Connetics Corp · 10-Q · For 9/30/01

Filed On 11/14/01   ·   SEC File 0-27406   ·   Accession Number 891618-1-502227

Quarterly Report   ·   Form 10-Q
Filing Table of Contents

Document/Exhibit                   Description                      Pages   Size 

 1: 10-Q        Form 10-Q for Period Ended 9/30/01                    29    140K 
 2: EX-10.1     Material Contract                                     29     98K 
 3: EX-10.2     Material Contract                                     24    125K 
 4: EX-10.3     Material Contract                                     11     23K 
 5: EX-10.4     Material Contract                                     16     36K 
 6: EX-10.5     Material Contract                                     15     52K 

10-Q   ·   Form 10-Q for Period Ended 9/30/01
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 UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 FORM 10-Q

 QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 SECURITIES EXCHANGE ACT OF 1934

 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001

 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 Employer  
  incorporation or organization)                        Identification Number)

 3400 WEST BAYSHORE ROAD
 PALO ALTO, CALIFORNIA 94303
(Address of principal executive offices)

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

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

As of November 8, 2001, 30,032,722 shares of the Registrant's common stock were 
outstanding, at $0.001 par value.                                               

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 CONNETICS CORPORATION
 TABLE OF CONTENTS

                                                                [Download Table]

                                                                                Page
                                                                                ----
                                                                                    
PART I. FINANCIAL INFORMATION                                                       

     Item 1. Condensed Consolidated Financial Statements                            

             Condensed Consolidated Balance Sheets at September 30, 2001 and        
             December 31, 2000 ................................................   3 

             Condensed Consolidated Statements of Operations for the three          
             months and  nine months ended September 30, 2001 and 2000 ........   4 

             Condensed Consolidated Statements of Cash Flows for the nine           
             months ended September 30, 2001 and 2000 .........................   5 

             Notes to Condensed Consolidated Financial Statements .............   6 

     Item 2. Management's Discussion and Analysis of Financial Condition and        
             Results of Operations ............................................  12 

     Item 3. Quantitative and Qualitative Disclosures About Market Risks ......  26 

PART II. OTHER INFORMATION                                                          

     Item 6. Exhibits and Reports on Form 8-K .................................  27 

             (a) Exhibits .....................................................  27 

             (b) Reports on Form 8-K ..........................................  27 

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PART I. FINANCIAL INFORMATION                                                   

ITEM 1. FINANCIAL STATEMENTS                                                    

 CONNETICS CORPORATION
 CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)

                                                                [Download Table]

                                                     September 30,  December 31,
                                                         2001          2000     
                                                      (unaudited)     (Note 1)  
                                                     ------------   ------------
                                                                                
                              ASSETS                                            

Current assets:                                                                 
  Cash and cash equivalents                          $  15,997      $  58,577   
  Short-term investments                                34,814         21,607   
  Accounts receivable                                    4,309          2,749   
  Other current assets                                   1,398            545   
                                                     ---------      ---------   
          Total current assets                          56,518         83,478   

Property and equipment, net                              2,465          1,807   
Deposits and other assets                                  329            428   
Goodwill and other purchased intangibles, net           14,033             --   
                                                     ---------      ---------   
Total assets                                         $  73,345      $  85,713   
                                                     =========      =========   

                      LIABILITIES AND STOCKHOLDERS' EQUITY                      

Current liabilities:                                                            
  Accounts payable                                   $   3,933      $   5,115   
  Accrual for Relaxin related liabilities                5,534             --   
  Accrued process development expenses                   1,127          1,389   
  Accrued payroll and related expenses                   2,118          1,797   
  Other accrued liabilities                              2,055          3,228   
  Notes payable and capital lease obligations               --            787   
  Current portion of deferred revenue                      332            132   
                                                     ---------      ---------   
          Total current liabilities                     15,099         12,448   

Deferred revenue                                           560            659   

Stockholders' equity:                                                           
Preferred stock                                             --             --   
Common stock and additional paid-in capital            161,816        159,242   
Deferred compensation                                       (7)           (21)  
Accumulated deficit                                   (109,196)       (92,756)  
Accumulated other comprehensive income                   5,073          6,141   
                                                     ---------      ---------   
          Total stockholders' equity                    57,686         72,606   
                                                     ---------      ---------   
Total liabilities and stockholders' equity           $  73,345      $  85,713   
                                                     =========      =========   

See accompanying notes to condensed consolidated financial statements.

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 CONNETICS CORPORATION
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 (UNAUDITED)

                                                        [Enlarge/Download Table]

                                                       Three Months Ended      Nine Months Ended     
                                                          September 30,           September 30,      
                                                     ----------------------   ---------------------- 
                                                       2001          2000       2001          2000   
                                                     --------      --------   --------      -------- 
                                                                                                     
Revenues:                                                                                            
  Product                                               7,650      $  5,657   $ 21,882      $ 15,118 
  Royalty                                                 425            --        548            -- 
  Contract and other                                      123         1,430      1,789        16,094 
                                                     --------      --------   --------      -------- 
        Total revenues                                  8,198         7,087     24,219        31,212 
                                                     --------      --------   --------      -------- 

Operating costs and expenses:                                                                        
  Cost of sales                                           700           719      2,408         2,979 
  Research and development                              4,460         5,828     14,433        15,956 
  Selling, general and administrative                   8,761         6,765     26,071        18,330 
  Acquired in-process research and development             --            --      1,080            -- 
  Charge for Relaxin program                               --            --      5,976            -- 
                                                     --------      --------   --------      -------- 
  Total operating costs and expenses                   13,921        13,312     49,968        37,265 
                                                     --------      --------   --------      -------- 
Loss from operations                                   (5,723)       (6,225)   (25,749)       (6,053)

Interest and other income                                 491           659      3,022         1,305 
Gain on sale of investments                                --             4        122           707 
Gain on sale of Ridaura product line                       --            --      8,055            -- 
Interest and other expense                               (186)          (38)    (1,890)         (207)
                                                     --------      --------   --------      -------- 

Loss before cumulative effect of change in                                                           
   accounting principle                              $ (5,418)     $ (5,600)  $(16,440)     $ (4,248)
Cumulative effect of change in accounting principle        --            --         --        (5,192)
                                                     --------      --------   --------      -------- 
Net loss                                             $ (5,418)     $ (5,600)  $(16,440)     $ (9,440)
                                                     ========      ========   ========      ======== 

Basic and diluted loss per share:                                                                    

Loss per share before cumulative effect                                                              
  of change in accounting principle                  $  (0.18)     $  (0.19)  $  (0.55)     $  (0.15)

Cumulative effect of change in accounting principle        --            --         --      $  (0.19)

                                                     --------      --------   --------      -------- 
Net loss per share                                   $  (0.18)     $  (0.19)  $  (0.55)     $  (0.34)
                                                     ========      ========   ========      ======== 

Shares used to calculate loss per share                29,920        29,507     29,801        28,032 

See accompanying notes to condensed consolidated financial statements.

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 CONNETICS CORPORATION
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
 (UNAUDITED)

                                                        [Enlarge/Download Table]

                                                                              Nine Months Ended     
                                                                                 September 30,      
                                                                             ---------------------- 
                                                                               2001          2000   
                                                                             --------      -------- 
                                                                                                    
Cash flows from operating activities:                                                               
     Net loss                                                                $(16,440)     $ (9,440)
     Adjustments to reconcile net loss to net cash                                                  
         used in operating activities:                                                              
        Depreciation and amortization                                           1,339           548 
        Gain on sale of investment                                               (122)         (707)
        Gain on sale of Ridaura product line                                   (8,055)           -- 
        Stock compensation expense                                              1,554         1,384 
        In-process research and development                                     1,080            -- 
        Amortization of deferred compensation                                      14            14 
        Loss on foreign exchange forward contract                                 555            -- 
     Changes in assets and liabilities, excluding effects of acquisition           --            -- 
        Accounts receivable                                                        (8)         (123)
        Current and other assets                                                 (779)          (20)
        Accounts payable                                                       (1,348)       (3,015)
        Other current liabilities                                               1,843          (207)
        Deferred revenue                                                          101         5,126 
                                                                             --------      -------- 
     Net cash used in operating activities                                    (20,266)       (6,440)
                                                                             --------      -------- 

Cash flows from investing activities:                                                               
     Purchases of short-term investments                                      (40,439)      (13,522)
     Sales and maturities of short-term investments                            26,289        14,368 
     Purchases of property and equipment                                         (762)         (620)
     Proceeds from sale of Ridaura product line                                 8,979            -- 
     Acquisition of a business, net of cash acquired                          (16,611)           -- 
                                                                             --------      -------- 
     Net cash provided by (used in) investing activities                      (22,544)          226 
                                                                             --------      -------- 

Cash flows from financing activities:                                                               
     Payment of notes payable                                                    (750)       (2,453)
     Payments on obligations under capital leases and capital loans               (37)         (203)
     Proceeds from issuance of common stock, net of issuance costs              1,020        21,828 
                                                                             --------      -------- 
     Net cash provided by financing activities                                    233        19,172 
     Effect of foreign currency exchange rates on cash and cash equivalents        (3)           -- 
                                                                             --------      -------- 
     Net change in cash and cash equivalents                                  (42,580)       12,958 
     Cash and cash equivalents at beginning of period                          58,577         8,460 
                                                                             --------      -------- 
     Cash and cash equivalents at end of period                              $ 15,997      $ 21,418 
                                                                             ========      ======== 

Supplementary information:                                                                          
     Interest paid                                                           $     27      $    207 

Financing activity:                                                                                 
      Issuance of common stock as payment on accrued liabilities                   --      $    888 

See accompanying notes to condensed consolidated financial statements.

