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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549


FORM 10-Q

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|           |  |                                                    
|---------- |  | ---------------------------------------------------
|(Mark One)
|[X]        |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
|           |  | THE SECURITIES EXCHANGE ACT OF 1934.               

For the quarterly period ended June 30, 2003

OR

|      |  |                                                     
|----- |  | ----------------------------------------------------
|[   ] |  | 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. 0-18734

AVANIR PHARMACEUTICALS

(Exact name of registrant as specified in its charter)


|                                |  |                                     
|------------------------------- |  | ------------------------------------
|California                      |  | 33-0314804                          
|(State or other jurisdiction of |  | (I.R.S. Employer Identification No.)
|incorporation or organization)  |  |                                     

|                                                             |  |           
|------------------------------------------------------------ |  | ----------
|11388 Sorrento Valley Road, Suite 200, 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 [X] NO [   ]

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

The number of shares of Common Stock of the registrant issued and outstanding
as of August 4, 2003:

|                                   |  |  |            | 
|---------------------------------- |  |  | ---------- | 
|Class A Common stock, no par value |  |  | 65,816,434 | 
|Class B Common stock, no par value |  |  | 13,500     | 



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TABLE OF CONTENTS



|                              |                                                                                               |                                            |  |  |  |  |  | 
|----------------------------- | --------------------------------------------------------------------------------------------- | ------------------------------------------ |  |  |  |  |  | 
|PART I. FINANCIAL INFORMATION
|                              | Item 1. FINANCIAL STATEMENTS                                                                 
|                              |                                                                                               | INDEPENDENT ACCOUNTANTS REPORT           
|                              |                                                                                               | CONSOLIDATED BALANCE SHEETS               
|                              |                                                                                               | CONSOLIDATED STATEMENTS OF OPERATIONS     
|                              |                                                                                               | CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                              |                                                                                               | NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|                              | Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|                              | Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                           
|                              | Item 4. CONTROLS AND PROCEDURES                                                              
|PART II. OTHER INFORMATION   
|                              | Item 6. EXHIBITS AND REPORTS ON FORM 8-K                                                     
|SIGNATURES                   
|EXHIBIT INDEX                
|EXHIBIT 15                   
|EXHIBIT 31.1                 
|EXHIBIT 31.2                 
|EXHIBIT 32.1                 
|EXHIBIT 32.2                 



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##### Table of Contents



Table of Contents

|         |  |                                                                                       |  |  |    |      |  | 
|-------- |  | ------------------------------------------------------------------------------------- |  |  | -- | ---- |  | 
|         |  |                                                                                       |  |  |    | Page
|         |  |                                                                                       |  |  |    |     
|PART I.  |  | FINANCIAL INFORMATION                                                                 |  |  |    |     
|Item 1.  |  | Financial Statements                                                                  |  |  |    |     
|         |  | Independent
Accountants Report                                                       |  |  | 3  |     
|         |  | Consolidated Balance Sheets                                                           |  |  | 4  |     
|         |  | Consolidated Statements of Operations                                                 |  |  | 5  |     
|         |  | Consolidated Statements of Cash Flows                                                 |  |  | 6  |     
|         |  | Notes to Consolidated Financial Statements                                            |  |  | 7  |     
|Item 2.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  |  | 16 |     
|Item 3.  |  | Quantitative and Qualitative Disclosures about Market Risk                            |  |  | 34 |     
|Item 4.  |  | Controls and Procedures                                                               |  |  | 34 |     
|PART II. |  | OTHER INFORMATION                                                                     |  |  |    |     
|Item 6.  |  | Exhibits and Reports on Form 8-K                                                      |  |  | 34 |     

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##### Table of Contents






PART I. FINANCIAL INFORMATION




Item 1. FINANCIAL STATEMENTS




INDEPENDENT ACCOUNTANTS REPORT

Board of Directors and Shareholders
AVANIR Pharmaceuticals

We have reviewed the accompanying consolidated balance sheet of AVANIR
Pharmaceuticals (the Company) and subsidiary as of June 30, 2003 and the related consolidated
statements of operations and cash flows for the three-month and nine-month
periods ended June 30, 2003 and 2002. These interim financial statements are the
responsibility of the Companys management.

We conducted our review in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures to
financial data and of making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an audit conducted
in accordance with auditing standards generally accepted in the United States
of America, 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 review, we are not aware of any material modifications that should
be made to such 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 auditing standards generally
accepted in the United States of America, the consolidated balance sheet of the
Company as of September 30, 2002 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 24, 2002, we expressed an
unqualified opinion on those financial statements. In our opinion, the
information set forth in the accompanying consolidated balance sheet as of
September 30, 2002 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
August 6, 2003

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AVANIR PHARMACEUTICALS




CONSOLIDATED BALANCE SHEETS (UNAUDITED)

|                                               |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |               |            |            |            | 
|---------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------ | ------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------ | ------------------------------------ | ---------- | ---------- | ---------- | ------------- | ---------- | ---------- | ---------- | 
|                                               |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            | June 30,   |            | September 30,
|                                               |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            | 2003       |            | 2002         
|                                               |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |              
|ASSETS                                         |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |              
|Current assets:                                |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |              
|                                               | Cash and cash equivalents                                                                                                                        |                           | $                                                                                                                                                            | 12,291,647                           |            |            | $          | 8,630,547     |           
|                                               | Short-term investments in securities                                                                                                             |                           |                                                                                                                                                              | 1,203,954                            |            |            |            | 695,840       |           
|                                               | Receivables, net                                                                                                                                 |                           |                                                                                                                                                              | 126,919                              |            |            |            | 1,098,954     |           
|                                               | Inventory                                                                                                                                        |                           |                                                                                                                                                              | 210,854                              |            |            |            | 238,126       |           
|                                               | Prepaid expenses                                                                                                                                 |                           |                                                                                                                                                              | 838,086                              |            |            |            | 683,111       |           
|                                               |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |              
|                                               |                                                                                                                                                  | Total current assets      |                                                                                                                                                              |                                      | 14,671,460 |            |            |               | 11,346,578 |           
|Investments in securities                      |                                                                                                                                                  |                           | 704,695                                                                                                                                                      |                                      |            |            | 2,986,023  |              
|Restricted investments                         |                                                                                                                                                  |                           | 856,597                                                                                                                                                      |                                      |            |            | 856,597    |              
|Property and equipment, net                    |                                                                                                                                                  |                           | 7,798,651                                                                                                                                                    |                                      |            |            | 3,180,966  |              
|Intangible assets, net                         |                                                                                                                                                  |                           | 1,925,681                                                                                                                                                    |                                      |            |            | 1,659,418  |              
|Other assets                                   |                                                                                                                                                  |                           | 342,762                                                                                                                                                      |                                      |            |            | 303,347    |              
|                                               |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |              
|                                               | TOTAL ASSETS                                                                                                                                     |                           | $                                                                                                                                                            | 26,299,846                           |            |            | $          | 20,332,929    |           
|                                               |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |               |           
|LIABILITIES
AND SHAREHOLDERS EQUITY (DEFICIT) |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |              
|Current liabilities:                           |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |              
|                                               | Accounts payable                                                                                                                                 |                           | $                                                                                                                                                            | 2,067,406                            |            |            | $          | 2,705,606     |           
|                                               | Accrued expenses and other liabilities                                                                                                           |                           |                                                                                                                                                              | 1,642,557                            |            |            |            | 1,598,625     |           
|                                               | Accrued compensation and payroll taxes                                                                                                           |                           |                                                                                                                                                              | 439,146                              |            |            |            | 462,118       |           
|                                               | Loan payable                                                                                                                                     |                           |                                                                                                                                                              |                                     |            |            |            | 299,980       |           
|                                               | Current portion of deferred revenue                                                                                                              |                           |                                                                                                                                                              | 1,794,745                            |            |            |            | 233,333       |           
|                                               | Current portion of capital lease obligations                                                                                                     |                           |                                                                                                                                                              | 138,492                              |            |            |            | 128,833       |           
|                                               |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |              
|                                               |                                                                                                                                                  | Total current liabilities |                                                                                                                                                              |                                      | 6,082,346  |            |            |               | 5,428,495  |           
|                                               | Deferred revenue, net of current portion                                                                                                         |                           |                                                                                                                                                              | 21,350,232                           |            |            |            |              |           
|                                               | Capital lease obligations, net of current portion                                                                                                |                           |                                                                                                                                                              | 229,438                              |            |            |            | 323,764       |           
|                                               |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |              
|                                               |                                                                                                                                                  | Total liabilities         |                                                                                                                                                              |                                      | 27,662,016 |            |            |               | 5,752,259  |           
|                                               |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |              
|CONTINGENCIES (Note 13)                        |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |              
|REDEEMABLE CONVERTIBLE PREFERRED STOCK         |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |              
|                                               | Series D
 no par value, 500 shares authorized; no and 50 shares
issued and outstanding as of June 30, 2003 and
September 30, 2002, respectively |                           |                                                                                                                                                              |                                     |            |            |            | 521,189       |           
|                                               |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |              
|SHAREHOLDERS
EQUITY (DEFICIT)                 |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |              
|                                               | Preferred stock  no par value, 9,999,500 shares authorized:                                                                                     |                           |                                                                                                                                                              |                                      |            |            |            |               |           
|                                               |                                                                                                                                                  |                           | Series C Junior Participating - 1,000,000 shares
authorized; no shares issued or outstanding                                                                 |                                      |            |           |            |               |            |           |           
|                                               | Common stock  no par value:                                                                                                                     |                           |                                                                                                                                                              |                                      |            |            |            |               |           
|                                               |                                                                                                                                                  |                           | Class A - 99,288,000 shares authorized; 59,088,038
and 58,270,533 shares issued and outstanding as of
June 30, 2003 and September 30, 2002, respectively     |                                      |            | 87,872,865 |            |               |            | 87,053,257 |           
|                                               |                                                                                                                                                  |                           | Class B - 712,000 shares authorized; 13,500 shares
issued and outstanding as of June 30, 2003 and
September 30, 2002 (convertible into Class A common
stock) |                                      |            | 8,395      |            |               |            | 8,395      |           
|                                               | Accumulated deficit                                                                                                                              |                           |                                                                                                                                                              | (89,260,062                          | )          |            |            | (73,002,878   | )         
|                                               | Accumulated other comprehensive income                                                                                                           |                           |                                                                                                                                                              | 16,632                               |            |            |            | 707           |           
|                                               |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |              
|                                               |                                                                                                                                                  |                           |                                                                                                                                                              | Total shareholders equity (deficit) |            |            | (1,362,170 | )             |            |            | 14,059,481 | 
|                                               |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |              
|                                               | TOTAL LIABILITIES AND SHAREHOLDERS EQUITY (DEFICIT)                                                                                             |                           | $                                                                                                                                                            | 26,299,846                           |            |            | $          | 20,332,929    |           
|                                               |                                                                                                                                                  |                           |                                                                                                                                                              |                                      |            |            |            |               |           

See notes to consolidated financial statements.

