CONNETICS CORP - 10-K Annual Report

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

The aggregate market value of the voting stock held by non-affiliates of the registrant was approximately $225,516,073 as of March 22, 2002, based upon the closing sale price on the Nasdaq National Market reported for that date. The calculation excludes shares of common stock held by each officer and director and by each person who owns 5% or more of the outstanding common stock in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

There were 30,566,234 shares of registrant’s common stock issued and outstanding as of March 22, 2002.

The information required by Part III of this Report, to the extent that it is not set forth in this Report, is incorporated by reference to the registrant’s definitive proxy statement for the Annual Meeting of Stockholders to be held on May 16, 2002.

Our disclosure and analysis in this Report, in other reports that we file with the Securities and Exchange Commission, in our press releases and in public statements of our officers contain forward-looking statements within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act. Forward-looking statements give our current expectations or forecasts of future events. You can identify these statements by the fact that they do not relate strictly to historical or current events. They use words such as “anticipate,” “estimate,” “expect,” “will,” “may,” “intend,” “plan,” “believe” and similar expressions in connection with discussion of future operating or financial performance. These include statements relating to future actions, prospective products or product approvals, future performance or results of current and anticipated products, sales efforts, expenses, the outcome of contingencies such as legal proceedings, and financial results.

Forward-looking statements may turn out to be wrong. They can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Many factors mentioned in this Report — for example, governmental regulation and competition in our industry — will be important in determining future results. No forward-looking statement can be guaranteed, and actual results may vary materially from those anticipated in any forward-looking statement.

Although we believe that our plans, intentions and expectations reflected in these forward-looking statements are reasonable, we may not achieve these plans, intentions or expectations. Forward-looking statements in this Report include, but are not limited to, those relating to the commercialization of our currently marketed products, the progress of our product development programs, developments with respect to clinical trials and the regulatory approval process, developments related to acquisitions and clinical development of drug candidates, and developments relating to the growth of our sales and marketing capabilities. Actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements contained in this Report. Important factors that could cause actual results to differ materially from our forward-looking statements are set forth in this Report. These factors are not intended to represent a complete list of the general or specific factors that may affect us. It should be recognized that other factors, including general economic factors and business strategies, and other factors not currently known to us, may be significant, presently or in the future, and the factors set forth in this Report may affect us to a greater extent than indicated. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements set forth in this Report. Except as required by law, we do not undertake any obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise.

References in this Report to “Connetics,” “the Company,” “we,” “our” and “us” refer to Connetics Corporation, a Delaware corporation, and its consolidated subsidiaries. Our principal executive offices are located at 3290 West Bayshore Road, Palo Alto, CA 94303. Our telephone number is (650) 843-2800. Connetics®, Luxíq®, and OLUX® are registered trademarks, and Liquipatch^TM and the seven interlocking “C’s” design are trademarks, of Connetics. All other trademarks or service marks appearing in this Report are the property of their respective companies. We disclaim any proprietary interest in the marks and names of others.

Connetics is a specialty pharmaceutical company focusing exclusively on the treatment of dermatological conditions. We currently market two pharmaceutical products, Luxíq® Foam (betamethasone valerate), 0.12%, and OLUX® Foam (clobetasol propionate), 0.05%. Our commercial business is focused on the dermatology marketplace, which is characterized by a large patient population that is served by relatively small number of treating physicians. Our two dermatology products have clinically proven therapeutic

In 2001 we established the Connetics Center for Skin Biology, with a goal of connecting the scientific understanding of skin disease with better treatment options. The Center was created to bring together dermatologists and pharmacologists from across the country to explore how topical drugs interact with and penetrate the skin. The purpose of the Center for Skin Biology is to learn how to optimize drug penetration, distribution, and efficiency at the targeted treatment site on the skin and to evaluate new chemical entities for the development of innovative dermatological products. The Center will assist in the continued development of innovative topical dermatology products through rigorous scientific evaluation of products and potential products. We believe this novel approach to drug development will enable us to bring even more effective and novel treatments to our product platform and the dermatology market.

Our products, Luxíq and OLUX, compete in the topical steroids market. According to IMS Health, in 2001, the value of the retail topical steroid market for mid-potency and high and super-high potency steroids was $850 million. Luxíq competes in the mid-potency steroid market and OLUX competes in the high- and super-high potency steroid market.

Dermatological diseases often persist for an extended period of time and are treated with clinically proven drugs that are currently delivered in a variety of formulations, including solutions, creams, gels and ointments. These existing delivery systems often inadequately address a patient’s needs for efficacy and cosmetic elegance, and the failure to address those needs may decrease patient compliance. We believe that the proprietary foam delivery system unique to Luxíq and OLUX has significant advantages over conventional therapies for dermatoses, including more localized delivery of the active agent. The foam formulation liquefies when applied to the skin, and enables rapid penetration of the active therapeutic agent. When the foam is applied, it dries quickly, and does not leave any residue, stains or odor. We believe that the combination of the increased efficacy and the cosmetic elegance of the foam may actually improve patient compliance and satisfaction. In market research sponsored by Connetics, 80% of patients said that they preferred the foam over other topical delivery vehicles.

On March 21, 2001, we entered into a definitive agreement to acquire Soltec Research Pty Ltd, a division of Australia-based F. H. Faulding & Co Limited. Under the agreement, Connetics acquired all of Soltec’s issued capital stock for approximately U.S. $16.9 million. The acquisition of Soltec was intended to provide Connetics powerful product innovation and development capabilities and to fuel an extensive new product pipeline as well as contributing revenue and profits to Connetics’ financial results. For over 10 years Soltec has been developing unique and highly effective means of administering drugs to the skin. Prior to the acquisition, Soltec leveraged its broad range of drug delivery technologies by entering into license agreements with many well-known dermatology companies around the world. Those license agreements for marketed products bear royalties payable to Soltec. In addition, Soltec provides a solid platform to keep our pipeline filled with products as well as an opportunity to enter product partnerships for over-the-counter and foreign markets.

The acquisition of Soltec established Connetics as the only independent company serving the dermatology specialty that has integrated product innovation, development and commercialization capabilities, and enabled us to control our innovative topical delivery technologies worldwide. As a result of the acquisition, cash royalties and license fees payable to Soltec in connection with agreements with Soltec are now eliminated in consolidation. The acquisition of Soltec provides us with a broad development platform of delivery technologies to advance our pipeline and a talented group of scientists to drive research and innovation. We gained worldwide rights to a number of unique topical delivery systems, including several distinctive aerosol foams including water-, ethanol-and petrolatum- based foams. Consolidating the rights to these technologies enables us to populate our own product development portfolio, as well as pursue business development agreements with other pharmaceutical companies.

