##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended March 31, 2005 Commission file number: 0-27406 CONNETICS CORPORATION (Exact name of registrant as specified in its charter)
 Delaware
    
    94-3173928(State or other jurisdiction of
    
    (IRS Employerincorporation or organization)
    
    Identification Number)3160 Porter DrivePalo Alto, California
    
    94304(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number, including area code: (650) 843-2800 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 þ No £ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). Yes þ No £ As
of April 29, 2005, 34,790,675 shares of the Registrants common stock at $0.001 par
value, were outstanding.




---



CONNETICS CORPORATION TABLE OF CONTENTS PagePART I FINANCIAL INFORMATIONItem 1.
    
    Financial Statements
    
    
    1-3Condensed Consolidated Balance Sheets at March 31, 2005 and December 31, 2004
    
    
    1Condensed Consolidated Statements of Operations for the Three Months ended March 31, 2005 and 2004
    
    
    2Condensed Consolidated Statements of Cash Flows for the Three Months ended March 31, 2005 and 2004
    
    
    3Notes to Condensed Consolidated Financial Statements
    
    
    4Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    11Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    16Item 4.
    
    Controls and Procedures
    
    
    16PART II OTHER INFORMATIONItem 2.
    
    Purchases of Equity Securities by the Issuer
    
    
    17Item 6.
    
    Exhibits
    
    
    17SignaturesExhibitsEXHIBIT 10.1EXHIBIT 10.2EXHIBIT 10.3EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2




---



##### Table of Contents



PART I. FINANCIAL INFORMATION 
 Item 1. Financial Statements CONNETICS CORPORATION 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited) March 31,
    
    
    December 31,2005
    
    
    2004ASSETSCurrent assets:Cash and cash equivalents
    
    $
    181,480
    
    
    $
    18,261Marketable securities
    
    
    52,225
    
    
    
    54,122Restricted cash  current
    
    
    1,000
    
    
    
    1,000Accounts receivable, net of allowances
    
    
    10,558
    
    
    
    10,642Inventory
    
    
    7,567
    
    
    
    5,020Prepaid expenses
    
    
    6,088
    
    
    
    7,561Other current assets
    
    
    2,634
    
    
    
    1,963Total current assets
    
    
    261,552
    
    
    
    98,569Property and equipment, net
    
    
    12,813
    
    
    
    11,830Restricted cash  long term
    
    
    3,109
    
    
    
    2,963Debt issuance costs, deposits and other assets
    
    
    11,608
    
    
    
    3,707Goodwill, net
    
    
    6,271
    
    
    
    6,271Other intangible assets, net
    
    
    118,988
    
    
    
    122,388Total assets
    
    $
    414,341
    
    
    $
    245,728LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    14,985
    
    
    $
    14,531Assumed liabilities related to acquisition of product rights
    
    
    2,402
    
    
    
    2,710Accrued payroll and related expenses
    
    
    4,954
    
    
    
    5,746Accrued clinical trial costs
    
    
    733
    
    
    
    751Other accrued liabilities
    
    
    5,364
    
    
    
    3,650Total current liabilities
    
    
    28,438
    
    
    
    27,388Convertible senior notes
    
    
    290,000
    
    
    
    90,000Other non-current liabilities
    
    
    446
    
    
    
    420Commitments and contingenciesStockholders equity:Preferred stock
    
    
    
    
    
    
    Common stock
    
    
    36
    
    
    
    36Additional paid-in capital
    
    
    204,462
    
    
    
    237,666Deferred stock compensation
    
    
    (9
    )
    
    
    (13
    )Accumulated deficit
    
    
    (110,131
    )
    
    
    (111,173
    )Accumulated other comprehensive income
    
    
    1,099
    
    
    
    1,404Total stockholders equity
    
    
    95,457
    
    
    
    127,920Total liabilities and stockholders equity
    
    $
    414,341
    
    
    $
    245,728
 See accompanying notes to condensed consolidated financial statements. 1




---



##### Table of Contents



CONNETICS CORPORATION 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited) Three Months EndedMarch 31,2005
    
    
    2004Revenues:Product
    
    $
    42,190
    
    
    $
    23,566Royalty and contract
    
    
    181
    
    
    
    1,416Total revenues
    
    
    42,371
    
    
    
    24,982Operating costs and expenses:Cost of product revenues
    
    
    3,766
    
    
    
    1,568Amortization of intangible assets
    
    
    3,399
    
    
    
    1,272Research and development
    
    
    5,898
    
    
    
    4,441Selling, general and administrative
    
    
    27,809
    
    
    
    15,293Total operating costs and expenses
    
    
    40,872
    
    
    
    22,574Income from operations
    
    
    1,499
    
    
    
    2,408Interest income
    
    
    477
    
    
    
    348Interest expense
    
    
    (771
    )
    
    
    (691
    )Other income (expense), net
    
    
    (59
    )
    
    
    51Income before income taxes
    
    
    1,146
    
    
    
    2,116Income tax provision
    
    
    105
    
    
    
    243Net income
    
    $
    1,041
    
    
    $
    1,873Net income per share:Basic
    
    $
    0.03
    
    
    $
    0.06Diluted
    
    $
    0.03
    
    
    $
    0.05Shares used to compute basic and diluted net income per share:Basic
    
    
    35,699
    
    
    
    33,587Diluted
    
    
    38,014
    
    
    
    35,887
 See accompanying notes to condensed consolidated financial statements. 2




---



##### Table of Contents



CONNETICS CORPORATION 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited) Three Months EndedMarch 31,2005
    
    
    2004Cash flows from operating activities:Net income
    
    $
    1,041
    
    
    $
    1,873Adjustments
to reconcile net income to net cash provided by (used in) operating activities:Depreciation
    
    
    346
    
    
    
    377Amortization of intangible assets
    
    
    3,399
    
    
    