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AVANIR PHARMACEUTICALS

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

|                                                      |                                                                         |                          |            |                    |           |                   |            |            |           |      |             |             |            |   |            |            |            | 
|----------------------------------------------------- | ----------------------------------------------------------------------- | ------------------------ | ---------- | ------------------ | --------- | ----------------- | ---------- | ---------- | --------- | ---- | ----------- | ----------- | ---------- | - | ---------- | ---------- | ---------- | 
|                                                      |                                                                         |                          |            | Three months ended |           | Nine months ended
|                                                      |                                                                         |                          |            | June 30,           |           | June 30,         
|                                                      |                                                                         |                          |            |                    |           |                  
|                                                      |                                                                         |                          |            | 2003               |           | 2002              |            | 2003       |           | 2002
|                                                      |                                                                         |                          |            |                    |           |                   |            |            |           |     
|REVENUES:                                             |                                                                         |                          |            |                    |           |                   |            |            |           |      |             |             |            |   |            |           
|                                                      | Research contracts and licenses                                         |                          | $          |                   |           |                   | $          | 5,000      |           |      | $           | 50,000      |            |   | $          | 5,089,167  |           
|                                                      | Royalties and sale of royalty rights                                    |                          |            | 302,741            |           |                   |            | 763,851    |           |      |             | 1,377,486   |            |   |            | 2,547,151  |           
|                                                      | Government research grants                                              |                          |            | 95,481             |           |                   |            | 27,129     |           |      |             | 394,085     |            |   |            | 28,255     |           
|                                                      | Product sales                                                           |                          |            |                   |           |                   |            | 23,360     |           |      |             | 17,400      |            |   |            | 23,360     |           
|                                                      |                                                                         |                          |            |                    |           |                   |            |            |           |      |             |             |            |   |            |            |           
|                                                      |                                                                         | Total revenues           |            |                    | 398,222   |                   |            |            | 819,340   |      |             |             | 1,838,971  |   |            |            | 7,687,933  | 
|                                                      |                                                                         |                          |            |                    |           |                   |            |            |           |      |             |             |            |   |            |           
|OPERATING EXPENSES:                                   |                                                                         |                          |            |                    |           |                   |            |            |           |      |             |             |            |   |            |           
|                                                      | Research and development                                                |                          |            | 4,523,860          |           |                   |            | 4,119,526  |           |      |             | 12,995,762  |            |   |            | 9,631,293  |           
|                                                      | General and administrative                                              |                          |            | 1,185,881          |           |                   |            | 1,343,075  |           |      |             | 3,477,765   |            |   |            | 3,376,114  |           
|                                                      | Sales and marketing                                                     |                          |            | 727,465            |           |                   |            | 392,881    |           |      |             | 1,758,933   |            |   |            | 1,073,678  |           
|                                                      | Cost of product sales                                                   |                          |            |                   |           |                   |            | 4,731      |           |      |             | 3,102       |            |   |            | 4,731      |           
|                                                      |                                                                         |                          |            |                    |           |                   |            |            |           |      |             |             |            |   |            |            |           
|                                                      |                                                                         | Total operating expenses |            |                    | 6,437,206 |                   |            |            | 5,860,213 |      |             |             | 18,235,562 |   |            |            | 14,085,816 | 
|                                                      |                                                                         |                          |            |                    |           |                   |            |            |           |      |             |             |            |   |            |           
|LOSS FROM OPERATIONS                                  |                                                                         |                          | (6,038,984 | )                  |           |                   | (5,040,873 | )          |           |      | (16,396,591 | )           |            |   | (6,397,883 | )         
|                                                      | Interest income                                                         |                          |            | 49,375             |           |                   |            | 150,833    |           |      |             | 202,525     |            |   |            | 519,659    |           
|                                                      | Other income                                                            |                          |            | 8,060              |           |                   |            | 8,649      |           |      |             | 19,919      |            |   |            | 95,597     |           
|                                                      | Interest expense                                                        |                          |            | (11,113            | )         |                   |            | (13,874    | )         |      |             | (34,448     | )          |   |            | (46,717    | )         
|                                                      |                                                                         |                          |            |                    |           |                   |            |            |           |      |             |             |            |   |            |           
|LOSS BEFORE INCOME TAXES                              |                                                                         |                          | (5,992,662 | )                  |           |                   | (4,895,265 | )          |           |      | (16,208,595 | )           |            |   | (5,829,344 | )         
|                                                      | Provision for income taxes                                              |                          |            | (36,766            | )         |                   |            |           |           |      |             | (36,766     | )          |   |            |           |           
|                                                      |                                                                         |                          |            |                    |           |                   |            |            |           |      |             |             |            |   |            |           
|NET LOSS                                              |                                                                         | $                        | (6,029,428 | )                  |           | $                 | (4,895,265 | )          |           | $    | (16,245,361 | )           |            | $ | (5,829,344 | )         
|                                                      |                                                                         |                          |            |                    |           |                   |            |            |           |      |             |             |            |   |            |           
|NET LOSS ATTRIBUTABLE TO COMMON
SHAREHOLDERS:         |                                                                         |                          |            |                    |           |                   |            |            |           |      |             |             |            |   |            |           
|                                                      | Net loss                                                                |                          | $          | (6,029,428         | )         |                   | $          | (4,895,265 | )         |      | $           | (16,245,361 | )          |   | $          | (5,829,344 | )         
|                                                      | Dividends on redeemable convertible
preferred stock                     |                          |            | (3,622             | )         |                   |            | (6,250     | )         |      |             | (16,122     | )          |   |            | (18,750    | )         
|                                                      | Accretion of discount related to
redeemable convertible preferred
stock |                          |            | (2,705             | )         |                   |            | (4,559     | )         |      |             | (11,823     | )          |   |            | (13,677    | )         
|                                                      |                                                                         |                          |            |                    |           |                   |            |            |           |      |             |             |            |   |            |            |           
|NET LOSS ATTRIBUTABLE TO COMMON
SHAREHOLDERS          |                                                                         | $                        | (6,035,755 | )                  |           | $                 | (4,906,074 | )          |           | $    | (16,273,306 | )           |            | $ | (5,861,771 | )         
|                                                      |                                                                         |                          |            |                    |           |                   |            |            |           |      |             |             |            |   |            |            |           
|NET LOSS PER SHARE:                                   |                                                                         |                          |            |                    |           |                   |            |            |           |      |             |             |            |   |            |           
|                                                      | BASIC AND DILUTED                                                       |                          | $          | (0.10              | )         |                   | $          | (0.08      | )         |      | $           | (0.28       | )          |   | $          | (0.10      | )         
|                                                      |                                                                         |                          |            |                    |           |                   |            |            |           |      |             |             |            |   |            |           
|WEIGHTED AVERAGE NUMBER OF COMMON SHARES
OUTSTANDING: |                                                                         |                          |            |                    |           |                   |            |            |           |      |             |             |            |   |            |           
|                                                      | BASIC AND DILUTED                                                       |                          |            | 58,741,635         |           |                   |            | 58,275,445 |           |      |             | 58,463,328  |            |   |            | 58,180,998 |           
|                                                      |                                                                         |                          |            |                    |           |                   |            |            |           |      |             |             |            |   |            |           

See notes to consolidated financial statements.

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AVANIR PHARMACEUTICALS




CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

|                                                                         |                                                                                            |   |                                                                                       |                                                      |   |                   |            |            |   |           |            |  
|------------------------------------------------------------------------ | ------------------------------------------------------------------------------------------ | - | ------------------------------------------------------------------------------------- | ---------------------------------------------------- | - | ----------------- | ---------- | ---------- | - | --------- | ---------- | -
|                                                                         |                                                                                            |   |                                                                                       |                                                      |   | Nine Months Ended
|                                                                         |                                                                                            |   |                                                                                       |                                                      |   | June 30,         
|                                                                         |                                                                                            |   |                                                                                       |                                                      |   |                  
|                                                                         |                                                                                            |   |                                                                                       |                                                      |   | 2003              |            | 2002      
|                                                                         |                                                                                            |   |                                                                                       |                                                      |   |                   |            |           
|OPERATING ACTIVITIES:                                                    |                                                                                            |   |                                                                                       |                                                      |   |                   |            |           
|                                                                         | Net loss                                                                                   |   | $                                                                                     | (16,245,361                                          | ) |                   | $          | (5,829,344 | )
|                                                                         | Adjustments to reconcile net loss to net cash provided by
(used for) operating activities: |   |                                                                                       |                                                      |   |                   |            |            |  
|                                                                         | Depreciation and amortization                                                              |   |                                                                                       | 672,980                                              |   |                   |            | 424,142    |  
|                                                                         | Compensation paid with common stock and stock options                                      |   |                                                                                       | 213,749                                              |   |                   |            | 133,947    |  
|                                                                         | Loss on disposal of assets                                                                 |   |                                                                                       | 1,896                                                |   |                   |            | 485        |  
|                                                                         | Intangible assets abandoned                                                                |   |                                                                                       | 74,432                                               |   |                   |            |           |  
|                                                                         | Changes in assets and liabilities:                                                         |   |                                                                                       |                                                      |   |                   |            |            |  
|                                                                         |                                                                                            |   | Receivables, net                                                                      |                                                      |   | 972,035           |            |            |   | 1,743     |           
|                                                                         |                                                                                            |   | Inventory                                                                             |                                                      |   | 27,272            |            |            |   | 8,629     |           
|                                                                         |                                                                                            |   | Prepaid expenses and other assets                                                     |                                                      |   | (194,390          | )          |            |   | 63,933    |           
|                                                                         |                                                                                            |   | Accounts payable                                                                      |                                                      |   | (638,200          | )          |            |   | 1,276,317 |           
|                                                                         |                                                                                            |   | Accrued expenses and other liabilities                                                |                                                      |   | 43,928            |            |            |   | 783,771   |           
|                                                                         |                                                                                            |   | Accrued compensation and payroll taxes                                                |                                                      |   | (22,972           | )          |            |   | 1,734     |           
|                                                                         |                                                                                            |   | Deferred revenue                                                                      |                                                      |   | 22,911,644        |            |            |   |          |           
|                                                                         |                                                                                            |   |                                                                                       |                                                      |   |                   |            |           
|                                                                         |                                                                                            |   |                                                                                       | Net cash provided by (used for) operating activities |   |                   | 7,817,013  |            |   |           | (3,134,643 | )
|                                                                         |                                                                                            |   |                                                                                       |                                                      |   |                   |            |           
|INVESTING ACTIVITIES:                                                    |                                                                                            |   |                                                                                       |                                                      |   |                   |            |           
|                                                                         | Investments in securities                                                                  |   |                                                                                       | (710,861                                             | ) |                   |            | (8,577,566 | )
|                                                                         | Proceeds from sales and maturities of investments in securities                            |   |                                                                                       | 2,500,000                                            |   |                   |            | 3,875,000  |  
|                                                                         | Patent costs                                                                               |   |                                                                                       | (392,741                                             | ) |                   |            | (455,929   | )
|                                                                         | Purchases of property and equipment                                                        |   |                                                                                       | (5,240,514                                           | ) |                   |            | (693,739   | )
|                                                                         |                                                                                            |   |                                                                                       |                                                      |   |                   |            |           
|                                                                         |                                                                                            |   |                                                                                       | Net cash used for investing activities               |   |                   | (3,844,116 | )          |   |           | (5,852,234 | )
|                                                                         |                                                                                            |   |                                                                                       |                                                      |   |                   |            |           
|FINANCING ACTIVITIES:                                                    |                                                                                            |   |                                                                                       |                                                      |   |                   |            |           
|                                                                         | Proceeds from issuance of common stock                                                     |   |                                                                                       | 85,350                                               |   |                   |            | 260,574    |  
|                                                                         | Dividends paid on preferred stock                                                          |   |                                                                                       | (12,500                                              | ) |                   |            | (18,750    | )
|                                                                         | Payments on loans and capital lease obligations                                            |   |                                                                                       | (384,647                                             | ) |                   |            | (271,039   | )
|                                                                         |                                                                                            |   |                                                                                       |                                                      |   |                   |            |            |  
|                                                                         |                                                                                            |   |                                                                                       | Net cash used for financing activities               |   |                   | (311,797   | )          |   |           | (29,215    | )
|                                                                         |                                                                                            |   |                                                                                       |                                                      |   |                   |            |            |  
|Net increase (decrease) in cash and cash equivalents                     |                                                                                            |   | 3,661,100                                                                             |                                                      |   |                   | (9,016,092 | )         
|Cash and cash equivalents at beginning of period                         |                                                                                            |   | 8,630,547                                                                             |                                                      |   |                   | 16,542,545 |           
|                                                                         |                                                                                            |   |                                                                                       |                                                      |   |                   |            |            |  
|Cash and cash equivalents at end of period                               |                                                                                            | $ | 12,291,647                                                                            |                                                      |   | $                 | 7,526,453  |           
|                                                                         |                                                                                            |   |                                                                                       |                                                      |   |                   |            |            |  
|SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:                       |                                                                                            |   |                                                                                       |                                                      |   |                   |            |           
|                                                                         |                                                                                            |   | Interest paid                                                                         |                                                      | $ | 34,448            |            |            | $ | 46,717    |           
|                                                                         |                                                                                            |   | Income
taxes paid                                                                     |                                                      | $ | 91,600            |            |            | $ | 1,600     |           
|SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND FINANCING
ACTIVITIES: |                                                                                            |   |                                                                                       |                                                      |   |                   |            |           
|                                                                         |                                                                                            |   | Acquisition of equipment under capital leases                                         |                                                      | $ |                  |            |            | $ | 122,662   |           
|                                                                         |                                                                                            |   | Conversion
of Series D redeemable convertible preferred stock to Class A common stock |                                                      | $ | 536,630           |            |            | $ |          |           

See notes to consolidated financial statements.