Our principal business objective is to be a leading specialty pharmaceutical company focused on providing innovative treatments in targeted fields, initially in the field of dermatologic disease. To achieve this

objective, we intend to continue to pursue our commercial strategy of maximizing product sales by leveraging novel delivery technologies, accelerating the processes of getting products to market, and targeting specific market opportunities with unmet needs. Key elements of our related business and commercialization strategy include the following:


	•	Maximizing Near-Term Commercial Opportunities for Luxíq and OLUX. We have a focused sales force dedicated to establishing Luxíq and OLUX as the standard of care. Our commercial strategy permits us to effectively reach the majority of the treating dermatologists. In 2001 we launched 50-gram cans of both products, and in 2002 we anticipate introducing physician samples. We also intend to expand the near-term commercial opportunities for Olux by seeking approval to market the product for the treatment of non-scalp dermatoses.

	•	Advancing the Development of Novel Dermatology Drugs. We plan to continue to leverage our investment in Soltec and the Center for Skin Biology to enhance our ability to develop novel formulations and drug delivery technologies for the dermatology market.

	•	Broadening Our Product Portfolio Through Development, License or Acquisition. We believe that we can leverage our dermatology-dedicated sales force by marketing additional products to the dermatology market. We are evaluating the licensing or acquisition of additional product candidates, several of which are in the field of dermatologic disease. We may also acquire additional technologies or businesses that we believe will enhance our research and development capabilities.

	•	Collaborating Selectively With Pharmaceutical Companies. As we expand certain aspects of our development pipeline and delivery technologies, we intend to partner with pharmaceutical companies to gain access to additional marketing expertise, particularly as it relates to the over-the-counter pharmaceutical market. Our approach to partnership will be on a selective basis, seeking to maintain the highest possible value of our product candidates.

Luxíq is a foam formulation of betamethasone valerate, a mid-potency topical steroid prescribed for the treatment of mild-to-moderate steroid-responsive scalp dermatoses such as psoriasis, eczema and seborrheic dermatitis. In our pivotal clinical trial, patients treated with Luxíq experienced a statistically significant improvement over patients treated with placebo or betamethasone valerate lotion. We began selling Luxíq commercially in the United States in April 1999.

OLUX is a foam formulation of clobetasol propionate, one of the most widely prescribed super high-potency topical steroids. We began selling OLUX in November 2000 for the short-term, topical treatment of inflammatory and pruritic manifestations of moderate to severe corticosteroid-responsive scalp dermatoses. In our pivotal clinical trial, patients treated with OLUX experienced a statistically significant improvement over patients treated with placebo or clobetasol solution.

In December 2001, we filed a supplemental New Drug Application, or sNDA, with the U.S. Food and Drug Administration, requesting clearance to market OLUX for non-scalp indications. The application is currently under review with the FDA. The sNDA was based on results from a Phase IV clinical trial of OLUX for the treatment of mild-to-moderate non-scalp psoriasis. The results were first presented on January 30, 2002 at the 26th Annual Hawaii Dermatology Seminar. During the study, patients with mild to moderate plaque-type psoriasis of non-scalp regions treated with OLUX experienced a statistically significant improvement in clearance of disease (p < 0.0001) over patients in the placebo group. The 279-patient, placebo-controlled, randomized, double-blind, Phase IV study was conducted at 17 clinical centers. Patients self-administered either OLUX or placebo twice daily for 14 days. They were evaluated using the Physician’s Static Global Assessment score as the primary endpoint, and patient’s global assessment and erythema, scaling, plaque thickness, and pruritus baselines as secondary endpoints. Using the Physician’s Static Global Assessment, 71%

of patients treated with OLUX had complete or almost complete clearance of disease compared with 22% of patients treated with placebo based on a per protocol analysis. There was no statistical difference in the reported adverse events between the OLUX and placebo groups. The most common adverse events reported were application site reactions (burning and stinging at 5%).

A separate study conducted at Stanford University School of Medicine, also presented at the Annual Hawaii Dermatology Seminar, compared the effectiveness, patient satisfaction, quality of life, and cost-effectiveness of two clobetasol regimens in the treatment of psoriasis. In a single-blind design, 29 patients were randomized to receive either clobetasol foam on the skin and scalp or a combination of clobetasol cream on the skin and lotion on the scalp for 14 days. Severity of disease and quality of life were evaluated using several tools, including the Psoriasis Area Severity Index and the Dermatology Life Quality Index. The trial was conducted by Alexa Boer Kimball, M.D., M.P.H., Assistant Professor of Dermatology, Director Clinical Trials Center at Stanford University School of Medicine. Dr. Kimball reported that the increased improvement in clinical severity, decreased application time, and increased perception of relative efficacy, combined with similar cost of treatment, suggest that Olux is a better choice than cream and solution for some patients. This study supports our belief that improved patient compliance with the foam will yield better treatment results than the same active ingredient in a traditional formulation.

Ridaura. On May 1, 2001, we announced the completion of the sale of all of our rights and interests in Ridaura® (auranofin) to Prometheus Laboratories, Inc., a California corporation. The sale was made pursuant to an Asset Purchase Agreement dated April 9, 2001 and closed on April 30, 2001. Ridaura is an oral formulation of a gold salt which is prescribed for the treatment of rheumatoid arthritis. The decision to divest the product was consistent with our decision to focus exclusively on dermatology.

Under the terms of the Asset Purchase Agreement, we sold all of our, rights, interests and assets for or related to the use, manufacture or sale of Ridaura in the United States and Puerto Rico for $9.0 million in cash plus a royalty on annual sales of Ridaura in excess of $4.0 million over the next five years. Prometheus agreed to assume, effective as of the closing date of the transaction, our obligations under the Supply Agreement with Pharmascience, Inc., our obligations under the Supply Agreement with SmithKline Beecham Corporation (now known as GlaxoSmithKline), and certain of our obligations under the SmithKline Beecham Asset Purchase Agreement pursuant to which we originally acquired the rights to Ridaura.

Actimmune. In December 1995, we entered into a license agreement with Genentech to acquire exclusive U.S. development and marketing rights to interferon gamma for dermatological indications. Subsequent amendments to the original license agreement expanded the fields of use for which the license applies, and added Japan and Canada to the licensed territory. Interferon gamma is one of a family of proteins involved in the regulation of the immune system and has been shown to reduce the frequency and severity of certain infections. We formed a subsidiary, InterMune Pharmaceuticals, Inc. (now InterMune, Inc.), to develop Actimmune for various infections and fungal diseases. In March 2000, InterMune became a public company, and effective April 1, 2000 we assigned our remaining rights and obligations under the license with Genentech and the corresponding supply agreement to InterMune. In exchange, InterMune paid us approximately $6.1 million, of which $0.9 million was paid to us in March 2001 and the balance was paid in 2000. We retained the option to purchase the product rights for potential dermatological applications of Actimmune, and are entitled to receive royalties on Actimmune sales beginning January 1, 2002.

