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SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, DC 20549

FORM 10-Q

(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, 2002          
|                                                      
|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
incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                              
|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 [   ]

The number of shares of Common Stock of the Registrant issued and outstanding
as of August 1, 2002:

|                                                                      |  |  |                   | 
|--------------------------------------------------------------------- |  |  | ----------------- | 
|Class A Common stock, no par value
Class B Common stock, no par value |  |  | 58,270,533
13,500 | 



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TABLE OF CONTENTS



|                           |                                                                                               |                                            |  |  |  |  |  | 
|-------------------------- | --------------------------------------------------------------------------------------------- | ------------------------------------------ |  |  |  |  |  | 
|                           | Item 1. FINANCIAL STATEMENTS                                                                 
|                           |                                                                                               | 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                           
|PART II. OTHER INFORMATION
|                           | Item 6. EXHIBITS AND REPORTS ON FORM 8-K                                                     
|SIGNATURES                
|EXHIBIT 10.1              
|EXHIBIT 99.1              
|EXHIBIT 99.2              



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Table of Contents

|         |  |                                                                                       |  |     
|-------- |  | ------------------------------------------------------------------------------------- |  | ----
|         |  |                                                                                       |  | Page
|         |  |                                                                                       |  |     
|PART I.  |  | FINANCIAL INFORMATION                                                                 |  |     
|        
|Item 1.  |  | Financial Statements                                                                  |  |     
|        
|         |  | Consolidated Balance Sheets                                                           |  | 3   
|        
|         |  | Consolidated Statements of Operations                                                 |  | 4   
|        
|         |  | Consolidated Statements of Cash Flows                                                 |  | 5   
|        
|         |  | Notes to Consolidated Financial Statements                                            |  | 6   
|        
|Item 2.  |  | Managements Discussion and Analysis of Financial Condition and Results of
Operations |  | 11  
|        
|Item 3.  |  | Quantitative and Qualitative Disclosures about Market Risk                            |  | 30  
|        
|PART II. |  | OTHER INFORMATION                                                                     |  |     
|        
|Item 6.  |  | Exhibits and Reports on Form 8-K                                                      |  | 30  

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Item 1. FINANCIAL STATEMENTS

AVANIR Pharmaceuticals




CONSOLIDATED BALANCE SHEETS (Unaudited)

