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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, 2004 Commission file number: 0-27406 CONNETICS CORPORATION (Exact name of registrant as specified in its charter)
 Delaware(State or other jurisdiction of
incorporation or organization)
    
    94-3173928(IRS Employer
Identification Number)3290 West Bayshore Road
Palo Alto, California(Address of principal executive offices)
    
    94303(Zip Code)
 Registrants telephone number, including area code: (650) 843-2800 Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes x No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes x No o As of July 30, 2004, 35,503,541 shares of the Registrants common stock at
$0.001 par value, were outstanding.




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CONNETICS CORPORATION TABLE OF CONTENTS PagePART I FINANCIAL INFORMATIONItem 1.
    
    Financial StatementsCondensed Consolidated Balance Sheets at June 30, 2004 and December 31, 2003
    
    3Condensed Consolidated Statements of Operations for the Three and Six Months ended
    
    4June 30, 2004 and 2003Condensed Consolidated Statements of Cash Flows for the Six Months ended June 30,
    
    52004 and 2003Notes to Condensed Consolidated Financial Statements
    
    6Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    13Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    18Item 4.
    
    Controls and Procedures
    
    18PART II OTHER INFORMATIONItem 2.
    
    Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    20Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    20Item 6.
    
    Exhibits and Reports on Form 8-K
    
    20(a) Exhibits(b) Reports on Form 8-KSignatures
    
    
    
    22Exhibits
    
    
    
    23EXHIBIT 10.1EXHIBIT 10.2EXHIBIT 10.3EXHIBIT 10.4EXHIBIT 10.5EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
 2




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PART I. FINANCIAL INFORMATION 
 Item 1. Financial Statements 
 CONNETICS CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited) June 30,
    
    December 31,2004
    
    2003ASSETSCurrent assets:Cash and cash equivalents
    
    $
    32,938
    
    
    $
    17,946Marketable securities
    
    
    33,054
    
    
    
    96,716Restricted cash  current
    
    
    1,000
    
    
    
    304Accounts receivable, net of allowances
    
    
    2,027
    
    
    
    2,594Inventory
    
    
    4,204
    
    
    
    1,035Prepaid and other current assets
    
    
    7,420
    
    
    
    3,779Total current assets
    
    
    80,643
    
    
    
    122,374Property and equipment, net
    
    
    6,276
    
    
    
    5,628Restricted cash  long term
    
    
    2,000
    
    
    
    Debt issuance costs, deposits and other assets
    
    
    4,581
    
    
    
    5,418Goodwill
    
    
    6,271
    
    
    
    6,271Other intangible assets, net
    
    
    129,187
    
    
    
    6,206Total assets
    
    $
    228,958
    
    
    $
    145,897LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    11,791
    
    
    $
    3,884Assumed liabilities related to acquisition of product rights
    
    
    4,123
    
    
    
    Accrued payroll and related expenses
    
    
    3,539
    
    
    
    3,792Notes payable
    
    
    1,663
    
    
    
    Accrued clinical trial costs
    
    
    150
    
    
    
    857Other accrued liabilities
    
    
    3,454
    
    
    
    1,594Total current liabilities
    
    
    24,720
    
    
    
    10,127Convertible senior notes
    
    
    90,000
    
    
    
    90,000Other non-current liabilities
    
    
    15
    
    
    
    16Commitments and contingenciesStockholders equity:Preferred stock
    
    
    
    
    
    
    Common stock
    
    
    35
    
    
    
    32Additional paid-in capital
    
    
    233,999
    
    
    
    174,080Deferred stock compensation
    
    
    (22
    )
    
    
    (31
    )Accumulated deficit
    
    
    (120,857
    )
    
    
    (130,188
    )Accumulated other comprehensive income
    
    
    1,068
    
    
    
    1,861Total stockholders equity
    
    
    114,223
    
    
    
    45,754Total liabilities and stockholders equity
    
    $
    228,958
    
    
    $
    145,897
 See accompanying notes to condensed consolidated financial statements. 3




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CONNETICS CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited) Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Revenues:Product
    
    $
    37,999
    
    
    $
    15,528
    
    
    $
    61,565
    
    
    $
    29,839Royalty and contract
    
    
    254
    
    
    
    4,442
    
    
    
    1,670
    
    
    
    5,442Total revenues
    
    
    38,253
    
    
    
    19,970
    
    
    
    63,235
    
    
    
    35,281Operating costs and expenses:Cost of product revenues
    
    
    3,578
    
    
    
    1,185
    
    
    
    5,146
    
    
    
    2,257Amortization of intangible assets
    
    
    3,400
    
    
    
    202
    
    
    
    4,672
    
    
    
    403Research and development
    
    
    5,096
    
    
    
    8,619
    
    
    
    9,537
    
    
    
    17,236Selling, general and administrative
    
    
    17,467
    
    
    
    10,590
    
    
    
    32,760
    
    
    
    21,493Total operating costs and expenses
    
    
    29,541
    
    
    
    20,596
    
    
    
    52,115
    
    
    
    41,389Income (loss) from operations
    
    
    8,712
    
    
    
    (626
    )
    
    
    11,120
    
    
    
    (6,108
    )Interest income
    
    
    152
    
    
    
    169
    
    
    
    500
    
    
    
    294Interest expense
    
    
    (690
    )
    
    
    (230
    )
    
    
    (1,381
    )
    
    
    (231
    )Other income (expense), net
    
    
    (70
    )
    
    
    33
    
    
    
    (19
    )
    
    
    87Income (loss) before income taxes
    
    
    8,104
    
    
    
    (654
    )
    
    
    10,220
    
    
    
    (5,958
    )Income tax expense
    
    
    (647
    )
    
    
    (1,202
    )
    
    
    (890
    )
    
    
    (1,279
    )Net income (loss)
    
    $
    7,457
    
    
    $
    (1,856
    )
    
    $
    9,330
    
    
    $
    (7,237
    )Net income (loss) per share:Basic
    
    $
    0.21
    
    
    $
    (0.06
    )
    
    $
    0.27
    
    
    $
    (0.23
    )Diluted
    
    $
    0.19
    
    
    $
    (0.06
    )
    
    $
    0.25
    
    
    $
    (0.23
    )Shares used to calculate net income (loss) per share:Basic
    
    
    35,242
    
    
    
    31,519
    
    
    
    34,439
    
    
    
    31,403Diluted
    
    
    41,627
    
    
    
    31,519
    
    
    
    36,722
    
    
    
    31,403
 See accompanying notes to condensed consolidated financial statements. 4




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CONNETICS CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited) Six Months EndedJune 30,2004
    
    2003Cash flows from operating activities:Net income (loss)
    
    $
    9,330
    
    
    $
    (7,237
    )Adjustments
to reconcile net income (loss) to net cash from operating activities:Depreciation
    
    
    744
    
    
    
    649Amortization of intangible assets
    
    
    4,672
    
    
    
    403Amortization of convertible debt offering costs
    
    
    368
    
    
    
    56Allowance for rebates, returns and chargebacks
    
    
    7,105
    
    
    
    2,150Stock compensation expense
    
    
    9
    
    
    
    9Changes in assets and liabilities:Accounts receivable
    
    
    (6,589
    )
    
    
    1,909Other assets
    
    
    (1,628
    )
    
    
    (2,421
    )Inventory
    
    
    (3,147
    )
    
    
    (19
    )Accounts payable
    
    
    7,944
    
    
    
