##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON, DC 20549
 FORM 10-Q
 
  þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934.
  OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
 
  AVANIR PHARMACEUTICALS
  California
    
    33-0314804(State or other jurisdiction of
    
    (I.R.S. Employer Identification No.)incorporation or organization)11388 Sorrento Valley Road, San Diego, California
    
    92121(Address of principal executive offices)
    
    (Zip Code)
 (858) 622-5200
 þ o
 þ o
 o þ




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Table of Contents
 PagePART I.
    
    FINANCIAL INFORMATIONItem 1.
    
    Financial Statements (Unaudited)Report of Independent Registered Public Accounting Firm
    
    
    3Condensed Consolidated Balance Sheets
    
    
    4Condensed Consolidated Statements of Operations
    
    
    5Condensed Consolidated Statements of Cash Flows
    
    
    6Notes to Condensed Consolidated Financial Statements
    
    
    7Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    22Item 3.
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    42Item 4.
    
    Controls and Procedures
    
    
    42PART II.
    
    OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    43Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    43Item 3.
    
    Defaults Upon Senior Securities
    
    
    43Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    43Item 5.
    
    Other Information
    
    
    43Item 6.
    
    Exhibits
    
    
    43Signatures
    
    
    44EXHIBIT 10.1EXHIBIT 15.1EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
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PART I. FINANCIAL INFORMATION
 
 Item 1. FINANCIAL STATEMENTS
 
 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 Avanir
 Avanir
   Avanir
  
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A VANIR Pharmaceuticals
 
 CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
 December 31,
    
    
    September 30,2005
    
    
    2005ASSETSCurrent assets:Cash and cash equivalents
    
    $
    30,801,894
    
    
    $
    8,620,143Short-term investments in securities
    
    
    17,476,908
    
    
    
    14,215,005Receivables, net
    
    
    6,598,575
    
    
    
    1,169,654Inventory
    
    
    136,487
    
    
    
    27,115Prepaid expenses
    
    
    3,050,191
    
    
    
    2,370,801Total current assets
    
    
    58,064,055
    
    
    
    26,402,718Investments in securities
    
    
    2,206,450
    
    
    
    3,845,566Restricted investments in securities
    
    
    856,872
    
    
    
    856,872Property and equipment, net
    
    
    6,147,438
    
    
    
    6,004,527Intangible assets, net
    
    
    3,591,003
    
    
    
    3,665,086Long-term inventory
    
    
    602,619
    
    
    
    347,424Other assets
    
    
    274,828
    
    
    
    279,797TOTAL ASSETS
    
    $
    71,743,265
    
    
    $
    41,401,990LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    3,083,727
    
    
    $
    6,751,781Accrued expenses and other liabilities
    
    
    7,079,723
    
    
    
    4,094,295Accrued compensation and payroll taxes
    
    
    1,188,347
    
    
    
    1,272,231Current portion of deferred revenue
    
    
    2,002,922
    
    
    
    1,970,989Current portion of notes payable
    
    
    325,408
    
    
    
    317,667Current portion of capital lease obligations
    
    
    26,983
    
    
    
    26,305Total current liabilities
    
    
    13,707,110
    
    
    
    14,433,268Deferred revenue, net of current portion
    
    
    16,601,691
    
    
    
    17,187,221Notes payable, net of current portion
    
    
    552,972
    
    
    
    637,285Capital lease obligations, net of current portion
    
    
    2,330
    
    
    
    9,337Total liabilities
    
    
    30,864,103
    
    
    
    32,267,111COMMITMENTS AND CONTINGENCIES(Note 13)SHAREHOLDERS EQUITY:Preferred stock  no par value, 10,000,000 shares
authorized, no shares issued and outstanding as of
December 31, 2005 and September 30, 2005
    
    
    
    
    
    
    Common stock  no par value, Class A, 200,000,000
shares authorized, 30,569,493 and 27,341,732
shares issued and outstanding as of December 31,
2005 and September 30, 2005, respectively (Note 2)
    
    
    201,739,213
    
    
    
    167,738,303Unearned compensation
    
    
    
    
    
    
    (3,477,144
    )Accumulated deficit
    
    
    (160,686,900
    )
    
    
    (155,012,466
    )Accumulated other comprehensive loss
    
    
    (173,151
    )
    
    
    (113,814
    )Total shareholders equity
    
    
    40,879,162
    
    
    
    9,134,879TOTAL LIABILITIES AND SHAREHOLDERS EQUITY
    
    $
    71,743,265
    
    
    $
    41,401,990
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A VANIR Pharmaceuticals
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
 Three months endedDecember 31,2005
    