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 CONNETICS CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2001
 (UNAUDITED)

1.      BASIS OF PRESENTATION AND POLICIES                                      

  We have prepared the accompanying unaudited condensed consolidated
financial statements of Connetics Corporation ("Connetics") in accordance with  
generally accepted accounting principles for interim financial information and  
pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X.     
Accordingly, the financial statements do not include all of the information and 
footnotes required by generally accepted accounting principles for complete     
financial statements. In our opinion, all adjustments, consisting of normal     
recurring adjustments, considered necessary for a fair presentation have been   
included. Operating results for the nine months ended September 30, 2001 are not
necessarily indicative of the results that may be expected for the year ended   
December 31, 2001. Certain prior year balances have been reclassified for       
comparative purposes.                                                           

      These condensed, consolidated financial statements and notes should be
read in conjunction with audited financial statements and notes to those        
financial statements for the year ended December 31, 2000 included in our Annual
Report on Form 10-K as filed with the Securities and Exchange Commission.       

Principles of Consolidation                                                     

      The accompanying unaudited condensed consolidated financial statements
include the accounts of Connetics and its wholly-owned subsidiary, Soltec       
Research Pty Ltd. ("Soltec"). All significant intercompany accounts and         
transactions are eliminated in consolidation.                                   

Revenue Recognition                                                             

    Product Sales and Royalty Revenue. We recognize revenue from product
sales when there is persuasive evidence that an arrangement exists, when title
has passed, generally upon shipment, the price is fixed or determinable, and  
collectibility is reasonably assured. We recognize product revenue net of     
 allowances for estimated returns, rebates, and chargebacks. We are obligated to
accept from customers the return of pharmaceuticals that have reached their   
 expiration date. To date we have not experienced significant returns of expired
product. Royalties from licensees are based on third-party sales and are      
recognized in the quarter in which the royalty payment is either received from
the licensee or may be reasonably estimated, which is typically one quarter   
following the related sale of the licensee.                                   

Contract revenue. We record contract revenue for research and 
development as it is earned based on the performance requirements of the      
contract.                                                                     

We recognize non-refundable contract fees for which no further
performance obligation exists, and for which Connetics has no continuing      
involvement, on the earlier of when the payments are received or when         
collection is assured.                                                        

     We recognize revenue from non-refundable upfront license fees under
collaborative agreements ratably over the period in which we have continuing  
development obligations when,                                                 

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at the time the agreement is executed, there remains significant risk due to the
incomplete stage of the product's development.                                  

        Revenue associated with substantial "at risk" performance milestones, as
defined in the respective agreements, is recognized based upon the achievement  
of the milestones.                                                              

       Royalty expense directly related to product sales is classified in cost
of sales.                                                                       

Foreign Currency Translation                                                    

        The functional currency of Connetics' Australian subsidiary is the local
currency. The translation of the Australian currency into U.S. dollars is       
performed for balance sheet accounts using the exchange rates in effect at the  
balance sheet date and for revenue and expense accounts using a weighted average
exchange rate during the period. Foreign currency translation adjustments are   
recorded in comprehensive income (loss).                                        

Goodwill and Purchased Intangible Assets                                        

   Goodwill and purchased intangibles are amortized on a straight-line
basis over 10 year lives (See note 4).                                          

     We periodically perform reviews to determine if the carrying value of
long-term assets is impaired. The reviews look for the existence of facts or    
circumstances, either internal or external, which indicate that the carrying    
value of the asset cannot be recovered. No such impairment has been indicated to
date. If in the future, management determines the existence of impairment       
indicators, we would use undiscounted cash flows to initially determine whether 
impairment should be recognized. If necessary, we would perform subsequent      
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, the fair value would be calculated     
using the present value of estimated expected future cash flows or other        
appropriate valuation methodologies. The cash flow calculation would be based on
management's best estimates, using appropriate assumptions and projections at   
the time.                                                                       

Recent Accounting Pronouncements                                                

       Statement of Financial Accounting Standards No. 133 ("SFAS 133"): As of
January 1, 2001, Connetics adopted Financial Accounting Standards Board         
Statement No. 133, "Accounting for Derivative Instruments and Hedging           
Activities."                                                                    

As a result of the adoption of SFAS 133, we recognize derivative
financial instruments in our financial statements at their fair value,        
regardless of the purpose or intent for holding the instrument. Changes in the
fair value of derivative financial instruments are either recognized          
periodically in income or in stockholders' equity as a component of           
comprehensive income (loss) depending on whether the derivative financial     
 instrument qualifies for hedge accounting, and if so, whether it qualifies as a
fair value hedge or cash flow hedge.                                          

     Connetics entered into a foreign exchange forward contract related to
our acquisition of Soltec. That contract was entered into in relation to a      
business combination and does not qualify as a hedge under SFAS 133. The purpose
of the contract was to lock in to the purchase price paid for Soltec. As of the 
closing date, April 20, 2001, we incurred a loss of $0.6 million on this        

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contract. The foreign exchange forward contract was terminated on the closing   
date of the acquisition of Soltec.                                              

    Statement of Financial Accounting Standards No. 141 ("SFAS 141"): In
June 2001, the FASB issued Statement of Financial Accounting Standards No. 141, 
Business Combinations. SFAS 141 establishes new standards for accounting and    
reporting for business combinations and will require that the purchase method of
accounting be used for all business combinations initiated after June 30, 2001. 
This statement was adopted effective July 1, 2001. The adoption of SFAS 141 had 
no impact on our financial position or results of operations.                   

        Statement of Financial Accounting Standards No. 142 ("SFAS 142"): In
June 2001, the FASB issued Statement of Financial Accounting Standards No. 142, 
Goodwill and Other Intangible Assets, which establishes new standards for       
goodwill and other intangible assets, including the elimination of goodwill     
amortization, to be replaced with periodic evaluation of goodwill for           
impairment. SFAS 142 is effective for fiscal years ending after December 15,    
2001, but any goodwill and intangible assets resulting from a business          
combination after July 1, 2001 will be accounted for under SFAS 142. Goodwill   
and intangible assets from business combination before July 1, 2001 will        
continue to be amortized prior to the adoption of SFAS 142.                     

          Connetics will adopt SFAS 142 on January 1, 2002. Upon the adoption of
SFAS 142, we are required to evaluate our existing goodwill and intangibles     
assets from business combinations completed before July 1, 2001 and make any    
necessary reclassifications in order to comply with the new criteria in SFAS 141
for recognition of intangible assets.                                           

          At September 30, 2001, Connetics has goodwill and intangible assets of
$14.0 million subject to SFAS 141 and SFAS 142. Amortization expense for        
goodwill and intangible assets amounted to $0.4 million and $0.7 million for the
three and nine month periods ended September 30, 2001. Due to the extensive     
efforts needed to comply with the adoption of SFAS 142, it is not practical to  
reasonably estimate the impact of adoption of theses statements on our financial
statements at the date of this report, including whether any transitional       
impairment losses will be required to be recognized as a cumulative effect of a 
change in accounting principle.                                                 

          Statement of Financial Accounting Standards No. 144 ("SFAS 144"): In
October 2001, the FASB issued the Statement of Financial Accounting Standards   
No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets, which   
addresses financial accounting and reporting for the disposal of long-lived     
assets. SFAS 144 becomes effective for financial statements issued for fiscal   
years beginning after December 15, 2001 and interim periods within those fiscal 
years. Connetics is currently evaluating the potential impact, if any, the      
adoption of FAS 144 will have its financial position and results of operation.  

2.      NET INCOME (LOSS) PER SHARE                                             

      We compute basic net income (loss) per common share using the weighted
average number of shares outstanding during the period. We compute diluted net  
income per share using the weighted average of common and diluted equivalent    
stock options and warrants outstanding during the period. We excluded all stock 
option and warrants from the calculation of diluted loss per common share for   
the three and nine month periods ended September 30, 2001 and September 30, 2000
because these securities are anti-dilutive during these periods. The following  
table sets forth the computations for basic and diluted earnings per share.     

