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 March 31, 2005

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 þ No £

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

     As of April 29, 2005, 34,790,675 shares of the Registrant’s common stock at $0.001 par value, were outstanding.

CONNETICS CORPORATION

TABLE OF CONTENTS

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

1. Basis of Presentation and Policies

     We prepared the accompanying unaudited condensed consolidated financial statements of Connetics Corporation, or Connetics, in accordance with accounting principles generally accepted in the United States for interim financial information and in compliance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the financial statements do not include all of the information and footnotes required by 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.

     Operating results for the three months ended March 31, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. 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, 2004, which are included in our Annual Report on Form 10-K as filed with the Securities and Exchange Commission, or SEC.

Principles of Consolidation

     The accompanying condensed consolidated financial statements include the accounts of Connetics and its subsidiaries, Connetics Holdings Pty Ltd., and Connetics Australia Pty Ltd. Connetics owns 100% of the outstanding stock of its subsidiaries. We eliminated all significant intercompany accounts and transactions in consolidation. We reclassified certain prior year amounts and balances to conform to the current year presentation. On the condensed consolidated balance sheets, raw material inventory balances that were previously included in prepaid expenses, other current assets, and other assets as of December 31, 2004 have been reclassified to inventory. On the condensed consolidated statements of operations, certain expense for the three months ended March 31, 2004 was reclassified from interest expense to selling, general and administrative expense to conform to amounts reported for the six month period ended June 30, 2004.

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 ongoing 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 and indirect promotional expenses. We base our estimates on historical experience and on various other specific assumptions that we believe are 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 revenue reserves, which consist of allowances for discounts, returns, rebates, and chargebacks. We accept from customers the return of pharmaceuticals that are within six months before 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. We also recognize revenue net of fees paid to wholesalers under distribution service agreements in exchange for certain product distribution, inventory, management, information, return goods processing, and administrative services. We record accounts receivable net of revenue reserves.

     During the first three months of 2005, we performed a detailed analysis of our chargeback allowance. As a result of the analysis of our actual chargeback history, we reduced our estimated chargeback allowance by $445,000, which resulted in an increase in revenue for the three months ended March 31, 2005 of the same amount.

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

     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. When we receive advance payments that exceed amounts earned, we classify them as deferred revenue until they are earned.

Inventory

     Inventory consists of raw materials and finished goods primarily related to currently marketed products. In addition, inventory may include similar costs for product candidates awaiting regulatory approval, which are capitalized based on our management’s judgment of probable near term commercialization and alternative future uses. We state inventory at the lower of cost (determined on a first-in first-out method) or market. If inventory costs exceed expected market value due to obsolescence or lack of demand, reserves are recorded for the difference between the cost and the market value. These reserves are based on significant estimates.

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,” or 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 on the date of grant. 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.

     For options granted to non-employees, we have recorded compensation expense in accordance with Statement of Financial Accounting Standards No. 123 “Accounting for Stock-Based Compensation,” or SFAS 123, 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.

     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. Because the estimated value is determined as of the date of grant, the actual value ultimately realized by the employee may be significantly different.

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     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. We used the following weighted average assumptions in the model:

     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 weighted average fair value of the options granted, determined using the Black-Scholes model, was $9.64 and $7.96, respectively, for the three months ended March 31, 2005 and 2004.

     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.

Recent Accounting Pronouncements

     In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123 (revised 2004), “Share-Based Payment,” or SFAS 123R, which requires companies to measure and recognize compensation expense for all stock-based awards at fair value. Stock-based awards include grants of employee stock options. SFAS 123R replaces SFAS 123 and supersedes APB 25, which are discussed above. SFAS 123R requires companies to recognize all stock-based awards to employees and to reflect those awards in the financial statements based on the fair values of the awards. In April 2005, the SEC modified the effective date for SFAS 123R, resulting in the pronouncement being effective for all annual periods beginning after June 15, 2005. We are required to adopt SFAS 123R in our fiscal year beginning January 1, 2006, after which the profroma disclosures previously permitted under SFAS 123 will no longer be an alternative to financial statement recognition. Under SFAS 123R, we must determine the appropriate fair value model to be used for valuing share-based awards, the amortization method for compensation cost, and the transition method to be used at date of adoption. The transition methods include options for adopting the model retroactively or prospectively. The prospective method requires that we record compensation expense for all unvested stock options and restricted stock at the beginning of the year we adopt SFAS 123R. Under the retroactive method, we may restate prior periods either as of the beginning of the year of adoption or for all periods presented, and we would record compensation expense for all unvested stock options and restricted stock beginning with the first period restated. We are evaluating the requirements of SFAS 123R and we expect that the adoption of SFAS 123R will have a material impact on our consolidated results of operations and earnings per share. We have not yet determined which method of adoption we will use or the effect of adopting SFAS 123R, and we have not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123.

