
    )
    
    
    Net cash provided by (used in) investing activities
    
    
    (35,796
    )
    
    
    12,153Cash flows from financing activities:Restricted cash
    
    
    312
    
    
    
    1,429Proceeds from issuance of convertible senior notes, net of issuance costs
    
    
    86,407
    
    
    
    Proceeds from issuance of common stock, net of issuance costs
    
    
    3,030
    
    
    
    3,844Net cash provided by financing activities
    
    
    89,749
    
    
    
    5,273Effect of foreign currency exchange rate changes on cash and cash equivalents
    
    
    133
    
    
    
    97Net change in cash and cash equivalents
    
    
    41,342
    
    
    
    1,298Cash and cash equivalents at beginning of period
    
    
    8,624
    
    
    
    3,603Cash and cash equivalents at end of period
    
    $
    49,966
    
    
    $
    4,901


See accompanying notes to condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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 have reclassified certain prior year
balances to conform to the current year presentation.

Operating results for the nine months ended September 30, 2003 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2003. 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
ending December 31, 2002, which are included in our Annual Report on Form
10-K/A as filed with the Securities and Exchange Commission.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of
Connetics Corporation, Connetics Holdings Pty Ltd., and Connetics Australia Pty
Ltd. (formerly Soltec Research Pty Ltd.). All intercompany accounts and
transactions have been eliminated 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. Actual results could differ from those estimates based
upon future events.

We evaluate our estimates on an on-going basis. In particular, we
regularly evaluate estimates related to recoverability of accounts receivable
and inventory, revenue recognition 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 Sales.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 collection of the resulting receivable is
reasonably assured. We recognize product revenue net of estimated allowances
for discounts, rebates, returns and chargebacks. We are obligated to accept
from customers the return of pharmaceuticals that have reached their expiration
date. We authorize returns for damaged products and exchanges for expired
products in accordance with our return goods policy and procedures, and we
establish reserves for such amounts at the time of sale. To date we have not
experienced significant returns of damaged or expired product. Product shipping
and handling costs are included in the cost of product revenues.

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

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

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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.
Advance payments that we receive in excess of amounts earned are classified as
deferred revenue until they are earned.

Cash Equivalents and Marketable Securities

Cash and cash equivalents consist of cash on deposit with banks and money
market instruments with original maturities of 90 days or less at the date of
purchase. Investments with maturities beyond three months at the date of
acquisition are included in marketable securities and are classified either as
current or non-current based on their maturity date. Marketable
securities with maturities less than one year are classified as
current. Marketable securities
are classified as available for sale at the time of purchase and are carried at
fair value, and we report unrealized gains and losses as a separate component
of stockholders equity. We determine the cost of securities sold using the
specific identification method.

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

Foreign Currency

Connetics Australias functional currency is the Australian dollar. We
translate Connetics Australias local currency balance sheet into U.S. dollars
using the exchange rates in effect at the balance sheet date. For revenue and
expense accounts we use a weighted average exchange rate during the period.
Foreign currency translation adjustments are recorded in comprehensive income
(loss). Net gains and losses resulting from foreign exchange transactions are
included in the consolidated 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. We establish a valuation
for the net deferred tax assets when realization is uncertain. Our income tax
provision relates primarily to the operations of our Australian subsidiary.

Property and Equipment

Property and equipment are stated 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. Equipment we have
purchased on behalf of our contract manufacturer is being depreciated using the
units of production method based on contractual minimum quantities to be
produced over the term of the agreement. We amortize leasehold improvements
and assets acquired under capital lease arrangements over the shorter of the
estimated useful lives of the assets or the lease term.

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Goodwill, Purchased Intangibles and Impairment of Long Lived Assets

We record goodwill in a business combination when the purchase price of
the net tangible and intangible assets we acquire exceeds their fair value.
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.

We adopted SFAS 142 effective January 1, 2002, and in conjunction with the
implementation of SFAS 142 we performed an impairment test of goodwill as of
that date, which did not result in an impairment charge at transition. SFAS 142
also requires that we test goodwill for impairment on an annual basis or more
frequently if indicators of potential impairment exist. We performed the
annual test as of October 1, 2002, which 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), is 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 assumption 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.
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.

