Back to GetFilings.com

Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Form 10-K

For the Fiscal Year Ended December 31, 2002

Commission file number: 0-27406

CONNETICS CORPORATION

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

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.001 par value per share
Preferred Share Purchase Rights

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

     Indicate by check mark 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

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). YES x  NO o

     The aggregate market value of the voting stock held by non-affiliates of the registrant was approximately $354,126,000 as of March 3, 2003, 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 31,398,567 shares of registrant’s common stock issued and outstanding as of March 3, 2003.

DOCUMENTS INCORPORATED BY REFERENCE

     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 14, 2003.

Table of Contents

Table of Contents

Table of Contents

Forward-Looking Information

     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 development of drug candidates, and developments relating to 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. In particular, this Report sets forth important factors that could cause actual results to differ materially from our forward-looking statements. 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, now 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.

PART I

Item 1. Business

THE COMPANY

     References in this Report to “Connetics,” “the Company,” “we,” “our” and “us” refer to Connetics Corporation, a Delaware corporation, and its consolidated subsidiaries. Unless the context specifically requires otherwise, “we” includes Connetics Australia Pty Ltd. Our principal executive offices are located at 3290 West Bayshore Road, Palo Alto, California 94303. Our telephone number is (650) 843-2800. Connetics®, Luxíq®, and OLUX® are registered trademarks, and Extina™, Actiza™, Liquipatch™, Solux™ 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, OLUX® Foam (clobetasol propionate), 0.05%, and Luxíq® Foam (betamethasone valerate), 0.12%. Our commercial business is focused on the dermatology marketplace, which is characterized by a large patient population that is served by a relatively small number of treating physicians. Our two dermatology products have clinically proven therapeutic advantages for the treatment of dermatoses in a novel formulation, and we are providing quality customer service to dermatologists through our experienced sales and marketing professionals.

1

Table of Contents

     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 interact with our researchers to explore how topical drugs interact with and penetrate the skin. The purpose of the Center is to learn how to optimize drug penetration, distribution, and efficiency at the targeted treatment site on the skin, and to assess novel formulations and new delivery technologies. The Center will assist in the continued development of innovative topical dermatology products through rigorous scientific evaluation of products and product candidates. 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, OLUX and Luxíq, compete in the topical steroid market. According to NDC Health, in 2002, the value of the retail topical steroid market for mid-potency and high and super-high potency steroids was $831 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 a variety of clinically proven drugs that are 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 OLUX and Luxíq has significant advantages over conventional therapies for dermatoses. The foam formulation liquefies when applied to the skin, and enables the active therapeutic agent to penetrate rapidly. 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 to other topical delivery vehicles.

     We acquired our wholly-owned subsidiary, Connetics Australia Pty Ltd. (formerly Soltec Research Pty Ltd.) in 2001. The acquisition, for which we paid approximately U.S. $16.9 million, was intended to provide us with powerful product innovation and development capabilities and to fuel an extensive new product pipeline as well as contributing revenue and profits to our financial results. We have leveraged our 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 us. In connection with the acquisition, 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 for over-the-counter and foreign markets.

OUR STRATEGY

     Our principal business objective is to be a leading specialty pharmaceutical company focused on providing innovative treatments 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. We have described our development paradigm as a “4:2:1 model.” We strive in any given year to have four product candidates in product formulation, two product candidates in late-stage clinical trials, and one product or new indication launched commercially. We fuel our product pipeline by a combination of internally developing product candidates and in-licensing novel products that fit with our broader strategy. Key elements of our business and commercialization strategy include the following:

•

Maximizing Near-Term Commercial Opportunities for OLUX and Luxíq. We have a focused sales force dedicated to establishing OLUX and Luxíq as the standard of care. Our commercial strategy permits us to effectively reach the majority of the treating dermatologists. In 2002, we introduced sample-size versions of both our products. In December 2002, we received approval from the FDA to market OLUX for the treatment of non-scalp psoriasis, specifically the short-term topical treatment of mild to moderate plaque-type psoriasis of non-scalp regions excluding the face and intertriginous areas.

