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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 June 30, 2002

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 94303(Address of principal executive offices)

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

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for at least the past 90 days.    Yes  [X]    No  [   ]

As of August 9,
2002, 30,933,800 shares of the Registrants common stock
were outstanding, at $0.001 par value.





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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                           
|PART II. OTHER INFORMATION   
|                              | Item 4. Submission of Matters to a Vote of Security Holders                                  
|                              | Item 6. Exhibits and Reports on Form 8-K                                                     
|SIGNATURE                    
|INDEX TO EXHIBITS            
|EXHIBIT 10.1                 
|EXHIBIT 10.2                 



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CONNETICS CORPORATION
TABLE OF CONTENTS

|                              |  |         |  |                                                                                                                      |  |      |    | 
|----------------------------- |  | ------- |  | -------------------------------------------------------------------------------------------------------------------- |  | ---- | -- | 
|                              |  |         |  |                                                                                                                      |  | Page
|                              |  |         |  |                                                                                                                      |  |     
|PART I  FINANCIAL INFORMATION |  |         |  |                                                                                                                     
|                             
|                              |  | Item 1. |  | Condensed Consolidated Financial Statements                                                                          |  |      |    | 
|                             
|                              |  |         |  | Condensed Consolidated Balance Sheets at June 30, 2002 and December 31, 2001                                         |  |      | 3  | 
|                             
|                              |  |         |  | Condensed Consolidated Statements of Operations for the three months and the six months ended June 30, 2002 and 2001 |  |      | 4  | 
|                             
|                              |  |         |  | Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2002 and 2001                      |  |      | 5  | 
|                             
|                              |  |         |  | Notes to Condensed Consolidated Financial Statements                                                                 |  |      | 6  | 
|                             
|                              |  | Item 2. |  | Management's Discussion and Analysis of Financial Condition and Results of Operations                                |  |      | 13 | 
|                             
|                              |  | Item 3. |  | Quantitative and Qualitative Disclosures About Market Risks                                                          |  |      | 20 | 
|                             
|PART II  OTHER INFORMATION    |  |         |  |                                                                                                                     
|                             
|                              |  | Item 4. |  | Submission of Matters to a Vote of Security Holders                                                                  |  |      | 20 | 
|                             
|                              |  | Item 6. |  | Exhibits and Reports on Form 8-K                                                                                     |  |      | 21 | 
|                             
|                              |  |         |  | (a) Exhibits                                                                                                         |  |      | 21 | 
|                             
|                              |  |         |  | (b) Reports on Form 8-K                                                                                              |  |      | 21 | 





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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,
|                                           |                                             |   |                            |          |   | 2002     |        | 2001        
|                                           |                                             |   |                            |          |   |          |        |             
|Assets                                     |                                             |   |                            |          |   |          |        |             
|Current assets:                            |                                             |   |                            |          |   |          |        |             
|                                           | Cash and cash equivalents                   |   | $                          | 9,158    |   |          | $      | 3,603        |  
|                                           | Short-term investments                      |   |                            | 27,954   |   |          |        | 42,734       |  
|                                           | Restricted cash                             |   |                            | 410      |   |          |        | 1,539        |  
|                                           | Accounts receivable, net                    |   |                            | 4,124    |   |          |        | 5,392        |  
|                                           | Other current assets                        |   |                            | 2,156    |   |          |        | 1,204        |  
|                                           |                                             |   |                            |          |   |          |        |             
|                                           |                                             |   | Total current assets       |          |   | 43,802   |        |              |   | 54,472 | 
|                                          
|Property and equipment, net                |                                             |   | 5,084                      |          |   |          | 3,167  |             
|Restricted cash                            |                                             |   | 300                        |          |   |          | 600    |             
|Deposits and other assets                  |                                             |   | 660                        |          |   |          | 332    |             
|Goodwill, net                              |                                             |   | 6,271                      |          |   |          | 6,132  |             
|Other intangible assets, net               |                                             |   | 7,078                      |          |   |          | 7,624  |             
|                                           |                                             |   |                            |          |   |          |        |             
|Total assets                               |                                             | $ | 63,195                     |          |   | $        | 72,327 |             
|                                           |                                             |   |                            |          |   |          |        |             
|Liabilities and Stockholders Equity       |                                             |   |                            |          |   |          |        |             
|Current liabilities:                       |                                             |   |                            |          |   |          |        |             
|                                           | Accounts payable                            |   | $                          | 6,821    |   |          | $      | 3,636        |  
|                                           | Accrued payroll and related expenses        |   |                            | 1,852    |   |          |        | 2,599        |  
|                                           | Accrued process development expenses        |   |                            | 909      |   |          |        | 1,209        |  
|                                           | Other accrued current liabilities           |   |                            | 835      |   |          |        | 1,507        |  
|                                           | Notes payable                               |   |                            | 352      |   |          |        |             |  
|                                           | Other current liabilities                   |   |                            | 836      |   |          |        | 663          |  
|                                           | Current portion of deferred revenue         |   |                            | 582      |   |          |        | 832          |  
|                                           |                                             |   |                            |          |   |          |        |             
|                                           |                                             |   | Total current liabilities  |          |   | 12,187   |        |              |   | 10,446 | 
|                                          
|Deferred revenue, net of current portion   |                                             |   | 461                        |          |   |          | 527    |             
|                                          
|Stockholders equity:                      |                                             |   |                            |          |   |          |        |             
|                                           | Preferred stock                             |   |                            |         |   |          |        |             |  
|                                           | Common stock and additional paid-in capital |   |                            | 167,231  |   |          |        | 164,300      |  
|                                           | Deferred compensation                       |   |                            | (57      | ) |          |        | (69          | )
|                                           | Accumulated deficit                         |   |                            | (117,987 | ) |          |        | (109,498     | )
|                                           | Accumulated other comprehensive income      |   |                            | 1,360    |   |          |        | 6,621        |  
|                                           |                                             |   |                            |          |   |          |        |             
|                                           |                                             |   | Total stockholders equity |          |   | 50,547   |        |              |   | 61,354 | 
|                                           |                                             |   |                            |          |   |          |        |             
|Total liabilities and stockholders equity |                                             | $ | 63,195                     |          |   | $        | 72,327 |             
|                                           |                                             |   |                            |          |   |          |        |             

