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

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

     As of October 31, 2006, 34,525,850 shares of the Registrant’s common stock at $0.001 par value, were outstanding.

TABLE OF CONTENTS

See accompanying notes to condensed consolidated financial statements.

See accompanying notes to condensed consolidated financial statements.

See accompanying notes to condensed consolidated financial statements.

     On October 22, 2006, Connetics Corporation, or Connetics entered into a definitive merger agreement with Stiefel Laboratories, Inc., or Stiefel, for Stiefel to acquire Connetics. Unless otherwise indicated, the discussions in this document relate to Connetics as a standalone entity and do not reflect the impact of the proposed merger with Stiefel. See Note 13 for further discussion of this proposed transaction.

Interim Financial Information

     We prepared the accompanying unaudited condensed consolidated financial statements of Connetics Corporation, or Connetics, in accordance with U.S. generally accepted accounting principles, or GAAP, for interim financial information and in compliance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the financial statements do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. We believe that we have included all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation. The balance sheet as of December 31, 2005 has been derived from audited financial statements.

     Operating results for the three and nine months ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. For a better understanding of Connetics and its financial statements, we recommend reading these unaudited condensed consolidated financial statements and notes in conjunction with the audited consolidated financial statements and notes to those financial statements for each of the three years in the period ended December 31, 2005, as restated, which are included in our Annual Report on Form 10-K/A as filed with the Securities and Exchange Commission, or SEC.

     The accompanying condensed consolidated financial statements include the accounts of Connetics and its subsidiaries, Connetics Holdings Pty Ltd., and Connetics Australia Pty Ltd. We have eliminated all intercompany accounts and transactions in consolidation.

     We have prepared our condensed consolidated financial statements in conformity with GAAP. Such preparation requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates based upon future events.

     We evaluate our estimates on an on-going basis. In particular, we regularly evaluate estimates related to revenue reserves, recoverability of accounts receivable and inventory, intangible assets, and assumed liabilities related to acquired product rights, accrued liabilities for clinical trial activities and indirect promotional expenses. We base our estimates on historical experience and on various other specific assumptions that we believe to be reasonable under the circumstances. Those estimates and assumptions form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates depending on the outcome of future events, although we believe that the estimates and assumptions upon which we rely are reasonable based on information available to us at the time they are made. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected.

     Financial results for the three and nine months ended September 30, 2005 have been restated to correct errors in our estimated accruals for rebates, chargebacks and returns. Refer to our Annual Report on Form 10-K/A for the year ended December 31, 2005 for a detailed discussion of the restatement.

     In order to facilitate improved management of wholesaler inventory levels of all of our products, we have shipped below estimated prescription demand during 2006 with the goal of reducing average wholesaler inventory levels to less than two months on-hand by the end of 2006. In connection with this effort, on June 30, 2006 we halted an in-transit shipment to one of our wholesalers; the product was brought back to our warehouse and the wholesaler never received delivery. We properly reversed the revenue and accounts receivable related to this shipment, and those amounts were not included in the June 30, 2006 Form 10-Q financial statements. However, during our third quarter 2006 close procedures we noted that the financial statements in the June 30, 2006 Form 10-Q did not reflect the reversal of the cost of product revenues and increase in inventory associated with the halted shipment. Therefore, our June 30, 2006 results overstated cost of product revenues by $368,000 and understated inventory by the same amount. In accordance with Accounting Principles Board Opinion 28, Interim Financial Reporting, or APB 28, paragraph 29 because the amount is not material to our full year results we have recorded the $368,000 reversal of cost of product revenues as an adjustment in June 2006 by amending the year-to-date amounts in the September 30, 2006 financial information included in this Report. The table below sets forth the effect of the adjustment on the Condensed Consolidated Statement of Operations as of June 30, 2006 (in thousands except per share amounts):

     In July 2006 the Financial Accounting Standards Board, or the FASB, issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, or FIN 48. FIN 48 is an interpretation of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, or SFAS 109. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS 109 and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The provisions of FIN 48 are required to be applied to all tax positions upon initial adoption. The cumulative effect of applying the provisions of FIN 48 are required to be reported as an adjustment to the opening balance of retained earnings in the year of adoption. FIN 48 will be effective beginning with the first annual period after December 15, 2006. We are still evaluating what impact, if any, the adoption of this standard will have on our financial position or results of operations.

     In September 2006 the FASB issued FASB Statement No. 157, Fair Value Measurements, or SFAS 157. The standard provides guidance for using fair value to measure assets and liabilities. The standard also responds to investors’ requests for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. The standard applies whenever other standards require or permit assets or liabilities to be measured at fair value. The standard does not expand the use of fair value in any new circumstances. SFAS 157 must be adopted prospectively as of the beginning of the year it is initially applied. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We are still evaluating what impact, if any, the adoption of this standard will have on our financial position or results of operations.

Revenue Recognition

     Our revenue recognition policy is in accordance with SEC Staff Accounting Bulletin No. 104, or SAB 104, “Revenue Recognition.” We recognize revenue for sales when substantially all the risks and rewards of ownership have transferred to the customer, which generally occurs on the date of shipment. Our revenue recognition policy has a substantial impact on our reported results and relies on certain estimates that require difficult, subjective and complex judgments on the part of management.

     We recognize product revenues net of allowances and accruals for estimated returns, rebates, chargebacks and discounts. We estimate allowances and accruals based primarily on our past experience. We also consider the volume and price mix of products in the retail channel, trends in distributor inventory, trends in patient mix, economic trends that might impact patient demand for our products (including competitive environment) and other factors. In addition, in December 2005 we began to use information about products in the wholesaler channel furnished to us in connection with distribution service agreements entered into in late 2004 and 2005. The sensitivity of our estimates can vary by program, type of customer and geographic location. In addition, estimates associated with U.S. Medicaid and contract rebates and returns are subject to adjustments based on new and updated business factors, in part due to the time delay between the recording of the accrual and its ultimate settlement, an interval that can range up to one year for rebates and up to several years for returns. Because of this time lag, in any given quarter our estimates of returns, rebates and chargebacks recorded in prior periods may be adjusted to reflect current business factors.

     The following significant categories of gross-to-net sales adjustments impact our reporting: product returns, managed care rebates, Medicaid rebates, chargebacks, cash discounts, and other adjustments, most of which involve significant estimates and judgments and require us to use information from external sources. We account for these gross-to-net sales adjustments in accordance with Emerging Issues Task Force Issue No. 01-9, or EITF 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products),” and Statement of Financial Accounting Standard No. 48, or FAS 48, “Revenue Recognition When Right of Return Exists,” as applicable.

     Our product returns accrual is primarily based on estimates of future product returns over the period during which wholesalers have a right of return, which in turn is based in part on estimates of the remaining shelf life of the products. We allow wholesalers and pharmacies to return unused product stocks that are within six months before and up to one year after their expiration date for a credit at the then-current wholesale price less five percent. As a general practice, we do not ship product that has less than 15 months until its expiration date. We also authorize returns for damaged products and credits for expired products in accordance with our returned goods policy and procedures. At the time of sale, we estimate the quantity and value of goods that may ultimately be returned pursuant to these rights.

     We estimate the rate of future product returns based on our historical experience using the most recent three years’ data, the relative risk of return based on expiration date and other qualitative factors that could impact the level of future product returns, such as competitive developments, product discontinuations and our introduction of new products. We assess the risk of return on a production lot basis and apply our estimated return rate to the units at risk for return. Beginning in the first quarter of 2006, as a result of more extensive revenue forecasting, we revalued our estimate of product returns using current and anticipated price increases. This resulted in an increase to our returns reserve of $1.1 million and an increase in our net loss per share of $0.03 for the nine months ended September 30, 2006. We monitor inventories held by our distributors as well as prescription trends to help us assess the rate of return. In situations where we are aware of products in the distribution channel nearing their expiration date, we analyze the situation and if the analysis indicates that product returns will be larger than previously expected, we adjust the product return accrual in which our analysis indicates the adjustment is necessary. If a product begins to face significant competition from generic products, we will give particular attention to the possible level of returns. To date, none of our products has direct generic competition.