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                                                        [Enlarge/Download Table]

                                                Three months ended        Nine months ended     
                                                   September 30,            September 30,       
                                              -----------------------   ----------------------- 
(In thousand, except per share amounts)         2001           2000       2001          2000    
                                              --------       --------   --------       -------- 
                                                                                                
Numerator  for  basic  and  diluted earnings                                                    
  per share --                                                                                  
       Net income (loss)                      $ (5,418)      $ (5,600)  $(16,440)      $ (9,440)

Denominator for basic and diluted                                                               
  earnings per share                            29,920         29,507     29,801         28,032 
                                              --------       --------   --------       -------- 
Basic and diluted loss per share              $  (0.18)      $  (0.19)  $  (0.55)      $  (0.34)
                                              ========       ========   ========       ======== 

3. COMPREHENSIVE INCOME (LOSS)                                                  

       During the three and nine month periods ended September 30, 2001, total
comprehensive loss amounted to $5.1 million and $17.5 million, respectively,    
compared to a comprehensive income of $7.8 million and $47.0 million for the    
comparable periods in 2000. The components of comprehensive income (loss) for   
the three and nine month periods ended September 30, 2001 and September 30, 2000
are as follows:                                                                 

                                                        [Enlarge/Download Table]

                                       Three months ended        Nine months ended     
                                           September 30,            September 30,      
                                      ----------------------   ----------------------- 
(In thousands)                          2001          2000       2001           2000   
                                      -------       --------   --------       -------- 
                                                                                       
Net income (loss)                     $(5,418)      $ (5,600)  $(16,440)      $ (9,440)
Cumulative translation adjustment          (2)            --         (3)            -- 
Unrealized gain (loss) on securities      348         13,398     (1,064)        56,436 
                                      -------       --------   --------       -------- 
Comprehensive income (loss)           $(5,072)      $  7,798   $(17,507)      $ 46,996 
                                      =======       ========   ========       ======== 

4. ACQUISITION OF SOLTEC                                                        

             In April 2001, Connetics completed its acquisition of Soltec, a
division of Australia-based F.H. Faulding & Co Limited. Connetics' two marketed 
dermatology products and current product development programs are based on      
technology developed by Soltec. Soltec has been developing innovative delivery  
systems for new dermatology products for over 10 years, and has leveraged its   
broad range of drug delivery technologies by entering into license agreements   
with dermatology companies around the world. Those license agreements bear      
royalties payable to Soltec for currently marketed products, as well as         
potential future royalties for products under development. The acquisition was  
accounted for using the purchase method of accounting and accordingly, the      
purchase price was allocated to the assets acquired and liabilities assumed     
based on their estimated fair values on the acquisition date. Since April 19,   
2001, Soltec's results of operations have been included in the Connetics'       
consolidated statements of operations. The fair value of the intangible assets  
was determined based upon an independent valuation using a combination of       
methods, including an income approach for the in-process research and           
development and existing technology, a cost approach for the assembled workforce
and the royalty savings approach for the patents and core technology.           

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     Connetics purchased all of the shares of Soltec's capital stock for a
purchase price of approximately $16.9 million. The purchase price was allocated,
based on an independent valuation, to existing technology of $6.8 million,      
goodwill of $6.4 million, tangible net assets assumed of $1.3 million, patents  
and core technology of $1.2 million, acquired in-process research and           
development of $1.1 million, and assembled workforce of $0.1 million.           

    The value of the acquired in-process technology was computed using a
discounted cash flow analysis with a discount rate of 20% on the anticipated    
income stream and the expected completion stage of the related product revenues.
The acquired in-process research and development programs are in early stages of
development, have not reached technological feasibility, and have no foreseeable
alternative future uses. The value of the existing technology was computed using
a discounted cash flow analysis with a discount rate of 15%. The discounted cash
flow analysis was based on management's forecast of future revenues, cost of    
revenues and operating expenses related to the products and technologies        
purchased from Soltec. Amortization of the acquired intangibles and goodwill    
associated with this acquisition totaled $0.4 million and $0.7 million for the  
three and nine months ended September 30, 2001.                                 

     The following table presents unaudited pro forma results of operation
taking the transaction into account. The pro forma results are not necessarily  
indicative of what actually would have occurred if the transaction had been in  
effect for the entire periods presented, are not intended to be a projection of 
future results, and do not reflect any cost savings that might be achieved from 
the combined operations.                                                        

                                                                [Download Table]

                                                       Nine months ended     
                                                          September 30,      
                                                     ----------------------- 
                                                       2001           2000   
                                                     --------       -------- 
                                                           (Unaudited)       
                                                                             
Pro forma revenue                                    $ 26,144       $ 35,084 
                                                     ========       ======== 
Pro forma loss before cumulative effect of                                   
  change in accounting principle                     $(14,193)      $ (2,570)
Cumulative effect of change in accounting principle        --       $ (5,192)
                                                     --------       -------- 
Pro forma net loss                                   $(14,193)      $ (7,762)
                                                     ========       ======== 

BASIC AND DILUTED PRO FORMA EARNINGS PER SHARE:                              
Pro forma loss before cumulative effect of                                   
  change in accounting principle                     $  (0.48)      $  (0.09)

Cumulative effect of change in accounting principle        --       $  (0.19)
                                                     --------       -------- 
Pro forma net loss per share                         $  (0.48)      $  (0.28)
                                                     ========       ======== 

The pro forma loss amounts above exclude the charge for in-process research and 
development because of its non-recurring nature.                                

5. REDUCTION IN RELAXIN PROGRAM                                                 

 In May 2001, Connetics announced its decision to pursue a license
partner or other strategic alternative for its relaxin program. As a result, we 
have reduced our investment in the development of relaxin in favor of focusing  
our resources on expanding our dermatology business. During the second quarter, 
we eliminated 27 positions related to relaxin. We took a one-time charge of     
approximately $6.0 million in the second quarter of 2001, which represents      

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$0.5 million accrued in connection with the reduction in workforce as well as   
$5.5 million for the wind down of relaxin development contracts. Of the amounts 
accrued in the second quarter, $5.5 million remains accrued as of September 30, 
2001.                                                                           

      Boehringer Ingelheim, or BIA, manufactures relaxin for us for clinical
uses under a long-term contract. In July 2000, in anticipation of successful    
results in our relaxin clinical trial for scleroderma, we submitted a purchase  
order to BIA for product to be used for commercial supply. The purchase order   
was for a price to be negotiated. We have been in discussions with BIA since the
beginning of 2001 regarding whether any additional monies are owed under the    
contract in view of the failure of the clinical trial. In July 2001, following  
our May 2001 announcement about downsizing the relaxin program, BIA notified us 
that BIA believes we are in breach of the relaxin manufacturing agreement and   
that BIA intends to terminate the agreement and seek remedies if we do not      
remedy the alleged breach. We disagree with BIA's allegation that we have       
breached the contract. Nevertheless, consistent with other reserves taken in    
connection with the downsizing of the relaxin program, we have recorded a       
reserve for our potential exposure in the dispute with BIA. There can be no     
guarantee, however, that the actual resolution of this dispute will not result  
in charges in excess of the reserve we have recorded.                           

6. SALE OF RIDAURA                                                              

In April 2001, Connetics sold its rights to Ridaura(R) including
inventory and identified liabilities to Prometheus Laboratories Inc. for $9.0   
million in cash plus a royalty on annual sales in excess of $4.0 million for the
next five years. Ridaura(R) is a prescription pharmaceutical product for the    
treatment of rheumatoid arthritis. We accrued approximately $0.9 million for    
transaction related costs and contractual liabilities incurred as of the date of
the sale. After recognizing the above amounts, we recorded a gain of $8.1       
million on this transaction during the second quarter of 2001.                  

7. LICENSE OF LIQUIPATCH(TM) TECHNOLOGY                                         

      In June 2001, Connetics announced a global licensing agreement between
Soltec and a major international healthcare company for Soltec's innovative     
multi-polymer gel delivery system ("Liquipatch"). The agreement follows         
successful pilot development work and gives the licensee exclusive global right 
to use the Liquipatch technology in a field in dermatology, particularly for the
delivery of a topical over-the-counter product. The licensee will be responsible
for all development costs, and will be obligated to pay license fees, milestone 
payments, and royalties on future product sales. As of September 30, 2001, there
was no financial statement impact as a result of this agreement.                