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 Ended
|                                                 |                                              |                |        | June 30,           |        | June 30,        
|                                                 |                                              |                |        |                    |        |                 
|                                                 |                                              |                |        | 2002               |        | 2001             |         | 2002   |       | 2001
|                                                 |                                              |                |        |                    |        |                  |         |        |       |     
|Revenues:                                        |                                              |                |        |                    |        |                  |         |        |       |      |         |        |        |   |         |       
|                                                 | Product                                      |                | $      | 11,423             |        |                  | $       | 6,577  |       |      | $       | 21,563 |        |   | $       | 14,232 |       
|                                                 | Royalty                                      |                |        | 766                |        |                  |         | 123    |       |      |         | 1,416  |        |   |         | 123    |       
|                                                 | License, contract and other                  |                |        | 437                |        |                  |         | 863    |       |      |         | 1,178  |        |   |         | 1,667  |       
|                                                 |                                              |                |        |                    |        |                  |         |        |       |      |         |        |        |   |         |       
|                                                 |                                              | Total revenues |        |                    | 12,626 |                  |         |        | 7,563 |      |         |        | 24,157 |   |         |        | 16,022 | 
|                                                 |                                              |                |        |                    |        |                  |         |        |       |      |         |        |        |   |         |       
|Operating costs and expenses:                    |                                              |                |        |                    |        |                  |         |        |       |      |         |        |        |   |         |       
|                                                 | Cost of product revenues                     |                |        | 973                |        |                  |         | 603    |       |      |         | 1,648  |        |   |         | 1,708  |       
|                                                 | Research and development                     |                |        | 5,613              |        |                  |         | 5,621  |       |      |         | 10,653 |        |   |         | 9,973  |       
|                                                 | Selling, general and administrative          |                |        | 10,746             |        |                  |         | 9,698  |       |      |         | 20,327 |        |   |         | 17,310 |       
|                                                 | Acquired in-process research and development |                |        | 2,000              |        |                  |         | 1,080  |       |      |         | 2,000  |        |   |         | 1,080  |       
|                                                 | Charge for Relaxin and related liabilities   |                |        | 312                |        |                  |         | 5,976  |       |      |         | 312    |        |   |         | 5,976  |       
|                                                 |                                              |                |        |                    |        |                  |         |        |       |      |         |        |        |   |         |       
|                                                 | Total operating costs and expenses           |                |        | 19,644             |        |                  |         | 22,978 |       |      |         | 34,940 |        |   |         | 36,047 |       
|                                                 |                                              |                |        |                    |        |                  |         |        |       |      |         |        |        |   |         |       
|Loss from operations                             |                                              |                | (7,018 | )                  |        |                  | (15,415 | )      |       |      | (10,783 | )      |        |   | (20,025 | )     
|                                                
|Interest and other income                        |                                              |                | 366    |                    |        |                  | 690     |        |       |      | 796     |        |        |   | 1,691   |       
|Gain on sale of investments                      |                                              |                | 1,552  |                    |        |                  |        |        |       |      | 1,570   |        |        |   | 122     |       
|Gain (loss) on foreign exchange forward contract |                                              |                |       |                    |        |                  | 840     |        |       |      |        |        |        |   | (555    | )     
|Gain on sale of Ridaura product line             |                                              |                |       |                    |        |                  | 8,055   |        |       |      |        |        |        |   | 8,055   |       
|Interest and other expense                       |                                              |                | (60    | )                  |        |                  |        |        |       |      | (135    | )      |        |   | (6      | )     
|                                                 |                                              |                |        |                    |        |                  |         |        |       |      |         |        |        |   |         |       
|Loss before income taxes                         |                                              |                | (5,160 | )                  |        |                  | (5,830  | )      |       |      | (8,552  | )      |        |   | (10,718 | )     
|Income tax benefit (expense)                     |                                              |                | (161   | )                  |        |                  | (305    | )      |       |      | 63      |        |        |   | (305    | )     
|                                                 |                                              |                |        |                    |        |                  |         |        |       |      |         |        |        |   |         |       
|Net loss                                         |                                              | $              | (5,321 | )                  |        | $                | (6,135  | )      |       | $    | (8,489  | )      |        | $ | (11,023 | )     
|                                                 |                                              |                |        |                    |        |                  |         |        |       |      |         |        |        |   |         |       
|Basic and diluted loss per share                 |                                              | $              | (0.17  | )                  |        | $                | (0.21   | )      |       | $    | (0.28   | )      |        | $ | (0.37   | )     
|                                                 |                                              |                |        |                    |        |                  |         |        |       |      |         |        |        |   |         |       
|Shares used to calculate loss per share          |                                              |                | 30,608 |                    |        |                  | 29,777  |        |       |      | 30,552  |        |        |   | 29,741  |       
|                                                 |                                              |                |        |                    |        |                  |         |        |       |      |         |        |        |   |         |       

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 Ended
|                                      |                                                                             |                                              |   | June 30,        
|                                      |                                                                             |                                              |   |                 
|                                      |                                                                             |                                              |   | 2002             |        | 2001
|                                      |                                                                             |                                              |   |                  |        |     
|Cash flows from operating activities: |                                                                             |                                              |   |                  |        |      |   |        
|                                      | Net loss                                                                    |                                              | $ | (8,489           | )      |      | $ | (11,023 | )     
|                                      | Adjustments to reconcile net loss to net cash
used in operating activities: |                                              |   |                  |        |      |   |         |       
|                                      |                                                                             | Depreciation and amortization                |   |                  | 1,022  |      |   |         | 742    |  
|                                      |                                                                             | Gain on sale of investment                   |   |                  | (1,570 | )    |   |         | (122   | )
|                                      |                                                                             | Gain on sale of Ridaura product line         |   |                  |       |      |   |         | (8,055 | )
|                                      |                                                                             | Stock compensation expense                   |   |                  | 24     |      |   |         | 1,276  |  
|                                      |                                                                             | Acquired in-process research and development |   |                  |       |      |   |         | 1,080  |  
|                                      |                                                                             | Loss on foreign exchange forward contract    |   |                  |       |      |   |         | 555    |  
|                                      | Changes in assets and liabilities, excluding effects of acquisition         |                                              |   |                  |        |      |   |         |       
|                                      |                                                                             | Accounts receivable                          |   |                  | 1,268  |      |   |         | 348    |  
|                                      |                                                                             | Other assets                                 |   |                  | (778   | )    |   |         | (449   | )
|                                      |                                                                             | Accounts payable                             |   |                  | 3,185  |      |   |         | (1,671 | )
|                                      |                                                                             | Accrued and other current liabilities        |   |                  | (1,546 | )    |   |         | 1,882  |  
|                                      |                                                                             | Deferred revenue                             |   |                  | (316   | )    |   |         | 134    |  
|                                      |                                                                             |                                              |   |                  |        |      |   |        
|                                      | Net cash used in operating activities                                       |                                              |   | (7,200           | )      |      |   | (15,303 | )     
|                                      |                                                                             |                                              |   |                  |        |      |   |        
|Cash flows from investing activities: |                                                                             |                                              |   |                  |        |      |   |        
|                                      | Purchases of short-term investments                                         |                                              |   | (19,405          | )      |      |   | (35,815 | )     
|                                      | Sales and maturities of short-term investments                              |                                              |   | 30,415           |        |      |   | 12,521  |       
|                                      | Purchases of property and equipment                                         |                                              |   | (2,531           | )      |      |   | (332    | )     
|                                      | Proceeds from sale of Ridaura product line                                  |                                              |   |                 |        |      |   | 8,979   |       
|                                      | Acquisition of a business, net of cash acquired                             |                                              |   |                 |        |      |   | (16,611 | )     
|                                      |                                                                             |                                              |   |                  |        |      |   |        
|                                      | Net cash provided by (used in) investing activities                         |                                              |   | 8,479            |        |      |   | (31,258 | )     
|                                      |                                                                             |                                              |   |                  |        |      |   |        
|Cash flows from financing activities: |                                                                             |                                              |   |                  |        |      |   |        
|                                      | Restricted cash                                                             |                                              |   | 1,429            |        |      |   | (1,050  | )     
|                                      | Payment of notes payable                                                    |                                              |   | (151             | )      |      |   | (750    | )     
|                                      | Payments on obligations under capital leases                                |                                              |   |                 |        |      |   | (25     | )     
|                                      | Proceeds from issuance of common stock, net of issuance costs               |                                              |   | 2,919            |        |      |   | 918     |       
|                                      |                                                                             |                                              |   |                  |        |      |   |        
|                                      | Net cash provided by (used in) financing activities                         |                                              |   | 4,197            |        |      |   | (907    | )     
|                                      | Effect of foreign currency exchange rates on cash and cash equivalents      |                                              |   | 79               |        |      |   | (1      | )     
|                                      |                                                                             |                                              |   |                  |        |      |   |        
|                                      | Net change in cash and cash equivalents                                     |                                              |   | 5,555            |        |      |   | (47,469 | )     
|                                      | Cash and cash equivalents at beginning of period                            |                                              |   | 3,603            |        |      |   | 58,314  |       
|                                      |                                                                             |                                              |   |                  |        |      |   |        
|                                      | Cash and cash equivalents at end of period                                  |                                              | $ | 9,158            |        |      | $ | 10,845  |       
|                                      |                                                                             |                                              |   |                  |        |      |   |        