---

|                                                                                 |                                                                                                                              |   |                            |            |          |            |               |            |  |            | 
|-------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------- | - | -------------------------- | ---------- | -------- | ---------- | ------------- | ---------- |  | ---------- | 
|                                                                                 |                                                                                                                              |   |                            |            | June 30, |            | September 30,
|                                                                                 |                                                                                                                              |   |                            |            | 2002     |            | 2001         
|                                                                                 |                                                                                                                              |   |                            |            |          |            |              
|ASSETS                                                                           |                                                                                                                              |   |                            |            |          |            |               |           
|Current assets:                                                                  |                                                                                                                              |   |                            |            |          |            |               |           
|                                                                                 | Cash and cash equivalents                                                                                                    |   | $                          | 7,526,453  |          |            | $             | 16,542,545 | 
|                                                                                 | Short-term investments in securities                                                                                         |   |                            | 678,179    |          |            |               | 23,179     | 
|                                                                                 | Receivables                                                                                                                  |   |                            | 896,933    |          |            |               | 898,676    | 
|                                                                                 | Inventory                                                                                                                    |   |                            | 213,956    |          |            |               | 222,585    | 
|                                                                                 | Prepaid expenses                                                                                                             |   |                            | 521,891    |          |            |               | 581,298    | 
|                                                                                 |                                                                                                                              |   |                            |            |          |            |               |           
|                                                                                 |                                                                                                                              |   | Total current assets       |            |          | 9,837,412  |               |            |  | 18,268,283 | 
|Investments in securities                                                        |                                                                                                                              |   | 8,907,597                  |            |          |            | 4,897,390     |           
|Restricted investment                                                            |                                                                                                                              |   | 388,122                    |            |          |            | 388,122       |           
|Property and equipment, net                                                      |                                                                                                                              |   | 2,648,182                  |            |          |            | 2,217,094     |           
|Intangible assets, net                                                           |                                                                                                                              |   | 1,591,544                  |            |          |            | 1,174,928     |           
|Other assets                                                                     |                                                                                                                              |   | 103,610                    |            |          |            | 108,136       |           
|                                                                                 |                                                                                                                              |   |                            |            |          |            |               |           
|TOTAL ASSETS                                                                     |                                                                                                                              | $ | 23,476,467                 |            |          | $          | 27,053,953    |           
|                                                                                 |                                                                                                                              |   |                            |            |          |            |               |           
|LIABILITIES AND SHAREHOLDERS EQUITY                                             |                                                                                                                              |   |                            |            |          |            |               |           
|Current liabilities:                                                             |                                                                                                                              |   |                            |            |          |            |               |           
|                                                                                 | Accounts payable                                                                                                             |   | $                          | 2,011,018  |          |            | $             | 734,701    | 
|                                                                                 | Accrued expenses and other liabilities                                                                                       |   |                            | 1,642,755  |          |            |               | 858,991    | 
|                                                                                 | Accrued compensation and payroll taxes                                                                                       |   |                            | 357,260    |          |            |               | 355,526    | 
|                                                                                 | Loan payable                                                                                                                 |   |                            | 12,609     |          |            |               | 186,122    | 
|                                                                                 | Current portion of capital lease obligations                                                                                 |   |                            | 121,814    |          |            |               | 105,366    | 
|                                                                                 |                                                                                                                              |   |                            |            |          |            |               |           
|                                                                                 |                                                                                                                              |   | Total current liabilities  |            |          | 4,145,456  |               |            |  | 2,240,706  | 
|Capital lease obligations, net of current portion                                |                                                                                                                              |   | 360,473                    |            |          |            | 351,784       |           
|                                                                                 |                                                                                                                              |   |                            |            |          |            |               |           
|                                                                                 |                                                                                                                              |   | Total liabilities          |            |          | 4,505,929  |               |            |  | 2,592,490  | 
|COMMITMENTS AND CONTINGENCIES (Note 8)                                           |                                                                                                                              |   |                            |            |          |            |               |           
|REDEEMABLE CONVERTIBLE PREFERRED STOCK                                           |                                                                                                                              |   |                            |            |          |            |               |           
|Series D  no par value, 500 shares authorized;
50 shares issued and outstanding |                                                                                                                              |   | 516,579                    |            |          |            | 502,903       |           
|SHAREHOLDERS EQUITY                                                             |                                                                                                                              |   |                            |            |          |            |               |           
|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; 58,270,533 and
57,976,381 shares issued and outstanding                              |   |                            | 87,013,627 |          |            |               | 86,626,355 | 
|                                                                                 | Class B  712,000 shares authorized; 13,500 and 36,500
shares issued and outstanding (convertible into Class A
common stock) |   |                            | 8,394      |          |            |               | 19,895     | 
|Accumulated deficit                                                              |                                                                                                                              |   | (68,578,093                | )          |          |            | (62,735,080   | )         
|Accumulated other comprehensive income                                           |                                                                                                                              |   | 10,031                     |            |          |            | 47,390        |           
|                                                                                 |                                                                                                                              |   |                            |            |          |            |               |           
|                                                                                 |                                                                                                                              |   | Total shareholders equity |            |          | 18,453,959 |               |            |  | 23,958,560 | 
|                                                                                 |                                                                                                                              |   |                            |            |          |            |               |           
|TOTAL LIABILITIES AND SHAREHOLDERS EQUITY                                       |                                                                                                                              | $ | 23,476,467                 |            |          | $          | 27,053,953    |           
|                                                                                 |                                                                                                                              |   |                            |            |          |            |               |           

See notes to consolidated financial statements.