     Due to the significant reduction of inventory held by our distributors during the third quarter of 2006, our accrual for product returns of $14.4 million as of September 30, 2006 represented a significant amount of the value of the inventory in the distribution channel. We believe this reduction of wholesaler inventory will correlate to a lower amount of product returns in the future. We believe the methodology we utilize to calculate our returns reserve continues to be appropriate; however, we do not have adequate information at the end of the third quarter to determine a more appropriate estimated rate of return than the rate indicated by our most recent three years’ data. During the fourth quarter of 2006, we will attempt to obtain additional information on the inventory held by our largest wholesalers in order to determine the potential return profile of the existing channel inventory. If, as anticipated, the return rate profile supported by the information and our on-going returns experience indicate a significantly lower rate for future returns, we will have a basis for determining a more appropriate accrual for returns, at which time we could potentially release a substantial portion of our returns reserve. Even if we release a significant amount of the accrual in the fourth quarter of 2006, we expect that over the next one to several quarters our estimated return rate, and therefore our product returns accrual, will continue to decrease at a more modest rate over time as a result of our target wholesaler inventory levels.

     It is more difficult for us to estimate returns from new products than returns for established products. We estimate the product return accrual for new products primarily based on our historical product returns experience with similar products, products that have similar characteristics at various stages of their life cycle, and other available information pertinent to the intended use and marketing of the new product.

     Our actual experience and the qualitative factors that we use to determine the necessary accrual for future product returns are susceptible to change based on unforeseen events and uncertainties. We assess the trends that could affect our estimates and make changes to the accrual quarterly.

     We offer rebates to key managed care and other direct and indirect customers. Several of these arrangements require the customer to achieve certain performance targets relating to value of product purchased, formulary status or pre-determined market shares relative to competitors in order to earn such rebates.

     We establish an accrual in an amount equal to our estimate of managed care rebates attributable to our sales in the period in which we record the sale as revenue. We estimate the managed care rebates accrual primarily based on the specific terms in each agreement, current contract prices, historical and estimated future usage by managed care organizations, and levels of inventory in the distribution channel. We analyze the accrual at least quarterly and adjust the balance as needed.

     We participate in the Federal Medicaid rebate program, as well as several state government-managed supplemental Medicaid rebate programs, which were developed to provide assistance to certain vulnerable and needy individuals and families. Under the Medicaid rebate program, we pay a rebate to each participating state and local government for our products that their programs reimburse. Federal law also requires that any company that participates in the Medicaid program must extend comparable discounts to qualified purchasers under the Public Health Services, or PHS, pharmaceutical pricing program. The PHS pricing program extends discounts comparable to the Medicaid rebate to a variety of community health clinics and other entities that receive health services grants from the PHS, as well as hospitals that serve a disproportionate share of Medicare and Medicaid beneficiaries. For purposes of this discussion, discounts and rebates provided through these programs are considered Medicaid rebates and are included in our Medicaid rebate accrual.

     We establish an accrual in the amount equal to our estimate of Medicaid rebates attributable to our sales in the period in which we record the sale as revenue. Although we accrue a liability for estimated Medicaid rebates at the time we record the sale, the actual Medicaid rebate related to that sale is typically not billed to us for up to one year after the sale, when a prescription is filled that is covered by that program. We analyze the accrual at least quarterly and adjust the balance as needed. In determining the appropriate accrual amount we consider the then-current Medicaid rebate laws and interpretations; the historical and estimated future percentage of our products that are sold to Medicaid recipients by pharmacies, hospitals, and other retailers that buy from our customers; our product pricing and current rebate and/or discount contracts; and the levels of inventory in the distribution channel. We analyze the accrual at least quarterly and adjust the balance as needed.

     Medicare Part D programs offered by managed care organizations, which began to provide prescription drug benefit coverage effective January 1, 2006, were expected by us to reduce the number of Medicaid eligible prescriptions processed by state Medicaid programs. Accordingly, our rebate reserves for 2005 and the first quarter of 2006 were established based on our estimate of the pending impact of these programs. Based on Medicaid claims recently received attributable to prescriptions filled for the first three months of 2006, the reduction in prescriptions processed by state Medicaid programs was significantly greater than the reduction we had originally estimated. In late July and August, we conducted a review of the impact of the Medicare Part D

     We also make our products available to authorized users of the Federal Supply Schedule, or FSS, of the General Services Administration under an FSS contract negotiated by the Department of Veterans Affairs. The Veterans Health Care Act of 1992, or VHCA, establishes a price cap, known as the “federal ceiling price” for sales of covered drugs to the Veterans Administration, the Department of Defense, the Coast Guard, and the PHS. Specifically, our sales to these federal groups are discounted by a minimum of 24% off the average manufacturer price charged to non-federal customers. These groups purchase product from the wholesalers, who then charge back to Connetics the difference between the current retail price and the price the federal entity paid them for the product.

     We establish an accrual in the amount equal to our estimate of chargeback claims attributable to our sales in the period in which we record the sale as revenue. Although we accrue a liability for estimated chargebacks at the time we record the sale, the actual chargeback related to that sale is not processed until the federal group purchases the product from the wholesaler. We estimate the rate of chargebacks based on historical experience and changes to current contract prices. We also consider our claim processing lag time and the level of inventory held at wholesalers. We analyze the accrual at least quarterly and adjust the balance as needed. The inventory at retail pharmacies, which represents the rest of the distribution channel, is not considered in this accrual, as the entities eligible for chargebacks buy directly from wholesalers.

     We offer cash discounts to our customers, generally 2% of the sales price, as an incentive for prompt payment. We account for cash discounts by reducing accounts receivable by the full amount of the discounts we expect our customers to take. We consider payment performance and adjust the allowance to reflect actual experience and our current expectations about future activity.

     In addition to the significant gross-to-net sales adjustments described above, we periodically make other sales adjustments. For example, we may offer sales discounts to our customers and discounts and coupons to patients. “Other adjustments” also includes payments owing to distributors pursuant to distribution services agreements. We generally account for these other gross-to-net adjustments by establishing an accrual in the amount equal to our estimate of the adjustments attributable to the sale. We estimate the accruals for these other gross-to-net sales adjustments primarily based our historical experience, and other relevant factors, including levels of inventory in the distribution channel, if relevant, and adjust the accruals periodically throughout the quarter to reflect the actual experience.

      In 2004, the Department of Defense, or DOD, took the position that the Federal Supply Schedule discounted price extends to retail pharmacy transactions through the DOD’s TRICARE Retail Pharmacy program,

or TRRx. The intention was to obtain refunds for the government on retail pharmacy utilization based on the difference between wholesaler pricing and Federal Ceiling Prices as defined under the Veterans Health Care Act of 1992. The refund requirement was announced to us and other manufacturers in an October 2004 letter. Based on the receipt of rebate invoices, we began to reserve for an estimated liability for prescriptions filled under the TRRx program beginning in the third quarter of 2005 and had reserved $1.4 million through June 30, 2006 for potential liability under the TRRx program. That accrual is part of product-related accruals on the Balance Sheet. A trade association challenged the legality of the TRRx program in Federal court, and on September 11, 2006 the U.S. Court of Appeals for the Federal Circuit struck down the TRRx program. We now believe that, as a result of the Federal Court of Appeals decision, it is unlikely that the TRRx Program, even if ultimately implemented, will be made retroactive. As a result, we released the $1.4 million accrual in September 2006, which decreased our net loss per share by $0.04 for the three month and nine month periods ended September 30, 2006.