6



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##### Table of Contents



AVANIR PHARMACEUTICALS




NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS (UNAUDITED)



|1. |  | BASIS OF PRESENTATION
|-- |  | ---------------------

AVANIR Pharmaceuticals (AVANIR, we or the Company) has prepared the
unaudited 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 footnote 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
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, 2002. In our opinion, all
adjustments (consisting only of normal recurring adjustments) necessary to
present a fair statement of our financial position as of June 30, 2003 and
September 30, 2002, and the results of operations for the three-month and
nine-month periods ended June 30, 2003 and 2002, have been made. The results
of operations for the three-month and nine-month periods ended June 30, 2003
are not necessarily indicative of the results for the fiscal year ending
September 30, 2003 or any future periods.



|2. |  | STOCK-BASED COMPENSATION
|-- |  | ------------------------

In December 2002, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 148 (SFAS No. 148),
Accounting for Stock-based Compensation  Transition and Disclosure, an
Amendment of FASB Statement No. 123. SFAS No. 148 amends the disclosure
requirements of SFAS No. 123 to require prominent disclosures in both annual
and interim financial reports about the method of accounting for stock-based
compensation and the effect of the method used on reported results. SFAS No.
123, as amended, encourages, but does not require, companies to record
compensation cost for stock-based employee compensation at fair value. The
Company has chosen to continue to account for stock-based compensation using
the intrinsic value method prescribed in Accounting Principles Board (APB)
Opinion No. 25, Accounting for Stock Issued to Employees, and related
interpretations for all periods presented. Accordingly, compensation costs for
stock options is 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 June 30, |            | Nine Months Ended June 30,
|                                                                                                                |                                 |                                                        |            |                             |            |                           
|                                                                                                                |                                 |                                                        |            | 2003                        |            | 2002                       |            | 2003  |            | 2002
|                                                                                                                |                                 |                                                        |            |                             |            |                            |            |       |            |     
|Net loss attributable to common
shareholders, as reported                                                       |                                 | $                                                      | (6,035,755 | )                           |            | $                          | (4,906,074 | )     |            | $    | (16,273,306 | )     |             | $ | (5,861,771 | )    
|Add: Stock-based employee
compensation included in
reported net loss attributable
to common shareholders        |                                 |                                                        | 29,343     |                             |            |                            | 42,966     |       |            |      | 205,086     |       |             |   | 128,898    |      
|Deduct: Total stock-based
employee compensation expense
determined under fair value
based method for all awards |                                 |                                                        | (386,189   | )                           |            |                            | (529,975   | )     |            |      | (1,444,397  | )     |             |   | (1,850,384 | )    
|                                                                                                                |                                 |                                                        |            |                             |            |                            |            |       |            |      |             |       |             |   |            |      
|                                                                                                                |                                 | Pro forma net loss
attributable to common
shareholders |            | $                           | (6,392,601 | )                          |            | $     | (5,393,083 | )    |             | $     | (17,512,617 | ) |            | $     | (7,583,257 | )
|                                                                                                                |                                 |                                                        |            |                             |            |                            |            |       |            |      |             |       |             |   |            |      
|Net loss per share:                                                                                             |                                 |                                                        |            |                             |            |                            |            |       |            |      |             |       |             |   |            |      
|                                                                                                                | Basic and diluted  as reported |                                                        | $          | (0.10                       | )          |                            | $          | (0.08 | )          |      | $           | (0.28 | )           |   | $          | (0.10 | )         
|                                                                                                                | Basic and diluted  pro forma   |                                                        | $          | (0.11                       | )          |                            | $          | (0.09 | )          |      | $           | (0.30 | )           |   | $          | (0.13 | )         

7



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##### Table of Contents



The Company accounts for stock options granted to non-employees using the fair
value method. Compensation expense for options granted to non-employees has
been determined in accordance with Emerging Issues Task Force (EITF) No.
96-18, Accounting for Equity Instruments That Are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling, Goods or Services, as
the fair value of the consideration received or the fair value of the equity
instruments issued, whichever is more reliably measurable.



|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.

Receivables. Receivables consist of the following:

|            |  |               |         |                    |  |     |        |       |  |          |         |               |  |   |           |  |  |   |   |  |  |   |           | 
|----------- |  | ------------- | ------- | ------------------ |  | --- | ------ | ----- |  | -------- | ------- | ------------- |  | - | --------- |  |  | - | - |  |  | - | --------- | 
|            |  | June 30, 2003 |         | September 30, 2002
|            |  |               |         |                   
|            |  | Gross         |         | Allowance for      |  |     |        |       |  | Gross    |         | Allowance for |  |   |           | 
|            |  | Carrying      |         | Doubtful           |  |     |        |       |  | Carrying |         | Doubtful      |  |   |           | 
|            |  | Value         |         | Accounts           |  | Net |        | Value |  | Accounts |         | Net          
|            |  |               |         |                    |  |     |        |       |  |          |         |              
|Receivables |  | $             | 132,291 |                    |  | $   | (5,372 | )     |  | $        | 126,919 |               |  | $ | 1,098,954 |  |  | $ |  |  |  | $ | 1,098,954 | 
|            |  |               |         |                    |  |     |        |       |  |          |         |               |  |   |           |  |  |   |   |  |  |   |           | 

Property and Equipment.During
the three months ended June 30, 2003, the Company
completed construction on approximately 31,700 square feet of
laboratory and office space, located at 11388 and 11750 Sorrento
Valley Road, San Diego, CA.
At the time of completion of construction, $3.9 million that was classified as
construction in progress was reclassified as leasehold improvements. Property
and equipment as of June 30, 2003 and September 30, 2002 consist of the
following:

|                                          |                              |   |               |           |                    |   |            |            |       |   |              |           |             |   |           |           |  |   |          |            |   |   |           |           | 
|----------------------------------------- | ---------------------------- | - | ------------- | --------- | ------------------ | - | ---------- | ---------- | ----- | - | ------------ | --------- | ----------- | - | --------- | --------- |  | - | -------- | ---------- | - | - | --------- | --------- | 
|                                          |                              |   | June 30, 2003 |           | September 30, 2002
|                                          |                              |   |               |           |                   
|                                          |                              |   | Gross         |           |                    |   |            |            |       |   |              |           | Gross       |   |           |           |  |   |          |            |  
|                                          |                              |   | Carrying      |           | Accumulated        |   |            |            |       |   | Carrying     |           | Accumulated |   |           |           | 
|                                          |                              |   | Value         |           | Depreciation       |   | Net        |            | Value |   | Depreciation |           | Net        
|                                          |                              |   |               |           |                    |   |            |            |       |   |              |           |            
|Research and
development equipment        |                              | $ | 3,267,262     |           |                    | $ | (1,176,212 | )          |       | $ | 2,091,050    |           |             | $ | 2,420,028 |           |  | $ | (867,991 | )          |   | $ | 1,552,037 |          
|Computer equipment and
related software   |                              |   | 1,090,533     |           |                    |   | (348,436   | )          |       |   | 742,097      |           |             |   | 851,952   |           |  |   | (238,199 | )          |   |   | 613,753   |          
|Leasehold improvements                    |                              |   | 4,771,523     |           |                    |   | (325,987   | )          |       |   | 4,445,536    |           |             |   | 866,318   |           |  |   | (175,410 | )          |   |   | 690,908   |          
|Office equipment,
furniture, and
fixtures |                              |   | 456,108       |           |                    |   | (166,227   | )          |       |   | 289,881      |           |             |   | 254,731   |           |  |   | (128,557 | )          |   |   | 126,174   |          
|Construction in
progress                  |                              |   | 230,087       |           |                    |   |           |            |       |   | 230,087      |           |             |   | 198,094   |           |  |   |         |            |   |   | 198,094   |          
|                                          |                              |   |               |           |                    |   |            |            |       |   |              |           |             |   |           |           |  |   |          |            |   |   |           |          
|                                          | Total property and
equipment |   | $             | 9,815,513 |                    |   | $          | (2,016,862 | )     |   | $            | 7,798,651 |             |   | $         | 4,591,123 |  |   | $        | (1,410,157 | ) |   | $         | 3,180,966 | 
|                                          |                              |   |               |           |                    |   |            |            |       |   |              |           |             |   |           |           |  |   |          |            |   |   |           |          

Intangible Assets.Effective October 1, 2002, the Company adopted SFAS No.
142, Goodwill and Other Intangible Assets, which 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 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 and
nine-month periods ended June 30, 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

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##### Table of Contents



Impairment or Disposal of Long-lived Assets. 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, are as follows:

|                                               |                             |   |               |           |                    |   |          |          |       |   |              |           |             |   |           |         |  |   |          |          |   |   |           |         | 
|---------------------------------------------- | --------------------------- | - | ------------- | --------- | ------------------ | - | -------- | -------- | ----- | - | ------------ | --------- | ----------- | - | --------- | ------- |  | - | -------- | -------- | - | - | --------- | ------- | 
|                                               |                             |   | June 30, 2003 |           | September 30, 2002
|                                               |                             |   |               |           |                   
|                                               |                             |   | Gross         |           |                    |   |          |          |       |   |              |           | Gross       |   |           |         |  |   |          |          |  
|                                               |                             |   | Carrying      |           | Accumulated        |   |          |          |       |   | Carrying     |           | Accumulated |   |           |         | 
|                                               |                             |   | Value         |           | Amortization       |   | Net      |          | Value |   | Amortization |           | Net        
|                                               |                             |   |               |           |                    |   |          |          |       |   |              |           |            
|Intangible assets with
finite lives:           |                             |   |               |           |                    |   |          |          |       |   |              |           |             |   |           |         |  |   |          |          |   |   |           |        
|                                               | Patent applications
pending |   | $             | 1,259,232 |                    |   | $        |         |       |   | $            | 1,259,232 |             |   | $         | 966,781 |  |   | $        |         |   |   | $         | 966,781 | 
|                                               | Patents                     |   |               | 840,002   |                    |   |          | (237,863 | )     |   |              | 602,139   |             |   |           | 741,175 |  |   |          | (192,190 | ) |   |           | 548,985 | 
|                                               | Licenses                    |   |               | 41,215    |                    |   |          | (12,818  | )     |   |              | 28,397    |             |   |           | 41,215  |  |   |          | (6,445   | ) |   |           | 34,770  | 
|                                               | Licenses pending            |   |               |          |                    |   |          |         |       |   |              |          |             |   |           | 22,101  |  |   |          |         |   |   |           | 22,101  | 
|                                               |                             |   |               |           |                    |   |          |          |       |   |              |           |             |   |           |         |  |   |          |          |   |   |           |        
|Total intangible
assets with finite
lives      |                             |   | 2,140,449     |           |                    |   | (250,681 | )        |       |   | 1,889,768    |           |             |   | 1,771,272 |         |  |   | (198,635 | )        |   |   | 1,572,637 |        
|Intangible assets with
indefinite useful
lives |                             |   | 35,912        |           |                    |   |         |          |       |   | 35,912       |           |             |   | 86,781    |         |  |   |         |          |   |   | 86,781    |        
|                                               |                             |   |               |           |                    |   |          |          |       |   |              |           |             |   |           |         |  |   |          |          |   |   |           |         | 
|Total intangible assets                        |                             | $ | 2,176,361     |           |                    | $ | (250,681 | )        |       | $ | 1,925,680    |           |             | $ | 1,858,053 |         |  | $ | (198,635 | )        |   | $ | 1,659,418 |        
|                                               |                             |   |               |           |                    |   |          |          |       |   |              |           |             |   |           |         |  |   |          |          |   |   |           |        

Amortization expense related to
amortizable intangible assets was $17,000 and
$52,000 for the three-month and nine-month periods ended June 30, 2003, and
$16,000 and $39,000 for the same periods, respectively, in the prior year.
Based solely on the amortizable intangible assets as of June 30, 2003, the
estimated annual amortization expense of intangible assets for the fiscal years
ending September 30 is as 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.

|                                  |                             |          |           |           |  | 
|--------------------------------- | --------------------------- | -------- | --------- | --------- |  | 
|Amortization Expense             
|                                 
|                                 
|Quarter
ending September 30, 2003 | $                           | 13,693   |          
|Fiscal
year ending September 30:  |                             |          |          
|                                  | 2004                        |          | 61,059    |          
|                                  | 2005                        |          | 60,574    |          
|                                  | 2006                        |          | 60,109    |          
|                                  | 2007                        |          | 58,842    |          
|                                  | Thereafter                  |          | 376,259   |          
|                                  |                             |          |           |          
|                                  |                             | Subtotal |           | 630,536   | 
|                                  | Patent applications pending |          | 1,259,232 |          
|                                  |                             |          |           |          
|                                  |                             | Total    | $         | 1,889,768 | 
|                                  |                             |          |           |          



|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 reported amounts
of assets and liabilities and disclosure of contingent assets and liabilities
as of the date of the financial statements and the reported amounts of revenues
and expenses during the reporting period. Actual results could differ from
those estimates.

9



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##### Table of Contents





|6. |  | INVENTORY
|-- |  | ---------

Inventory is stated at the lower of cost (first-in, first-out) or market.
Inventory consists primarily of the raw material docosanol, which is the active
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. |  | ASSET SALE
|-- |  | ----------

On December 24, 2002, 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). Under the terms of the Drug Royalty
USA agreement, Drug Royalty USA acquired the rights to all royalties accruing
after September 30, 2002 from the sale of Abreva for cold sores in the United
States and Canada payable under the Abreva license agreement, subject to
AVANIRs right to receive 50% of all such royalties payable on sales of Abreva
over $62 million per year. Drug Royalty USA paid AVANIR $20.5 million at the
closing and an additional $3.6 million in April 2003 upon AVANIRs receipt from
the United States Patent and Trademark Office of a grant of patent term
extension for U.S. Patent Number 4,874,794. In connection with the sale,
AVANIR and Drug Royalty USA entered into a security agreement pursuant to which
AVANIR granted Drug Royalty USA a security interest in AVANIRs United States
and Canadian patents related to the treatment of cold sores.

AVANIR retains all rights to develop and license docosanol 10% cream (or
Abreva, as marketed by SBs parent, GlaxoSmithKline) outside the United States
and Canada for the treatment of cold sores. AVANIR also retains all rights to
develop and license docosanol 10% cream worldwide for all other indications,
subject to certain rights of SB in the United States and Canada.

In recording the sale transaction in December 2002, AVANIR increased cash by
$20.4 million (net of transaction costs), reduced accrued expenses by $301,000
in connection with the forgiveness of a related advance, and recorded deferred
revenue in the amount of $20.7 million. We recorded the initial net proceeds
of the transaction as deferred revenue because of our ongoing involvement in
earning future revenues under our license agreement with SB. We also
classified the additional $3.6 million received in April 2003 as deferred
revenue, to be recognized ratably over the life of the license agreement.