Foam Technology. In December 2001, we entered into an agreement granting Pharmacia Corporation exclusive global rights, excluding Japan, to our proprietary foam drug delivery technology for use with Pharmacia’s Rogaine® hair loss treatment. The license with Pharmacia will expand the reach of the foam vehicle to the non-prescription (over-the-counter) pharmaceutical market. Under the agreement, Pharmacia will pay us an undisclosed initial licensing fee, milestone payments and a royalty on product sales. Pharmacia will be responsible for most product development activities and costs.

Before April 2001, Soltec had entered into a number of other agreements for the foam technology. Soltec licensed the technology to betamethasone valerate foam to Celltech plc in Europe, and Celltech has licensed

the worldwide rights to their patent on the technology to Soltec. Soltec pays Celltech royalties on all sales worldwide of foam formulations containing steroids. Celltech markets their product as Bettamousse^TM (the product equivalent of Luxíq). Soltec has license agreements with Bayer (in the U.S.) and Pfizer and Mipharm (internationally) for the use of pyrethrin foam for head lice. That product is marketed in the U.S. as RID®, as Banlice® in Australia, and as Milice in Italy. We receive royalties on sales of those products, but the amount of royalties was immaterial in 2001. Soltec has entered into development agreements with other companies to develop the foam for specific indications.

Liquipatch. Soltec has entered into agreements with several companies to develop Liquipatch^TM for various indications. On June 26, 2001, we announced that Soltec had entered into a global licensing agreement with a major, international healthcare company for Liquipatch. The agreement followed successful pilot development work and gives the licensee the exclusive, worldwide right to use the Liquipatch technology in a particular 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. Soltec has entered into development agreements with other companies to develop Liquipatch for specific indications.

Aerosol Spray. Soltec has licensed to a major international company the rights to a super-concentrated aerosol spray that is marketed in the U.S. and internationally. We receive royalties on sales of the product. In 2001, on a consolidated basis, we received $0.8 million in royalties in connection with this agreement.

We have an experienced, highly productive sales and marketing organization, which is 100% dedicated to dermatology. Through March 2001, we supplemented our sales force with contract sales representatives to increase the frequency and reach of our sales calls and to assist with the launch of products. In March 2001, we discontinued using the contract sales force. In April and May 2001, we hired 30 additional full-time sales representatives and two additional regional sales directors, to maximize our reach to the dermatologists throughout the country. As of March 1, 2002, we had 77 employees in our sales and marketing organization, including 62 field sales directors and representatives. We believe we have created an incentive program that financially rewards our sales force based on the number of topical steroid prescriptions for our products written by the dermatologists in their geographic territory.

Our marketing efforts are focused on assessing and meeting the needs of dermatologists, dermatology nurses, and physicians’ assistants. Our sales representatives focus on cultivating relationships of trust and confidence with the physicians they call upon. We use a variety of advertising, promotional material (including journal advertising, promotional materials, and rebate coupons), specialty publications, participation in educational conferences, advisory board meetings, and product internet sites to achieve our marketing objectives. Beginning in the second quarter of 2002, we also expect to have product samples available to distribute to physicians. Of the 7,500 U.S. dermatologists our sales force called on in 2001, we focused our efforts on the approximately 6,500 dermatologists who are responsible for approximately 90% of all prescriptions written by dermatologists in the United States.

In addition to traditional marketing approaches and field sales relationships with dermatologists, we use internet marketing to convey basic information about our products and our company. Our corporate website at http://www.connetics.com includes fundamental information about the company as well as descriptions of ongoing research, development and clinical work. Our product websites, at http://www.luxiq.com and http://www.olux.com, provide information about the products and their approved indications, as well as copies of the full prescribing information, the patient information booklet, and rebate coupons.

The specialty pharmaceutical industry is characterized by intense market competition, extensive product development and substantial technological change. We also face competition from other manufacturers of prescription pharmaceuticals for our dermatology products as well as other products that we may develop and market in the future. Many of our competitors are large, well-established pharmaceutical, chemical, cosmetic

or health care companies with considerably greater financial, marketing, sales and technical resources than those available to us. Additionally, many of our present and potential competitors have research and development capabilities that may allow such competitors to develop new or improved products that may compete with our product lines. Our products could be rendered obsolete or made uneconomical by the development of new products to treat the conditions addressed by our products, technological advances affecting the cost of production, or marketing or pricing actions by one or more of our competitors. Each of our products competes for a share of the existing market with numerous products that have become standard treatments recommended or prescribed by dermatologists.

Luxíq and Olux compete with a number of corticosteroid brands in the super-, high- and mid-potency categories for the treatment of inflammatory skin conditions. Competing brands include Halog® and Ultravate®, marketed by Bristol-Myers Squibb Company; Elocon® and Diprolene®, marketed by Schering-Plough Corporation; Locoid®, marketed by Ferndale Labs; Temovate® and Cutivate®, marketed by Elan; and Psorcon®, marketed by Dermik Laboratories, Inc. In addition, both Luxíq and Olux compete with generic (non-branded) pharmaceuticals, which claim to offer equivalent therapeutic benefits at a lower cost. In some cases, insurers and other third-party payors seek to encourage the use of generic products making branded products less attractive, from a cost perspective, to buyers.

Many of our existing or potential competitors, particularly large pharmaceutical companies, have substantially greater financial, technical and human resources than we do. In addition, many 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. Accordingly, our competitors may succeed in obtaining FDA approval for products more rapidly or successfully than we do.

We intend to compete on the basis of the quality and efficacy of our products and unique drug delivery vehicles, combined with the effectiveness of our marketing and sales efforts. Competing successfully will depend on our continued ability to attract and retain skilled and experienced personnel, to identify, secure the rights to, and develop pharmaceutical products and compounds, and to exploit these products and compounds commercially before others are able to develop competitive products.

