UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

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

For the Quarterly Period Ended September 30, 2004

Commission file number: 0-27406

CONNETICS CORPORATION

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

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

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

     As of October 29, 2004, there were 35,611,904 shares of the Registrant’s common stock at $0.001 par value outstanding.

CONNETICS CORPORATION

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

CONNETICS CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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CONNETICS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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CONNETICS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Basis of Presentation and Policies

     We have prepared the accompanying unaudited condensed consolidated financial statements of Connetics Corporation (“Connetics”) in accordance with accounting principles generally accepted in the United States for interim financial information and pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the financial statements do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. We believe that we have included all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation. We reclassify as necessary certain prior year balances to conform to the current year presentation.

     Operating results for the three and nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. For a better understanding of Connetics and its financial statements, we recommend reading these unaudited condensed consolidated financial statements and notes in conjunction with the audited consolidated financial statements and notes to those financial statements for the year ended December 31, 2003, which are included in our Annual Report on Form 10-K as filed with the Securities and Exchange Commission.

Principles of Consolidation

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

Use of Estimates

     To prepare financial statements in conformity with accounting principles generally accepted in the United States, management must make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Future events could cause our actual results to differ.

     We evaluate our estimates on an on-going basis. In particular, we regularly evaluate estimates related to recoverability of accounts receivable and inventory, revenue reserves, assumed liabilities related to acquired product rights and accrued liabilities for clinical trial activities. We base our estimates on historical experience and on various other specific assumptions that we believe to be reasonable under the circumstances. Those estimates and assumptions form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources.

Revenue Recognition

     Product Revenues. We recognize revenue from product sales when there is persuasive evidence that an arrangement exists, when title has passed, the price is fixed or determinable, and we are reasonably assured of collecting the resulting receivable. We recognize product revenues net of estimated allowances for discounts, returns, rebates, and chargebacks. We are obligated to accept from customers the return of pharmaceuticals that have reached their expiration date. We authorize returns for damaged products and exchanges for expired products in accordance with our return goods policy and procedures, and we establish reserves for such amounts at the time of sale. To date we have not experienced significant returns of damaged or expired product. We include product shipping and handling costs in the cost of product revenues.

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

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

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     If, at the time an agreement is executed, there remains significant risk due to the incomplete state of the product’s development, we recognize revenue from non-refundable upfront license fees ratably over the period in which we have continuing development obligations. We recognize revenue associated with substantial “at risk” performance milestones, as defined in the respective agreements, based upon the achievement of the milestones. We recognize revenue under R&D cost reimbursement contracts as the related costs are incurred. When we receive advance payments in excess of amounts earned, we classify them as deferred revenue until they are earned.

Cash Equivalents and Marketable Securities

     Cash and cash equivalents consist of cash on deposit with banks, money market and other debt instruments with original maturities of 90 days or less at the date of purchase. Investments with maturities beyond three months at the date of acquisition are included in marketable securities. We classify marketable securities as available for sale at the time of purchase and we carry them at fair value. We report unrealized gains and losses on marketable securities as a component of other comprehensive income (loss) in stockholders’ equity. We use the specific identification method to determine the cost of securities sold.

     Cash, cash equivalents and marketable securities are financial instruments that potentially subject us to concentration of risk to the extent we record them on our balance sheet. We believe we have established guidelines for investing our excess cash in a way that will maintain safety and liquidity with respect to diversification and maturities. We invest our excess cash in debt instruments of the U.S. Government and its agencies, and high-quality corporate issuers. By policy, we restrict our exposure to any single corporate issuer by imposing concentration limits. To minimize the exposure due to adverse shifts in interest rates, we maintain investments at an average maturity of generally less than one year.

Restricted Cash

     Restricted cash reflects certificates of deposit used to secure letter of credit arrangements. Restricted cash – current includes deposits of $1,000,000 that support our annual insurance renewal and restricted cash – long term includes deposits of $2,963,000 that support two office facility leases and two vehicle fleet services leases.

Foreign Currency

     Connetics Australia’s functional currency is the Australian dollar. We translate Connetics Australia’s local currency balance sheet into U.S. dollars using the exchange rates in effect at the balance sheet date. For revenue and expense accounts, we use a weighted average exchange rate during the period. We record foreign currency translation adjustments in other comprehensive income (loss). Net gains and losses that result from foreign exchange transactions are included in the condensed consolidated statements of operations and were immaterial for all periods presented.

Income Taxes

     We account for income taxes using the asset and liability method. Under this method, we recognize deferred tax assets and liabilities for the future tax consequences attributable to differences between (1) the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and (2) operating loss and tax credit carryforwards. We measure deferred tax assets and liabilities using enacted tax rates that are expected to apply to taxable income in the years in which we anticipate those temporary differences will be recovered or settled. When the timing of the realization is uncertain, we establish a valuation allowance for the net deferred tax assets. Historically our income tax provision related primarily to the operations of our Australian subsidiary. In 2004, however, the income tax provision is primarily related to the domestic corporation due to our expected full-year profitability and a reduction in profitability at our Australian subsidiary in 2004.