See accompanying notes to condensed consolidated financial statements.

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CONNETICS CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2002
(Unaudited)

1. Basis of Presentation and Policies

We have prepared the accompanying unaudited condensed consolidated
financial statements of Connetics Corporation (Connetics) in accordance with
generally accepted accounting principles 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. In our opinion, all adjustments, consisting of normal
recurring adjustments, considered necessary for a fair presentation have been
included. Operating results for the six months ended June 30, 2002 are not
necessarily indicative of the results that may be expected for the year ended
December 31, 2002. Certain prior year balances have been reclassified for
comparative purposes.

These unaudited, condensed, consolidated financial statements and notes
should be read in conjunction with audited financial statements and notes to
those financial statements for the year ended December 31, 2001 included in our
Annual Report on Form 10-K/A as filed with the Securities and Exchange
Commission.

Principles of Consolidation

The accompanying unaudited condensed consolidated financial statements
include the accounts of Connetics and its wholly-owned subsidiary, Soltec
Research Pty Ltd. (Soltec) since April 20, 2001, the day following the
acquisition. All significant intercompany accounts and transactions are
eliminated in consolidation.

Use of Estimates

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.

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 allowances for
estimated returns, rebates, and chargebacks. We are obligated to accept from
customers the return of pharmaceuticals that have reached their expiration
date. To date we have not experienced significant returns of expired product.
Product shipping and handling costs are included in 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

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be reasonably estimated, which is typically one quarter following the related
sale by the licensee.

Royalty expenses directly related to product sales are classified in cost of
product revenues. Royalty expenses related to agreements with Soltec are
eliminated in consolidation.

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 obligation exists, and for which Connetics has no continuing
involvement, on the earlier of when the payments are received or when
collection is assured.

We recognize revenue from non-refundable upfront license fees ratably over
the period in which we have continuing development obligations when, at the
time the agreement is executed, there remains significant risk due to the
incomplete stage of the products development. Revenue associated with
substantial at risk performance milestones, as defined in the respective
agreements, is recognized 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 the amount earned
are classified as deferred revenue until they are earned.

Cash Equivalents and Short-term Investments

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 and that mature within one year from the balance sheet date are
considered to be short-term investments. Short-term investments are classified
as available for sale at the time of purchase and are carried at fair value,
with unrealized gains and losses reported as a separate component of
stockholders equity. The cost of securities sold is based on the specific
identification method.

Cash equivalents and investments 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 investment of our
excess cash relative 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 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

Soltecs functional currency is the Australian dollar. We translate
Soltec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 statement of operations and were immaterial for the six months
ended June 30, 2002 and the year ended December 31, 2001.

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Income
Taxes

We recognized income tax expense of $161,000 for the three month
period ended June 30, 2002 related to a foreign tax provision
recorded by our Australian subsidiary, Soltec. We recognized an
income tax benefit of $63,000 for the six month period ended
June 30, 2002, that reflects a tax benefit of $540,000 reduced
by $477,000 of foreign tax provision recorded by Soltec. According to
the provisions of the Job Creation and Worker Assistance Act of 2002
enacted on March 9, 2002, taxpayers are allowed to carry back
net operation losses generated in 2001 and 2002 to offset alternative
minimum tax paid in the last five years. For the tax year ending
December 31, 2001, the Company incurred a net operating loss of
approximately $25 million of which a portion of the net
operating loss may be carried back to offset approximately $540,000
of alternative minimum tax incurred in the tax year ending
December 31, 2000. We recognized income tax expense of $305,000
for the three and six month periods ended June 30, 2001, all
related to foreign tax provisions recorded by Soltec.

Property and Equipment

Property and equipment are stated at cost less accumulated depreciation.
Depreciation is determined using the straight-line method over the estimated
useful lives of the assets, generally three to five years. Leasehold
improvements and assets acquired under capital lease arrangements are amortized
over the shorter of the estimated useful lives of the assets or the lease term.

Impairment of Long Lived Assets

We periodically perform reviews to determine if the carrying value of
long-term assets (goodwill, purchased intangibles, property and equipment) is
impaired. The reviews look for existence of facts and circumstances, either
internal or external, which indicate that the carrying value of the asset
cannot be recovered. No such impairment has been indicated to date. If in the
future management determines the existence of impairment indicators, we would
use undiscounted cash flows to initially determine whether impairment should be
recognized. If necessary, we would perform subsequent calculations to measure
the amount of the 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, the fair value would be calculated using the present
value of estimated expected future cash flows or other appropriate valuation
methodologies. The cash flow calculation would be based on managements best
estimates using appropriate assumptions and projections at the time. Please
see discussion below under recent accounting pronouncements regarding SFAS 144
implementation.

Recent Accounting Pronouncements

SFAS 142.In July 2001 the Financial Accounting Standards Board (FASB)
issued Statement of Financial Accounting Standards No. 142, Goodwill and Other
Intangible Assets (SFAS 142). Under SFAS 142, effective January 1, 2002, we
are no longer 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 will continue
to be amortized over their useful lives. We adopted SFAS 142 effective January
1, 2002 and reclassified amounts to goodwill that were previously allocated to
assembled workforce. Upon adoption we ceased the amortization of goodwill
previously representing expense of approximately $700,000 per year. In
conjunction with the implementation of SFAS 142 we performed an impairment test
of goodwill as of January 1, 2002, which did not result in an impairment charge
at transition. We continue to monitor the carrying value of goodwill and
intangible assets through the annual impairment tests. See also Note 4
Goodwill and Other Intangible Assets.

SFAS 144. In October 2001, the FASB issued Statement of Financial
Accounting Standards No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets (SFAS 144), which establishes a single accounting model
for the impairment or disposal of long-lived assets, including discontinued
operations. SFAS 144 supercedes SFAS 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of. SFAS 144
requires that long-lived assets to be disposed of by sale be measured at the
lower of carrying amount or fair value less cost to sell, whether reported in
continuing operations or in discontinued operations. SFAS 144 excludes from
the definition of long-lived assets goodwill and other intangibles that are not
amortized in accordance with SFAS 142. SFAS 144 also

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expands the reporting of discontinued operations to include components of an
entity that have been or will be disposed of rather than limiting such
discontinuance to a segment of a business. SFAS 144 is effective for years
ending after December 15, 2001. We adopted SFAS 144 effective January 1, 2002,
and experienced no impact on our financial position or results of operations,
to date as a result of the adoption of this pronouncement.