Our customers include the nation’s leading wholesale pharmaceutical distributors, such as McKesson HBOC, Inc., Cardinal Health, Inc., Bergen Brunswig Corporation, Bindley Western Industries, Inc., and major drug chains. During 2001, McKesson, Cardinal, Bindley and Bergen Brunswig accounted for 29%, 26%, 18%, and 12%, respectively, of our gross product revenues. The distribution network for pharmaceutical products is subject to increasing consolidation. As a result, a few large wholesale distributors control a significant share of the market. In addition, the number of independent drug stores and small chains has decreased as retail consolidation has occurred. Further consolidation among, or any financial difficulties of, distributors or retailers could result in the combination or elimination of warehouses, which may result in reductions in purchases of our products, returns of our products, or cause a reduction in the inventory levels of distributors and retailers, any of which could have a material adverse impact on our business. If we lose any of these customer accounts, or if our relationship with them were to deteriorate, our business could also be materially and adversely affected.

Currently, all of our product distribution activities are handled by CORD Logistics, Inc., a national warehousing corporation. CORD stores and distributes our products from a warehouse in Tennessee. Upon the receipt of a purchase order through electronic data input, phone, mail or facsimile, the order is processed into CORD’s inventory system. After CORD ships the product to the customer placing the order, usually within 24 hours, CORD automatically processes the invoice on our behalf. Any delay or interruption in the process or in payment could have a material effect on our business.

Innovation by our research and development operations is very important to the success of our business. Our research and development expenses were $19.2 million in 2001, $21.9 million in 2000, and $21.3 million in 1999. Our goal is to discover, develop and bring to market innovative products that address unmet healthcare needs, which requires both clinical and manufacturing development. Our substantial investment in research and development supports this goal. We have the rights to a variety of pharmaceutical agents in various stages of pre-clinical and clinical development in several novel delivery technologies.

Our development activities involve work related to product formulation, preclinical and clinical study coordination, regulatory administration, manufacturing, and quality control and assurance. Many pharmaceutical companies conduct early stage research and drug discovery, but to obtain the most value from our development portfolio, we are focusing on later-stage development. This approach helps to minimize the risk and time requirements for us to get a product on the market. Our strategy involves targeting those product candidates that we believe have the largest market potential, and then rapidly evaluating and formulating new therapeutics by using previously approved active ingredients reformulated in our proprietary delivery system. This product development strategy allows us to conduct limited preclinical safety trials, and to move rapidly into safety and efficacy testing in humans with products that offer significant improvements over existing products. A secondary strategy is to evaluate the acquisition of products from other companies.

Our relationship with Soltec led to our development of Luxíq and Olux. Soltec has developed several additional aerosol foams similar to our foam delivery system for Luxíq and Olux, including water-, ethanol- and petrolatum-based foams. We believe these formulations may offer improved efficacy over traditional formulations due to greater absorption of the active ingredient to the skin. In addition to the potential for improved efficacy, the foam formulations represent a cosmetically elegant alternative to existing dermatologic treatments. Another invention by Soltec, Liquipatch, is a multi-polymer gel-matrix delivery system that applies to the skin like a normal gel and dries to form a very thin, invisible, water-resistant film. This film enables a controlled release of the active agent, which we believe will provide a longer treatment period. We anticipate developing one or more new products in the aerosol foam or Liquipatch formulations, by incorporating leading dermatologic agents in formulations that are tailored to treat specific diseases or different areas of the body. We currently expect to seek partners for over-the-counter market opportunities worldwide and for development and commercialization of prescription products outside the United States.

All products and technologies under development require significant commitments of personnel and financial resources. In addition to our in-house staff and resources, we contract a substantial portion of development work to outside parties. For example, we typically engage contract research organizations to manage our clinical trials. We have contracts with vendors to conduct product analysis and stability studies, and we outsource all of our manufacturing scale-up and production activities. We also use collaborative relationships with pharmaceutical partners and academic researchers to augment our product development activities, and from time to time we enter agreements with academic or university-based researchers to conduct various studies for us.

Several products require extensive clinical evaluation and clearance by the FDA and comparable agencies in other countries before we can sell them commercially. We anticipate conducting simultaneous studies on several products over the next several years. In particular, our intention is to have several product candidates in formulation development at a given time, and to target two product candidates for clinical development each year. However, we regularly re-evaluate our product development efforts. On the basis of these reevaluations, we have in the past, and may in the future, abandon development efforts for particular products. In addition, any product or technology under development may not result in the successful introduction of a new product.

In addition to Luxíq and Olux, we are developing the foam technology for other disease indications. Our most promising preclinical candidates include a petrolatum-based foam as a line extension for Olux, an antifungal foam, and an anti-acne foam. We are exploring the anti-acne indication for Liquipatch as well. We have completed pre-clinical work for our antifungal foam, and anticipate beginning clinical trials in mid-2001. In late 2001, we decided to delay beginning that clinical trial to re-formulate the foam to eliminate a particular

Our success will depend in part on our ability and our licensors’ ability to obtain and retain patent protection for our products and processes, to preserve our trade secrets, and to operate without infringing the proprietary rights of third parties.

We own or are exclusively licensed under pending applications and/or issued patents worldwide relating to Luxíq and OLUX, recombinant human relaxin, and other products in the earlier stages of research. Through Soltec, we own over 20 patents related to the technologies developed by Soltec, expiring between 2002 and 2018, and we have several pending applications.

U.S. Patent 6,126,920 covers the delivery technology that is the basis for OLUX and Luxíq, specifically methods of treating various skin diseases, and in particular, scalp psoriasis, using a foam pharmaceutical composition comprising a corticosteroid active substance, a propellant and a buffering agent. The Liquipatch technology is covered by U.S. Patent 6,211,250.

With respect to patent applications that we or our licensors have filed, and patents issued to us or our licensors, we cannot assure you that:


	•	any of our or our licensors’ patent applications will issue as patents,

	•	any issued patents will provide competitive advantage to us, or

	•	our competitors will not successfully challenge or circumvent any issued patents.

We rely on and expect to continue to rely on unpatented proprietary know-how and continuing technological innovation in the development and manufacture of many of our principal products. We require all our employees, consultants and advisors to enter into confidentiality agreements with us. These agreements, however, may not provide adequate protection for our trade secrets or proprietary know-how in the event of any unauthorized use or disclosure of such information. In addition, others may obtain access to or independently develop similar or equivalent trade secrets or know-how.

We believe that trademark protection is an important part of establishing product recognition. We own eight registered trademarks and several trademark applications and common law trademarks. United States federal registrations for trademarks remain in force for 10 years and may be renewed every 10 years after issuance, provided the mark is still being used in commerce. However, any such trademark or service mark registrations may not afford us adequate protection, and we may not have the financial resources to enforce our rights under any such trademark or service mark registrations. If we are unable to protect our trademarks or service marks from infringement, any goodwill developed in such trademarks or service marks could be impaired.