8. LICENSING AGREEMENT WITH MIPHARM                                             

        In September 2001, Connetics and Soltec entered into a product licensing
agreement with Mipharm S.p.A. ("Mipharm"), based in Milan, Italy. The licensing 
agreement grants Mipharm commercial rights in Italy for OLUX(TM), (a topical    
foam formulation of clobetasol propianate), permethrin foam, and Hexifoam(TM), a
hand disinfectant. Connetics and Soltec received upfront license fees, and are  
entitled to milestone payments and royalties on future product sales. Connetics 
and Soltec retain marketing and manufacturing rights for the rest of Europe.    
Mipharm will be responsible for the costs and activities of obtaining the       
required product marketing approvals in the European Union for OLUX(TM).        
Connetics recognized $50,000 of revenue related to this agreement in the quarter
ended September 30, 2001.                                                       

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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION             
AND RESULTS OF OPERATIONS                                       

     This MD&A should be read in conjunction with the MD&A included in our
Annual Report on Form 10-K for the year ended December 31, 2000, and with the   
unaudited condensed consolidated financial statements and notes to financial    
statements included in this report and in the report on Forms 10-Q for the      
quarters ended March 31, 2001 and June 30, 2001, respectively. Except for       
historical information, the discussion in this report contains forward-looking  
statements that involve risks and uncertainties. When used in this report, the  
words "anticipate," "believe," "estimate," "will," "intend" and "expect" and    
similar expressions identify forward-looking statements. Although we believe    
that our plans, intentions and expectations reflected in these forward-looking  
statements are reasonable, these plans, intentions, or expectations may not be  
achieved. Some of the factors that, in our view, could cause actual results to  
differ are discussed under the caption "Factors That May Affect Future Results, 
Financial Condition and the Market Price of Securities" and in our Annual Report
on Form 10-K. Our historical operating results are not necessarily indicative of
the results to be expected in any future period.                                

OVERVIEW                                                                        

We currently market two pharmaceutical products, OLUX(TM) Foam  
(clobetasol propionate), 0.05% for the treatment of moderate to severe scalp    
dermatoses, and Luxiq(R) (betamethasone valerate) Foam, 0.12%, for the treatment
of mild to moderate scalp dermatoses. We launched OLUX on November 6, 2000. 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. Our two           
dermatology products have clinically proven therapeutic advantages and we       
provide quality customer service to physicians through our experienced sales and
marketing staff.                                                                

       In April 2001, we completed the acquisition of Soltec for approximately
$16.9 million. $1.1 million of the purchase price was allocated, based on an    
independent valuation, to in-process research and development, with the balance 
to the tangible assets of Soltec, existing technology and goodwill. As we are   
now focusing on our dermatology business, in April 2001 we sold our rights to   
Ridaura(R) including inventory to Prometheus Laboratories Inc. for $9.0 million 
in cash plus a royalty on annual sales in excess of $4.0 million for the next   
five years. Ridaura(R) is a prescription pharmaceutical product for the         
treatment of rheumatoid arthritis.                                              

In addition to our commercial business, we hold the rights to a 
biotechnology product that has the potential to treat multiple diseases, a      
recombinant form of a natural hormone called relaxin. Relaxin reduces the       
hardening, or fibrosis, of skin and organ tissue, dilates existing blood vessels
and stimulates new blood vessel growth. On May 23, 2001, we announced our       
decision to reduce our investment in the development of relaxin and to search   
for licensing opportunities or other strategic alternatives for the product. We 
eliminated 27 positions related to relaxin. The one-time charge in the second   
quarter of 2001 represents amounts accrued in connection with the reduction in  
workforce as well as a wind down of relaxin development contracts. For          
additional information, see "Risks Related to Our Products" for a discussion of 
the relationship with Boehringer Ingelheim.                                     

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RESULTS OF OPERATIONS                                                           

REVENUES                                                                

                                                                [Download Table]

                                    Three Months Ended    Nine months Ended  
                                      September 30,         September 30,    
                                   -------------------   --------------------
Revenues (In thousands)              2001       2000      2001         2000  
                                   ------      -------   -------      -------
                                                                             
Product:                                                                     
   Luxiq(R)                        $3,500        2,856   $10,795      $ 7,704
   OLUX(TM)                         4,100           --     9,022           --
   Ridaura                             --        2,801     2,015        5,516
   Actimmune                           --           --        --        1,898
   Soltec Product Revenue              50           --        50           --
                                   ------      -------   -------      -------
Total product revenues              7,650        5,657    21,882       15,118

Contract and royalty:                                                        
   Medeva (formerly Celltech)          --        1,125       756        8,377
   Suntory Ltd.                        --           47        --          139
   F.H. Faulding & Co., Ltd.           20           (5)       59           20
   Paladin Labs, Inc.                  13          213        40          690
   InterMune                           --           --        --        1,500
   Immune Response Corp.               --           50        --          150
   Mipharm                             50           --        50           --
   Other contract                      40           --       113           --
   Royalty                            425           --       548           --
                                   ------      -------   -------      -------
Total contract & royalty revenues     548        1,430     1,566       10,876
Sale of InterMune Revenue Rights       --           --       771        5,218
                                   ------      -------   -------      -------
       Total revenues              $8,198      $ 7,087   $24,219      $31,212
                                   ======      =======   =======      =======

Our product revenues for the three and nine month periods ended 
September 30, 2001, were $7.7 million and $21.9 million, respectively, compared 
to $5.7 million and $15.1 million for the three and nine months ended September 
30, 2000. The increase in total product revenues for the three and nine months  
ended September 30, 2001 was due to continued sales growth of Luxiq and OLUX,   
which we began marketing in April 1999 and November 2000, respectively, offset  
by lower sales of Ridaura(R) and Actimmune. As part of the June 27, 2000        
agreement with InterMune, we did not record Actimmune sales beginning with the  
second quarter of 2000. As part of the April 30, 2001 sale agreement to         
Prometheus we did not record Ridaura sales beginning with May 2001.             

        Contract and royalty revenues for the three and nine month periods ended
September 30, 2001 were $0.5 million and $1.6 million, compared to $1.4 million 
and $10.9 million for the three and nine months ended September 30, 2000. The   
decrease in total contract and royalty revenue for the nine month period ended  
September 30, 2001, is mainly due to the receipt of a one-time license payment, 
a milestone payment of $5.0 million from a former collaborative partner for     
relaxin, and $1.5 million paid by InterMune for Actimmune rights, all in the    
first quarter of 2000. We had no royalty revenue in 2000. We expect contract    
revenues to fluctuate significantly depending on our remaining partners         
achieving milestones under existing agreements, and on new business             
opportunities.                                                                  

     InterMune purchased our commercial rights and revenue to Actimmune on
June 27, 2000. As part of the transaction, InterMune paid $5.2 million in 2000  
which included the prepayment of a $1.0 million obligation owed in 2002. In     
March 2001 InterMune made a final payment on this                               

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arrangement to Connetics in the amount $0.9 million which has been offset by    
related product rebates and chargebacks of $0.1 million.                        

Our cost of sales for 2001 includes the costs of Luxiq, OLUX and
Ridaura, royalty payments on these products based on a percentage of our product
revenues, and product freight and distribution costs from our distributor. We   
recorded cost of sales of $0.7 million and $2.4 million, respectively, for the  
three and nine months ended September 30, 2001, compared to $0.7 million and    
$3.0 million, respectively, for the three and nine months ended September 30,   
2000. The cost of sales for the first nine months of 2001 decreased compared to 
the first nine months of 2000 primarily because in 2001 we did not recognize    
Actimmune revenue and its associated cost of sales under the revenue rights     
agreement, and did not recognize Ridaura revenue and its associated cost of     
sales following the sale of Ridaura in April 2001.                              

RESEARCH AND DEVELOPMENT                                                

     Research and development expenses were $4.5 million and $14.4 million
for the three and nine month periods ended September 30, 2001, compared to $5.8 
and $16.0 million for the comparable periods in 2000. The decrease in expenses  
for the three months ended September 30, 2001 was due to decreased relaxin      
development activity compared to the prior year.                                

     We expect research and development expenses to remain consistent over
the next few quarters. In May 2001, we announced our decision to pursue a       
license partner or other strategic alternative for its relaxin program. As a    
result, we have reduced our investment in the development of relaxin in favor of
focusing our resources on expanding our dermatology business. The reduction in  
expenses related to relaxin clinical work, manufacturing and overhead will be   
offset by the increase in expenditures for dermatology research, development and
marketing.                                                                      

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES                            

        Selling, general and administrative expenses were $8.8 million and $26.1
million for the three and nine months ended September 30, 2001, compared to $6.8
million and $18.3 million for the comparable periods in 2000. The increase in   
expenses was due to increased headcount and increased market research and sales 
promotions costs related to the OLUX launch and the launch of OLUX and Luxiq 50 
gram units, a one-time non-cash compensation charge, as well as the amortization
of intangibles associated with the acquisition of Soltec. We expect selling,    
general and administrative expenses to remain consistent or be slightly higher  
for the remainder of the year due to the launch of the OLUX(TM) and Luxiq(R) 50 
gram units during the fourth quarter of 2001.                                   

ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT                    

     We recorded a charge of $1.1 million for acquired in-process research
and development associated with the acquisition of Soltec, during the three     
month period ended June 30, 2001.                                               

Acquired in-process research and development consists of several
projects which involve the use of novel technologies to improve the delivery of 
drugs. Several of these projects are being developed in connection with other   
companies who own rights to the drugs. We may earn milestone and other fees     
under these arrangements and, if the drugs are successfully developed, will be  
entitled to royalties based on net sales. The projects are in various stages of 
development                                                                     

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and are subject to substantial risks. We currently estimate that completion of  
the first projects will occur in the period from 2001 to 2002 and we expect to  
incur research and development expenses of up to $1.4 million, assuming all     
drugs are successfully developed (before considering any research funding from  
our partners). The value of the in-process research and development was         
determined by an independent valuation firm using a discounted cash flow        
analysis with a rate of 20%. In addition, the stage of completion of each       
project was considered in determining the value.                                

There is no assurance that any of the projects will meet either 
technological or commercial success. The products under development have no     
foreseeable alternative future uses. The estimates used in valuing in-process   
research and development were based on assumptions we believe to be reasonable, 
but which are inherently uncertain and unpredictable. Our assumption may be     
incomplete or inaccurate, and no assurance can be given that unanticipated      
events and circumstances will not occur. Accordingly, actual results may vary   
from the results projected for purposes of determining the fair value of the    
acquired in-process research and development.                                   

CHARGE FOR RELAXIN PROGRAM                                      

        In the second quarter of this year we recorded a one-time charge of $6.0
million related to the relaxin program following our May 2001 decision to       
strategically reduce the program. The charge included amounts related to        
severance and costs associated with winding down contracts.                     

INTEREST INCOME (EXPENSE)                                       

    Interest and other income were $0.5 million and $3.0 million for the
three and nine month periods ended September 30, 2001, compared with $0.7       
million and $1.3 million for the comparable periods in 2000. The decrease in    
interest income during the three month period ended September 30, 2001 was due  
to lower interest rates during this period compared to the same period in 2000. 
The overall increase in year to date interest income was due to higher cash and 
short-term investment balances for the first nine months of the year compared to
the same period in 2000. The increase in interest and other expense for the nine
months ended September 30, 2001 compared to the same period in 2000 was         
primarily the result of a net loss of $0.6 million on the foreign exchange      
forward contract that was entered into in February 2001 in connection with the  
Soltec acquisition.                                                             

NET LOSS                                                                

       We expect to incur losses for the remainder of 2001 and the foreseeable
future. These losses are expected to fluctuate from period to period based on   
timing of product revenues, sales and marketing expenses, clinical material     
purchases, clinical trial expenses, and possible acquisitions of new products   
and technologies.                                                               

LIQUIDITY AND CAPITAL RESOURCES                                                 

       We have financed our operations to date primarily through proceeds from
equity financings, collaborative arrangements with corporate partners and bank  
loans. At September 30, 2001, cash, cash equivalents and short-term investments 
totaled $50.8 million compared to $80.2 million at December 31, 2000. Our       
investments are held in a variety of interest-bearing instruments including     
high-grade corporate bonds, commercial paper and money market accounts.         

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     Cash flows from operating activities. Cash used in operations for the
nine month period ended September 30, 2001 and 2000, was $20.3 million and $6.4 
million, respectively. Net loss of $16.4 million for the first nine months of   
2001 was affected by non-cash charges of $1.3 million of depreciation and       
amortization expense and $0.6 million in other expense related to the Soltec    
foreign exchange forward contract, a one time in-process research and           
development charge of $1.1 million related to the Soltec acquisition, a one-time
$6.0 million charge related to the reduction in the relaxin program, and        
non-cash compensation charges in the amount of $1.6 million, partially offset by
the $8.1 million gain on the sale of Ridaura(R).                                

     Cash flows from investing activities. Investing activities used $22.5
million in cash during the nine month period ended September 30, 2001, due in   
part to sales of $26.3 million of short-term investments offset by $40.4 million
of short term investment purchases, as well as the acquisition of Soltec in the 
amount of $16.6 million (net of cash acquired), which is partially offset by the
proceeds from the sale of Ridaura in the amount of $9.0 million.                

Cash flows from financing activities. Cash provided by financing
activities of $0.2 million for the nine months ended September 30, 2001 included
a $0.8 million bank loan payment in the first quarter, offset by $1.0 million in
proceeds from issuance of common stock.                                         

    Working Capital. Working capital decreased by $29.6 million to $41.4
million at September 30, 2001 from $71.0 million at December 31, 2000. The      
decrease in working capital was due to use of our cash in operations, payment of
debt obligations, and the acquisition of Soltec, which was partially offset by  
the sale of Ridaura.                                                            

We believe our existing cash, cash equivalents and short-term   
investments 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.       

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

     Please also read Item 1 in our 2000 Annual Report on Form 10-K where we
have described our business and the challenges and risks we may face in the     
future.                                                                         

       Our results of operation have varied widely in the past, and they could
continue to vary significantly from quarter to quarter due to a number of       
factors, including those listed below. Any shortfall in revenues would have an  
immediate impact on our earnings (loss) per share, which could adversely affect 
the market price of our common stock. Our operating expenses, which include     
sales and marketing, research and development and general and administrative    
expenses, are based on our expectations of future revenues and are relatively   
fixed in the short term. Accordingly, if revenues fall below our expectations,  
we will not be able to reduce our spending rapidly in response to such a        
shortfall. Due to the foregoing factors, we believe that quarter-to-quarter     
comparisons of our results of operations are not a good indication of our future
performance.                                                                    

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RISKS RELATED TO OUR BUSINESS                                                   

If we do not sustain profitability, stockholders may lose their investment.     

    Except for fiscal year 2000, we have lost money every year since our
inception. We had net losses of $27.3 million in 1999 and net income of $27.0   
million in 2000. If we exclude a gain of $43.0 million on sales of stock we held
in InterMune, and the associated income tax, our net loss for 2000 would have   
been $15.0 million. We had a net loss of $16.4 million for the nine months ended
September 30, 2001. Our accumulated deficit was $109.2 million at September 30, 
2001. We may incur additional losses during the next few years. If we do not    
eventually achieve and maintain profitability, our stock price may decline.     

If we do not obtain the capital necessary to fund our operations, we will be    
unable to develop or market our products.                                       

We currently believe that our available cash resources will be  
sufficient to fund our operating and working capital requirements for at least  
the next 12 months. If in the future our product revenue does not continue to   
grow or we are unable to raise additional funds when needed, we may not be able 
to market our products as planned or continue development of our other products.

If we fail to protect our proprietary rights, competitors may be able to use our
technologies, which would weaken our competitive position, reduce our revenues  
and increase our costs.                                                         

        Our commercial success depends in part on our ability and the ability of
our licensors to protect our technology and processes. The foam technology used 
in our Luxiq(R) and OLUX(TM) products is covered by one issued patent.          

       We are pursuing several U. S. and foreign patent applications, although
we cannot be sure that any of these patents will ever be issued. We and Soltec  
also have acquired rights under certain patents and patent applications in      
connection with our licenses to distribute products and from the assignment of  
rights to patents and patent applications from certain of our consultants and   
officers. These patents and patent applications may be subject to claims of     
rights by third parties. If there are conflicting claims to the same patent or  
patent application, we may not prevail and, even if we do have some rights in a 
patent or application, those rights may not be sufficient for the marketing and 
distribution of products covered by the patent or application.                  

The patents and applications in which we have an interest may be
challenged as to their validity or enforceability. Challenges may result in     
potentially significant harm to our business. The cost of responding to these   
challenges and the inherent costs to defend the validity of our patents,        
including the prosecution of infringements and the related litigation, could be 
substantial whether or not we are successful. Such litigation also could require
a substantial commitment of management's time. A judgment adverse to us in any  
patent interference, litigation or other proceeding arising in connection with  
these patent applications could materially harm our business.                   

    The ownership of a patent or an interest in a patent does not always
provide significant protection. Others may independently develop similar        
technologies or design around the patented aspects of our technology. We only   
conduct patent searches to determine whether our products infringe upon any     
existing patents, when we think such searches are appropriate. If we are        

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unsuccessful in any challenge to the marketing and sale of our products or      
technologies, we may be required to license the disputed rights, if the holder  
of those rights is willing, or to cease marketing the challenged products, or to
modify our products to avoid infringing upon those rights. Under these          
circumstances, we may not be able to obtain a license to such intellectual      
property on favorable terms, if at all. We may not succeed in any attempt to    
redesign our products or processes to avoid infringement.                       