2. Net Income (Loss) Per Share

We compute basic net income (loss) per common share by dividing net income
(loss) applicable to common stockholders by the weighted average of common
shares outstanding during the period. We compute diluted net income per share
using the weighted average of common and diluted equivalent stock options and
warrants outstanding during the period. We excluded all stock option and
warrants from the calculation of diluted loss per common share for the six
months ended June 30, 2002 and June 30, 2001 because these securities are
anti-dilutive during this period.

3. Comprehensive Loss

During the three and six month periods ended June 30, 2002, total
comprehensive loss amounted to $7.7 million and $13.8 million, respectively,
compared to a comprehensive loss of $4.0 million and $12.4 million for the
comparable periods in 2001. The components of comprehensive loss for the three
and six month period ended June 30, 2002 and June 30, 2001 are as follows:

|                                                                                                             |  |                    |        |                  |  |      |        |      |  |   |         |   |  |   |         |  
|------------------------------------------------------------------------------------------------------------ |  | ------------------ | ------ | ---------------- |  | ---- | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                                             |  | Three months ended |        | Six months ended
|                                                                                                             |  | June 30,           |        | June 30,        
|                                                                                                             |  |                    |        |                 
|(In thousands)                                                                                               |  | 2002               |        | 2001             |  | 2002 |        | 2001
|                                                                                                             |  |                    |        |                  |  |      |        |     
|Net loss                                                                                                     |  | $                  | (5,321 | )                |  | $    | (6,135 | )    |  | $ | (8,489  | ) |  | $ | (11,023 | )
|Foreign currency translation adjustment                                                                      |  |                    | 54     |                  |  |      | (1     | )    |  |   | 79      |   |  |   | (1      | )
|Change in unrealized gain (loss) on
securities, net of reclassification
adjustments for realized gain (loss) |  |                    | (2,441 | )                |  |      | 2,156  |      |  |   | (5,340  | ) |  |   | (1,412  | )
|Comprehensive loss                                                                                           |  |                    |        |                  |  |      |        |      |  |   |         |   |  |   |         |  
|Comprehensive loss                                                                                           |  | $                  | (7,708 | )                |  | $    | (3,980 | )    |  | $ | (13,750 | ) |  | $ | (12,436 | )
|Comprehensive loss                                                                                           |  |                    |        |                  |  |      |        |      |  |   |         |   |  |   |         |  

4. Goodwill and Other Intangible Assets

In April 2001, we acquired Soltec and accounted for the acquisition using
the purchase method of accounting. Accordingly, the purchase price was
allocated to the assets acquired and liabilities assumed based on their
estimated fair values on the acquisition date. We purchased all of the shares
of Soltecs capital stock for cash of $16.9 million plus transaction costs of
approximately $250,000. The purchase price was allocated to: existing
technology of $6.8 million, goodwill of $6.6 million, tangible net assets
assumed of $1.3 million, patents and core technology of $1.2 million, acquired
in-process research and development of $1.1 million, and assembled workforce of
$150,000.

Upon the adoption of SFAS 142 effective January 1, 2002 we reclassified
amounts to goodwill that were previously allocated to assembled workforce.
Upon adoption we ceased the amortization of goodwill previously representing
expense of approximately $700,000 per year.

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Other intangible assets that meet the criteria for separate recognition from
goodwill, will continue to be amortized over their useful lives. We completed
a transitional goodwill impairment test as of January 1, 2002 in the second
quarter of fiscal 2002, which did not result in an impairment charge. SFAS 142
also requires that goodwill be tested for impairment on an annual basis or more
frequently if indicators of potential impairment exist.

Changes in the carrying amount of goodwill for the six month period ended June
30, 2002, is as follows (in thousands):

|                                                                             |  |   |       | 
|---------------------------------------------------------------------------- |  | - | ----- | 
|Balance as of December 31,2001                                               |  | $ | 6,132 | 
|Reclassification of net intangible asset  assembled workforce into goodwill |  |   | 139   | 
|                                                                             |  |   |       | 
|Balance as of June 30, 2002                                                  |  | $ | 6,271 | 
|                                                                             |  |   |       | 

The components of our other intangible assets at June 30, 2002, are as follows
(in thousands):

|                    |  |                |       |              |  |     |        |   |  |   |       | 
|------------------- |  | -------------- | ----- | ------------ |  | --- | ------ | - |  | - | ----- | 
|                    |  | Gross Carrying |       | Accumulated  |  |     |        |  
|                    |  | Amount         |       | Amortization |  | Net
|                    |  |                |       |              |  |    
|Existing technology |  | $              | 6,810 |              |  | $   | (823   | ) |  | $ | 5,987 | 
|Patents             |  |                | 1,307 |              |  |     | (216   | ) |  |   | 1,091 | 
|                    |  |                |       |              |  |     |        |   |  |   |       | 
|Total               |  | $              | 8,117 |              |  | $   | (1,039 | ) |  | $ | 7,078 | 
|                    |  |                |       |              |  |     |        |   |  |   |       | 

Amortization expense for our other intangible assets for the three and six
months ended June 30, 2002 was $205,000 and $407,000, respectively. The
second quarter of 2001 was the first quarter during 2001 that we recognized
amortization expense. As such, we reported $400,000 in amortization expense
for that quarter and for the six month period ended June 30, 2001.

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

|                                             |  |                      |       | 
|-------------------------------------------- |  | -------------------- | ----- | 
|                                             |  | Amortization Expense
|                                             |  |                     
|For the six month period ended June 30, 2002 |  | $                    | 407   | 
|Remaining six months in 2002                 |  |                      | 403   | 
|                                             |  |                      |       | 
|Total for the year ended December, 31, 2002  |  | $                    | 810   | 
|                                            
|For the year ended December 31, 2003         |  | $                    | 805   | 
|For the year ended December 31, 2004         |  | $                    | 805   | 
|For the year ended December 31, 2005         |  | $                    | 805   | 
|For the year ended December 31, 2006         |  | $                    | 805   | 
|For the year ended December, 31 2007         |  | $                    | 805   | 
|Thereafter                                   |  | $                    | 2,650 | 

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SFAS 142 does not permit restatement of previously issued financial
statements. The following table sets forth pro forma operating results and per
share information for Connetics for the three and six month periods ended June
30, 2001, as adjusted to
exclude goodwill amortization expense.