The expiration date for U.S. Patent
Number 4,874,794 has been extended from April 2009 to April 2014. The effect of extending the expiration of the patent from 2009 to 2014 has
extended the term of the patent royalty and the accounting period
over which the deferred revenue that relates to the patent royalty will
be recognized as revenue. Thus, less deferred revenue is being recognized as
revenue during the fiscal quarter ended June 30, 2003 than the fiscal quarter
ended March 31, 2003. Deferred revenues recognized as revenue
for the three-month and nine-month periods ended June 30, 2003
were $298,000 and $1.4 million, respectively. Abreva royalties
earned for the three-month and nine-month periods ended June 30,
2002 were $764,000 and $2.5 million, respectively.

AVANIR is recognizing the deferred revenue amount as revenue over the life of
the Drug Royalty USA agreement. 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. The
portion of deferred revenue classified as part of current liabilities
represents the amount AVANIR expects to realize as revenue within the next 12
months.

10



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##### Table of Contents



The following table sets forth the deferred revenue recorded from the sale to
Drug Royalty USA of rights to future Abreva royalties and other deferred
revenue balances as of June 30, 2003 and September 30, 2002.

|                                          |                                                       |                               |            |               |            |            |         |         |         |   |            |            |            | 
|----------------------------------------- | ----------------------------------------------------- | ----------------------------- | ---------- | ------------- | ---------- | ---------- | ------- | ------- | ------- | - | ---------- | ---------- | ---------- | 
|                                          |                                                       |                               |            | Drug Royalty  |            | Other      |         |         |         |  
|                                          |                                                       |                               |            | USA Agreement |            | Agreements |         | Total  
|                                          |                                                       |                               |            |               |            |            |         |        
|Deferred revenue as of September 30, 2002 |                                                       | $                             |           |               |            | $          | 233,333 |         |         | $ | 233,333    |           
|                                          |                                                       |                               |            |               |            |            |         |         |         |   |            |           
|Changes during the period:                |                                                       |                               |            |               |            |            |         |         |         |   |            |           
|                                          | Initial
proceeds from sale of future Abreva royalties |                               |            | 20,500,000    |            |            |         |        |         |   |            | 20,500,000 |           
|                                          | Less cost of transaction                              |                               |            | (143,982      | )          |            |         |        |         |   |            | (143,982   | )         
|                                          |                                                       |                               |            |               |            |            |         |         |         |   |            |           
|                                          |                                                       | Net proceeds                  |            |               | 20,356,018 |            |         |         |        |   |            |            | 20,356,018 | 
|                                          | Forgiveness of a related advance                      |                               |            | 300,912       |            |            |         |        |         |   |            | 300,912    |           
|                                          |                                                       |                               |            |               |            |            |         |         |         |   |            |           
|                                          |                                                       | Subtotal                      |            |               | 20,656,930 |            |         |         |        |   |            |            | 20,656,930 | 
|                                          |                                                       | Additions to deferred revenue |            |               | 3,620,748  |            |         |         |         |   |            |            | 3,620,748  | 
|                                          | Recognized as revenues during the period              |                               |            | (1,366,034    | )          |            |         |        |         |   |            | (1,366,034 | )         
|                                          |                                                       |                               |            |               |            |            |         |         |         |   |            |           
|Deferred revenue as of June 30, 2003      |                                                       | $                             | 22,911,644 |               |            | $          | 233,333 |         |         | $ | 23,144,977 |           
|                                          |                                                       |                               |            |               |            |            |         |         |         |   |            |           
|Classified as:                            |                                                       |                               |            |               |            |            |         |         |         |   |            |           
|                                          | Current portion of deferred revenue                   |                               | $          | 1,561,412     |            |            | $       | 233,333 |         |   | $          | 1,794,745  |           
|                                          | Deferred revenue, net of current portion              |                               |            | 21,350,232    |            |            |         |        |         |   |            | 21,350,232 |           
|                                          |                                                       |                               |            |               |            |            |         |         |         |   |            |           
|                                          |                                                       | Total deferred revenue        |            | $             | 22,911,644 |            |         | $       | 233,333 |   |            | $          | 23,144,977 | 
|                                          |                                                       |                               |            |               |            |            |         |         |         |   |            |           



|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 our licensed products when
earned. 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. Sales of
Abreva, if publicly reported by the licensees parent, GlaxoSmithKline, could
differ from net sales used in calculating royalties and in determining the
royalties earned in accordance with the license agreement. 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 ratably over the life of the license agreement.

Revenue arrangements with multiple deliverables.In certain circumstances, we
may enter into 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 customer-specific objective evidence of fair value. In
the case of other forms of research collaborations, milestone payments are
deferred and recognized ratably over the period of the obligation. We
recognize revenue related to the delivered products or services only if: (i)
the 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

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products or services; and (v) as discussed above, there is evidence of the fair
value for each of the undelivered products or services.

Federal research grant revenue.We recognize revenues from federal research
grants during the period in which the related expenditures are incurred.



|9. |  | INVESTMENTS
|-- |  | -----------

The following tables summarize the Companys investments in securities:

|                     |                         |                                  |                       |           |           |           |           |            |        |            |   |        |        |   |   |           |           |  |  | 
|-------------------- | ----------------------- | -------------------------------- | --------------------- | --------- | --------- | --------- | --------- | ---------- | ------ | ---------- | - | ------ | ------ | - | - | --------- | --------- |  |  | 
|                     |                         |                                  |                       |           |           |           |           |            |        | Gross      |   | Gross  |        |   |   |          
|                     |                         |                                  |                       |           |           | Amortized |           | Unrealized |        | Unrealized |   | Fair  
|                     |                         |                                  |                       |           |           | Cost      |           | Gains (2)  |        | Losses (2) |   | Value 
|                     |                         |                                  |                       |           |           |           |           |            |        |            |   |       
|As of June 30, 2003: |                         |                                  |                       |           |           |           |           |            |        |            |   |        |        |   |   |          
|                     | Certificates of deposit |                                  | $                     | 2,056,597 |           |           | $         | 21,387     |        |            | $ |       |        |   | $ | 2,077,984 |          
|                     | Government securities   |                                  |                       | 692,017   |           |           |           |           |        |            |   | (4,755 | )      |   |   | 687,262   |          
|                     |                         |                                  |                       |           |           |           |           |            |        |            |   |        |        |   |   |          
|                     |                         | Total                            |                       | $         | 2,748,614 |           |           | $          | 21,387 |            |   | $      | (4,755 | ) |   | $         | 2,765,246 | 
|                     |                         |                                  |                       |           |           |           |           |            |        |            |   |        |        |   |   |          
|Reported as:         |                         |                                  |                       |           |           |           |           |            |        |            |   |        |        |   |   |          
|                     | Short-term investments: |                                  |                       |           |           |           |           |            |        |            |   |        |        |   |   |           |          
|                     |                         | Classified as available-for-sale |                       | $         | 1,203,954 |           |           |            |        |            |   |        |        |   |   |           |           | 
|                     |                         |                                  |                       |           |           |           |           |            |        |            |   |        |        |   |   |          
|                     | Long-term investments:  |                                  |                       |           |           |           |           |            |        |            |   |        |        |   |   |           |          
|                     |                         | Classified as available-for-sale |                       |           | 704,695   |           |           |            |        |            |   |        |        |   |   |           |           | 
|                     |                         | Restricted investments (1)       |                       |           | 856,597   |           |           |            |        |            |   |        |        |   |   |           |           | 
|                     |                         |                                  |                       |           |           |           |           |            |        |            |   |        |        |   |   |          
|                     |                         |                                  | Long-term investments |           |           | 1,561,292 |           |            |        |            |   |        |        |   |   |           |           |  | 
|                     |                         |                                  |                       |           |           |           |           |            |        |            |   |        |        |   |   |          
|                     |                         |                                  |                       | Total     |           | $         | 2,765,246 |            |        |            |   |        |        |   |   |           |           |  |  | 
|                     |                         |                                  |                       |           |           |           |           |            |        |            |   |        |        |   |   |          

|                          |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |           |           |  |  | 
|------------------------- | ----------------------- | -------------------------------- | ---------------------- | --------- | --------- | --------- | --------- | ---------- | ------ | ---------- | - | ------- | ------- | - | - | --------- | --------- |  |  | 
|                          |                         |                                  |                        |           |           |           |           |            |        | Gross      |   | Gross   |         |   |   |          
|                          |                         |                                  |                        |           |           | Amortized |           | Unrealized |        | Unrealized |   | Fair   
|                          |                         |                                  |                        |           |           | Cost      |           | Gains (3)  |        | Losses (3) |   | Value  
|                          |                         |                                  |                        |           |           |           |           |            |        |            |   |        
|As of September 30, 2002: |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          
|                          | Certificates of deposit |                                  | $                      | 2,056,597 |           |           | $         | 10,434     |        |            | $ |        |         |   | $ | 2,067,031 |          
|                          | Government securities   |                                  |                        | 2,281,156 |           |           |           | 3,173      |        |            |   | (12,900 | )       |   |   | 2,271,429 |          
|                          | Commercial paper        |                                  |                        | 200,000   |           |           |           | 5,542      |        |            |   |        |         |   |   | 205,542   |          
|                          |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          
|                          |                         | Total                            |                        | $         | 4,537,753 |           |           | $          | 19,149 |            |   | $       | (12,900 | ) |   | $         | 4,544,002 | 
|                          |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          
|Reported as:              |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          
|                          | Short-term investments: |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |           |          
|                          |                         | Classified as available-for-sale |                        | $         | 495,840   |           |           |            |        |            |   |         |         |   |   |           |           | 
|                          |                         | Classified as held-to-maturity   |                        |           | 200,000   |           |           |            |        |            |   |         |         |   |   |           |           | 
|                          |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          
|                          |                         |                                  | Short-term investments |           |           | 695,840   |           |            |        |            |   |         |         |   |   |           |           |  | 
|                          |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          
|                          | Long-term investments:  |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |           |          
|                          |                         | Classified as available-for-sale |                        |           | 2,986,023 |           |           |            |        |            |   |         |         |   |   |           |           | 
|                          |                         | Restricted investments (1)       |                        |           | 856,597   |           |           |            |        |            |   |         |         |   |   |           |           | 
|                          |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          
|                          |                         |                                  | Long-term investments  |           |           | 3,842,620 |           |            |        |            |   |         |         |   |   |           |           |  | 
|                          |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          
|                          |                         |                                  |                        | Total     |           | $         | 4,538,460 |            |        |            |   |         |         |   |   |           |           |  |  | 
|                          |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          



|(1) |  | Restricted investments amounting to $856,597 as of June 30, 2003
and September 30, 2002 represent amounts that we pledged to our bank as
collateral for letters of credit that our bank issued in connection
with our leases of office and laboratory space.                                                 
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) |  | Gross unrealized gains of $21,387 and gross unrealized losses of
$4,755 on government securities and certificates of deposit represent
an accumulated net unrealized gain of $16,632, which is reported as
Accumulated other comprehensive income on the consolidated balance
sheet as of June 30, 2003.   
|   
|(3) |  | Gross unrealized gains of $13,607 and gross unrealized losses of
$12,900 on government securities and certificates of deposit represent
an accumulated net unrealized gain of $707, which is reported as
Accumulated other comprehensive income on the consolidated balance
sheet as of September 30, 2002.

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|10. |  | COMPUTATION OF NET LOSS PER COMMON SHARE
|--- |  | ----------------------------------------

We compute basic net loss per common share by dividing the net loss
attributable to common shareholders 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 attributable to common
shareholders 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 and conversion of preferred stock. In the
accompanying consolidated statements of operations, we have presented our net
loss per share for the three-month and nine-month periods ended June 30, 2003
and 2002 using the Basic EPS Method and the Diluted EPS Method. The shares of
common stock issuable upon exercise of stock options and warrants and
conversion of preferred stock under the Diluted EPS method were excluded from
the three-month and nine-month periods ended June 30, 2003 and 2002, as the
inclusion of such shares would have been anti-dilutive.