     We use information from external sources to estimate our significant gross-to-net sales adjustments. Our estimates of inventory in the distribution channel are based on the projected prescription demand-based sales for our products and historical inventory experience, as well as our analysis of third-party information, including written and oral information obtained from certain wholesalers with respect to their inventory levels and sell-through to customers, third-party market research data, and our internal information. The inventory information received from wholesalers is a product of their record-keeping process and excludes inventory held by intermediaries to whom they sell, such as retailers and hospitals. Prior to December 31, 2005, we estimated inventory in the distribution channel using historical shipment and return information from our accounting records and data on prescriptions filled, which we purchase from Per-Se Technologies, formerly NDC Health Corporation, one of the leading providers of prescription-based information. In April 2005, we began to receive weekly reporting of inventory on hand and sales information under the distribution service agreements from our two largest customers. We identified errors in the reported information that impaired the accuracy and, as a result, usefulness of this reporting. These errors were not corrected until December 2005. In December 2005 we also began to receive weekly reporting of inventory on hand and sales information for two other customers. As a result of the improved accuracy and increased scope of our inventory reporting, we began to use the reported inventory on hand information to estimate inventory in the distribution channel as of December 31, 2005.

     We use the information from Per-Se Technologies to project the prescription demand for our products. Our estimates are subject to inherent limitations pertaining to reliance on third-party information, as certain third-party information is itself in the form of estimates. In addition, our estimates reflect other limitations including lags between the date as of which third-party information is generated and the date on which we receive the third-party information.

     We believe that our allowances and accruals for items that are deducted from gross revenues are reasonable and appropriate based on current facts and circumstances. It is possible, however, that other parties applying reasonable judgment to the same facts and circumstances could develop different allowance and accrual amounts for items that are deducted from gross revenues. Additionally, changes in actual experience or changes in other qualitative factors could cause our allowances and accruals to fluctuate, particularly with newly launched or acquired products. We review the rates and amounts in our allowance and accrual estimates on a quarterly basis. If future estimated rates and amounts are significantly greater than those reflected in our recorded reserves, the resulting adjustments to those reserves would decrease our reported net revenues; conversely, if actual returns, rebates and chargebacks are significantly less than those reflected in our recorded reserves, the resulting adjustments to those reserves would increase our reported net revenue. If we changed our assumptions and estimates, our revenue reserves would change, which would impact the net revenues we report.

     We collect royalties from our third-party licensees based on their sales. We recognize royalties either in the quarter in which we receive the royalty payment from the licensee or in the period in which we can reasonably estimate the royalty, which is typically one quarter following the related sale by the licensee.

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

     We recognize revenue from non-refundable upfront license fees ratably over the period in which we have continuing development obligations. We recognize revenue associated with substantial “at risk” performance milestones, as defined in the respective agreements, based upon the achievement of the milestones. When we receive advance payments in excess of amounts earned, we classify them as deferred revenue until they are earned.

     On January 1, 2006, we adopted the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, or SFAS 123R, requiring us to recognize expense related to the fair value of our stock-based compensation awards. We elected to use the modified prospective transition method as permitted by SFAS 123R and therefore have not restated our financial results for prior periods. Under this transition method, stock-based compensation expense for the three and nine months ended September 30, 2006 includes compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, or SFAS 123. Stock-based compensation expense for all stock-based compensation awards granted subsequent to January 1, 2006 was based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R.

     We use the Black-Scholes option-pricing model which requires the input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. We record stock-based compensation expense net of expected forfeitures. The estimation of stock awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. We use a blend of historical volatility of our common stock and implied volatility of tradable forward call and put options to purchase and sell shares of our common stock. Changes in the subjective input assumptions can materially affect the estimate of fair value of options granted and our results of operations could be materially impacted.

     We recognize stock-based compensation as expense over the requisite service periods in our Condensed Consolidated Statements of Operations, using a graded vesting expense attribution approach for unvested stock option awards granted before we adopted SFAS 123R and using the straight-line expense attribution approach for stock option awards granted after we adopted SFAS 123R.

     We compute basic net income (loss) per common share by dividing net income (loss) by the weighted average number of unrestricted common shares outstanding during the period.

     The calculation of basic and diluted net income (loss) per share is as follows:

     In calculating diluted net income (loss) per share, we excluded the following shares, as the effect would be anti-dilutive (in thousands):

     In 2006 and subsequent years, our dilutive securities may include incremental shares issuable upon conversion of all or part of the $200 million in 2.00% convertible senior notes currently outstanding. The conversion feature of these notes is triggered when our common stock reaches a certain market price and, if triggered, may require us to pay a stock premium in addition to redeeming the accreted principal amount for cash. The $200 million principal amount can only be redeemed for cash, and therefore, has no impact on the diluted earnings per share calculation. In accordance with the consensus from EITF No. 04-8, “The Effect of Contingently Convertible Instruments on Diluted Earnings per Share,” we will include the dilutive effect of the notes in our calculation of net income per diluted share when the impact is dilutive. The conversion feature of these notes was not included as the notes had no dilutive effect on our computation of net income (loss) per share for any period since issuance in March 2005.

     On January 1, 2006, we adopted the provisions of SFAS 123R, requiring us to measure and recognize compensation expense for all stock-based awards at fair value. We elected to use the modified prospective transition method as permitted by SFAS 123R and therefore have not restated our financial results for the impact of SFAS 123R on prior periods. Under this transition method, stock-based compensation expense for the three and nine months ended September 30, 2006 includes compensation expense for all stock-based awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. Stock-based compensation expense for all stock-based compensation awards granted subsequent to January 1, 2006 was based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R.

     Stock-based compensation is recognized as expense over the requisite service periods in our Condensed Consolidated Statement of Operations for the three and nine month periods ended September 30, 2006 using a graded vesting expense attribution approach for unvested stock option awards granted prior to the adoption of SFAS 123R and using the straight-line expense attribution approach for stock option awards granted after the adoption of SFAS 123R. We record stock-based compensation expense net of expected forfeitures. The following table sets forth the total stock-based compensation expense resulting from stock options, non-vested stock awards and our Employee Stock Purchase Plan, or “Purchase Plan,” included in our Condensed Consolidated Statement of Operations.

     The fair value of the options vested for the nine months ended September 30, 2006 was $2.4 million. As of September 30, 2006, there was $9.5 million (before any related tax benefit) of total unrecognized compensation cost related to unvested stock-based compensation that is expected to be recognized over a weighted-average period of approximately 1.9 years.

     We received net cash from the exercise of stock options of $385,000 for the three months ended September 30, 2006, and $3.6 million for the nine months ended September 30, 2006. Net cash proceeds from the exercise of stock options were $2.2 million and $7.1 million for the three and nine months ended September 30, 2005, respectively. We did not realize any income tax benefit from stock option exercises during the three and nine months ended September 30, 2006 and 2005. In accordance with SFAS 123R, we present excess tax benefits from the exercise of stock options, if any, as financing cash flows rather than operating cash flows.

     Prior to the adoption of SFAS 123R, we applied SFAS 123, amended by SFAS 148, which allowed companies to apply the existing accounting rules under APB 25 and related Interpretations. Accordingly, we did not recognize any compensation expense in our financial statements in connection with stock options granted to employees when those options had exercise prices equal to or greater than fair market value of our common stock on the date of grant. We also did not record any compensation expense in connection with our Purchase Plan as long as the purchase price was not less than 85% of the fair market value at the beginning or end of each offering period, whichever was lower. As required by SFAS 148 prior to the adoption of SFAS 123R, we provided pro forma net income (loss) and pro forma net income (loss) per share disclosures for stock-based awards, as if the fair-value-based method defined in SFAS 123 had been applied.

     The following table illustrates the effect on net income after tax and net income per share as if we had applied the fair value recognition provisions of SFAS 123 to stock-based compensation during the three and nine months ended September 30, 2005:

     The pro forma stock-based compensation expense determined under the fair value method for the nine months ended September 30, 2005 of $12.3 million, as reported above, differs from the previously reported pro forma amount of $13.7 million. The previously reported amount erroneously included the expense related to our Purchase Plan for the full year of 2005 rather than only the nine month period ended September 30, 2005.