|                                                                 |                                 |   |               |      |               |   |         |      | 
|---------------------------------------------------------------- | ------------------------------- | - | ------------- | ---- | ------------- | - | ------- | ---- | 
|                                                                 |                                 |   | Three Months  |      | Six Months   
|                                                                 |                                 |   | Ended         |      | Ended        
|                                                                 |                                 |   | June 30, 2001 |      | June 30, 2001
|                                                                 |                                 |   |               |      |              
|Reported net loss                                                |                                 | $ | (6,135        | )    |               | $ | (11,023 | )   
|                                                                 | Add back: goodwill amortization |   |               | 141  |               |   |         | 141  | 
|                                                                 |                                 |   |               |      |               |   |         |     
|Net loss excluding goodwill amortization                         |                                 |   | (5,994        | )    |               |   | (10,882 | )   
|                                                                 |                                 |   |               |      |               |   |         |     
|Reported basic and diluted loss per share                        |                                 | $ | (0.21         | )    |               | $ | (0.37   | )   
|                                                                 | Add back: goodwill amortization |   |               | 0.01 |               |   |         | 0.01 | 
|                                                                 |                                 |   |               |      |               |   |         |     
|Basic and diluted loss per share excluding
goodwill amortization |                                 | $ | (0.20         | )    |               | $ | (0.36   | )   
|                                                                 |                                 |   |               |      |               |   |         |     
|Shares used to calculate loss per share                          |                                 |   | 29,777        |      |               |   | 29,741  |     

5. Licensing Agreement with Pharmacia

At the end of December 2001, we entered into an agreement granting
Pharmacia Corporation exclusive global rights, excluding Japan, to our
proprietary foam drug-delivery technology for use with Pharmacias Rogaine hair
loss treatment. Under the agreement, Pharmacia paid an initial licensing fee.
They will also make milestone payments as well as royalty payments on product
sales. Pharmacia will be responsible for product development activities and
costs, and we have agreed to provide certain pre-clinical development support.
We recognized $375,000 and $500,000 of contract revenue related to this
agreement in the three and six month periods ended June 30, 2002, respectively.

6. License for Liquipatch

In March 2002, Soltec expanded its exclusive global license to Novartis
Consumer Health S.A. to cover Liquipatch drug-delivery system for use in
topical antifungal applications. Novartis exercised its right to expand the
license agreement, and will continue to be responsible for all product
development costs, and pay Soltec license fees, milestone payments and
royalties on future product sales. We recognized contract revenue related to
this agreement of $580,000 in the quarter ended March 31, 2002 and $0 in the
quarter ended June 30, 2002.

7. DPT Laboratories, Ltd.

In March 2002, we entered into an agreement with DPT Laboratories, Ltd. to
construct an aerosol filling line at DPTs plant on their premises in Texas.
The agreement is retroactive to November 1, 2001, to cover certain
pre-construction payments we made in December 2001. We are responsible for the
cost of the construction and the related equipment, which is currently expected
to be approximately $2.6 million. After the aerosol line is completed,
Connetics will

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pay DPT rent for the facility in the amount of $56,000 per year, which under
current agreements would constitute the next 10 years. DPT and Connetics
simultaneously entered into a manufacturing agreement for DPT to manufacture
and fill Connetics commercial aerosol products. We are also party to a
separate research and development agreement for the manufacture of clinical
supplies for our aerosol products and product candidates.

8. Yamanouchi Europe B.V.

In May 2002, we entered into an agreement with Yamanouchi Europe B.V. to
license Velac® gel (a first in class combination of 1% clindamycin, and 0.025%
tretinoin). We have licensed exclusive rights to develop and commercialize the
product in the U.S. and Canada, and have licensed non-exclusive rights in
Mexico. Under the terms of the agreement, we paid Yamanouchi an initial $2
million licensing fee that we recognized as in-process research and development
expense during the quarter ended June 30, 2002, because the product remains in
clinical development and has no alternative future use.

9. Pro Forma Results of Operations as per SFAS 142

Effective January 1, 2002, we adopted SFAS 142, Goodwill and Other
Intangible Assets, and ceased goodwill amortization as of that date. We
completed the required transitional goodwill impairment analysis as of January
1, 2002, which did not result in an impairment charge. SFAS 142 does not
permit restatement of previously issued financial statements. The following
table sets forth pro forma operating results and per share information for
Connetics for the preceding three years ended December 31, as adjusted to
exclude goodwill amortization expense.

|                                                                  |                                |         |         |                          |        |      |        |      |        |   |         |   |        | 
|----------------------------------------------------------------- | ------------------------------ | ------- | ------- | ------------------------ | ------ | ---- | ------ | ---- | ------ | - | ------- | - | ------ | 
|                                                                  |                                |         |         | Years Ended December 31,
|                                                                  |                                |         |         |                         
|                                                                  |                                |         |         | 2001                     |        | 2000 |        | 1999
|                                                                  |                                |         |         |                          |        |      |        |     
|Reported net income (loss)                                        |                                | $       | (16,742 | )                        |        | $    | 26,996 |      |        | $ | (27,283 | )
|                                                                  | Add back goodwill amortization |         |         | 478                      |        |      |        |     |        |   |         |  |       
|                                                                  |                                |         |         |                          |        |      |        |      |        |   |         |  
|Net income (loss) excluding goodwill amortization                 |                                | $       | (16,264 | )                        |        | $    | 26,996 |      |        | $ | (27,283 | )
|                                                                  |                                |         |         |                          |        |      |        |      |        |   |         |  
|Reported basic earnings (loss) per share                          |                                | $       | (0.56   | )                        |        | $    | 0.95   |      |        | $ | (1.21   | )
|                                                                  | Add back goodwill amortization |         |         | 0.02                     |        |      |        |     |        |   |         |  |       
|                                                                  |                                |         |         |                          |        |      |        |      |        |   |         |  
|Basic earnings (loss) per share excluding
goodwill amortization   |                                | $       | (0.54   | )                        |        | $    | 0.95   |      |        | $ | (1.21   | )
|                                                                  |                                |         |         |                          |        |      |        |      |        |   |         |  
|Reported diluted earnings (loss) per share                        |                                | $       | (0.56   | )                        |        | $    | 0.90   |      |        | $ | (1.21   | )
|                                                                  | Add back goodwill amortization |         |         | 0.02                     |        |      |        |     |        |   |         |  |       
|                                                                  |                                |         |         |                          |        |      |        |      |        |   |         |  
|Diluted earnings (loss) per share excluding
goodwill amortization |                                | $       | (0.54   | )                        |        | $    | 0.90   |      |        | $ | (1.21   | )
|                                                                  |                                |         |         |                          |        |      |        |      |        |   |         |  
|Weighted average shares outstanding:                              |                                |         |         |                          |        |      |        |      |        |   |         |  
|                                                                  |                                | Basic   |         |                          | 29,861 |      |        |      | 28,447 |   |         |   | 22,619 | 
|                                                                  |                                | Diluted |         |                          | 29,861 |      |        |      | 30,086 |   |         |   | 22,619 | 

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Item 2. Managements Discussion and Analysis of Financial Condition
and Results of Operations

This MD&A should be read in conjunction with the MD&A included in our
Annual Report on Form 10-K for the year ended December 31, 2001, and with the
unaudited condensed consolidated financial statements and notes to financial
statements included in this report. Our disclosure and analysis in this
Report, in other reports that we file with the Securities and Exchange
Commission, in our press releases and in public statements of our officers
contain forward-looking statements within the meaning of Section 27A of the
Securities Act, and Section 21E of the Securities Exchange Act.
Forward-looking statements give our current expectations or forecasts of future
events. You can identify these statements by the fact that they do not relate
strictly to historical or current events. They use words such as anticipate,
estimate, expect, will, may, intend, plan, believe and similar
expressions in connection with discussion of future operating or financial
performance. These include statements relating to future actions, prospective
products or product approvals, future performance or results of current and
anticipated products, sales efforts, expenses, the outcome of contingencies
such as legal proceedings, and financial results. Forward-looking statements
may turn out to be wrong. They can be affected by inaccurate assumptions or by
known or unknown risks and uncertainties. Many factors mentioned in this
Report  for example, governmental regulation and competition in our industry 
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 on Form 10-K. Our historical
operating results are not necessarily indicative of the results to be expected
in any future period.