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

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

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Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,(in thousands except per share amounts):
    
    2003
    
    2002
    
    2003
    
    2002Net income (loss), as reported
    
    $
    1,616
    
    
    $
    (2,490
    )
    
    $
    (5,621
    )
    
    $
    (10,979
    )Add: Stock-based compensation expense, included
in reported net loss
    
    
    4
    
    
    
    4
    
    
    
    13
    
    
    
    16Deduct: Total stock-based employee compensation
expense determined under the fair value method
for all awards
    
    
    (2,072
    )
    
    
    (1,207
    )
    
    
    (5,838
    )
    
    
    (3,322
    )Pro forma net loss
    
    $
    (452
    )
    
    $
    (3,693
    )
    
    $
    (11,446
    )
    
    $
    (14,285
    )Net income (loss) per share:Basic income (loss)  as reported
    
    $
    0.05
    
    
    $
    (0.08
    )
    
    $
    (0.18
    )
    
    $
    (0.36
    )Diluted income (loss)  as reported
    
    $
    0.05
    
    
    $
    (0.08
    )
    
    $
    (0.18
    )
    
    $
    (0.36
    )Basic income (loss)  pro forma
    
    $
    (0.01
    )
    
    $
    (0.12
    )
    
    $
    (0.36
    )
    
    $
    (0.47
    )Diluted income (loss)  pro forma
    
    $
    (0.01
    )
    
    $
    (0.12
    )
    
    $
    (0.36
    )
    
    $
    (0.47
    )


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 PlansThree Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2003
    
    2002
    
    2003
    
    2002Expected stock volatility
    
    
    59.2
    %
    
    
    65.3
    %
    
    
    61.6
    %
    
    
    65.3
    %Risk-free interest rate
    
    
    2.2
    %
    
    
    4.6
    %
    
    
    4.3
    %
    
    
    4.6
    %Expected life (in years)
    
    
    2.6
    
    
    
    3.0
    
    
    
    3.3
    
    
    
    3.5Expected dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %


Stock Purchase PlanThree Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2003
    
    2002
    
    2003
    
    2002Expected stock volatility
    
    
    59.9
    %
    
    
    81.5
    %
    
    
    61.7
    %
    
    
    81.5
    %Risk-free interest rate
    
    
    4.5
    %
    
    
    5.9
    %
    
    
    4.7
    %
    
    
    6.0
    %Expected life (in years)
    
    
    1.5
    
    
    
    1.7
    
    
    
    1.4
    
    
    
    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.

Recent Accounting Pronouncements

SFAS 146. In July 2002, the Financial Accounting Standards Board, or
FASB, issued SFAS No. 146, Accounting for Costs Associated with Exit and
Disposal Activities (SFAS 146). This statement revises prior accounting
guidance for exit and disposal activities. Specifically, SFAS 146 requires
that companies record the costs to exit an activity or dispose of long-lived
assets when those costs are incurred. SFAS 146 requires that the liability be
measured at fair value. The provisions of SFAS 146 are effective prospectively
for exit or disposal activities initiated after December 31, 2002. Adoption of
SFAS 146 did not have a significant impact on our financial statements.

FIN 45. In November 2002, the FASB issued Interpretation No. 45,
Guarantors Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others (FIN 45). FIN 45 requires that
upon issuance of a guarantee, the guarantor must recognize a liability for the
fair value of the obligation it assumes under that guarantee. FIN 45 is
effective on a prospective basis to guarantees issued or modified after
December 31, 2002. The disclosure requirements of FIN 45 are effective for
financial statements of interim or annual periods ending after December 15,
2002. The adoption of FIN 45 did not have a significant impact on our
financial statements. See also Note 7.

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

EITF 00-21. In November 2002, the Emerging Issues Task Force (or EITF)
of the FASB issued EITF 00-21, Revenue Arrangements with Multiple
Deliverables, which addresses certain aspects of the accounting for
arrangements that involve the delivery or performance of multiple products,
services, and/or rights to use assets. EITF 00-21 requires us to divide
revenue arrangements with multiple deliverables into separate units of
accounting if the deliverables meet certain criteria, including whether the
fair value of the delivered items can be determined and whether there is
evidence of fair value of the undelivered items. EITF 00-21 also requires us
to allocate the consideration among the separate units of accounting based on
their fair values, and to consider applicable revenue recognition criteria
separately for each of the separate units of accounting. EITF 00-21 is
effective for revenue arrangements we enter into after June 30, 2003. There
was no impact on our financial statements from the adoption of EITF 00-21 and
we will evaluate its impact on revenue arrangements we enter into in the
future.

2. Net Income (Loss) Per Share

We compute basic net income (loss) per share by dividing net loss by the
weighted average 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
ended September 30, 2003 we included all dilutive stock options and warrants in
the calculation of diluted net income per share. We excluded convertible debt
because its effect is anti-dilutive. For the three and nine month periods ended
September 30, 2002 and the nine months ended September 30, 2003, we excluded
all stock options, warrants, and convertible debt in the calculation of diluted
net loss per share because these securities were anti-dilutive during these
periods.