The following table provides a reconciliation from the basic to the diluted EPS
computations for the three and nine-month periods ended June 30, 2003 and 2002:

|                                                                                      |                                                                         |                                                                                         |                                                                                       |            |                             |            |                            |            |            |            |            |             |             |             |            |            |            |            |  
|------------------------------------------------------------------------------------- | ----------------------------------------------------------------------- | --------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------- | ---------- | --------------------------- | ---------- | -------------------------- | ---------- | ---------- | ---------- | ---------- | ----------- | ----------- | ----------- | ---------- | ---------- | ---------- | ---------- | -
|                                                                                      |                                                                         |                                                                                         |                                                                                       |            | Three Months Ended June 30, |            | Nine Months Ended June 30,
|                                                                                      |                                                                         |                                                                                         |                                                                                       |            |                             |            |                           
|                                                                                      |                                                                         |                                                                                         |                                                                                       |            | 2003                        |            | 2002                       |            | 2003       |            | 2002      
|                                                                                      |                                                                         |                                                                                         |                                                                                       |            |                             |            |                            |            |            |            |           
|Numerator:                                                                            |                                                                         |                                                                                         |                                                                                       |            |                             |            |                            |            |            |            |            |             |             |             |            |           
|                                                                                      | Net loss                                                                |                                                                                         | $                                                                                     | (6,029,428 | )                           |            | $                          | (4,895,265 | )          |            | $          | (16,245,361 | )           |             | $          | (5,829,344 | )         
|Less:                                                                                 |                                                                         |                                                                                         |                                                                                       |            |                             |            |                            |            |            |            |            |             |             |             |            |           
|                                                                                      | Dividends on redeemable
convertible preferred stock                     |                                                                                         |                                                                                       | (3,622     | )                           |            |                            | (6,250     | )          |            |            | (16,122     | )           |             |            | (18,750    | )         
|                                                                                      | Accretion of discount related to
redeemable convertible preferred
stock |                                                                                         |                                                                                       | (2,705     | )                           |            |                            | (4,559     | )          |            |            | (11,823     | )           |             |            | (13,677    | )         
|                                                                                      |                                                                         |                                                                                         |                                                                                       |            |                             |            |                            |            |            |            |            |             |             |             |            |            |           
|                                                                                      |                                                                         |                                                                                         | Net loss attributable to
common shareholders for basic
earnings per share
computation |            |                             | (6,035,755 | )                          |            |            | (4,906,074 | )          |             |             | (16,273,306 | )          |            |            | (5,861,711 | )
|Effect of dilutive securities:                                                        |                                                                         |                                                                                         |                                                                                       |            |                             |            |                            |            |            |            |            |             |             |             |            |           
|                                                                                      | Stock options, warrants and
convertible preferred stock                 |                                                                                         |                                                                                       |           |                             |            |                            |           |            |            |            |            |             |             |            |           |           
|                                                                                      |                                                                         |                                                                                         |                                                                                       |            |                             |            |                            |            |            |            |            |             |             |             |            |            |           
|                                                                                      |                                                                         | Net loss attributable to common
shareholders for diluted
earnings per share computation |                                                                                       | $          | (6,035,755                  | )          |                            | $          | (4,906,074 | )          |            | $           | (16,273,306 | )           |            | $          | (5,861,711 | )         
|                                                                                      |                                                                         |                                                                                         |                                                                                       |            |                             |            |                            |            |            |            |            |             |             |             |            |            |           
|Denominator:                                                                          |                                                                         |                                                                                         |                                                                                       |            |                             |            |                            |            |            |            |            |             |             |             |            |           
|Shares for basic and diluted net
loss per share  weighted average
shares outstanding |                                                                         |                                                                                         | 58,741,635                                                                            |            |                             |            | 58,275,445                 |            |            |            | 58,463,328 |             |             |             | 58,180,998 |           
|                                                                                      |                                                                         |                                                                                         |                                                                                       |            |                             |            |                            |            |            |            |            |             |             |             |            |            |           
|Basic and diluted net loss per share                                                  |                                                                         | $                                                                                       | (0.10                                                                                 | )          |                             | $          | (0.08                      | )          |            | $          | (0.28      | )           |             | $           | (0.10      | )         
|                                                                                      |                                                                         |                                                                                         |                                                                                       |            |                             |            |                            |            |            |            |            |             |             |             |            |           

For the three months and nine months ended June 30, 2003 and 2002, options to purchase
6,388,238 and 5,602,842 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 months and nine months ended June 30, 2003 and 2002, warrants to purchase 944,227
and 1,184,550 shares of common stock were excluded from the computation of
diluted net loss per share, as the inclusion of such shares would be
antidilutive.

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For the three months and nine months ended June 30, 2002, preferred stock convertible into
347,211 shares of common stock was excluded from the computation of diluted net
loss per share, as the inclusion of such shares would be antidilutive.



|11. |  | SHAREHOLDERS EQUITY
|--- |  | --------------------

Preferred Stock

Preferred stock consists of Series C Junior Participating Preferred Stock and
Series D Redeemable Convertible Preferred Stock.

Series C Junior Participating Preferred Stock.

None of the Series C Junior
Participating Preferred Stock is outstanding.

Series D Redeemable Convertible Preferred Stock.

During May 2003, the holders of Series D redeemable convertible preferred stock
(Series D Shares) exercised their rights to convert 50 Series D Shares,
representing $500,000 in redeemable convertible preferred stock and $36,630 in
accrued and unpaid dividends, into 660,305 shares of Class A common stock, for
an average stock price of $0.81 per share. None of the Series D Shares
remained outstanding on June 30, 2003.



|12. |  | RECENT ACCOUNTING PRONOUNCEMENTS
|--- |  | --------------------------------

In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities, which addresses financial accounting and
reporting for costs associated with exit or disposal activities and supersedes
EITF Issue 94-3, Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring). SFAS No. 146 requires that a liability for a cost
associated with an exit or disposal activity be recognized when the liability
is incurred. Under Issue 94-3, a liability for an exit cost as defined in EITF
94-3 was recognized at the date of an entitys commitment to an exit plan. SFAS
No. 146 also establishes that the liability should initially be measured and
recorded at fair value. SFAS No. 146 became effective for the Company on
January 1, 2003. The application of SFAS No. 146 did not have a material
impact on the Companys financial statements.

In November 2002, the FASB issued FASB Interpretation No. 45, Guarantors
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others, which elaborates on the disclosures to
be made by a guarantor about its obligation under certain guarantees issued.
It also clarifies that a guarantor is required to recognize, at the inception
of a guarantee, a liability for the fair value of the obligation undertaken in
issuing the guarantee. The Interpretation expands on the accounting guidance
of SFAS No. 5, Accounting for Contingencies, SFAS No. 57, Related Party
Disclosures, and SFAS No. 107, Disclosures about Fair Value of Financial
Instruments. It also incorporates without change the provisions of FASB
Interpretation No. 34, Disclosure of Indirect Guarantees of Indebtedness of
Others. FASB Interpretation No. 45 became effective for the Company on
January 1, 2003. The application of FASB Interpretation No. 45 did not have a
material impact on the Companys financial statements.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based
Compensation -Transition and Disclosure, an Amendment of FASB Statement No.
123. SFAS No. 148 provides alternative methods of transition for a voluntary
change to the fair value-based method of accounting for

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stock-based employee compensation. In addition, SFAS No. 148 amends the
disclosure requirements of SFAS No. 123 to require prominent disclosures in
both annual and interim financial statements about the method of accounting for
stock-based compensation and the effect of the method used on reported results.
The voluntary transition and amended disclosure requirements are effective for
the Company for the fiscal year ending September 30, 2003. The interim
reporting requirements became effective for the Companys interim periods
beginning January 1, 2003. The Company currently accounts for stock-based
employee compensation under the intrinsic value method in accordance with APB
No. 25. The Company does not plan to voluntarily change its method of
accounting, but has implemented the amended disclosure requirements for the
quarter ended June 30, 2003.

In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of
Variable Interest Entities, an Interpretation of ARB No. 51. Interpretation
No. 46 provides guidance for identifying a controlling financial interest
established by means other than voting interests. It requires consolidation of
a variable interest entity by an enterprise that holds such a controlling
financial interest. The Interpretation is effective for all newly formed
variable interest entities after January 31, 2003. The Interpretation is
effective for fiscal years or interim periods beginning after June 15, 2003 for
variable interest entities in which a company holds a variable interest that it
acquired before February 1, 2003. The adoption of FASB Interpretation No. 46
did not have a material impact on the Companys financial statements.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity. SFAS No. 150
establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. It
requires that an issuer classify a financial instrument that is within its
scope as a liability (or an asset in some circumstances). SFAS No. 150 is
effective for financial instruments entered into or modified after May 15,
2003, and otherwise is effective for public entities at the beginning of the
first interim period beginning after June 15, 2003. The effect,
if any, of SFAS
No. 150 on the Companys financial statements has not yet been determined.



|13. |  | 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.



|14. |  | SUBSEQUENT EVENT
|--- |  | ----------------

On July 23, 2003, AVANIR sold and
issued 6,728,396 shares of Class A common
stock and warrants to purchase an aggregate of up to
1,345,673 shares of the Companys Class A common stock to several accredited investors and received gross proceeds
totaling $10,025,320. The warrant exercise price is $2.23 per
share. The financing transaction was made pursuant to the terms
of a securities purchase agreement that provided each investor with a warrant
to purchase one share of Class A common stock for every five shares of Class A
common stock purchased under the agreement. The effect of the
financing transaction was an increase in cash and shareholders
equity in the amount of $10,025,320 before taking into effect the
costs of the transaction.

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|        |  |                                                                                      
|------- |  | -------------------------------------------------------------------------------------
|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. You should not rely
excessively on these forward-looking statements, because they are only
predictions based on our current expectations and assumptions. When used in
this report, the words intend, estimate, anticipate, believe, plan or
expect and similar expressions are included to identify forward-looking
statements. 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 as set forth below and under
Risk Factors that Might Affect Future Results and in our most recent Annual
Report on Form 10-K filed with the Securities and Exchange Commission (SEC).
We disclaim any obligation or intent to update or announce revisions to any
forward-looking statements to reflect actual events or developments.

Overview

AVANIR Pharmaceuticals, based in San Diego and incorporated in California in
1988, is a drug discovery and development company with a commercialized
FDA-approved product (Abreva®) and products in clinical development for the
treatment of pseudobulbar affect (Phase III), neuropathic pain (Phase II), and
allergy and asthma (Phase I). AVANIR is engaged in small-molecule research to
development treatments for central nervous system disorders and inflammatory
diseases. Through the use of its Xenerex technology, AVANIR also develops
human monoclonal antibodies for infectious diseases and other therapeutic
applications.

AVANIRs first commercialized product, docosanol 10% cream, is a topical
treatment for cold sores. The product is also known as Abreva in the United
States and Canada, Herepair in South Korea and Abrax in Israel and is being
marketed in those countries. A regulatory decision on marketing approval of
the product in Sweden is pending. AVANIR has out-licensed docosanol 10% cream
in the United States and in several foreign countries. AVANIR is continuing to
expand its commercialization efforts for docosanol 10% cream while pursuing a
broader effort to discover new drugs and develop others that are already in our
development pipeline.

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AVANIRs offices and research facilities are located at 11388 Sorrento Valley
Road, Suite 200, 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 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.

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
actions that may impact the Company in the future, actual results may differ
from these estimates and assumptions.

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 regarding expense
recognition are principally related to research contracts. Our critical
accounting policies also involve 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, registration 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 expect to enter into 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.

17



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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, 2003, 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 December 2002, we sold an undivided interest in our license agreement with
SB Pharmco Puerto Rico, Inc. (SB or GlaxoSmithKline) to Drug Royalty USA,
Inc. (Drug Royalty USA) and received a payment of $20.5 million at closing
and an additional $3.6 million in April 2003. 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 the
transaction and after the forgiveness of certain advances, as deferred revenue.
(See Note 7, Asset Sale, in the accompanying financial statements.) The
amount recorded as deferred revenue is being recognized as revenue under the
units-of-revenue method. 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 part of current liabilities
represents the amount AVANIR expects to realize as revenue within the next 12
months.

Recognition of Revenues in Research Contracts

In certain circumstances, we may enter into research contracts or
collaborations having 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.

Antibody generation services.As of June 30, 2003, Xenerex Biosciences, our
subsidiary, was engaged in work on two research collaboration agreements, both
of which have research initiation fees. In these agreements, the customer
provides antigens to Xenerex. Xenerex then performs 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 Xenerex has completed its efforts to
create the antibodies. In the research phases of the research collaboration
agreement, Xenerex 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 undelivered products or services are not essential to the
functionality of the delivered products or services;     
| 
| |  | Payment for the delivered products or services is not contingent on
delivery of the remaining products or services; and

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| |  | We have an enforceable claim to receive the amount due in the event we
do not deliver the remaining undelivered 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 set to approximate the effort associated
with the completion of each phase.

Recognition of Expenses in Research Contracts

The Company recognizes expenses related to its clinical trials and other
research contracts as the services are provided.

Valuation of Long-Lived and Intangible Assets

We assess the impairment of identifiable intangible assets and long-lived
assets whenever events or changes in circumstances indicate that the carrying
value may not be recoverable. 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.

RESULTS OF OPERATIONS 

Comparison of Three Months Ended June 30, 2003 and 2002

Revenues

Revenues in the third quarter of
fiscal 2003 amounted to $398,000, compared to
$819,000 for the same period last year. Revenues in the third quarter of
fiscal 2003 included $298,000 in revenues that the Company recognized from the
sale of Abreva® royalty rights to Drug Royalty USA and $95,000 from government
research grants. In December 2002, AVANIR sold rights to a portion of Abreva
royalties to Drug Royalty USA and received $20.5 million at the closing and an
additional $3.6 million in April 2003. AVANIR is recognizing the payments as
revenue over the term of the agreement with Drug Royalty USA, or until April
2014. (See Note 7, Asset Sale.) Revenues in the third quarter of fiscal
2002 included $764,000 in royalties on Abreva product sales.