2

Table of Contents

	•		Advancing the Development of Novel Dermatology Drugs. We plan to continue to leverage our investment in Connetics Australia and the Center for Skin Biology to enhance our ability to develop novel products 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. In 2002, we acquired the rights to Velac®, a first-in-class combination of 1% clindamycin and 0.025% tretinoin for the treatment of acne. Also in 2002, we in-licensed the rights to access the clinical, regulatory and manufacturing records of a currently approved and marketed dermatological product. Connetics intends to reformulate and market the product using its proprietary foam delivery vehicle. Details regarding the product and the target market were not disclosed. We are evaluating the licensing or acquisition of additional product candidates. We may also acquire additional technologies or businesses that we believe will enhance our research and development capabilities.
	•		Selective Collaborations. As we expand certain aspects of our development pipeline and delivery technologies, we intend to partner with pharmaceutical or biotech companies to gain access to additional marketing expertise, such as over-the-counter or non-U.S. markets. Our approach to partnership will be on a selective basis, seeking to maintain the highest possible value of our product candidates.

OUR PRODUCTS

OLUX Foam

     OLUX is a foam formulation of clobetasol propionate, one of the most widely prescribed super high-potency topical steroids. OLUX has been proven to deliver rapid and effective results for scalp and non-scalp psoriasis. In fact, according to Physician Global Assessments, significantly more patients were completely clear or almost clear after two weeks of treatment.

     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 moderate to severe scalp psoriasis significantly more patients (74%) treated with OLUX achieved 90 - 100% clearance (Investigators’ Global Assessment) within two weeks as compared with patients treated with placebo (10%; p<0.001). In a more rigorous assessment of efficacy from the Phase III clinical trial, treatment success was achieved in 63% of OLUX -treated patients compared to 57% of patients treated with clobetasol solution.

     In December 2002, the FDA approved our supplemental New Drug Application, or sNDA, to market OLUX for a non-scalp indication. The sNDA was based on results from a 279-patient, placebo-controlled, randomized, double-blind, Phase III clinical trial of OLUX for the treatment of mild-to-moderate non-scalp psoriasis. During the study, patients treated with OLUX experienced a statistically significant improvement in clearance of disease (p < 0.0001) over patients in the placebo group after treatment twice a day for 14 days. Patients 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. In non-scalp psoriasis significantly more patients (68%) treated with OLUX achieved a Physician’s Static Global Assessment score of 0 or 1 within two weeks as compared with patients treated with placebo (21%; p<0.001). In a more rigorous assessment of efficacy, treatment success was achieved in 28% of OLUX-treated patients vs. 3% of patients treated with placebo. Treatment success was scored on a severity scale from 0 to 5, and was defined as a Physician’s Static Global Assessment score of 0 or 1, plus a plaque thickness score of 0, an erythema score of 0 or 1, and a scaling score of 0 or 1 at endpoint. 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 dryness).

     A separate study conducted at Stanford University School of Medicine, presented at the Annual Hawaii Dermatology Seminar in January 2002, compared the safety and 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 showed that the

3

Table of Contents

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 other formulations.

     Mipharm S.p.A., which holds a license to market OLUX in Italy, filed a Marketing Authorization Application, or MAA, in April 2002 for OLUX with the Medicines Control Agency, or MCA, in the United Kingdom. It is our intention to submit the MAA to all additional concerned member states in the European Union after the MCA grants authorization, using a process called the Mutual Recognition process. We are seeking commercial partners outside the territory licensed to Mipharm.

Luxíq Foam

     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. We began selling Luxíq commercially in the United States in April 1999. In a clinical trial, a majority of patients were judged to be almost clear or completely clear (90-100%) of scalp psoriasis at the end of treatment as judged by Investigator’s Global Assessment of response. Luxíq also significantly reduced scaling, erythema, and plaque thickness, as compared with betamethasone valerate lotion.