The following table shows a reconciliation of the denominator used in
basic and diluted net income (loss) per share computations for the three and
nine months ended September 30, 2003 and 2002 (in thousands):

Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,(in thousands)
    
    (in thousands)2003
    
    2002
    
    2003
    
    2002Numerator:Net income (loss)
    
    $
    1,616
    
    
    $
    (2,490
    )
    
    $
    (5,621
    )
    
    $
    (10,979
    )Denominator:Weighted-average shares outstanding used for
basic net income (loss) per share
    
    
    31,648
    
    
    
    30,866
    
    
    
    31,485
    
    
    
    30,656Effect of Dilutive Securities:Stock options
    
    
    1,905
    
    
    
    
    
    
    
    
    
    
    
    Warrants
    
    
    54
    
    
    
    
    
    
    
    
    
    
    
    Weighted-average shares used for diluted net
income (loss) per share
    
    
    33,607
    
    
    
    30,866
    
    
    
    31,485
    
    
    
    30,656


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3. Comprehensive Income (Loss)

During the nine months ended September 30, 2003, total comprehensive loss
amounted to $5.9 million, compared to a total comprehensive loss of $16.2
million for the comparable period in 2002. The components of comprehensive
income (loss) are as follows (in thousands):

Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2003
    
    2002
    
    2003
    
    2002Net income (loss)
    
    $
    1,616
    
    
    $
    (2,490
    )
    
    $
    (5,621
    )
    
    $
    (10,979
    )Foreign currency translation adjustment
    
    
    59
    
    
    
    (31
    )
    
    
    128
    
    
    
    48Change in unrealized gain (loss) on securities,
net of reclassification adjustments for
realized gain (loss)
    
    
    175
    
    
    
    94
    
    
    
    (357
    )
    
    
    (5,246
    )Comprehensive income (loss)
    
    $
    1,850
    
    
    $
    (2,427
    )
    
    $
    (5,850
    )
    
    $
    (16,177
    )


Accumulated other comprehensive income included $670,000 of net unrealized
gains on investments and $180,000 of foreign currency translation adjustments
as of September 30, 2003 and $1.0 million of unrealized gains on investments
and $53,000 of foreign currency translation adjustments as of December 31,
2002.

4. Goodwill and Other Intangible Assets

There were no changes in the carrying amount of goodwill during the three
months ended September 30, 2003. The components of our other intangible assets
at September 30, 2003, are as follows (in thousands):

Gross Carrying
    
    AccumulatedAmount
    
    Amortization
    
    NetExisting technology
    
    $
    6,810
    
    
    $
    (1,674
    )
    
    $
    5,136Patents
    
    
    1,661
    
    
    
    (383
    )
    
    
    1,278Total
    
    $
    8,471
    
    
    $
    (2,057
    )
    
    $
    6,414


Amortization expense for our other intangible assets was $208,000 and
$611,000 for the three and nine months ended September 30, 2003, respectively.
For the same reporting periods in the prior year the amortization expense was
$202,000 and $609,000, respectively.

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

Amortization ExpenseRemaining three months in 2003
    
    $
    208For the year ending December 31, 2004
    
    $
    833For the year ending December 31, 2005
    
    $
    833For the year ending December 31, 2006
    
    $
    833For the year ending December 31, 2007
    
    $
    833For the year ending December 31, 2008
    
    $
    833Thereafter
    
    $
    2,041$
    6,414


5. Convertible Subordinated Notes

On May 28, 2003, we issued $90 million of 2.25% convertible senior notes
due May 30, 2008 in a private offering to Goldman, Sachs & Co., who resold the
notes to qualified institutional investors. The notes are unsecured and rank
equal to all of our future unsecured and unsubordinated debts. The notes are
convertible at any time at the option of the note holders into Connetics common
stock at a conversion price equivalent to $21.41 per share subject to adjustment in
certain circumstances. This conversion price was higher than our stock price
on the notes issuance date. Interest on the notes is payable semi-annually in
arrears in May and November, and we can redeem all or a

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portion of the notes at any time on or after May 30, 2005. Offering
expenses of $3.5 million related to the sale of these notes have been included
in other assets and are amortized to interest expense over the contractual term
of the notes. As of September 30, 2003, the fair value of these notes
approximated $94.9 million.

6. Assignment of Relaxin Rights

On July 15, 2003, we assigned our rights to recombinant human relaxin to
BAS Medical, Inc., a private, development-stage company focused on the
development and marketing of novel medical treatments. As part of the
transaction, we may receive up to $1.0 million in licensing and milestone fees,
plus royalties on future product sales. Upon the execution of the definitive
agreement, we received a $100,000 upfront assignment fee that we recognized as
license revenue in the third quarter of 2003. We will receive the remaining
$900,000 upon the achievement by BAS Medical of various milestones. BAS
Medical will assume rights to develop and commercialize relaxin for all
indications of use. All of our obligations under existing contracts related to
relaxin were also transferred to BAS Medical as part of this transaction, and
as a result, in the third quarter of 2003, we recognized $661,000 in deferred
revenue relating to previous relaxin license agreements.

7. 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.