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AVANIR Pharmaceuticals




CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

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|                                                                        |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |           |            |  
|----------------------------------------------------------------------- | ------------------------ | ------- | ---------- | ------------------ | ---------- | ----------------- | ---------- | --------- | ---------- | ---- | ---------- | ---------- | ---------- | - | ---------- | --------- | ---------- | -
|                                                                        |                          |         |            | Three months ended |            | Nine months ended
|                                                                        |                          |         |            | June 30,           |            | June 30,         
|                                                                        |                          |         |            |                    |            |                  
|                                                                        |                          |         |            | 2002               |            | 2001              |            | 2002      |            | 2001
|                                                                        |                          |         |            |                    |            |                   |            |           |            |     
|REVENUES:                                                               |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |          
|Contract and license revenues                                           |                          | $       | 5,000      |                    |            | $                 | 5,000      |           |            | $    | 5,089,167  |            |            | $ | 5,017,350  |          
|Royalty revenues                                                        |                          |         | 763,851    |                    |            |                   | 508,739    |           |            |      | 2,547,151  |            |            |   | 1,761,790  |          
|Grant revenue                                                           |                          |         | 27,129     |                    |            |                   |           |           |            |      | 28,255     |            |            |   | 72,535     |          
|Product sales                                                           |                          |         | 23,360     |                    |            |                   |           |           |            |      | 23,360     |            |            |   |           |          
|                                                                        |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |          
|                                                                        | Total revenues           |         |            | 819,340            |            |                   |            | 513,739   |            |      |            | 7,687,933  |            |   |            | 6,851,675 |           
|                                                                        |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |          
|OPERATING EXPENSES:                                                     |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |          
|Cost of product sales                                                   |                          |         | 4,731      |                    |            |                   |           |           |            |      | 4,731      |            |            |   |           |          
|Product launch expenses                                                 |                          |         |           |                    |            |                   | 235,919    |           |            |      |           |            |            |   | 728,148    |          
|Research and development                                                |                          |         | 4,119,526  |                    |            |                   | 1,394,732  |           |            |      | 9,631,293  |            |            |   | 5,165,822  |          
|General and administrative                                              |                          |         | 1,343,075  |                    |            |                   | 799,002    |           |            |      | 3,376,114  |            |            |   | 2,620,613  |          
|Sales and marketing                                                     |                          |         | 392,881    |                    |            |                   | 360,550    |           |            |      | 1,073,678  |            |            |   | 866,844    |          
|                                                                        |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |          
|                                                                        | Total operating expenses |         |            | 5,860,213          |            |                   |            | 2,790,203 |            |      |            | 14,085,816 |            |   |            | 9,381,427 |           
|                                                                        |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |          
|LOSS FROM OPERATIONS                                                    |                          |         | (5,040,873 | )                  |            |                   | (2,276,464 | )         |            |      | (6,397,883 | )          |            |   | (2,529,752 | )        
|Interest income                                                         |                          |         | 150,833    |                    |            |                   | 284,975    |           |            |      | 519,659    |            |            |   | 960,474    |          
|Other income                                                            |                          |         | 8,649      |                    |            |                   |           |           |            |      | 95,597     |            |            |   |           |          
|Interest expense                                                        |                          |         | (13,874    | )                  |            |                   | (870       | )         |            |      | (46,717    | )          |            |   | (5,308     | )        
|                                                                        |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |          
|NET LOSS                                                                |                          | $       | (4,895,265 | )                  |            | $                 | (1,992,359 | )         |            | $    | (5,829,344 | )          |            | $ | (1,574,586 | )        
|                                                                        |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |          
|NET LOSS ATTRIBUTABLE TO
COMMON SHAREHOLDERS:                           |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |          
|Net loss                                                                |                          | $       | (4,895,265 | )                  |            | $                 | (1,992,359 | )         |            | $    | (5,829,344 | )          |            | $ | (1,574,586 | )        
|Dividends on redeemable
convertible preferred stock                     |                          |         | (6,250     | )                  |            |                   | (6,233     | )         |            |      | (18,750    | )          |            |   | (18,698    | )        
|Accretion of discount
related to redeemable
convertible preferred stock |                          |         | (4,559     | )                  |            |                   | (4,559     | )         |            |      | (13,677    | )          |            |   | (13,677    | )        
|                                                                        |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |          
|NET LOSS ATTRIBUTABLE TO
COMMON SHAREHOLDERS                            |                          | $       | (4,906,074 | )                  |            | $                 | (2,003,151 | )         |            | $    | (5,861,771 | )          |            | $ | (1,606,961 | )        
|                                                                        |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |          
|NET LOSS PER SHARE:                                                     |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |          
|                                                                        |                          | BASIC   |            | $                  | (0.08      | )                 |            | $         | (0.03      | )    |            | $          | (0.10      | ) |            | $         | (0.03      | )
|                                                                        |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |          
|                                                                        |                          | DILUTED |            | $                  | (0.08      | )                 |            | $         | (0.03      | )    |            | $          | (0.10      | ) |            | $         | (0.03      | )
|                                                                        |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |          
|WEIGHTED AVERAGE NUMBER OF
COMMON SHARES OUTSTANDING:                   |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |          
|                                                                        |                          | BASIC   |            |                    | 58,275,445 |                   |            |           | 57,542,291 |      |            |            | 58,180,998 |   |            |           | 57,368,194 |  
|                                                                        |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |          
|                                                                        |                          | DILUTED |            |                    | 58,275,445 |                   |            |           | 57,542,291 |      |            |            | 58,180,998 |   |            |           | 57,368,194 |  
|                                                                        |                          |         |            |                    |            |                   |            |           |            |      |            |            |            |   |            |          

See notes to consolidated financial statements.