PRODUCT CANDIDATES AND CLINICAL TRIALS

     Our product candidates require extensive clinical evaluation and clearance by the FDA before we can sell them commercially. Our 4:2:1 development model anticipates that we will conduct simultaneous studies on several products at a given time. However, we regularly re-evaluate our product development efforts. On the basis of these re-evaluations, 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.

     At the end of 2002, we had three product candidates in Phase III clinical trials. We are in Phase III clinical trials with Extina™, a foam formulation of a 2% concentration of the antifungal drug ketoconazole, for the treatment of seborrheic dermatitis. The Extina clinical program consists of a pivotal trial and two small supplemental clinical studies required by the FDA. In the pivotal trial, which completed enrollment in late January 2003, patients were treated for four weeks in a double-blind, placebo- and active-controlled protocol. Subject to a successful outcome, we intend to submit a New Drug Application, or NDA, to the FDA for Extina in mid-2003. We believe Extina will compete primarily in the topical antifungal market, representing approximately $484 million in U.S. prescriptions in 2002. Prescriptions for all antifungals in the U.S. in 2002 were approximately $693 million.

     We are in Phase III clinical trials with Actiza™, a formulation of 1% clindamycin in our proprietary foam delivery system, for the treatment of acne. The Actiza clinical program consists of a pivotal trial, a pilot trial, and two small supplemental clinical studies required by the FDA. In the pivotal trial, patients will be treated for 12 weeks in a double-blind, placebo- and active-controlled protocol. Subject to a successful outcome, we intend to submit an NDA to the FDA for Actiza in late 2003. We believe Actiza will compete primarily in the topical antibiotic market, representing approximately $594 million in U.S. prescriptions in 2002. Prescriptions for the entire U.S. acne market in 2002 were approximately $1.5 billion not including oral antibiotics.

     In December, we initiated the Phase III program for Velac® gel, a first-in-class combination of 1% clindamycin and 0.025% tretinoin for the treatment of acne. The Velac clinical program consists of two pivotal trials, and two small supplemental clinical studies required by the FDA. The two pivotal trials will enroll approximately 2,000 patients. Assuming successful clinical development, we anticipate that we will submit an NDA to the FDA for Velac in 2004 and be able to launch Velac in mid-2005. We believe Velac will compete with topical retinoids as well as topical antibiotics, representing approximately $977 million in U.S. prescriptions in 2002. Prescriptions for the entire U.S. acne market in 2002 were approximately $1.5 billion not including oral antibiotics.

     In February 2003, we began a promotional giveaway to dermatologists of Solux™, a sunscreen formulated in our proprietary foam delivery system. The goal of the program is to introduce the foam delivery vehicle to a broad physician audience.

4

Table of Contents

     In addition to the product candidates described above, we are also developing the foam technology for other disease indications. Our most promising preclinical candidates include a petrolatum-based foam as line extensions for OLUX and Luxíq, and other formulation candidates in early stages of development. We are exploring various product formulations for Liquipatch™ as well.

ROYALTY-BEARING PRODUCTS AND LICENSED TECHNOLOGY

     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 paid us an initial licensing fee, and agreed to pay us when it achieves specified milestones, plus a royalty on product sales. We have recognized $1.0 million under the agreement through December 31, 2002. Pharmacia will be responsible for most product development activities and costs.

     Before April 2001, Connetics Australia (under the name Soltec) had entered into a number of other agreements for the foam technology. Connetics Australia licensed the technology to betamethasone valerate foam to Celltech plc in Europe, and Celltech has licensed the worldwide rights to their patent on the steroid foam technology to us through Connetics Australia. We pay Celltech royalties on all sales worldwide of foam formulations containing steroids. Celltech markets their product as Bettamousse® (the product equivalent of Luxíq), and pays us royalties on those sales. We have 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. In 2002, on a consolidated basis, we received $307,000 in royalties for foam-based technology. We have development agreements with other companies to develop the foam for specific indications.