     On September 30, 2004, the Emerging Issues Task Force, or EITF, reached a consensus on Issue No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share, concluding that contingently convertible debt instruments should be included in diluted earnings per share computations (if dilutive) regardless of whether the market price trigger (or other contingent feature) has been met. This consensus is effective for reporting periods ending after December 15, 2004, and requires companies to

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restate prior period earnings per share amounts presented for comparative purposes utilizing a transition method. As of December 31, 2004, we had no outstanding contingently convertible debt. In March 2005, we issued contingently convertible debt and adopted the consensus. Our adoption of EITF No. 04-8 had no impact on diluted earnings per share for the three months ended March 31, 2005 or for prior years.

2. Net Income Per Share

     We compute basic net income per share by dividing net income by the weighted average number of common shares actually outstanding during the period. We compute diluted net income per share using the weighted average of all shares of common stock outstanding and potentially outstanding during the period. For the three months ended March 31, 2005 and 2004, we included all dilutive stock options in the calculation of diluted net income per share, and we excluded convertible debt because its effect is anti-dilutive. For the three months ended March 31, 2004 we also included all warrants in the calculation. No warrants were outstanding in 2005.

     The calculation of basic and diluted net income per share is as follows (in thousands except per share amounts):

     We excluded the following weighted-average options and convertible debt from the calculation of diluted net income per share as their effect would be anti-dilutive (in thousands):

     In 2005 and subsequent years, our dilutive securities may include incremental shares issuable upon conversion of all or part of the $200 million in 2.00% convertible senior notes. Since the $200 million principal amount can only be redeemed for cash, it has no impact on the diluted earnings per share calculation. The conversion feature of these notes, that may result in our payment of a stock premium along with redeeming the accreted principal amount for cash, is triggered when our common stock reaches a certain market price. In accordance with the consensus from EITF No. 04-8 we will include the dilutive effect of our notes in the calculation of income per diluted share when the impact is dilutive. As of March 31, 2005, the conversion feature of these notes did not have a dilutive affect as the weighted average market price of our common stock did not exceed the initial conversion price of $35.46 to trigger any shares to be issuable upon conversion. Therefore, the notes had no effect on our dilutive securities or our income per diluted share for the period ended March 31, 2005.

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3. Comprehensive Income

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

     Accumulated other comprehensive income recorded in stockholders’ equity included $55,000 of net unrealized gains on investments and $1.0 million of foreign currency translation adjustments as of March 31, 2005 and, as of December 31, 2004, included $276,000 of net unrealized gains on investments and $1.1 million of foreign currency translation adjustments.

4. Convertible Senior Notes and Stock Repurchase

     On March 23, 2005, we issued $150 million of 2.00% convertible senior notes due March 30, 2015 to qualified institutional buyers in a private placement exempt from registration pursuant to Rule 144A of the Securities Act of 1933, as amended. The initial purchasers exercised in full an option to purchase up to an additional $50 million principal amount of notes with the same terms, and the sale was completed on March 30, 2005. The notes were sold at par and we received net cash proceeds of $159 million after expenses of $6.0 million and net of approximately $35.0 million used to repurchase our common stock. We repurchased 1,332,300 shares of common stock at an average price of $26.27 per share.

     The notes are senior, unsecured obligations and rank equal in right of payment with all of our existing and future unsecured and unsubordinated debt. The notes are convertible into cash or, under certain circumstances, cash and shares of our common stock. The initial conversion rate of the note is 28.1972 shares of common stock per each $1,000 principal amount of notes, subject to adjustment in certain circumstances, which represents a conversion price of approximately $35.46 per share. This conversion price is higher than the prices of our common stock on the dates the notes were issued. The notes bear interest at a rate of 2.00% per annum for the initial five year period, which is payable in arrears on March 30 and September 30 of each year until March 30, 2010. The first interest payment will be made on September 30, 2005. For the remaining five year period commencing on March 30, 2010, we will pay contingent interest for six-month periods if the average trading price of a note is above a specified level for a specified period prior to the six month period. In addition, beginning on March 30, 2010, the original principal amount shall be increased at a rate that provides holders with an aggregate annual yield to maturity of 2.00%.