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AVANIR Pharmaceuticals




CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

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|                                                                             |                                                      |   |            |                   |   |      |            |            |   | 
|---------------------------------------------------------------------------- | ---------------------------------------------------- | - | ---------- | ----------------- | - | ---- | ---------- | ---------- | - | 
|                                                                             |                                                      |   |            | Nine Months Ended
|                                                                             |                                                      |   |            | June 30,         
|                                                                             |                                                      |   |            |                  
|                                                                             |                                                      |   |            | 2002              |   | 2001
|                                                                             |                                                      |   |            |                   |   |     
|OPERATING ACTIVITIES:                                                        |                                                      |   |            |                   |   |      |            |           
|Net loss                                                                     |                                                      | $ | (5,829,344 | )                 |   | $    | (1,574,586 | )         
|Adjustments to reconcile net loss to net cash used for
operating activities: |                                                      |   |            |                   |   |      |            |           
|Depreciation and amortization                                                |                                                      |   | 424,142    |                   |   |      | 516,770    |           
|Compensation paid with common stock and stock options                        |                                                      |   | 133,947    |                   |   |      | 95,271     |           
|Loss on disposal of assets                                                   |                                                      |   | 485        |                   |   |      | 16,482     |           
|Changes in assets and liabilities:                                           |                                                      |   |            |                   |   |      |            |           
|                                                                             | Receivables                                          |   |            | 1,743             |   |      |            | (465,131   | )
|                                                                             | Inventory                                            |   |            | 8,629             |   |      |            | (212,781   | )
|                                                                             | Prepaid expenses and other assets                    |   |            | 63,933            |   |      |            | (72,090    | )
|                                                                             | Deferred costs                                       |   |            |                  |   |      |            | (256,175   | )
|                                                                             | Accounts payable                                     |   |            | 1,276,317         |   |      |            | (374,353   | )
|                                                                             | Accrued expenses and other liabilities               |   |            | 783,771           |   |      |            | 366,320    |  
|                                                                             | Accrued compensation and payroll taxes               |   |            | 1,734             |   |      |            | 30,421     |  
|                                                                             |                                                      |   |            |                   |   |      |            |           
|                                                                             | Net cash used for operating activities               |   |            | (3,134,643        | ) |      |            | (1,929,852 | )
|INVESTING ACTIVITIES:                                                        |                                                      |   |            |                   |   |      |            |           
|Investments in securities                                                    |                                                      |   | (8,577,566 | )                 |   |      | (4,450,000 | )         
|Proceeds from sales and maturities of investments in securities              |                                                      |   | 3,875,000  |                   |   |      | 367,101    |           
|Patent costs                                                                 |                                                      |   | (455,929   | )                 |   |      | (386,059   | )         
|Purchases of property and equipment                                          |                                                      |   | (693,739   | )                 |   |      | (882,278   | )         
|                                                                             |                                                      |   |            |                   |   |      |            |           
|                                                                             | Net cash used for investing activities               |   |            | (5,852,234        | ) |      |            | (5,351,236 | )
|FINANCING ACTIVITIES:                                                        |                                                      |   |            |                   |   |      |            |           
|Proceeds from issuance of common stock, net                                  |                                                      |   | 260,574    |                   |   |      | 1,198,255  |           
|Dividends paid on preferred stock                                            |                                                      |   | (18,750    | )                 |   |      |           |           
|Proceeds from issuance of notes payable                                      |                                                      |   |           |                   |   |      | 27,648     |           
|Repayment of loans payable                                                   |                                                      |   | (271,039   | )                 |   |      | (168,105   | )         
|                                                                             |                                                      |   |            |                   |   |      |            |           
|                                                                             | Net cash (used for) provided by financing activities |   |            | (29,215           | ) |      |            | 1,057,798  |  
|                                                                             |                                                      |   |            |                   |   |      |            |           
|Net decrease in cash and cash equivalents                                    |                                                      |   | (9,016,092 | )                 |   |      | (6,223,290 | )         
|Cash and cash equivalents at beginning of period                             |                                                      |   | 16,542,545 |                   |   |      | 19,699,768 |           
|                                                                             |                                                      |   |            |                   |   |      |            |           
|Cash and cash equivalents at end of period                                   |                                                      | $ | 7,526,453  |                   |   | $    | 13,476,478 |           
|                                                                             |                                                      |   |            |                   |   |      |            |           
|SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:                           |                                                      |   |            |                   |   |      |            |           
|Interest paid                                                                |                                                      | $ | 46,717     |                   |   | $    | 5,308      |           
|                                                                             |                                                      |   |            |                   |   |      |            |           
|SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND FINANCING
ACTIVITIES:     |                                                      |   |            |                   |   |      |            |           
|Acquisition of equipment under capital leases                                |                                                      | $ | 122,662    |                   |   | $    |           |           
|Patent purchased with common stock                                           |                                                      | $ |           |                   |   | $    | 111,158    |           

See notes to consolidated financial statements

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AVANIR Pharmaceuticals




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

---

1. BASIS OF PRESENTATION

We have 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. These 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, 2001.
These statements include all adjustments, consisting primarily of normal
recurring accruals, necessary to present fairly our financial position as of
June 30, 2002, and the results of operations for the three and nine-month
periods ended June 30, 2002. The results of operations for the three and
nine-month periods ended June 30, 2002 may not be indicative of the results
that may be expected for the fiscal year ending September 30, 2002.

2. RECLASSIFICATIONS

Certain amounts from the prior period have been reclassified to conform to the
current period presentation.

3. 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
at 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.

4. BALANCE SHEET DETAILS

The following tables provide details of selected balance sheet items.