During fiscal 2003, we expect to recognize approximately $1.7 million in
revenues from the sale transaction to Drug Royalty USA, with a corresponding
reduction in deferred revenue. Also during the fiscal year, we expect to earn
approximately $500,000 in revenues from research being performed under
government research grants. Potential revenues from license fees, milestone
payments, and royalties on foreign sales of docosanol 10% cream will depend
substantially on the timing of approval decisions by foreign regulatory
agencies and our ability to enter into additional license arrangements and
achieve milestones under those arrangements. Potential revenues from licensing
and/or selling products in

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clinical and preclinical development, including Neurodex and treatments for
inflammatory diseases and high cholesterol, are less predictable.

Revenue-generating Contracts

Partnering, licensing and research collaborations have been, and will continue
to be, an important part of AVANIRs business development strategy. We intend
to partner with pharmaceutical companies that can help fund AVANIRs research
in exchange for sharing in the rights to commercialize new drugs coming from
this research. We have licensed and continue to seek licensees in other
countries for docosanol 10% cream and other potential products in our
development pipeline. Research collaborations also represent an important way
to achieve our development goals, while sharing in the risks and the
opportunities that come from such development efforts.

As of August 4, 2003, we had several contracts and grants that are generating
or could generate revenues in the future to help fund our research and
development programs. Five contracts are in the form of docosanol 10% cream
(Abreva) license agreements, one contract is for a Neurodex license, and two
contracts are in the form of antibody research service agreements. For the
last three years, GlaxoSmithKline has been our most significant revenue source,
representing over 95% of the Companys revenues in fiscal 2002. A list of our
revenue-generating contracts is set forth in the following table.

Revenue-generating Contracts

|                                                        |  |                                                                                                                                                        |  |                                                                              
|------------------------------------------------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------ |  | -----------------------------------------------------------------------------
|                                                        |  |                                                                                                                                                        |  | Product License, Sale,                                                       
|Company or Research Grant                               |  | Description                                                                                                                                            |  | Service or Research                                                          
|                                                        |  |                                                                                                                                                        |  |                                                                              
|GlaxoSmithKline                                         |  | Undivided interest in the license agreement
for Abreva® (U.S. and Canada)                                                                              |  | Cold sore product license                                                    
|                                                        |  |                                                                                                                                                        |  |                                                                              
|Drug Royalty USA                                        |  | License Purchase Agreement with Drug
Royalty USA
represents an undivided interest in the
Abreva license agreement (U.S. and Canada)                    |  | Sale of undivided interest
in Abreva license agreement
and royalties         
|                                                        |  |                                                                                                                                                        |  |                                                                              
|Miscellaneous docosanol
licenses outside North
America  |  | - Israel - CTS Chemical Industries, Ltd.
- South Korea - Boryung Pharmaceuticals
Co., Ltd.
- Egypt - BioPharm Group
- Italy - Bruno Farmaceutici S.p.A |  | Cold sore product licenses                                                   
|                                                        |  |                                                                                                                                                        |  |                                                                              
|Medison Pharma, Ltd.                                    |  | Neurodex license
(Israel)                                                                                                                              |  | Research and
commercialization agreement
related to pseudobulbar
affect      
|                                                        |  |                                                                                                                                                        |  |                                                                              
|DNAX Research, Inc. and
Peregrine
Pharmaceuticals       |  | Pre-funded antibody research currently
totaling $233,000                                                                                               |  | Antibody generation services                                                 
|                                                        |  |                                                                                                                                                        |  |                                                                              
|Miscellaneous
Federal
and State Government
grant awards |  | Represents five grant awards totaling
approximately $1.4 million                                                                                       |  | Pre-clinical research
related to genital herpes,
anthrax, and
cytomegalovirus

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Expenses

Operating Expenses. Total operating expenses were $6.4 million in the third
fiscal quarter 2003, compared to $5.9 million in the same period in fiscal
2002. Contributing to the $577,000 increase in operating expenses were
increases of $404,000 in research and development and $335,000 in sales and
marketing, partially offset by a $157,000 reduction in general and
administrative expenses. Research and development programs accounted for 70%
of total operating expenses for the fiscal quarters ended June 30, 2003 and
2002. General and administrative expenses accounted for 19% and 23% of total
operating expenses for the fiscal quarters ended June 30, 2003 and 2002,
respectively. Sales and marketing expenses accounted for 11% and 7% of total
operating expenses for the fiscal quarters ended June 30, 2003 and 2002,
respectively. These and other costs are more fully described below.

Research and Development Expenses. Research and development (R&D) expenses
were $4.5 million in the third fiscal quarter 2003, compared to $4.1 million in
the same period a year ago. We had four clinical trials under way in the
third fiscal quarter 2003, compared to one clinical trial during the same
period a year ago. Increases in our clinical development programs for Neurodex
in the treatment of pseudobulbar affect (PBA) in patients with multiple
sclerosis and in the treatment of neuropathic pain, and increases in our
research related to regulating MIF in the treatment of inflammatory diseases,
were partially offset by decreases in spending on allergy and asthma research
following completion of preclinical toxicology in 2002. (See the table on R&D
spending on the page that follows.)

During the third fiscal quarter 2003, the Phase III clinical trials for
Neurodex in the treatment of PBA in patients with multiple sclerosis and the
open-label study of Neurodex accounted for 28% of all R&D spending. The
recently completed Phase II open-label study of Neurodex for the treatment of
neuropathic pain accounted for 14% of total R&D spending. Costs associated
with AVANIRs allergy and asthma research program, including the Phase I
clinical trials underway on our lead compound, accounted for 21% of total R&D
spending. The balance of R&D spending was primarily for drug discovery and
pre-clinical research related to development of treatments for various
inflammatory diseases, cholesterol, cancer, and antibody research programs,
including pre-clinical research on antibodies to the anthrax toxin and
cytomegalovirus.

In the third fiscal quarter 2002, we were engaged in extensive toxicology and
other pre-clinical work related to development of an orally-bioavailable
compound for the treatment of allergy and asthma. Other spending in the third
fiscal quarter 2002 related to the Phase II/III clinical trial for Neurodex in
treating pseudobulbar affect and preparing for a Phase II open label study of
Neurodex in the treatment of neuropathic pain.

We expect to continue efforts on current clinical development programs in
fiscal 2003  treatments for PBA (Phase III trial and open-label study),
neuropathic pain (Phase II) and allergy and asthma (Phase I)  and
earlier-stage research in the areas of inflammation, cholesterol reduction,
cancer and infectious diseases.

We caution that many of our R&D efforts could experience delays, setbacks and
failures, with no assurance that any of our clinical research or research
conducted by our licensees or partners will ever reach the stage of a new drug
application (NDA) with the FDA or that the NDA will be approved. The following
table sets forth the status of, and costs attributable to, our proprietary
research and clinical development programs.

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Research and Development Projects and Other Research Programs Expense

|                                                                                                                                                                                                                                                                                               |       |          |                    |           |                   |          |           |           |             |             |           |             |  |   |           |           |  |   |            |            |  |   |      |     | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----- | -------- | ------------------ | --------- | ----------------- | -------- | --------- | --------- | ----------- | ----------- | --------- | ----------- |  | - | --------- | --------- |  | - | ---------- | ---------- |  | - | ---- | --- | 
|                                                                                                                                                                                                                                                                                               |       |          | Three Months Ended |           | Nine Months Ended |          |           |           |             |             |           |             | 
|                                                                                                                                                                                                                                                                                               |       |          |                    |           |                   |          | Inception |           | Estimated  
|                                                                                                                                                                                                                                                                                               |       |          | June 30,           |           | June 30,          |          | Through   |           | Cost       
|                                                                                                                                                                                                                                                                                               |       |          |                    |           |                   |          | June 30,  |           | To Complete
|Company-Funded Projects (1):                                                                                                                                                                                                                                                                   |       | 2003 (2) |                    | 2002 (2)  |                   | 2003 (2) |           | 2002 (2)  |             | 2003(2) (3) |           | Project (2)
|                                                                                                                                                                                                                                                                                               |       |          |                    |           |                   |          |           |           |             |             |           |            
|Development of Neurodex for
FDA marketing approval in
treating PBA. Estimated
timing to complete
remaining phases of project
necessary to file an NDA
with the FDA is mid- 2004                                                                                                                |       | $        | 1,260,026          |           |                   | $        | 969,804   |           |             | $           | 3,355,826 |             |  | $ | 2,256,716 |           |  | $ | 8,094,637  |            |  | $ | 7M   |    
|Development of Neurodex for
neuropathic pain. Phase II
open-label study completed                                                                                                                                                                                                              |       |          | 618,340            |           |                   |          | 568,724   |           |             |             | 1,315,872 |             |  |   | 1,152,932 |           |  |   | 4,606,936  |            |  |   |     | (4)
|Develop AVP-13358 as a
treatment for allergy and
asthma. Estimated timing
to complete Phase I and
bioanalytical work: third
quarter of 2004. Estimated
timing to license the
product: second quarter of
2005                                                                                   |       |          | 965,104            |           |                   |          | 1,564,295 |           |             |             | 3,468,760 |             |  |   | 2,989,563 |           |  |   | 13,281,892 |            |  |   | 9M   |    
|Develop compound for
regulating the target, MIF,
as a potential treatment
for inflammatory diseases
Estimated timing to
complete Phase I and
license the product: fourth quarter of 2005                                                                                                       |       |          | 591,435            |           |                   |          | 206,714   |           |             |             | 1,606,606 |             |  |   | 1,022,799 |           |  |   | 4,437,303  |            |  |   | 12M  |    
|Government-Funded Projects:                                                                                                                                                                                                                                                                    |       |          |                    |           |                   |          |           |           |             |             |           |             |  |   |           |           |  |   |            |            |  |   |      |    
|Pre-clinical research for
potential treatments for
genital herpes and anthrax
and development of a blood
donor program for
infectious diseases
Estimated timing to
complete the various
projects is up to one year                                                                             |       |          | 220,454            |           |                   |          | 35,056    |           |             |             | 564,505   |             |  |   | 37,531    |           |  |   | 866,328    |            |  |   | 0.7M | (5)
|Other Pre-clinical Research
Projects:                                                                                                                                                                                                                                                          |       |          |                    |           |                   |          |           |           |             |             |           |             |  |   |           |           |  |   |            |            |  |   |      |    
|Use of proprietary
technologies (CCM and
antibody generation
technology) to pursue
potential treatments for
lowering cholesterol and
treating infectious
diseases. Costs and timing
to complete pre-clinical
research are unpredictable
because of the uncertainty
of outcomes of the research |       |          | 868,501            |           |                   |          | 774,933   |           |             |             | 2,684,193 |             |  |   | 2,171,752 |           |  |   | 12,300,609 |            |  |   |     |    
|                                                                                                                                                                                                                                                                                               |       |          |                    |           |                   |          |           |           |             |             |           |             |  |   |           |           |  |   |            |            |  |   |      |    
|                                                                                                                                                                                                                                                                                               | Total |          | $                  | 4,523,860 |                   |          | $         | 4,119,526 |             |             | $         | 12,995,762  |  |   | $         | 9,631,293 |  |   | $          | 43,587,705 |  |   |      |     | 
|                                                                                                                                                                                                                                                                                               |       |          |                    |           |                   |          |           |           |             |             |           |             |  |   |           |           |  |   |            |            |  |   |      |    



| | 1. |  | At June 30, 2003, we held the worldwide rights to manufacture, market
and sell all of the products in clinical development and any of the
products that might come from our own internal R&D programs. All dates
in the schedule refer to calendar year.
| | -- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | 2. |  | Each project includes allocation of laboratory occupancy costs. M
refers to millions.                                                                                                                                                                 
|
| | 3. |  | Inception dates are on or after October 1, 1998, at which time we
began identifying and tracking costs for these research programs.                                                                                                                     
|
| | 4. |  | Clinical development and licensing strategy are being evaluated.                                                                                                                                                                                        
|
| | 5. |  | State and Federal research grants totaling $1.4 million are related
to genital herpes, antibodies to anthrax and cytomegalovirus, and a
blood donor program.                                                                                            

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Research and Development Program Strategy

We are pursuing an R&D program strategy that is intended to provide a stream of
potential products in various stages of development as well as in several
therapeutic areas and technology platforms. Our approach is not to rely on any
one therapeutic area or technology platform, but to extend our development
expertise across several therapeutic areas, technology platforms and research
targets that could lead to a product. To help conserve cash resources as we
continue these R&D programs, we intend to use our own funds for clinical trials
that are relatively small and license our products and technologies to others
when we expect the development costs will exceed available cash resources. We
are pursuing this strategy because the costs of pursuing all of our development
programs through all clinical phases are beyond our current available cash
resources. There can be no assurances that we will be successful in licensing
any of our products or technologies.

Neurodex for the treatment of PBA.We completed the initial Phase II/III
clinical trial in May 2002. We intend to use the trial to qualify as one of
two required pivotal clinical trials necessary to obtain FDA approval for
marketing the product in the United States. A second Phase III clinical trial
and an open label study are currently underway. Our goal is to complete the
enrollments in those trials before the end of calendar year 2003. If the
trials are successful, we intend to file an NDA with the FDA by mid-2004
calendar year. If we are successful in filing an NDA, then we expect to
develop our own sales force in preparation for selling the product if it is
approved by the FDA. We also intend to find a licensee and/or co-promotion
partner for Neurodex for both indications of PBA and neuropathic pain, as more
fully described below.