    
    2004REVENUES:Licenses
    
    $
    5,000,000
    
    
    $
    200,000Research and development services
    
    
    2,478,018
    
    
    
    Royalties and sale of royalty rights
    
    
    582,045
    
    
    
    510,314Government research grants
    
    
    84,825
    
    
    
    160,651Product sales
    
    
    
    
    
    
    17,400Total revenues
    
    
    8,144,888
    
    
    
    888,365OPERATING EXPENSES:Research and development
    
    
    9,363,402
    
    
    
    5,054,241Selling, general and administrative
    
    
    4,768,743
    
    
    
    2,951,003Cost of product sales
    
    
    
    
    
    
    3,102Total operating expenses
    
    
    14,132,145
    
    
    
    8,008,346LOSS FROM OPERATIONS
    
    
    (5,987,257
    )
    
    
    (7,119,981
    )Interest income
    
    
    328,166
    
    
    
    121,832Interest expense
    
    
    (23,438
    )
    
    
    (21,621
    )Other income (expense), net
    
    
    10,512
    
    
    
    (66,921
    )LOSS BEFORE INCOME TAXES
    
    
    (5,672,017
    )
    
    
    (7,086,691
    )Provision for income taxes
    
    
    (2,417
    )
    
    
    (1,898
    )NET LOSS
    
    $
    (5,674,434
    )
    
    $
    (7,088,589
    )NET LOSS PER SHARE:BASIC AND DILUTED (Note 2)
    
    $
    (0.20
    )
    
    $
    (0.30
    )WEIGHTED AVERAGE NUMBER OF COMMON
SHARES OUTSTANDING:BASIC AND DILUTED (Note 2)
    
    
    28,579,357
    
    
    
    23,962,989
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AVANIR Pharmaceuticals
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
 Three Months Ended December 31,2005
    
    
    2004OPERATING ACTIVITIES:Net loss
    
    $
    (5,674,434
    )
    
    $
    (7,088,589
    )Adjustments to reconcile net loss to net cash used for
operating activities:Depreciation and amortization
    
    
    480,127
    
    
    
    470,289Share-based compensation expense
    
    
    462,013
    
    
    
    2,701Other-than-temporary impairment of investment
    
    
    
    
    
    
    78,012Loss on disposal of assets
    
    
    1,225
    
    
    
    785Intangible assets abandoned
    
    
    34,728
    
    
    
    170,328Changes in operating assets and liabilities:Receivables
    
    
    (5,428,921
    )
    
    
    (51,815
    )Inventory
    
    
    (364,567
    )
    
    
    3,102Prepaid expenses and other assets
    
    
    (679,390
    )
    
    
    344,077Accounts payable
    
    
    (3,581,490
    )
    
    
    (229,828
    )Accrued expenses and other liabilities
    
    
    2,887,539
    
    
    
    592,289Accrued compensation and payroll taxes
    
    
    (83,884
    )
    
    
    (42,406
    )Deferred revenue
    
    
    (553,597
    )
    
    
    (608,329
    )Net cash used for operating activities
    
    
    (12,500,651
    )
    
    
    (6,359,384
    )INVESTING ACTIVITIES:Investments in securities
    
    
    (13,532,124
    )
    
    
    (4,259,665
    )Proceeds from sales and maturities of investments in securities
    
    
    11,850,000
    
    
    
    4,900,000Patent costs
    
    
    (25,314
    )
    
    
    (203,937
    )Purchases of property and equipment
    
    
    (543,300
    )
    
    
    (57,652
    )Net cash (used for) provided by investing activities
    
    
    (2,250,738
    )
    
    
    378,746FINANCING ACTIVITIES:Proceeds from issuance of common stock, net
    
    
    37,016,041
    
    
    
    7,055,590Proceeds from issuance of notes payable
    
    
    
    
    
    
    136,438Payments on notes and capital lease obligations
    
    
    (82,901
    )
    
    
    (90,079
    )Net cash provided by financing activities
    
    
    36,933,140
    
    
    
    7,101,949Net increase in cash and cash equivalents
    
    
    22,181,751
    
    
    
    1,121,311Cash and cash equivalents at beginning of period
    
    
    8,620,143
    
    
    
    13,494,083Cash and cash equivalents at end of period
    
    $
    30,801,894
    
    
    $
    14,615,394SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:Interest paid
    
    $
    23,438
    
    
    $
    21,621Income taxes paid
    
    $
    2,417
    
    
    $
    1,898NONCASH INVESTING ACTIVITIES:Purchases of property and equipment which are included in
accounts payable and accrued expenses
    
    $
    253,538
    
    
    $
    5,253Elimination of unearned compensation against common stock
    
    $
    3,477,144
    
    
    $
    
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A VANIR Pharmaceuticals
 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 1.
    