    (2,997
    )Accrued and other current liabilities
    
    
    920
    
    
    
    (421
    )Net cash from operating activities
    
    
    19,728
    
    
    
    (7,919
    )Cash flows from investing activities:Purchases of marketable securities
    
    
    (22,578
    )
    
    
    (59,974
    )Sales and maturities of marketable securities
    
    
    85,809
    
    
    
    17,903Purchases of property and equipment
    
    
    (1,492
    )
    
    
    (423
    )Acquisition of patent and product rights
    
    
    (123,529
    )
    
    
    (200
    )Net cash from investing activities
    
    
    (61,790
    )
    
    
    (42,694
    )Cash flows from financing activities:Restricted cash
    
    
    (2,696
    )
    
    
    312Proceeds from issuance of common stock, net of issuance costs
    
    
    56,901
    
    
    
    86,503Proceeds from exercise of stock options and employee stock purchase plan, net of
repurchases of unvested shares
    
    
    3,021
    
    
    
    2,638Net cash from financing activities
    
    
    57,226
    
    
    
    89,453Effect of foreign currency exchange rate changes on cash and cash equivalents
    
    
    (172
    )
    
    
    98Net change in cash and cash equivalents
    
    
    14,992
    
    
    
    38,938Cash and cash equivalents at beginning of period
    
    
    17,946
    
    
    
    8,624Cash and cash equivalents at end of period
    
    $
    32,938
    
    
    $
    47,562
 See accompanying notes to condensed consolidated financial statements. 5




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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Note 1. Basis of Presentation and Policies We have prepared the accompanying unaudited condensed consolidated
financial statements of Connetics Corporation (Connetics) in accordance with
accounting principles generally accepted in the United States for interim
financial information and pursuant to the instructions to Form 10-Q and Article
10 of Regulation S-X. Accordingly, the financial statements do not include all
of the information and footnotes required by generally accepted accounting
principles for complete financial statements. We believe that we have included
all adjustments, consisting of normal recurring adjustments, considered
necessary for a fair presentation. We reclassify as necessary certain prior
year balances to conform to the current year presentation. Operating results for the three and six months ended June 30, 2004 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2004. For a better understanding of Connetics and its financial
statements, we recommend reading these unaudited condensed consolidated
financial statements and notes in conjunction with the audited consolidated financial statements and notes to those financial statements for
the year ended December 31, 2003, which are included in our Annual Report on
Form 10-K as filed with the Securities and Exchange Commission. Principles of Consolidation The accompanying condensed consolidated financial statements include the
accounts of Connetics Corporation, Connetics Holdings Pty Ltd., and Connetics
Australia Pty Ltd. (formerly Soltec Research Pty Ltd.). We have eliminated all
intercompany accounts and transactions in consolidation. Use of Estimates To prepare financial statements in conformity with accounting principles
generally accepted in the United States, management must make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates based
upon future events. We evaluate our estimates on an on-going basis. In particular, we
regularly evaluate estimates related to recoverability of accounts receivable
and inventory, revenue reserves, assumed liabilities related to acquired
product rights and accrued liabilities for clinical trial activities. We base
our estimates on historical experience and on various other specific
assumptions that we believe to be reasonable under the circumstances. Those
estimates and assumptions form the basis for making judgments about the
carrying value of assets and liabilities that are not readily apparent from
other sources. Revenue Recognition Product Revenues.We recognize revenue from product sales when there is
persuasive evidence that an arrangement exists, when title has passed, the
price is fixed or determinable, and we are reasonably assured of collecting the
resulting receivable. We recognize product revenues net of estimated
allowances for discounts, returns, rebates, and chargebacks. We are obligated
to accept from customers the return of pharmaceuticals that have reached their
expiration date. We authorize returns for damaged products and exchanges for
expired products in accordance with our return goods policy and procedures, and
we establish reserves for such amounts at the time of sale. To date we have
not experienced significant returns of damaged or expired product. We include
product shipping and handling costs in the cost of product revenues. During the first half of 2004, we made a decision to bring in house the
function of Contract Administration responsibility for the calculation and
related reporting of all allowances and discounts for which Managed care plans
and Medicaid programs are eligible. Previously we utilized third parties to
perform the allowance calculation and related reporting. In connection with this change we
performed a comprehensive review of our calculation for Medicaid product
pricing allowances, which resulted in an adjustment to reserves recorded in
prior periods. As a result, we recorded a one-time reduction of product
revenues in the amount of $564,000 in the second quarter of 2004. We have
determined that the effect of this change in estimate would not have had a material
impact on our financial statements 6




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in any prior quarterly or annual period. Royalty Revenue.We collect royalties from our third-party licensees
based on their sales. We recognize royalties either in the quarter in which we
receive the royalty payment from the licensee or in which we can reasonably
estimate the royalty, which is typically one quarter following the related sale
by the licensee. Contract Revenue.We record contract revenue for research and
development, or R&D, as it is earned based on the performance requirements of
the contract. We recognize non-refundable contract fees for which no further
performance obligations exist, and for which Connetics has no continuing
involvement, on the date we receive the payments or the date when collection is
assured, whichever is earlier. If, at the time an agreement is executed, there remains significant risk
due to the incomplete state of the products development, we recognize revenue
from non-refundable upfront license fees ratably over the period in which we
have continuing development obligations. We recognize revenue associated with
substantial at risk performance milestones, as defined in the respective
agreements, based upon the achievement of the milestones. We recognize revenue
under R&D cost reimbursement contracts as the related costs are incurred. When
we receive advance payments in excess of amounts earned, we classify them as
deferred revenue until they are earned. Cash Equivalents and Marketable Securities Cash and cash equivalents consist of cash on deposit with banks, money
market and other debt instruments with original maturities of 90 days or less
at the date of purchase. Investments with maturities beyond three months at
the date of acquisition are included in marketable securities. Marketable
securities are classified as available for sale at the time of purchase and are
carried at fair value, and we report unrealized gains and losses thereon as a
component of other comprehensive income (loss) in stockholders equity. We
determine the cost of securities sold using the specific
identification method. Cash,
cash equivalents and marketable securities are financial instruments that
potentially subject us to concentration of risk to the extent recorded on the
balance sheet. We believe we have established guidelines for investing our
excess cash 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 Connetics Australias functional currency is the Australian dollar. We
translate Connetics Australias local currency balance sheet into U.S. dollars
using the exchange rates in effect at the balance sheet date. For revenue and
expense accounts, we use a weighted average exchange rate during the period.
We record foreign currency translation adjustments in other comprehensive
income (loss). Net gains and losses resulting from foreign exchange
transactions are included in the condensed consolidated statements of
operations and were immaterial for all periods presented. Income Taxes We account for income taxes using the asset and liability method. Under
this method, we recognize deferred tax assets and liabilities for the future
tax consequences attributable to differences between (1) the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases, and (2) operating loss and tax credit carryforwards. We
measure deferred tax assets and liabilities using enacted tax rates that are
expected to apply to taxable income in the years in which we anticipate those
temporary differences will be recovered or settled. We establish a valuation
allowance for the net deferred tax assets when realization is uncertain.
Historically our income tax provision related primarily to the operations of
our Australian subsidiary. In 2004, however, the income tax provision is
primarily related to the domestic corporation due to our expected
profitability in 2004. 7