     The weighted average fair value of options granted, based on the assumptions and criteria discussed below, was $4.95 and $6.37 per share for the three and nine months ended September 30, 2006, respectively; and $7.28 and $9.53 per share for the three and nine months ended September 30, 2005, respectively.

     The fair value of stock-based awards was estimated using the Black-Scholes model with the following weighted-average assumptions:

     We estimated the fair value of each option grant on the date of the grant using the Black-Scholes valuation model. The expected life of the options represents the weighted average period of time that options granted are expected to be outstanding giving consideration to vesting schedules, option cancellations and the historical exercise patterns we have experienced. For the three and nine month periods ended September 30, 2006, we estimate the expected stock price volatility based on a combination of our common stock’s historical volatility and the implied volatility of tradable forward call and put options to purchase and sell shares of our

stock. For the three and nine month periods ended September 30, 2005, we estimated expected stock volatility primarily using a combination of the historical volatility of our stock and our peers’ stock, and to a lesser extent, the implied volatility as described above. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. In 2006, we have reduced gross compensation expense to account for estimated forfeitures, because the expense related to stock option awards recognized on adoption of SFAS 123R is based on awards ultimately expected to vest. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We estimated forfeitures based on our historical experience.

     Through November 30, 2005, our Purchase Plan permitted eligible employees to purchase our common stock through payroll deductions at a price equal to the lower of 85% of the fair market value at the beginning or end of the offering period, which was two years. On December 1, 2005, we modified the Purchase Plan so that employee purchases were made at 85% of the fair market value of our common stock at the end of each six month offering period. The elimination of the “look back” period as well as a decrease in employee participation in the Purchase Plan has resulted in a significant decrease of the expense related to the Purchase Plan in 2006 and simplified the calculation of the related stock-based compensation to represent 15% of the contributions to the Purchase Plan. We recognized $81,000 and $226,000 in stock-based compensation expense related to the Purchase Plan during the three and nine months ended September 30, 2006, respectively. Stock-based compensation expense related to the Purchase Plan recognized in our pro forma disclosure was $749,000 and $1,472,000 for the three and nine month periods ended September 30, 2005, respectively.

     On January 27, 2006, we granted 475,000 shares of restricted stock in lieu of option grants to members of our executive management. Of the total awards, 50% are subject to time-based vesting and the remaining 50% are subject to both performance-based and time-based vesting with certain 2006 performance goals determined by the Compensation Committee. For all of the shares subject to time-based vesting and the shares ultimately issued based on performance, the vesting restriction for one-half will lapse on February 1, 2008 and the remaining one-half will lapse February 1, 2009. Through September 30, 2006 we have not recorded compensation expense for the restricted stock grants which have performance-based criteria due to the probability that the performance criteria will not be met; however, the Compensation Committee will make a final assessment in late 2006 or the first quarter of 2007, at which time they will consider business conditions and other factors. On February 1, 2006, we also granted 58,000 shares of restricted stock in lieu of option grants to certain management individuals; all of those shares are subject only to time-based vesting. Of the total awards, the restriction for one-third lapses on the first anniversary and one-sixth each six months thereafter. On May 22, 2006 we granted an additional 60,000 shares of restricted stock in lieu of annual option grants to our Board of Directors. The restriction on these awards lapses one year from the date of grant. We did not grant restricted stock prior to January 1, 2006. We recognized approximately $568,000 and $1,240,000 of compensation expense during the three and nine month periods ended September 30, 2006, respectively. The weighted average fair value of restricted stock granted, determined using the Black-Scholes model, was $10.44 per share for the three months ended September 30, 2006 and $14.75 per share for the nine months ended September 30, 2006, respectively.

     We have seven plans pursuant to which we have granted stock options to employees, directors, and consultants. In general, all of the plans authorize the grant of stock options vesting at a rate to be set by the Board or the Compensation Committee. Generally, stock options under all of our employee stock plans become exercisable at a rate of 25% per year for a period of four years from date of grant. The plans require that the options be exercisable at a rate no less than 20% per year. The exercise price of stock options under the employee stock plans generally meets the following criteria: exercise price of incentive stock options must be at least 100% of the fair market value on the grant date, exercise price of non-statutory stock options must be at least 85% of the fair market value on the grant date, and exercise price of options granted to 10% (or greater) stockholders must be

at least 110% of the fair market value on the grant date. The 1995 Director’s Plan expired on January 1, 2006. The 2000 Non- Officer Stock Plan, the 2002 Employee Stock Plan and the International Stock Incentive Plan do not permit the grant of incentive stock options. The weighted stock options under all of our employee stock plans have a term of ten years from date of grant. Below is a general description of the plans from which we are currently granting stock options.

     2000 Stock Plan. Our 2000 Stock Plan (the 2000 Plan) was approved by the Board and our stockholders in 1999. The 2000 Plan became available on January 1, 2000, and was initially funded with 808,512 shares. On the first day of each new calendar year during the term of the 2000 Plan, the number of shares available will be increased (with no further action needed by the Board or the stockholders) by a number of shares equal to the lesser of three percent (3%) of the number of shares of common stock outstanding on the last preceding business day, or an amount determined by the Board.

     Non-Officer Stock Option Plans. The 2000 Non-Officer Stock Plan was funded with 500,000 shares. No additional shares will be added to this plan, although shares may be granted if they become available through cancellation. The 2002 Employee Stock Plan was initially funded with 500,000 shares. In 2003, the 2002 Employee Stock Plan was amended to increase the shares available for issuance by 750,000 shares, for a total of 1,250,000 shares, and to permit the issuance of options under the plan to officers of Connetics who are not executive officers within the meaning of Section 16 of the Securities Exchange Act of 1934. Our stockholders approved those amendments in 2003. The options granted under both plans are nonstatutory stock options.

     International Stock Incentive Plan. In 2001, the Board approved an International Stock Incentive Plan, which provided for the grant of Connetics’ stock options to employees of Connetics or its subsidiaries where the employees are based outside of the United States. The plan was funded with 250,000 shares. The options granted under the plan are nonstatutory stock options.

     Inducement Stock Option Grants. In 2005, the Compensation Committee of the Board of Directors approved a pool of 600,000 shares to be granted to certain employees. Pursuant to NASDAQ Marketplace Rule 4350(i)(1)(A)(IV), we issue a press release for all inducement grants disclosing the grants and their material terms.

     Summary of All Option Plans and Non-Plan Grants. The following table summarizes information concerning stock options outstanding under all of our stock option plans and certain grants of shares and options outside of our plans. Options canceled under terminated plans are no longer available for grant.

     The aggregate intrinsic value of options exercised during the three and nine months ended September 30, 2006 was $373,000 and $2.4 million, respectively. The aggregate intrinsic value of options exercised during the three and nine months ended September 30, 2005 was $2.4 million and $8.9 million, respectively.

     The following table summarizes information concerning outstanding and exercisable options at September 30, 2006:

     The aggregate intrinsic value of options outstanding and options exercisable at September 30, 2006 was $6.9 million and $6.6 million, respectively. Options exercisable at September 30, 2006 had a weighted-average remaining contractual life of 5.63 years.

     The components of comprehensive income (loss) are as follows (in thousands):

     Accumulated other comprehensive income recorded in stockholders’ equity included $105,000 of net unrealized losses on investments and $934,000 of foreign currency translation unrealized gains as of September 30, 2006 and, as of December 31, 2005, included $447,000 of net unrealized losses on investments and $974,000 of foreign currency translation unrealized gains.

     Inventory consists of raw materials and finished goods costs primarily related to our marketed products. We state inventory at the lower of cost (determined on a first-in first-out method) or market. If inventory costs

exceed expected market value due to obsolescence, expiration or lack of demand for the product, we record reserves in an amount equal to the difference between the cost and the estimated market value. These reserves are based on estimates and assumptions made by management. These estimates and assumptions can have a significant impact on the amounts of reserves.