Property and Equipment

     We state property and equipment at cost less accumulated depreciation. We calculate depreciation using the straight-line method over the estimated useful lives of the assets, generally three to five years. We are depreciating equipment we have purchased on behalf of our contract manufacturer using the units of production method based on contractual minimum quantities to be produced over the term of the agreement. We amortize leasehold improvements over the shorter of the estimated useful lives of the assets or the lease term.

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Inventory

     Inventory consists primarily of finished goods. We state inventory at the lower of cost (determined on a first-in first-out method) or market.

     While we do not directly manufacture any of our products, we do incur internal manufacturing support and quality assurance costs. Before January 1, 2004, inventory and cost of goods sold only captured third party product manufacturing costs, depreciation on Connetics-owned equipment at our third-party manufacturers, product freight and distribution costs from the third party that handles all of our product distribution activities, and royalties. Effective January 1, 2004, we began including in our finished goods inventory and samples inventory costs certain manufacturing support and quality assurance costs which had previously been classified as research and development expense. Those activities include overseeing third party manufacturing, process development, quality assurance and quality control activities. Capitalizing these costs in inventory and samples inventory in the three and nine months ended September 30, 2004 had the effect of increasing net income (net of tax effect) by $465,000 and $1.9 million, or approximately $0.01 and $0.05 per diluted share, respectively. We have determined that the effect of this change in accounting would not have had a material impact on our financial statements in any prior quarterly or annual period.

     For the three months ended September 30, 2004, we allocated $1.2 million of costs which in previous periods would have been included in R&D expense as follows: (1) we charged $307,000 to cost of goods sold, (2) we charged $454,000 to sales expense, (3) we added $645,000 to the value of commercial inventory, and (4) we reduced by $161,000 the value of samples inventory.

     For the nine months ended September 30, 2004, we allocated $3.3 million of costs which in previous periods would have been included in R&D expense as follows: (1) we charged $432,000 to cost of goods sold, (2) we charged $824,000 to sales expense, (3) we added $1.7 million to the value of commercial inventory, and (4) we added $317,000 to the value of samples inventory.

Goodwill, Other Purchased Intangibles and Impairment of Long Lived Assets

     We record goodwill in a business combination when the purchase price of the net tangible and intangible assets we acquire exceeds their fair value. Under Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets,” effective January 1, 2002, we are not required to amortize goodwill and intangible assets with indefinite lives, but are required to periodically review these assets for impairment. Intangible assets determined to have definite lives are amortized over their useful lives, generally ten years.

     SFAS 142 requires that we test goodwill for impairment on an annual basis or more frequently if indicators of potential impairment exist. We performed the annual test as of October 1, 2004, which did not result in an impairment charge. We will perform this test on October 1 of each year or more frequently if indicators of potential impairment exist.

     We periodically perform reviews to determine if the carrying value of long-term assets, other than goodwill (purchased intangibles, property and equipment), are impaired. The reviews look for the existence of facts or circumstances, either internal or external, which indicate that the carrying value of the asset cannot be recovered. Our reviews have indicated no such impairment to date. If in the future we determine that impairment indicators exist, we would use undiscounted cash flows to initially determine whether we should recognize any impairment. If necessary, we would perform a subsequent calculation to measure the amount of impairment loss based on the excess of the carrying value over the fair value of the impaired assets. If quoted market prices for the assets are not available, we would calculate the fair value using the present value of estimated expected future cash flows or other appropriate valuation methodologies. The cash flow calculation would be based on management’s best estimates, using appropriate assumptions and projections at the time.

Stock-Based Compensation

     We use the intrinsic-value method of accounting for stock-based awards granted to employees, as allowed under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), and related interpretations. Accordingly, we do not recognize any compensation in our financial statements in connection with stock options granted to employees when those options have exercise prices equal to or greater than fair market value of our common stock. We also do not record any compensation expense in connection with our Employee Stock Purchase Plan as long as the purchase price is not less than 85% of the fair market value at the beginning or end of each offering period, whichever is lower.

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     For options granted to non-employees, we have determined compensation expense in accordance with SFAS No. 123 “Accounting for Stock-Based Compensation,” as amended, and Emerging Issues Task Force No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling Goods or Services.” By those criteria, we quantify compensation expense as the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measured. We periodically re-measure the compensation expense for options granted to non-employees as they vest.

     Although SFAS 123 allows us to continue to follow the APB 25 guidelines, we are required to disclose pro forma net income (loss) and basic and diluted income (loss) per share as if we had applied the fair value based method to all awards.

     For purposes of this analysis, we estimate the fair value of each option grant on the date of grant using the Black-Scholes option-pricing model. The weighted average assumptions used in the model were as follows:

     The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. This model also requires us to make highly subjective assumptions, including the expected volatility of our stock. Because our stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, we do not believe that the existing models necessarily provide a reliable single measure of the fair value of our options.