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Property and Equipment We state property and equipment at cost less accumulated depreciation. We
calculate depreciation using the straight-line method over the estimated useful
lives of the assets, generally three to five years. We are depreciating
equipment we have purchased on behalf of our contract manufacturer using the
units of production method based on contractual minimum quantities to be
produced over the term of the agreement. We amortize leasehold improvements
over the shorter of the estimated useful lives of the assets or the lease term. Inventory Inventory consists primarily of finished goods. We state inventory at the
lower of cost (determined on a first-in first-out method) and market. Effective January 1, 2004, we began including certain manufacturing
support and quality assurance costs in the cost of finished goods inventory and
samples inventory (included in prepaid and other current assets) on the
accompanying condensed consolidated balance sheets. We do not directly
manufacture any of our products, and prior to January 1, 2004, we classified as
R&D expense all our internal manufacturing support and quality assurance
activities such as overseeing third party manufacturing, process development,
quality assurance and quality control activities. Also, prior to January 1,
2004, inventory and cost of goods sold only captured third party product
manufacturing costs, depreciation based on a units-of-production methodology on
Connetics-owned equipment at our third-party manufacturers, product freight and
distribution costs from the third party that handles all of our product
distribution activities, and royalties. The amounts attributable to
capitalizing these costs in inventory and samples inventory in the three and
six months ended June 30, 2004, are $800,000 and $1.6 million, of net
income (net of tax effect), or approximately $0.02 and $0.04 per diluted share,
respectively. We have determined that the effect of this change in accounting
would not have had a material impact on our financial statements in any prior
quarterly or annual period. For the three months ended June 30, 2004, we allocated $1.1 million of
costs which in previous periods had been included in R&D expense as follows:
(1) we charged $87,000 to cost of goods sold, (2) we charged $168,000 to sales
expense, (3) we added $687,000 to the value of commercial inventory, and (4) we
added $113,000 to the value of samples inventory. For the six months ended June 30, 2004, we allocated $2.1 million of costs
which in previous periods had been included in R&D expense as follows: (1) we
charged $124,000 to cost of goods sold, (2) we charged $371,000 to sales
expense, (3) we added $1.1 million to the value of commercial inventory, and
(4) we added $478,000 to the value of samples inventory. Goodwill, Other Purchased Intangibles and Impairment of Long Lived Assets We record goodwill in a business combination when the purchase price of
the net tangible and intangible assets we acquire exceeds their fair value.
Under Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and
Other Intangible Assets, effective January 1, 2002, we are not required to
amortize goodwill and intangible assets with indefinite lives, but are required
to periodically review these assets for impairment. Intangible assets
determined to have definite lives are amortized over their useful lives,
generally ten years. SFAS 142 requires that we test goodwill for impairment on an annual basis
or more frequently if indicators of potential impairment exist. We performed
the annual test as of October 1, 2003, which did not result in an impairment
charge. We will perform this test on October 1 of each year or more frequently
if indicators of potential impairment exist. We periodically perform reviews to determine if the carrying value of
long-term assets, other than goodwill (purchased intangibles, property and
equipment), are impaired. The reviews look for the existence of facts or
circumstances, either internal or external, which indicate that the carrying
value of the asset cannot be recovered. Our reviews have indicated no such
impairment to date. If in the future we determine that impairment indicators
exist, we would use undiscounted cash flows to initially determine whether we
should recognize any impairment. If necessary, we would perform a subsequent
calculation to measure the amount of impairment loss based on the excess of the
carrying value over the fair value of the impaired assets. If quoted market
prices for the assets are not available, we would calculate the fair value
using the present value of estimated expected future cash flows or other 8




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appropriate valuation methodologies. The cash flow calculation would be based
on managements best estimates, using appropriate assumption and projections at
the time. Stock-Based Compensation We use the intrinsic-value method of accounting for stock-based awards
granted to employees, as allowed under Accounting Principles Board Opinion No.
25, Accounting for Stock Issued to Employees (APB 25) and related
interpretations. Accordingly, we do not recognize any compensation in our
financial statements in connection with stock options granted to employees when
those options have exercise prices equal to or greater than fair market value
of our common stock. We also do not record any compensation expense in
connection with our Employee Stock Purchase Plan as long as the purchase price
is not less than 85% of the fair market value at the beginning or end of each
offering period, whichever is lower. For options granted to non-employees, we have determined compensation
expense in accordance with SFAS No. 123 Accounting for Stock-Based
Compensation, as amended, and Emerging Issues Task Force No. 96-18 (EITF
96-18), Accounting for Equity Instruments That Are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling Goods or Services. By
those criteria, we quantify compensation expense as the fair value of the
consideration received or the fair value of the equity instruments issued,
whichever is more reliably measured. We periodically re-measure the
compensation expense for options granted to non-employees as they vest. Although SFAS 123 allows us to continue to follow the APB 25 guidelines,
we are required to disclose pro formanet income (loss) and basic and diluted
income (loss) per share as if we had applied the fair value based method to all
awards. Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,(in thousands except per share amounts):
    
    2004
    
    2003
    
    2004
    
    2003Net income (loss), as reported
    
    $
    7,457
    
    
    $
    (1,856
    )
    
    $
    9,330
    
    
    $
    (7,237
    )Add: Stock-based employee compensation
expense, included in reported net
income (loss), net of related tax
effect
    
    
    4
    
    
    
    5
    
    
    
    8
    
    
    
    9Deduct: Total stock-based employee
compensation expense determined under
the fair value method for all awards,
net of related tax effect
    
    
    (2,617
    )
    
    
    (2,017
    )
    
    
    (5,301
    )
    
    
    (3,766
    )Pro forma net income (loss)
    
    $
    4,844
    
    
    $
    (3,868
    )
    
    $
    4,037
    
    
    $
    (10,994
    )Net income (loss) per share:Basic income (loss)  as reported
    
    $
    0.21
    
    
    $
    (0.06
    )
    
    $
    0.27
    
    
    $
    (0.23
    )Diluted income (loss)  as reported
    
    $
    0.19
    
    
    $
    (0.06
    )
    
    $
    0.25
    
    
    $
    (0.23
    )Basic income
(loss)  pro forma
    
    $
    0.14
    
    
    $
    (0.12
    )
    
    $
    0.12
    
    
    $
    (0.35
    )Diluted income (loss)  pro forma
    
    $
    0.13
    
    
    $
    (0.12
    )
    
    $
    0.11
    
    
    $
    (0.35
    )
 9




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For purposes of this analysis, we estimate the fair value of each option
grant on the date of grant using the Black-Scholes option-pricing model. The
weighted average assumptions used in the model were as follows: Stock Option Plans
    
    Stock Option PlansThree Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Expected stock volatility
    
    
    55.8
    %
    
    
    61.6
    %
    
    
    56.6
    %
    
    
    63.5
    %Risk-free interest rate
    
    
    3.3
    %
    
    
    4.4
    %
    
    
    2.8
    %
    
    
    5.9
    %Expected life (in years)
    
    
    3.4
    
    
    
    3.2
    
    
    
    3.4
    
    
    
    4.0Expected dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %
 Stock Purchase Plan
    
    Stock Purchase PlanThree Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Expected stock volatility
    
    
    51.6
    %
    
    
    61.7
    %
    
    
    51.6
    %
    
    
    61.7
    %Risk-free interest rate
    
    
    3.8
    %
    
    
    4.7
    %
    
    
    3.8
    %
    
    
    4.7
    %Expected life (in years)
    
    
    1.6
    
    
    
    1.4
    
    
    
    1.6
    
    
    