|                             |                                                |                             |           |            |           |               |           |           |           | 
|---------------------------- | ---------------------------------------------- | --------------------------- | --------- | ---------- | --------- | ------------- | --------- | --------- | --------- | 
|                             |                                                |                             |           | June 30,   |           | September 30,
|                             |                                                |                             |           | 2002       |           | 2001         
|                             |                                                |                             |           |            |           |              
|Property and equipment, net: |                                                |                             |           |            |           |               |           |          
|                             | Leasehold improvements                         |                             | $         | 845,505    |           |               | $         | 753,824   |          
|                             | Computer equipment and related software        |                             |           | 703,436    |           |               |           | 296,862   |          
|                             | Research and development equipment             |                             |           | 2,123,338  |           |               |           | 1,831,645 |          
|                             | Office equipment, furniture, and fixtures      |                             |           | 244,765    |           |               |           | 218,796   |          
|                             |                                                |                             |           |            |           |               |           |          
|                             |                                                |                             | 3,917,044 |            |           |               | 3,101,127 |          
|                             | Less accumulated depreciation and amortization |                             |           | (1,268,862 | )         |               |           | (884,033  | )        
|                             |                                                |                             |           |            |           |               |           |          
|                             |                                                | Property and equipment, net |           | $          | 2,648,182 |               |           | $         | 2,217,094 | 
|                             |                                                |                             |           |            |           |               |           |          
|Intangible assets, net:      |                                                |                             |           |            |           |               |           |          
|                             | Intangible costs                               |                             | $         | 1,769,634  |           |               | $         | 1,313,704 |          
|                             | Less accumulated amortization                  |                             |           | (178,090   | )         |               |           | (138,776  | )        
|                             |                                                |                             |           |            |           |               |           |          
|                             |                                                | Intangible assets, net      |           | $          | 1,591,544 |               |           | $         | 1,174,928 | 
|                             |                                                |                             |           |            |           |               |           |          

6



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##### Table of Contents



5. INVENTORY

Inventory is stated at the lower of cost (first-in, first-out) or market value.
Inventory consists 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.
The Company does not own or store any product in its final form, such as
docosanol 10% cream.

6. 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, 2002: |                         |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          
|                     | Certificates of deposit |                                  | $                     | 1,588,122 |           |           | $         | 2,436      |        |            | $ | (1,615  | )       |   | $ | 1,588,943 |           
|                     | Government securities   |                                  |                       | 8,200,000 |           |           |           | 32,640     |        |            |   | (23,430 | )       |   |   | 8,209,210 |           
|                     | Commercial paper        |                                  |                       | 200,000   |           |           |           | 6,992      |        |            |   |        |         |   |   | 206,992   |           
|                     |                         |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          
|                     |                         | Total                            |                       | $         | 9,988,122 |           |           | $          | 42,068 |            |   | $       | (25,045 | ) |   | $         | 10,005,145 | 
|                     |                         |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          
|Reported as:         |                         |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          
|                     | Short-term investments: |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |           |           
|                     |                         | Classified as available for sale |                       | $         | 678,179   |           |           |            |        |            |   |         |         |   |   |           |            | 
|                     | Long-term investments:  |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |           |           
|                     |                         | Classified as available for sale |                       |           | 8,707,597 |           |           |            |        |            |   |         |         |   |   |           |            | 
|                     |                         | Classified as held to maturity   |                       |           | 200,000   |           |           |            |        |            |   |         |         |   |   |           |            | 
|                     |                         | Restricted investment (1)        |                       |           | 388,122   |           |           |            |        |            |   |         |         |   |   |           |            | 
|                     |                         |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          
|                     |                         |                                  | Long-term investments |           |           | 9,295,719 |           |            |        |            |   |         |         |   |   |           |            |  | 
|                     |                         |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          
|                     |                         |                                  |                       | Total     |           | $         | 9,973,898 |            |        |            |   |         |         |   |   |           |            |  |  | 
|                     |                         |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          

|                          |                         |                         |                                  |                       |           |           |           |            |        |            |        |       |   |   |   |   |           |   |           | 
|------------------------- | ----------------------- | ----------------------- | -------------------------------- | --------------------- | --------- | --------- | --------- | ---------- | ------ | ---------- | ------ | ----- | - | - | - | - | --------- | - | --------- | 
|                          |                         |                         |                                  |                       |           |           |           |            |        | Gross      |        | Gross |   |   |   |  
|                          |                         |                         |                                  |                       |           | Amortized |           | Unrealized |        | Unrealized |        | Fair 
|                          |                         |                         |                                  |                       |           | Cost      |           | Gains(3)   |        | Losses     |        | Value
|                          |                         |                         |                                  |                       |           |           |           |            |        |            |        |      
|As of September 30, 2001: |                         |                         |                                  |                       |           |           |           |            |        |            |        |       |   |   |   |  
|                          |                         | Certificates of deposit |                                  | $                     | 411,301   |           |           | $          |       |            |        | $     |  |   |   | $ | 411,301   |  
|                          |                         | Government securities   |                                  |                       | 4,650,000 |           |           |            | 48,952 |            |        |       |  |   |   |   | 4,698,952 |  
|                          |                         | Commercial paper        |                                  |                       | 200,000   |           |           |            | 8,862  |            |        |       |  |   |   |   | 208,862   |  
|                          |                         |                         |                                  |                       |           |           |           |            |        |            |        |       |   |   |   |  
|                          |                         |                         |                                  | Total                 |           | $         | 5,261,301 |            |        | $          | 57,814 |       |   | $ |  |   |           | $ | 5,319,115 | 
|                          |                         |                         |                                  |                       |           |           |           |            |        |            |        |       |   |   |   |  
|Reported as:              |                         |                         |                                  |                       |           |           |           |            |        |            |        |       |   |   |   |  
|                          | Short-term investments: |                         |                                  |                       |           |           |           |            |        |            |        |       |   |   |   |   |          
|                          |                         |                         | Classified as held to maturity   |                       | $         | 23,179    |           |            |        |            |        |       |   |   |   |   |           |   |          
|                          | Long-term investments:  |                         |                                  |                       |           |           |           |            |        |            |        |       |   |   |   |   |          
|                          |                         |                         | Classified as available for sale |                       |           | 4,497,390 |           |            |        |            |        |       |   |   |   |   |           |   |          
|                          |                         |                         | Classified as held to maturity   |                       |           | 400,000   |           |            |        |            |        |       |   |   |   |   |           |   |          
|                          |                         |                         | Restricted investment (1)        |                       |           | 388,122   |           |            |        |            |        |       |   |   |   |   |           |   |          
|                          |                         |                         |                                  |                       |           |           |           |            |        |            |        |       |   |   |   |  
|                          |                         |                         |                                  | Long-term investments |           |           | 5,285,512 |            |        |            |        |       |   |   |   |   |           |   |           | 
|                          |                         |                         |                                  |                       |           |           |           |            |        |            |        |       |   |   |   |  
|                          |                         |                         |                                  | Total                 |           | $         | 5,308,691 |            |        |            |        |       |   |   |   |   |           |   |           | 
|                          |                         |                         |                                  |                       |           |           |           |            |        |            |        |       |   |   |   |  