    1,272Amortization of convertible debt issuance costs
    
    
    196
    
    
    
    184Allowance for discounts, rebates, returns and chargebacks
    
    
    3,467
    
    
    
    1,763Stock compensation expense
    
    
    4
    
    
    
    5Changes in assets and liabilities:Accounts receivable
    
    
    (3,389
    )
    
    
    (9,291
    )Other assets
    
    
    (621
    )
    
    
    (2,122
    )Inventory
    
    
    (2,521
    )
    
    
    (1,426
    )Accounts payable
    
    
    460
    
    
    
    1,391Accrued and other current liabilities
    
    
    (66
    )
    
    
    748Other non-current liabilities
    
    
    26
    
    
    
    Net cash provided by (used in) operating activities
    
    
    2,342
    
    
    
    (5,226
    )Cash flows from investing activities:Purchases of marketable securities
    
    
    (15,980
    )
    
    
    (1,712
    )Sales and maturities of marketable securities
    
    
    17,655
    
    
    
    84,351Purchases of property and equipment
    
    
    (1,369
    )
    
    
    (356
    )Acquisition of product rights
    
    
    
    
    
    
    (123,212
    )Net cash provided by (used in) investing activities
    
    
    306
    
    
    
    (40,929
    )Cash flows from financing activities:Transfer (to) from restricted cash
    
    
    (146
    )
    
    
    304Proceeds from issuance of convertible senior notes, net of issuance costs
    
    
    194,000
    
    
    
    Proceeds from issuance of common stock, net of issuance costs
    
    
    
    
    
    
    57,007Repurchase of common stock
    
    
    (35,000
    )
    
    
    Proceeds from exercise of stock options and employee stock purchase plan,
net of repurchases of unvested shares
    
    
    1,756
    
    
    
    1,093Net cash provided by financing activities
    
    
    160,610
    
    
    
    58,404Effect of foreign currency exchange rate changes on cash and cash equivalents
    
    
    (39
    )
    
    
    (12
    )Net change in cash and cash equivalents
    
    
    163,219
    
    
    
    12,237Cash and cash equivalents at beginning of period
    
    
    18,261
    
    
    
    17,946Cash and cash equivalents at end of period
    
    $
    181,480
    
    
    $
    30,183
 See accompanying notes to condensed consolidated financial statements. 3




---



##### Table of Contents



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. Basis of Presentation and Policies We prepared the accompanying unaudited condensed consolidated financial statements of
Connetics Corporation, or Connetics, in accordance with accounting principles generally accepted in
the United States for interim financial information and in compliance with 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. Operating results for the three months ended March 31, 2005 are not necessarily indicative of
the results that may be expected for the year ending December 31, 2005. 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, 2004, which are
included in our Annual Report on Form 10-K as filed with the Securities and Exchange Commission, or
SEC. Principles of Consolidation The accompanying condensed consolidated financial statements include the accounts of Connetics
and its subsidiaries, Connetics Holdings Pty Ltd., and Connetics Australia Pty Ltd. Connetics owns
100% of the outstanding stock of its subsidiaries. We eliminated all
significant intercompany accounts and
transactions in consolidation. We reclassified certain prior year amounts and balances to conform
to the current year presentation. On the condensed consolidated balance sheets, raw material
inventory balances that were previously included in prepaid expenses, other current assets, and
other assets as of December 31, 2004 have been reclassified to inventory. On the condensed
consolidated statements of operations, certain expense for the three months ended March 31, 2004
was reclassified from interest expense to selling, general and administrative expense to conform to
amounts reported for the six month period ended June 30, 2004. Use of Estimates To prepare financial statements in conformity with accounting principles generally accepted in
the United States, management must make estimates and assumptions that affect the amounts reported
in the financial statements and accompanying notes. Future events could cause our actual results to
differ. We evaluate our estimates on an ongoing 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 and indirect promotional expenses. We base our estimates on historical experience and on
various other specific assumptions that we believe are 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
revenue reserves, which consist of allowances for discounts, returns, rebates, and chargebacks. We
accept from customers the return of pharmaceuticals that are within six months before 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. We also
recognize revenue net of fees paid to wholesalers under distribution service agreements in exchange
for certain product distribution, inventory, management, information, return goods processing, and
administrative services. We record accounts receivable net of revenue reserves. During the first three months of 2005, we performed a detailed analysis of our chargeback
allowance. As a result of the analysis of our actual chargeback history, we reduced our estimated
chargeback allowance by $445,000, which resulted in an increase in revenue for the three months
ended March 31, 2005 of the same amount. 4




---



##### Table of Contents



Royalty Revenues.We collect royalties from our third-party licensees based on their sales.
We recognize royalties either in the quarter in which we receive the royalty payment from the
licensee or in the quarter in which we can reasonably estimate the royalty, which is typically one
quarter following the related sale by the licensee. Contract Revenues.We record contract revenue for research and development, or R&D, and
milestone payments as 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. When we receive advance payments that
exceed amounts earned, we classify them as deferred revenue until they are earned. Inventory Inventory consists of raw materials and finished goods primarily related to
currently marketed products. In addition, inventory may include similar costs for product
candidates awaiting regulatory approval, which are capitalized based on our managements judgment
of probable near term commercialization and alternative future uses. We state inventory at the lower of cost (determined on a
first-in first-out method) or market. If inventory costs exceed expected market value due to
obsolescence or lack of demand, reserves are recorded for the difference between the cost and the
market value. These reserves are based on significant estimates. 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, or 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
on the date of grant. 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 recorded compensation expense in accordance with
Statement of Financial Accounting Standards No. 123 Accounting for Stock-Based Compensation, or
SFAS 123, as amended, and Emerging Issues Task Force No. 96-18, Accounting for Equity Instruments
That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling Goods or
Services. By those criteria, we quantify compensation expense as the fair value of the
consideration received or the fair value of the equity instruments issued, whichever is more
reliably measured. 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. Because the estimated value is determined as of
the date of grant, the actual value ultimately realized by the employee may be significantly
different. Three Months EndedMarch 31,(in thousands except per share amounts):
    