We contract with independent sources to manufacture our products, which enables us to focus on product and clinical development strengths, minimize fixed costs and capital expenditures, and gain access to advanced manufacturing process capabilities. Company policy and the FDA require that we contract only with manufacturers that comply with current Good Manufacturing Practice, or cGMP, regulations and other applicable laws and regulations. Whether or not we have manufacturing contracts with third-party manufacturers, we may not be able to obtain adequate supplies of our products in a timely fashion, on acceptable terms, or at all.

Miza Pharmaceuticals (formerly CCL Pharmaceuticals) manufactures Luxíq and OLUX for us in England. We are in the process of qualifying AccraPac Group to manufacture physician samples, Luxíq and

OLUX for us in the United States. On March 12, 2002, we entered into an agreement with DPT Laboratories, Ltd., to construct an aerosol filling line at DPT’s plant in Texas. The agreement is retroactive to November 1, 2001. Pursuant to the agreement, DPT has agreed to permit us to construct the aerosol line on DPT’s premises in Texas. We are responsible for the costs of the construction and the related equipment. After the aerosol line is completed, we will pay DPT monthly rent for the facility. DPT and Connetics simultaneously entered into a manufacturing agreement for DPT to manufacture and fill our commercial aerosol products. DPT and Connetics are also party to a separate research and development agreement for the manufacture of clinical supplies for our aerosol products and product candidates. While DPT manufactures other pharmaceutical products and has passed inspection by the FDA in connection with those products, we must still apply to the FDA to qualify DPT to manufacture our commercial products for us in the United States.

Boehringer Ingelheim manufactured relaxin for us for clinical uses under a long-term contract. Following the failure of the pivotal clinical trial for relaxin, we entered into discussions with Boehringer Ingelheim to discuss the future of the contract. In December 2001 we mutually agreed to terminate the contract, in exchange for a settlement payment by Connetics. The final installment of the settlement is payable in June 2002, after Boehringer Ingelheim delivers certain documentation and reports to us. After that, neither party will have any further obligations under the contract.

Generally — Product Development. The pharmaceutical and biotechnology industries are subject to regulation by the FDA under the Food, Drug and Cosmetic Act, by the states under state food and drug laws, and by similar agencies outside of the United States. In order to clinically test, manufacture, and market products for therapeutic use, we must satisfy mandatory procedures and safety and effectiveness standards established by various regulatory bodies. We have provided a more detailed explanation of the standard we are subject to under “Factors Affecting Our Business and Prospects — We may spend a significant amount of money to obtain FDA and other regulatory approvals, which may never be granted” and “— We cannot sell our current products and product candidates if we do not obtain and maintain governmental approvals” below.

We expect that all of our pharmaceutical products will require regulatory approval by governmental agencies before we can commercialize them, although the nature and extent of the review process for our potential products will vary depending on the regulatory categorization of particular products. Federal, state, and international regulatory bodies govern or influence, among other things, the testing, manufacture, labeling, storage, record keeping, approval, advertising, and promotion of our products on a product-by-product basis. Failure to comply with applicable requirements can result in, among other things, warning letters, fines, injunctions, penalties, recall or seizure of products, total or partial suspension of production, denial or withdrawal of approval, and criminal prosecution. Accordingly, ongoing regulation by governmental entities in the United States and other countries will be a significant factor in the production and marketing of any pharmaceutical products that we have or may develop.

Product development and approval within this regulatory framework, and the subsequent compliance with appropriate federal and foreign statutes and regulations, takes a number of years and involves the expenditure of substantial resources. Generally, a company must conduct pre-clinical studies before it can obtain FDA approval for a new therapeutic agent. The basic purpose of pre-clinical investigation is to gather enough evidence on the potential new agent through laboratory experimentation and animal testing, to determine if it is reasonably safe to begin preliminary trials in humans. The results of these studies are submitted as a part of an investigational new drug application, which the FDA must review before human clinical trials of an investigational drug can start. We have filed and will continue to be required to sponsor and file investigational new drug applications, and will be responsible for initiating and overseeing the clinical studies to demonstrate the safety and efficacy that are necessary to obtain FDA approval of our products.

Clinical trials are normally done in phases and generally take two to five years, but may take longer, to complete. Phase I trials generally involve administration of a product to a small number of patients to determine safety, tolerance and the metabolic and pharmacologic actions of the agent in humans and the side effects associated with increasing doses. Phase II trials generally involve administration of a product to a larger

group of patients with a particular disease to obtain evidence of the agent’s effectiveness against the targeted disease, to further explore risk and side effect issues, and to confirm preliminary data regarding optimal dosage ranges. Phase I and Phase II trials can sometimes be combined, with the FDA’s concurrence, into a Phase I/II trial. Phase III trials involve more patients, and often more locations and clinical investigators than the earlier trials. At least one such trial is required for FDA approval to market a drug. Phase II and Phase III trials can sometimes be combined, with the FDA’s concurrence, into a Phase II/III trial, which is an accelerated clinical trial intended to provide sufficient data for approval.

The rate of completion of our clinical trials depends upon, among other factors, the rate at which patients enroll in the study. Patient enrollment is a function of many factors, including the size of the patient population, the nature of the protocol, the proximity of patients to clinical sites and the eligibility criteria for the study. Delays in planned patient enrollment may result in increased costs and delays, which could have a material adverse effect on our business. In addition, side effects or adverse events that are reported during clinical trials can delay, impede, or prevent marketing approval.

Section 505(b)(2) of the Food, Drug and Cosmetic Act makes it possible for a company to possibly accelerate the FDA approval process. A so-called 505(b)(2) application permits a sponsor of a drug to satisfy the requirements for a full New Drug Application, or NDA, by relying on published studies or the FDA’s findings of safety and effectiveness based on studies in a previously-approved NDA sponsored by another person, together with the studies generated on its own drug products. The FDA evaluates 505(b)(2) applications using the same standards of approval for an NDA, but the number of clinical trials required to support a 505(b)(2) application, and the amount of information in the application itself, may be substantially less than that required to support an NDA application. We used the 505(b)(2) application process for both Luxíq and OLUX, but the 505(b)(2) process may not be available for our other product candidates, and as a result the FDA process may be longer for those product candidates than it was for Luxíq and OLUX.

After we complete the clinical trials of a new drug product, we must file an NDA with the FDA. We must receive FDA clearance before we can commercialize the product, and the FDA may not grant approval on a timely basis or at all. The FDA can take between one and two years to review an NDA, and can take longer if significant questions arise during the review process. While various legislative and regulatory initiatives have focused on the need to reduce FDA review and approval times, the ultimate impact of such initiatives on our products cannot be certain. In addition, if there are changes in FDA policy while we are in product development, we may encounter delays or rejections that we did not anticipate when we submitted the new drug application or biologics license application for that product. We may not obtain regulatory approval for any products that we develop, even after committing such time and expenditures to the process. Even if regulatory approval of a product is granted, it may entail limitations on the indicated uses for which the product may be marketed.