     We have licensed to Mipharm commercial rights for Italy to OLUX, and we will receive milestone payments and royalties on future product sales. In April 2002, Mipharm began the process to obtain marketing authorization in Europe, by filing a Marketing Authorization Application with the Medicines Control Agency in the United Kingdom. Under the Mutual Recognition process in Europe, after the MCA approves the MAA, we will be able to submit the MAA to all other European Union concerned member states for approval to sell OLUX. We retained marketing and manufacturing rights for the rest of Europe and are seeking commercial partners outside of Mipharm’s territory.

     Aerosol Spray. Connetics Australia 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 2002, on a consolidated basis, we received $2.4 million in royalties in connection with this agreement.

     Liquipatch. We have agreements with several companies to develop Liquipatch™ for various indications. In June 2001, we entered into a global licensing agreement with Novartis Consumer Health SA for the Liquipatch drug-delivery system for use in topical antifungal applications. The agreement followed successful pilot development work and gives Novartis the exclusive, worldwide right to use the Liquipatch technology in the topical antifungal field. In March 2002, Novartis paid $580,000 to exercise its then-existing option to expand the license agreement. Novartis will be responsible for all development costs, and will be obligated to pay license fees, milestone payments and royalties on future product sales. We have development agreements with other companies to develop Liquipatch for specific indications.

     Actimmune®. In 1995, we acquired from Genentech, Inc. the exclusive development and marketing rights to interferon gamma for dermatological and other indications in the U.S., Japan, and Canada. 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. In April 2000, we assigned our remaining rights and obligations under the license with Genentech and the corresponding supply agreement to InterMune Pharmaceuticals, Inc. (now InterMune, Inc.), to develop Actimmune for various infections and fungal diseases. In exchange, InterMune paid us approximately $6.1 million, of which $942,000 was paid to us in March 2001 and the balance was paid in 2000. We recorded $172,000 in royalty revenue related to Actimmune sales in 2002. In August 2002, we entered into an

5

Table of Contents

agreement with InterMune to terminate our exclusive option for certain rights in the dermatology field in exchange for a payment of $350,000. We recognized the full amount of this revenue in 2002.

     Ridaura®. In April 2001, we sold all of our rights and interests in Ridaura® (auranofin) to Prometheus Laboratories, Inc. Ridaura is a prescription pharmaceutical product 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 agreement with Prometheus, 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 per calendar year through March 2006. We received no royalties in 2002. Prometheus agreed to assume, effective as of the closing date of the transaction, our obligations under existing agreements with Pharmascience, Inc. and SmithKline Beecham Corporation (now known as GlaxoSmithKline).

SALES AND MARKETING

     We have an experienced, highly productive sales and marketing organization, which is 100% dedicated to dermatology. As of March 3, 2003, we had 76 employees in our sales and marketing organization, including 60 field sales directors and representatives.

     Our marketing efforts are focused on assessing and meeting the needs of dermatologists, residents, dermatology nurses, and physicians’ assistants. Our sales representatives focus on cultivating relationships of trust and confidence with the physicians they call on. Of the 7,500 U.S. dermatologists our sales force called on in 2002, we focused our efforts on the approximately 5,000 dermatologists who are responsible for approximately 90% of all prescriptions written by dermatologists in the United States. To achieve our marketing objectives, we use a variety of advertising, promotional material (including journal advertising, promotional literature, and rebate coupons), specialty publications, participation in educational conferences, support of continuing medical education activities, and advisory board meetings, as well as product internet sites 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.olux.com and http://www.luxiq.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.

     In addition to traditional marketing approaches and field sales relationships with dermatologists, we sponsor several programs that support the dermatology field. We currently provide funding to sponsor one dermatology resident at the Stanford University Medical School, and a dermatology fellow at the University of California – San Francisco. We are working to provide an innovative surgery-tracking program for dermatology residents. We also provide corporate sponsorship to various dermatology groups, including the National Psoriasis Foundation, the Dermatology Foundation, the Skin Disease Education Foundation, and the Foundation for Research & Education in Dermatology. In 2002, we sponsored 15 children to attend Camp Wonder, a summer camp sponsored by the Childrens’ Skin Disease Foundation for children suffering from serious and fatal skin diseases.