     The components of inventory are as follows (in thousands):

     Inventory may also include similar costs for product candidates awaiting regulatory approval to be sold upon receipt of approval. We capitalize those costs based on management’s judgment of probable near-term commercialization or alternative future uses for the inventory. If not approved, we assess the realizability of the asset based on several factors including management’s estimates of future regulatory work required, alternative uses, and potential resale value. We included $1.9 million of product packaging material and equipment costs related to Velac Gel in the other assets line item on our balance sheet at December 31, 2005. After completion of certain studies in the third quarter of 2006 and communications with the FDA in September 2006, our management team reassessed the realizability of these assets based on future regulatory work required, the potential resale value and other relevant factors. We determined these assets were impaired and expensed $1.9 million to the research and development line item on our statement of operations for the three and nine month periods ended September 30, 2006. Connetics remains committed to bringing the product to market and development activities are ongoing.

     Effective February 1, 2006, we acquired the sales organization of PediaMed Pharmaceuticals, Inc., a privately-held pharmaceutical company specializing in the pediatric market, for cash of $12.5 million plus transaction costs of approximately $37,000. We recorded an intangible asset for the assembled workforce and trademark rights acquired in connection with this acquisition of approximately $12.5 million based on a cost approach. We are amortizing the assembled workforce over an estimated useful life of five years. The acquired sales force is promoting our products to selected pediatricians nationwide. We added Verdeso, our first product with a pediatric label approved by the FDA, to the group’s portfolio in October 2006. The FDA approved Verdeso on September 19, 2006. The PediaMed acquisition did not include any commercial products historically sold by the PediaMed sales organization, or rights to any products developed by PediaMed. The $12.5 million included $0.3 million for trademark rights acquired in connection with the acquisition which were amortized over six months.

      There was no change in the carrying amount of goodwill of $6.3 million during the three and nine months ended September 30, 2006. The components of our intangible assets are as follows (in thousands):

     Amortization expenses for our other intangible assets were $4.1 million and $12.1 million during the three and nine months ended September 30, 2006, respectively. Amortization expenses for our other intangible assets were $3.4 million and $10.2 million during the three and nine months ended September 30, 2005, respectively.

     Pursuant to FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others,” or FIN No. 45, upon issuance the guarantor must recognize a liability for the fair value of the obligations it assumes under that guarantee. We enter into indemnification provisions under our agreements with certain key employees and other companies in the ordinary course of our business, typically with business partners, contractors, clinical sites, insurers, and customers. Under these provisions we generally indemnify and hold harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of our activities. These indemnification provisions generally survive termination of the underlying agreement. In some cases, the maximum potential amount of future payments Connetics could be required to make under these indemnification provisions is unlimited. The estimated fair value of the indemnity obligations of these agreements is insignificant. Accordingly, we have not recorded liabilities for these agreements as of September 30, 2006. We have not incurred material costs to defend lawsuits or settle claims related to these indemnification provisions.

     In April 2005, we entered into an agreement with Ventiv Pharma Services, LLC, or VPS, a subsidiary of Ventiv Health, Inc., under which VPS provided sales support for certain of our products to primary care physicians and pediatricians. Product sales activities under this agreement commenced in mid-April 2005. We recorded 100% of the revenue from product sales of OLUX Foam, Luxíq Foam, and Evoclin Foam generated by promotional efforts of VPS; paid VPS a fee for the personnel providing the promotional efforts, which are included in selling, general and administrative expense; and bore the marketing costs for promoting the products, including product samples and marketing materials. In January 2006, the parties mutually agreed to discontinue the agreement, and the agreement terminated effective February 10, 2006.

     On October 31, 2005, our Board of Directors authorized the repurchase of up $50 million of our common stock. As of December 31, 2005, we had repurchased 1.8 million shares of our common stock at a cost of $24.4 million. During the nine months ended September 30, 2006, we repurchased an additional 143,000 shares at a cost of $2.2 million.

     As previously disclosed, the SEC is conducting an investigation into potential securities law violations by the Company and/or current and former officers, directors and employees. The Company has received and responded to multiple subpoenas and requests for information, most recently a document subpoena dated October 6, 2006, to which the Company has responded. The SEC investigation is ongoing.

          On October 22, 2006, Connetics entered into a definitive merger agreement (Merger Agreement) with Stiefel Laboratories, Inc., or Stiefel, for Stiefel to acquire Connetics. This transaction is subject to certain closing conditions, including (i) approval by at least a majority of the voting power of the shares of the Company’s common stock outstanding, and (ii) the termination or expiration of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976.

Upon the closing of the merger:

          In connection with the Merger Agreement, the directors and executive officers of Connetics, concurrently with the execution and delivery of the Merger Agreement, entered into Voting Agreements with Stiefel (Voting Agreements), pursuant to which they each agreed, among other things, to vote the shares of Connetics common stock held by them in favor of the Merger and against any other proposal or offer to acquire Connetics. If the Merger Agreement is terminated for any reason, the Voting Agreements will also terminate. The directors and executive officers who have entered into Voting Agreements own, in the aggregate, 1,033,051 shares of Connetics common stock as of October 22, 2006, representing approximately three percent of Connetics’ outstanding common stock.

          Immediately prior to the execution of the Merger Agreement, the Company and Computershare Trust Company, N.A. entered into an amendment (Rights Agreement Amendment) to the Company’s Rights Agreement dated as of November 21, 2001 (Rights Agreement). The purpose and effect of the Rights Agreement Amendment is to make the Rights Agreement inapplicable to the announcement, approval, execution, delivery or performance of the Merger Agreement or the Voting Agreements, or the consummation of the Merger or any of the other transactions contemplated by the Merger Agreement, so that these events will not trigger the separation or exercise of the Rights (as defined in the Rights Agreement).

          Connetics and Stiefel also entered into a Distribution and Supply Agreement (Distribution and Supply Agreement) in which they agreed that if a third party should begin selling a generic version of Connetics’ Soriatane® product, Stiefel would be authorized to also sell a generic version of Soriatane in the United States, Connetics would supply Stiefel with its requirements of the product (subject to certain limitations) and Connetics would not supply any other party with a generic version of Soriatane. If the Merger Agreement is terminated, then Connetics would be entitled to terminate the Distribution and Supply Agreement.

          The Company currently expects the transaction to close in late 2006 or early 2007, although there can be no assurances that it will close. Under terms specified in the merger agreement, Connetics or Stiefel may terminate the agreement, and, in connection with a termination under certain specified circumstances, Connetics may be required to pay a $19.1 million termination fee to Stiefel.

          As a result of the merger, each holder of the convertible notes shall have the right to require Connetics to repurchase any or all of the holder’s notes for cash at 100% of the principal amount plus accrued and unpaid interest on such amount to the applicable repurchase date. Furthermore, each holder of the notes shall have the right to convert all of such holder’s notes into shares of the Connetics Common Stock pursuant to the conversion ratio set forth in the respective indenture agreements.

          For more information about the proposed transaction, refer to the Current Report on Form 8-K filed by the Company on October 24, 2006.

          This discussion and analysis should be read in conjunction with the MD&A included in our Annual Report, as amended, on Form 10-K /A for the year ended December 31, 2005 and with the unaudited condensed consolidated financial statements and notes to financial statements included in this Report. Our disclosure and analysis in this Report, in other reports that we file with the Securities and Exchange Commission, in our press releases and in public statements of our officers may contain forward-looking statements within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act. Forward-looking statements give our current expectations or forecasts of future events. You can identify these statements by the fact that they do not relate strictly to historical or current events. They use words such as “anticipate,” “estimate,” “expect,” “will,” “may,” “intend,” “plan,” “believe” and similar expressions in connection with discussion of future operating or financial performance. These include statements relating to future actions, prospective products or product approvals, future performance or results of current and anticipated products, sales efforts, expenses, the outcome of contingencies such as legal proceedings, and financial results. Forward-looking statements may turn out to be wrong. They can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Many factors will be important in determining future results. No forward-looking statement can be guaranteed, and actual results may vary materially from those anticipated in any forward-looking statement. Some of the factors that, in our view, could cause actual results to differ are discussed under the caption “Risk Factors” in our 2005 Annual Report, as amended, on Form 10-K/A for the year ended December 31, 2005, as amended. Our historical operating results are not necessarily indicative of the results to be expected in any future period.