Neurodex for the treatment of neuropathic pain.In June 2003, we announced the
results of a four-week open-label dose escalation study of Neurodex in patients
with painful diabetic neuropathy. Results of the Phase II study indicated that
Neurodex was well tolerated up to the highest target dose, and patients
reported decreased pain intensity that was significantly different from
baseline (p < 0.0001). Out of 36 adult patients with diabetic neuropathy
who experience pain on a daily basis in the lower extremities, three did not
complete the study. Of those patients not completing the study, two were due
to adverse events (one serious and not related, one serious and possibly
related) and one due to inability to comply with the protocol. Commonly
reported adverse events (reported by three or more individuals) included
nausea, constipation, diarrhea, dry mouth, fatigue, dizziness, insomnia,
headache, upper respiratory tract infection, and somnolence. Most adverse
events were either mild or moderate in intensity, and 92% of participants
completed the study.

We are currently evaluating the Phase II study results for Neurodex for the
treatment of neuropathic pain and are developing plans for next steps in
clinical development. As part of our strategy, we intend to seek a licensee of
Neurodex for all markets outside the United States and a co-promotion partner
to share in the distribution of the product in the United States. Thereafter,
we expect to begin recognizing revenues from the license or co-promotion
arrangement. There can be no assurances as to the timing of such a license or
co-promotion arrangement.

Development program for allergy and asthma (IgE regulator).In March 2003, we
initiated Phase Ia clinical trials of our lead oral compound for the treatment
of allergy and asthma. Our compound appears capable of selectively inhibiting
the production of immunoglobulin epsilon (IgE) antibodies, a target that has
been identified in the pathophysiology of allergy and asthma. Phase 1a trials
are intended to establish safety of the drug in single rising doses in healthy
patients and to assess the compounds affect on certain disease biomarkers.
These trials will be followed by Phase Ib clinical trials using rising
multi-doses in healthy patients. We estimate that Phase Ib clinical trials for
this compound will be completed by mid-2004 calendar year. Assuming the
results are favorable, we expect to license the drug to another pharmaceutical
company and begin recognizing revenues from our partner by mid-2005 calendar
year.

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Anti-inflammatory research program (MIF inhibitor). We are currently
conducting toxicology studies and other preclinical 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 filing with the FDA for an
investigational new drug (IND), we intend to license the compound to another
pharmaceutical company by December 2005 and begin recognizing positive cash
flows thereafter from our partner.

Government research contracts.AVANIR also is engaged in research funded by
$1.4 million in government research grants. The government research grants are
to be used for investigating the market potential for a topical genital herpes
treatment, conducting research on various docosanol-based formulations for a
potential genital herpes product, development of antibodies to anthrax toxins
and cytomegalovirus, and development of a blood donor program intended to find
high-affinity antibodies to infectious diseases. We expect the current
government-funded research programs will continue through fiscal years 2003 and
part of fiscal 2004.

Other Operating Expenses

General and Administrative Expenses. During the third fiscal quarter 2003,
general and administrative expenses amounted to $1.2 million, compared to $1.3
million in the same period a year ago. The Company continues to concentrate
its efforts on R&D programs and market research for Neurodex and expects that

near-term increases in general and administrative expenses will be moderate.

Sales and Marketing Expenses. During the third fiscal quarter 2003, sales and
marketing expenses were $727,000, compared to $393,000 in the same period a
year ago. Higher expenses in the third fiscal quarter 2003 were related to
market research and planning and preparation for product launch of Neurodex for
the treatment of pseudobulbar affect.

Loss from Operations

For the third fiscal quarter 2003, the loss from operations was $6.0 million,
compared to $5.0 million for the same period a year ago. Contributing to the
higher losses were the higher R&D expenses associated with additional clinical
development programs and costs related to product planning for Neurodex.
Revenues decreased by $421,000, reflecting the sale of rights to a portion of
future Abreva royalties. Higher operating expenses reflected the greater
number and extent of R&D programs and increases in sales and marketing
activities, including market research and planning for the product launch of
Neurodex in the treatment of PBA.

Other Income and Expenses

Interest Income. In the third fiscal quarter 2003, interest income amounted to
$49,000, compared to $151,000 for the same period a year ago. The decrease in
interest income during the second fiscal quarter 2003 was primarily due to
lower average interest rates on investments and lower average invested amounts
compared with the same period a year ago.

Other Income. Other income, consisting of rental income, was $8,000 in the
third quarter of fiscal 2003, compared to $9,000 in the same period a year ago.

Interest Expense. In the third fiscal quarter 2003, interest expense amounted
to $11,000, compared to $14,000 for the same period a year ago. Lower interest
expense for the second fiscal quarter 2003 was due to lower interest rates on
extended payment plans for our insurance policies.

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Net Loss

For the third fiscal quarter 2003, the net loss attributable to common
shareholders was $6.0 million, compared to $4.9 million for the same period a
year ago. The basic and diluted net loss per share was $0.10 for the third
fiscal quarter 2003, compared to $0.08 for the same period a year ago.

For the remainder of the 2003 fiscal year, we expect to continue developing our
current products, with particular emphasis on products engaged in clinical
trials. We intend to continue to develop Neurodex for the treatment of both
pseudobulbar affect (Phase III status) and neuropathic pain (Phase II status)
and our lead compound for the treatment of allergy and asthma (Phase I status).
We expect that our spending on clinical trials and earlier stage R&D programs,
combined with other operating costs, will exceed our revenues for at least the
next two quarters. We anticipate that we will file a New Drug Application with
the FDA by mid-2004 calendar year for Neurodex for the treatment of
pseudobulbar affect.

RESULTS OF OPERATIONS 

Comparison of Nine Months Ended June 30, 2003 and 2002

Revenues

Revenues for the first nine months of fiscal 2003 amounted to $1.8 million,
compared to $7.7 million for the same period last year. Revenues for the first
nine months of fiscal year 2003 included $1.4 million in revenues that the
Company recognized from the sale of certain rights to future Abreva royalties
to Drug Royalty USA, $394,000 from government research grants and $17,000 in
sales of the raw material docosanol. Revenues for the first nine months of
fiscal 2003 included a $5 million milestone payment from GlaxoSmithKline and
$2.5 million in royalties on Abreva® product sales.

Expenses

Operating Expenses. Total operating expenses were $18.2 million in the first
nine months of fiscal 2003, compared to $14.1 million in the same period in
fiscal 2002. The 29% increase in operating expenses was primarily caused by a
35% increase in spending on research and development programs. Research and
development programs accounted for 71% and 68% of total operating expenses for
the first nine months of fiscal 2003 and 2002, respectively. General and
administrative expenses accounted for 19% and 24% of total operating expenses
for the first nine months of fiscal 2003 and 2002, respectively. Sales and
marketing expenses accounted for 10% and 8% of total operating expenses for
first nine months of fiscal 2003 and 2002, respectively. These and other costs
are more fully described below.

Research and Development Expenses. Research and development (R&D) expenses
were $13.0 million in the first nine months of fiscal 2003, compared to $9.6
million in the same period a year ago. Costs associated with completion of
toxicology, filing an IND and initiating Phase I clinical trials of AVANIRs
lead compound for the treatment of allergies and asthma accounted for 27% of
total R&D spending in the first nine months of fiscal 2003. The clinical
trials of Neurodex in the treatment of pseudobulbar affect in patients with
multiple sclerosis and in the treatment of neuropathic pain accounted for 36%
of all R&D spending in the first nine months of fiscal 2003. The balance of
R&D spending was for other programs, including pre-clinical research related to
inflammation and cholesterol-lowering compounds and antibody research programs.

In the first nine months of fiscal 2002, R&D expenses were primarily related to
costs associated with pre-clinical development of an orally-bioavailable
compound for the treatment of allergy and asthma, a Phase II/III clinical trial
for Neurodex in treating pseudobulbar affect, and development of the antibody
generation technology.

25



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General and Administrative Expenses. General and administrative expenses
amounted to $3.5 million in the first nine months of fiscal 2003, representing
a 3% increase over expenses of $3.4 million in the same period in the prior
year. Higher expenses were attributable to modest increases in staff size to
support growing Company operations. General and administrative expenses
continued the trend established in fiscal 2002 of growing at a slower rate than
R&D and sales and marketing expenses.

Sales and Marketing Expenses. During the first nine months of fiscal 2003,
sales and marketing expenses were $1.8 million, compared to $1.1 million in the
same period a year ago. Higher expenses in the first nine months of fiscal
2003 were related to market research and planning and preparation for product
launch of Neurodex for the treatment of pseudobulbar affect.

Loss from Operations

For the first nine months of fiscal 2003, the loss from operations was $16.4
million, compared to $6.4 million for the same period a year ago.
Contributing to the higher losses were $5.8 million lower revenues, $3.4
million higher R&D expenses, $685,000 higher sales and marketing expenses and
$102,000 higher general and administrative expenses. During the first nine
months of fiscal 2003, AVANIR did not receive any milestone payments from its
licensees and incurred higher R&D expenses associated with three clinical
development programs and costs related to product planning for Neurodex.
During the first nine months of fiscal 2002, AVANIR received a $5.0 million
milestone from GlaxoSmithKline and had only one clinical development program
underway.

Other Income and Expenses

Interest Income. In the first nine months of fiscal 2003, interest income
amounted to $203,000 compared to $520,000 for the same period a year ago. The
decrease in interest income during the first nine months of fiscal 2003 was
primarily due to lower average interest rates on investments and lower average
invested amounts compared with the same period a year ago.

Other Income. Other income amounting to $20,000 in the first nine months of
fiscal 2003 represents rental income on emergency standby power generating
equipment. Other income, amounting to $96,000 in the first nine months of
fiscal 2003, represents miscellaneous Xenerex contract services, rental income
for use of the Companys conference center and rental income on emergency
standby power generating equipment.

Interest Expense. In the first nine months of fiscal 2003, interest expense
amounted to $34,000 compared to $47,000 for the same period a year ago. Lower
interest expense for the first nine months of fiscal 2003 was due to lower
interest rates on extended payment plans for our insurance policies.

Net Loss

For the first nine months of fiscal 2003, the net loss attributable to common
shareholders was $16.3 million, compared to $5.9 million for the same period a
year ago. The basic and diluted net loss per share was $0.28 for the first
nine months of fiscal 2003, compared to $0.10 for the same period a year ago.

LIQUIDITY AND CAPITAL RESOURCES

As of June 30, 2003, we had cash and investments totaling $15.1 million,
including cash and cash equivalents of $12.3 million, short and long-term
investments of $1.9 million and restricted investments of $857,000. Our net
working capital balance as of June 30, 2003 was $8.6 million. As of September
30,

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2002, we had cash and investments totaling $13.2 million, including cash and
cash equivalents of $8.6 million, short and long-term investments of $3.7
million and restricted investments of $857,000. Our net working capital
balance as of September 30, 2002 was $5.9 million.

Operating Activities. Net cash provided by operating activities amounted to
$7.8 million in the first nine months of fiscal 2003, compared to net cash used
for operating activities of $3.1 million during the same period a year ago. On
December 24, 2002, we sold to Drug Royalty USA an undivided interest in our
Abreva license agreement with GlaxoSmithKline and received $20.4 million, net
of transaction costs, at closing and an additional $3.6 million in April 2003.
The net cash provided by operating activities in the first nine months of
fiscal 2003 reflects the $24.1 million in cash received from Drug Royalty USA
and an $876,000 royalty payment from GlaxoSmithKline, partially offset by the
$16.2 million net loss for the first nine months of the fiscal year. The sale
of rights to future Abreva royalties was recorded as deferred revenue and is
being recognized as revenue over the life of the license agreement with
GlaxoSmithKline. (See Note 7, Asset Sale in the accompanying notes to the
financial statements.) For the first nine months of fiscal 2002, net cash used
for operations amounting to $3.1 million reflected a loss of $5.8 million,
partially offset by a $1.3 million increase in accounts payable, a $784,000
increase in accrued expenses and other liabilities, depreciation and
amortization ($424,000) and compensation paid with stock options ($134,000).

Investing Activities. Net cash used for investing activities during the first
nine months of 2003 amounted to $3.8 million, including investments in
securities totaling $711,000, capital expenditures related to purchases of
capital equipment and leasehold improvements totaling $5.2 million, and patent
costs of $393,000, partially offset by sales and maturities of investments
totaling $2.5 million. Net cash used for investing activities during the first
nine months of fiscal 2002 amounted to $5.9 million, including investments in
securities totaling $8.6 million, capital expenditures for property and
equipment totaling $694,000 and patent costs of $456,000, partially offset by
sales and maturities of investments totaling $3.9 million.

In May 2003, the Company completed construction on approximately
31,700 square feet of existing leased laboratory and office space, located at
11388 and 11750 Sorrento Valley Road, San Diego, California. The facilities
are subject to a lease between the Company and Sorrento Plaza, a California
limited partnership, effective May 20, 2002. Leasehold improvements to the
facilities were necessary before taking occupancy. The Company also made
leasehold improvements to laboratory and office space at 11388 Sorrento Valley
Road to accommodate the relocation of several departments. The expenditures at
all three facilities are intended to accommodate current as well as potential
future expanded business operations. The Company has 57,065 square feet of
usable laboratory and office space and the capacity to accommodate
approximately 100 employees. The Company currently has about 65 employees.
Total leasehold improvements that the Company has made for the nine months
ended June 30, 2003 have amounted to $3.9 million. (See Note 4, Balance Sheet
Details  Property and Equipment.)