    2005
    
    
    2004Net income, as reported
    
    $
    1,041
    
    
    $
    1,873Add: Stock based compensation expense, net of related tax effects
    
    
    4
    
    
    
    5Deduct: Total stock-based employee compensation expense
determined under the fair value method for all awards, net of
related tax effects
    
    
    (5,321
    )
    
    
    (2,855
    )Pro forma net loss
    
    $
    (4,276
    )
    
    $
    (977
    )Net income (loss) per share:Basic income  as reported
    
    $
    0.03
    
    
    $
    0.06Diluted income  as reported
    
    $
    0.03
    
    
    $
    0.05Basic loss  pro forma
    
    $
    (0.12
    )
    
    $
    (0.03
    )Diluted loss  pro forma
    
    $
    (0.12
    )
    
    $
    (0.03
    )
 5




---



##### Table of Contents



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. We used the following weighted average
assumptions in the model: Stock Option PlansThree Months EndedMarch 31,2005
    
    
    2004Expected stock volatility
    
    
    47.3
    %
    
    
    57.3
    %Risk-free interest rate
    
    
    3.5
    %
    
    
    2.3
    %Expected life (in years)
    
    
    4.0
    
    
    
    3.4Expected dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
 Stock Purchase PlansThree Months EndedMarch 31,2005
    
    
    2004Expected stock volatility
    
    
    45.9
    %
    
    
    52.0
    %Risk-free interest rate
    
    
    1.6
    %
    
    
    1.6
    %Expected life (in years)
    
    
    1.4
    
    
    
    1.6Expected dividend yield
    
    
    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 weighted average fair value of the options granted,
determined using the Black-Scholes model, was $9.64 and $7.96, respectively, for the three months
ended March 31, 2005 and 2004. The effects on pro formadisclosures of applying SFAS 123 are not likely to be representative
of the effects on reported results of future periods. Recent Accounting Pronouncements In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123
(revised 2004), Share-Based Payment, or SFAS 123R, which requires companies to measure and
recognize compensation expense for all stock-based awards at fair value. Stock-based awards include
grants of employee stock options. SFAS 123R replaces SFAS 123 and supersedes APB 25, which are
discussed above. SFAS 123R requires companies to recognize all stock-based awards to employees and
to reflect those awards in the financial statements based on the fair values of the awards. In
April 2005, the SEC modified the effective date for SFAS 123R, resulting in the pronouncement being
effective for all annual periods beginning after June 15, 2005. We are required to adopt SFAS 123R
in our fiscal year beginning January 1, 2006, after which the profroma disclosures previously
permitted under SFAS 123 will no longer be an alternative to financial statement recognition. Under
SFAS 123R, we must determine the appropriate fair value model to be used for valuing share-based
awards, the amortization method for compensation cost, and the transition method to be used at date
of adoption. The transition methods include options for adopting the model retroactively or
prospectively. The prospective method requires that we record compensation expense for all unvested
stock options and restricted stock at the beginning of the year we adopt SFAS 123R. Under the
retroactive method, we may restate prior periods either as of the beginning of the year of adoption
or for all periods presented, and we would record compensation expense for all unvested stock
options and restricted stock beginning with the first period restated. We are evaluating the
requirements of SFAS 123R and we expect that the adoption of SFAS 123R will have a material impact
on our consolidated results of operations and earnings per share. We have not yet determined which
method of adoption we will use or the effect of adopting SFAS 123R, and we have not determined
whether the adoption will result in amounts that are similar to the current pro forma disclosures
under SFAS 123. On September 30, 2004, the Emerging Issues Task Force, or EITF, reached a consensus on Issue
No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share,concluding
that contingently convertible debt instruments should be included in diluted earnings per share
computations (if dilutive) regardless of whether the market price trigger (or other contingent
feature) has been met. This consensus is effective for reporting periods ending after December 15,
2004, and requires companies to 6




---



##### Table of Contents



restate prior period earnings per share amounts presented for comparative purposes utilizing a
transition method. As of December 31, 2004, we had no outstanding contingently convertible debt.
In March 2005, we issued contingently convertible debt and adopted the consensus. Our adoption of
EITF No. 04-8 had no impact on diluted earnings per share for the three months ended March 31, 2005
or for prior years. 2. Net Income Per Share We compute basic net income per share by dividing net income by the weighted average number of
common shares actually outstanding during the period. We compute diluted net income per share using
the weighted average of all shares of common stock outstanding and potentially outstanding during
the period. For the three months ended March 31, 2005 and 2004, we included all dilutive stock
options in the calculation of diluted net income per share, and we excluded convertible debt
because its effect is anti-dilutive. For the three months ended March 31, 2004 we also included all
warrants in the calculation. No warrants were outstanding in 2005. The calculation of basic and diluted net income per share is as follows (in thousands except
per share amounts): Three Months EndedMarch 31,2005
    
    
    2004Net income
    
    $
    1,041
    
    
    $
    1,873Weighted average shares outstanding:Basic common shares
    
    
    35,699
    
    
    
    33,587Effect of dilutive options
    
    
    2,315
    
    
    
    2,262Effect of dilutive warrants
    
    
    
    
    
    
    38Total weighted average common shares
    
    
    38,014
    
    
    
    35,887Net income per share:Basic
    
    $
    0.03
    
    
    $
    0.06Dilutive
    
    $
    0.03
    
    
    $
    0.05
 We excluded the following weighted-average options and convertible debt from the calculation
of diluted net income per share as their effect would be anti-dilutive (in thousands): Three Months EndedMarch 31,2005
    