|(1) |  | A restricted investment amounting to $388,122 as of June 30, 2002
and September 30, 2001 represents an amount that we pledged to our
bank as collateral for a letter of credit that our bank issued in
connection with our lease of office and laboratory space.                                           
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|   
|   
|   
|(2) |  | Gross unrealized gains of $35,076 and
gross unrealized losses of $25,045 on government securities and
certificates of deposit represent an
accumulated net unrealized gain of $10,031, which is reported as
Accumulated other comprehensive income on the consolidated balance
sheet as of June 30, 2002.
|   
|   
|   
|   
|(3) |  | Includes government securities with maturities in excess of 90 days
and having gross unrealized gains totaling $47,390, which has been
reported as Accumulated other comprehensive income on the
consolidated balance sheet as of September 30, 2001.                                                    

7



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##### Table of Contents



7. COMPUTATION OF NET LOSS PER SHARE

We computed basic net loss per 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 computed diluted net loss per 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 the amounts for net loss per share for the three and nine-month
periods ended June 30, 2002 and 2001 using the Basic EPS Method and the
Diluted EPS Method.

The following table provides a reconciliation from the basic to the diluted net
loss per share computations for net loss for the three and nine-month periods
ended June 30, 2002 and 2001:

|                                                                          |                                |                                                                         |                                       |                                                                             |            |                             |            |                            |            |            |            |      |            |            |            |   |            |            |            |  
|------------------------------------------------------------------------- | ------------------------------ | ----------------------------------------------------------------------- | ------------------------------------- | --------------------------------------------------------------------------- | ---------- | --------------------------- | ---------- | -------------------------- | ---------- | ---------- | ---------- | ---- | ---------- | ---------- | ---------- | - | ---------- | ---------- | ---------- | -
|                                                                          |                                |                                                                         |                                       |                                                                             |            | Three Months Ended June 30, |            | Nine Months Ended June 30,
|                                                                          |                                |                                                                         |                                       |                                                                             |            |                             |            |                           
|                                                                          |                                |                                                                         |                                       |                                                                             |            | 2002                        |            | 2001                       |            | 2002       |            | 2001
|                                                                          |                                |                                                                         |                                       |                                                                             |            |                             |            |                            |            |            |            |     
|Numerator:                                                                |                                |                                                                         |                                       |                                                                             |            |                             |            |                            |            |            |            |      |            |            |            |  
|                                                                          |                                | Net loss                                                                |                                       | $                                                                           | (4,895,265 | )                           |            | $                          | (1,992,359 | )          |            | $    | (5,829,344 | )          |            | $ | (1,574,586 | )         
|Less:                                                                     |                                |                                                                         |                                       |                                                                             |            |                             |            |                            |            |            |            |      |            |            |            |  
|                                                                          |                                | Dividends on redeemable
convertible preferred
stock                     |                                       |                                                                             | (6,250     | )                           |            |                            | (6,233     | )          |            |      | (18,750    | )          |            |   | (18,698    | )         
|                                                                          |                                | Accretion of discount
related to redeemable
convertible preferred stock |                                       |                                                                             | (4,559     | )                           |            |                            | (4,559     | )          |            |      | (13,677    | )          |            |   | (13,677    | )         
|                                                                          |                                |                                                                         |                                       |                                                                             |            |                             |            |                            |            |            |            |      |            |            |            |  
|                                                                          |                                |                                                                         |                                       | Net loss attributable
to common shareholders
for basic earnings per
share   |            |                             | (4,906,074 | )                          |            |            | (2,003,151 | )    |            |            | (5,861,771 | ) |            |            | (1,606,961 | )
|Effect of dilutive securities:                                            |                                |                                                                         |                                       |                                                                             |            |                             |            |                            |            |            |            |      |            |            |            |  
|                                                                          |                                | Convertible preferred stock                                             |                                       |                                                                             |           |                             |            |                            |           |            |            |      |           |            |            |   |           |           
|                                                                          |                                |                                                                         |                                       |                                                                             |            |                             |            |                            |            |            |            |      |            |            |            |  
|                                                                          |                                |                                                                         |                                       | Net loss attributable
to common shareholders
for diluted earnings