          On October 22, 2006, Connetics entered into a definitive merger agreement (Merger Agreement) with Stiefel Laboratories, Inc., or Stiefel, for Stiefel to acquire Connetics. This transaction is subject to certain closing conditions, including (i) approval by at least a majority of the voting power of the shares of the Company’s common stock outstanding, and (ii) the termination or expiration of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976.

Upon the closing of the merger:

          This Management’s Discussion and Analysis of Financial Condition and Results of Operations section is intended to help the reader understand our historical results and anticipated outlook prior to the close of the proposed merger. We currently expect the transaction to close in late 2006 or early 2007, although we cannot assure you that it will close. Under terms specified in the merger agreement, Connetics or Stiefel may terminate the agreement, and, in connection with a termination under certain specified circumstances, Connetics may be required to pay a $19.1 million termination fee to Stiefel. For more information about the proposed transaction, refer to the Current Report on Form 8-K filed by the Company on October 24, 2006. We intend to file a proxy statement with the SEC that, when final, will detail a meeting of our stockholders to enable our stockholders to vote to adopt the merger agreement. The proxy statement will be sent to all our stockholders and will contain

which has been accepted for filing and assigned a user fee date of January 2007.

     As previously disclosed, the SEC is conducting an investigation into potential securities law violations by the Company and/or current and former officers, directors and employees. The Company has received and responded to multiple subpoenas and requests for information, most recently a document subpoena dated October 6, 2006, to which the Company has responded. The SEC investigation is ongoing.

          On August 28, 2006 we announced the positive outcome of our Phase III clinical trial evaluating Extina® (ketoconazole) Foam, 2%, formulated in VersaFoam-HF™, for the treatment of seborrheic dermatitis. The Extina Phase III clinical study was a four-week, double-blinded, active- and placebo-controlled trial that included 1,162 patients at 24 centers in the United States. The trial was designed to demonstrate that Extina is superior to placebo foam as measured by the primary endpoint of Investigator’s Static Global Assessment, or ISGA. The ISGA for this trial was an overall assessment of the severity of seborrheic dermatitis with respect to the clinically relevant signs of the disease. Adverse events with Extina were mild to moderate in nature and were related primarily to burning and stinging at the application site.

          On September 19, 2006, the FDA approved Verdeso (desonide) Foam, 0.05%, for the treatment of mild-to-moderate atopic dermatitis. Verdeso, formerly referred to as Desilux, is a low-potency topical steroid and is the first approved product formulated in Connetics’ proprietary VersaFoam®-EF emulsion formulation foam vehicle. Verdeso is also our first product approved for pediatric use. Connetics began marketing Verdeso to physicians in the late October 2006.

          On October 22, 2006, upon Board of Directors authorization, we signed a definitive merger agreement with Stiefel Laboratories, Inc., a privately held company based in Coral Gables, Florida. Upon the closing of the transaction, holders of Connetics’ common stock will receive $17.50 per share in cash. The closing is subject to approval by holders of a majority of Connetics’ outstanding common stock, antitrust clearance and other customary closing conditions. We anticipate closing the merger in late 2006 or early 2007.

          We made no material changes to our critical accounting policies and estimates included in our Annual Report on Form 10-K/A for the year ended December 31, 2005, except as noted below.

          Historically we have recognized revenue based on a sell-in model for new products. Starting in the fourth quarter of 2006, our policy will be to recognize revenue for new products based on estimated units filled in prescriptions until our wholesalers establish consistent ordering and inventory levels that are consistent with our targeted wholesaler inventory stocking levels (generally between four and six weeks of sales). This is the policy we are following with sales of Verdeso™ , which we launched in October 2006. We will estimate units filled in prescriptions using prescription data we purchase from Per-Se Technologies, formerly NDC Health Corporation, one of the leading providers of prescription-based information. When wholesalers have established consistent ordering and inventory levels consistent with our targeted wholesaler inventory stocking levels, we will recognize product revenue upon shipment. Regardless of the timing of recognition, we recognize product revenues net of applicable estimated allowances and product-related accruals.

          On January 1, 2006, we adopted the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, or SFAS 123R, requiring us to recognize expense related to the fair value of our stock-based compensation awards. We elected to use the modified prospective transition method as permitted by SFAS 123R and therefore have not restated our financial results for prior periods. Under this transition method, stock-based compensation expense for the three and nine months ended September 30, 2006 includes compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of January 1, 2006. Compensation expense is based on the grant date fair value estimated in accordance with the original provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, or SFAS 123. Stock-based compensation expense for all stock-based compensation awards granted on or after January 1, 2006 is based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R.

          We use the Black-Scholes option-pricing model, which requires the input of highly subjective assumptions, including the option’s expected life, the price volatility of the underlying stock, and the estimated forfeiture rate. The estimation of stock awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. We use a blend of historical volatility of our common stock and implied volatility of tradable forward call and put options to purchase and sell shares of our common stock. Changes in the subjective input assumptions can materially affect the estimate of fair value of options granted and our results of operations could be materially impacted.

          We recognize stock-based compensation as expense over the requisite service periods in our Condensed Consolidated Statements of Operations, using a graded vesting expense attribution approach for unvested stock option awards granted before we adopted SFAS 123R and using the straight-line expense attribution approach for stock option awards granted after we adopted SFAS 123R.

Net Revenues

          The following table summarizes our gross-to-net sales deductions (in thousands):

          The following table summarizes our net product and royalty and contract revenues (in thousands):

          Our net product revenues were $18.8 million for the three months ended September 30, 2006 and $50.8 million for the three months ended September 30, 2005, representing a decrease of $32.0 million or 63%. The decrease in net product revenues is primarily attributable to the reduction of inventory levels of our products at our major wholesalers, which resulted in shipment of units to the wholesalers below unit demand. We estimate that we shipped approximately $31.4 million less than unit demand during the third quarter resulting in a decrease in the estimated months of demand in the distribution channel of 3.6 months at June 30, 2006 to 1.5 months at September 30, 2006 (see further discussion below). This $32.0 million decrease in net revenues was partially offset by a $1.4 million release for accruals related to the TRICARE Retail Pharmacy Program, or TRRx. In 2004, the Department of Defense, or DOD, took the position that the Federal Supply Schedule discounted price extends to retail pharmacy transactions through the DOD’s TRRx. The intention was to obtain refunds for the government on retail pharmacy utilization based on the difference between wholesaler pricing and Federal Ceiling Prices as defined under the Veterans Health Care Act of 1992. The refund requirement was announced to us and other manufacturers in an October 2004 letter. Based on the receipt of rebate invoices, we began to reserve for an estimated liability for prescriptions filled under the TRRx program beginning in the third quarter of 2005 and had reserved $1.4 million through June 30, 2006 for potential liability under the TRRx program. That accrual is part of product-related accruals on the Balance Sheet. A trade association challenged the legality of the TRRx program in Federal court, and on September 11, 2006 the U.S. Court of Appeals for the Federal Circuit struck down the TRRx program. We now believe that, as a result of the Federal Court of Appeals decision, it is unlikely that the TRRx Program, even if ultimately implemented will be made retroactive to 2004. As a result, we released the $1.4 million accrual in September 2006, which decreased our net loss per share by $0.04 for the three month and nine month periods ended September 30, 2006.