Financing Activities. Net cash used for financing activities amounted to
$312,000 during the first nine months of 2003, compared to $29,000 in cash used
for financing activities for the same period a year ago. We believe that cash,
short and long-term investments in securities and restricted investments
totaling $15.1 million as of June 30, 2003, together with the sale of Class A
Common Stock that raised an additional $10.0 million in July 2003, plus
anticipated future payments and revenues, should be sufficient to sustain our
planned level of operations for at least the next twelve months. Additionally,
to continue to enhance our capital base and liquidity and to continue to fund
the development of our drug candidates and technology platforms, we expect to
continue to pursue various alternatives for raising additional funds during the
next twelve months. Potential alternatives that we are considering for raising
capital include, but are not limited to, partnering arrangements where partners
share development costs, issuance

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of debt or equity securities, and licensing or sales of any of our platform
technologies or new drug candidates.

RECENT ACCOUNTING PRONOUNCEMENTS

See Note 12, Recent Accounting Pronouncements in the accompanying financial
statements for a discussion of recent accounting pronouncements and their
effect, if any, on the Company.

RISK FACTORS THAT MIGHT AFFECT FUTURE OPERATIONS

We expect that we will need to raise additional capital to fund ongoing
operations. If we cannot raise additional capital, we may be forced to curtail
operations. If we succeed in raising additional capital, it may affect our
stock price and future revenues.

In order to maintain sufficient cash and investments for future operations, we
will need to raise additional capital. We expect to seek to raise additional
capital over the next twelve months through various alternatives, including
licensing or sales of our technologies and drug candidates and sale of shares
of our Class A common stock.



| |  |  | If we raise capital through licensing or sales of one or more of our
technologies and drug candidates, then we may lose an opportunity for
product sales if a product is successfully developed, approved by the
U.S. Food and Drug Administration (FDA) and marketed. If we license
any of our technologies or drug candidates, then the development of
the product or technology will 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, there can be no
assurance that the sales price will 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, then the value of the shares of Class A common stock
outstanding will be diluted or 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 common stock and dilute your voting rights in
the Company.                                                                                                                                                                                                                                                
|
| |  |  | We may not be able raise capital on terms that we find acceptable, if
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 research programs. Any of these
actions could be expected to have an adverse effect on our stock
price.                                                                                                                                                                                                                                                                                                                                                                                             

AVANIR and its licensees may not be successful in obtaining regulatory approval
of docosanol 10% cream immediately as an over-the-counter (OTC) product in
the rest of the world or in licensing, marketing and selling the product in
foreign countries.

AVANIR and its licensees face a wide 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 prescription status first
before obtaining sufficient experience to warrant approval as an OTC product;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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| |  |  | 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.                                                                                                   

Developing and testing a drug candidate is a very expensive and time-consuming
process that may not ultimately lead to a marketable product.

We may spend millions of dollars in pre-clinical studies researching the
potential safety and efficacy of our drug candidates. If any such drug
candidate fails 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 pre-clinical studies, we may decide to proceed with human
clinical trials. The full complement of clinical trials required to obtain
regulatory approval for a new drug may involve several million dollars. Because
of the Companys limited financial resources, we may be required to license the
compound to a pharmaceutical company with greater financial resources in order
to complete development of the drug. There is no assurance that we will be able
to find a large pharmaceutical company interested in licensing the drug or, if
we do locate such a licensee, that the proposed license terms will 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.

Future operating results will continue to be subject to significant quarterly
fluctuations based on a variety of factors, including:



| |  |  | 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
sales exceed $62 million, at which time we will receive one-half of
the stated royalty rate on any excess sales. 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 and royalties earned from a single licensee
(GlaxoSmithKline) accounted for approximately 95% and 99% of our
fiscal 2002 and 2001 revenues, respectively. We have now received all
of the milestone payments from GlaxoSmithKline. 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 our raw materials from a sole foreign
supplier that has been approved for manufacture by the FDA. Any
disturbances or delays in the manufacture of the raw materials could
seriously and adversely affect our business.

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| |  |  | Achievement of milestones under license agreements may be outside our
control  Recognition of revenue under several of our license
agreements may depend solely on the efforts and performance of our
licensees in reaching milestones outside of our control. Such
milestones may include specific events, such as regulatory approval,
product launch, the passage of time, or reaching a sales threshold.                                                                                                                                                                                          
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | 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 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 of our acquisition or
alliance activities are not successful.

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
only. We also have exclusive license agreements for docosanol 10% cream for
Israel, South Korea, Italy and Egypt. 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 ability to deliver products abroad 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;                                        
|
| |  |  | difficulty in finding foreign partners with sufficient capital to effectively launch,
market and promote the product;
|
| |  |  | shipping delays;                                                                                                     
|
| |  |  | difficulties in managing operations across disparate geographic areas;                                               
|
| |  |  | fluctuations in foreign currency 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.                                                                                        

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Our Xenerex antibody generation technology faces intense competition and rapid
technological change, particularly in the area of product development for
infectious diseases. If we fail to develop antibody products that keep pace
with competitive products and new technologies, our products and technologies
could become obsolete.

The biotechnology industry is highly competitive and subject to significant and
rapid technological change. We compete with several companies that develop and
market antibody products and technologies. These competitors have specific
expertise and technologies related to antibody development. Also, they
introduce new or modified technologies from time to time. These companies
include Abgenix, Inc., Medarex, GenPharm, Kirin Brewing Co., Genmab, Cambridge
Antibody Technology Group, Protein Design Labs, Dyax, and MorphoSys. Many of
these companies, either alone or together with their customers, have
substantially greater financial resources, larger research and development
staffs, and substantially greater experience than we do.

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.

Governmental 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 testing and regulatory
approval process can take a number of 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 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
governmental regulation might arise from future U.S. or foreign legislative or
administrative action. 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. Future changes could
affect adversely the time frame required for regulatory review, our financial
resources, and the sale prices of our proposed products, if approved for sale.

Unsuccessful or lengthy research and development programs for proposed new
products could negatively affect our business.

The drug development process is lengthy and capital intensive. Our drug
development programs are exposed to all of the risks inherent in product
development based on innovative technologies, including unanticipated
development problems and the possible lack of funding or collaborative
partners. Any of a number of problems in the development process could result
in the abandonment or substantial change in the development of a specific
product. Our Phase III clinical trial of Neurodex for the treatment of
pseudobulbar affect in multiple sclerosis patients may experience setbacks or
failures for reasons we have not anticipated. We might experience delays in our
plans for review with the FDA of the results of our Phase II open-label dose
escalation clinical trial of Neurodex for the treatment of neuropathic pain and
in gaining timely acceptance by the FDA of our Phase III study plans. Our Phase
I clinical trial of our lead compound for treating allergy and asthma may not
demonstrate the efficacy of, or have the safety profile necessary for, a
proposed product for human use. Unsuccessful clinical trial results for our
proposed products could affect materially and adversely our future business
operations and financial condition.

Business interruptions could adversely affect our business.

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Our operations are vulnerable to interruption by fire, earthquake, power loss,
telecommunications failure, terrorist attacks and other events beyond our
control. For example, during 2001 and again in 2003, we have experienced
blackouts, where we experienced a period of time lasting several hours in
which our utility provider was unable to provide us with electrical power. The
loss of electrical power or blackouts 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 on our premises emergency power equipment, which we have used on
several occasions to supply electricity in the areas that we consider to be the
most critical to our operations. However, the emergency power unit does not
cover all of our electrical needs and, further, it might not operate properly
in the event of a power loss.

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 biotech 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.

Our future success also depends on our continuing ability to identify, hire,
train and retain highly qualified, technical, sales, marketing and customer
service personnel. We presently employ approximately 65 people. Further, we
expect to hire additional people over the next twelve months. 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 issued patents and patent applications. Patents and
patent applications owned or controlled by the Company are for
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 the treatment of several
inflammatory diseases, 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 not be available to us;                                             
|
| |  |  | any of our issued patents will provide us with significant competitive advantages; or                                                                                                

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| |  |  | 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 our first
product and other products still under development.

If we do not protect our technical innovations, then our business may be
negatively affected.

We rely substantially on confidentiality agreements to protect our
innovations. We cannot assure you 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. It is costly to litigate these disputes and an unfavorable result
could adversely affect our intellectual property portfolio as well as our
business and financial condition.

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
$2 million per incident and $2 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 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.

We could incur significant liabilities as a result of material litigation.

In the ordinary course of business, we 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.

Abreva faces competition from a number of existing and well-established
products and the companies that market their products.

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We have the opportunity to earn royalties on Abreva product wholesale sales if
sales exceed $62 million a year. 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. Most of our competitors, including such companies as
Bayer Corp. and Schering Plough, have substantial financial resources, research
and development facilities and manufacturing and marketing experience. Even
with Abreva being marketed by one of the worlds largest consumer healthcare
companies, GlaxoSmithKline, not all competitive responses and the impacts of
those responses can be foreseen.




|        |  |                                                           
|------- |  | ----------------------------------------------------------
|Item 3. |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK

We are exposed to market risks related to changes in interest rates. Because
substantially all of our revenue, expense, 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. 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 exposures as the needs
and risks should arise.

Interest rate sensitivity

Our investment portfolio consists primarily of fixed income instruments with an
average duration of 1.7 years as of June 30, 2003 (2.3 years as of September
30, 2002). The primary objective of our investments in debt securities is to
preserve principal while achieving attractive yields, without significantly
increasing risk. We carry some investments that we intend to hold to maturity
and others that we classify as available-for-sale. These available-for-sale
securities are subject to interest rate risk. In general, we would expect that
the volatility of this portfolio would increase as its duration increases.




|        |  |                        
|------- |  | -----------------------
|Item 4. |  | CONTROLS AND PROCEDURES

The Companys Chief Executive
Officer and Chief Financial Officer carried out an evaluation of 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, these officers have
concluded that the Companys disclosure controls and procedures
were adequate and designed to ensure that material information
relating to the Company and the Companys consolidated
subsidiary would be made known to them by others within those
entities.




PART II. OTHER INFORMATION

|           |  |               
|---------- |  | --------------
|Items 1-5. |  | NOT APPLICABLE




|        |  |                                 
|------- |  | --------------------------------
|Item 6. |  | EXHIBITS AND REPORTS ON FORM 8-K

| |  |              |  |      |  |  |  |                                                                    
| |  | ------------ |  | ---- |  |  |  | -------------------------------------------------------------------
| |  | (a)
Exhibits |  |      |  | 
| |  |              |  |      |  |  |  |                                                                    
| |  |              |  | 15.0 |  |  |  | Letter on unaudited interim financial information                  
| |  |              |  | 31.1 |  |  |  | Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002

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| |  |     |  |  |                                                                                                                                                                                        |  |  |                                                                    
| |  | --- |  |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  | -------------------------------------------------------------------
| |  |     |  |  | 31.2                                                                                                                                                                                   |  |  | Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002
| |  |     |  |  |                                                                                                                                                                                        |  |  |                                                                    
| |  |     |  |  | 32.1                                                                                                                                                                                   |  |  | Certification pursuant to Section 906 of Sarbanes-Oxley Act of 2002
| |  |     |  |  |                                                                                                                                                                                        |  |  |                                                                    
| |  |     |  |  | 32.2                                                                                                                                                                                   |  |  | Certification pursuant to Section 906 of Sarbanes-Oxley Act of 2002
| |  |     |  |  |                                                                                                                                                                                        |  |  |                                                                    
| |  | (b) |  |  | Current Reports on Form 8-K                                                                                                                                                           
| |  |     |  |  |                                                                                                                                                                                        |  |  |                                                                    
| |  |     |  |  | On May 8, 2003, we filed a current report on Form 8-K, furnishing
under Item 9 a press release that reported the Companys results of
operations for the quarter ended March 31, 2003.




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                          |  | August 14, 2003
|                            |  | Executive Officer                            |  |                
|Gerald J. Yakatan, Ph.D.    |  | (Principal Executive Officer)                |  |                
|                            |  |                                              |  |                
|/s/Gregory P. Hanson        |  | Vice President, Finance and Chief            |  | August 14, 2003
|                            |  | Financial Officer                            |  |                
|Gregory P. Hanson           |  | (Principal Financial and Accounting Officer) |  |                

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EXHIBIT INDEX

|     |  |                                                                    
|---- |  | -------------------------------------------------------------------
|15.0 |  | Letter on unaudited interim financial information                  
|     |  |                                                                    
|31.1 |  | Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002
|     |  |                                                                    
|31.2 |  | Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002
|     |  |                                                                    
|32.1 |  | Certification pursuant to Section 906 of Sarbanes-Oxley Act of 2002
|     |  |                                                                    
|32.2 |  | Certification pursuant to Section 906 of Sarbanes-Oxley Act of 2002

36