per share |            | $                           | (4,906,074 | )                          |            | $          | (2,003,151 | )    |            | $          | (5,861,771 | ) |            | $          | (1,606,961 | )
|                                                                          |                                |                                                                         |                                       |                                                                             |            |                             |            |                            |            |            |            |      |            |            |            |  
|Denominator:                                                              |                                |                                                                         |                                       |                                                                             |            |                             |            |                            |            |            |            |      |            |            |            |  
|Shares for basic net loss per
share  weighted average
shares outstanding |                                |                                                                         | 58,275,445                            |                                                                             |            |                             | 57,542,291 |                            |            |            | 58,180,998 |      |            |            | 57,368,194 |  
|Effect of dilutive securities:                                            |                                |                                                                         |                                       |                                                                             |            |                             |            |                            |            |            |            |      |            |            |            |  
|                                                                          | Stock options(1)               |                                                                         |                                       |                                                                            |            |                             |            |                           |            |            |            |     |            |            |            |  |           
|                                                                          | Warrant shares(2)              |                                                                         |                                       |                                                                            |            |                             |            |                           |            |            |            |     |            |            |            |  |           
|                                                                          | Convertible preferred
stock(3) |                                                                         |                                       |                                                                            |            |                             |            |                           |            |            |            |     |            |            |            |  |           
|                                                                          |                                |                                                                         |                                       |                                                                             |            |                             |            |                            |            |            |            |      |            |            |            |  
|                                                                          |                                |                                                                         | Shares for diluted net
loss per share |                                                                             |            | 58,275,445                  |            |                            |            | 57,542,291 |            |      |            | 58,180,998 |            |   |            | 57,368,194 |           
|                                                                          |                                |                                                                         |                                       |                                                                             |            |                             |            |                            |            |            |            |      |            |            |            |  
|Basic net loss per share                                                  |                                | $                                                                       | (0.08                                 | )                                                                           |            | $                           | (0.03      | )                          |            | $          | (0.10      | )    |            | $          | (0.03      | )
|                                                                          |                                |                                                                         |                                       |                                                                             |            |                             |            |                            |            |            |            |      |            |            |            |  
|Diluted net loss per share                                                |                                | $                                                                       | (0.08                                 | )                                                                           |            | $                           | (0.03      | )                          |            | $          | (0.10      | )    |            | $          | (0.03      | )
|                                                                          |                                |                                                                         |                                       |                                                                             |            |                             |            |                            |            |            |            |      |            |            |            |  



|(1) |  | For the three-month periods ended June 30, 2002 and 2001, options to
purchase 5,602,842 and 5,189,169 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 nine-month
periods ended June 30, 2002 and 2001, options to purchase 5,602,842 and
5,189,169 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.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|   
|   
|   
|(2) |  | For the three-month periods ended June 30, 2002 and 2001, warrants to
purchase 1,184,550 and 1,372,131 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 nine-month
periods ended June 30, 2002 and 2001, warrants to purchase 1,184,550 and
1,372,131 shares of common stock were excluded from the computation of
diluted net loss per share, as the inclusion of such shares would be
antidilutive.              
|   
|   
|   
|   
|(3) |  | For the three-month periods ended June 30, 2002 and 2001, preferred stock
convertible into 347,211 and 183,534 shares of common stock, respectively,
were excluded from the computation of diluted net loss per share as the
inclusion of such                                                                                                                                                                                                                                                                                          



8



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##### Table of Contents



| |  | shares would be antidilutive. For the nine-month periods ended June 30,
2002 and 2001, preferred stock convertible into 347,211 and 183,534 shares
of common stock were excluded from the computation of diluted net loss per
share, as the inclusion of such shares would be antidilutive.
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

8. COMMITMENTS AND CONTINGENCIES

On May 20, 2002, we signed a ten-year lease with Sorrento Plaza LP for use of
approximately 26,770 square feet of office space in buildings located at 11404
and 11408 Sorrento Valley Road in San Diego, California, commencing on January
15, 2003. Our total financial commitment to the lessor for the term of the
lease is $9,742,080 (See Exhibit 10.1). In connection with this lease, on
August 5, 2002 we entered into an irrevocable standby letter of credit,
available through Bank of America, N.A., in the amount of $468,475, which names
the lessor as the beneficiary in the event that we default on our payments to
the lessor.

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.
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.