OVERVIEW

Our 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, Luxíq® and OLUX®. Both products have
clinically proven therapeutic advantages and we are providing quality customer
service to physicians through our experienced sales and marketing staff. In
December 2001, we filed a supplemental New Drug Application, or sNDA, with the
FDA, requesting clearance to market OLUX for expanded usage. The application
is currently under review with the FDA.

In April 2001, we completed the acquisition of Soltec for approximately
$16.9 million. We accounted for this transaction using the purchase method and
allocated $1.1 million of the purchase price to in-process research and
development, based on an independent valuation, and the balance to the tangible
assets of Soltec, existing technology and goodwill. As we are now focusing on
our dermatology business, in April 2001 we sold our rights to Ridaura,
including inventory, to Prometheus for $9.0 million in cash plus a royalty on
annual sales in excess of $4.0 million for the next five years.

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In addition to our commercial business, we own the rights to a recombinant
form of a natural hormone called relaxin. On May 23, 2001, we announced our
decision to reduce our investment in the development of relaxin and to search
for licensing opportunities or other strategic alternatives for the product.
We eliminated 27 employee positions related to relaxin. In the second quarter
of 2001, we recorded a $6.0 million charge, which represented
$0.5 million accrued
in connection with the reduction in workforce as well as $5.5 million for our
estimate of our potential exposure for the wind down of relaxin development
contracts. In December 2001, we reached an amicable settlement related to our
relaxin manufacturing agreement with Boehringer Ingelheim. As a result of this
settlement, in the fourth quarter of 2001, we reversed $4.9 million of the
amount we originally accrued in the second quarter of 2001. The net amount
recognized as a one-time charge for relaxin and related liabilities in the year
ended December 31, 2001 was $1.1 million. In June 2002, we recorded an
additional $312,000 expense representing the final payment due for satisfaction
of the final deliverables under the Boehringer Ingelheim settlement.

During the second quarter of 2002, Connetics announced the initiation of
two Phase III clinical trials. The first trial is for Actiza , a formulation
of 1% clindamycin in the Companys proprietary foam delivery system, for the
treatment of acne. The clinical program for Actiza  will consist of two Phase
III trials in which patients will be treated for 12 weeks in a double-blinded
placebo and active controlled format. Subject to successful outcome of these
trials, Connetics intends to submit a new Drug Application to the FDA in late
2003. The second trial is for Extina , a formulation of 2% ketoconazole in
the Companys proprietary foam delivery system, for the treatment of seborrheic
dermatitis. The four week, double-blinded, placebo and active controlled trial
is designed to include 600 patients at 28 centers. Subject to a successful
outcome of this trial, Connetics intends to submit a New Drug Application to
the FDA in 2003.

RESULTS OF OPERATIONS

Revenues

|                                             |                                |                |                |        |                    |        |                  |       |       |       |       |        |        |        |       |        |       |        | 
|-------------------------------------------- | ------------------------------ | -------------- | -------------- | ------ | ------------------ | ------ | ---------------- | ----- | ----- | ----- | ----- | ------ | ------ | ------ | ----- | ------ | ----- | ------ | 
|                                             |                                |                |                |        | Three Months Ended |        | Six months Ended
|                                             |                                |                |                |        | June 30,           |        | June 30,        
|                                             |                                |                |                |        |                    |        |                 
|Revenues (In thousands)                      |                                | 2002           |                | 2001   |                    | 2002   |                  | 2001 
|                                             |                                |                |                |        |                    |        |                  |      
|                                             | Product:                       |                |                |        |                    |        |                  |       |       |       |       |        |        |        |       |        |      
|                                             |                                | Luxíq®         |                |        | 3,653              |        |                  |       | 3,399 |       |       |        | 6,975  |        |       |        | 7,294 |       
|                                             |                                | OLUX®          |                |        | 7,728              |        |                  |       | 3,184 |       |       |        | 14,526 |        |       |        | 4,923 |       
|                                             |                                | Other          |                |        | 42                 |        |                  |       |      |       |       |        | 62     |        |       |        |      |       
|                                             |                                | Ridaura®       |                |        |                   |        |                  |       | (6    | )     |       |        |       |        |       |        | 2,015 |       
|                                             |                                |                |                |        |                    |        |                  |       |       |       |       |        |        |        |       |       
|                                             | Total product revenues         |                |                | 11,423 |                    |        |                  | 6,577 |       |       |       | 21,563 |        |        |       | 14,232 |      
|                                             | License, contract and royalty: |                |                |        |                    |        |                  |       |       |       |       |        |        |        |       |        |      
|                                             |                                | Royalty        |                |        | 766                |        |                  |       | 123   |       |       |        | 1,416  |        |       |        | 123   |       
|                                             |                                | Pharmacia      |                |        | 375                |        |                  |       |      |       |       |        | 500    |        |       |        |      |       
|                                             |                                | Novartis       |                |        |                   |        |                  |       |      |       |       |        | 580    |        |       |        |      |       
|                                             |                                | Celltech       |                |        |                   |        |                  |       | 756   |       |       |        |       |        |       |        | 756   |       
|                                             |                                | Other contract |                |        | 62                 |        |                  |       | 107   |       |       |        | 98     |        |       |        | 140   |       
|                                             |                                | Intermune      |                |        |                   |        |                  |       |      |       |       |        |       |        |       |        | 771   |       
|                                             |                                |                |                |        |                    |        |                  |       |       |       |       |        |        |        |       |       
|Total license, contract and royalty revenues |                                |                | 1,203          |        |                    |        | 986              |       |       |       | 2,594 |        |        |        | 1,790 |       
|                                             |                                |                |                |        |                    |        |                  |       |       |       |       |        |        |        |       |       
|                                             |                                |                | Total revenues |        |                    | 12,626 |                  |       |       | 7,563 |       |        |        | 24,157 |       |        |       | 16,022 | 
|                                             |                                |                |                |        |                    |        |                  |       |       |       |       |        |        |        |       |       

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Our product revenues for the three and six months ended June 30, 2002,
were $11.4 million and $21.6 million, respectively, compared to $6.6 million
and $14.2 million for the three and six months ended June 30, 2001. The
increase in total product revenues for the three and six months ended June 30,
2002 was due to continued sales growth in the number of units of OLUX sold,
which we began marketing in November 2000. We also recognized product revenue
on sales of Ridaura until the April 2001 sale of that product line to
Prometheus Laboratories, Inc.

Contract and royalty revenues for the three and six month periods ended
June 30, 2002 were $1.2 million and $2.6 million, respectively, compared to
$986,000 and $1.8 million for the three and six months ended June 30, 2001.
The increase in year to date contract and royalty revenue is attributable to
income received under Soltec contract and royalty agreements, following the
acquisition of Soltec in April 2001. We expect contract revenues to fluctuate
significantly depending on achieving milestones under existing agreements, and
on new business opportunities.