Our products will also be subject to foreign regulatory requirements governing human clinical trials, manufacturing and marketing approval for pharmaceutical products. The requirements governing the conduct of clinical trials, product licensing, pricing and reimbursement are similar, but not identical, to FDA requirements, and they vary widely from country to country.

Manufacturing. The FDA regulates and inspects equipment, facilities, and processes used in the manufacturing of pharmaceutical products before providing approval to market a product. If after receiving clearance from the FDA, we make a material change in manufacturing equipment, location, or process, we may have to undergo additional regulatory review. We must apply to the FDA to change the manufacturer we use to produce any of our products. We and our contract manufacturers must adhere to current Good Manufacturing Practice and product-specific regulations enforced by the FDA through its facilities inspection program. The FDA also conducts regular, periodic visits to re-inspect equipment, facilities, and processes after the initial approval. If, as a result of these inspections, the FDA determines that our (or our contract manufacturers’) equipment, facilities, or processes do not comply with applicable FDA regulations and conditions of product approval, the FDA may seek sanctions and/or remedies against us, including suspension of our manufacturing operations.

Post-Approval Regulation. The FDA continues to review marketed products even after granting regulatory clearances, and later discovery of previously unknown problems or failure to comply with the applicable regulatory requirements may result in restrictions on the marketing of a product or withdrawal of the product from the market, recalls, seizures, injunctions or criminal sanctions. 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.

Pharmacy Boards. We are required in most states to be licensed with the state pharmacy board as either a manufacturer, wholesaler, or wholesale distributor. Many of the states allow exemptions from licensure if our products are distributed through a licensed wholesale distributor. The regulations of each state are different, and the fact that we are licensed in one state does not authorize us to sell our products in other states. Accordingly, we undertake an annual review of our license status and that of CORD to ensure continued compliance with the state pharmacy board requirements.

Fraud and Abuse Regulations. We are subject to various federal and state laws pertaining to health care “fraud and abuse,” including anti-kickback laws and false claims laws. Anti-kickback laws make it illegal for a prescription drug manufacturer to solicit, offer, receive, or pay any remuneration in exchange for, or to induce, the referral of business, including the purchase or prescription of a particular drug. The federal government has published regulations that identify “safe harbors” or exemptions for certain payment arrangements that do not violate the anti-kickback statutes. We seek to comply with the safe harbors where possible. Due to the breadth of the statutory provisions and the absence of guidance in the form of regulations or court decisions addressing some of our practices, it is possible that our practices might be challenged under anti-kickback or similar laws. False claims laws prohibit anyone from knowingly and willingly presenting, or causing to be presented for payment to third party payors (including Medicare and Medicaid) claims for reimbursed drugs or services that are false or fraudulent, claims for items or services not provided as claimed, or claims for medically unnecessary items or services. Our activities relating to the sale and marketing of our products may be subject to scrutiny under these laws. Violations of fraud and abuse laws may be punishable by criminal and/or civil sanctions, including fines and civil monetary penalties, as well as the possibility of exclusion from federal health care programs (including Medicare and Medicaid).

We participate in the Medicaid rebate program established by the Omnibus Budget Reconciliation Act of 1990. Under the Medicaid rebate program, we pay a rebate to each state Medicaid program for each unit of our product reimbursed by those programs. As a manufacturer currently of single source products only, the amount of the rebate for each of our products is set by law as the greater of 15.1% of the average manufacturer price of that product, or the difference between the average manufacturer price and the best price available from the company to any customer, with the final rebate amount adjusted upward if increases in average manufacturer price since product launch have outpaced inflation. The Medicaid rebate amount is computed each quarter based on our submission to the United States Department of Health and Human Services Centers for Medicare and Medicaid Services of our current average manufacturer price and best price for each of our products. The terms of our participation in the Medicaid program could require us to correct the prices that we reported in previous quarters, if necessary. Any such corrections could result in a change (positive or negative) in our Medicaid rebate liability for past quarters. As part of our revenue recognition policy, we provide reserves on this potential exposure at the time of product shipment. In addition to penalties that may be applicable under other federal statutes, the Medicaid rebate statute imposes civil monetary penalties in amounts up to $100,000 per item for the knowing submission of false information to the program.

Under amendments to the Omnibus Budget Reconciliation Act of 1990 that became effective in October 1993, participation in the Medicaid program has required the extension of 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 poor Medicare and Medicaid beneficiaries.

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, imposes a requirement that the prices a company such as Connetics charges the Veterans Administration, the Department of Defense, the Coast Guard, and the PHS be discounted by a minimum of 24% off the average manufacturer price charged to non-federal customers. Our computation of the average price to non-federal customers is used in establishing the FSS price for these four purchasers. The government maintains the right to audit the accuracy of our computations. Among the remedies available to the government for failure to accurately calculate FSS pricing and the average manufacturer price charged to non-federal customers is recoupment of any overpayments made by FSS purchasers as a result of errors in computations that affect the FSS price. The law also provides that civil monetary penalties may be assessed for knowingly providing false information in connection with discharging the pricing and reporting requirements under the VHCA. The amount that may be assessed is up to $100,000 “for each item of false information.”

Pharmaceutical companies can petition the FDA to grant new drug product exclusivity for a drug, independent of any orphan drug or patent term exclusivity accorded to that drug. The exclusivity granted by the FDA essentially prevents competition from other manufacturers who wish to put generic versions of the product into U.S. commerce. The FDA has granted us marketing exclusivity for foam-based products incorporating clobetasol propionate for three years beginning in November 2000. The exclusivity prevents other parties from submitting or getting approval for any application before the exclusive period expires. The FDA determines whether a drug is eligible for exclusivity on a case-by-case basis. The FDA may grant three-year exclusivity provided that the application included at least one new clinical investigation other than bioavailability studies, the investigation was conducted or sponsored by the drug company, and the reports of the clinical investigation were essential to the approval of the application.