Our current product revenue does not cover the cost of fully developing and     
commercializing our product candidates.                                         

  Product revenue from sales of our marketed products does not currently
cover the full cost of developing products in our pipeline. We also generate    
revenue by licensing our products to third parties for specific territories and 
indications. Our reliance on licensing arrangements with third parties carries  
several risks, including the possibilities that:                                

 o    a product development contract may expire or a relationship may be
 terminated, and we will not be able to attract a satisfactory
alternative corporate partner within a reasonable time;     

  o    we may be contractually bound to terms that, in the future, are not
commercially favorable to us; and                           

    o    royalties generated from licensing arrangements may be insignificant.

If any of these risks occurs, we may not be able to successfully develop our    
products.                                                                       

If we do not successfully partner or commercialize relaxin, we will lose        
fundamental intellectual property rights to the product.                        

Licenses with Genentech, Inc. and The Howard Florey Institute of
Experimental Physiology and Medicine require us to use our best efforts to      
commercialize relaxin. If we fail to successfully commercialize relaxin, our    
rights under these licenses may revert to Genentech and the Florey Institute.   
The termination of these agreements and subsequent reversion of rights could    
prevent us from leveraging our additional patents and know-how by securing a    
partnership arrangement for the relaxin program.                                

We rely on our employees and consultants to keep our trade secrets confidential.

We rely on trade secrets and unpatented proprietary know-how and
continuing technological innovation in developing and manufacturing our         
products. We require each of our and Soltec's employees, consultants and        
advisors to enter into confidentiality agreements prohibiting them from taking  
our proprietary information and technology or from using or disclosing          
proprietary information to third parties except in specified circumstances. The 
agreements also provide that all inventions conceived by an employee, consultant
or advisor, to the extent appropriate for the services provided during the      
course of the relationship, shall be our exclusive property, other than         
inventions unrelated to us and developed entirely on the individual's own time. 
Nevertheless, these agreements may not provide meaningful protection of our     
trade secrets and proprietary know-how if they are used or disclosed. Despite   
all of the precautions we may take, people who are not parties to               
confidentiality agreements may obtain                                           

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access to our trade secrets or know-how. In addition, others may independently  
develop similar or equivalent trade secrets or know-how.                        

Our use of hazardous materials exposes us to the risk of environmental          
liabilities, and we may incur substantial additional costs to comply with       
environmental laws.                                                             

     Our research and development activities involve the controlled use of
hazardous materials, chemicals and various radioactive materials. We are subject
to laws and regulations governing the use, storage, handling and disposal of    
these materials and certain waste products. In the event of accidental          
contamination or injury from these materials, we could be liable for any damages
that result and any liability could exceed our resources. We may also be        
required to incur significant costs to comply with environmental laws and       
regulations as our research activities increase.                                

RISKS RELATED TO OUR PRODUCTS                                                   

Manufacturing difficulties could delay commercialization of our products or     
future revenues from product sales.                                             

        We depend on third parties to manufacture our products, and each product
is manufactured by a sole source manufacturer. Currently, Miza Pharmaceuticals  
is our sole source manufacturer for Luxiq and OLUX. All of our contractors must 
comply with the applicable FDA good manufacturing practice regulations, which   
include quality control and quality assurance requirements as well as the       
corresponding maintenance of records and documentation. Manufacturing facilities
are subject to ongoing periodic inspection by the FDA and corresponding state   
agencies, including unannounced inspections, and must be licensed before they   
can be used in commercial manufacturing of our products. If our sole source     
manufacturer cannot provide us with our product requirements in a timely and    
cost-effective manner, if the product they are able to supply cannot meet       
commercial requirements for shelf life, or if they are not able to comply with  
the applicable good manufacturing practice regulations and other FDA regulatory 
requirements, our sales of marketed products could be reduced and we could      
suffer delays in the progress of clinical trials for products under development.
We do not have control over our third-party manufacturer's compliance with these
regulations and standards. In addition, any commercial dispute with any of our  
sole source suppliers could result in delays in the manufacture of product, and 
affect our ability to commercialize our products.                               

If we are unable to contract with third parties to manufacture and distribute   
our products in sufficient quantities, on a timely basis, or at an acceptable   
cost, we may be unable to meet demand for our products and may lose potential   
revenues.                                                                       

We have no manufacturing or distribution facilities for any of our  
products. Instead, we contract with third parties to manufacture our products   
for us. We have manufacturing agreements with the following companies:          

o    Miza Pharmaceuticals, a U.K. corporation, for Luxiq and OLUX; and

o    Boehringer Ingelheim Austria GmbH for relaxin.                   

    Boehringer Ingelheim, or BIA, manufactures relaxin for us for clinical
uses under a long-term contract. In July 2000, in anticipation of successful    
results in our relaxin clinical trial for scleroderma, we submitted a purchase  
order to BIA for product to be used for commercial supply.                      

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The purchase order was for a price to be negotiated. We have been in discussions
with BIA since the beginning of 2001 regarding whether any additional monies are
owed under the contract in view of the failure of the clinical trial. In July   
2001, following our May 2001 announcement about downsizing the relaxin program, 
BIA notified us that BIA believes we are in breach of the relaxin manufacturing 
agreement and that BIA intends to terminate the agreement and seek remedies if  
we do not remedy the alleged breach. We disagree with BIA's allegation that we  
have breached the contract. Nevertheless, consistent with other reserves taken  
in connection with the Company's downsizing of the relaxin program and this     
dispute with BIA, we have recorded a reserve for our estimate of our potential  
exposure in the dispute with BIA. There can be no guarantee, however, that the  
actual resolution of this dispute will not result in charges in excess of the   
reserve we have recorded.                                                       

Typically, these manufacturing contracts are short-term. We are 
dependent upon renewing agreements with our existing manufacturers or finding   
replacement manufacturers to satisfy our requirements. As a result, we cannot be
certain that manufacturing sources will continue to be available or that we can 
continue to out-source the manufacturing of our products on reasonable or       
acceptable terms.                                                               

       Any loss of a manufacturer or any difficulties which could arise in the
manufacturing process could significantly affect our inventories and supply of  
products available for sale. If third parties are unable or unwilling to produce
our products in sufficient quantities, with appropriate quality, and under      
commercially reasonable terms, it could have a negative effect on our sales     
margins and our market share, as well as our overall business and financial     
results. If we are unable to supply sufficient amounts of our products on a     
timely basis, our market share could decrease and, correspondingly, our         
profitability could decrease.                                                   

If our contract manufacturers fail to comply with current Good Manufacturing    
Practice, or cGMP regulations, we may be unable to meet demand for our products 
and may lose potential revenue.                                                 

        The FDA requires that all manufacturers used by pharmaceutical companies
comply with the FDA's regulations, including those cGMP regulations applicable  
to manufacturing processes. The cGMP validation of a new facility and the       
approval of that manufacturer for a new drug product may take a year or more    
before manufacture can begin at the facility. Delays in obtaining FDA validation
of a replacement manufacturing facility could cause an interruption in the      
supply of our products. Although we have business interruption insurance        
covering the loss of income for up to $8.0 million, which may mitigate the harm 
to our business from the interruption of the manufacturing of products caused by
certain events, the loss of a manufacturer could still have a negative effect on
our sales, margins and market share, as well as our overall business and        
financial results.                                                              

If our supply of finished products is interrupted, our ability to maintain our  
inventory levels could suffer.                                                  

      We try to maintain inventory levels that are no greater than necessary
to meet our current projections. Any interruption in the supply of finished     
products could hinder our ability to timely distribute finished products. If we 
are unable to obtain adequate product supplies to satisfy our customers' orders,
we may lose those orders and our customers may cancel other orders and stock and
sell competing products. This in turn could cause a loss of our market share and
negatively affect our revenues.                                                 

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     We cannot be certain that supply interruptions will not occur or that
our inventory will always be adequate. Numerous factors could cause             
interruptions in the supply of our finished products including shortages in raw 
material required by our manufacturers, changes in our sources for              
manufacturing, our failure to timely locate and obtain replacement manufacturers
as needed and conditions effecting the cost and availability of raw materials.  

If we do not obtain and maintain governmental approvals for our products, we    
cannot sell these products for their intended uses.                             