     The effects on pro forma disclosures of applying SFAS 123 are not likely to be representative of the effects on reported results of future periods.

Note 2. Net Income (Loss) Per Share

     We compute basic net income (loss) per share by dividing net income (loss) by the weighted average number of common shares outstanding during the period. We compute diluted net income (loss) per share using the weighted average of all potential shares of common stock outstanding during the period. For the three months and nine months ended September 30, 2004 and the three months ended September 30, 2003, we included all dilutive stock options and warrants in the calculation of diluted net income per share. For

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the nine months ended September 30, 2003, we excluded all stock options and warrants in the calculation of diluted net loss per share because these securities were anti-dilutive during this period. We excluded convertible debt in the calculation of diluted net income per share as it was anti-dilutive for all periods.

     The following table shows a reconciliation of the numerator and denominator used in diluted net income (loss) per share computations (in thousands):

Note 3. Comprehensive Income (Loss)

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

     Accumulated other comprehensive loss included $289,000 of net unrealized gains on investments and $749,000 of foreign currency translation adjustments as of September 30, 2004, and $861,000 of unrealized gains on investments and $1.0 million of foreign currency translation adjustments as of December 31, 2003.

Note 4. Goodwill and Purchased Intangible Assets

     There were no changes in the carrying amount of goodwill during the nine months ended September 30, 2004. The components of our other intangible assets at September 30, 2004, are as follows (in thousands):

     Amortization expense for our other intangible assets was $3.4 million for the three months ended September 30, 2004 and $8.1 million for the nine months ended September 30, 2004. For the same reporting periods in 2003, amortization expense was $208,000 and $611,000, respectively.

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     The expected future amortization expense of our other purchased intangible assets is as follows (in thousands):

Note 5. Guaranties and Indemnifications

     In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others” (FIN No. 45). FIN No. 45 requires that upon issuance of a guarantee, the guarantor must recognize a liability for the fair value of the obligations it assumes under that guarantee.

     We enter into indemnification provisions under our agreements with other companies in the ordinary course of our business, typically with business partners, contractors, clinical sites, insurers, and customers. Under these provisions we generally indemnify and hold harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of our activities. These indemnification provisions generally survive termination of the underlying agreement. In some cases, the maximum potential amount of future payments Connetics could be required to make under these indemnification provisions is unlimited. The estimated fair value of the indemnity obligations of these agreements is minimal. Accordingly, we have no liabilities recorded for these agreements as of September 30, 2004. We have not incurred any costs to defend lawsuits or settle claims related to these indemnification arrangements.

Note 6. In-License Agreement

     In August 2004, we submitted a New Drug Application (NDA) for Velac® (1% clindamycin and 0.025% tretinoin) Gel with the Food and Drug Administration (FDA) and, in October 2004, we received notification that the FDA accepted the NDA for filing as of August 23, 2004. For the three months ended September 30, 2004, we recorded a $3.5 million fee payable to the licensor upon the filing of the NDA. Because the product was not yet approved and had no alternative future use, we recorded the fee as acquired in-process research and development and milestone expense. Under the terms of the license agreement entered into in 2002 with Yamanouchi Europe B.V., we hold exclusive rights to develop and commercialize the product in the U.S. and Canada and non-exclusive rights in Mexico.

Note 7. Equity Issuance

     On February 13, 2004, we completed a private placement of 3.0 million shares of our common stock to accredited institutional investors at a price of $20.25 per share, for net proceeds of approximately $56.9 million. We used a portion of the net proceeds to pay for the acquisition of the exclusive U.S. rights to Soriatane®, and we are using the balance for general corporate purposes, including working capital.

Note 8. Soriatane® Product Line Acquisition and Distribution Agreement

     On February 6, 2004, we entered into a binding agreement with Roche to acquire exclusive U.S. rights to Soriatane-brand acitretin, an approved oral therapy for the treatment of severe psoriasis in adults. The transaction closed on March 4, 2004, and we have recognized revenue, net of applicable reserves, for all sales of the product from that date. Under the terms of the purchase agreement, we paid Roche a total of $123.0 million in cash at the closing to acquire Soriatane. We also assumed certain liabilities in connection with returns, rebates and chargebacks associated with prior sales of Soriatane by Roche totaling $4.1 million, and purchased Roche’s existing inventory of Soriatane at a cost of approximately $1.5 million. In addition, we incurred transaction costs, originally estimated at approximately $500,000 and finalized at $529,000, during the second quarter of 2004. Including the cash paid to acquire the rights, liabilities assumed, and transactions costs, the total value of the acquired product rights for accounting purposes is $127.7 million. We are amortizing this amount over the ten-year estimated useful life of the Soriatane asset.

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     In July 2004, we entered into a multi-year consent with Roche to sell Soriatane to a U.S.-based distributor that exports branded pharmaceutical products to select international markets. Product sold to this distributor is not permitted to be resold in the U.S. Under the terms of the agreement, we will pay a royalty to Roche on Soriatane sales made during the term of the agreement to t