COMPETITION

     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.

6

Table of Contents

     OLUX and Luxíq 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®, which are marketed by GlaxoSmithKline as of late 2002; DermaSmoothe FS®, marketed by Hill Dermaceuticals; and Psorcon®, marketed by Dermik Laboratories, Inc. In February 2003, Biogen announced that the FDA had approved its systemic drug, Amevive, for the treatment of psoriasis. In addition, both OLUX and Luxíq 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.

CUSTOMERS

     We sell product directly to wholesale distributors. Patients have their prescriptions filled by pharmacies that buy the drug from the wholesalers. Accordingly, the number of prescriptions written for our products only indirectly affects our product revenues. Our customers include the nation’s leading wholesale pharmaceutical distributors, such as McKesson HBOC, Inc., Cardinal Health, Inc., and AmerisourceBergen Corporation, and major drug chains. During 2002, Cardinal Health, McKesson, and AmerisourceBergen accounted for 43%, 26%, and 23%, 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.

RESEARCH AND DEVELOPMENT AND PRODUCT PIPELINE

     Innovation by our research and development operations is very important to the success of our business. Our research and development expenses were $25.8 million in 2002, $19.2 million in 2001, and $21.9 million in 2000. Our goal is to discover, develop and bring to market innovative products that address unmet healthcare needs. 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 product candidates that we believe have large 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

7

Table of Contents

humans with products that offer significant improvements over existing products. A secondary strategy is to evaluate the acquisition of products from other companies.

     We have developed several additional aerosol foams similar to our foam delivery system for OLUX and Luxíq, including water-, ethanol- and petrolatum-based foams. We have also developed Liquipatch, 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.

     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 into agreements with academic or university-based researchers to conduct various studies for us.

PATENTS AND PROPRIETARY RIGHTS

     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 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.

     We own or are exclusively licensed under pending applications and/or issued patents worldwide relating to OLUX and Luxíq, recombinant human relaxin, and other products in the earlier stages of research. We own over 20 patents related to the technologies developed by Connetics Australia, expiring between 2003 and 2018, and we have several pending applications.

     The delivery technology that is the basis for OLUX and Luxíq is covered by a U.S. patent on methods of treating various skin diseases using a foam pharmaceutical composition comprising a corticosteroid active substance, a propellant and a buffering agent. The Liquipatch technology is covered by one U.S. patent.

     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.

8

Table of Contents

TRADEMARKS

     We believe that trademark protection is an important part of establishing product and brand recognition. We own 12 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.

MANUFACTURING

     We do not operate manufacturing or distribution facilities for any of our products. Instead, we contract with third parties to manufacture our products for us. 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. Currently, DPT, Miza Pharmaceuticals and Accra Pac Group, Inc. manufacture commercial supplies of OLUX and Luxíq, as well as physician samples of those products for us. DPT also manufactures clinical supplies for our various clinical trial programs. 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. The aerosol line was completed in September 2002, and effective February 21, 2003, is approved for the manufacture of OLUX in the United States. We anticipate that DPT will be approved to manufacture Luxíq commercially in the spring of 2003.

WAREHOUSING AND DISTRIBUTION

     Currently, all of our product distribution activities are handled by Cardinal Health Specialty Pharmaceutical Services (formerly CORD Logistics, Inc.). Cardinal Health Specialty Pharmaceutical Services, or SPS, is a division of Cardinal Health, which was our largest customer in 2002. For more information about our customers, see “Customers” above, and Note 2 of Notes to Consolidated Financial Statements. SPS stores and distributes products to our customers from a warehouse in Tennessee. When SPS receives a purchase order, it processes the order into a computerized distribution database. Generally, our customers’ orders are shipped from SPS within 24 hours after their order is received. Once the order has shipped, SPS generates and mails out invoices on our behalf. Any delay or interruption in the distribution process or in payment by our customers could have a material effect on our business.