     The holders may convert the notes under the following circumstances: (1) on or before March 30, 2009, if the closing sale price of our common stock is above a specified level, (2) at any time after March 30, 2009, or (3) if a specified fundamental change occurs, such as a merger or acquisition of the company. On or after March 30, 2010, holders of the notes may require us to repurchase all or a portion of their notes at 100% of the principal amount of the notes plus accrued and unpaid interest. On or after April 4, 2010, at our option, we may redeem all or a portion of the notes at a redemption price equal to the accreted principal amount of the notes to be redeemed plus accrued and unpaid interest. If we undergo a specified fundamental change, holders will have the right, at their option, except in certain defined circumstances, to require us to purchase for cash all or any portion of their notes at a price equal to the accreted principal amount plus accrued and unpaid interest. If a holder elects to convert its notes in connection with the occurrence of a specified fundamental change, the holder will be entitled to receive additional shares of common stock upon conversion in certain circumstances.

     At March 31, 2005, we did not have a sufficient number of shares of common stock to issue to a holder upon conversion of the notes. Accordingly, if shares of common stock were not provided pursuant to the exchange arrangement, then we were permitted to issue shares of our newly created Series C Preferred Stock in lieu of common stock. The Series C Preferred Stock is convertible into shares of common stock at a rate of 1,000 shares of common stock for every 1.1 shares of Series C Preferred Stock, contingent upon the reservation of sufficient shares of common stock. At our annual meeting held on April 22, 2005, our stockholders approved the increase of our authorized shares of common stock from 50 million to 100 million shares. As a result, there are a sufficient number of shares of common stock to issue to holders upon conversion.

     We included offering expenses estimated at $6.7 million related to the issuance of these notes in debt issuance costs, deposits, and other assets as of March 31, 2005. We are amortizing those expenses on a straight-line basis over the ten year contractual term of the notes.

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5. Inventory

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

      As of March 31, 2005, inventory included $636,000 in raw materials for Velac, a product not yet approved by the Food and Drug Administration, or FDA, for commercial use, but with a planned launch in the second half of 2005.

6. Goodwill and Other Intangible Assets

     There were no changes in the carrying amount of goodwill during the three months ended March 31, 2005. The components of our other intangible assets are as follows (in thousands):

     Amortization expenses for our other intangible assets were $3.4 million for the three months ended March 31, 2005, and $1.3 million for the three months ended March 31, 2004.

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

7. 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,” or 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. FIN No. 45 also requires the guarantor to make additional disclosures about the obligations associated with its guarantees in its interim and annual financial statements.

     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 we could be required to make under these indemnification provisions is unlimited. The estimated fair value of the indemnity obligations of these agreements is insignificant. Accordingly, we have no liabilities recorded for these agreements as of March 31, 2005. We have not incurred material costs to defend lawsuits or settle claims related to these indemnification provisions.

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8. Acquisition of Soriatane Product Line

     On March 4, 2004, we acquired from Hoffmann-La Roche Inc., or Roche, the exclusive U.S. rights to Soriatane-brand acitretin, an approved oral therapy for the treatment of severe psoriasis in adults. We have recognized revenue, net of applicable reserves, for all sales of the product from March 4, 2004. Under the terms of the purchase agreement, we paid Roche a total of $123 million in cash to acquire the rights to Soriatane. We also assumed certain liabilities totaling $4.1 million in connection with returns, rebates and chargebacks associated with Roche’s prior sales of Soriatane and we purchased Roche’s existing inventory of Soriatane at a cost of approximately $1.5 million. The total value of the acquired product rights for accounting purposes was $127 million, including transaction related costs of approximately $500,000. This amount is being amortized over the ten year estimated useful life of Soriatane.

9. UCB Co-Promotion Agreement

     In March 2004, we entered into an agreement with UCB Pharma Inc., or UCB, a subsidiary of UCB Group Inc., pursuant to which we authorized UCB to promote OLUX and Luxíq to a segment of U.S. primary care physicians, or PCP’s. In July 2004, UCB acquired Celltech plc, and in connection with other post-acquisition changes, UCB notified us that it intended to discontinue the co-promotion agreement effective March 31, 2005. UCB continued to promote OLUX and Luxíq until that date. We recorded 100% of the revenue from sales generated by promotional efforts of UCB and paid UCB a portion of revenue as a promotional expense, which is included in selling, general and administrative expense. UCB bore the marketing costs for promoting the products (including pro