Connetics enters into indemnification provisions under its agreements with
other companies in its ordinary course of business, typically with business
partners, contractors, clinical sites, insurers and customers. Under these
provisions Connetics generally indemnifies and holds 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, 2003. We have not incurred material costs to defend
lawsuits or settle claims related to these indemnification agreements.

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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 onForm 10-K/Afor the year ended December 31,
2002, 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
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 Factors That May
Affect Future Results, Financial Condition and the Market Price of Securities
and in our Annual Report onForm 10-K/A. Our historical operating results are
not necessarily indicative of the results to be expected in any future period.

Overview

Our commercial business is focused on the dermatology marketplace, which
is characterized by a large patient population that is served by relatively
small, and therefore more accessible, groups of treating physicians. We
currently market two pharmaceutical products, OLUX® and Luxíq®. Both products
have clinically proven therapeutic advantages and we are providing quality
customer service to physicians through our experienced sales and marketing
professionals. In December 2002, we received approval from the U.S. Food and
Drug Administration, or FDA, to sell OLUX for the treatment of non-scalp
psoriasis.

In addition to revenue from product sales, we receive royalties on sales
of RID®, Actimmune® and Ridaura® in the U.S., internationally on sales of
Banlice®, Milice®, Bettamousse®, and on a super-concentrated aerosol spray
licensed worldwide. We have licenses with Novartis and Pfizer, Inc., formerly
Pharmacia Corporation, which have the potential to bear royalties in the future
depending on approval of their products for sale.

During the first nine months of 2003, we had three product candidates in
Phase III clinical trials: Extina, a foam formulation of a 2% concentration of the
antifungal drug ketoconazole, for the treatment of seborrheic dermatitis;
Actiza, a foam formulation of 1% clindamycin for the treatment of acne; and
Velac ® Gel (a first-in-class combination of 1% clindamycin and 0.025%
tretinoin) for the treatment of acne. Extina and Actiza are delivered in our
proprietary foam delivery system.

In April 2003, we announced the outcome of a Phase III clinical trial
evaluating Extina. The four-week, double-blinded active- and
placebo-controlled trial included 619 patients at 25 centers. As designed, the
trial results demonstrated that Extina was not inferior to Nizoral®
(ketoconazole) 2% Cream as measured by the primary endpoint of Investigators
Static Global Assessment (ISGA). The trial was also designed to compare Extina
to placebo foam per the ISGA. The result, although in favor of Extina, did not
achieve statistical significance. On all other endpoints, statistical
significance was achieved; therefore we believe that the totality of the data
demonstrated that Extina was clinically superior to placebo foam.

On July 2,
2003 we announced we had submitted a New Drug Application (NDA) with the FDA
for Extina. We have
been informed by the FDA that they think a user fee is involved for
the Extina NDA on the basis that it contains a new indication for
use. That NDA does not contain any new indication for use, and was
filed in accordance with FDA regulations using the same regulatory
pathway used for Luxiq and OLUX, neither of which required the
payment of a user fee. We are working with the FDA to resolve this
issue as quickly as possible. We expect it to be resolved in the
fairly near future, but the resolution could result in some delay in
the processing of our application.

In May 2003 we issued $90 million of convertible senior notes in a private
placement exempt from registration under the Securities Act of 1933. The notes bear
an interest rate of 2.25% per year and have a five-year term. The notes are
convertible into Connetics common stock at a price equal to approximately
$21.41 per share, subject to adjustment in certain circumstances, which
represents a 35% premium over the closing price of our common stock on the date the offering was
announced. We will use the proceeds from the offering to augment our cash
reserves for general corporate purposes, including potential future product or
company acquisitions, capital expenditures and working capital.

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On July 15, 2003, we assigned our rights to recombinant human relaxin to
BAS Medical, Inc., a private, development-stage company focused on the
development and marketing of novel medical treatments. As part of the
transaction, we may receive up to $1.0 million in licensing and milestone fees,
plus royalties on future product sales. Upon the execution of the definitive
agreement, we received a $100,000 upfront assignment fee that we recognized as
license revenue in the third quarter of 2003. We will receive the remaining
$900,000 upon the achievement by BAS Medical of various milestones. BAS
Medical will assume rights to develop and commercialize relaxin for all
indications of use. All of our obligations under existing contracts related to
relaxin were also transferred to BAS Medical as part of this transaction, and
as a result, in the third quarter of 2003, we recognized $661,000 in deferred
revenue relating to previous relaxin license agreements.