    
    2004Options
    
    
    255
    
    
    
    19Convertible Debt
    
    
    4,203
    
    
    
    4,203Convertible Debt
    
    
    4,458
    
    
    
    4,222
 In 2005 and subsequent years, our dilutive securities may include incremental shares issuable
upon conversion of all or part of the $200 million in 2.00% convertible senior notes. Since the
$200 million principal amount can only be redeemed for cash, it has no impact on the diluted
earnings per share calculation. The conversion feature of these notes, that may result in our
payment of a stock premium along with redeeming the accreted principal amount for cash, is
triggered when our common stock reaches a certain market price. In accordance with the consensus
from EITF No. 04-8 we will include the dilutive effect of our notes in the calculation of income
per diluted share when the impact is dilutive. As of March 31, 2005, the conversion feature of
these notes did not have a dilutive affect as the weighted average market price of our common stock
did not exceed the initial conversion price of $35.46 to trigger any shares to be issuable upon
conversion. Therefore, the notes had no effect on our dilutive securities or our income per diluted
share for the period ended March 31, 2005. 7




---



##### Table of Contents



3. Comprehensive Income The components of comprehensive income are as follows (in thousands): Three Months EndedMarch 31,2005
    
    
    2004Net income
    
    $
    1,041
    
    
    $
    1,873Foreign currency translation adjustment
    
    
    (82
    )
    
    
    (129
    )Change in unrealized gain (loss) on
securities, net of reclassification
adjustments for realized gain (loss)
    
    
    (222
    )
    
    
    (116
    )Comprehensive income
    
    $
    737
    
    
    $
    1,628
 Accumulated other comprehensive income recorded in stockholders equity included $55,000 of net
unrealized gains on investments and $1.0 million of foreign currency translation adjustments as of
March 31, 2005 and, as of December 31, 2004, included $276,000 of net unrealized gains on
investments and $1.1 million of foreign currency translation adjustments. 4. Convertible Senior Notes and Stock Repurchase On March 23, 2005, we issued $150 million of 2.00% convertible senior notes due March 30, 2015
to qualified institutional buyers in a private placement exempt from registration pursuant to Rule
144A of the Securities Act of 1933, as amended. The initial purchasers exercised in full an option
to purchase up to an additional $50 million principal amount of notes with the same terms, and the
sale was completed on March 30, 2005. The notes were sold at par and we received net cash proceeds
of $159 million after expenses of $6.0 million and net of approximately $35.0 million used to
repurchase our common stock. We repurchased 1,332,300 shares of common stock at an average price of
$26.27 per share. The notes are senior, unsecured obligations and rank equal in right of payment with all of our
existing and future unsecured and unsubordinated debt. The notes are convertible into cash or,
under certain circumstances, cash and shares of our common stock. The initial conversion rate of
the note is 28.1972 shares of common stock per each $1,000 principal amount of notes, subject to
adjustment in certain circumstances, which represents a conversion price of approximately $35.46
per share. This conversion price is higher than the prices of our common stock on the dates the
notes were issued. The notes bear interest at a rate of 2.00% per annum for the initial five
year period, which is payable in arrears on March 30 and September 30 of each year until March 30, 2010.
The first interest payment will be made on September 30, 2005. For the remaining five year period
commencing on March 30, 2010, we will pay contingent interest for six-month periods if the average
trading price of a note is above a specified level for a specified period prior to the six month
period. In addition, beginning on March 30, 2010, the original principal amount shall be increased at a rate that provides holders with an aggregate annual yield to maturity of 2.00%. The holders may convert the notes under the following circumstances: (1) on or before March
30, 2009, if the closing sale price of our common stock is above a specified level, (2) at any time
after March 30, 2009, or (3) if a specified fundamental change occurs, such as a merger or
acquisition of the company. On or after March 30, 2010, holders of the notes may require us to
repurchase all or a portion of their notes at 100% of the principal amount of the notes plus
accrued and unpaid interest. On or after April 4, 2010, at our option, we may redeem all or a
portion of the notes at a redemption price equal to the accreted principal amount of the notes to
be redeemed plus accrued and unpaid interest. If we undergo a specified fundamental change, holders
will have the right, at their option, except in certain defined circumstances, to require us to
purchase for cash all or any portion of their notes at a price equal to the accreted principal
amount plus accrued and unpaid interest. If a holder elects to convert its notes in connection with
the occurrence of a specified fundamental change, the holder will be entitled to receive additional
shares of common stock upon conversion in certain circumstances. At March 31, 2005, we did not have a sufficient number of shares of common stock to issue to a
holder upon conversion of the notes. Accordingly, if shares of common stock were not provided
pursuant to the exchange arrangement, then we were permitted to issue shares of our newly created
Series C Preferred Stock in lieu of common stock. The Series C Preferred Stock is convertible into
shares of common stock at a rate of 1,000 shares of common stock for every 1.1 shares of Series C
Preferred Stock, contingent upon the reservation of sufficient shares of common stock. At our
annual meeting held on April 22, 2005, our stockholders approved the increase of our authorized
shares of common stock from 50 million to 100 million shares. As a result, there are a sufficient number of shares of common stock to issue to holders upon conversion. We included offering expenses estimated at $6.7 million related to the issuance of these notes
in debt issuance costs, deposits, and other assets as of March 31, 2005. We are amortizing those
expenses on a straight-line basis over the ten year contractual term of the notes. 8




---



##### Table of Contents



5. Inventory The components of inventory are as follows (in thousands): March 31,
    
    
    December 31,2005
    
    
    2004Raw materials
    
    $
    1,589
    
    
    $
    677Finished goods
    
    
    5,978
    
    
    