Effective April 1, 2000 we assigned to InterMune, Inc. (formerly InterMune
Pharmaceuticals, Inc.) our remaining rights and obligations under a license with
Genentech for Actimmune and the corresponding supply agreement. In exchange,
InterMune paid us approximately $5.2 million, which included the prepayment of
a $1.0 million obligation owed in 2002. An additional $942,000 was payable at
the end of March 2001, and was offset by related product rebates and
chargebacks of $171,000.

Cost of Product Revenues

Our cost of product revenues includes the costs of manufacturing Luxíq and
OLUX and (until April 2001) Ridaura, royalty payments based on a percentage of
our product revenues and product freight and distribution costs from CORD
Logistics, Inc., the third party that handles all of our product distribution
activities. Miza Pharmaceuticals (formerly CCL Pharmaceuticals) manufactures
Luxiq and OLUX for us in England, under a manufacturing and supply agreement
that expires in September 2004. We are in the process of qualifying two
additional vendors to manufacture these products for us in the United States.
We recorded costs of product revenues of $973,000 and $1.6 million,
respectively for the three and six months ended June 30, 2002, compared to
$603,000 and $ 1.7 million for the three and six months ended June 30, 2001.
The change in cost of product revenues is primarily due to the change in
product mix arising from the discontinued sales of Ridaura effective April 1,
2001 and to the continued growth of our OLUX and Luxiq product lines.

Research and Development

Research and development expenses include salaries and benefits,
laboratory supplies, external research programs, clinical studies and allocated
overhead costs such as rent, supplies and utilities. In addition to clinical
site payments, clinical costs include costs of manufacturing clinical supplies
and costs associated with product stability studies. Research and development
expenses were $5.6 million and $10.7 million for the three month and six month
periods ended June 30, 2002, compared to $5.6 and $10.0 million for the
comparable periods in 2001.

We expect research and development expenses for our internally funded
activities to remain at the same level or increase for the next few quarters,
as we continue to develop our

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current products for new indications, as well as continue to engage in new product discovery
and development activities, including the clinical trial activity stated above.
We are unable to predict the total level of spending on any particular
development program because of the uncertainty of clinical study programs and
the timing of FDA approval.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $10.7 million and $20.3
million for the three and six months ended June 30, 2002, compared to $9.7
million and $17.3 million for the three and six month periods June 30, 2001.
The increase in expenses was due to increased headcount and increased market
research and sales promotions costs related to the launch of OLUX and Luxiq 50
gram units, OLUX and Luxiq physician samples, as well as the amortization of
intangible assets associated with the acquisition of Soltec, over their
estimated useful lives.

We expect selling, general and administrative expenses to remain
consistent or be slightly higher in 2002 due to the commencement of marketing
efforts relating to the anticipated outcome of clinical trials for antifungal
foam and anti-acne foam.

Acquired In-Process Research and Development

In May 2002, we entered into an agreement with Yamanouchi Europe B.V. to
license Velac® gel (a first in class combination of 1% clindamycin, and 0.025%
tretinoin). We have licensed exclusive rights to develop and commercialize the
product in the U.S. and Canada, and have licensed non-exclusive rights in
Mexico. Under the terms of the agreement, we paid Yamanouchi an initial $2.0
million licensing fee, which we recorded as an in-process research and
development expense during the quarter ended June 30, 2002, because the product
remains in clinical development and has no alternative future use.

In connection with the Soltec acquisition we recorded a charge of $1.1
million for acquired in-process research and development associated with the
acquisition of Soltec, during the three month period ended June 30, 2001.
Acquired in-process research and development consisted of several projects,
which involved the use of novel technologies to improve the delivery of drugs.
The projects were and still are in various stages of development and are
subject to substantial risks, and did not have alternative future uses. The
value of the in-process research and development was determined by an
independent valuation expert using a discounted cash flow analysis with a rate
of 20%. In addition, the stage of completion of each project was considered in
determining the value.

Sale of Ridaura

In April 2001, we sold our rights to Ridaura® including inventory and
identified liabilities to Prometheus Laboratories Inc. for $9.0 million in cash
plus a royalty on annual sales in excess of $4.0 million for the next five
years. Ridaura® is a prescription pharmaceutical product for the treatment of
rheumatoid arthritis. We accrued approximately $900,000 for transaction
related costs and contractual liabilities incurred as of the date of the sale.
After recognizing the above amounts, we recorded a gain on $8.1 million on this
transaction.

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Gain on sale of investments

Gain on the sale of investments was $1.6 million for the three and six
month periods ended June 30, 2002, compared to $0 and $122,000 for comparable
periods in 2001. The gains are the result of sales of shares of InterMune,
Inc. stock held by the Company.

Interest and other income (expense)

Interest and other income were $366,000 and $796,000 for the three month
and six month periods ended June 30, 2002, compared with $690,000 and $1.7
million for the comparable periods in 2001. The decrease in interest income
during the three month period ended June 30, 2002 was due to lower interest
rates during this period compared to the same period in 2001, as well as lower
cash and investment balances. Other income also includes amounts received
under sublease agreements that were entered into in the third quarter of 2001
and the second quarter of 2002.

Interest and other expense was $60,000 and $135,000 for the three and six
month periods ended June 30, 2002, compared with zero and $7,000 for the same
periods in 2001. The increase in interest and other expense for three months
ended June 30, 2002 compared to the same period in 2001 was primarily the
result of the financing of business and D&O insurance which in prior years was
paid for in cash instead of financed. Other expense also includes amounts paid
on leased properties that are now subleased to third parties.

Gain (loss) on foreign exchange forward contract

In February 2001, Connetics entered into a foreign exchange forward
contract in connection with the Soltec acquisition. During the first quarter
of 2001 we recorded a loss on this contract of $1.4 million. This loss was
partially offset in the second quarter of 2001 when a gain of $840,000 was
recorded on this same contract. The contract was terminated at the closing
date of the Soltec acquisition in the second quarter of 2001.

Income Taxes

We recognized income tax expense of $161,000 for the three month period
ended June 30, 2002 related to a foreign tax provision recorded by our
Australian subsidiary, Soltec. We recognized an income tax benefit of $63,000
for the six month period ended June 30, 2002, that reflects a tax benefit of
$540,000 reduced by $477,000 of foreign tax provision recorded by Soltec.
According to the provisions of the Job Creation and Worker Assistance Act of
2002 enacted on March 9, 2002, taxpayers are allowed to carry back net
operation losses generated in 2001 and 2002 to offset alternative minimum tax
paid in the last fiver years. For the tax year ending December 31, 2001, the
Company incurred a net operating loss of approximately $25 million of which a
portion of the net operating loss may be carried back to offset approximately
$540,000 of alternative minimum tax incurred in the tax year ending December
31, 2000. We recognized income tax expense of $305,000 for the three and six
month periods ended June 30, 2001, all related to foreign tax provisions
recorded by Soltec.

Net Loss

We expect to incur losses for the remainder of 2002 and the foreseeable
future. These losses are expected to fluctuate from period to period based on
timing of product revenues, sales

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and marketing expenses, clinical material purchases, clinical trial
expenses, and possible acquisitions of new products and technologies.