On September 30, 2003, we announced the positive outcome of the Phase III
clinical trial evaluating Actiza. The 12-week, double-blinded, active- and
placebo-controlled trial included 1,026 patients at 18 centers across the U.S.
The trial was designed to demonstrate that Actiza was not inferior to
Clindagel® (clindamycin phosphate 1% topical gel) as measured by the primary
endpoints of Investigators Static Global Assessment (ISGA) and percent
reduction in lesion counts (total, inflammatory and non-inflammatory) from
Baseline to Week 12 (end of treatment). Success was defined as achieving
non-inferiority to Clindagel for two out of three lesion counts and for ISGA.
The trial results met or exceeded all of these requirements. Additionally,
Actiza was statistically superior to placebo for all primary endpoints.
Adverse events with Actiza were mild to moderate in nature and were related
primarily to burning at the application site.

Critical Accounting Policies

There have been no material changes to our critical accounting policies
from those reported in the section entitled Managements Discussion and
Analysis of Financial Condition and Results of Operations in our annual report
on Form 10-K/A for the year ended December 31, 2002.

Results of Operations

Revenues

Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,(in thousands)
    
    (in thousands)2003
    
    2002
    
    2003
    
    2002Product Revenues:OLUX®
    
    $
    12,941
    
    
    $
    8,532
    
    
    $
    33,820
    
    
    $
    23,059Luxíq®
    
    
    4,693
    
    
    
    3,875
    
    
    
    13,572
    
    
    
    10,849Other
    
    
    18
    
    
    
    42
    
    
    
    99
    
    
    
    104Total product revenues
    
    
    17,652
    
    
    
    12,449
    
    
    
    47,491
    
    
    
    34,012Royalty, license and contract:Royalty
    
    
    1,256
    
    
    
    741
    
    
    
    6,576
    
    
    
    2,156Relaxin related contract revenue
    
    
    761
    
    
    
    32
    
    
    
    827
    
    
    
    98Pfizer
    
    
    19
    
    
    
    125
    
    
    
    75
    
    
    
    625Novartis
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    580InterMune
    
    
    
    
    
    
    250
    
    
    
    
    
    
    
    250Other contract
    
    
    24
    
    
    
    44
    
    
    
    24
    
    
    
    77Total royalty, license and contract revenues
    
    
    2,060
    
    
    
    1,192
    
    
    
    7,502
    
    
    
    3,786$
    19,712
    
    
    $
    13,641
    
    
    $
    54,993
    
    
    $
    37,798


Our product revenues were $17.7 million for the three months ended
September 30, 2003 and $47.5 million for the nine months ended September 30,
2003, compared to $12.4 million and $34.0 million for the three and nine months
ended September 30, 2002. Total net
product sales increased 42% in the third quarter and 40% in the first
nine months of 2003 as compared with the same periods in the prior
year. Increased sales volumes accounted for a 26% increase in the net
product sales in the third quarter of 2003 and a 25% increase in the
net product sales in the nine months ended September 30, 2003
compared to the same periods in 2002. Higher sales prices for our
dermatology products accounted for the remainder of the increases in
net product sales in the three and nine months ended
September 30, 2003 compared to the same periods in 2002.

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Royalty, license and contract revenues were $2.1 million and $7.5 million
for the three and nine months ended September 30, 2003, compared to $1.2
million and $3.8 million for the three and nine months ended September 30,
2002. Royalty, license and contract revenue was higher for the third quarter
of 2003 compared to the third quarter of 2002 primarily due to two factors:
(1) in the third quarter of 2003, we experienced an increase of $502,000 in
royalty revenue from a third party in connection with our aerosol spray
technology; and (2) in the third quarter of 2003, we recognized $761,000 of
relaxin-related revenue associated with the execution of the agreement with BAS
Medical in July of 2003. Of the relaxin-related revenue, $661,000 represented
previously deferred revenue associated with relaxin license agreements with
other parties that was fully recognized upon the execution of the BAS Medical
agreement. These increases were partially offset by decreases in contract
revenue from various third parties, in relation to one-time contract payments
made in 2002. We expect no further relaxin-related revenue.

The increase in royalty, license and contract revenue for the nine months
ended September 30, 2003 compared to the nine months ended September 30, 2002
was primarily due to our receipt of a one-time royalty payment made in the
second quarter of 2003 by a third party in the amount of $2.9 million in
connection with our aerosol spray technology, and an increase in royalties paid
by the same party of approximately $1.3 million. The increase in royalty,
license and contract revenue for the nine months ended September 30, 2003
compared to the nine months ended September 30, 2002 was also affected by the
increase in relaxin-related revenue in 2003 as discussed above, offset by the
fact that certain payments in 2002 by Novartis, Pfizer (then Pharmacia) and
InterMune were one-time payments.

We have an agreement with Prometheus Laboratories, Inc. pursuant to which
we receive a royalty on Prometheus annual sales of Ridaura in excess of $4.0
million, in any calendar year through March 2006. We recognize royalty revenue
in the quarter in which the royalty payment is either received or may be
reasonably estimated. We recognized $0 and $133,000 of royalty revenue in the
three and nine months ended September 30, 2003 and $0 in both of the comparable
periods for 2002 in conjunction with this agreement.