    1.4Expected dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %
 The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options that have no vesting restrictions
and are fully transferable. This model also requires us to make highly
subjective assumptions, including the expected volatility of our stock.
Because our stock options have characteristics significantly different from
those of traded options, and because changes in the subjective input
assumptions can materially affect the fair value estimate, we do not believe
that the existing models necessarily provide a reliable single measure of the
fair value of our options. The effects on pro formadisclosures of applying SFAS 123 are not likely
to be representative of the effects on reported results of future periods. Note 2. Net Income (Loss) Per Share We compute basic net income (loss) per share by dividing net income (loss)
by the weighted average number of common shares outstanding during the period.
We compute diluted net income (loss) per share using the weighted average of
all potential shares of common stock outstanding during the period. For the
three months ended June 30, 2004, we included all dilutive stock options,
warrants, and convertible debt in the calculation of diluted net income per
share. As part of the dilutive calculation we excluded interest expense
related to the convertible debt, net of tax effect from net income, to arrive at net income for
the three months ended June 30, 2004. For the six months ended June 30, 2004
the effect of the convertible debt was not included in the calculation of diluted net income
per share as it was anti-dilutive. The following table shows a reconciliation of the numerator and
denominator used in diluted net income (loss) per share computations (in
thousands except share amounts): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Numerator:Net income (loss)
    
    $
    7,457
    
    
    $
    (1,856
    )
    
    $
    9,330
    
    
    $
    (7,237
    )Interest expense, net of tax effect
    
    
    649
    
    
    
    
    
    
    
    
    
    
    
    8,106
    
    
    
    (1,856
    )
    
    
    9,330
    
    
    
    (7,237
    )Denominator:Weighted-average shares outstanding
used for basic net income (loss)
per share
    
    
    35,242
    
    
    
    31,519
    
    
    
    34,439
    
    
    
    31,403Effect of dilutive securities:Stock options
    
    
    2,150
    
    
    
    
    
    
    
    2,247
    
    
    
    Warrants
    
    
    32
    
    
    
    
    
    
    
    36
    
    
    
    Convertible debt
    
    
    4,203
    
    
    
    
    
    
    
    
    
    
    
    Weighted-average shares used for
diluted net income (loss) per share
    
    
    41,627
    
    
    
    31,519
    
    
    
    36,722
    
    
    
    31,403
 10




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Note 3. Comprehensive Income (Loss) The components of comprehensive income (loss) are as follows (in
thousands): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net income (loss)
    
    $
    7,457
    
    
    $
    (1,856
    )
    
    $
    9,330
    
    
    $
    (7,237
    )Foreign currency translation adjustment
    
    
    (233
    )
    
    
    31
    
    
    
    (362
    )
    
    
    69Change in unrealized gain (loss) on
securities, net of reclassification
adjustments for realized gain (loss)
    
    
    (315
    )
    
    
    (308
    )
    
    
    (431
    )
    
    
    (532
    )Comprehensive income (loss)
    
    $
    6,909
    
    
    $
    (2,133
    )
    
    $
    8,537
    
    
    $
    (7,700
    )
 Accumulated other comprehensive loss included $429,000 of net unrealized
gains on investments and $639,000 of foreign currency translation adjustments
as of June 30, 2004, and $861,000 of unrealized gains on investments and $1.0
million of foreign currency translation adjustments as of December 31, 2003. Note 4. Goodwill and Purchased Intangible Assets There
were no changes in the carrying amount of goodwill during the six
months ended June 30, 2004. The components of our other intangible assets at
June 30, 2004, are as follows (in thousands): Gross Carrying
    
    AccumulatedAmount
    
    Amortization
    
    NetAcquired product rights
    
    $
    127,652
    
    
    $
    (4,255
    )
    
    $
    123,397Existing technology
    
    
    6,810
    
    
    
    (2,185
    )
    
    
    4,625Patents
    
    
    1,590
    
    
    
    (425
    )
    
    
    1,165Total
    
    $
    136,052
    
    
    $
    (6,865
    )
    
    $
    129,187
 Amortization expense for our other intangible assets was $3.4 million for
the three months ended June 30, 2004 and $4.7 million for the six months ended
June 30, 2004. For the same reporting periods in 2003, amortization expense
was $202,000 and $403,000, respectively. The expected future amortization expense of our other purchased intangible
assets is as follows (in thousands): Amortization ExpenseRemaining six months in 2004
    
    $
    6,799For the year ending December 31, 2005
    
    
    13,598For the year ending December 31, 2006
    
    
    13,598For the year ending December 31, 2007
    
    
    13,598For the year ending December 31, 2008
    
    
    13,598For the year ending December 31, 2009
    
    
    13,598Thereafter
    
    
    54,398$
    129,187
 Note 5. Guaranties and Indemnifications In November 2002, the FASB issued Interpretation No. 45, Guarantors
Accounting and Disclosure Requirements for Guarantees, including Indirect
Guarantees of Indebtedness of Others (FIN No. 45). FIN No. 45 requires that
upon issuance of a guarantee, the guarantor must recognize a liability for the
fair value of the obligations it assumes under that guarantee. 11




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We enter into indemnification provisions under our agreements with other
companies in the ordinary course of our business, typically with business partners, contractors, clinical
sites, insurers, and customers. Under these provisions we generally indemnify
and hold harmless the indemnified party for losses suffered or incurred by the
indemnified party as a result of our activities. These indemnification
provisions generally survive termination of the underlying agreement. In some
cases, the maximum potential amount of future payments Connetics could be
required to make under these indemnification provisions is unlimited. The
estimated fair value of the indemnity obligations of these agreements is
minimal. Accordingly, we have no liabilities recorded for these agreements as
of June 30, 2004. We have not incurred any costs to defend lawsuits or settle
claims related to these indemnification arrangements. Note 6. Equity Issuance On February 13, 2004, we completed a private placement of 3.0 million
shares of our common stock to accredited institutional investors at a price of
$20.25 per share, for net proceeds of approximately $56.9 million. We used a
portion of the net proceeds to pay for the acquisition of the exclusive U.S.
rights to Soriatane®, and intend to use the balance for general corporate
purposes, including working capital. Note 7. Acquisition of Soriatane® Product Line On February 6, 2004, we entered into a binding agreement with Roche to
acquire exclusive U.S. rights to Soriatane-brand (acitretin), an approved oral
therapy for the treatment of severe psoriasis in adults. The transaction
closed on March 4, 2004, and we have recognized revenue, net of applicable
reserves, for all sales of the product from that date. Under the terms of the
purchase agreement, we paid Roche a total of $123.0 million in cash at the
closing to acquire Soriatane. We also assumed certain liabilities in
connection with returns, rebates and chargebacks associated with prior sales of
Soriatane by Roche totaling $4.1 million, and purchased Roches existing
inventory of Soriatane at a cost of approximately $1.5 million. In addition,
we incurred transaction costs, originally estimated at approximately $500,000
and finalized at $529,000 during the second quarter. Including the cash paid
to acquire the rights, liabilities assumed and transactions costs, the total
value of the acquired product rights for accounting purposes is $127.7 million.
We are amortizing this amount over the ten year estimated useful life of the
Soriatane asset. Note 8. UCB Co-Promotion Agreement In the first quarter of 2004, we entered into an agreement with UCB
Pharma, a subsidiary of UCB Group, pursuant to which UCB Pharmas 400-person
U.S. sales force will promote OLUX and Luxíq to a segment of U.S. primary care
physicians (PCPs). UCBs focus will be on the approximately 10% of PCPs who
are active prescribers of dermatology products, including OLUX and Luxíq. The
purpose of the co-promotion agreement is to build value for the OLUX and Luxíq
brands with the additional benefit of ensuring appropriate use of OLUX and
Luxíq with the current PCP users. We estimate that, historically, PCPs have
written approximately 15% of prescriptions for OLUX and Luxíq, even though we
have promoted exclusively to dermatologists. We will record 100% of the revenue from sales generated by promotional efforts
of UCB and pay UCB a portion of revenue as a promotion expense. UCB will bear
the marketing costs for promoting the products (including product samples,
marketing materials, etc.). The agreement is structured with a two-year
promotional period followed by a two-year tail of additional compensation to
UCB. Note 9. Facility Lease In
June 2004, we signed a series of lease agreements with Incyte
Corporation and The Board of Trustees of the Leland Stanford Junior
University to lease approximately 96,000 square feet of space in Palo
Alto, California. Our commitments, including those disclosed in the
Annual Report on Form 10-K for the year ended December 31,
2003, consist primarily of operating lease agreements for our
facilities as well as minimum purchase commitments under one of our
contract manufacturing agreements. As a result of this new
leasing arrangement our operating lease obligations will increase as
follows (in thousands): Increase in operating
lease obligationsFor the year
ending December 31, 2005
    