    4,343Total inventory
    
    $
    7,567
    
    
    $
    5,020
 As of March 31, 2005, inventory included $636,000 in raw materials
for Velac, a product not yet approved by the Food and Drug Administration, or FDA, for commercial
use, but with a planned launch in the second half of 2005. 6. Goodwill and Other Intangible Assets There were no changes in the carrying amount of goodwill during the three months ended March
31, 2005. The components of our other intangible assets are as follows (in thousands): March 31, 2005
    
    
    December 31, 2004Useful Life
    
    
    Gross Carrying
    
    
    Accumulated
    
    
    
    
    
    
    Gross Carrying
    
    
    Accumulatedin Years
    
    
    Amount
    
    
    Amortization
    
    
    Net
    
    
    Amount
    
    
    Amortization
    
    
    NetAcquired product rights
    
    
    10
    
    
    $
    127,652
    
    
    $
    (13,829
    )
    
    $
    113,823
    
    
    $
    127,652
    
    
    $
    (10,638
    )
    
    $
    117,014Existing technology
    
    
    10
    
    
    
    6,810
    
    
    
    (2,696
    )
    
    
    4,114
    
    
    
    6,810
    
    
    
    (2,525
    )
    
    
    4,285Patents
    
    
    10-13
    
    
    
    1,661

    
    
    
    (610
    )
    
    
    1,051
    
    
    
    1,661
    
    
    
    (572
    )
    
    
    1,089Total
    
    
    
    
    
    $
    136,123
    
    
    $
    (17,135
    )
    
    $
    118,988
    
    
    $
    136,123
    
    
    $
    (13,735
    )
    
    $
    122,388
 Amortization expenses for our other intangible assets were $3.4 million for the three
months ended March 31, 2005, and $1.3 million for the three months ended March 31, 2004. The expected future amortization expense of our other intangible assets is as follows (in
thousands): AmortizationExpenseRemaining nine months in 2005
    
    $
    10,198For 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
    
    
    13,598For the year ending December 31, 2010
    
    
    13,598Thereafter
    
    
    40,800$
    118,988
 7. Guaranties and Indemnifications In November 2002, the FASB issued Interpretation No. 45, Guarantors Accounting and
Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others,
or 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. FIN No. 45 also
requires the guarantor to make additional disclosures about the obligations associated with its
guarantees in its interim and annual financial statements. 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 we could be required to
make under these indemnification provisions is unlimited. The estimated fair value of the indemnity
obligations of these agreements is insignificant. Accordingly, we have no liabilities recorded for
these agreements as of March 31, 2005. We have not incurred material costs to defend lawsuits or
settle claims related to these indemnification provisions. 9




---



##### Table of Contents



8. Acquisition of Soriatane Product Line On March 4, 2004, we acquired from Hoffmann-La Roche Inc., or Roche, the exclusive U.S. rights
to Soriatane-brand acitretin, an approved oral therapy for the treatment of severe psoriasis in
adults. We have recognized revenue, net of applicable reserves, for all sales of the product from
March 4, 2004. Under the terms of the purchase agreement, we paid Roche a total of $123 million in
cash to acquire the rights to Soriatane. We also assumed certain liabilities totaling $4.1 million
in connection with returns, rebates and chargebacks associated with Roches prior sales of
Soriatane and we purchased Roches existing inventory of Soriatane at a cost of approximately $1.5
million. The total value of the acquired product rights for accounting purposes was $127 million,
including transaction related costs of approximately $500,000. This amount is being amortized over
the ten year estimated useful life of Soriatane. 9. UCB Co-Promotion Agreement In March 2004, we entered into an agreement with UCB Pharma Inc., or UCB, a subsidiary of UCB
Group Inc., pursuant to which we authorized UCB to promote OLUX and Luxíq to a segment of U.S.
primary care physicians, or PCPs. In July 2004, UCB acquired Celltech plc, and in connection with
other post-acquisition changes, UCB notified us that it intended to discontinue the co-promotion
agreement effective March 31, 2005. UCB continued to promote OLUX and Luxíq until that date. We
recorded 100% of the revenue from sales generated by promotional efforts of UCB and paid UCB a
portion of revenue as a promotional expense, which is included in selling, general and
administrative expense. UCB bore the marketing costs for promoting the products (including product
samples, marketing materials, etc.). We do not have any financial obligation to UCB on
prescriptions generated by PCPs after March 31, 2005. 10. Commitments Our commitments, including those disclosed in our Annual Report on Form 10-K for the year
ended December 31, 2004, consist primarily of operating lease agreements for our facilities as well
as minimum purchase commitments under one of our contract manufacturing agreements, minimum royalty
commitments under one of our license agreements, and noncancellable purchase orders as of December
31, 2004. In March 2005, we received landlord approval for a sublease signed in August 2004 for
approximately 19,500 square feet of office space in Palo Alto, California. Payments under the
sublease will commence on January 1, 2006. As a result of this new leasing arrangement, our operating lease payments will increase as
follows (in thousands): Increase inOperating LeasePaymentsFor the year ending December 31, 2006
    
    $
    339For the year ending December 31, 2007
    
    
    303For the year ending December 31, 2008
    
    
    315For the year ending December 31, 2009
    
    
    338For the year ending December 31, 2010
    
    
    88Thereafter
    
    
    $
    1,383
 11. Subsequent Event In April 2005, we entered into an agreement with Ventiv Pharma Services, LLC, or VPS, a
subsidiary of Ventiv Health, Inc., under which VPS will provide sales support for certain of our
products to primary care physicians and pediatricians. Product sales activities under this
agreement commenced in mid-April. VPS will promote OLUX, Luxíq and Evoclin. We will record 100% of
the revenue from product sales generated by promotional efforts of VPS. We will pay VPS a fee for
the personnel providing the promotional efforts and bear the marketing costs for promoting the
products including product samples and marketing materials. 10