We have an agreement with InterMune, Inc. pursuant to which we receive a
royalty on InterMunes sales of Actimmune in the United States. We recognized
$83,000 and $270,000 of royalty revenue for the three and nine months ended
September 30, 2003. For the three and nine months ended September 30, 2002 we
recognized $56,000 and $100,000 of Actimmune royalty, in connection with this
agreement.

Cost of Product Revenues

Our cost of product revenues includes the third party costs of
manufacturing OLUX and Luxíq, depreciation costs associated with
Connetics-owned equipment located at the DPT facility in Texas, royalty
payments based on a percentage of our product revenues, and product freight and
distribution costs from Cardinal Health Specialty Pharmaceutical Services
(formerly CORD Logistics, Inc.), the third party that handles all of our
product distribution activities. Currently, DPT Laboratories, Ltd., AccraPac
Group, Inc., and InyX Pharma, Ltd. (formerly Miza Pharmaceuticals) manufacture
commercial supplies of OLUX and Luxíq. We recorded costs of product revenues
of $1.4 million for the three months ended September 30, 2003 and $3.6 million
for the nine months ended September 30, 2003, compared to $1.1 million and $2.8
million for the three and nine months ended September 30, 2002. The increase
in the cost of product revenues in the three and nine months ended September
30, 2003 compared to the same period in 2002 is primarily attributable to the
increase in sales volume of our products, as well as the establishment of a
$150,000 reserve in the third quarter of 2003 related to minimum purchase
commitments under our manufacture and supply agreement with DPT. If the
effects of the $150,000 reserve from the third quarter of 2003 are excluded, we
experienced a slight improvement in our gross product margin due to the
combined effects of the price increases for OLUX and Luxíq, initiated in the
fourth quarter of 2002 and the second quarter of 2003, and slightly lower costs
of manufacturing our products.

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Research and Development

Research and development expenses include costs of personnel to support
our research and development activities, costs of preclinical studies, costs of
conducting our clinical trials, such as clinical investigator fees, monitoring
costs, data management and drug supply costs, external research programs, and
an allocation of facilities costs, salaries and benefits, and overhead costs
such as rent, supplies and utilities. In the nine months ended September 30,
2003 we incurred costs associated with ten clinical trials in various stages of
completion, compared to five clinical trials in various stages of completion in
the nine months ended September 30, 2002. There was also a significant
increase in the number of patients enrolled in the clinical trial work
performed during the nine months ended September 30, 2003 compared to the same
nine-month period in 2002. As of September 30, 2003, we were still conducting
Phase III clinical trials for Velac.

Research and development expenses were $6.2 million for the three months
ended September 30, 2003 and $7.0 million for the three months ended September
30, 2002. The decrease is primarily related to $776,000 in contract
manufacturing expenses incurred in 2002 to manufacture clinical trial product
used in clinical trials in 2002 and 2003. Other factors contributing to the
decrease in the three-month period are decreases due to the timing of various
process and product development activities, the one-time reversal of a
previously recorded liability of $575,000 for clinical trial materials which we
have concluded is not owed, and a decrease of $563,000 in expenses in quality
affairs due to timing on certain stability work. These decreases were
partially offset by an increase of $688,000 in clinical trial expenses, and a
$458,000 increase in employee and travel related costs associated with the
increased headcount needed to support the increased clinical trial activities
as well as other R&D activities.

Research and development expenses were $23.4 million and $17.7 million for
the nine months ended September 30, 2003 and 2002, respectively. The increase
is due primarily to increased clinical trial costs of $6.3 million, an
increase in employee related costs of $1.3 million associated with the
increased headcount needed to support the increased clinical trial activities
as well as other R&D activities, and an increase of $569,000 in consulting and
outside services. These increases were partially offset by a $1.7 million
decrease in contract manufacturing expenses incurred to manufacture clinical
trial product used in clinical trials during 2002 and 2003, as well as
decreases due to the timing of various process and product development
activities, the one-time reversal of a previously recorded liability of
$575,000 for clinical trial materials which we have concluded is not owed.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $10.2 million for the
three months ended September 30, 2003 and $32.1 million for the nine months
ended September 30, 2003, compared to $8.5 million and $28.8 million for the
comparable periods in 2002. For the three months ended September 30, 2003 the
overall increase was primarily related to a $799,000 increase in
employee-related costs due to increased headcount and an increase in consulting
and outside services expenses of $669,000, compared with the same period in
2002.

For the nine months ended September 30, 2003 the overall increase compared
with the same period in 2002 was primarily related to an increase of $1.4
million in employee-related costs due to increased headcount, and an increase
of $1.3 million in consulting and outside service expenses.