    BASIS OF PRESENTATION
 Avanir Avanir
  Avanir
 2.
    
    REVERSE STOCK SPLIT
  3.
    
    SIGNIFICANT ACCOUNTING POLICIES
 Change in Accounting Method for Share-Based Compensation
   7




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
    8




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Quarter EndedDecember 31, 2005Research and development
    
    $
    76,347Selling, general and administrative
    
    
    385,666Share-based compensation expense before taxes
    
    
    462,013Related income tax benefits
    
    
    Share-based compensation expense
    
    $
    462,013Net share-based compensation expense per basic
and diluted common share
    
    $
    (0.02
    )
   Stock Options
 a.
    
    25% of the option shares vest and become exercisable on the first anniversary of the
grant date and the remaining 75% of the option shares vest and become exercisable quarterly
in equal installments thereafter over three years.b.
    
    One-third of the option shares vest and become exercisable on the first anniversary of
the grant date and the remaining two-thirds of the option shares vest and become
exercisable daily or quarterly in equal installments thereafter over two years.c.
    
    Fully vest and become exercisable at the date of grant.
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Expected volatility
    
    
    79.1% - 80.4
    %Weighted-average volatility
    
    
    79.1
    %Average expected term in years
    
    
    4.5Risk-fee interest rate (zero coupon U.S. Treasury Note)
    
    
    4.2
    %Expected dividend yield
    
    
    0
    %
  WeightedWeighted
    
    
    averageaverage
    
    
    remaining
    
    
    Aggregateexercise
    
    
    contractual
    
    
    intrinsicNumber of
    
    
    price per
    
    
    term
    
    
    valueshares
    
    
    share
    
    
    (in years)
    
    
    (in millions)Outstanding at September 30, 2005
    
    
    1,600,032
    
    
    $
    8.76Granted
    
    
    221,813
    
    
    $
    11.71Exercised
    
    
    (58,000
    )
    
    $
    3.29Forfeited or expired
    
    
    (11,000
    )
    
    $
    12.08Outstanding at December 31, 2005
    
    
    1,752,845
    
    
    $
    9.27
    
    
    
    6.20
    
    
    $
    8.1Exercisable at December 31, 2005
    
    
    1,245,735
    
    
    $
    8.26
    
    
    
    4.85
    
    
    $
    7.1
   Weightedaveragegrant-dateNumber of
    
    
    fair value pershares
    
    
    shareNonvested at September 30, 2005
    
    
    342,137
    
    
    $
    8.37Granted
    
    
    221,813
    
    
    $
    7.44Vested
    
    
    (56,839
    )
    
    $
    8.22Nonvested at December 31, 2005
    
    
    507,111
    
    
    $
    7.87
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Restricted stock awards
 WeightedaverageWeighted
    
    
    remainingNumber of
    
    
    average grant
    
    
    contractual lifeshares
    
    
    date fair value
    
    
    (in years)Unvested, September 30, 2005
    
    
    250,000
    
    
    $
    3.56
    
    
    
    2.9Granted
    
    
    12,500
    
    
    $
    3.27Unvested, December 31, 2005
    
    
    262,500
    
    
    $
    3.54
    
    
    
    2.7
   Pro Forma Information under SFAS 123 for Periods Prior to Fiscal 2006
 11




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Quarter EndedDecember 31, 2004Net loss, as reported
    
    $
    (7,088,589
    )Add: Share-based employee compensation expense
    
    
    Deduct: Total share-based employee compensation
expense determined under fair value based method for all awards
    
    
    (281,691
    )Pro forma net loss
    
    $
    (7,370,280
    )Net loss per
share (adjusted for a one-for-four reverse stock
split. See Note 2, Reverse Stock Split):Basic and diluted  as reported
    
    $
    (0.30
    )Basic and diluted  pro forma
    
    $
    (0.31
    )
   Revenue Recognition
  Contract Revenue from Collaborations
 12




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Royalty Revenues.
 Revenues from Sale of Royalty Rights . ®
 Revenue Arrangements with Multiple Deliverables .
 Government Research Grant Revenue.
 Product Sales  Active Pharmaceutical Ingredient Docosanol.
 13




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Recognition of Expenses in Outsourced Contracts
  Research and Development Expenses
   
    
    The technology is in the early stage of development and has no alternative uses;
    
    There is substantial uncertainty of the technology or product being successful;
    
    There will be difficulty in completing the remaining development; and
    
    There is substantial cost to complete the work.
 Acquired contractual rights
 Capitalization and Valuation of Long-Lived and Intangible Assets
   14




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
    
    A significant underperformance relative to expected historical or projected future
operating results;
    
    A significant change in the manner of our use of the acquired asset or the strategy for
our overall business; and/or
    
    A significant negative industry or economic trend.
  Stock Offering Costs
  4. INVESTMENTS
  Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    FairCost
    
    
    Gains (1)
    
    
    Losses (1)
    
    
    ValueAs of December 31, 2005:Certificates of deposit
    
    $
    856,872
    
    
    $
    
    
    
    $
    
    
    
    $
    856,872Government debt securities
    
    
    19,856,509
    
    
    
    
    
    
    
    (173,151
    )
    
    
    19,683,358Total
    
    $
    20,713,381
    
    
    $
    
    
    
    $
    (173,151
    )
    
    $
    20,540,230Classified and reported as:Short term investments:Classified as available-for-sale
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    17,476,908Long term investments:Classified as available-for-sale
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,206,450Restricted investments in
securities (2)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    856,872Long-term investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,063,322Total
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    20,540,230
 Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    FairCost
    
    
    Gains (3)
    
    
    Losses (3)
    
    
    ValueAs of September 30, 2005:Certificates of deposit
    
    $
    956,872
    
    
    $
    48
    
    
    $
    
    
    
    $
    956,920Government debt securities
    
    
    18,074,385
    
    
    
    
    
    
    
    (113,862
    )
    
    
    17,960,523Total
    
    $
    19,031,257
    
    
    $
    48
    
    
    $
    (113,862
    )
    
    $
    18,917,443Classified and reported as:Short term investments:Classified as available-for-sale
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    14,215,005Long term investments:Classified as available-for-sale
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,845,566Restricted investments in
securities (2)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    856,872Long-term investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,702,438Total
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    18,917,443
 
 (1)
    
    Gross unrealized losses of $173,151 on government debt securities are reported as
accumulated other comprehensive loss on the consolidated balance sheet as of December 31,
2005.(2)
    
    Represents amounts pledged to our bank as collateral for letters of credit issued in
connection with our leases of office and laboratory space. (3)
    
    Gross unrealized gains of $48 and gross unrealized losses of $113,862 on government
securities and certificates of deposit represent an accumulated net unrealized loss of
$113,814, which is reported as accumulated other comprehensive loss on the consolidated
balance sheet as of September 30, 2005. 15




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5. RECEIVABLES, NET
  December 31,
    
    
    September 30,2005
    
    
    2005Receivables
    
    $
    5,181,922
    
    
    $
    186,851Unbilled receivables
    
    
    1,444,752
    
    
    
    1,010,9026,626,674
    
    
    
    1,197,753Allowance for doubtful accounts
    
    
    (28,099
    )
    
    
    (28,099
    )Receivables, net
    
    $
    6,598,575
    
    
    $
    1,169,654
 6. INVENTORY
  December 31,
    
    
    September 30,2005
    
    
    2005Inventory
    
    $
    739,106
    
    
    $
    374,539Less: current portion
    
    
    136,487
    
    
    
    27,115Long-term portion
    
    $
    602,619
    
    
    $
    347,424
 7. PROPERTY AND EQUIPMENT
  December 31, 2005
    
    
    September 30, 2005Gross
    
    
    
    
    
    
    
    
    
    
    GrossCarrying
    
    
    Accumulated
    
    
    
    
    
    
    Carrying
    
    
    AccumulatedValue
    
    
    Depreciation
    
    
    Net
    
    
    Value
    
    
    Depreciation
    
    
    NetResearch and
development
equipment
    
    $
    3,970,343
    
    
    $
    (2,721,921
    )
    
    $
    1,248,422
    
    
    $
    3,903,735
    
    
    $
    (2,567,843
    )
    
    $
    1,335,892Computer equipment
and related
software
    
    
    1,197,575
    
    
    
    (595,478
    )
    
    
    602,097
    
    
    
    1,038,390
    
    
    
    (565,137
    )
    
    
    473,253Leasehold
improvements
    
    
    5,621,308
    
    
    
    (1,822,656
    )
    
    
    3,798,652
    
    
    
    5,583,177
    
    
    
    (1,641,485
    )
    
    
    3,941,692Furniture, fixtures
and equipment
    
    
    825,869
    
    
    
    (327,602
    )
    
    
    498,267
    
    
    
    558,911
    
    
    
    (305,221
    )
    
    
    253,690Total property
and equipment
    
    $
    11,615,095
    
    
    $
    (5,467,657
    )
    
    $
    6,147,438
    
    
    $
    11,084,213
    
    
    $
    (5,079,686
    )
    
    $
    6,004,527
  16




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8. INTANGIBLE ASSETS
  December 31, 2005
    
    
    September 30, 2005Gross
    
    
    
    
    
    
    
    
    
    
    GrossCarrying
    
    
    Accumulated
    
    
    
    
    
    
    Carrying
    
    
    AccumulatedValue
    
    

Amortization
    
    
    Net
    
    
    Value
    
    
    Amortization
    
    
    NetIntangible assets with
finite lives:Patent applications
pending (1)
    
    $
    2,917,181
    
    
    $
    (363,872
    )
    
    $
    2,553,309
    
    
    $
    3,029,127
    
    
    $
    (336,457
    )
    
    $
    2,692,670Patents
    
    
    1,521,313
    
    
    
    (533,097
    )
    
    
    988,216
    
    
    
    1,429,532
    
    
    
    (506,144
    )
    
    
    923,388Licenses
    
    
    42,461
    
    
    
    (18,468
    )
    
    
    23,993
    
    
    
    42,461
    
    
    
    (17,904
    )
    
    
    24,557Total intangible
assets with finite
lives
    
    
    4,480,955
    
    
    
    (915,437
    )
    
    
    3,565,518
    
    
    
    4,501,120
    
    
    
    (860,505
    )
    
    
    3,640,615Intangible assets with
indefinite useful
lives:Trademarks
    
    
    25,485
    
    
    
    
    
    
    
    25,485
    
    
    
    24,471
    
    
    
    
    
    
    
    24,471Total intangible assets
    
    $
    4,506,440
    
    
    $
    (915,437
    )
    
    $
    3,591,003
    
    
    $
    4,525,591
    
    
    $
    (860,505
    )
    
    $
    3,665,086
 
 (1)
    
    Patent applications pending include the net effect of $34,728 and $170,328 (net of
accumulated amortization of $3,409 and $18,321) in intangible assets abandoned during the
quarters ended December 31, 2005 and 2004, respectively. We abandoned certain patents
pending related to docosanol 10% cream in selected countries where we determined there are
no viable markets.  Amortization Expense
 Fiscal year ending September 30:2006 (remaining nine months)
    
    $
    192,0002007
    
    
    257,0002008
    
    
    257,0002009
    
    
    248,0002010
    
    
    226,000Thereafter
    
    
    2,386,000Total
    
    $
    3,566,000
 17




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9. DEFERRED REVENUE
  Drug Royalty
    
    
    OtherUSA Agreement
    
    
    Agreements
    
    
    TotalDeferred revenue as of September 30, 2005
    
    $
    19,049,877
    
    
    $
    108,333
    
    
    $
    19,158,210Changes during the period:Additions during period
    
    
    
    
    
    
    28,300
    
    
    
    28,300Recognized as revenue during period
    
    
    (581,897
    )
    
    
    
    
    
    
    (581,897
    )Deferred revenue as of December 31, 2005
    
    $
    18,467,980
    
    
    $
    136,633
    
    
    $
    18,604,613Classified and reported as:Current portion of deferred revenue
    
    $
    1,941,289
    
    
    $
    61,633
    
    
    $
    2,002,922Deferred revenue, net of current portion
    
    
    16,526,691
    
    
    
    75,000
    
    
    
    16,601,691Total deferred revenue
    
    $
    18,467,980
    
    
    $
    136,633
    
    
    $
    18,604,613
 10. COMPUTATION OF NET LOSS PER COMMON SHARE
  11. COMPREHENSIVE LOSS
  Three Months EndedDecember 31,2005
    
    
    2004Net loss
    
    $
    (5,674,434
    )
    
    $
    (7,088,589
    )Other comprehensive loss, net of tax:Unrealized (loss) gain on
available-for-sale securities
    
    
    (59,337
    )
    
    
    40,935Total comprehensive loss
    
    $
    (5,733,771
    )
    
    $
    (7,047,654
    )
 18




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12. SHAREHOLDERS EQUITY
  Unearned compensation
 Common stock
   13. COMMITMENTS AND CONTINGENCIES
  14. ASTRAZENECA LICENSE AGREEMENT
  19




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14. SEGMENT INFORMATION
    15.
RECENT ACCOUNTING PRONOUNCEMENTS
 Financial
Accounting Standards No. 151 (SFAS 151)
 Financial
Accounting Standards No. 154 (SFAS 154).
 16. SUBSEQUENT EVENTS
   20




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Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
  EXECUTIVE OVERVIEW
 Avanir
    22




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®
   
 (a) Timelines in this pictorial representation are not to scale.
(b) Investigational New Drug Application.
(c) Licensed to AstraZeneca which assumed all responsibility for ongoing product
development expenses.
(d) Licensed to Novartis which assumed all responsibility for ongoing product development
expenses.  23




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info@avanir.com Avanir www.avanir.com www.sec.gov .
 CRITICAL ACCOUNTING POLICIES AND ESTIMATES
  24




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Share-based compensation expense
    25




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Revenue Recognition
  Contract Revenue from Collaborations
 26




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Royalty Revenues.
 Revenues from Sale of Royalty Rights .
 Revenue Arrangements with Multiple Deliverables .
 Government Research Grant Revenue.
 Product Sales  Active Pharmaceutical Ingredient Docosanol.
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Recognition of Expenses in Outsourced Contracts
  Research and Development Expenses
   
    
    The technology is in the early stage of development and has no alternative uses;
    
    There is substantial uncertainty of the technology or product being successful;
    
    There will be difficulty in completing the remaining development; and
    
    There is substantial cost to complete the work.
 Acquired contractual rights
 Capitalization and Valuation of Long-Lived and Intangible Assets
  28




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
    
    A significant underperformance relative to expected historical or projected future
operating results;
    
    A significant change in the manner of our use of the acquired asset or the strategy for
our overall business; and/or
    
    A significant negative industry or economic trend.
  RESULTS OF OPERATIONS
 COMPARISON OF THREE MONTHS ENDED DECEMBER 31, 2005 AND 2004
 Revenues
   Operating Expenses
  29




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Three Months EndedDecember 31,2005
    
    
    2004Operating expenses:Research and development
    
    
    66
    %
    
    
    63
    %Selling, general and administrative
    
    
    34
    %
    
    
    37
    %Costs of sales
    
    
    
    %
    
    
    
    %Total operating expenses
    
    
    100
    %
    
    
    100
    %
 Research and development (R&D) expenses .
  Research and Development Projects and Expenses
 Three Months Ended
    
    
    Inception Through
    
    
    Estimated Cost toDecember 31,
    
    
    December 31,
    
    
    License or Complete2005 (1)
    
    
    2004 (1)(4)
    
    
    2005 (1)(2)(4)
    
    
    Project (1)(3)Company-funded Projects:Develop programs for
Neurodex, selective
cytokine inhibitor and
other programs projected
through fiscal 2007 (3)
    
    $
    7,273,480
    
    
    $
    3,384,312
    
    
    $
    86,021,878
    
    
    $35M to $45MPartner-funded Projects:Reverse
cholesterol transport and
MIF inhibitor research
programs
    
    
    2,018,799
    
    
    
    1,508,751
    
    
    
    21,464,714
    
    
    Funded by PartnersGovernment-funded Projects:Preclinical research on
various projects.
Estimated timing to
complete the current
anthrax research project
is less than 12 months
    
    
    71,123
    
    
    
    161,178
    
    
    
    2,594,575
    
    
    $0.1 MTotal
    
    $
    9,363,402
    
    
    $
    5,054,241
    
    
    $
    110,081,167
 
 (1)
    
    Each project includes an allocation of laboratory occupancy costs. M refers to
millions. Estimated costs and timing to complete the projects are subject to the
availability of funds. For each of the projects set forth in the table, other than
Neurodex for IEED/PBA (which we intend to market ourselves) and the reverse cholesterol
transport and the MIF inhibitor programs (which we have partnered), we may seek development
partners or licensees to defray part or all of the ongoing development costs.(2)
    
    Inception dates are on or after October 1, 1998, at which time we began identifying
and tracking program costs.(3)
    
    Assumes completion of development of Neurodex in the treatment of IEED/PBA and for
one Phase III clinical trial in the treatment of neuropathic pain and continuation of Phase
I studies of our selective cytokine inhibitor program. Projected spending thereafter will
be subject to progress made in research that is currently underway.(4)
    
    Includes expenses funded by us prior to partnering these projects in the amounts of
$1.5 million and $17.1 million for the three-month period ended December 31, 2004 and since
inception through December 31, 2005, respectively. 30




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Status of R&D Programs and Plans  Company-funded Projects
 Neurodex for the treatment of Involuntary Emotional Expression Disorder/Pseudobulbar Affect.
 Neurodex for the treatment of neuropathic pain.
 Development program for selective cytokine inhibitor (IgE regulator).
 Status of R&D Programs and Plans  Partner-funded Projects
 Development program for reverse cholesterol transport.
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Anti-inflammatory research program (MIF inhibitor).
 Status of R&D programs and plans  government-funded projects
 .
   Selling, general and administrative expenses .
 
    
    $848,000 increase in expenses related to the continued expansion of our medical
education and awareness programs for IEED/PBA, market research, and pre-launch planning
activities for Neurodex and hiring of additional sales and marketing personnel;
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
    
    $411,000 increase in expenses related to increases in headcount and compensation levels
in general and administrative areas;
    
    $386,000 increase in share-based compensation expense; and
    
    $207,000 increase in professional services mainly associated with corporate governance
and SEC reporting, internal controls documentation and testing under the Sarbanes-Oxley Act
of 2002.
  Share-Based Compensation
  Interest Income
  Net Loss
   33




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LIQUIDITY AND CAPITAL RESOURCES
  December 31,
    
    
    Increase (Decrease)
    
    
    September 30,2005
    
    
    During Period
    
    
    2005Cash, cash equivalents and investment in securities
    
    $
    51,342,124
    
    
    $
    23,804,538
    
    
    $
    27,537,586Cash and cash equivalents
    
    $
    30,801,894
    
    
    $
    22,181,751
    
    
    $
    8,620,143Net working capital
    
    $
    44,356,945
    
    
    $
    32,387,495
    
    
    $
    11,969,450
 Three MonthsEnded
    
    
    Change
    
    
    Three Months EndedDecember 31,
    
    
    Between
    
    
    December 31,2005
    
    
    Periods
    
    
    2004Net cash used for operating activities
    
    $
    (12,500,651
    )
    
    $
    (6,141,267
    )
    
    $
    (6,359,384
    )Net cash (used for) provided by investing activities
    
    
    (2,250,738
    )
    
    
    (2,629,484
    )
    
    
    378,746Net cash provided by financing activities
    
    
    36,933,140
    
    
    
    29,831,191
    
    
    
    7,101,949Net increase in cash and cash equivalents
    
    $
    22,181,751
    
    
    $
    21,060,440
    
    
    $
    1,121,311
 Operating activities.
   Investing activities.
 34




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Financing activities.
     35




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MANAGEMENT OUTLOOK
   RECENT ACCOUNTING PRONOUNCEMENTS
  RISK FACTORS
 Risks Relating to Our Business
 We have a history of losses and we may never achieve or maintain profitability.
   36




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We have experienced delays in obtaining the FDAs acceptance for filing of our new drug application
for Neurodex due to requests by the Agency for additional discussions about the data. Any further
delays or any adverse decisions in the regulatory review or approval process may harm our prospects
and could harm our stock price.
    We have yet to market or sell Neurodex or any of our other potential products.
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We expect that over the next 12 to 24 months we will need to raise additional capital to fund
ongoing operations and support our planned product launch. If we are unable to raise additional capital, we may be forced to curtail
operations. If we succeed in raising additional capital through a licensing or financing
transaction, it may affect our stock price and future revenues.
    Changes in board and management composition that are intended to strengthen the board and
management team could adversely disrupt our operations.
  Our inability to attract and retain key management and scientific personnel could negatively affect
our business.
  38




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Our patents may be challenged and our pending patents may be denied. Either result would seriously
jeopardize our ability to compete in the intended markets for our proposed products.
  
    
    The claims in any pending patent applications will be allowed or that patents will be
granted;
    
    Competitors will not develop similar or superior technologies independently, duplicate
our technologies, or design around the patented aspects of our technologies;
    
    Our proposed technologies will not infringe other patents or rights owned by others,
including licenses that may be not be available to us;
    
    Any of our issued patents will provide us with significant competitive advantages; or
    
    Challenges will not be instituted against the validity or enforceability of any patent
that we own or, if instituted, that these challenges will not be successful.
  We depend on third parties to manufacture compounds for our drugs and drug candidates. The failure
of these third parties to perform successfully could harm our business.
  39




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Because we depend on clinical research centers and other contractors for clinical testing and for
certain research and development activities, the results of our clinical trials and such research
activities are, to a certain extent, beyond our control.
  Developing new pharmaceutical products for human use involves product liability risks, for which we
currently have limited insurance coverage.
  Risks Relating to Our Stock
 Our stock price has historically been volatile and we expect that this volatility may continue for
the foreseeable future.
  