       Pharmaceutical companies are subject to heavy regulation by a number of
national, state and local agencies. Of particular importance is the FDA in the  
United States. It has jurisdiction over all of our business and administers     
requirements covering testing, manufacture, safety, effectiveness, labeling,    
storage, record keeping, approval, advertising and promotion of our products.   
Failure to comply with applicable regulatory requirements could, among other    
things, result in fines; suspensions of regulatory approvals of products;       
product recalls; delays in product distribution, marketing and sale; and civil  
or criminal sanctions.                                                          

 The process of obtaining and maintaining regulatory approvals for
pharmaceutical and biological drug products, and obtaining and maintaining      
regulatory approvals to market these products for new indications, is lengthy,  
expensive and uncertain. The manufacturing and marketing of drugs are subject to
continuing FDA and foreign regulatory review, and later discovery of previously 
unknown problems with a product, manufacturing process or facility may result in
restrictions, including withdrawal of the product from the market. Our products 
receive FDA review regarding their safety and effectiveness. However, the FDA is
permitted to revisit and change its prior determinations and we cannot be sure  
that the FDA will not change its position with regard to the safety or          
effectiveness of our products. If the FDA's position changes, we may be required
to change our labeling or formulations, or cease to manufacture and market the  
challenged products. Even before any formal regulatory action, we could         
voluntarily decide to cease distribution and sale or recall any of our products 
if concerns about the safety or effectiveness develop.                          

        To market our products in countries outside of the United States, we and
our partners must obtain similar approvals from foreign regulatory bodies. The  
foreign regulatory approval process includes all of the risks associated with   
obtaining FDA approval, and approval by the FDA does not ensure approval by the 
regulatory authorities of any other country. The process of obtaining these     
approvals is time consuming and requires the expenditure of substantial         
resources.                                                                      

   In recent years, various legislative proposals have been offered in
Congress and in some state legislatures that include major changes in the health
care system. These proposals have included price or patient reimbursement       
constraints on medicines and restrictions on access to certain products. We     
cannot predict the outcome of such initiatives, and it is difficult to predict  
the future impact of the broad and expanding legislative and regulatory         
requirements affecting us.                                                      

We may spend a significant amount of money to obtain FDA and other regulatory   
approvals, which may never be granted.                                          

      The process of obtaining FDA and other regulatory approvals is lengthy and
expensive. To obtain approval, we must show in preclinical and clinical trials  
that our products are safe and effective, and the marketing and manufacturing of
pharmaceutical products are subject to rigorous                                 

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testing procedures. The FDA approval processes require substantial time and     
effort, the FDA continues to modify product development guidelines, and the FDA 
may not grant approval on a timely basis or at all. Clinical trial data can be  
the subject of differing interpretation, and the FDA has substantial discretion 
in the approval process. The FDA may not interpret our clinical data the way we 
do. The FDA may also require additional clinical data to support approval. The  
FDA can take between one and two years to review new drug applications and      
biologics license applications, or longer if significant questions arise during 
the review process. We may not be able to obtain FDA approval to conduct        
clinical trials or to manufacture and market any of the products we develop,    
acquire or license. Moreover, the costs to obtain approvals could be            
considerable and the failure to obtain or delays in obtaining an approval could 
have a significant negative effect on our business performance and financial    
results. Even if we obtain approval from the FDA, the FDA is authorized to      
impose post-marketing requirements such as:                                     

o    testing and surveillance to monitor the product and its continued
compliance with regulatory requirements;                    

     o    submitting products for inspection and, if any inspection reveals that
        the product is not in compliance, the prohibition of the sale of all
products from the same lot;                                 

o    suspending manufacturing;                                        

o    recalling products; and                                          

o    withdrawing marketing clearance.                                 

In its regulation of advertising, the FDA from time to time issues  
correspondence to pharmaceutical companies alleging that some advertising or    
promotional practices are false, misleading or deceptive. The FDA has the power 
to impose a wide array of sanctions on companies for such advertising practices,
and the receipt of correspondence from the FDA alleging these practices can     
result in the following:                                                        

     o    incurring substantial expenses, including fines, penalties, legal fees
and costs to comply with the FDA's requirements;            

o    changes in the methods of marketing and selling products;        

o    taking FDA-mandated corrective action, which may include placing 
       advertisements or sending letters to physicians rescinding previous
advertisements or promotion; and                            

 o    disruption in the distribution of products and loss of sales until
compliance with the FDA's position is obtained.             

If Luxiq and OLUX do not achieve or sustain market acceptance, our revenues will
not increase and may not cover our operating expenses.                          

     Our future revenues will depend upon dermatologist and patient acceptance
of Luxiq and OLUX. Factors that could affect acceptance of Luxiq and OLUX       
include:                                                                        

o    satisfaction with existing alternative therapies;                

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o    the effectiveness of our sales and marketing efforts;            

o    undesirable and unforeseeable side effects; and                  

o    the cost of the product as compared with alternative therapies.  

      Since we have had approval to sell Luxiq for less than three years, and we
only began selling OLUX in November 2000, we cannot predict the potential       
long-term patient acceptance of either product.                                 

We rely on third parties to conduct clinical trials for our product candidates, 
and those third parties may not perform satisfactorily.                         

     We do not have the ability to independently conduct clinical studies,
and we rely on third parties to perform this function. If these third parties do
not perform satisfactorily, we may not be able to locate acceptable replacements
or enter into favorable agreements with them, if at all. If we are unable to    
rely on clinical data collected by others, we could be required to repeat       
clinical trials, which could significantly delay commercialization and require  
significantly greater capital.                                                  

If we are unable to develop new products, our expenses may increase without any 
immediate return on the investment.                                             

We currently have a variety of new products in various stages of
research and development and are working on possible improvements, extensions   
and reformulations of some existing products. These research and development    
activities, as well as the clinical testing and regulatory approval process,    
which must be completed before commercial quantities of these developments can  
be sold, will require significant commitments of personnel and financial        
resources. Delays in the research, development, testing or approval processes   
will cause a corresponding delay in revenue generation from those products.     
Regardless of whether they are ever released to the market, the expense of such 
processes will have already been incurred.                                      

      We reevaluate our research and development efforts regularly to assess
whether our efforts to develop a particular product or technology are           
progressing at a rate that justifies our continued expenditures. On the basis of
these reevaluations, we have abandoned in the past, and may abandon in the      
future, our efforts on a particular product or technology. There can be no      
certainty that any product we are researching or developing will ever be        
successfully released to the market. If we fail to take a product or technology 
from the development stage to market on a timely basis, we may incur significant
expenses without a near-term financial return.                                  

If we do not successfully integrate new products, we may not be able to sustain 
revenue growth and we may not be able to compete effectively.                   

     When we acquire or develop new products and product lines, we must be
able to integrate those products and product lines into our systems for         
marketing, sales and distribution. If these products or product lines are not   
integrated successfully, the potential for growth is limited. The new products  
we acquire or develop could have channels of distribution, competition, price   
limitations or marketing acceptance different from our current products. As a   
result, we do not know whether we will be able to compete effectively and obtain
market acceptance in any new product categories. After acquiring or developing a
new product, we may need to significantly increase our sales force and incur    
additional marketing, distribution and other operational                        

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expenses. These additional expenses could negatively affect our gross margins   
and operating results. In addition, many of these expenses could be incurred    
prior to the actual distribution of new products. Because of this timing, if the
new products are not accepted by the market or if they are not competitive with 
similar products distributed by others, the ultimate success of the acquisition 
or development could be substantially diminished.                               

RISKS RELATED TO OUR INDUSTRY                                                   

We face intense competition, which may limit our commercial opportunities and   
our ability to become profitable.                                               

     The pharmaceutical industry is highly competitive. Competition in our
industry occurs on a variety of fronts, including developing and bringing new   
products to market before others, developing new technologies to improve        
existing products, developing new products to provide the same benefits as      
existing products at less cost and developing new products to provide benefits  
superior to those of existing products.                                         

    Most of our competitors are large, well-established companies in the
fields of pharmaceuticals and health care. Many of these companies have         
substantially greater financial, technical and human resources than we have to  
devote to marketing, sales, research and development and acquisitions. Some of  
these competitors have more collective experience than we do in undertaking     
preclinical testing and human clinical trials of new pharmaceutical products and
obtaining regulatory approvals for therapeutic products. As a result, they have 
a greater ability to undertake more extensive research and development and sales
and marketing programs. It is possible that our competitors may develop new or  
improved products to treat the same conditions as our products treat. Our       
commercial opportunities will be reduced or eliminated if our competitors       
develop and market products that are more effective, have fewer or less severe  
adverse side effects or are less expensive than our products. These competitors 
also may develop products that make our current or future products obsolete. Any
of these events could have a significant negative impact on our business and    
financial results, including reductions in our market share and gross margins.  