---



##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations This discussion and analysis should be read in conjunction with the MD&A included in our
Annual Report onForm 10-Kfor the year ended December 31, 2004, 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 under the
caption Factors Affecting Our Business and Prospects in our 2004 Annual Report onForm 10-K. Our
historical operating results are not necessarily indicative of the results to be expected in any
future period. Overview We are a specialty pharmaceutical company that develops and commercializes innovative products
for the dermatology market. This market is characterized by a large patient population that is
served by relatively small, and therefore more accessible, groups of treating physicians. Our
products aim to improve the management of dermatological diseases and provide significant product
differentiation. We have branded our proprietary foam drug delivery vehicle, VersaFoam®. We currently market four pharmaceutical products:  
    OLUX®, a super high-potency topical steroid prescribed for the treatment of steroid responsive dermatological diseases;
    Luxíq®, a mid-potency topical steroid prescribed for scalp dermatoses such as
psoriasis, eczema and seborrheic dermatitis;
    Soriatane®, an oral medicine for the treatment of severe psoriasis; and
    Evoclin, a topical treatment for acne vulgaris. We began selling Soriatane in March 2004 after we acquired the U.S. product rights from Roche.
We launched Evoclin commercially in December 2004 after we received product approval from the FDA.
Sales of these new products contributed significantly to our revenue growth in 2004 and into 2005. In March 2005, we completed a private placement of convertible senior notes maturing March 30,
2015 in the principal amount of $200 million to qualified institutional buyers. We received net
cash proceeds of approximately $159 million after expenses and net of approximately $35 million
used to repurchase our common stock. The notes are convertible into cash and, under specified
circumstances, shares of common stock at an initial conversion price of approximately $35.46 per
share. We expect to use the net proceeds from the sale of the notes for general corporate
purposes, including potential future product or company acquisitions, capital expenditures, and
working capital. In April 2005, we entered into an agreement with Ventiv Pharma Services, LLC, or VPS, a
subsidiary of Ventiv Health, Inc., under which VPS will provide sales support for certain of our
products to primary care physicians and pediatricians. Product sales activities under this
agreement commenced in mid-April. VPS will promote OLUX, Luxíq and Evoclin. We will record 100% of
the revenue from product sales generated by promotional efforts of VPS. We will pay VPS a fee for
the personnel providing the promotional efforts and bear the marketing costs for promoting the
products including product samples and marketing materials. Critical Accounting Policies We made 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, 2004. 11




---



##### Table of Contents



Results of Operations Revenues Three Months EndedMarch 31,(In thousands)2005
    
    
    2004Product revenues:Soriatane
    
    $
    17,581
    
    
    $
    3,640OLUX
    
    
    15,792
    
    
    
    14,370Luxiq
    
    
    5,654
    
    
    
    5,471Evoclin
    
    
    3,067
    
    
    
    Other
    
    
    96
    
    
    
    85Total product revenues
    
    
    42,190
    
    
    
    23,566Royalty and contract:Royalty
    
    
    98
    
    
    
    1,353Contract
    
    
    83
    
    
    
    63Total royalty and contract revenues
    
    
    181
    
    
    
    1,416Total revenues
    
    $
    42,371
    
    
    $
    24,982
 Our product revenues were $42.2 million for the three months ended March 31, 2005, compared to
$23.6 million for the three months ended March 31, 2004. Total product revenues increased $18.6
million or 79% in the first three months of 2005 as compared to the same period in 2004. The
introduction of two new products, Soriatane in March 2004 and Evoclin in December 2004, accounted
for 91% of the increase in product revenues. For our other marketed products, primarily OLUX and
Luxiq, increased sales volumes accounted for 6% of the increase in total product revenues and
higher sales prices accounted for the remaining 3%. During the three months ended March 31, 2005,
we recorded an increase in revenue of $445,000 related to the reduction of certain revenue reserves
recorded on sales of Soriatane through December 31, 2004. We reduced the reserves to reflect our
actual experience of chargebacks processed since the acquisition of the Soriatane product rights. Royalty and contract revenues were $0.2 million for the three months ended March 31, 2005,
compared to $1.4 million for the three months ended March 31, 2004. Royalty and contract revenues
were lower for the first quarter of 2005 compared to the same period in the prior year due to the
final royalty payment of $1.2 million made by S.C. Johnson in the first quarter of 2004. Cost of Product Revenues Our cost of product revenues includes the third party costs of manufacturing OLUX, Luxiq and
Evoclin, the cost of Soriatane inventory acquired from Roche, depreciation costs associated with
Connetics-owned equipment located at the DPT facility in Texas, allocation of overhead, royalty
payments based on a percentage of our product revenues, product freight and distribution costs from
SPS and certain manufacturing support and quality assurance costs. We recorded cost of product revenues of $3.8 million for the three months ended March 31,
2005, compared to $1.6 million for the three months ended March 31, 2004, for an increase of $2.2
million or 138%. The increase was primarily due to $0.7 million of increased production costs
relating to our new products Soriatane and Evoclin, $0.7 million of increased royalty payments
resulting primarily from royalties paid on Soriatane sales to a U.S.-based distributor that exports
branded pharmaceuticals to select international markets, and $0.8 million of increased overhead
costs allocated to cost of finished goods sold. Amortization of Intangible Assets We recorded amortization expenses of $3.4 million for the three months ended March 31, 2005,
compared to $1.3 million for the three months ended March 31, 2004, for an increase of $2.1
million. The increase is the result of a full quarters amortization in the first quarter of 2005
of the Soriatane product rights acquired in March 2004. 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. Year to year changes in research and
development expenses are primarily due to the timing of and sample sizes required for particular
trials. 12