    $
    2,975For the year
ending December 31, 2006
    
    
    1,325For the year
ending December 31, 2007
    
    
    1,325For the year
ending December 31, 2008
    
    
    1,325For the year
ending December 31, 2009
    
    
    1,325Thereafter
    
    
    8,009$
    16,284
 Note 10. Subsequent Events We have entered into a multi-year consent with Roche to sell Soriatane to
a U.S.-based distributor that exports branded pharmaceutical products to select
international markets. Product sold to this distributor is not permitted to be
resold in the U.S. Under the terms of the agreement Connetics will pay a
royalty to Roche on Soriatane sales made during the term of the agreement to
this distributor. 12




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Item 2.Managements Discussion and Analysis of Financial Condition and
Results of Operations This discussion and analysis should be read in conjunction with the MD&A
included in our Annual Report onForm 10-Kfor the year ended December 31,
2003, and with the unaudited condensed consolidated financial statements and
notes to financial statements included in this Report. Our disclosure and
analysis in this Report, in other reports that we file with the Securities and
Exchange Commission, in our press releases and in public statements of our
officers contain forward-looking statements within the meaning of Section 27A
of the Securities Act, and Section 21E of the Securities Exchange Act.
Forward-looking statements give our current expectations or forecasts of future
events. You can identify these statements by the fact that they do not relate
strictly to historical or current events. They use words such as anticipate,
estimate, expect, will, may, intend, plan, believe and similar
expressions in connection with discussion of future operating or financial
performance. These include statements relating to future actions, prospective
products or product approvals, future performance or results of current and
anticipated products, sales efforts, expenses, the outcome of contingencies
such as legal proceedings, and financial results. Forward-looking statements
may turn out to be wrong. They can be affected by inaccurate assumptions or by
known or unknown risks and uncertainties. Many factors will be important in
determining future results. No forward-looking statement can be guaranteed,
and actual results may vary materially from those anticipated in any
forward-looking statement. Some of the factors that, in our view, could cause
actual results to differ are discussed in this report under the caption
Factors That May Affect Future Results, Financial Condition and the Market
Price of Securities and under the caption Factors Affecting Our Business and
Prospects in our 2003 Annual Report onForm 10-K. Our historical operating
results are not necessarily indicative of the results to be expected in any
future period. Overview Our commercial business is focused on the dermatology marketplace, which
is characterized by a large patient population that is served by relatively
small, and therefore more accessible, groups of treating physicians. We
currently market three pharmaceutical products, OLUX®, Luxíq®, and
Soriatane®-brand (acitretin). Our products have clinically proven therapeutic
advantages and we are providing quality customer service to physicians through
our experienced sales and marketing professionals. On March 4, 2004, we completed the acquisition of the exclusive U.S.
rights to Roches Soriatane-brand (acitretin), an approved oral therapy for the
treatment of severe psoriasis in adults. Including purchase price of
$123.0 million, assumed liabilities of $4.1 million and
transaction costs of $529,000, we recorded an intangible asset of approximately $127.7 million
related to this acquisition, which we are amortizing over an estimated useful
life of 10 years. In the first quarter of 2004, we entered into an agreement with UCB
Pharma, a subsidiary of UCB Group, pursuant to which UCB Pharmas 400-person
U.S. sales force will promote OLUX and Luxíq to a segment of U.S. primary care
physicians (PCPs). UCBs focus will be on the approximately 10% of PCPs who
are active prescribers of dermatology products, including OLUX and Luxíq. The
purpose of the co-promotion agreement is to build value for the OLUX and Luxíq
brands with the additional benefit of ensuring appropriate use of OLUX and
Luxíq with the current PCP prescribers. We will book 100% of the revenue from
sales generated by UCB and pay UCB a portion of revenue as a promotion expense.
UCB will bear the marketing costs for selling to its customers. The agreement
is structured as a two-year promotional period followed by a two-year tail of
additional compensation to UCB. On May 17, 2004, we announced that the United States Patent and Trademark
Office issued to Connetics Patent No. 6,730,288B1. The patent covers a
pharmaceutical aerosol foam composition having occlusive capability. We expect
to incorporate this technology into our next generation of foam products. This
emollient foam delivery vehicle will serve patients with dermatoses that
require a stronger moisturizing vehicle to alleviate dryness and scaling. In June 2004, we signed a series of lease agreements with Incyte
Corporation and The Board of Trustees of the Leland Stanford Junior University
to lease approximately 96,000 square feet of space in Palo Alto, California.
We anticipate that we will move from our current facilities in late 2004 or
early 2005. 13




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Critical Accounting Policies There have been no material changes to our critical accounting policies,
which are included in our Annual Report on Form 10-K for the year ended
December 31, 2003. Results of Operations Revenues Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,(In thousands)
    
    (In thousands)2004
    
    2003
    
    2004
    
    2003Product revenues:OLUX
    
    $
    15,223
    
    
    $
    11,004
    
    
    $
    29,593
    
    
    $
    20,879Luxíq
    
    
    5,614
    
    
    
    4,491
    
    
    
    11,085
    
    
    
    8,879Soriatane
    
    
    17,154
    
    
    
    
    
    
    
    20,794
    
    
    
    Other
    
    
    8
    
    
    
    33
    
    
    
    93
    
    
    
    81Total product revenues
    
    
    37,999
    
    
    
    15,528
    
    
    
    61,565
    
    
    
    29,839Royalty and contract revenues:Royalty
    
    
    172
    
    
    
    4,384
    
    
    
    1,525
    
    
    
    5,320Contract
    
    
    82
    
    
    
    58
    
    
    
    145
    
    
    
    122Total royalty and contract revenues
    
    
    254
    
    
    
    4,442
    
    
    
    1,670
    
    
    