Our operating results will depend in part on whether adequate reimbursement is available for our products from third-party payors, such as government entities, private health insurers and managed care organizations. Medicare, Medicaid, health maintenance organizations and other third-party payors may not authorize or otherwise budget such reimbursement. Such governmental and third-party payors increasingly are seeking to negotiate the pricing of medical services and products and to promote the use of generic, non-branded pharmaceuticals through payor-based reimbursement policies designed to encourage their use. In some cases, third-party payors will pay or reimburse users or suppliers of a prescription drug product only a portion of the product purchase price. Consumers and third-party payors may not view our marketed products as cost-effective, and consumers may not be able to get reimbursement or reimbursement may be so low that we cannot market our products on a competitive basis. If government entities or other third-party payors do not provide adequate reimbursement levels for our products, or if those reimbursement policies increasingly favor the use of generic products, our sales could decline and our business could be seriously harmed.

Furthermore, federal and state regulations govern or influence the reimbursement to health care providers of fees and capital equipment costs in connection with medical treatment of certain patients. We cannot predict the likelihood that federal and state legislatures will pass laws related to health care reform or lowering pharmaceutical costs. Continued significant changes in the health care system could have a material adverse effect on our business.

In addition to our commercial business, we own the development and commercialization rights to a recombinant form of a natural human hormone called relaxin. Relaxin reduces the hardening, or fibrosis, of

On October 8, 2000, we announced that our pivotal trial for scleroderma showed no statistically significant difference between the response to relaxin and the response to placebo with respect to the “primary endpoint” of that trial. There were, however, statistically significant responses with respect to secondary parameters measured in that trial. Infertility, peripheral vascular disease, cardiovascular disease, and kidney disease represent opportunities for relaxin’s biologic properties of enhancing blood flow.

Based on the result of the pivotal trial, and following an extensive evaluation of other potential uses for relaxin, on May 23, 2001, we announced our decision to reduce our investment in relaxin in favor of focusing our resources on expanding our dermatology business, and to pursue a license partner or other strategic alternative for the relaxin program. As part of that decision we reduced our work force by eliminating 27 positions related to relaxin. Prior to May 2001, our strategy had been to retain U.S. rights for all potential indications for the drug. We maintain North American rights for relaxin and have entered into collaborative relationships for this program for markets outside of the United States. We have licensed rights to relaxin development and commercialization to Paladin Labs, Inc. for Canada, and to F.H. Faulding & Co. for Australia.

Paladin Labs, Inc. In July 1999, we entered into a collaboration and exclusive license agreement with Paladin for the development and commercialization of relaxin in Canada. Although we have discontinued our development efforts for relaxin for scleroderma, Paladin has indicated that it will continue the collaboration for other indications. Under the terms of the agreement, Paladin would owe additional milestone payments for the approval of indications other than scleroderma for relaxin in Canada. Paladin is responsible for all development and commercialization activities in Canada, and is obligated to pay royalties on all sales of relaxin in Canada.

F.H. Faulding & Co., Ltd. In April 2000, we entered into a collaboration and exclusive license agreement with Faulding for the development and commercialization of relaxin in Australia. Although we have discontinued our development efforts for relaxin for scleroderma, Faulding has indicated that it will continue the collaboration for other indications. Under the agreement, Faulding would owe additional milestone payments for the approval of non-scleroderma indications for relaxin in Australia. Faulding is responsible for all development and commercialization activities in Australia, and will pay royalties on all sales of relaxin in Australia. In October 2001, Faulding was acquired by Mayne Group Limited, Australia’s largest private health care provider.

Genentech. In September 1993, we entered into an agreement with Genentech, which was subsequently amended in July 1994 and April 1996. The agreement, as amended, grants to us exclusive rights, for indications other than reproductive indications, to make, have made, use, import and sell certain products derived from recombinant human relaxin. Many of our relaxin patent rights are owned by The Florey Institute, and we license them through Genentech. Genentech retains co-exclusive rights for reproductive indications. The agreement also includes technology transfer, supply, and intellectual property provisions, including a provision requiring us to meet milestones. If we fail to achieve designated milestones, Genentech may terminate the license. Upon termination, the patent rights and know-how we licensed from Genentech would revert to Genentech, and under certain circumstances depending on the reason for the termination, Genentech would automatically receive a non-exclusive, sublicensable and fully paid up license to our relaxin technology.

Our research and development activities involve the controlled use of hazardous and biohazardous materials, chemicals such as solvents and active pharmaceutical agents, compressed gases, and certain radioactive materials, such as hydrogen 3, carbon-14, and phosphorous-33. We are subject to federal, state and local laws and regulations governing the use, storage, handling and disposal of such materials and certain waste products. Although we believe that our safety procedures for handling and disposing of such materials comply

Compliance with federal, state and local law regarding the discharge of materials into the environment or otherwise relating to the protection of the environment has not had, and is not expected to have, any adverse effect on our capital expenditures, earnings or competitive position. We are not presently a party to any litigation or administrative proceeding with respect to our compliance with such environmental standards. In addition, we do not anticipate being required to expend any funds in the near future for environmental protection in connection with our operations.

As of March 1, 2002, we had 162 full-time employees. Of the full-time employees, 77 were engaged in sales and marketing, 57 were in research and development and 28 were in general and administrative positions. We believe our relations with our employees are good.

There are many factors that affect our business and results of operations, some of which are beyond our control. The following is a description of some of the important factors that may cause the actual results of our operations in future periods to differ materially from the results currently expected or desired. Due to the foregoing factors, we believe that quarter-to-quarter comparisons of our results of operations are not a good indication of our future performance.

Our operating results may fluctuate from period to period for a number of reasons, and even a relatively small revenue shortfall may cause a period’s results to be below our expectations or projections. A revenue shortfall could arise from any number of factors, some of which we cannot control. For example, we may face:


	•	lower than expected demand for our products,

	•	changes in the government’s or private payors’ reimbursement policies for our products,

	•	changes in wholesale buying patterns,

	•	increased competition from new or existing products, or

	•	changes in our product pricing strategies.

Of these, we would only have control over changes in our product pricing strategies, and of course there may be other factors that affect our revenues in any given period.

Product revenue from sales of our marketed products does not currently cover the full cost of developing products in our pipeline. We currently believe that our available cash resources will be sufficient to fund our operating and working capital requirements for the next 18 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. Accordingly, we may need to raise additional funds through public or private financings, strategic relationships or other arrangements.

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 $16.7 for the year ended December 31, 2001. Our accumulated deficit was $109.5 million at December 31, 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.

We generate contract and royalty 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:


	•	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,

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

	•	royalties generated from licensing arrangements may be insignificant.

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

Our commercial success depends in part on our ability and the ability of our licensors to obtain and maintain patent protection on technologies, to preserve trade secrets, and to operate without infringing the proprietary rights of others. The foam technology used in Luxíq and OLUX is covered by one issued patent.

We are pursuing several U.S. and international patent applications, although we cannot be sure that any of these patents will ever be issued. We also have acquired rights 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. As a result, the products and technologies we currently market, and those we may market in the future, may infringe on patents and other rights owned by others. If we are 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.