LIQUIDITY AND CAPITAL RESOURCES

Sources and Use of Cash.We have financed our operations to date
primarily through proceeds from equity financings, sale of investments,
collaborative arrangements with corporate partners, bank loans, gross margins
and product revenues. At June 30, 2002, cash, cash equivalents and short-term
investments totaled $37.1 million compared to $46.3 million at December 31,
2001. Our cash balances are held in a variety of interest-bearing instruments
including high-grade corporate bonds, commercial paper and money market
accounts.

Cash flows from operating activities.Cash used in operations for the six
month period ended June 30, 2002 and June 30, 2001 was $ 7.2 million and $ 15.3
million, respectively. Net loss of $8.5 million for the first six months of
2002 was affected by a non-cash charge of $1.0 million for depreciation and
amortization and a $1.6 million gain on the sale of investments.

Cash flows from investing activities.Investing activities provided $8.5
million in cash during the six month period ended June 30, 2002, due primarily
to the sale of $30.4 million of short-term investments offset by $19.4 million
of short term investment purchases. In addition, we invested approximately $2.5 million in
construction and equipment costs related to the aerosol filling line
at DPT and to the addition of lab space at Soltec.

Cash flows from financing activities.Financing activities provided $4.2
million for the six months ended June 30, 2002, including $1.4 million
representing the release of previously restricted certificates of deposit from
our controlled disbursements account, security for building rent, and
collateral on certain officers personal bank loans. We also received $2.9
million in proceeds from the issuance of common stock, net of costs, during the
six month period ended June 30, 2002.

Working Capital.Working capital decreased by $12.4 million to $31.6
million at June 30, 2002 from $44.0 million at December 31, 2001. Our working
capital primarily decreased as we used cash in operations and in the
construction of the aerosol filling line at DPT.

Contractual Obligations and Commercial Commitments.There have been no
material changes in the reported contractual obligations and commercial
commitments since December 31, 2001. As of June 30, 2002, we had no
off-balance sheet financing arrangements or commitments other than those
disclosed in the Annual Report on Form 10-K/A for the year ended December 31,
2001, consisting primarily of operating lease agreements for our facilities as
well as some purchase commitments under our contract manufacturing agreements.

Restricted Cash and Cash Equivalents.In the six month period ended, $1.4
million was released from previously restricted certificates of deposit from
our controlled disbursements account, security for building rent, and
collateral on certain officers personal bank loans. As of June 30, 2002,
$710,000 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,

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including the progress of our research and development programs, the
progress of clinical testing, the time and costs involved in building and
qualifying a new aerosol filling facility, 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. Therefore such capital uses and
requirements may increase in future periods. As a result, we may require
additional funds prior to reaching profitability and may attempt to raise
additional funds through equity or debt financings, collaborative arrangements
with corporate partners or from other sources. We are currently evaluating a
number of 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 issuing stock in connection with the transaction.

We currently have no commitments for any additional financings. If we
need to raise additional money to fund our operations, funding may not be
available to us on acceptable terms, or at all. If we are unable to raise
additional funds when needed, we may not be able to market our products as
planned or continue development of our other products, or we could be required
to delay, scale back or eliminate some or all of our research and development
programs.

FACTORS THAT MAY AFFECT FUTURE RESULTS, FINANCIAL CONDITION AND THE MARKET
PRICE OF SECURITIES

Please also read Item 1 in our 2001 Annual Report on Form 10-K/A where we have
described our business and the challenges and risks we may face in the future.

There are many factors that affect our business and results of operations,
some of which are beyond our control. In our Annual Report on Form 10-K/A 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, 2001, 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 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 amount we spend to promote our products,     

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| |  |  | 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, and                                                                                                  
|
| |  |  | our responses to price competition.                                                                                                                           




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 since December 31, 2001.




PART II. OTHER INFORMATION




Item 4. Submission of Matters to a Vote of Security Holders

On May 16, 2002, we held our annual meeting of stockholders. At the
meeting, the stockholders approved the following matters by the following
votes:



| | 1) |  | Election of the following directors:
| | -- |  | ------------------------------------

|                        |  |     |            |          |  |  |           | 
|----------------------- |  | --- | ---------- | -------- |  |  | --------- | 
|                        |  | FOR |            | WITHHELD
|                        |  |     |            |         
|Alexander E. Barkas, MD |  |     | 26,686,430 |          |  |  | 665,968   | 
|Eugene Bauer, MD        |  |     | 26,687,030 |          |  |  | 665,368   | 
|John C. Kane            |  |     | 26,721,430 |          |  |  | 630,968   | 
|Thomas D. Kiley         |  |     | 26,721,630 |          |  |  | 630,768   | 
|Glenn A. Oclassen       |  |     | 26,686,730 |          |  |  | 665,668   | 
|Leon E. Panetta         |  |     | 26,684,117 |          |  |  | 668,281   | 
|G. Kirk Raab            |  |     | 26,905,458 |          |  |  | 446,940   | 
|Thomas G. Wiggans       |  |     | 24,027,582 |          |  |  | 3,324,816 | 



| | 2) |  | Ratification of the appointment of Ernst & Young LLP to serve as
the Companys independent auditors for the fiscal year ended December
31, 2002.
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------

| |            |  |         |         |         |  |  |       | 
| | ---------- |  | ------- | ------- | ------- |  |  | ----- | 
| | FOR        |  | AGAINST |         | ABSTAIN
| |            |  |         |         |        
| | 26,755,668 |  |         | 591,155 |         |  |  | 5,574 | 

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Item 6. Exhibits and Reports on Form 8-K



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

|     |  |                                                                                                                                     
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------
|10.1 |  | Sublease agreement dated June 20, 2002, by and between
Connetics (Sublessor), and Tolerion, Inc., a Delaware corporation
(Sublessee)

|      |  |                                                                                                          
|----- |  | ---------------------------------------------------------------------------------------------------------
|10.2* |  | License and development agreement dated May 14, 2002, by and between
Connetics and Yamanouchi Europe B.V.

*     
Certain confidential portions of this exhibit have been omitted and
filed separately with the Securities and Exchange Commission.



|(b) |  | Reports on Form 8-K.
|--- |  | --------------------

| |                                                                                 
| | --------------------------------------------------------------------------------
| | We filed the Current Reports on
Form 8-K during the quarter ended June 30, 2002:

| |     |                                                                                                                                                                                                  
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (i) | We filed a Current Report on Form 8-K dated May 14, 2002,
with the Securities and Exchange Commission on May 24, 2002, under
Item 5. Other Events, and Item 7. Financial Statements and 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 CORPORATION
|
|
| |  | By:                   |  | /s/ JOHN L. HIGGINS                                                                                
| |  |                       |  |                                                                                                    
| |  |                       |  | John L. Higgins
Exec. Vice President, Finance and
Corporate Development and Chief
Financial Officer

Date: August 14, 2002

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INDEX TO EXHIBITS

|               |  |                                                                                                                                     
|-------------- |  | ------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                         
|               |  |                                                                                                                                     
|10.1           |  | Sublease agreement dated June 20, 2002, by and between Connetics
(Sublessor), and Tolerion, Inc., a Delaware corporation (Sublessee)
|              
|10.2*          |  | License and development agreement dated May 14, 2002, by and
between Connetics and Yamanouchi Europe B.V.                           

*     
Certain confidential portions of this exhibit have been omitted and
filed separately with the Securities and Exchange Commission.

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