    5,442Total revenues
    
    $
    38,253
    
    
    $
    19,970
    
    
    $
    63,235
    
    
    $
    35,281
 Our product revenues were $38.0 million for the three months ended June
30, 2004, and $61.6 million for the six months ended June 30, 2004, compared to
$15.5 million and $29.8 million, respectively, for the three and six months
ended June 30, 2003. Total product revenues increased by 145% in the three
months ended June 30, 2004, and by 106% in the six months ended June 30, 2004,
as compared to the same periods in the prior year. The increase in product
revenues in the three months ended June 30, 2004 represents 111% attributable
to the introduction of Soriatane to our product portfolio, 17% attributable to
increases in sales volumes, and 17% attributable to higher sales prices for our
OLUX and Luxíq product lines. The increase in product revenues in the six
months ended June 30, 2004 represents 70% attributable to the introduction of
Soriatane to our product portfolio, 17% attributable to increases in sales
volumes, and 19% attributable to higher sales prices for our OLUX and Luxíq
product lines. During the first half of 2004, we made a decision to bring in house the
function of Contract Administration responsibility for the calculation and
related reporting of all allowances and discounts for which Managed care plans
and Medicaid programs are eligible. Previously we utilized third parties to
perform the allowance calculation and related reporting. In connection with
this change we performed a comprehensive review of our calculation for Medicaid
product pricing allowances, which resulted in an adjustment to reserves
recorded in prior periods. As a result, we recorded a one-time reduction of
product revenues in the amount of $564,000 in the second quarter of 2004. We
have determined that the effect of this adjustment would not have had a
material impact on our financial statements in any prior quarterly or annual
period. Royalty and contract revenues were $254,000 for the three months ended
June 30, 2004, and $1.7 million for the six months ended June 30, 2004,
compared to $4.4 million and $5.4 million, respectively, for the three and six
months ended June 30, 2003. Royalty and contract revenues decreased primarily
because in the second quarter of 2003 we recognized $4.2 million of royalties
from S.C. Johnson related to their concentrated aerosol spray which was
marketed in the U.S. and internationally. As the royalty agreement with S.C.
Johnson was terminated in the first quarter of 2004, no royalties were received
or recognized in the second quarter of 2004. Cost of Product Revenues Currently, DPT Laboratories, Ltd. and AccraPac Group, Inc. manufacture
commercial supplies of OLUX and Luxíq, and Roche manufactures commercial
supplies of Soriatane. Cardinal Health Specialty Pharmaceutical Services
(formerly CORD Logistics, Inc.) handles all of our product distribution
activities. Our cost of product revenues includes the third party costs of
manufacturing OLUX and Luxíq, the cost of Soriatane inventory acquired from
Roche, depreciation costs associated with Connetics-owned equipment located at
the DPT facility in Texas, 14




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allocation of overhead, royalty payments based on a percentage of our product
revenues, and product freight and distribution costs from Cardinal Health SPS.
We recorded costs of product revenues of $3.6 million for the three months
ended June 30, 2004, and $5.1 million for the six months ended June 30, 2004,
compared to $1.2 million and $2.3 million for the comparable periods in 2003.
The increase in the cost of product revenues in 2004 is primarily attributable
to the introduction of Soriatane to our product portfolio in 2004 as well as an
increase in sales volume of our OLUX and Luxíq products. Effective January 1, 2004, we began including in the cost of finished
goods inventory and prepaid sample cost, certain manufacturing support and
quality assurance costs which had previously been classified as research and
development expense. While we do not directly manufacture any of our products,
our internal activities include overseeing third party manufacturing, process
development, quality assurance and quality control activities. Previously only
third party product manufacturing costs, depreciation based on a units of
production methodology on Connetics-owned equipment at our third-party
manufacturers, product freight and distribution costs from the third party that
handles all of our product distribution activities, and royalties were being
captured in inventory and cost of goods sold. We have determined that the
effect of this change in accounting would not have had a material impact on our
financial statements in any prior quarterly or annual period. For the three months ended June 30, 2004, $1.1 million of costs which in
previous periods had been included in research and development expense were
allocated as follows: (1) $87,000 was charged to cost of goods sold, (2)
$168,000 was charged to sales expense, (3) $687,000 was added to the value of
commercial inventory, and (4) $113,000 was added to the value of samples
inventory. For the six months ended June 30, 2004, $2.1 million of costs which in
previous periods had been included in research and development expense were
allocated as follows: (1) $124,000 was charged to cost of goods sold, (2)
$371,000 was charged to sales expense, (3) $1.1 million was added to the value
of commercial inventory, and (4) $478,000 was added to the value of samples
inventory. Research and Development Research and development expenses include costs of personnel to support
our research and development activities, costs of preclinical studies, costs of
conducting our clinical trials, such as clinical investigator fees, monitoring
costs, data management and drug supply costs, external research programs, and
an allocation of facilities costs, salaries and benefits, and overhead costs
such as rent, supplies and utilities. In the three months ended June 30, 2004
we incurred costs associated with two Velac trials in various stages of
completion as well as start up costs associated with trials for three other
product candidates. During the first quarter of 2003, we incurred costs
associated with concurrent trials in Velac, Actiza, and Extina, which were in
varying stages of completion. Research and development expenses were $5.1 million for the three months
ended June 30, 2004, compared to $8.6 million for the three months ended June
30, 2003. The decrease represents a reduction of $2.7 million of costs related
to clinical trials activities underway in 2003 as well as a $1.1 million change
in classification from research and development costs to cost of goods sold,
inventory, and selling expense. For additional information about this change,
see Note 1 of the accompanying Notes to Consolidated Financial Statements.For
the six months ended June 30, 2004 and 2003, research and development expenses
were $9.5 million and $17.2 million, respectively. The decrease represents a
reduction of $3.3 million of costs related to clinical trials activities
underway in 2003 as well as a $2.1 million change in classification from
research and development costs to cost of goods sold, inventory, and selling
expense. While we do not directly manufacture any of our products, our
internal research and development activities include manufacturing associated
costs such as overseeing third-party manufacturing, process development, and
quality assurance and quality control activities. Selling, General and Administrative Expenses Selling, general and administrative expenses were $17.5 million for the
three months ended June 30, 2004, compared to $10.6 million for the comparable
period in 2003. For the three months ended June 30, 2004 the overall increase
in expenses, compared with the same period in 2003 was primarily related to a
$2.3 million increase in direct and indirect sales promotion capabilities, a
$994,000 increase in employee-related costs due to increased headcount in the
marketing and general and administrative departments, an increase of $389,000
in travel expenses 15