          Our net product revenues were $109.4 million for the nine months ended September 30, 2006 and $136.3 million for the nine months ended September 30, 2005, representing a decrease of $26.9 million or 20%. The decrease in net product revenues is primarily attributable to the reduction of inventory levels of our products at our major wholesalers of $38.6 in the second and third quarters of 2006. This decrease is slightly offset by a $1.4 million release of a reserve for TRRx in the third quarter, which decreased our net loss per share by $0.04 for the nine months ended September 30, 2006. The decrease is also partially offset by a $2.9 million release of Medicaid reserves in the second quarter discussed below which decreased our net loss by $0.09 per share for the nine months ended September 30, 2006 (see Medicare Part D discussion below).

          We expected Medicare Part D programs to reduce the number of Medicaid eligible prescriptions processed by state Medicaid programs. Medicare Part D programs are offered by managed care organizations and began to provide prescription drug benefit coverage effective January 1, 2006. Based, however, on the Medicaid claims we have recently received attributable to prescriptions filled for the first three months of 2006, the reduction in prescriptions processed by, and therefore the reduction in rebates due to, state Medicaid programs was significantly greater than we anticipated. Because of this discrepancy, in late July and August, we conducted a review of the claims activity including calls to all of the significant state programs we contract with, to ensure that we had actually received all of the claims relating to the first three months of 2006. We anticipate that Medicare Part D programs will continue to reduce the prescriptions processed by, and therefore rebates to, state Medicaid programs in the future, which would be partially offset by rebates due to Medicare Part D programs. Based on this review we revised our estimate of the impact of these programs and as a result, during the second quarter we released approximately $2.9 million of Medicaid rebate reserves accrued at March 31, 2006, which resulted in a corresponding positive contribution to our net product revenues for the nine months ended September 30, 2006. The impact of Medicare Part D programs will continue to be evaluated and as additional market data and rebate claims activity become known the estimated rebate claims reserve will be adjusted accordingly.

          We estimate inventory in the distribution channel using reports we receive from wholesalers and we calculate months’ supply on a weighted average basis by product relative to unit demand. Our estimated levels of inventory in the distribution channel as of December 31, 2005, March 31, 2006, June 30, 2006, and September 30, 2006 are approximately the following months of estimated unit demand:

          The decrease in the estimated levels of inventory in the first quarter of 2006 was primarily a function of increased unit demand experienced by the wholesalers while the decrease in the second and third quarter of 2006 was principally the result of shipment of units to the wholesalers below unit demand.

          In order to facilitate improved management of wholesale inventory levels of all of our products, at the end of 2005 we announced our intention to reduce wholesale inventory levels of our products. On July 10, 2006, we announced that we intend to continue to ship below estimated prescription demand during the remainder of 2006 at a greater rate than originally planned for the year, with a goal of reducing average wholesaler inventory levels to approximately two months on-hand by the end of 2006. In September 2006, based on the logistical efficiencies gained in the distribution system, we reduced the goal of average wholesaler inventory levels to between four and six weeks. The rate at which we continue to reduce inventory is subject to many variables, however, including

estimates of the amounts currently in inventory at each wholesaler and predictions of end-user prescription demand for our products.

          Because shipments to our wholesalers have been and, to a lesser extent, will continue to be below levels indicated by prescription demand, our net product revenues under U.S. GAAP reported in our quarterly and annual financial statements have been and, to a lesser extent, will continue to be lower than the actual prescription demand levels for our products would suggest. These actions have resulted in lower levels of accounts receivable due to the reductions in shipments, slower increases and even decreases in returns and chargeback accruals and accruals for rebates reserves on our balance sheet, and modest write-offs of excess finished goods inventory balances, all of which have affected and could continue to affect our liquidity. We also have minimum production obligations with DPT Laboratories, Ltd., or DPT, and may be required to pay fees to DPT if we do not order as much product as projected. Any future changes in prescription demand will impact the amount of inventory reductions necessary to achieve desired levels of inventory in the distribution channel. We believe that our reduction of inventory levels in the distribution channel is consistent with improved wholesaler reporting, improved distribution logistics under centralized warehousing offerings from our two largest wholesalers, and the relative maturity of most of our products.

          We estimate the rate of future product returns based on our historical experience using the most recent three years’ data, the relative risk of return based on expiration date and other qualitative factors that could impact the level of future product returns, including monitoring inventories held by our distributors. Due to the significant reduction of inventory held by our distributors during 2006, our accrual for product returns of $14.4 million as of September 30, 2006 represented a significant amount of the retail value of the inventory in the distribution channel. We believe this reduction of wholesaler inventory will correlate to a lower amount of product returns in the future. We believe the methodology we utilize to calculate our returns reserve continues to be appropriate; however, we do not have adequate information at the end of the third quarter to determine a more appropriate estimated rate of return than the rate indicated by our most recent three years’ data. During the fourth quarter of 2006, we will attempt to obtain additional information on the inventory held by our largest wholesalers in order to determine the potential return profile of the existing channel inventory. If, as anticipated, the return rate profile supported by the information and our on-going returns experience indicate a significantly lower rate for future returns, we will have a basis for determining a more appropriate accrual for returns, at which time we could potentially release a substantial portion of our returns reserve. Even if we release a significant amount of the accrual in the fourth quarter of 2006, we expect that over the next one to several quarters our estimated return rate, and therefore our product returns accrual, will continue to decrease at a more modest rate over time as a result of our target wholesaler inventory levels.

          Our cost of product revenues includes the third party costs of manufacturing OLUX, Luxíq and Evoclin, the cost of Soriatane inventory supplied from Hoffmann-La Roche, Inc., or Roche, depreciation costs associated with Connetics-owned equipment located at the DPT facility in Texas, allocation of overhead, royalty payments based on a percentage of our net product revenues, product freight and distribution costs from Cardinal Health Specialty Pharmaceutical Services, or SPS, and certain manufacturing support and quality assurance costs.

          Our cost of product revenues were $1.7 million and $4.2 million for the three months ended September 30, 2006 and 2005, respectively, representing a decrease of $2.5 million or 60%, and $9.2 million and $12.9 million for the nine months ended September 30, 2006 and 2005, respectively, representing a decrease of $3.7 million or 29%. The decrease in both periods was principally due to significantly lower shipments of product to the wholesalers as a result of the reduction of inventory levels of our products at our major wholesalers. This decrease is also attributable to reduced royalty payments paid on Soriatane sales to a U.S.-based distributor that exports branded pharmaceutical products to select international markets in 2006 as compared to 2005 of $0.5 million and $1.6 million in the three and nine months ended September 30, 2006, respectively.

     In order to facilitate improved management of wholesaler inventory levels of all of our products, we have shipped below estimated prescription demand during 2006 with the goal of reducing average wholesaler inventory levels to less than two months on-hand by the end of 2006. In connection with this effort, on June 30, 2006 we halted an in-transit shipment to one of our wholesalers; the product was brought back to our warehouse and the wholesaler never received delivery. We properly reversed the revenue and accounts receivable related to this shipment, and those amounts were appropriately not reflected in the June 30, 2006 Form 10-Q financial statements. However, during our third quarter 2006 close procedures we noted that the Form 10-Q did not reflect the reversal of the cost of product revenues and increase in inventory associated with the halted shipment. Therefore, our June 30, 2006 results overstated cost of product revenues by $368,000 and understated inventory by the same amount. We have recorded the $368,000 reversal of cost of product revenues as an adjustment in June 2006 by amending the year-to-date amounts in the September 30, 2006 financial information included in Note 1 to this Report.

     We recorded amortization expenses of $4.1 million and $12.1 million for the three and nine months ended September 30, 2006, compared to $3.4 million and $10.2 million for the comparable periods in 2005. The increase in amortization expense was attributable to amortization of identified intangibles recorded from the acquisition of the pediatric sales force from PediaMed.

     R&D expenses include costs of personnel to support our research and development activities, costs of preclinical studies, costs of conducting our clinical trials (such as clinical investigator fees, monitoring costs, data management and drug supply costs), external research programs and an allocation of facilities costs. Year to year changes in R&D expenses are primarily due to the timing and size of particular clinical trials, as well as the recognition of stock-based compensation in the current year due to the adoption of SFAS 123(R).