GOVERNMENT REGULATION

     Generally – Product Development. The pharmaceutical industry is 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 prescription 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.

9

Table of Contents

     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 sponsor of these studies submits the results to the FDA 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 product candidates.

     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 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.

     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.

     The Food, Drug and Cosmetic Act includes provisions for accelerating the FDA approval process under certain circumstances. For example, we used the so-called 505(b)(2) application process for both OLUX and Luxíq, which permitted us to satisfy the requirements for a full 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 applicant, together with the studies generated on our products. While the FDA evaluation used the same standards of approval as an NDA, 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. The 505(b)(2) process will not be available for all of our other product candidates, and as a result the FDA process may be longer for those product candidates than it was for OLUX and Luxíq.

     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. 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 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

10

Table of Contents

any of our products. We and our contract manufacturers must adhere to cGMP 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 if previously unknown problems are discovered or if we fail to comply with the applicable regulatory requirements, the FDA may restrict the marketing of a product or impose the 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 SPS 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 Federal Medicaid rebate program established by the Omnibus Budget Reconciliation Act of 1990, as well as several state supplemental rebate programs. Under the Medicaid rebate program, we pay a rebate to each state Medicaid program for our products that are 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. As part of our revenue recognition policy, we provide reserves on this potential exposure at the time of product shipment.

     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 poor Medicare and Medicaid beneficiaries.

11

Table of Contents

     We also make our products available to authorized users of the Federal Supply Schedule, of 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 Medicaid rebate statute and the VHCA also provide that, in addition to penalties that may be applicable under other federal statutes, civil monetary penalties may be assessed for knowingly providing false information in connection with the pricing and reporting requirements under the laws. The amount that may be assessed is up to $100,000 for each item of false information. We have provided additional information about the risks associated with participation in the Medicaid and similar programs, under “Factors Affecting Our Business and Prospects – Our sales depend on payment and reimbursement from third party payors, and if they reduce or refuse payment or reimbursement, the use and sales of our products will suffer, we may not increase our market share, and our revenues and profitability will suffer” and “—The growth of managed care organizations and other third-party reimbursement policies may have an adverse effect on our pricing policies and our margins” below.

MARKETING TO HEALTHCARE PROFESSIONALS

     A number of guidelines were issued in 2002 relating to how pharmaceutical manufacturers interact with doctors and other healthcare professionals. We intend for our relationships with doctors to benefit patients and to enhance the practice of medicine, and at the same time represent the interests of our stockholders in maintaining and growing our company. We have adopted internal policies that emphasize to our employees that all interactions with healthcare professionals should be focused on informing them about our products, providing scientific and educational information, or supporting medical research and education. Recent draft guidance issued by the Office of Inspector General of Health and Human Services recommends significant restrictions on how pharmaceutical companies can interact with the medical community. We believe that effective marketing of our products is necessary to ensure that patients have access to the products they need, and that the products are correctly used for maximum patient benefit. Our marketing and sales organization is critical to achieving these goals, because they foster relationships that enable us to inform healthcare professionals about the benefits and risks of our products, provide scientific and educational information, support medical research and education, and obtain feedback and advice about our products through consultation with medical experts. We intend to closely follow developments in this field, and to continue to assess the impact that any new regulations might have on our business.

MARKETING EXCLUSIVITY

     The FDA has the power to grant pharmaceutical companies new drug product exclusivity for a drug, independent of any orphan drug or patent term exclusivity accorded to that drug. This marketing exclusivity 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 until May 26, 2003. 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. At the time we submitted the sNDA for the expanded label for OLUX, we requested exclusivity for the new indication. The FDA has not advised us of its position on that issue.

THIRD PARTY REIMBURSEMENT

     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.

12

Table of Contents

     Medicare, Medicaid, health maintenance organizations and other third-party payors may not authorize or otherwise budget such reimbursement. Because of the size of the patient population covered by managed care organizations, marketing of prescription drugs to them and the pharmacy benefit managers that serve many of these organizations is important to our business. Managed care organizations and other third-party payors try to negotiate the pricing of medical services and products to control their costs. Managed care organizations and pharmacy benefit managers typically develop formularies to reduce their cost for medications. Due to their lower costs, generic products are often favored on such formularies. The breadth of the products covered by formularies varies considerably from one managed care organization to another, and many formularies include alternative and competitive products for treatment of particular medical conditions. The exclusion of a product from a formulary can sharply reduce usage of that product in the managed care organization’s patient population. 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 managed care organizations or other third-party payors do not provide adequate reimbursement levels for our products, or if those reimbursement policies predominantly 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 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.

RELAXIN DEVELOPMENT PROGRAM

Overview

     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 skin and organ tissue, dilates existing blood vessels and stimulates new blood vessel growth. Relaxin circulates in the blood and has a broad spectrum of biological activities.

     In October 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.

Relaxin Alliances

     Canadian and Australian Licenses. In July 1999, we entered into a collaboration and exclusive license agreement with Paladin Labs, Inc. for the development and commercialization of relaxin in Canada. 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, Paladin and Faulding have indicated that they will continue the collaboration for other indications. Under the terms of the agreements, Paladin and Faulding would owe additional milestone payments for the approval of non-scleroderma indications for relaxin in Canada and Australia, respectively. Paladin is responsible for all development and commercialization activities in Canada, and is obligated to pay royalties on all sales of relaxin in

13

Table of Contents

Canada. 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. We are party to an agreement with Genentech which 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.

ENVIRONMENTAL REGULATION

     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 with the standards prescribed by state, federal, and local laws and regulations, we cannot completely eliminate the risk of accidental contamination or injury from these materials.

     Compliance with federal, state and local laws 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.

EMPLOYEES

     As of March 3, 2003, we had 190 full-time employees. Of the full-time employees, 76 were engaged in sales and marketing, 79 were in research and development and 35 were in general and administrative positions. We believe our relations with our employees are good.

FACTORS AFFECTING OUR BUSINESS AND PROSPECTS

     There are many factors that affect our business and results of operations, some of which are beyond our control. The following describes 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, and so materially affect our future developments and performance. This list of factors that may affect future performance and the accuracy of forward-looking statements is illustrative, but not exhaustive. Accordingly, you should evaluate all forward-looking statements with the understanding of their inherent uncertainty. 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.

Risks Related To Our Business

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

     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,

14

Table of Contents

	•		changes in the government’s or private payors’ reimbursement policies for our products,
	•		changes in wholesale buying patterns,
	•		increases in returns of our product, or rebates paid for our products,
	•		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.

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

     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 at least the next 12 months. If in the future our product revenue does not continue to grow or we are unable to raise additional funds when needed, we may not be able to market our products as planned or continue development of our other products. Accordingly, we may need to raise additional funds through public or private financings, strategic relationships or other arrangements.

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

     Except for fiscal year 2000, we have lost money every year since our inception. We had net losses of $27.3 million in 1999, $16.0 million in 2000 (after excluding a one-time gain of $43.0 million on sales of stock we held in InterMune, and the associated income tax), $16.7 million in 2001, and $16.6 million for the year ended December 31, 2002. Our accumulated deficit was $126.1 million at December 31, 2002. We may incur additional losses during the next few years. If we do not eventually achieve and maintain profitability, our stock price may decline.

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

     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 events occurs, we may not be able to successfully develop our products.

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

     We believe that the protection of our intellectual property, including patents and trademarks, is an important factor in product recognition, maintaining goodwill, and maintaining or increasing market share. If we do not adequately protect our rights in our trademarks from infringement, any goodwill which has been developed in those marks could be lost or impaired. If the marks we use are found to infringe upon the trademark of another company, we could be forced to stop using those marks, and as a result we could lose all the goodwill which has been developed in those marks and could be liable for damaged caused by an infringement.

15

Table of Contents

     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.

     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 doe