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related to supporting business activities, and an increase of approximately
$2.3 million in increased marketing and sales activities such as tradeshows,
sales meetings, product samples, advertising and market research. Selling, general and administrative expenses were $32.8 million for the
six months ended June 30, 2004, compared to $21.5 million for the comparable
period in 2003. For the six months ended June 30, 2004 the overall increase in
expenses, compared with the same period in 2003 was primarily related to a $3.0
million increase in direct and indirect sales promotion capabilities, a $1.5
million increase in employee-related costs due to increased headcount in the
marketing and general and administrative departments, an increase of $761,000
in travel expenses related to supporting business activities, and an increase
of approximately $3.6 million in increased marketing and sales activities such
as trade shows, sales meetings, product samples, advertising and market
research. Interest and other income (expense), net Interest income was $152,000 for the three months ended June 30, 2004, and
$500,000 for the six months ended June 30, 2004, compared to $169,000 and
$294,000 for the three and six months ended June 30, 2003, respectively. The
increase in interest income during 2004 was the result of higher average cash
and investment balances in connection with the cash we received by issuing
$90.0 million of convertible senior notes in May 2003, as well as the $56.9
million net receipts from a private placement of common stock in February 2004,
partially offset by lower market interest rates on investments. Interest expense was $690,000 for the three months ended June 30, 2004,
and $1.4 million for the six months ended June 30, 2004, compared to $230,000
and $231,000, respectively, for the three and six months ended June 30, 2003.
The increase in interest expense during 2004 was directly related to the
interest expense associated with the convertible senior notes issued in the
second quarter of 2003. Income Taxes We recognized income tax expense of $647,000 for the three months ended
June 30, 2004, and $890,000 for the six months ended June 30, 2004. We
recorded tax provisions for domestic income taxes because we had a profitable
first and second quarter and anticipate that we will be profitable for the full
year of 2004. Specifically, for the three months ended June 30, 2004, we
recorded a domestic tax provision of $511,000, and for the six months ended June 30,
2004, we recorded a domestic tax provision of $572,000. We also recorded foreign tax
provisions in the three and six months ended June 30, 2004 related to our
Australian operations. By comparison, we recognized income tax expense of $1.2
million and $1.3 million, respectively, in the three and six months ended June
30, 2003 related to our Australian operations. Liquidity and Capital Resources Sources and Use of Cash.We have financed our operations to date
primarily through proceeds from equity and debt financings, collaborative
arrangements with corporate partners, bank loans, and product revenues. At
June 30, 2004, cash, cash equivalents and marketable securities totaled $66.0
million compared to $114.7 million at December 31, 2003. Our cash balances are
held in a variety of interest-bearing instruments including high-grade
obligations, commercial paper, obligations of the U.S. Government and state and
local agencies, and money market accounts. Cash from operating activities.Cash provided by operations for the six
months ended June 30, 2004 was $19.7 million compared to $7.9 million of cash
used for the six months ended June 30, 2003. Net income of $9.3 million for
the six months ended June 30, 2004 was affected by non-cash charges of $5.8
million of depreciation and amortization expense and $7.1 million of increased
reserves related to product returns, chargebacks, rebates and coupon programs.
Cash usage was primarily due to an increase in gross accounts receivable of
approximately $6.6 million primarily attributable to receivables related to the
Soriatane product line; the balance of the change in accounts receivable was
related to the timing of sales on OLUX and Luxíq, and collection of outstanding
amounts. The increase in 2004 was also a result of an increase in other assets
of $4.8 million related to various prepaid activities including payments in
connection with our UCB co-promotion agreement, insurance, samples inventory
and sales and marketing activities, as well as an increase in accounts payable
and other accrued and current 16




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liabilities of $8.8 million primarily due to the timing of payments and other
business activities. Cash from investing activities.We used $61.8 million cash in investing
activities for the six months ended June 30, 2004, compared to $42.7 million
for the six months ended June 30, 2003. The increase in cash used in investing
activities is primarily related to the 2004 acquisition of the Soriatane
product line for $123.5 million, partially offset by $85.8 million from
maturities and sales of marketable securities necessary to fund the
acquisition. Cash from financing activities.Financing activities provided $57.2
million for the six months ended June 30, 2004 compared to $89.5 million for
the six months ended June 30, 2003. The 2003 change is primarily because in May 2003 we
had net cash proceeds of $86.5 million from the issuance of convertible senior notes.
The 2004 change is primarily due to the net cash proceeds of $56.9 million from a private
placement of our common stock in February 2004. Working Capital.Working capital decreased by $56.3 million to $55.9
million at June 30, 2004 from $112.2 million at December 31, 2003, primarily
because we used cash to fund the acquisition of exclusive U.S. rights to
Soriatane and related inventory in March 2004 and we assumed approximately $4.1
million in liabilities associated with the Soriatane acquisition. The amounts
related to the acquisition were partially offset by net proceeds of $56.9
million from a private placement of our common stock in February 2004. Contractual Obligations and Commercial Commitments.In June 2004, we
signed a series of lease agreements with Incyte Corporation and The Board of
Trustees of the Leland Stanford Junior University to lease approximately 96,000
square feet of space in Palo Alto, California. We anticipate that we will move
from our current facilities in late 2004 or early 2005. Our commitments,
including those disclosed in the Annual Report on Form 10-K for the year ended
December 31, 2003, consist primarily of operating lease agreements for our
facilities as well as minimum purchase commitments under one of our contract
manufacturing agreements. As a result of this new leasing arrangement our operating lease obligations
will increase as follows (in thousands): Increase in operating leaseobligationsFor the year ending December 31, 2005
    
    $
    2,975For the year ending December 31, 2006
    
    
    1,325For the year ending December 31, 2007
    
    
    1,325For the year ending December 31, 2008
    
    
    1,325For the year ending December 31, 2009
    
    
    1,325Thereafter
    
    
    8,009$
    16,284
 Restricted Cash and Cash Equivalents.In the three and six months ended
June 30, 2004, we entered into two Letter of Credit arrangements, which are
secured by certificates of deposit. The first arrangement is a $1.0 million
Letter of Credit required as part of our annual corporate insurance renewal.
The second Letter of Credit is for $2.0 million and is required as part of the
new office facility leasing arrangement that will begin in late 2004 or early
2005. Both of these certificates of deposit are classified as restricted cash,
current and non-current, respectively, on the June 30, 2004 balance sheet. We believe our existing cash, cash equivalents and marketable securities,
cash generated from product sales and collaborative arrangements with corporate
partners, will be sufficient to fund our operating expenses, debt obligations
and capital requirements through at least the next 12 months. Our future
capital uses and requirements depend on numerous factors, including the
progress of our research and development programs, the progress of clinical
testing, the time and costs involved in obtaining regulatory approvals, the
cost of filing, prosecuting, and enforcing patent claims and other intellectual
property rights, competing technological and market developments, the level of
product revenues, and the possible acquisition of new products and
technologies. A key element of our strategy is to in-license or acquire
additional marketed or late-stage development products. A portion of the funds
needed to acquire, develop and market any new products may come from our
existing cash, which will result in 17




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fewer resources available to our current products and clinical programs. We
continually evaluate various business development opportunities, including the
possibility of acquiring or in-licensing other products. If we successfully
reach agreements with third parties, these transactions may require us to use
some of our available cash, or to raise additional cash by liquidating some of
our investment portfolio and/or raising additional funds through equity or debt
financings in connection with the transaction. Factors that May Affect Future Results, Financial Condition and the Market
Price of Securities Please also read Item 1 in our Annual Report onForm 10-Kfor the year ended
December 31, 2003, where we have described our business and the challenges and
risks we may face in the future. There are many factors that affect our business and results of operations,
some of which are beyond our control. In our Annual Report on Form 10-K for
the year ended December 31, 2003 we list some of the important factors that may
cause the actual results of our operations in future periods to differ
materially from the results currently expected or desired. Due to these
factors, we believe that quarter-to-quarter comparisons of our results of
operations are not a good indication of our future performance. The factors
discussed in our reports filed with the Securities and Exchange Commission,
including our 2003 Annual Report on Form 10-K, in particular under the caption
Factors Affecting Our Business and Prospects, should be carefully considered
when evaluating our business and prospects. Our Business Strategy May Cause Fluctuating Operating Results Our operating results and financial condition may fluctuate from quarter
to quarter and year to year depending upon the relative timing of events or
uncertainties that may arise. For example, the following events or occurrences
could cause fluctuations in our financial performance from period to period:  
    
    changes in the levels we spend to develop new product lines,
    
    changes in the amounts we spend to promote our products,
    
    changes in treatment practices of physicians that currently prescribe our products,
    