Interest and other income (expense), net

Interest income was $330,000 for the three months ended September 30, 2003
and $624,000 for the nine months ended September 30, 2003, compared to $165,000
and $661,000 for the three and nine months ended September 30, 2002. The
increase in interest income during the three months ended September 30, 2003
compared to the same period in 2002 was the result of higher cash and
investment balances in connection with the money we raised by issuing $90
million of convertible senior notes in May 2003, partially offset by lower
market interest rates on investments.

Interest expense was $699,000 for the three months ended September 30,
2003 and $930,000 for the nine months ended September 30, 2003, compared to
$3,000 and $9,000 for the three and nine months ended September 30, 2002. The
increase in interest expense during the first nine months of 2003 compared to
the same period in 2002 was directly related to the interest expense associated
with the convertible senior notes issued in the second quarter of
2003.

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Income Taxes

We recognized an income tax expense of $13,000 for the three months ended
September 30, 2003 and $1.3 million for the nine months ended September 30,
2003, related to the foreign tax provision recorded by Connetics Australia. We
recognized income tax expense of $128,000 for the three months ended September
30, 2002 and of $65,000 for the nine months ended September 30, 2002. The net
income tax expense for the nine months ended September 30, 2002 reflects a
foreign tax provision recorded by Connetics Australia of $605,000 reduced by a
U.S. tax benefit of $540,000. The U.S. tax benefit arose principally because
of the provisions of the U.S. Job Creation and Worker Assistance Act of 2002
enacted on March 9, 2002, which allows taxpayers to carry back net operating
losses generated in 2001 and 2002 to offset alternative minimum tax paid in the
last five years.

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, 2003, cash, cash equivalents and short and long-term investments
totaled $109.0 million compared to $33.1 million at December 31, 2002. Our
cash balances are held in a variety of interest-bearing instruments including
high-grade corporate bonds, commercial paper, U.S. Government agencies papers,
and money market accounts.

Cash used in operating activities.Cash used in operations for the nine
months ended September 30, 2003 was $12.7 million compared to $16.2 million for
the nine months ended September 30, 2002. Net loss of $5.6 million for the
nine months ended September 30, 2003 was affected by non-cash charges of $1.9
million of depreciation and amortization expense and $2.4 million of increased
reserves related to product returns, chargebacks, rebates and coupon programs.
Cash usage was primarily affected by an increase in accounts receivable of
approximately of $3.3 million related to the timing of sales and collection of
outstanding amounts, an increase in other assets of $2.5 million primarily
related to various prepaid activities, and a decrease in accounts payable and
other accrued and current liabilities of $4.9 million primarily related to the
timing of payments and activities related to product development and other
business activity.

Net loss of $11.0 million for the nine months ending September 30, 2002
was affected by non-cash charges of $1.5 million of depreciation and
amortization expense and $832,000 of increased reserves related to returns,
chargebacks, rebates and coupon programs, and a $2.1 million gain on the sale
of investments. Cash usage related primarily to an increase in accounts
receivable of $4.0 million relating to the timing of sales and collection of
outstanding amounts, an increase of $941,000 in various prepaid activities, and
an increase in accounts payable and other accrued and current liabilities of
$329,000 related to increased business and development activities.

Cash flows provided by (used in) investing activities.Cash flows used in
investing activities was $35.8 million for the nine months ended
September 30, 2003, compared to cash flows provided by investing activities of
$12.2 million for the nine months ended September 30, 2002. The increase in
cash used in investing activities is primarily the result of an increase in
purchasing activity of both short and long-term investments of $69.8 million
following the convertible debt financing, partially offset by a net increase of
$19.4 million in sales activity of short-term investments. We had only
moderate increases in operating expenses in the nine month period ended
September 30, 2003 compared to the same period in 2002, but our property and
equipment expenditures decreased by $2.7 million for the nine-month period
ended September 30, 2003 compared to the same period last year. The decrease
is primarily the result of expenditures in 2002 that were not repeated in 2003,
including $2.1 million related to the DPT facility build-out which occurred in
2002, $307,000 related to leasehold improvements and other costs in connection
with moving our offices to 3290 West Bayshore in 2002, and higher regular
business equipment and property purchases in the first nine months of 2002
compared to the same period in 2003.

Cash flows from financing activities.Financing activities provided $89.7
million for the nine months ended September 30, 2003 and $5.3 million for the
nine months ended September 30, 2002. This increase is primarily due to the
$86.4 million of net proceeds from the issuance of convertible senior notes in
the second quarter of 2003. The

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increase due to the financing was partially offset by the decrease of $1.1
million in restricted cash activity in 2003 compared to the same time frame in
2002. During the first nine months of 2002, $1.4 million of previously
restricted certificates of deposits related to our controlled disbursements
account, security deposit on facility, and collateral on certain officers
personal bank loans were released. For the same period in 2003, $312,000 of a
previously restricted certificate of deposit related to a security deposit on
our facility was released. We recognized $3.0 million in net proceeds from the
issuance of common stock under stock option plans, the employee stock
purchase plan, and warrant exercises in the first nine months of 2003 and $3.9 million for
the same period in 2002.