     R&D expenses were $10.0 million for the three months ended September 30, 2006, compared to $8.4 million for the three months ended September 30, 2005, representing an increase of $1.6 million or 19%. The increase is primarily due to $1.9 million of expense recorded for product packaging material and equipment costs related to Velac Gel that we had previously capitalized. After completion of certain studies in the third quarter of 2006 and communications with the FDA in September 2006, our management team reassessed the realizability of these assets based on future regulatory work required, the potential resale value and other relevant factors. We determined these assets were impaired and expensed $1.9 million to the research and development line item on our statement of operations for the three and nine month periods ended September 30, 2006. Connetics remains committed to bringing the product to market and development activities are ongoing.

     For the nine months ended September 30, 2006 and 2005, R&D expenses were $26.2 million and $23.2 million, respectively, representing an increase of $3.0 million or 13%. The increase was partially attributable to $1.9 million of expense recognized for inventory and equipment costs related to Velac Gel as discussed in the preceding paragraph. We determined these assets were impaired and expensed $1.9 million to the research and development line item on our statement of operations in September 2006. The increase is also attributable to the $0.8 million filing fee for the Primolux(TM) Foam NDA in January 2006 and expense resulting from the recognition of stock-based compensation due to the adoption of SFAS 123R of $0.9 million in the nine months ended September 30, 2006.

     Selling, general and administrative expenses include expenses and costs associated with finance, legal,

insurance, marketing, sales, and other administrative matters.

     Selling, general and administrative expenses were $31.6 million for the three months ended September 30, 2006, compared to $23.7 million for the three months ended September 30, 2005, representing an increase of $7.9 million or 33%. The increase primarily consists of $4.9 million for increased legal, audit, tax and other administrative expenses primarily driven by our recent restatement and our pending SEC investigation, $3.8 million in increased personnel costs driven by our sales department due to the purchase of the PediaMed sales organization, $1.0 million resulting from the recognition of stock-based compensation in 2006, $600,000 in consulting and recruiting fees, partially offset by $2.0 million in decreased direct and indirect promotional activities.

     For the nine months ended September 30, 2006 and 2005, selling, general and administrative expenses were $93.0 million and $76.9 million, respectively, representing an increase of $16.1 million or 21%. The increase primarily consists of $9.0 million for increased legal, audit, tax and other administrative expenses primarily driven by our recent restatement and our pending SEC investigation, $9.1 million in increased personnel costs primarily driven by our sales department due to the purchase of the PediaMed sales organization, $3.0 million resulting from the recognition of stock-based compensation in 2006, $1.0 million in consulting and recruiting fees partially offset by $6.7 million in decreased direct and indirect promotional activities.

     On January 1, 2006, we adopted the provisions of SFAS 123R requiring us to recognize expense related to the fair value of our stock-based compensation awards. Total stock-based compensation expense was $1.3 million for the three months ended September 30, 2006 and $3.9 million for nine months ended September 30, 2006.

     Prior to the adoption of SFAS 123R, we approved the acceleration of vesting for “out-of-the-money” unvested incentive and non-qualified stock options previously awarded to employees and outside directors with option exercise prices equal to or greater than $18.00 effective November 7, 2005. We took this action to reduce the impact of compensation expense that we would otherwise be required to recognize in our consolidated statements of operations pursuant to SFAS 123R beginning January 1, 2006. As a result of the acceleration, our pro forma stock-based employee compensation expense for the fourth quarter of 2005 increased $8.5 million, which represents the amount by which we reduced the stock-based compensation expense we would otherwise have been required to recognize on a pre-tax basis over fiscal years 2006, 2007 and 2008.

     Prior to the adoption of SFAS 123R, we applied SFAS 123, amended by SFAS 148, which allowed companies to apply the existing accounting rules under Accounting Principles Board Opinion 25, or APB 25, and related Interpretations. Accordingly, we did not recognize any compensation in our financial statements in connection with stock options granted to employees when those options had exercise prices equal to or greater than the fair market value of our common stock on the date of grant.

     As of September 30, 2006, there was $9.5 million (before any related tax benefit) of total unrecognized compensation cost related to non vested stock-based compensation that is expected to be recognized over a weighted-average period of approximately 1.9 years.

     On January 27, 2006, we granted 475,000 shares of restricted stock in lieu of option grants to members of our executive management. Of the total awards, 50% are subject to time-based vesting and the remaining 50% are subject to both performance-based and time-based vesting with certain 2006 performance goals determined by the Compensation Committee. For all of the shares subject to time-based vesting and the shares ultimately issued based on performance, the vesting restriction for one-half will lapse on February 1, 2008 and the remaining one-half will lapse February 1, 2009. Through September 30, 2006 we have not recorded compensation expense for the restricted stock grants which will have performance-based criteria due to the probability that the performance criteria will not be met; however, the Compensation Committee will make a final assessment in late 2006 or the first quarter of 2007, at which time they will consider business conditions and other factors.

On February 1, 2006, we also granted 58,000 shares of restricted stock in lieu of option grants to certain management individuals; all of those shares are subject only to time-based vesting. Of the total awards, the restriction for one-third lapses on the first anniversary and one-sixth each six months thereafter. On May 22, 2006 we granted an additional 60,000 shares of restricted stock in lieu of annual option grants to our Board of Directors. The restriction on these awards lapses one year from the date of grant. We did not grant restricted stock before January 1, 2006. We recognized approximately $568,000 and $1,240,000 of compensation expense for the grants subject to time-based vesting criteria during the three and nine month periods ended September 30, 2006, respectively. The weighted average fair value of restricted stock granted, determined using the Black-Scholes model, was $10.44 per share for the three months ended September 30, 2006 and $14.75 per share for the nine months ended September 30, 2006.

     Interest income was $3.0 million and $8.0 million for the three and nine months ended September 30, 2006, respectively, compared to $2.1 million and $4.5 million for the comparable periods in 2005. The increase in interest income was the result of higher interest rates and yield on our investments in 2006 coupled with a full nine months in 2006 of interest earned on our investments that were a result of the issuance of the $200 million in notes in March 2005.

     Interest expense was $3.2 million and $6.9 million for the three and nine months ended September 30, 2006, respectively, compared to $2.0 million and $4.6 million for the comparable periods in 2005. The increase in interest expense is primarily due to the $1.4 million we paid in the third quarter of 2006 to the consenting holders of the 2003 Notes in consideration for the amendments and waivers which provided us with additional time to file our first quarter Form 10-Q. The increase in interest expense during the nine month period September 30, 2006 is also due to a full nine months of interest expense in 2006 related to the sale of 2005 Notes.

     We recognized an income tax benefit of $274,000 and $533,000 for the three and nine months ended September 30, 2006, respectively, primarily related to a tax asset recorded for losses generated by our foreign operations which we believe is more likely than not to be realized. This benefit has been partially offset by withholding taxes. We recognized income tax expense of $470,000 and $728,000 for the three and nine months ended September 30, 2005, respectively, related to U.S. Federal alternative minimum taxes and state income taxes, offset by foreign tax benefit related to our activities in Australia.

Working Capital

     We have financed our operations to date primarily through proceeds from equity and debt financings, and net product revenues. Cash, cash equivalents, marketable securities and long-term investments totaled $241.8 million at September 30, 2006, down from $271.1 million at December 31, 2005. Of the $29.3 million decrease, $12.5 million is related to the acquisition of the PediaMed sales organization, $6.0 million is related to legal, audit, tax, banking and other administrative expenses driven by our recent restatement and our pending SEC investigation and $2.2 million is related to the repurchase of 143,000 shares of our stock.

     Working capital at September 30, 2006 was $214.2 million compared to $245.6 million at December 31, 2005 representing a $39.4 million decrease in current assets and an $8.1 million decrease in current liabilities. Significant changes in working capital during 2006 can be summarized as follows: