##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549
 FORM 10-Q 
 (Mark One) þ
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the quarterly period ended December 31, 2004 OR  o
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the transition period from to . Commission File No. 0-1734 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
(Registrants telephone number, including area code) 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 and Exchange Act of 1934 during the preceding 12 months (or
for such shorter periods that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. YES þ NO o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Exchange Act). YES þ NO o As of January 28, 2005, the registrant had 97,722,586 shares of Class A common stock issued and
outstanding.




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Table of Contents PagePART I. FINANCIAL INFORMATIONItem 1. Financial StatementsReport 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
    
    
    15Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    36Item 4. Controls and Procedures
    
    
    36PART II. OTHER INFORMATIONItem 6. Exhibits
    
    
    37EXHIBIT 15.0EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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PART I. FINANCIAL INFORMATION 
 Item 1. FINANCIAL STATEMENTS 
 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and ShareholdersAvanirPharmaceuticals We have reviewed the accompanying condensed consolidated balance sheet of Avanir
Pharmaceuticals and subsidiary (the Company) as of December 31, 2004, and the related condensed
consolidated statements of operations and cash flows for the three-month periods ended December 31,
2004 and 2003. These interim financial statements are the responsibility of the Companys
management. We conducted our reviews in accordance with standards of the Public Company Accounting Oversight
Board (United States). A review of interim financial information consists principally of applying
analytical procedures and making inquiries of persons responsible for financial and accounting
matters. It is substantially less in scope than an audit conducted in accordance with standards of
the Public Company Accounting Oversight Board (United States), the objective of which is the
expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do
not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to such
condensed consolidated interim financial statements for them to be in conformity with accounting
principles generally accepted in the United States of America. We have previously audited, in accordance with standards of the Public Company Accounting Oversight
Board (United States), the consolidated balance sheet of the Company as of September 30, 2004, and
the related consolidated statements of operations, shareholders equity, and cash flows for the
year then ended (not presented herein); and in our report dated December 13, 2004, we expressed an
unqualified opinion on those consolidated financial statements. In our opinion, the information
set forth in the accompanying condensed consolidated balance sheet as of September 30, 2004 is
fairly stated, in all material respects, in relation to the consolidated balance sheet from which
it has been derived. DELOITTE & TOUCHE LLP San Diego, California
February 9, 2005 3




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AVANIR Pharmaceuticals 
 CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)  
 December 31,
    
    
    September 30,2004
    
    
    2004ASSETSCurrent assets:Cash and cash equivalents
    
    $
    14,615,394
    
    
    $
    13,494,083Short-term investments in securities
    
    
    7,992,211
    
    
    
    8,803,982Receivables, net
    
    
    291,694
    
    
    
    239,879Inventory
    
    
    6,200
    
    
    
    9,302Prepaid expenses
    
    
    1,182,205
    
    
    
    1,526,282Total current assets
    
    
    24,087,704
    
    
    
    24,073,528Investments in securities
    
    
    2,886,226
    
    
    
    2,751,867Restricted investments in securities
    
    
    856,597
    
    
    
    856,597Property and equipment, net
    
    
    6,031,032
    
    
    
    6,390,964Intangible assets, net
    
    
    3,021,414
    
    
    
    3,035,024Other assets
    
    
    291,004
    
    
    
    295,973TOTAL ASSETS
    
    $
    37,173,977
    
    
    $
    37,403,953LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,728,159
    
    
    $
    1,961,938Accrued expenses and other liabilities
    
    
    3,015,751
    
    
    
    2,418,209Accrued compensation and payroll taxes
    
    
    667,962
    
    
    
    710,368Current portion of deferred revenue
    
    
    1,948,137
    
    
    
    1,961,530Current portion of notes payable
    
    
    356,379
    
    
    
    211,092Current portion of capital lease obligations
    
    
    124,990
    
    
    
    156,770Total current liabilities
    
    
    7,841,378
    
    
    
    7,419,907Deferred revenue, net of current portion
    
    
    18,452,649
    
    
    
    19,047,585Notes payable, net of current portion
    
    
    642,741
    
    
    
    703,560Capital lease obligations, net of current portion
    
    
    29,313
    
    
    
    35,642Total liabilities
    
    
    26,966,081
    
    
    
    27,206,694COMMITMENTS AND CONTINGENCIES(Note 14)SHAREHOLDERS EQUITY:Preferred stock  no par value, 10,000,000 shares
authorized as of December 31, 2004 and September
30, 2004:
    
    
    
    
    
    
    Common stock  no par value:Class A  200,000,000 shares authorized as
of December 31, 2004 and September 30, 2004;
97,704,586 and 95,305,757 shares issued and
outstanding as of December 31, 2004 and
September 30, 2004, respectively
    
    
    141,745,826
    
    
    
    134,687,535Accumulated deficit
    
    
    (131,494,491
    )
    
    
    (124,405,902
    )Accumulated other comprehensive loss
    
    
    (43,439
    )
    
    
    (84,374
    )Total shareholders equity
    
    
    10,207,896
    
    
    
    10,197,259TOTAL LIABILITIES AND SHAREHOLDERS EQUITY
    
    $
    37,173,977
    
    
    $
    37,403,953
 See notes to consolidated financial statements. 4




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AVANIR Pharmaceuticals 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)  
 Three months endedDecember 31,2004
    
    
    2003REVENUES:Royalties and sale of royalty rights (Note 8)
    
    $
    510,314
    
    
    $
    538,496Research contracts and licenses
    
    
    200,000
    
    
    
    3,000Government research grants
    
    
    160,651
    
    
    
    198,211Product sales
    
    
    17,400
    
    
    
    769,938Total revenues
    
    
    888,365
    
    
    
    1,509,645OPERATING EXPENSES:Research and development
    
    
    5,054,241
    
    
    
    5,366,369General and administrative
    
    
    1,852,175
    
    
    
    1,405,210Sales and marketing
    
    
    1,098,828
    
    
    
    858,511Cost of product sales
    
    
    3,102
    
    
    
    210,090Total operating expenses
    
    
    8,008,346
    
    
    
    7,840,180LOSS FROM OPERATIONS
    
    
    (7,119,981
    )
    
    
    (6,330,535
    )Interest income
    
    
    121,832
    
    
    
    55,542Interest expense
    
    
    (21,621
    )
    
    
    (10,808
    )Other income (expense), net
    
    
    (66,921
    )
    
    
    7,647LOSS BEFORE INCOME TAXES
    
    
    (7,086,691
    )
    
    
    (6,278,154
    )Provision for income taxes
    
    
    (1,898
    )
    
    
    (2,058
    )NET LOSS
    
    $
    (7,088,589
    )
    
    $
    (6,280,212
    )NET LOSS PER SHARE:BASIC AND DILUTED
    
    $
    (0.07
    )
    
    $
    (0.09
    )WEIGHTED AVERAGE NUMBER OF COMMON SHARES
OUTSTANDING:BASIC AND DILUTED
    
    
    95,851,957
    
    
    
    67,804,604
 See notes to consolidated financial statements. 5




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AVANIR Pharmaceuticals 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)  
 Three Months EndedDecember 31,2004
    
    
    2003OPERATING ACTIVITIES:Net loss
    
    $
    (7,088,589
    )
    
    $
    (6,280,212
    )Adjustments to reconcile net loss to net cash used for
operating activities:Depreciation and amortization
    
    
    470,289
    
    
    
    393,495Compensation paid with common stock, stock options and
warrants
    
    
    2,701
    
    
    
    14,543Other-than-temporary impairment of investment
    
    
    78,012
    
    
    
    Loss on disposal of assets
    
    
    785
    
    
    
    Intangible assets abandoned
    
    
    170,328
    
    
    
    Changes in assets and liabilities:Receivables
    
    
    (51,815
    )
    
    
    (821,827
    )Inventory
    
    
    3,102
    
    
    
    198,450Prepaid expenses and other assets
    
    
    344,077
    
    
    
    447,331Accounts payable
    
    
    (233,779
    )
    
    
    (157,839
    )Accrued expenses and other liabilities
    
    
    597,542
    
    
    
    596,643Accrued compensation and payroll taxes
    
    
    (42,406
    )
    
    
    (84,154
    )Deferred revenue
    
    
    (608,329
    )
    
    
    (485,605
    )Net cash used for operating activities
    
    
    (6,358,082
    )
    
    
    (6,179,175
    )INVESTING ACTIVITIES:Investments in securities
    
    
    (4,259,665
    )
    
    
    (992,640
    )Proceeds from sales and maturities of investments in securities
    
    
    4,900,000
    
    
    
    700,000Patent costs
    
    
    (203,937
    )
    
    
    (238,249
    )Purchases of property and equipment
    
    
    (58,954
    )
    
    
    (68,386
    )Net cash provided by (used for) investing activities
    
    
    377,444
    
    
    
    (599,275
    )FINANCING ACTIVITIES:Proceeds from issuance of common stock and warrants, net
    
    
    7,055,590
    
    
    
    7,552,626Proceeds from issuance of notes payable
    
    
    136,438
    
    
    
    159,918Payments on notes and capital lease obligations
    
    
    (90,079
    )
    
    
    (142,991
    )Net cash provided by financing activities
    
    
    7,101,949
    
    
    
    7,569,553Net increase in cash and cash equivalents
    
    
    1,121,311
    
    
    
    791,103Cash and cash equivalents at beginning of period
    
    
    13,494,083
    
    
    
    12,198,408Cash and cash equivalents at end of period
    
    $
    14,615,394
    
    
    $
    12,989,511SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:Interest paid
    
    $
    21,621
    
    
    $
    10,808Income taxes paid
    
    $
    1,898
    
    
    $
    2,058
 See notes to consolidated financial statements. 6




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AVANIR Pharmaceuticals 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)  
 1. BASIS OF PRESENTATION AvanirPharmaceuticals (Avanir, we, or the Company) has prepared the
unaudited condensed consolidated financial statements in this quarterly report in accordance with
the instructions to Form 10-Q adopted under the Securities Exchange Act of 1934. Certain
information and note disclosures normally included in consolidated financial statements prepared in
accordance with accounting principles generally accepted in the United States have been condensed
or omitted pursuant to such rules and regulations. These unaudited condensed consolidated
financial statements should be read with our audited consolidated financial statements and the
accompanying notes included in our Annual Report on Form 10-K for the fiscal year ended September
30, 2004. In our opinion, all adjustments (consisting only of normal recurring adjustments)
necessary to present a fair statement of our financial position as of December 31, 2004 and
September 30, 2004, and the results of operations for the three-month periods ended December 31,
2004 and 2003, have been made. The results of operations for the three-month periods ended
December 31, 2004 and 2003 are not necessarily indicative of the results for the fiscal year ending
September 30, 2005 or any future periods. 2. STOCK-BASED COMPENSATION On December 16, 2004, the Financial Accounting Standards Board (FASB) issued a revised Statement
No. 123 SharedBased Payment, (SFAS
No. 123(R)). SFAS No. 123(R) will require the Company to
measure the cost of all employee stock-based compensation awards based on the grant date fair value
of those awards and to record that cost as compensation expense over the period during which the
employee is required to perform service in exchange for the award (generally over the vesting
period of the award). Excess tax benefits, as defined by SFAS
No. 123(R), will be recognized as an
addition to paid-in capital. SFAS No. 123(R) is effective for the Company for interim or annual
periods beginning after June 15, 2005. The Company is currently evaluating the effect of the
expanded guidance of this pronouncement on its financial statements. Until SFAS No. 123(R) becomes effective, the Company has chosen to continue to account for
stock-based compensation using the intrinsic value method prescribed in APB Opinion No. 25, and
related interpretations for all periods presented. Accordingly, compensation costs for stock
options are measured as the excess, if any, of the fair value of the Companys stock at the date of
the grant over the amount an employee must pay to acquire the stock. The following table summarizes the impact on the Companys net loss had compensation costs been
determined based upon the fair value at the grant date for awards under the stock option plans
consistent with the methodology prescribed under SFAS No 123. Three Months Ended December 31,2004
    
    
    2003Net loss, as reported
    
    $
    (7,088,589
    )
    
    $
    (6,280,212
    )Add: Stock-based employee
compensation included in reported
net loss
    
    

    
    
    
    
    11,842Deduct: Total stock-based
employee compensation expense
determined under fair value based
method for all awards
    
    
    (281,691
    )
    
    
    (302,844
    )Pro forma net loss
    
    $
    (7,370,280
    )
    
    $
    (6,571,214
    )Net loss per share:Basic and diluted  as reported
    
    $
    (0.07
    )
    
    $
    (0.09
    )Basic and diluted  pro forma
    
    $
    (0.08
    )
    
    $
    (0.10
    )
 7




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The Company accounts for stock options granted to non-employees in accordance with 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, (EITF No. 96-18).
Under EITF No. 96-18, the Company determines the fair value of the stock options granted as either
the fair value of the consideration received or the fair value of the equity instruments issued,
whichever is more reliably measurable. For the purpose of determining compensation expense for
stock options granted to non-employees, all of the Companys directors are considered to be
employees. 3. RECLASSIFICATIONS Certain amounts from the prior period have been reclassified to conform to the current period
presentation. 4. BALANCE SHEET DETAILS The following tables provide details of selected balance sheet items. Notes receivable, net.Receivables as of December 31, 2004 and September 30, 2004 consist of the
following: December 31,
    
    
    September 30,2004
    
    
    2004Total receivables
    
    $
    309,194
    
    
    $
    257,379Allowance for doubtful accounts
    
    
    (17,500
    )
    
    
    (17,500
    )Receivables, net
    
    $
    291,694
    
    
    $
    239,879
 Property and equipment.Property and equipment consist of the following: December 31, 2004
    
    
    September 30, 2004Gross
    
    
    
    
    
    
    
    
    
    
    GrossCarrying
    
    
    Accumulated
    
    

    
    
    
    
    Carrying
    
    
    AccumulatedValue
    
    
    Depreciation
    
    
    Net
    
    
    Value
    
    
    Depreciation
    
    
    NetResearch and
development
equipment
    
    $
    3,701,461
    
    
    $
    (2,222,181
    )
    
    $
    1,479,280
    
    
    $
    3,701,461
    
    
    $
    (2,021,193
    )
    
    $
    1,680,268Computer equipment
and related
software
    
    
    1,052,995
    
    
    
    (586,683
    )
    
    
    466,312
    
    
    
    999,073
    
    
    
    (545,953
    )
    
    
    453,120Leasehold
improvements
    
    
    5,034,679
    
    
    
    (1,199,011
    )
    
    
    3,835,668
    
    
    
    5,032,605
    
    
    
    (1,048,184
    )
    
    
    3,984,421Office equipment,
furniture, and
fixtures
    
    
    558,970
    
    
    
    (309,198
    )
    
    
    249,772
    
    
    
    558,970
    
    
    
    (285,815
    )
    
    
    273,155Total property
and equipment
    
    $
    10,348,105
    
    
    $
    (4,317,073
    )
    
    $
    6,031,032
    
    
    $
    10,292,109
    
    
    $
    (3,901,145
    )
    
    $
    6,390,964
 Depreciation expense related to property and equipment was approximately $418,000 and $376,000
for the three-month periods ended December 31, 2004 and 2003, respectively. Intangible assets.The Company accounts for intangible assets in accordance with Statement of
Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS No. 142),
which became effective on October 1, 2002. SFAS No. 142 requires goodwill and other intangible
assets that have indefinite useful lives to no longer be amortized; however, these assets must be
reviewed at least annually for impairment. Intangible assets with indefinite useful lives consist
of costs of trademarks for 8




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Avanir and Xenerex and similar names intended for use or potential use in the United
States and the rest of the world. Intangible assets with finite lives continue to be amortized
over their useful lives for the three months ended December 31, 2004, and are evaluated for
impairment whenever events or changes in circumstances indicate that their carrying value may not
be recoverable under SFAS No. 144, Accounting for Impairment or Disposal of Long-lived Assets.
If the review indicates that long-lived assets are not recoverable (i.e. the carrying amount is
less than the future projected undiscounted cash flows), then their carrying value would be reduced
to fair value. The Company carried no goodwill on its books at either December 31, 2004 or
September 30, 2004. We capitalize legal costs incurred in connection with patents, patent applications pending,
trademark applications and license agreements. We amortize costs of approved patents and license
agreements over their useful lives, or terms of the agreements, whichever are shorter. For patents
pending, we amortize the costs over the shorter of a period of twenty years from the date of filing
the application or, if licensed, the term of the license agreement. We re-assess the useful lives
of patents when they are issued, or whenever events or changes in circumstances indicate the useful
lives may have changed. For patent and trademark applications that we abandon, we charge the
remaining unamortized accumulated costs to research and development
expense. Avanirs amortizable intangible
assets consist of the costs of patents, patent applications, and licenses. Intangible assets, consisting of both intangible assets with finite and indefinite useful lives as
of December 31, 2004 and September 30, 2004, are as follows: December 31, 2004
    
    
    September 30, 2004Gross
    
    
    
    
    
    
    
    
    
    
    GrossCarrying
    
    
    Accumulated
    
    
    
    
    
    
    Carrying
    
    
    AccumulatedValue
    
    
    Amortization
    
    
    Net
    
    
    Value
    
    
    Amortization
    
    
    NetIntangible assets with
finite lives:Patent applications
pending (1)
    
    $
    2,432,627
    
    
    $
    (173,314
    )
    
    $
    2,259,313
    
    
    $
    2,462,704
    
    
    $
    (166,000
    )
    
    $
    2,296,704Patents
    
    
    1,047,790
    
    
    
    (358,463
    )
    
    
    689,327
    
    
    
    1,010,097
    
    
    
    (339,552
    )
    
    
    670,545Licenses
    
    
    42,461
    
    
    
    (16,212
    )
    
    
    26,249
    
    
    
    42,461
    
    
    
    (15,647
    )
    
    
    26,814Total intangible
assets with finite
lives
    
    
    3,522,878
    
    
    
    (547,989
    )
    
    
    2,974,889
    
    
    
    3,515,262
    
    
    
    (521,199
    )
    
    
    2,994,063Intangible assets with
indefinite useful
lives
    
    
    46,525
    
    
    
    
    
    
    
    46,525
    
    
    
    40,961
    
    
    
    
    
    
    
    40,961Total intangible assets
    
    $
    3,569,403
    
    
    $
    (547,989
    )
    
    $
    3,021,414
    
    
    $
    3,556,223
    
    
    $
    (521,199
    )
    
    $
    3,035,024
   (1)
    
    Patent applications pending includes the net effect of $170,328 in intangible assets
abandoned during the three-months ended December 31, 2004 (net of accumulated amortization of $18,321). The
intangible assets were abandoned in selected countries because
certain therapeutic use patents pending related to potential
treatments of allergy and asthma, and cancer, were covered by
Avanirs
composition-of-matter patents. Further, we believed that it would be
difficult to enforce therapeutic use patents in those countries.
 Amortization expense related to amortizable intangible assets was approximately $47,000 and
$18,000 for the three-month periods ended December 31, 2004, and 2003, respectively. Based solely
on the amortizable intangible assets as of December 31, 2004, the estimated annual amortization
expense of intangible assets for the fiscal years ending September 30 is shown in the following
table. Actual amortization expense to be reported in future periods could differ from these
estimates as a result of acquisitions, divestitures, and other relevant factors. 9




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Amortization ExpenseFiscal year ending September 30:2005 (remaining nine months)
    
    $
    149,6832006
    
    
    198,7442007
    
    
    198,7442008
    
    
    198,5072009
    
    
    192,044Thereafter
    
    
    2,037,167Total
    
    $
    2,974,889
 5. USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted
in the United States of America requires management to make estimates and assumptions that affect
the amounts reported in the financial statements and accompanying notes. Actual results could
differ from those estimates. 6. INVENTORY Inventory is stated at the lower of cost (first-in, first-out) or market. Inventory consists of
the raw material docosanol, which is the active pharmaceutical ingredient in docosanol 10% cream.
Docosanol in its present form as stored by the Company has a substantial shelf life, a relatively
stable value and long-term use, and carries a low risk of becoming excess inventory or obsolete.
Avanir does not own or store any docosanol 10% cream in its finished product form. The
Company and one of its licensees receive raw materials from a single supplier. Avanir
also supplies several other licensees with raw materials from the same supplier. The inability of
a sole supplier to fulfill supply requirements of the Company or its licensees could materially
impact future operating results. 7. DEFERRED REVENUE We have several license agreements with additional or continuing obligations to perform under the
agreements. In such arrangements, certain revenues have been deferred until the performance
obligations have been met or ratably achieved. In our largest agreement, Avanir sold an
undivided interest in its Abreva® license agreement with SB Pharmco Puerto Rico, Inc. (SB or
GlaxoSmithKline) to Drug Royalty USA, Inc. (Drug Royalty USA) on December 24, 2002 for $24.1
million. We recorded the net proceeds of the transaction as deferred revenue, to be recognized as
revenue over the life of the license agreement, because of our ongoing involvement in earning
future revenues under our license agreement with SB. The following table sets forth as of December
31, 2004 the deferred revenue balances for the Drug Royalty USA agreement and other agreements.
The portion of deferred revenue classified as a current liability represents the amount
Avanir expects to realize as revenue within the next 12 months. Drug Royalty
    
    
    OtherUSA Agreement
    
    
    Agreements
    
    
    TotalDeferred revenue as of September 30, 2004
    
    $
    20,800,782
    
    
    $
    208,333
    
    
    $
    21,009,115Changes during the period:Recognized as revenue during period
    
    
    (508,329
    )
    
    
    (100,000
    )
    
    
    (608,329
    )Deferred revenue as of December 31, 2004
    
    $
    20,292,453
    
    
    $
    108,333
    
    
    $
    20,400,786Classified as:Current portion of deferred revenue
    
    $
    1,914,804
    
    
    $
    33,333
    
    
    $
    1,948,137Deferred revenue, net of current portion
    
    
    18,377,649
    
    
    
    75,000
    
    
    
    18,452,649Total deferred revenue
    
    $
    20,292,453
    
    
    $
    108,333
    
    
    $
    20,400,786
 10




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8. REVENUE RECOGNITION Performance-based license fees.We recognize revenues from license fees when the performance
requirements have been met, the fee is fixed or determinable, and collection of fees is probable.
We defer revenues and recognize them ratably over the life of the agreement when we have continuing
obligations to perform under the agreement. Royalty revenues.We recognize royalty revenues from licensed products when earned in accordance
with the terms of the license agreements and reported by the licensees. Net sales figures used for
calculating royalties due to the Company can often include deductions for costs of unsaleable
returns, managed care chargebacks, cash discounts, freight and warehousing, and miscellaneous
write-offs, which may vary over the course of the license agreement. Revenues from sale of royalty rights.In agreements where we have sold our rights to future
royalties under license agreements and we maintain continuing involvement in earning such
royalties, we defer revenues and recognize them over the life of the license agreement. For
example, in the sale of an undivided interest of our Abreva license agreement to Drug Royalty USA,
revenue recognition is being determined under the units-of-revenue method. Under this method, the
amount of deferred revenue to be recognized as revenue in each period is calculated by multiplying
(i) the ratio of the royalty payments due to Drug Royalty USA for the period to the total remaining
royalties that we expect SB will pay Drug Royalty USA over the term of the agreement, by (ii) the
unamortized deferred revenue amount. Revenue arrangements with multiple deliverable.We have revenue arrangements whereby we are
obligated to deliver to the customer multiple products and/or services (multiple deliverables).
Such arrangements could include antibody generation services agreements and other forms of research
collaborations. In these transactions, we allocate the total revenue to be earned under the
arrangement among the various elements based on their relative fair value. In the case of antibody
generation services, the allocation is based on objective, customer-specific evidence of fair
value. We recognize revenue related to the delivered products or services only if: (i) the above
performance or service criteria are met; (ii) any undelivered products or services are not
essential to the functionality of the delivered products or services; (iii) payment for the
delivered products or services is not contingent upon delivery of the remaining products or
services; (iv) we have an enforceable claim to receive the amount due in the event we do not
deliver the undelivered products or services; and (v) as discussed above, there is evidence of the
fair value for each of the undelivered products or services. Government research grant revenue.We recognize revenues from federal research grants during the
period in which the related expenditures are incurred. 9. INVESTMENTS Investments are comprised of marketable securities consisting primarily of certificates of deposit,
federal, state and municipal government obligations, corporate bonds, and an investment in a mutual
fund that invests primarily in asset-backed and mortgage-backed securities. All marketable
securities are held in the Companys name and primarily under the custodianship of two major
financial institutions. The Companys policy is to protect the value of its investment portfolio
and minimize principal risk by earning returns based on current interest rates. Short-term
investments are marketable securities with maturities of less than one year from the balance sheet
date. Statement of Financial Accounting Standards No. 115 (SFAS No. 115), Accounting for Certain
Investments in Debt and Equity Securities, addresses the accounting and reporting for investments
in equity securities that have readily determinable fair values and for all investments in debt
securities. Those investments are to be classified in three categories and accounted for as
follows: 11




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
    Debt securities that the Company has the positive intent and ability to hold to maturity
are classified as held-to-maturity securitiesand reported at amortized cost.
    Debt and equity securities that are bought and held principally for the purpose of
selling them in the near term are classified as trading securitiesand reported at fair
value, with unrealized gains and losses included in the Companys Consolidated Statement of
Operations.
    Debt and equity securities not classified as either held-to-maturity securities or
trading securities are classified as available-for-sale securitiesand reported at fair
value, with unrealized gains and losses excluded from the Consolidated Statement of
Operations and reported in a separate component of shareholders equity. SFAS No. 115 also requires companies to determine whether a decline in fair value below the
amortized cost basis is other-than-temporary. If a decline in fair value is determined to be
other-than-temporary, SFAS No. 115 requires the carrying value of the debt or equity security to be
permanently written down to its fair value. In making an evaluation of whether or not an
investment is impaired, the Company applied the effective paragraphs of EITF 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments. In evaluating whether
or not the impairment is other-than-temporary, the Company considers the duration and severity of
the impairment, as well as the intent and ability to hold the investment until recovery, among
other factors. The following tables summarize the Companys investments in securities, all of which are classified
as available-for-sale except for restricted investments, which are classified as held-to-maturity. Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    FairCost
    
    
    Gains (1)
    
    
    Losses (1)
    
    
    ValueAs of December 31, 2004:Certificates of deposit
    
    $
    956,597
    
    
    $
    1,090
    
    
    $
    
    
    
    $
    957,687Adjustable rate mutual fund (2)
    
    
    2,936,353
    
    
    
    
    
    
    
    
    
    
    
    2,936,353Government debt securities
    
    
    7,885,523
    
    
    
    700
    
    
    
    (45,229
    )
    
    
    7,840,994Total
    
    $
    11,778,473
    
    
    $
    1,790
    
    
    $
    (45,229
    )
    
    $
    11,735,034Reported as:Short term investments:Classified as available-for-sale
    
    $
    7,992,211Long term investments:Classified as available-for-sale
    
    
    2,886,226Restricted investments in
securities (3)
    
    
    856,597Long-term investments
    
    
    3,742,823Total
    
    $
    11,735,034
 Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    FairCost
    
    
    Gains (4)
    
    
    Losses (4)
    
    
    ValueAs of September 30, 2004:Certificates of deposit
    
    $
    1,356,597
    
    
    $
    3,558
    
    
    $
    
    
    
    $
    1,360,155Adjustable rate mutual fund (2)
    
    
    3,014,365
    
    
    
    
    
    
    
    (68,650
    )
    
    
    2,945,715Government debt securities
    
    
    8,125,858
    
    
    
    6,186
    
    
    
    (25,468
    )
    
    
    8,106,576Total
    
    $
    12,496,820
    
    
    $
    9,744
    
    
    $
    (94,118
    )
    
    $
    12,412,446Reported as:Short term investments:Classified as available-for-sale
    
    $
    8,803,982Long term investments:Classified as available-for-sale
    
    
    2,751,867Restricted investments in
securities (3)
    
    
    856,597Long-term investments
    
    
    3,608,464Total
    
    $
    12,412,446
 12




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##### Table of Contents



(1)
    Gross unrealized gains of $1,790 and gross unrealized losses of $45,229 on government debt
securities and certificates of deposit represent an accumulated net unrealized loss of
$43,439, which is reported as accumulated other comprehensive loss on the consolidated
balance sheet as of December 31, 2004.(2)
    Represents an investment in a mutual fund that invests primarily in adjustable rate
mortgage-backed securities, and includes an other-than-temporary loss of $78,012 in the
amortized cost. The company determined that the impairment was other-than-temporary primarily
because the funds performance as of December 31, 2004 had continued to lag increases in
interest rates over the two-year period of the investment and the fund had no set maturity.
The Company sold the investment in February 2005.(3)
    Restricted investments amounting to $856,597 as of both December 31, 2004 and September 30,
2004 represent amounts pledged to our bank as collateral for letters of credit issued in
connection with our leases of office and laboratory space.(4)
    Gross unrealized gains of $9,744 and gross unrealized losses of $94,118 on government
securities, the adjustable rate mutual fund, and certificates of deposit represent an
accumulated net unrealized loss of $84,374, which is reported as accumulated other
comprehensive loss on the consolidated balance sheet as of September 30, 2004. 10. COMPUTATION OF NET LOSS PER COMMON SHARE We compute basic net loss per common share by dividing the net loss by the weighted-average number
of common shares outstanding during the period (Basic EPS Method). We compute diluted net loss
per common share by dividing the net loss by the weighted-average number of common and dilutive
common equivalent shares outstanding during the period (Diluted EPS Method). Dilutive common
equivalent shares consist of shares issuable upon exercise of stock options and warrants. In the
accompanying consolidated statements of operations, we have presented our net loss per share for
the three-month periods ended December 31, 2004 and 2003 using the Basic EPS Method and the Diluted
EPS Method. The shares of common stock issuable upon exercise of stock options and warrants under
the Diluted EPS Method were excluded from the three-month periods ended December 31, 2004 and 2003,
as the inclusion of such shares would have been antidilutive. For the three-month periods ended December 31, 2004 and 2003, options to purchase 5,909,040 and
5,285,588 shares of common stock, respectively, were excluded from the computation of diluted net
loss per share, as the inclusion of such shares would be antidilutive. For the three-month periods
ended December 31, 2004 and 2003, warrants to purchase 5,295,261 and 5,680,759 shares of common
stock, respectively, were excluded from the computation of diluted net loss per share, as the
inclusion of such shares would be antidilutive. 11. COMPREHENSIVE LOSS Comprehensive loss consists of the following: Three Months EndedDecember 31,2004
    
    
    2003Net loss
    
    $
    (7,088,589
    )
    
    $
    (6,280,212
    )Other comprehensive loss, net of tax:Unrealized loss on available-for-sale securities
    
    
    (40,935
    )
    
    
    (31,599
    )Total comprehensive loss
    
    $
    (7,129,524
    )
    
    $
    6,311,811
 12. SHAREHOLDERS EQUITY Preferred stock.Preferred stock consists of Series C Junior Participating Preferred Stock, of
which none is outstanding. Class A common stock.On December 10, 2004, the Company issued and sold to CDIB Capital Investment
America Ltd., a wholly-owned subsidiary of China Development Industrial Bank, Inc., 2,333,333
shares of Class A common stock at a price of $3.00 per share, for aggregate offering proceeds of
approximately $7 million. The offering was made pursuant to Avanirs shelf registration statement
on Form S-3, filed on April 9, 2004. 13




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During the three-month period ended December 31, 2004, we issued an aggregate of 65,496 shares of
Class A common stock in connection with the exercise of stock purchase warrants (26,845 shares) and
employee stock options (38,651 shares) for cash in the aggregate amount of approximately $88,962,
representing a weighted-average price per share of $1.36. 13. RECENT ACCOUNTING PRONOUNCEMENTS EITF Issue 04-8.In September 2004, the EITF reached consensus on EITF Issue 04-8, The Effect of
Contingently Convertible Debt on Diluted Earnings per Share, which provides guidance on when the
dilutive effect of contingently convertible debt securities with a market price trigger should be
included in diluted Earnings Per Share. The guidance is effective for all periods ending after
December 15, 2004. The guidance of EITF Issue 04-8 did not have a material impact on the Companys
earnings per share calculation. Financial Accounting Standards Board (FASB) SFAS No. 151.On November 24, 2004, the FASB
issued SFAS No. 151, Inventory Costs, an Amendment of ARB No. 43, Chapter 4,  that is effective
for inventory costs incurred during fiscal years beginning after June 15, 2005. SFAS 151 requires
that abnormal amounts of idle facility expense, freight, handling costs and wasted material
(spoilage), as well as unallocated overhead, be recognized as current period charges. The Company
does not expect SFAS 151 to significantly affect the Companys financial condition or results of
operations. Financial Accounting Standards Board (FASB) SFAS No. 153.On December 16, 2004, the FASB issued
SFAS No. 153, Exchanges of Nonmonetary Assets, an Amendment of APB Opinion No. 29, that is
effective for nonmonetary asset exchanges occurring in fiscal period after June 15, 2005. SFAS No.
153 replaces APB Opinion No. 29 exception for fair value measurement of nonmonetary exchanges of
similar productive assets with a new exception. Under SFAS No. 153, only exchanges that do not
have commercial substance meet the exception for fair value measurement. A nonmonetary exchange
has commercial substance if the future cash flows of the entity are expected to change
significantly as a result of the exchange. The Company does not expect SFAS No. 153 to
significantly affect the Companys financial condition or results of operations. 14. COMMITMENTS AND CONTINGENCIES In the ordinary course of business, we may face various claims brought by third parties, including
claims relating to the safety or efficacy of our products. Any of these claims could subject us to
costly litigation and, while we generally believe that we have adequate insurance to cover many
different types of liabilities, our insurance carriers may deny coverage or our policy limits may
be inadequate to fully satisfy any damage awards or settlements. If this were to happen, the
payment of any such awards could have a material adverse effect on our operations and financial
position. Additionally, any such claims, whether or not successful, could damage our reputation
and business. Management believes the outcome of currently identified claims and lawsuits will not
have a material adverse effect on the Companys operations or financial position. 15. SEGMENT INFORMATION We operate in one segment, which is the business of discovery, development and commercialization of
novel therapeutics for chronic diseases. Our chief operating decision-makers review our operating
results on an aggregate basis and manage our operations as a single operating segment. We have
developed one commercial product, docosanol 10% cream, known as Abreva® in the United States, and
we have several other product candidates in various stages of development. We have licensed
docosanol 10% cream to other companies that market the product and provide us royalties on product
sales. 14




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##### Table of Contents



Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Quarterly Report on Form 10-Q contains forward-looking statements concerning future events and
performance of our company. When used in this report, the words intend, estimate,
anticipate, believe, plan or expect and similar expressions are included to identify
forward-looking statements. These forward-looking statements are based on our current expectations
and assumptions and many factors could cause our actual results to differ materially from those
indicated in these forward-looking statements. You should review carefully the factors identified
in this report under the caption, Risk Factors that Might Affect Future Operations and in our
most recent Annual Report on Form 10-K filed with the Securities and Exchange Commission. We
disclaim any obligation to update or announce revisions to any forward-looking statements to
reflect actual events or developments. The three-month period ended December 31, 2004, may also be
referred to as the first quarter of fiscal 2005. EXECUTIVE OVERVIEW Avanir Pharmaceuticals is a drug discovery and development company focused primarily on
novel treatments for chronic diseases. Avanir is currently developing Neurodex  for the
treatment of pseudobulbar affect (PBA) and for the treatment of chronic diabetic neuropathic
pain. We have successfully completed two Phase III trials of Neurodex in the treatment of PBA, one
in patients with multiple sclerosis (MS) and the other in patients with Lou Gehrigs disease
(amyotrophic lateral sclerosis of ALS), and one Phase II trial for the treatment of diabetic
neuropathic pain. We also have a potential product for allergy and asthma, AVP-13358, which is in
Phase I clinical development. Our clinical and preclinical research and drug discovery programs are focused primarily on small
molecules that can be taken orally as therapeutic treatments. Other small molecule programs
include potential treatments for atherosclerosis and inflammation, which are both in the
preclinical development stage. Using our proprietary Xenerex technology, we are also conducting
research to develop injectable human monoclonal antibody products for anthrax, cytomegalovirus, and
other infectious diseases. 15




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##### Table of Contents



The following chart illustrates the approximate status of research activities for our products and
product candidates that are under development. (CHART) We strive to maintain a lean organizational structure while working on a diverse product
development pipeline. We also strive to maintain flexibility in our cost structure, by managing
over outsourced functions such as clinical trials, market research, legal counsel, documentation
and testing of internal controls, and portions of chemistry, rather than maintain all of these
functions in house. While outsourcing can lead to higher costs in some cases, we believe the
benefits of being flexible, and being able to rapidly respond to program delays, or successes, and
the availability of capital to advance our programs, far outweigh the disadvantages. However, even
with a lean, flexible organization, the continued development of our current product candidates and
the potential launch of Neurodex will require substantial additional capital. We intend to seek
partnerships with pharmaceutical companies to help fund several of our research and
development programs in exchange for sharing in the rights to commercialize new drugs. We have
licensed certain rights to docosanol 10% cream and continue to seek licensees for that product and
potential products in our pipeline. We may also seek to develop our drug candidates through
research collaborations with larger pharmaceutical companies, potentially allowing us to share the
risks and the opportunities that come from such development efforts. We expect that our development and operational costs will continue to exceed revenues from existing
sources through at least fiscal 2006. Trends in revenues and various types of expenses are
discussed further in the Results of Operations. We will have to raise significant amounts of
additional capital to continue our research and development
activities, prepare for and potentially execute a
product launch of Neurodex for PBA, if approved by the U.S. Food and
Drug Administration for marketing, and fund other operating activities. Our future capital needs
will depend substantially on the economic terms and the timing of any new partnership or
collaborative arrangements with pharmaceutical companies under which they will share the costs of
such activities. If we are unable to raise capital as 16




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needed to fund our operations, or if we are unable to enter into any such collaborative
arrangements, then we may need to slow the rate of development of some of our programs or sell the
rights to one or more of our drug candidates. For additional information about the risks and
uncertainties that may affect our business and prospects, please see Risk Factors that Might
Affect Future Operations. Our offices and research facilities are located at 11388 Sorrento Valley Road, San Diego,
California 92121. Our telephone number is (858) 622-5200 and our e-mail address is
info@avanir.com. Additional information about Avanir can be found on our website, at
www.avanir.com, and in our periodic and current reports filed with the Securities and Exchange
Commission (SEC). Copies of our current and periodic reports filed with the SEC are available at
the SEC Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549, and online at
www.sec.govand our website at www.avanir.com. RESULTS OF OPERATIONS COMPARISON OF THREE MONTHS ENDED DECEMBER 31, 2004 AND 2003 Revenues Revenues in the first quarter of fiscal 2005 amounted to $888,000, including $508,000 from the
recognition of deferred revenue relating to the sale of an undivided interest in our Abreva®
license agreement to Drug Royalty USA (See Note 7, Deferred Revenue, in the Notes to Condensed
Consolidated Financial Statements (Unaudited)), $200,000 relating to the achievement of milestones
under license agreements, $161,000 from government research grants, and $2,000 in other royalties.
Revenues from government research grants included preclinical research on a potential antibody to
anthrax ($107,000) and preclinical development of docosanol as a potential treatment for genital
herpes ($54,000). Revenues in the first quarter of fiscal 2004 amounted to $1.5 million, including
$770,000 from sales of the active ingredient docosanol to licensees, $536,000 from the recognition
of deferred revenue relating to the sale of an undivided interest in our Abreva license agreement,
$198,000 from government research grants, and $2,000 in other royalties. During fiscal 2005, we expect to recognize approximately $1.9 million in revenues from the
recognition of deferred revenue relating to the sale of an undivided interest in our Abreva license
agreement and $578,000 in revenues from research being performed under government research grants.
We expect sales of the active ingredient docosanol will be less than $100,000 in fiscal 2005.
Projected fiscal 2005 revenues from new sources, such as license fees and milestone payments, will
depend substantially on our ability to enter into additional license arrangements and achieve
milestones under those arrangements. Such arrangements could be in the form of licensing or
partnering agreements for docosanol 10% cream, Neurodex, or for our other product development
programs including potential treatments for PBA, allergy and asthma, inflammation and
atherosclerosis. Many of our product development programs could take years of additional
development before they reach the stage of licensing, if ever, by other pharmaceutical companies. Revenue-generating Contracts Commercial contracts that remained active at the end of the first quarter of fiscal 2005 include
seven docosanol 10% cream license agreements, and one Neurodex sublicense. The Abreva® license
arrangement has been our most significant revenue source during the past four years, accounting for
a majority of revenues in each of those years. Expenses Operating expenses.Total operating expenses were $8.0 million in the first quarter of fiscal
2005, compared to $7.8 million in the same period in fiscal 2004. The $168,000 increase in
operating expenses was primarily caused by an $447,000 increase in general and administrative
expenses, primarily related to 17




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increasing legal costs associated with corporate governance and compliance with the Sarbanes Oxley
Act, and a $240,000 increase in sales and marketing expenses, primarily associated with pre-launch
commercial development of Neurodex. These increases were partially offset by lower costs of sales
resulting from decreased sales of the active pharmaceutical ingredient docosanol. Research and
development expenses were slightly lower than they were in the same period a year ago. These and
other costs and trends are more fully described below. Three Months EndedDecember 31,2004
    
    
    2003Operating expenses:Research and development
    
    
    63
    %
    
    
    68
    %General and administrative
    
    
    23
    %
    
    
    18
    %Sales and marketing
    
    
    14
    %
    
    
    11
    %Costs of sales
    
    
    0
    %
    
    
    3
    %Total operating expenses
    
    
    100
    %
    
    
    100
    %
 Research and development (R&D) expenses.R&D expenses were $5.1 million in the first
quarter of fiscal 2005, compared to $5.4 million in the same period a year ago. The open label
study and costs associated with preparing to initiate submission of the new drug application
(NDA) to the U.S. Food and Drug Administration for Neurodex in the treatment of PBA accounted for
approximately 40% of all R&D spending in the first quarter of fiscal 2005. We expect that clinical
spending on Neurodex for the treatment of PBA will decline in future quarters in 2005 as the
program nears completion, and spending on Neurodex for neuropathic pain will increase as the
Company commences Phase III clinical development of Neurodex for diabetic neuropathic pain. The
balance of R&D spending in the first quarter of fiscal 2005 was primarily for preclinical research
related to the development of compounds for the treatment of atherosclerosis (25%), allergy and
asthma (14%), inflammation and antibody research programs. We expect R&D spending for all
identified programs in the table that follows, other than PBA, will begin to increase in the coming
quarters, as we expand and advance those programs in the development pipeline. Pharmaceutical R&D programs, by their very nature, require a substantial amount of financial and
human resources and there is no assurance that any drug candidate will be approved for marketing by
domestic and/or foreign regulatory agencies. The later stages of clinical development typically
require substantially greater funds for development than the earlier stages. Thus, for many of our
larger development programs, we intend to license our technology or partner with other
pharmaceutical companies that have substantially greater financial resources. We expect that our
licensees will continue to develop and fund those products and pay us up-front license fees,
milestone payments, and royalties on product sales if those products are successfully developed and
approved for marketing by the FDA and foreign regulatory agencies. We caution that we may not find
licensees or partners for our programs and many of our development efforts could experience delays,
setbacks and failures, with no assurance that any of our clinical research or our potential
licensees or partners will ever reach the stage of submitting an NDA to the FDA or that any NDA
will be approved. The following table sets forth the status of, and costs attributable to, our proprietary research
and clinical development programs. 18




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##### Table of Contents



Research and Development Projects and Expenses Three Months Ended
    
    
    Inception
    
    
    EstimatedDecember 31,
    
    
    Through
    
    
    CostDecember 31,
    
    
    To Complete ProjectCompany-funded Projects:
    
    2004 (1)
    
    
    2003 (1)
    
    
    2004 (1) (2)
    
    
    (1)Develop Neurodex for FDA
marketing approval in
treating PBA. Estimated
cost and timing to reach
NDA decision by end of
2005
    
    $
    2,036,645
    
    
    $
    1,777,597
    
    
    $
    19,880,926
    
    
    
    $6M
    (3)Develop Neurodex for
neuropathic pain. Phase II
open-label study
completed. Estimated cost
and timing to complete one
Phase III trial and
license the product: up to
2 years
    
    
    82,418
    
    
    
    594,760
    
    
    
    6,529,986
    
    
    
    $8M
    (4)Development program for
allergy and asthma.
Estimated timing to
complete Phase IIa and
license the product: up to
2 years
    
    
    710,497
    
    
    
    1,065,878
    
    
    
    19,031,881
    
    
    
    $13 MPreclinical
atherosclerosis research
program. Estimated timing
to complete proof of
concept and to license the
product: up to 3 years
    
    
    1,246,183
    
    
    
    223,616
    
    
    
    4,394,382
    
    
    
    $25 MPreclinical
anti-inflammatory research
program (MIF inhibitor).
Estimated timing to
complete Phase IIa and to
license product: up to 4
years
    
    
    262,568
    
    
    
    611,418
    
    
    
    10,486,633
    
    
    
    $21 MOther projects involving
monoclonal antibodies and
docosanol
    
    
    554,752
    
    
    
    865,995
    
    
    
    14,259,009
    
    
    
    3⁄4
    (5)Government-funded Projects:Preclinical research,
primarily for potential
treatments for genital
herpes and anthrax.
Estimated timing to
complete the various
projects varies from one
to two years
    
    
    161,178
    
    
    
    227,105
    
    
    
    2,205,431
    
    
    
    $0.6 M
    (6)Total
    
    $
    5,054,241
    
    
    $
    5,366,369
    
    
    $
    76,788,248
   (1)
    Each project includes allocation of laboratory occupancy costs. M refers to
millions. Estimated costs and timing to complete the projects are subject to the
availability of funds.  (2)
    Inception dates are on or after October 1, 1998, at which time we began identifying
and tracking programs costs.  (3)
    Total expenditures of $6.0 million include an additional $5.0 million in 2005
calendar year to complete the open label study and the NDA submission fee, estimated to be
$672,000.  (4)
    Licensing and/or co-promotion alternatives are being explored whereby the partner
would fund a portion of clinical development. See Status of R&D Programs and Plans.
Program expenditures for Neurodex for the treatment of neuropathic pain during each of the
listed periods include allocated costs of certain research programs that are shared with
Neurodex for PBA. We are in the process of developing our Phase III clinical study plan
and estimated costs could change substantially.  (5)
    The costs and timing to complete these projects are unpredictable because of the
uncertainty of outcomes of the research.  (6)
    Represents the remaining balance of state and Federal research grant awards totaling
approximately $602,000 for research related to genital herpes and anthrax. 19




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##### Table of Contents



Status of R&D Programs and Plans  Company-funded Projects Neurodex for the treatment of PBA.We began submission of an NDA to the FDA on a rolling review
basis, starting on December 16, 2004 and expect to complete its submission by mid-2005. The
rolling review process allows Avanir to submit the NDA in modules (reviewable units),
which can then be evaluated by the FDA as they are submitted. Although we have commenced
submission of our NDA, the FDA has not, to our knowledge, yet begun review of the first module.
The FDA has indicated that Neurodex would qualify for a priority review when the submission is
complete. Once the submission is complete, and assuming that the FDA grants us priority review, we
expect the FDA will take approximately six months to complete its review of the entire submission.
Avanir has been engaged in an open-label safety study for the treatment of PBA in a broad
pool of patients who could have PBA associated with one of several underlying neurodegenerative
diseases or conditions. We expect to complete this open-label study in mid-2005 and will need to
submit the data from this study to complete our NDA submission. In June 2004, we successfully
completed the treatment phase of a Phase III clinical trial of Neurodex for the treatment of PBA in
150 patients with MS. Prior to engaging in these recent and current ongoing studies, we
successfully completed the initial Phase III clinical trial of PBA in patients with amyotrophic
lateral sclerosis (ALS), in May 2002. Neurodex for the treatment of neuropathic pain.We are currently developing our Phase III clinical
development plan for the use of Neurodex in the treatment of neuropathic pain and have included the
costs to conduct one Phase III clinical trial during 2005-2006. Simultaneously, we are evaluating
commercial development alternatives for this indication; including continuing development on our
own or seeking funding from a potential co-promotion partner or potential licensee. There can be
no assurances as to the timing of a license or co-promotion arrangement, if any. Development program for allergy and asthma (IgE regulator).In 2004 we completed a Phase I
clinical trial of our asthma/allergy drug, AVP-13358, in 54 healthy volunteers. The
placebo-controlled study was intended to assess safety, tolerability and pharmacokinetics following
single rising oral doses. Results of the study suggest AVP-13358 was well tolerated at all doses
up through 16 milligrams. The study also demonstrated AVP-13358 was detectable in the bloodstream
at all doses administered and remains in circulation long enough to allow potentially once or twice
daily dosing. We intend to continue to evaluate the safety of the drug by conducting rising
multi-dose studies in healthy patients in fiscal 2005. Assuming the successful completion of Phase
I clinical trials and adequate funds to continue development without a partner, we intend to
continue development of the drug through Phase IIa. Assuming the results of such additional
studies are favorable, we will seek to license the drug to a larger pharmaceutical company for
further development. Development program for atherosclerosis.We are engaged in preclinical research investigating the
use of small, orally active molecules as a potential treatment of atherosclerosis (the build-up of
fatty plaques in blood vessel walls). Our research is focused on developing molecules that can
enhance the naturally occurring process known as reverse cholesterol transport or RCT, whereby
cholesterol is effluxed from the fatty-plaques in blood vessel walls and transported to the liver
for elimination from the body. Preliminary studies in animal models suggest our compounds may
both reduce fatty plaques and increase fecal cholesterol excretion. Anti-inflammatory research program (MIF inhibitor).We are currently conducting research on
several potential drug candidates capable of inhibiting or blocking the activity of macrophage
migration inhibitory factor (MIF). Our research indicates that MIF may serve as a potential drug
target in a variety of diseases, including rheumatoid arthritis, Crohns disease, colitis and
asthma. Assuming we are successful in finding a lead compound and submitting an investigational
new drug application (IND) to the FDA, and successfully complete some of the initial studies, we
intend to license the compound to another pharmaceutical company for further development. Any
delays to our product development 20




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timeline or in submitting an IND could cause a similar delay in the timing of when we expect that
we could license our MIF technology. Avanir acquired the rights to the MIF Inhibitor Technology from the Ciblex Corporation in
August 2001 on the basis that the technology could assist us in discovering a small molecule drug
capable of regulating MIF. The MIF Inhibitor Technology included several compounds, details of
their chemical structures and method of preparation, data from in vitroexperiments and in vivo
test models, and rights to provisional patent applications filed by Ciblex regarding use of those
or similar compounds in the treatment of autoimmune and inflammatory diseases. In August 2004, we entered into an amendment to the Ciblex Technology Acquisition Agreement (the
Amendment), whereby we are no longer obligated to make milestone payments to Ciblex in connection
with the clinical development and/or commercialization of the MIF Inhibitor Technology in the
United States, nor will we be obligated to share the receipt of milestone payments outside the
United States. We will, however, be required to pay a royalty to Ciblex if and when commercial
sales under the agreement commence. Status of R&D programs and plans  government-funded projects Government research grants have helped fund research on docosanol-based formulations for the
treatment of genital herpes and the development of antibodies to anthrax toxins, among other
research programs.Approximately $602,000 in aggregate funds remains to be spent in 2005 and
2006 calendar year under existing government research grants. Monoclonal antibodies anthrax toxin.Two of Avanirs most potent anthrax antibodies,
AVP-21D9 and AVP-22G12, appear unique both in mechanism of action and in terms of the binding site
on the anthrax toxin. AVP-21D9 is currently in preclinical development for use as a prophylactic
and therapeutic drug to treat anthrax infections. Ultimately, Avanir intends to submit an
IND application seeking clearance from the FDA to begin clinical trials to evaluate the safety,
tolerability, and pharmacology of AVP-21D9 in healthy human subjects. Much of our work targeting
infectious diseases has been funded by government research grants. Because all of our monoclonal
antibody research is at a very early preclinical stage of development and is unpredictable in terms
of the outcome, we are unable to predict the cost and timing for development of any antibody or
drug. General and administrative expenses.Our general and administrative expenses increased to $1.9
million in the first quarter of fiscal 2005, compared to $1.4 million for the same period a year
ago. These increased expenses primarily relate to:  
    a $270,000 increase related to legal and other professional
services mainly associated with
corporate governance and compliance with the Sarbanes-Oxley Act of 2002;
    an $85,000 increase in investor relations, primarily because
of higher costs to prepare the annual report, and higher costs
related to
conference calls and presentation fees; and
    a $59,000 increase in building occupancy costs, representing primarily increases in
rent, utilities, and insurance. We expect that costs associated with compliance with the Sarbanes-Oxley Act will continue to
increase. Sales and marketing expenses.Sales and marketing expenses increased to $1.1 million in the first
quarter of fiscal 2005, compared to $859,000 during fiscal 2003. Higher expenses in the first
quarter of fiscal 2005 were related to the continued expansion of our medical education and
awareness programs for PBA, market research, and pre-launch activities for Neurodex, assuming the
drug is approved by the FDA for marketing. We expect sales and marketing expenses by the end of
fiscal 2005 will be approximately double overall levels experienced in fiscal 2004, based on
current commercial development plans. 21




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Other Income (Expense) For the first quarter of fiscal 2005, we recognized a loss of approximately $78,000 as an
other-than- temporary impairment to one of our investments (See Note 9, Investments.) We
included that amount in Other income (expense) in our Unaudited Condensed Consolidated Statements
of Operations. Net Loss For the first quarter of fiscal 2005, the net loss was $7.1 million, compared to $6.3 million for
the same period a year ago. The net loss per share, basic and diluted, was $0.07 for the first
quarter of fiscal 2005, compared to $0.09 for the same period a year ago. A higher average number
of shares was outstanding during the first quarter of fiscal 2005, compared to the same period in
the prior year. (See Liquidity and Capital
Resources  Financing Activities and Note 12,
Shareholders Equity.) We expect to continue to pursue our drug development strategy focused on the
commercial development of Neurodex, followed by other programs in earlier stages of development
that are in larger therapeutic areas and that we expect will have significant partnering and
licensing potential. To help fund and develop our products, we intend to seek licensees and
partners to share the costs of development. These potential license arrangements could materially
change our outlook for future revenues and costs. However, the certainty and timing of such
potential arrangements is unpredictable. LIQUIDITY AND CAPITAL RESOURCES As of December 31, 2004, we had cash, cash equivalents and investments in securities totaling $26.4
million, including cash and cash equivalents of $14.6 million, short- and long-term investments of
$10.9 million and restricted investments in securities of approximately $857,000. Our net working
capital balance as of December 31, 2004 was $16.2 million. As of September 30, 2004, we had cash,
cash equivalents and investments in securities totaling $25.9 million, including cash and cash
equivalents of $13.5 million, short- and long-term investments of $11.6 million, and restricted
investments of approximately $857,000. Our net working capital balance as of September 30, 2004
was $16.7 million. Explanations of net cash provided by or used for operating, investing and
financing activities are provided below. IncreaseDecember 31,
    
    
    (Decrease)
    
    
    September 30,2004
    
    
    During Period
    
    
    2004Cash, cash equivalents and investment in securities
    
    $
    26,350,428
    
    
    $
    443,899
    
    
    $
    25,906,529Cash and cash equivalents
    
    $
    14,615,394
    
    
    $
    1,121,311
    
    
    $
    13,494,083Net working capital
    
    $
    16,246,326
    
    
    $
    (407,295
    )
    
    $
    16,653,621
 Quarter ended
    
    
    Change
    
    
    Quarter endedDecember 31,
    
    
    Between
    
    
    December 31,2004
    
    
    Periods
    
    
    2003Net cash used for operating activities
    
    $
    (6,358,082
    )
    
    $
    (178,907
    )
    
    $
    (6,179,175
    )Net cash provided by (used for) investing activities
    
    
    377,444
    
    
    
    976,719
    
    
    
    (599,275
    )Net cash provided by financing activities
    
    
    7,101,949
    
    
    
    (467,604
    )
    
    
    7,569,553Net increase in cash and cash equivalents
    
    $
    1,121,311
    
    
    $
    330,208
    
    
    $
    791,103
 Operating activities.Net cash used for operating activities amounted to $6.4 million in the
first quarter of fiscal 2005, $179,000 higher than the same period a year ago. Since September 30, 2004, accounts
payable decreased by $234,000 and accrued expenses and other liabilities increased by $598,000,
representing additional contracts for services, including work performed by others on our clinical
trials and marketing programs for which payments for portions of the work completed to date had not
been made. The first quarter
of fiscal 2005 also included non-cash charges of approximately $170,000 related to intangible assets
abandoned (net of approximately $18,000 in accumulated amortization).
During the quarter, management determined that certain patents and patents pending related to potential treatments of
allergy and asthma, and cancer, were covered by other patents. (See
Note 4, Balance Sheet Details  Intangible
Assets.) The net cash used for operating activities in 22




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the first three months of fiscal 2004 amounted to $6.2 million. During the first quarter of
fiscal 2004, accounts receivable increased by approximately $822,000, representing sales of the
active ingredient docosanol to licensees and services provided under government grants for which
payments were received after the quarter ended. Also, inventory declined by approximately $198,000 in
the first quarter of fiscal 2004, representing the cost of docosanol sold to various licensees. We
intend to replenish our docosanol inventory in fiscal 2005. Investing activities.Net cash provided by investing activities during the first quarter of fiscal
2005 amounted to $377,000, including sales and maturities of
investments totaling $4.9 million,
partially offset by investments in securities totaling $4.3 million, purchases of property and
equipment of $59,000 and patent costs of $204,000. Net cash used for investing activities during
the first three months of fiscal 2004 amounted to $599,000, including investments in securities
totaling $993,000, purchases of property and equipment of $68,000, and patent costs of $238,000,
partially offset by sales and maturities of investments totaling $700,000. We expect that capital
expenditures for property and equipment will likely increase in the coming quarters as we make
accommodations in our existing facilities for additional sales and marketing personnel that will be
necessary to support commercialization of Neurodex, assuming the drug is approved by the FDA. (See
Managements Discussion and Analysis of Financial Condition and Results of Operations, Sales and
Marketing Expenses.) Financing activities.Net cash provided by financing activities amounted to $7.1 million during
the first quarter of fiscal 2005, consisting primarily of $7.0 million received from the sale of
Class A common stock in December 2004. (See Note 12, Shareholders Equity in the Notes to
Condensed Consolidated Financial Statements (Unaudited)). Net cash provided by financing
activities amounted to $7.6 million in the first quarter of fiscal 2004, consisting primarily of
$7.6 million received from the sale of Class A common stock and warrants in December 2003. In April 2004, the Company filed a shelf registration statement on Form S-3 with the SEC to sell an
aggregate of up to $50 million in Class A common stock. The Companys sale of Class A common stock
in June 2004, representing $28.8 million in gross proceeds ($26.5 million net of underwriting
discount and costs of the financing transaction) was the first transaction for the sale of Class A
common stock under the existing shelf registration. In December 2004, we issued an additional $7.0
million in Class A common stock to an institutional investor at $3.00 per share. The balance of
Class A common stock available for sale under the shelf registration as of December 31, 2004 is
approximately $14.2 million. In September 2004, Avanir entered into an equipment line of credit with GE Healthcare
Financial Services for financing of up to $1.4 million. As of December 31, 2004 the Company had a
balance due of approximately $878,000 under the line of credit. MANAGEMENT OUTLOOK The substantial progress in research programs in fiscal 2004 has set the stage for continued
development of all of our programs in fiscal 2005, including the anticipated completion of
submission of an NDA for Neurodex in the treatment of PBA. We believe that cash, cash equivalents,
and investments in securities totaling $26.4 million at December 31, 2004, plus anticipated future
revenues, should be sufficient to sustain our planned level of operations for at least the next 12
months. However, to pay the $672,000 NDA filing fee and continue to fund the development of our
new drug candidates and technology platforms and expected product launch of Neurodex during the
next two years (assuming that Neurodex is approved for marketing by the FDA), we will need to raise
additional capital and expect to continue to pursue various alternatives for raising capital during
this two-year period. Potential alternatives that we are considering for raising capital include,
but are not limited to, partnering arrangements where partners share development costs, issuance of
debt or equity securities, and licensing or sales of one or more of our platform technologies or
new drug candidates. 23




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CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of financial statements in accordance with accounting principles generally accepted
in the United States requires that management make a number of assumptions and estimates that
affect the reported amounts of assets, liabilities, revenues and expenses in our consolidated
financial statements and accompanying notes. Management bases its estimates on historical
information and assumptions believed to be reasonable. Although these estimates are based on
managements best knowledge of current events and circumstances that may impact the Company in the
future, actual results may differ from these estimates. Our critical accounting policies are those that affect our financial statements materially and
involve a significant level of judgment by management. Our critical accounting policies regarding
revenue recognition are in the following areas: milestone payments in license agreements, royalties
on licensed products, sale of rights to future royalties, and recognition of revenues in research
contracts. Our critical accounting policies also include recognition of expenses in research
contracts and the valuation of long-lived and intangible assets. Milestone Payments in License Agreements We recognize revenues from license fees when the performance requirements have been met, the fee is
fixed or determinable, and collection of fees is probable. We defer revenues and recognize them
ratably over the life of the agreement when we have continuing obligations to perform under the
agreement. Our largest and most significant license agreement is with SB Pharmco Puerto Rico, Inc., a
subsidiary of GlaxoSmithKline (GlaxoSmithKline). On March 31, 2000, we transferred the rights to
manufacture, use, and sell Abreva in the United States and Canada to GlaxoSmithKline and gave them
full control, authority and responsibility over research, development, regulatory compliance
activities (including actions required to obtain appropriate government approvals), and
commercialization of the product in those territories. GlaxoSmithKline has achieved and paid all
of the performance milestones under the agreement. With regard to the milestones, we have no
further performance obligations. Future revenues, if any, to be earned under the GlaxoSmithKline
agreement will come solely from royalty revenues. We entered into additional
agreements in 2004 and expect to enter in to additional license
agreements in the future. We expect that each license agreement will have its own set of
circumstances and terms of performance. We will consider the specific facts and circumstances of
each license agreement to determine the appropriate revenue recognition for such items, including
nonrefundable up-front fees and milestone payments and taking into consideration when the earnings
process is complete and collection is reasonably assured. Royalties on Licensed Products We recognize royalty revenues from our licensed products based on the reported sales by our
licensees and computed in accordance with the specific terms of the license agreements. Since the
launch of Abreva in October 2000 through June 30, 2004, substantially all of our royalties have
come from GlaxoSmithKline. We have entered into additional license agreements that contain
royalties as a source of revenues, and we expect to enter into additional similar license
agreements with foreign-based companies. Sale of Rights to Future Abreva Royalties In fiscal 2003, we sold an undivided interest in our license agreement with GlaxoSmithKline to Drug
Royalty USA for $24.1 million. Because of our ongoing involvement with GlaxoSmithKline in earning
future royalty revenues, we have recorded the amounts received from Drug Royalty USA, net of costs
of 24




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the transaction and forgiveness of certain advances, as deferred revenue. The amount recorded as
deferred revenue is being recognized as revenue under the units-of-revenue method over the period
from October 2002 through April 2014. Under this method, the amount of deferred revenue being
recognized as revenue in each period is calculated by multiplying (i) the ratio of the royalty
payments due to Drug Royalty USA for the period to the total remaining royalties that we expect SB
will pay Drug Royalty USA over the term of the agreement, by (ii) the unamortized deferred revenue
amount. The portion of deferred revenue classified as a current liability represents the amount we
expect to realize as revenue within the next 12 months. (See Note 7, Deferred Revenue, in the
Notes to Condensed Consolidated Financial Statements (Unaudited).) Recognition of Revenues in Research Contracts We may enter into research contracts or collaborations that have obligations to deliver to the
customer multiple products and/or services (multiple deliverables) in exchange for fees or
milestone payments. Such contracts could include antibody generation services agreements and other
forms of research collaborations, as discussed below. Antibody generation services.As of December 31, 2004, we were engaged in work on one research
collaboration agreement that had research initiation fees. In this type of agreement, the customer
provides us with the target antigens. We then perform research services to develop potential
antibodies for those antigens. If we are able to estimate the period of service in the contract in
advance of beginning the work, then we recognize such research initiation fees ratably as revenue
over the estimated period of service. If we are unable to identify the period of service in the
contract in advance of beginning the work, we defer research initiation fees and recognize such
fees as revenue once we have completed our efforts to create the antibodies. In the research
phases of the research collaboration agreement, we may receive payment either to start a research
phase or to complete a research phase (including receipt by the customer of the deliverable). We
recognize revenue once the product has been delivered because the earning process would be complete
and an exchange has been made. Factors taken into consideration in recognizing revenues include
the following:  
    The performance criteria have been met;
    Any deliverable products or services are not essential to the functionality of the
delivered products or services; and
    Payment for the delivered products or services is not contingent on delivery of the
remaining products or services. Other research contracts.As with all our research contracts, including the up-front initiation
fee, we defer revenue recognition until services have been rendered or products (e.g. developed
antibodies) are delivered. The milestones established within the contract are typically set to
approximate the effort associated with the completion of each phase. Recognition of Expenses in Research Contracts Pursuant to managements assessment of the progress that has been made on clinical trials and
services provided in other research contracts, we recognize expenses as the services are provided.
Several of our contracts extend across multiple reporting periods, including our largest contract,
which had a balance remaining of $1.1 million as of December 31, 2004, in the $4.3 million
contract. A 5% variance in our estimate of the work completed in our largest contract could
increase or decrease our operating expenses by $217,000. Such contracts require an assessment of
the work that has been completed during the period, including measurement of progress, analysis of
data that justifies the progress, and finally, managements judgment. 25




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We assess our obligations to make milestone payments that may become due under licensed or acquired
technology to determine whether the payments should be expensed or capitalized. We charge
milestone payments to research and development expense when:  
    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. Capitalization and Valuation of Long-Lived and Intangible Assets We capitalize legal costs incurred in connection with patents, patent applications pending,
trademark applications and license agreements. We amortize costs of approved patents and license
agreements over their estimated useful lives, or terms of the agreements, whichever are shorter.
For patents pending, we amortize the costs over the shorter of a period of twenty years from the
date of filing the application or, if licensed, the term of the license agreement. We re-assess
the useful lives of patents when they are issued, or whenever events or changes in circumstances
indicate the useful lives may have changes. For patent and trademark applications that we abandon,
we charge the remaining unamortized accumulated costs to expense. Avanirs amortizable
intangible assets consist of the costs of patents, patent applications, and licenses. Intangible assets are evaluated for impairment whenever events or changes in circumstances indicate
that their carrying value may not be recoverable. If the review indicates that long-lived assets
are not recoverable (i.e. the carrying amount is less than the future projected undiscounted cash
flows), their carrying amount would be reduced to fair value. Factors we consider important that
could trigger an impairment review include the following:  
    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. When we determine that the carrying value of intangible assets or long-lived assets are not
recoverable based upon the existence of one or more of the above indicators of impairment, we may
be required to record impairment charges for these assets that have not been previously recorded. As of December 31, 2004, our largest group of intangible assets with finite lives was for our IgE
down-regulation technology, having net intangible assets of approximately $972,000. Any setback or
failure in our IgE technology, currently in Phase I clinical development for the treatment of
allergy and asthma, could cause a re-assessment of the value of this technology and possible
write-down of all or a portion of the costs of these assets. RECENT ACCOUNTING PRONOUNCEMENTS See Note 2,
Stock-based Compensation and Note 13, Recent Accounting Pronouncements in the Notes to Condensed Consolidated Financial
Statements (Unaudited) for a discussion of recent accounting pronouncements and their effect, if
any, on the Company. 26




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RISK FACTORS THAT MIGHT AFFECT FUTURE OPERATIONS Risks Relating to Our Business We have a history of losses and we may never achieve or maintain profitability. To date, we have experienced significant operating losses in funding the research, development and
clinical testing of our drug candidates and we expect to continue to incur substantial operating
losses through at least fiscal 2006. As of December 31, 2004, our accumulated deficit was
approximately $131.5 million. To achieve profitability, we would need to generate significant
additional revenue with positive gross margins to offset our other operating expenses.
Additionally, we intend to increase our pre-launch activities and sales and marketing efforts over
the next several quarters as we continue our rolling submission of an NDA to the FDA for Neurodex
and, thereafter, await the FDAs decision. We could also increase spending on our preclinical
programs to the extent our progress in development is favorable. Although we are seeking to
negotiate revenue-generating licenses and/or co-promotion arrangements for docosanol 10% cream and
other product candidates, we may not find attractive arrangements, if at all, and any such
arrangements may not provide adequate revenues to cover future operating expenses. Increases in
expenditures may not be offset by new or adequate sources of revenues, and as a result, we may not
achieve or maintain profitability. Although our Phase III clinical trial for Neurodex in MS patients with PBA showed favorable
results, we must submit our results for this study and other studies to the FDA for review and
approval prior to U.S. commercialization. Any delay in the regulatory review or approval process
may harm our prospects and could harm our stock price. We began submission of an NDA for Neurodex to the FDA on December 16, 2004 under a rolling review
basis with the FDA, and we must obtain FDA approval prior to commercialization in the United
States. Any delays in our submission or in the FDAs review or approval would delay market launch
and increase our cash requirements and could increase the volatility of our stock price and result
in additional operating losses. The process of obtaining FDA approval typically takes many years and can vary substantially based
upon the type, complexity and novelty of the products involved. FDAs review and approval of the
actual NDA submission is expensive and uncertain. Although we began submission of an NDA for
Neurodex to the FDA in December 2004, we may not be able to maintain our planned schedule and may
not complete our submission in a timely manner. If we complete the submission of an NDA for
Neurodex, the FDA must decide whether to accept or reject the submission for filing. The FDAs
official filing of an NDA is the action that begins the applications substantive review. The FDA
may refuse to file an NDA for review for many reasons, including if the submission contains
insufficient data to demonstrate efficacy and/or safety. We cannot be certain that our NDA
submission would be accepted for filing and reviewed by the FDA or that we would be able to respond
to any requests during the review period in a timely manner without delaying potential action on
our request for approval. Additionally, recent public announcements regarding safety problems with
certain approved drugs may affect the FDAs policies regarding safety data for new drug
applications and may result in the FDA requiring additional safety data before accepting our
planned NDA submission, as well as closer surveillance after commercialization if the drug is
approved. We also cannot be certain that Neurodex will receive a favorable recommendation from any FDA
advisory committees or be approved for marketing by the FDA. Even if the FDA grants us marketing
approval for Neurodex, we cannot be certain that we will be able to obtain the labeling claims
necessary or desirable for the promotion of the product. In addition, delays in approvals or
rejections of marketing applications may be based upon many factors, including regulatory requests
for additional analyses, reports, data and/or studies, regulatory questions regarding data and
results, changes in regulatory policy 27




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during the period of product development and/or the emergence of new information regarding our
products or other products. We have yet to market or sell Neurodex or any of our other potential products. Although we may market Neurodex in the United States through the recruitment of experienced
marketing and sales personnel, or through a contract sales
organization, assuming Neurodex is approved by the FDA, we have never before
marketed or sold any pharmaceutical products. In order to market or co-market Neurodex or certain
other drug candidates, we will need to hire a significant number of people with relevant
pharmaceutical experience to staff our sales management team and marketing group, and possibly also to make
appropriate arrangements with collaborative partners. If we cannot develop the required marketing
and sales expertise internally or through our partnering arrangements, our ability to generate
revenue from product sales will likely suffer. In international markets, we intend to rely on collaborative partners to obtain regulatory
approvals, and to market and sell our products in those markets. We have not yet entered into any
collaborative arrangement with respect to marketing or selling Neurodex, with the exception of one
such agreement relating to Israel. We cannot guarantee that we will be able to enter into any
other arrangements on terms favorable to us, or at all. If we are able to enter into marketing and
selling arrangements with collaborative partners, we cannot assure you that such marketing
collaborators will apply adequate resources and skills to their responsibilities, or that their
marketing efforts will be successful. If we are unable to enter into favorable collaborative
arrangements with respect to marketing or selling Neurodex or docosanol 10% cream or our marketing
collaborators efforts are not successful, our ability to generate revenue from product sales will
suffer. We expect that we will need to raise additional capital to fund ongoing operations through at least
2006. 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. In order to maintain sufficient cash and investments to fund future operations, we will need to
raise additional capital. We expect to seek to raise additional capital over the next 12 to 24
months through various alternatives, including licensing or sales of our technologies and drug
candidates and selling shares of our Class A common stock.  
    If we raise capital through licensing or sales of one or more of our technologies or
drug candidates, then we may not realize revenues from sales for products that are
successfully developed, approved by the FDA and marketed. If we license any of our
technologies or drug candidates, then the development of these products or technologies may
no longer be in our control. A licensee might not ever reach any of the milestones in a
license agreement and we would not earn any additional payments in such an event. Further,
if we sell any of our technologies or drug candidates, the sales price may not fully cover
our investment in such technology or drug candidate.
    If we raise capital by issuing additional shares of Class A common stock at a price per
share less than the then-current market price per share, the value of the shares of Class A
common stock then outstanding may be reduced. Further, even if we were to sell shares of
common stock at prices equal to or higher than the current market price, the issuance of
additional shares may depress the market price of our Class A common stock and dilute
voting rights.
    We may not be able to raise capital on terms that we find acceptable, or at all. If we
are unable to raise additional capital to fund future operations, then we might have to
reduce operations or defer or abandon one or more of our clinical or preclinical research
programs. Any of these actions could be expected to have an adverse effect on our stock
price. 28




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Developing and testing a drug candidate is a very expensive and time-consuming process that may not
ultimately lead to a marketable product. The drug development process is lengthy and capital-intensive. Since September 1998, we have spent
approximately $76.7 million in preclinical and clinical studies researching the safety and efficacy
of our drug candidates and potential drug candidates. If any of our drug candidates fail to
demonstrate the desired safety and efficacy, we may abandon the development of the compound, in
which event we would not recover our expenditures incurred to date for that compound. If a
compound appears to be safe and effective in preclinical studies, we may decide to proceed with
human clinical trials. The full complement of clinical trials required to obtain regulatory
approval for many of our drug development programs exceeds our available capital. Because of our
limited financial resources, we may be required to license the compound to a pharmaceutical company
with greater financial resources in order to complete the development of the drug. We may be
unable to find a large pharmaceutical company interested in licensing the drug or, if we do locate
such a licensee, the proposed license terms may not be acceptable to the Company. In the event
that we are unable to find a large pharmaceutical partner or licensee on acceptable terms, we may
be forced to abandon one or more of our drug candidates. We expect our quarterly operating results to fluctuate significantly from period-to-period for a
number of reasons. Historically, we have had only limited recurring revenue. As a result, operating results have
been, and will continue to be, subject to significant quarterly fluctuations based on a variety of
factors, including:  
    Co-promotion or license arrangements We are currently seeking co-promotion or
licensing partners for docosanol 10% cream and Neurodex, as well as for our compounds
targeting IgE (allergy and asthma), MIF (inflammation) and apolipoprotein A1
(atherosclerosis). It is difficult to predict whether any of these discussions will result
in a partnering or license arrangement and what the financial terms of such an arrangement
might be. If we do enter into any such arrangements, the recognition of the revenue under
those arrangements may depend on the efforts and performance of our licensees or partners
in reaching milestones that are outside our control. Such milestones may include specific
events, such as regulatory approval, product launch, the passage of time, or reaching a
sales threshold.
    Limited rights to future Abreva royalties In December 2002, we sold to Drug Royalty
USA the rights to a substantial portion of our future royalty revenues from sales of Abreva
by GlaxoSmithKline. We will not receive any future royalty payments unless and until
annual Abreva wholesale sales exceed $62 million, at which time we will receive one-half of
the stated royalty rate on any excess sales. We estimate that
wholesale sales reached approximately 89% of the $62 million
threshold in 2004. We expect that any royalty payments on these
excess sales, if any, would occur only once a year, after the end of each calendar year.
    Concentration of significant customers, suppliers and industries Milestone payments,
royalties earned, and revenues recognized from the sale of rights to royalties from a
single licensee (GlaxoSmithKline) accounted for approximately 48%, 73% and 95% of our
fiscal 2004, 2003 and 2002 revenues, respectively. We have now received all of the
milestone payments from GlaxoSmithKline for North America. With the sale of our Abreva
royalty rights to Drug Royalty USA, future royalty payments from GlaxoSmithKline will come
exclusively from our remaining 50% share of Abreva royalties on contract sales in excess of
$62 million a year. Additionally, we purchase the raw material docosanol from a sole
foreign supplier that has been approved by the FDA for manufacturing. Any disturbances or
delays in the manufacture of docosanol or other raw materials for our products and clinical
research programs could seriously and adversely affect our business.
    Acquisitions/alliances If, in the future, we acquire technologies, products, or
businesses, or we form alliances with companies requiring technology investments or
commitments, we will face a number of risks to our business. The risks that we may
encounter include those associated with 29




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integrating operations, personnel, and technologies acquired or licensed, and the potential
for unknown liabilities of the acquired business. Our business and operating results on a
quarterly basis could be adversely affected if any or our acquisition or alliance
activities, to the extent they exist in the future, are not successful. Our stock price is highly volatile and investors may not be able to sell their shares at or above
the price they pay for them. The market price of our Class A common stock has been, and is likely to continue to be, highly
volatile. The following factors, among others, could have a significant impact on the market price
of our Class A common stock:  
    Our success or failure in entering into license and/or co-promotion arrangements for our
products and product candidates;
    Unfavorable or delayed announcements by us regarding clinical trial results or results
of operations, or favorable announcements by our competitors;
    Delays in meeting goals or performance milestones by us or our marketing partners;
    Comments made by securities analysts, including changes in, or failure to achieve,
financial estimates or milestones;
    Announcements 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; and
    Market and economic conditions. In addition, the market for biotechnology and pharmaceutical stocks has experienced significant
price and volume fluctuations that are frequently unrelated to operating performance. This price
volatility is often more pronounced for companies with a low stock price and a small market
capitalization, such as ours. These broad market and industry factors might seriously harm the
market price of our Class A common stock, regardless of our operating performance. A significant decline in our stock price, or other factors, could also result in our Class A common
stock being delisted from the American Stock Exchange and could result in litigation, including a
securities class action lawsuit. Such a lawsuit against us could result in substantial costs,
potential liabilities and the diversion of managements attention and resources. The Board of Directors currently has the authority to effect a reverse stock split within a stated
range. If implemented, the reverse stock split may negatively affect the price and liquidity of
our Class A common stock. At our 2004 Annual Meeting of Shareholders, the Board of Directors received the authority to
implement, within its discretion and for a period of one year, a reverse split of our Class A
common stock within a range of 1:2 to 1:12.5. Although this authority expires in March 2005, the
Board of Directors is seeking shareholder approval at the 2005 Annual Meeting Stockholders to renew
for another year the authority to effectuate the reverse stock split within a range of 1:2 to 1:5.
If the Board of Directors were to effect a reverse stock split, the price of our Class A common
stock may not continue at a level in proportion to the reduction in the number of outstanding
shares resulting from the reverse stock split. For example, if the Board of Directors decided to
implement a reverse stock split at a ratio of 1-for-5, the post-split market price of our Class A
common stock may not be at least five times greater than the pre-split price. Accordingly, the
total market capitalization of our Class A common stock after a reverse stock split, if
implemented, could be lower than the total market capitalization before the proposed reverse stock
split. Additionally, the liquidity of our Class A common stock could be affected adversely by the
reduced number of shares outstanding after the reverse stock split. 30




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Avanir
and its licensees may not be successful in obtaining regulatory approval of
docosanol 10% cream immediately as an OTC product in additional countries, or in licensing, marketing
and selling the product in any other countries. Currently, docosanol 10% cream is approved for sale in the United States, Canada, Korea, Israel,
Sweden, Spain and Portugal. We are currently seeking approval in various other countries in the
European Union and intend to seek approval in Japan. Avanir and its licensees face a
variety of risks in foreign countries in obtaining regulatory approval and in marketing and selling
docosanol 10% cream, including:  
    Regulatory approval requirements differ by country, and obtaining approvals to market
the drug in foreign countries may be difficult to obtain, may require additional costly and
time consuming clinical trials, or may require being a prescription drug first before
obtaining sufficient experience to warrant approval as an OTC product;
    Building product awareness of a new drug, whether prescription or OTC, among customers
or retail store decision makers may require a substantial amount of product promotion,
which does not guarantee success:
    Consumers may not perceive that docosanol 10% cream is superior to existing and
potentially new OTC products for oral herpes;
    Acceptance of docosanol 10% cream in the OTC consumer market may not be widespread; and
    Potential price erosion could occur due to competitive products and responses to our
products introduction. Foreign sales of docosanol 10% cream and other potential products are subject to various foreign
trade risks. Our license agreement with GlaxoSmithKline is for the United States and Canada. We also have
exclusive license agreements for docosanol 10% cream for approximately fourteen other countries.
We are holding discussions with other potential licensees for marketing and selling docosanol 10%
cream in other countries not already licensed. However, we may not finalize any license or
distribution arrangements for other territories on a timely basis or on favorable terms, if at all.
Further, our foreign licensees expose us to various foreign trade risks relating to development
and marketing of docosanol 10% cream. We may arrange for contracts in the future for the
manufacture, marketing and distribution of docosanol 10% cream overseas by foreign licensees, which
will be substantially outside our control. Even if we are able to obtain experienced licensees in
foreign markets, specific risks that could impact significantly our potential revenues on foreign
sale include:  
    Difficulties in obtaining regulatory approval of docosanol 10% cream in foreign countries;
    Changes in the regulatory and competitive environments in foreign countries;
    Changes in a specific countrys or regions political or economic conditions;
    War, terrorism or natural disasters;
    Difficulty in finding foreign partners with sufficient capital to effectively launch,
market and promote the product;
    Manufacturing and shipping delays;
    Difficulties in managing operations across disparate geographic areas;
    Fluctuations in foreign exchange rates;
    Prices of competitive products;
    Difficulties associated with enforcing agreements through foreign legal systems;
    Trade protection measures, including customs duties and export quotas; and
    Foreign tax withholding laws. 31




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Our inability to attract and retain key management and scientific personnel could negatively affect
our business. Our success depends on the performance of a small core staff of key management and scientific
employees with biotechnology and drug development experience. Given our small staff size and
programs currently under development, we depend substantially on our ability to hire, train, retain
and motivate high quality personnel, especially our scientists and management team in this field.
If we were to lose one or more of our key scientists, then we would likely lose some portion of our
institutional knowledge and technical know-how, potentially causing a substantial delay in one or
more of our development programs until adequate replacement personnel could be hired and trained.
Other than our chief executive officer, our executives do not have employment agreements. We do
not have key person life insurance policies for any of our executives. The industry in which we
compete has a high level of employee mobility and aggressive recruiting of skilled personnel. This
type of environment creates intense competition for qualified personnel, particularly in product
research and development, sales and marketing, and accounting and finance. 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. We rely substantially on the protection of our intellectual property through our ownership or
control of 95 issued patents and 303 patent applications. Patents and patent applications owned or
licensed by the Company include docosanol-related products and technologies, Neurodex, compounds
capable of regulating the target IgE in controlling symptoms of allergy and asthma, compounds
capable of regulating the target MIF in treatment of inflammatory diseases, compounds targeting
apolipoprotein A1 for the treatment of atherosclerosis, and Xenerex technologies for developing
monoclonal antibodies. Because of the competitive nature of the biopharmaceutical industry, we
cannot assure you that:  
    The claims in any pending patent applications will be allowed or that patents will be
granted;
    Present and future 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. Our inability to obtain or maintain patent protections for our products in foreign markets may
negatively affect our financial condition. The process for the approval of patent applications in foreign countries may differ significantly
from the process in the U.S. These differences may delay our plans to market and sell docosanol
10% cream and other products in the international marketplace. Approval in one country does not
indicate that approval will be obtained in other countries. The patent authorities in each country
administer that countrys laws and regulations relating to patents independently of the laws and
regulations of any other country and we must seek and obtain the patents separately. Our inability
to obtain or maintain patent protections for docosanol 10% cream and other products in foreign
markets would severely hamper our ability to generate international sales from these products. 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. We have utilized, and intend to continue utilizing, third parties to manufacture docosanol 10%
cream, Neurodex, active pharmaceutical ingredients, and supplies for our other drug candidates. We
have no 32




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experience in manufacturing and do not have any manufacturing facilities. Currently, we have only
a single supplier for the raw material docosanol and we do not have any long-term supply agreements
in place with this manufacturer. Although GlaxoSmithKline and we try to maintain strategic
reserves of the active pharmaceutical ingredient, docosanol, to help mitigate a short-term supply
disruption, any sustained disruption of our supply could harm our results of operations. 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. The nature of clinical trials and our business strategy of outsourcing a substantial portion of our
research require that we rely on clinical research centers and other contractors to assist us with
research and development and clinical testing activities. As a result, our success depends
partially on the success of these third parties in performing their responsibilities. Although we
pre-qualify our contractors and we believe that they will fully perform their contractual
obligations, we cannot directly control the adequacy and timeliness of the resources and expertise
that they apply to these activities. If our contractors do not perform their activities in an
adequate or timely manner, the development and commercialization of our drug candidates could be
delayed. Developing new pharmaceutical products for human use involves product liability risks, for which we
currently have limited insurance coverage. The testing, marketing, and sale of pharmaceutical products involves the risk of product liability
claims by consumers and other third parties. We maintain product liability insurance coverage for
our clinical trials in the amount of $5 million per incident and $5 million in the aggregate.
However, product liability claims can be high in the pharmaceutical industry and our insurance may
not sufficiently cover our actual liabilities. If a suit against our business or proposed products
is successful, then the lack of or insufficiency of insurance coverage could affect materially and
adversely our business and financial condition. Furthermore, various distributors of
pharmaceutical products require minimum product liability insurance coverage before their purchase
or acceptance of products for distribution. Failure to satisfy these insurance requirements could
impede our ability to achieve broad distribution of our proposed products. Abreva® faces competition from a number of existing and well-established products and the companies
that market these products. We have the opportunity to earn royalties on Abreva product wholesale sales if sales exceed $62
million a year. We estimate that wholesale sales reached
approximately 89% of the $62 million threshold in 2004.
Abreva competes with several other products for oral-facial herpes currently on the market in the
U.S., as well as other products or potential products that are or may be under development or
undergoing FDA review. Many of these products are well established and are marketed by large
pharmaceutical companies with substantial resources and significant marketing experience. As a
result of this competition, annual wholesales sales of Abreva may never reach a level where we will
participate in further royalty income from this product. Business interruptions could adversely affect our business. Our operations are vulnerable to interruption by fire, earthquake, power loss, telecommunications
failure, and other events beyond our control. For example, during 2001 and again in 2003, we
experienced electrical power outages lasting several hours. The loss of electrical power for any
significant periods of time could adversely affect our ability to conduct experiments and could
also harm our vendors. Further, we could lose valuable data made to date in experiments currently
underway. We have mitigated the severity of power losses by installing emergency power equipment,
which we have used on several 33




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occasions to supply electricity to the areas that we consider to be the most critical to our
operations. However, the emergency power units do not cover all of our electrical needs and,
further, they might not operate properly in the event of a power loss. Our future financial results will be affected by changes in the accounting rules governing the
recognition of stock-based compensation expense. We measure compensation expense for our employee stock compensation plans under the intrinsic value
method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for
Stock Issued to Employees. In addition, we provide pro forma disclosures of our operating results
in our Notes to Consolidated Financial Statements as if the fair value method of accounting had
been applied in accordance with SFAS No. 123, Accounting for Stock-Based Compensation. Had we
accounted for our compensation expense under the fair value method accounting prescribed by SFAS
No. 123, the charges would have been significantly higher, by approximately $1,003,000, $1,554,000
and $2,176,000 during fiscal 2004, 2003, and 2002, respectively. In October 2004, the Financial
Accounting Standards Board (the FASB) announced the planned effective date for proposed changes
to accounting rules concerning the recognition of stock option compensation expense to be the first
period beginning after June 15, 2005, or commencing with our fourth quarter in fiscal 2005. We and
other companies will be required to measure compensation expense using the fair value method, which
will adversely affect our results of operations by reducing our income or increasing our losses by
an amount equal to the difference in the two measurement methods. 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. The pharmaceutical and biotechnology industries are highly competitive and subject to significant
and rapid technological change. We compete with hundreds of companies that develop and market
products and technologies in similar areas as our research. Additionally, many physicians
prescribe medications for indications other than those for which a certain drug has been approved
(so called off-label use). For example, if the FDA approves Neurodex for marketing as a
treatment of PBA, physicians may continue prescribing other products in an off-label manner for the
treatment of this condition, including:  
    Antidepressants, such as ProzacÒ, CelexaÒ, ZoloftÒ, PaxilÒ,
ElavilÒ and PamelorÒ and others;
    Atypical antipsychotics agents, such as ZyprexaÒ, ResperdalÒ,
AbilifyÒ, GeodonÒ and others; and
    Other agents, such as SymmetrelÒ and Lithium Our competitors may have specific expertise and technologies that are better than ours and many of
these companies, either alone or together with their research partners, have substantially greater
financial resources, larger research and development staffs and substantially greater experience
than we do. Accordingly, our competitors may develop a competing product approved specifically for
the treatment of PBA. If we commence commercial sales for Neurodex, we may potentially be competing
with other companies and their products with respect to manufacturing efficiencies and marketing
capabilities, areas where we have limited or no direct experience. 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. Government authorities in the U.S., including the FDA, and other countries highly regulate the
development, production, testing, manufacturing and marketing of pharmaceutical products. The
clinical 34




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testing and regulatory approval process can take many years and requires the expenditure of
substantial resources. Failure to obtain, or delays in obtaining, these approvals will adversely
affect our business operations, including our ability to commence marketing of any of the proposed
products. We may find it necessary to use a significant portion of our financial resources for
research and development and the clinical trials necessary to obtain these approvals for our
proposed products. We will continue to incur costs of development without any assurance that we
will ever obtain regulatory approvals for any of our products under development. Additionally, we
cannot predict the extent to which adverse government regulations might arise from future U.S. or
foreign legislative or administrative actions. Moreover, we cannot predict with accuracy the
effects of any future changes in the regulatory approval process and in the domestic health care
system for which we develop our products, or the costs of on-going compliance regulations after
marketing approval has been obtained. Future changes could affect adversely the time frame required
for regulatory review, our financial resources, and the sales prices of our proposed products, if
approved for sale. Companies in our industry must protect their intellectual property rights and operate without
infringing on or misappropriating the proprietary rights of others. Our inability to do so could
be costly and could significantly affect our business prospects. Biotechnology companies such as Avanirrely heavily on intellectual property rights to
protect their innovations. Although we attempt to protect these rights by regularly filing patent
applications and requiring all employees to sign confidentiality agreements, we cannot assure you
that patents will be issued, that secrecy obligations will be honored, or that others will not
independently develop similar or superior technology. Additionally, if our consultants, key
employees or other third parties apply technological information independently developed by them or
by others to our projects, then disputes may arise as to the ownership rights of these innovations. Even if we successfully preserve our intellectual property rights, other biotechnology or
pharmaceutical companies may allege that our technology infringes on their rights. Intellectual
property litigation is costly, and even if we were to prevail in such a dispute, the cost of
litigation would adversely affect our business, financial condition and results of operations.
Litigation is also time consuming and would divert managements attention and resources away from
our operations and other activities. If we were not to prevail in any litigation, in addition to
any damages we would have to pay, we could be required to stop the infringing activity or obtain a
license. Any required license might not be available to us on acceptable terms, or at all. Some
licenses might be non-exclusive, and our competitors could have access to the same technology
licensed to us. If we were to fail to obtain a required license or were unable to design around a
competitors patent, we would be unable to sell or continue to develop some of our products, which
would have a material adverse effect on our business, financial condition and results of
operations. Companies in our industry are frequently subjected to product liability claims, which can be very
costly to defend against. In the ordinary course of business, biotechnology and pharmaceutical companies face various claims
brought by third parties, including claims relating to the safety or efficacy of products. Any of
these claims could subject us to costly litigation and, while we generally believe that we have
adequate insurance to cover many different types of liabilities, our insurance carriers may deny
coverage or our policy limits may be inadequate to fully satisfy any damage awards or settlements.
If this were to happen, the payment of any such awards could have a material adverse effect on our
operations and financial position. Additionally, any such claims, whether or not successful, could
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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK As described below, we are exposed to market risks related to changes in interest rates. Because
substantially all of our revenue, expenses, and capital purchasing activities are transacted in
U.S. dollars, our exposure to foreign currency exchange rates is immaterial. However, in the
future we could face increasing exposure to foreign currency exchange rates as we expand
international distribution of docosanol 10% cream and purchase additional services from outside the
U.S. Until such time as we are faced with material amounts of foreign currency exchange rate
risks, we do not plan to use derivative financial instruments, which can be used to hedge such
risks. We will evaluate the use of derivative financial instruments to hedge our exposure as the
needs and risks should arise. Interest rate sensitivity Our investment portfolio consists primarily of fixed income instruments with an average duration of
1.4 years as of December 31, 2004 (1.2 years as of September 30, 2004). The primary objective of
our investments in debt securities is to preserve principal while achieving attractive yields,
without significantly increasing risk. We classify our investments in securities as of December
31, 2004 as available-for-sale and our restricted investments in securities as held-to-maturity.
These available-for-sale securities are subject to interest rate risk. In general, we would expect
that the volatility of this portfolio would decrease as its duration decreases. Based on the
average duration of our investments as of December 31, 2004 and 2003, an increase of one percentage
point in the interest rates would have resulted in increases in comprehensive losses of
approximately $113,000 and $31,000, respectively. 
 Item 4. CONTROLS AND PROCEDURES With the participation of the principal executive officer and principal financial officer of
Avanir Pharmaceuticals (the Registrant), the Registrants management has evaluated the
effectiveness of the Companys disclosure controls and procedures (as defined in the Securities
Exchange Act of 1934, Rules 13a-15(e) and 15(d)-15(e)), as of the end of the period covered by this
report. Based on that evaluation, the Registrants principal executive officer and principal
financial officer have concluded that:  
    Information required to be disclosed by the Registrant in this Quarterly Report on Form
10-Q and the other reports that the Registrant files or submits under the Exchange Act
would be accumulated and communicated to the Registrants management, including its
principal executive officer and principal officer, as appropriate to allow timely decisions
regarding required disclosure;
    Information required to be disclosed by the Registrant in this Quarterly Report on Form
10-Q and the other reports that the Registrant files or submits under the Exchange Act
would be recorded, processed, summarized and reported within the time periods specific in
the SECs rules and forms; and
    The Registrants disclosure controls and procedures are effective as of the end of the
period covered by this Quarterly Report on Form 10-Q to ensure that material information
relating to the Registrant and its consolidated subsidiary is made known to them,
particularly during the period in which the Registrants periodic reports, including this
Quarterly Report on Form 10-Q, are being prepared. Additionally, there were no changes in the Registrants internal control over financial reporting
(as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the Registrants fiscal
quarter ended December 31, 2004, that have materially affected, or are reasonably likely to
materially affect the Registrants internal control over financial reporting. 36




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PART II OTHER INFORMATION Items 1-5. NOT APPLICABLE 
 Item 6. EXHIBITS Exhibits 15.0
    
    
    Letter on unaudited interim financial information31.1
    
    
    Certification pursuant to Section 302 of Sarbanes-Oxley Act of 200231.2
    
    
    Certification pursuant to Section 302 of Sarbanes-Oxley Act of 200232.1
    
    
    Certification pursuant to Section 906 of Sarbanes-Oxley Act of 200232.2
    
    
    Certification pursuant to Section 906 of Sarbanes-Oxley Act of 2002
 37




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Signature
    
    Title
    
    Date/s/ Gerald J. Yakatan, Ph.D.
    
    President and Chief
    
    February 9, 2005Executive OfficerGerald J. Yakatan, Ph.D.
    
    (Principal Executive Officer)/s/Gregory P. Hanson, CMA
    
    Vice President, Finance and Chief
    
    February 9, 2005Financial OfficerGregory P. Hanson, CMA
    
    (Principal Financial and Accounting Officer)
 38




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EXHIBIT INDEX Exhibit No.
    
    Description15.0
    
    Letter on unaudited financial information31.1
    
    Certification pursuant to Section 302 of Sarbanes-Oxley Act of 200231.2
    
    Certification pursuant to Section 302 of Sarbanes-Oxley Act of 200232.1
    
    Certification pursuant to Section 906 of Sarbanes-Oxley Act of 200232.2
    
    Certification pursuant to Section 906 of Sarbanes-Oxley Act of 2002
 39