---



##### Table of Contents



For the three months ended March 31, 2005, research and development costs increased to $5.9
million from $4.4 million in the same period in 2004, for an increase of $1.5 million or 34%. The
increase is primarily attributable to $0.8 million for increased clinical trial activity in 2005 as
compared to 2004 and $0.6 million due to increased headcount costs. Selling, General and Administrative Expenses Selling, general and administrative expenses include sales and marketing activities as well as
expenses and costs associated with finance, legal, insurance, marketing, sales, and other
administrative matters. Selling, general and administrative expenses were $27.8 million for the
three months ended March 31, 2005, compared to $15.3 million for the comparable period in 2004. The
increase consists of $5.2 million in increased direct and indirect promotional activities, $1.5
million in increased headcount costs in the marketing, general and administrative departments, $2.9
million in marketing and sales expenses such as tradeshows, advertising and conventions and $1.0
million in increased product samples and market research costs. Interest and other income (expense), net Interest income was $0.5 million for the three months ended March 31, 2005, compared to $0.3
million for the three months ended March 31, 2004. The increase in interest income was primarily
due to higher market interest rates on investments. The investment proceeds from the March 2005
sale of convertible senior notes had an insignificant effect on interest income in the quarter. Interest expense was $0.8 million for the three months ended March 31, 2005, compared to $0.7
million for the same period in 2004. The increase in interest expense was primarily due to the sale
of convertible senior notes in March 2005. Income Taxes We recognized an income tax expense of $0.1 million for the three months ended March 31, 2005
primarily related to U.S. Federal income taxes. For the three months ended March 31, 2004, we
recognized an income tax expense of $0.2 million primarily related to foreign income taxes on our
activities in Australia. Liquidity and Capital Resources Working Capital We have financed our operations to date primarily through proceeds from equity and debt
financings, and product revenues. Cash, cash equivalents and marketable securities totaled $233.7
million at March 31, 2005, up from $72.4 million at December 31, 2004. The increase of $161.3
million was primarily due to receipt of the net cash proceeds of $194.0 million from the issuance
of convertible senior notes, partially offset by a $35.0 million repurchase of our common stock.
For a more complete description of the terms of the debt instruments and sales, refer to Note 4 in
the Notes to Condensed Consolidated Financial Statements elsewhere in this Report. Net cash
generated from operating activities for the first quarter of 2005 was $2.3 million. Working capital at March 31, 2005 was $233.1 million compared to $71.2 million at December 31,
2004. In addition to the increased amounts identified above, the other significant change in
working capital during the first quarter of 2005 was an increase of $2.5 million in inventory to
support increased product sales and the planned launch of Velac in the second half of 2005. Capital Expenditures We made capital expenditures of $1.4 million for the three months ended March 31, 2005
compared to $0.4 million for the same period in 2004. The expenditures in 2005 were primarily for
leasehold improvements on, and laboratory equipment purchased for, our new corporate headquarters,
which we occupied at the end of February 2005. Capital Resources We believe our existing cash, cash equivalents and marketable securities, and cash generated
from product sales will be sufficient to fund our operating expenses, debt obligations and capital
requirements through at least the next 12 months. We cannot be certain of the amount of our future
product revenues. Our product sales may be impacted by patent risks and competition from new
products. 13




---



##### Table of Contents



Products under development may not be safe and effective or approved by the FDA, or we may be
unable to produce them in commercial quantities at reasonable costs. Additionally, our products may
not gain satisfactory market acceptance. The amount of capital we require for operations in the
future depends on numerous factors, including the level of product revenues, the extent of
commercialization activities, the scope and progress of our clinical research and development
programs, the time and costs involved in obtaining regulatory approvals, the cost of filing,
prosecuting, and enforcing patent claims and other intellectual property rights, and competing
technological and market developments. If we need funds in the future to in-license or acquire
additional marketed or late-stage development products, a portion of the funds may come from our
existing cash, which will result in fewer resources available to our current products and clinical
programs. In order to take action on business development opportunities we may identify in the
future, we may need to use some of our available cash, or raise additional cash by liquidating some
of our investment portfolio and/or raising additional funds through equity or debt financings. 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 we need them, we may not be able to market our
products as planned or continue development of potential products, or we could be required to
delay, scale back or eliminate some or all of our research and development programs. Contractual Obligations and Commercial Commitments Our commitments, including those disclosed in our Annual Report on Form 10-K for the year
ended December 31, 2004, consist primarily of operating lease agreements for our facilities as well
as minimum purchase commitments under one of our contract manufacturing agreements, minimum royalty
commitments under one of our license agreements, and noncancellable purchase orders as of December
31, 2004. In March 2005, we received landlord approval for a sublease signed in August 2004 for
approximately 19,500 square feet of office space in Palo Alto, California. Payments for the
sublease will commence on January 1, 2006. As a result of this new leasing arrangement, our operating lease payments will increase as
follows (in thousands): Increase inOperating LeasePaymentsFor the year ending December 31, 2006
    
    $
    339For the year ending December 31, 2007
    
    
    303For the year ending December 31, 2008
    
    
    315For the year ending December 31, 2009
    
    
    338For the year ending December 31, 2010
    
    
    88Thereafter
    
    
    $
    1,383
 Recent Accounting Pronouncements In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123
(revised 2004), Share-Based Payment, or SFAS 123R, which requires companies to measure and
recognize compensation expense for all stock-based awards at fair value. Stock-based awards include
grants of employee stock options. SFAS 123R replaces Statement of Financial Accounting Standards
No. 123 Accounting for Stock-Based Compensation, or SFAS 123, and supersedes Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. SFAS 123R requires
companies to recognize all stock-based awards to employees and to reflect those awards in the
financial statements based on the fair values of the awards. In April 2005, the SEC modified the
effective date for SFAS 123R, resulting in the pronouncement being effective for all annual periods
beginning after June 15, 2005. We are required to adopt SFAS 123R in our fiscal year beginning
January 1, 2006, after which the profroma disclosures previously permitted under SFAS 123 will no
longer be an alternative to financial statement recognition. Under SFAS 123R, we must determine the
appropriate fair value model to be used for valuing share-based awards, the amortization method for
compensation cost, and the transition method to be used at date of adoption. The transition methods
include options for adopting the model retroactively or prospectively. The prospective method
requires that we record compensation expense for all unvested stock options and restricted stock at
the beginning of the year of we adopt of SFAS 123R. Under the retroactive method, we may restate
prior periods either as of the beginning of the year of adoption or for all periods presented, and
we would record compensation expense for all unvested stock options and restricted stock beginning
with the first period restated. We are evaluating the requirements of SFAS 123R and we expect 14