      Physicians may not adopt our products over competing products, and our
products may not offer an economically feasible alternative to existing modes of
therapy.                                                                        

       Our products compete with generic pharmaceuticals, which claim to offer
equivalent benefit at a lower cost. In some cases, insurers and other health    
care payment organizations try to encourage the use of these less expensive     
generic brands through their prescription benefits coverages and reimbursement  
policies. These organizations may make the generic alternative more attractive  
to the patient by providing different amounts of reimbursement so that the net  
cost of the generic product to the patient is less than the net cost of our     
prescription brand product. Aggressive pricing policies by our generic product  
competitors and the prescription benefits policies of insurers could cause us to
lose market share or force us to reduce our margins in response.                

If third party payors will not provide coverage or reimburse patients for the   
use of our products, our revenues and profitability will suffer.                

      Our products' commercial success is substantially dependent on whether
third-party reimbursement is available for the use of our products by hospitals,
clinics and doctors. Medicare,                                                  

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Medicaid, health maintenance organizations and other third-party payors may not 
authorize or otherwise budget for the reimbursement of our products. In         
addition, they may not view our products as cost-effective and reimbursement may
not be available to consumers or may not be sufficient to allow our products to 
be marketed on a competitive basis. Likewise, legislative proposals to reform   
health care or reduce government programs could result in lower prices for or   
rejection of our products. Changes in reimbursement policies or health care cost
containment initiatives that limit or restrict reimbursement for our products   
may cause our revenues to decline.                                              

If managed care organizations and other third-party reimbursement policies do   
not cover our products, we may not increase our market share and our revenues   
and profitability will suffer.                                                  

       Our operating results and business success depends in large part on the
availability of adequate third-party payor reimbursement to patients for our    
prescription-brand products. These third-party payors include governmental      
entities (such as Medicaid), private health insurers and managed care           
organizations. Over 70% of the U.S. population now participates in some version 
of managed care. Because of the size of the patient population covered by       
managed care organizations, marketing of prescription drugs to them and the     
pharmacy benefit managers that serve many of these organizations has become     
important to our business. Managed care organizations and other third-party     
payors try to negotiate the pricing of medical services and products to control 
their costs. Managed care organizations and pharmacy benefit managers typically 
develop formularies to reduce their cost for medications. Formularies can be    
based on the prices and therapeutic benefits of the available products. Due to  
their lower costs, generics are often favored. The breadth of the products      
covered by formularies varies considerably from one managed care organization to
another, and many formularies include alternative and competitive products for  
treatment of particular medical conditions. Exclusion of a product from a       
formulary can lead to its sharply reduced usage in the managed care organization
patient population. Payment or reimbursement of only a portion of the cost of   
our prescription products could make our products less attractive, from a       
net-cost perspective, to patients, suppliers and prescribing physicians. We     
cannot be certain that the reimbursement policies of these entities will be     
adequate for our products to compete on a price basis. If our products are not  
included within an adequate number of formularies or adequate reimbursement     
levels are not provided, or if those policies increasingly favor generic        
products, our market share and gross margins could be negatively affected, as   
could our overall business and financial condition.                             

If product liability lawsuits are brought against us, we may incur substantial  
costs.                                                                          

    Our industry faces an inherent risk of product liability claims from
allegations that our products resulted in adverse effects to the patient or     
others. These risks exist even with respect to those products that are approved 
for commercial sale by the FDA and manufactured in facilities licensed and      
regulated by the FDA. Our insurance may not provide adequate coverage against   
potential product liability claims or losses. We also cannot be certain that our
current coverage will continue to be available in the future on reasonable      
terms, if at all. Even if we are ultimately successful in product liability     
litigation, the litigation would consume substantial amounts of our financial   
and managerial resources, and might create adverse publicity, all of which would
impair our ability to generate sales. If we were found liable for any product   
liability claims in excess of our coverage or outside of our coverage, the cost 
and expense of such liability could severely damage our business, financial     
condition and profitability.                                                    

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RISKS RELATED TO OUR STOCK                                                      

Our stock price is volatile and the value of your investment in our stock could 
decline in value.                                                               

      The market prices for securities of specialty pharmaceutical companies
like our company have been and are likely to continue to be highly volatile. As 
a result, investors in these companies often buy at very high prices only to see
the price drop substantially a short time later, resulting in an extreme drop in
value in the stock holdings of these investors. In addition, the volatility     
could result in securities class action litigation. Any litigation would likely 
result in substantial costs, and divert our management's attention and          
resources.                                                                      

Our charter documents and Delaware law contain provisions that could delay or   
prevent an acquisition of us, even if the acquisition would be beneficial to our
stockholders.                                                                   

     Our certificate of incorporation authorizes our board of directors to
issue undesignated preferred stock and to determine the rights, preferences,    
privileges and restrictions of the preferred stock without further vote or      
action by our stockholders. The issuance of preferred stock could make it more  
difficult for third parties to acquire a majority of our outstanding voting     
stock. We also have a stockholder rights plan, which entitles existing          
stockholders to rights, including the right to purchase shares of preferred     
stock, in the event of an acquisition of 15% or more of our outstanding common  
stock, or an unsolicited tender offer for such shares. The existence of the     
rights plan could delay, prevent, or make more difficult a merger or tender     
offer or proxy contest involving us. Other provisions of Delaware law and of our
charter documents, including a provision eliminating the ability of stockholders
to take actions by written consent, could also delay or make difficult a merger,
tender offer or proxy contest involving us. Further, our stock option and       
purchase plans generally provide for the assumption of such plans or            
substitution of an equivalent option of a successor corporation or,             
alternatively, at the discretion of the board of directors, exercise of some or 
all of the option stock, including non-vested shares, or acceleration of vesting
of shares issued pursuant to stock grants, upon a change of control or similar  
event.                                                                          

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK              

      There have been no material changes in the reported market risks since
December 31, 2000 except for the foreign currency exchange risk related to the  
foreign currency exchange contract Connetics entered into during the quarter    
ended March 31, 2001. The contract was cancelled in April 2001 in conjunction   
with the acquisition of Soltec.                                                 

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PART II. OTHER INFORMATION                                                      

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K                                       

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

                                                                [Download Table]
                                                                       
10.1*     Amended and Restated Manufacturing and Supply Agreement dated
          September 19, 2001, by and between Connetics and Miza        
          Pharmaceuticals (UK) Limited                                 

10.2      Industrial Building Lease dated December 16, 1999, between   
          Connetics and West Bayshore Associates                       

10.3      Assignment and Assumption of Lease between Connetics and     
          Respond.com, Inc., dated August 21, 2001                     

10.4      Agreement dated August 21, 2001, between Connetics and       
          Respond.com, Inc.                                            

10.5      Sublease Agreements dated August 21, 2001, between Connetics 
          and Respond.com, Inc., with respect to 3290 and 3294 West    
          Bayshore Road, Palo Alto, California                         

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

(b)     Reports on Form 8-K.     None                                           

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SIGNATURE                                                                       

        Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Report to be signed on its behalf by the        
undersigned, thereunto duly authorized.                                         

             CONNETICS CORPORATION

               By: /s/ JOHN L. HIGGINS
                       -------------------------
               John L. Higgins
                                 Exec. Vice President, Finance and
                                  Administration and Chief Financial
       Officer

Date: November 14, 2001                                                         

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 INDEX TO EXHIBITS

                                                                [Download Table]

Exhibit Number   Description                                                  
--------------   -----------                                                  
                                                                              

  10.1*          Amended and Restated Manufacturing and Supply Agreement dated
                 September 19, 2001, by and between Connetics and Miza        
                 Pharmaceuticals (UK) Limited                                 

  10.2           Industrial Building Lease dated December 16, 1999, between   
                 Connetics and West Bayshore Associates                       

  10.3           Assignment and Assumption of Lease between Connetics and     
                 Respond.com, Inc., dated August 21, 2001                     

  10.4           Agreement dated August 21, 2001, between Connetics and       
                 Respond.com, Inc.                                            

  10.5           Sublease Agreements dated August 21, 2001, between Connetics 
                 and Respond.com, Inc., with respect to 3290 and 3294 West    
                 Bayshore Road, Palo Alto, California                         

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

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Dates Referenced Herein   and   Documents Incorporated By Reference

				Referenced-On Page
This 10-Q Filing		Date		First		Last			Other Filings
		12/16/99		27		29
		6/27/00		13
		9/30/00		2		16			10-Q
		11/6/00		12
		12/31/00		2		26			10-K
		1/1/01		7
		3/31/01		12		26			10-Q
		4/19/01		9					8-K
		4/20/01		7
		4/30/01		13					8-K
		5/23/01		12					8-K
		6/30/01		8		14			10-Q, S-3/A
		7/1/01		8
		8/21/01		27		29
		9/19/01		27		29
For The Period Ended		9/30/01		1		17
		11/8/01		1
Filed On / Filed As Of		11/14/01		28
		12/15/01		8
		12/31/01		6					10-K, 10-K/A
		1/1/02		8
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