Working Capital.Working capital increased by $73.7 million to $98.9
million at September 30, 2003 from $25.2 million at December 31, 2002,
primarily due to the convertible debt financing which we completed in the
second quarter of 2003.

Contractual Obligations and Commercial Commitments.There have been no
material changes in our contractual obligations and commercial commitments
since December 31, 2002. Our commitments, including those disclosed in the
Annual Report on Form 10-K/A for the year ended December 31, 2002, consist
primarily of operating lease agreements for our facilities as well as minimum
purchase commitments under one of our contract manufacturing agreements.

Restricted Cash and Cash Equivalents.In the nine months ended September
30, 2003, $312,000 was released from previously restricted certificates of
deposit related to security for our facilities rent. As of September 30, 2003,
$411,000 of our total cash and cash equivalents balance was restricted cash,
held in various certificates of deposit, for specific purposes.

We believe our existing cash, cash equivalents and short-term investments,
cash generated from product sales and collaborative arrangements with corporate
partners, will be sufficient to fund our operating expenses, debt obligations
and capital requirements through at least the next 12 months. 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 2002 Annual Report onForm 10-K/Awhere 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/A for
the year ended December 31, 2002 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 Annual Report on Form 10-K/A for the year ended December 31,
2002, in particular under the caption Factors That May Affect Future Results,
Financial Condition and the Market Price of Securities, should be carefully
considered when evaluating our business and prospects.

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

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



| |  |  | 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.
| | - |  | ------------------------------------------------




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/A for the year ended December 31, 2002.




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, 2003. 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, 2003, there has been
no change in our internal control over financial reporting that has materially
affected, or is reasonably likely to materially affect, our internal control
over financial reporting.

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PART II. OTHER INFORMATION




Item 6.Exhibits and Reports on Form 8-K



|(a) |  | Exhibits.
|--- |  | ---------

| |      |  |                                                                                                                               
| | ---- |  | ------------------------------------------------------------------------------------------------------------------------------
| | 31.1 |  | Certification of the Chief Executive Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                        
| | 31.2 |  | Certification of the Chief Financial Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                        
| | 32.1 |  | Certification of the Chief Executive Officer
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,
18 U.S.C. Section 1350
| | 32.2 |  | Certification of the Chief Executive Officer
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,
18 U.S.C. Section 1350



|(b) |  | Reports on Form 8-K. We filed or furnished the following Current Reports
on Form 8-K during the quarter ended September 30, 2003. The information
furnished under Item 9, Regulation FD Disclosure and Item 12, Results of
Operations and Financial Condition is not deemed to be filed for
purposes of Section 18 of the Securities Exchange Act of 1934.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (i) |  | Current Report on Form 8-K dated June 30, 2003, filed with
the Securities and Exchange Commission on July 1, 2003, under Item
5, Other Events, and Item 7, Financial Statements & Exhibits.
| | --- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (ii) |  | Current Report on Form 8-K dated July 2, 2003, filed with the
Securities and Exchange Commission on July 9, 2003, under Item 5,
Other Events, and Item 7, Financial Statements & Exhibits.
| | ---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (iii) |  | Current Report on Form 8-K dated July 15, 2003, filed with
the Securities and Exchange Commission on July 24, 2003, under Item
2, Acquisition or Disposition of Assets, and Item 7, Financial
Statements & Exhibits.
| | ----- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (iv) |  | Current Report on Form 8-K dated July 28,
2003, furnished to the Securities and Exchange Commission on
July 28, 2003, under Item 9, Regulation FD Disclosure,
and Item 12, Results of Operations and Financial Condition.
| | ---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (v) |  | Current Report on Form 8-K dated August 18, 2003, filed with
the Securities and Exchange Commission on August 19, 2003, under
Item 5, Other Events.
| | --- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------



| | (vi) |  | Current Report on Form 8-K dated September 26, 2003, filed
with the Securities and Exchange Commission on September 29, 2003,
under Item 5, Other Events, and Item 7, Financial Statements &
Exhibits.
| | ---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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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. HigginsJohn L. HigginsExec. Vice President, Finance and
Corporate Development and Chief
Financial Officer (Principal Financial Officer and
Duly Authorized Officer of the Registrant)


Date: November 14, 2003

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INDEX TO EXHIBITS

ExhibitNumber
    
    Description31.1
    
    Certification of the Chief Executive Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 200231.2
    
    Certification of the Chief Financial Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 200232.1
    
    Certification of the Chief Executive Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 135032.2
    
    Certification of the Chief Executive Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350


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