---



##### Table of Contents



that the adoption of SFAS 123R will have a material impact on our consolidated results of
operations and earnings per share. We have not yet determined which method of adoption we will use
or the effect of adopting SFAS 123R, and we have not determined whether the adoption will result in
amounts that are similar to the current pro forma disclosures under SFAS 123. On September 30, 2004, the Emerging Issues Task Force, or EITF, reached a consensus on Issue
No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share,concluding
that contingently convertible debt instruments should be included in diluted earnings per share
computations (if dilutive) regardless of whether the market price trigger (or other contingent
feature) has been met. This consensus is effective for reporting periods ending after December 15,
2004, and requires companies to restate prior period earnings per share amounts presented for
comparative purposes utilizing a transition method. As of December 31, 2004, we had no outstanding
contingently convertible debt. In March 2005, we issued contingently convertible debt and adopted
the consensus. Our adoption of EITF No. 04-8 had no impact on diluted earnings per share for the
three months ended March 31, 2005 or for prior years. 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, 2004,
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 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 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. 15




---



##### Table of Contents



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, 2004. 
 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
March 31, 2005. Our disclosure controls and procedures are designed with the objective of ensuring
that information required to be disclosed in our reports filed under the Securities Exchange Act of
1934 is recorded, processed, summarized and reported within the time periods specified in the SECs
rules and forms. Based on their evaluation, the CEO and CFO concluded that our disclosure controls
and procedures were effective in timely alerting them to material information required to be
included in our periodic SEC reports. In addition, our CEO and CFO concluded that during the
quarter ended March 31, 2005, there was 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. 16




---



##### Table of Contents



PART II. OTHER INFORMATION 
 Item 2. Purchase of Equity Securities by the Issuer Total Number of
    
    
    MaximumShares Purchased
    
    
    Number ofas Part of
    
    
    Shares that MayPublicly
    
    
    Yet Be PurchasedPeriod
    
    Total Number of
    
    
    Average Price
    
    
    Announced
    
    
    Under the2005
    
    Shares Purchased
    
    
    per Share Paid
    
    
    Programs
    
    
    ProgramsJanuary 1 to 31
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    February 1 to 28
    
    
    
    

    
    
    
    
    
    
    
    
    
    
    March 1 to 31
    
    
    1,332,300
    
    
    
    26.27
    
    
    
    
    
    
    
    Total
    
    
    1,332,300
    
    
    
    26.27
    
    
    
    
    
    
    
    
 In
March 2005, concurrent with the private placement of senior
convertible notes, we repurchased
1.3 million shares of our common stock at an average price of $26.27. The sale of the convertible
notes and repurchase of our shares was reported on a Form 8-K filed on March 25, 2005, which is
incorporated herein by reference. We do not have a plan or program to repurchase any additional shares of our common stock. 
 Item 6.Exhibits ExhibitNumber
    
    Description10.1*
    
    Service Agreement between Ventiv Pharma Services, LLC and Connetics Corporation, dated March 1, 200510.2
    
    Sublease Agreement for 1841 Page Mill Road, Palo Alto, California, dated August 9, 200410.3
    
    Non-Qualified Stock Option Agreement between Connetics Corporation and James A. Trah31.1
    
    Rule 13a-14(a) Certification of the Chief Executive Officer31.2
    
    Rule 13a-14(a) Certification of the Chief Financial Officer32.1
    
    Section 1350 Certification of the Chief Executive Officer 32.2
    
    Section 1350 Certification of the Chief Executive Officer 
   *
    
    Portions of this exhibit have been omitted and filed separately with the Commission.
Confidential treatment has been requested with respect to the omitted portions.
    
    The certifications attached as Exhibits 32.1 and 32.2 that accompany this quarterly
report on Form 10-Q, are not deemed filed with the Securities and Exchange Commission and are
not to be incorporated by reference into any filing of Connetics Corporation under the
Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended,
whether made before or after the date of this Form 10-Q, irrespective of any general
incorporation language contained in such filing. 17




---



##### Table of Contents



SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly
caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Connetics CorporationBy:
    /s/ John L. HigginsJohn L. 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: May 10, 2005 18




---



##### Table of Contents



INDEX TO EXHIBITS ExhibitNumber
    
    Description10.1*
    
    Service Agreement between Ventiv Pharma Services, LLC and Connetics Corporation, dated March 1, 200510.2
    
    Sublease Agreement for 1841 Page Mill Road, Palo Alto, California, dated August 9, 200410.3
    
    Non-Qualified Stock Option Agreement between Connetics Corporation and James A. Trah31.1
    
    Rule 13a-14(a) Certification of the Chief Executive Officer31.2
    
    Rule 13a-14(a) Certification of the Chief Financial Officer32.1
    
    Section 1350 Certification of the Chief Executive Officer 32.2
    
    Section 1350 Certification of the Chief Executive Officer 
   *
    
    Portions of this exhibit have been omitted and filed separately with the Commission.
Confidential treatment has been requested with respect to the omitted portions.
    
    The certifications attached as Exhibits 32.1 and 32.2 that accompany this quarterly
report on Form 10-Q, are not deemed filed with the Securities and Exchange Commission and are
not to be incorporated by reference into any filing of Connetics Corporation under the
Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended,
whether made before or after the date of this Form 10-Q, irrespective of any general
incorporation language contained in such filing. 19