    changes in reimbursement policies of health plans and other similar
health insurers, including changes that affect newly developed or newly
acquired products,
    
    forward-buying patterns by wholesalers that may result in
significant quarterly swings in revenue reporting,
    
    increases in the cost of raw materials used to manufacture our products,
    
    the development of new competitive products by others,
    
    the mix of products that we sell during any time period,
    
    our responses to price competition, and
    
    fluctuations in royalties paid by third parties. 
 Item 3.Quantitative and Qualitative Disclosures About Market Risk There have been no material changes in the reported market risks or
foreign currency exchange risks from those reported under Item 7A, Quantitative
and Qualitative Disclosures About Market Risk in our Annual Report on Form 10-K
for the year ended December 31, 2003. 
 Item 4.Controls and Procedures Our management, under the supervision and with the participation of our
Chief Executive Officer and Chief Financial Officer, performed an evaluation of
the effectiveness of the design and operation of Connetics disclosure controls
and procedures. This evaluation was performed as of June 30, 2004. Our
disclosure controls and procedures are designed with the objective of ensuring
that information required to be disclosed in our reports filed under the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported
within the time periods specified in the SECs rules and forms. Based on their
evaluation, the CEO and CFO concluded that our disclosure 18




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controls and procedures were effective in timely alerting them to material
information required to be included in our periodic SEC reports. In addition,
our CEO and CFO concluded that during the quarter ended June 30, 2004, there
has been no change in our internal control over financial reporting that has
materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting. 19




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PART II. OTHER INFORMATION 
 Item 2.Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities We do not have a plan or program to repurchase shares of our common stock.
Prior to 2000, however, we have accepted a total of 46,708 shares of our
common stock surrendered by our chief executive officer as partial repayments
of loans totaling approximately $321,000 plus accrued interest. 
 Item 4.Submission of Matters to a Vote of Security Holders On May 7, 2004, 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: Name
    
    For
    
    WithheldAlexander E. Barkas, Ph.D.
    
    
    26,857,393
    
    
    
    2,147,912Eugene Bauer, M.D.
    
    
    22,096,573
    
    
    
    6,908,732Andrew Eckert
    
    
    27,401,751
    
    
    
    1,603,554Denise Gilbert, Ph.D.
    
    
    27,793,331
    
    
    
    1,211,974John C. Kane
    
    
    27,401,836
    
    
    
    1,603,469Thomas D. Kiley
    
    
    27,610,226
    
    
    
    1,395,079Leon E. Panetta
    
    
    18,411,814
    
    
    
    10,593,491G. Kirk Raab
    
    
    26,735,521
    
    
    
    2,269,784Thomas G. Wiggans
    
    
    27,587,394
    
    
    
    1,417,911
  2)  Ratification of the appointment of Ernst & Young LLP to serve as the
Companys independent auditors for the fiscal year ending December 31, 2004: For
    
    Against
    
    Abstain27,536,743
    
    
    961,130
    
    
    
    507,432
 
 Item 6.Exhibits and Reports on Form 8-K 
 (a) Exhibits. ExhibitNumber
    
    Description10.1
    
    Connetics Corporation 1995 Employee Stock Purchase Plan (as
amended and restated through May 7, 2004) and form of Subscription
Agreement10.2
    
    Sublease Agreement between The Board of Trustees of the Leland
Stanford Junior University and Incyte Pharmaceuticals, Inc., dated
May 6, 200410.3
    
    Sublease Consent between The Board of Trustees of the Leland
Stanford Junior University and Incyte Corporation and Connetics
Corporation, dated May 6, 200410.4
    
    Agreement Regarding Sublease and Lease between The Board of
Trustees of the Leland Stanford Junior University and Connetics
Corporation, dated May 6, 2004
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ExhibitNumber
    
    Description10.5
    
    First Amendment to Lease between The Board of Trustees of the
Leland Stanford Junior University and Incyte Corporation, dated
May 6, 200431.1
    
    Certification of the Chief Executive Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 200231.2
    
    Certification of the Chief Financial Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 200232.1
    
    Certification of the Chief Executive Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 135032.2
    
    Certification of the Chief Executive Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350
 
 (b) Reports on Form 8-K. We filed or furnished the following Current Reports
on Form 8-K during the quarter ended June 30, 2004. The information furnished
under Item 9, Regulation FD Disclosure or Item 12, Results of Operations and
Financial Condition is not deemed to be filed for purposes of Section 18 of
the Securities Exchange Act of 1934.  (i)
    
    Current Report on Form 8-K dated April 8, 2004, filed with
the Securities and Exchange Commission on April 9, 2004, under
Item 5, Other Events, and Item 7, Financial Statements &
Exhibits.(ii)
    
    Current Report on Form 8-K dated April 14, 2004, filed with
the Securities and Exchange Commission on April 15, 2004, under
Item 5, Other Events, and Item 7, Financial Statements &
Exhibits.(iii)
    
    Current Report on Form 8-K/A dated March 4, 2004, filed
with the Securities and Exchange Commission on April 30, 2004,
under Item 2, Acquisition or Disposition of Assets, and Item 7
Financial Statements, Pro Forma Financial Information and
Exhibits.(iv)
    
    Current Report on Form 8-K dated May 4, 2004, furnished to
the Securities and Exchange Commission on May 4, 2004, under
Item 7, Financial Statements & Exhibits, and Item 12 Results of
Operations and Financial Condition.(v)
    
    Current Report on Form 8-K/A dated March 4, 2004, filed with
the Securities and Exchange Commission on May 6, 2004, under
Item 2, Acquisition or Disposition of Assets, and Item 7,
Financial Statements, Pro Forma Financial Information &
Exhibits.(vi)
    
    Current Report on Form 8-K dated June 10, 2004, filed with
the Securities and Exchange Commission on June 14, 2004, under
Item 5, Other Events.(vii)
    
    Current Report on Form 8-K dated June 15, 2004, furnished
to the Securities and Exchange Commission on June 15, 2004,
under Item 7, Financial Statements and Exhibits, and Item 9,
Regulation FD Disclosure. 21




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SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized. Connetics Corporation By:
    /s/ John L. HigginsJohn L. HigginsExecutive Vice President, Finance
and Corporate Development
and Chief Financial Officer
(Principal Financial Officer
and Principal Accounting
Officer and Duly Authorized
Officer of the Registrant) Date: August 5, 2004 22




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INDEX TO EXHIBITS ExhibitNumber
    
    Description10.1
    
    Connetics Corporation 1995 Employee Stock Purchase Plan (as
amended and restated through May 7, 2004) and form of Subscription
Agreement10.2
    
    Sublease Agreement between The Board of Trustees of the Leland
Stanford Junior University and Incyte Pharmaceuticals, Inc., dated
May 6,200410.3
    
    Sublease Consent between The Board of Trustees of the Leland
Stanford Junior University and Incyte Corporation and Connetics
Corporation, dated May 6, 200410.4
    
    Agreement Regarding Sublease and Lease between the Board of
Trustees of the Leland Stanford Junior University and Connetics
Corporation, dated May 6, 200410.5
    
    First Amendment to Lease between The Board of Trustees of the
Leland Stanford Junior University and Incyte Corporation, dated
May 6, 200431.1
    
    Certification of the Chief Executive Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 200231.2
    
    Certification of the Chief Financial Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 200232.1
    
    Certification of the Chief Executive Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 135032.2
    
    Certification of the Chief Executive Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350
 23