    
    Unfavorable announcements by us regarding our Neurodex NDA submission, clinical trial
results or results of operations;
    
    Announcements of developments regarding our agreements with Novartis and AstraZeneca,
including delays in meeting goals or performance milestones by us or our partners;
    
    Comments made by securities analysts, including changes in their recommendations;
    
    Announcements by us of financing transactions and/or future sales of equity or debt securities;
    
    Announcements by us of significant acquisitions, strategic partnerships, joint ventures,
or capital commitments;
    
    Sales of our Class A common stock by our directors, officers, or significant shareholders;
    
    Announcements by our competitors of clinical trial results or product approvals;
    
    Changes in operations and increase in operating expenses as
we prepare for the commercial launch of Neurodex, assuming it is
approved by the FDA; and
    
    Market and economic conditions.
  40




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
    
    Performance under partnering arrangements The recognition of the revenue under our
partnering arrangements, including our license agreements for our MIF and RCT programs,
will partially depend on the efforts and performance of our licensees in reaching
milestones that are outside of our control, such as regulatory approval, product launch, or
reaching a sales threshold.
    
    Timing of FDA regulatory decisions We are in the process of building a sales force
for the planned commercialization of Neurodex. The timing and extent of these development
expenditures will vary depending on the status and timing of the FDAs review and decision
on approval of our NDA for Neurodex. As a result, our expenses could vary significantly
from quarter-to-quarter while we await regulatory decisions and complete this building
process.
    
    Acquisitions/alliances Our acquisition of certain rights relating to Neurodex in
fiscal 2005 resulted in charges of approximately $7.2 million. In the future, if we
acquire complementary technologies, products, or businesses, we will incur potentially
significant charges in connection with such acquisitions and may have ongoing charges after
the closing of any such transaction. Any such acquisitions could adversely affect our
results of operations.
  Risks Relating to Our Industry
 The pharmaceutical industry is highly competitive and most of our competitors are larger and have
greater resources. As a result, we face significant competitive hurdles.
   Our industry is highly regulated and our failure or inability to comply with government regulations
regarding the development, production, testing, manufacturing and marketing of our products may
adversely affect our operations.
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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
  Interest rate sensitivity
  
 Item 4. CONTROLS AND PROCEDURES
 Evaluation of Disclosure Controls and Procedures
  Changes in Internal Controls over Financial Reporting
  42




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PART II OTHER INFORMATION
 
 Item 1. LEGAL PROCEEDINGS
  
 Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
  
 Item 3. DEFAULTS UPON SENIOR SECURITIES
  
 Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
  
 Item 5. OTHER INFORMATION
  
 Item 6. EXHIBITS
 Exhibits10.1
    
    Employment Agreement with Randall Kaye, dated December 23, 2005.15.1
    
    Letter on unaudited interim financial information.31.1
    
    Certification of Principal Executive Officer Required Under Rule
13a-14(a) of the Securities Exchange Act of 1934, as amended.31.2
    
    Certification of Principal Financial Officer Required Under Rule
13a-14(a) of the Securities Exchange Act of 1934, as amended.32.1
    
    Certification of Principal Executive Officer Required Under Rule
13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18
U.S.C. 1350.32.2
    
    Certification of Principal Financial Officer Required Under Rule
13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18
U.S.C. 1350.
 43




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SIGNATURES
  Signature
    
    Title
    
    Date/s/ Eric K. Brandt

Eric K. Brandt
    
    President and Chief
Executive Officer
(Principal Executive Officer)
    
    February 9, 2006/s/ Gregory P. Hanson, CMA

Gregory P. Hanson, CMA
    
    Vice President, Finance and Chief
Financial Officer
(Principal Financial and
Accounting Officer)
    
    February 9, 2006
 44




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EXHIBIT
INDEX
 Exhibits10.1
    
    Employment Agreement with Randall Kaye, dated December 23, 2005.15.1
    
    Letter on unaudited interim financial information.31.1
    
    Certification of Principal Executive Officer Required Under Rule
13a-14(a) of the Securities Exchange Act of 1934, as amended.31.2
    
    Certification of Principal Financial Officer Required Under Rule
13a-14(a) of the Securities Exchange Act of 1934, as amended.32.1
    
    Certification of Principal Executive Officer Required Under Rule
13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18
U.S.C. 1350.32.2
    
    Certification of Principal Financial Officer Required Under Rule
13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18
U.S.C. 1350.