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

Licenses with Genentech, Inc. and The Howard Florey Institute of Experimental Physiology and Medicine require us to use our best efforts to commercialize relaxin. Our failure to successfully commercialize relaxin may result in the reversion of our rights under these licenses 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.

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.

We currently have no manufacturing or distribution facilities for any of our products. Instead, we contract with third parties to manufacture our products for us. Typically, these manufacturing contracts are short-term. Currently, Miza Pharmaceuticals is our sole source manufacturer for Luxíq and OLUX. We are in the process of qualifying Accra Pac Group, Inc. to manufacture physician samples, Luxíq, and OLUX for us, but we have not yet received permission from the FDA to manufacture commercial product at that location. On March 12, 2002, we entered into agreements with DPT to construct an aerosol filling line at DPT’s plant in Texas and to manufacture and fill our commercial aerosol products. DPT cannot manufacture our products until the aerosol line is completed, at which time we will have to apply to the FDA to qualify DPT to manufacture our commercial products for us in the United States.

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 Miza cannot provide us with our product requirements in a timely and cost-effective manner, or if the product they are able to supply cannot meet commercial requirements for shelf life, our sales of marketed products could be reduced and we could suffer delays in the progress of clinical trials for products under development. In addition, any commercial dispute with any of suppliers could result in delays in the manufacture of product, and affect our ability to commercialize our products. 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 that could arise in the manufacturing process could significantly affect our inventories and supply of products available for sale. 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.

All of our contractors must comply with the applicable FDA cGMP regulations, which include quality control and quality assurance requirements as well as the corresponding maintenance of records and documentation. If Miza is not able to comply with the applicable cGMP 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 manufacturers’ compliance with these regulations and standards. 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. Our business interruption insurance, which covers the loss of income for up to $8.0 million, may not completely mitigate the harm to our business from the interruption of the manufacturing of products caused by certain events, as 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.

Supply interruptions may occur and our inventory may not 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.

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 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, including our products, 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. The FDA is permitted to revisit and change its prior determinations and it may change its position with regard to the safety or effectiveness of our products. Even if the FDA approves our products, the FDA is authorized to impose post-marketing requirements such as:


	•	testing and surveillance to monitor the product and its continued compliance with regulatory requirements,


	•	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,

	•	suspending manufacturing,

	•	recalling products, and

	•	withdrawing marketing clearance.

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.

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:


	•	incurring substantial expenses, including fines, penalties, legal fees and costs to comply with the FDA’s requirements,

	•	changes in the methods of marketing and selling products,

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

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

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.

Successful product development in our industry is highly uncertain, and the process of obtaining FDA and other regulatory approvals is lengthy and expensive. Very few research and development projects produce a commercial product. Product candidates that appear promising in the early phases of development may fail to reach the market for a number of reasons, including that the product candidate did not demonstrate acceptable clinical trial results even though it demonstrated positive preclinical trial results, or that the product candidate was not effective in treating a specified condition or illness, or that the FDA did not approve our product candidate for its intended use.

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 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, 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

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


	•	satisfaction with existing alternative therapies,

	•	the effectiveness of our sales and marketing efforts,

	•	the cost of the product as compared with alternative therapies, and undesirable and unforeseeable side effects.

We cannot predict the potential long-term patient acceptance of, or the effects of competition and managed health care on, sales of either product.

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, extend the duration of, or increase the size of, clinical trials, which could significantly delay commercialization and require significantly greater expenditures.

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 re-evaluate 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 re-evaluations, we have abandoned in the past, and may abandon in the future, our efforts on a particular product or technology. Products we are researching or developing may never 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


Delaware (State or other jurisdiction of incorporation or organization)		94-3173928 (I.R.S. Employer Identification No.)

3290 West Bayshore Road Palo Alto, California (Address of principal executive offices)		94303 (zip code)


FORWARD-LOOKING INFORMATION
PART I
	Item 1. Business
	Item 2. Properties
	Item 3. Legal Proceedings
	Item 4. Submission of Matters to a Vote of Security Holders
PART II
	Item 5. Market for the Company’s Common Equity and Related Stockholder Matters
	Item 6. Selected Financial Data
	Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 7A. Quantitative and Qualitative Disclosures About Market Risk
	Item 8. Financial Statements and Supplementary Data
	Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
PART III
	Item 10. Our Directors and Executive Officers
	Item 11. Executive Compensation
	Item 12. Security Ownership of Certain Beneficial Owners and Management
	Item 13. Certain Relationships and Related Transactions
PART IV
	Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
SIGNATURES
		CONSOLIDATED BALANCE SHEETS
		CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
INDEX TO EXHIBITS
Exhibit 3.5
Exhibit 10.4
Exhibit 10.5
Exhibit 10.12
Exhibit 10.13
Exhibit 10.39
Exhibit 10.49
Exhibit 10.54
Exhibit 10.55
Exhibit 10.56
Exhibit 21
Exhibit 23.1


		Page

Forward-Looking Information			1

PART I
Item 1.	Business		1
Item 2.	Properties		22
Item 3.	Legal Proceedings		22
Item 4.	Submission of Matters to a Vote of Security Holders		22

PART II
Item 5.	Market for the Company’s Common Equity and Related Stockholder Matters		22
Item 6.	Selected Financial Data		23
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		25
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk		34
Item 8.	Financial Statements and Supplementary Data		35
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		35

PART III
Item 10.	Our Directors and Executive Officers		35
Item 11.	Executive Compensation		37
Item 12.	Security Ownership of Certain Beneficial Owners and Management		37
Item 13.	Certain Relationships and Related Transactions		37

PART IV
Item 14.	Exhibits, Financial Statement Schedules and Reports on Form 8-K		37
Signatures			39
Consolidated Financial Statements and Report of Independent Auditors			F-1
Index to Exhibits			F-31

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	*Our operating results may fluctuate, and this fluctuation could cause financial results to be below expectations.*


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


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


	*Our total revenue depends on receiving royalties and contract payments from third parties, and we cannot control the amount or timing of those revenues.*


	*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.*


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


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


	*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.*


	*We currently rely on a sole source to manufacture Luxíq and OLUX, and future manufacturing difficulties could delay future revenues from product sales.*


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


	*We cannot sell our current products and product candidates if we do not obtain and maintain governmental approvals.*


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


	*If Luxíq and OLUX do not sustain market acceptance, our revenues will not be predictable and may not cover our operating expenses.*


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


	*If we are unable to develop new products, our expenses may continue to exceed our revenue indefinitely, without any return on the investment.*