9. SHAREHOLDERS EQUITY

Series C Junior Participating Preferred Stock

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

Series D Redeemable Convertible Preferred Stock

At June 30, 2002 and September 30, 2001, 50 shares of Series D redeemable
convertible preferred stock (Series D Shares) remained outstanding in
connection with a securities purchase agreement made with certain investors on
March 22, 1999. The Series D holders may convert any or all of the remaining
Series D Shares into shares of Class A common stock at a conversion rate equal
to $10,000 divided by a conversion price equal to the lesser of:



| |  | the Fixed Conversion Price  an amount equal to $2.715 per share
of Class A common stock; or                                    
|- |  | --------------------------------------------------------------------------------------------------------------------------------
| 
| |  | the Variable Conversion Price  an amount equal to 86% of the
market price of our Class A common stock, defined as the lower of:



| |  |  | the average of the five lowest trading prices per share of
Class A common stock on The American Stock Exchange during the 25
trading days immediately preceding a given date of determination,
where trading price is determined as the average of the high and
low trading prices of our Class A common stock on a particular
trading day; or
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the average of the high and low trading price per share of
Class A common stock on The American Stock Exchange on the date of
determination.                                                                                                                                                                                                  

9



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Class A Common Stock

On December 12, 2001, the holder of Class K Warrants exercised its right to
purchase 80,000 shares of Class A common stock at an exercise price of $1.125
per share, for cash in the aggregate amount of $90,000.

Class B Common Stock Conversion

On February 4, 2002 and June 28, 2002, 18,000 and 5,000 shares of Class B
common stock converted to 18,000 and 5,000 shares, respectively, of Class A
common stock, leaving a balance of 13,500 shares of Class B common stock
outstanding as of June 30, 2002.

10. RECENT ACCOUNTING PRONOUNCEMENTS

In July 2001, the Financial Accounting Standards Board (FASB) approved
Statement of Financial Accounting Standards No. 142 (SFAS No. 142), Goodwill
and Other Intangible Assets. SFAS No. 142 supercedes APB Opinion No. 17, Intangible Assets, and requires
goodwill and other intangible assets that have an indefinite useful life to no
longer be amortized; however, these assets must be reviewed at least annually
for impairment. Application of SFAS No. 142 is required for the Company on
October 1, 2002. We do not believe the adoption of SFAS No. 142 will have a
significant impact on the Companys financial statements.

In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets. This statement addresses financial accounting
and reporting for the impairment or disposal of long-lived assets. This
statement supercedes SFAS No. 121, Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed Of, and the accounting and
reporting provisions of APB Opinion No. 30, Reporting the Results of
Operations  Reporting the Effects of a Disposal of a Segment of a Business,
and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,
for the disposal of a segment of a business (as previously defined in that
Opinion). SFAS No. 144 becomes effective for the Company on October 1, 2002.
The effect, if any, of SFAS No. 144 on the Companys financial statements has
not yet been determined.

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. The Company will adopt the provisions of SFAS
No. 146 for exit or disposal activities that are initiated after
December 31, 2002.

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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
and expect and similar expressions as they relate to AVANIR 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 Additional Factors that Might Affect Future
Results and in our most recent annual report on Form 10-K filed with the
Securities and Exchange Commission. We disclaim any obligation to update or
announce revisions to any forward-looking statements to reflect actual events
or developments.

Overview

AVANIR Pharmaceuticals, based in San Diego and incorporated in California in
1988, is a biopharmaceutical drug discovery and development company. AVANIR is
engaged in research, discovery, development and licensing of innovative drug
products, and through its subsidiary, Xenerex Biosciences (Xenerex), sales of
antibody generation and product development services.

AVANIR successfully developed the first over-the-counter (OTC) drug that has
been approved by the United States Food and Drug Administration (FDA) for the
treatment of cold sores. Marketed in North America by GlaxoSmithKline, Abreva
(docosanol 10% cream) was launched in the United States in late 2000.
According to AC Nielson, Abreva is the largest selling consumer healthcare
product in the U.S. for the treatment of cold sores. The consumer research
group also ranked Abreva among the ten top selling new consumer healthcare
products introduced in the twelve-month period ended December 2001. AVANIR
expects to receive royalties on Abreva product sales until at least 2014.

We continue to expand our docosanol franchise worldwide. We now have license
and development agreements for docosanol 10% cream in Canada, Italy, China,
South Korea, Israel and Egypt. Since March 2002 the product has been approved
for marketing as an OTC product in Canada, South Korea and Israel. In
June 2002,
our marketing partner in South Korea launched docosanol 10% cream under the brand name
Herepair. In May 2002, we filed for marketing approval of docosanol 10% cream
with the Medical Products Agency (MPA) in Sweden. We selected Sweden as the
lead country for our European franchise and plan to pursue the process of
mutual recognition in obtaining regulatory review throughout the European
Union.

AVANIRs drug development pipeline consists of clinical, pre-clinical and drug
discovery programs. Current clinical development programs are centered around
Neurodex (AVP-923), which could potentially provide a novel approach for the
treatment of several central nervous system (CNS) disorders. The leading
clinical development program is for the treatment of pseudobulbar affect, also
known as emotional lability. Pseudobulbar affect is experienced by
approximately one million patients with various neurological conditions,
including ALS (amyotrophic lateral sclerosis, or Lou Gehrigs disease),
Alzheimers disease, multiple sclerosis (MS), stroke and traumatic brain
injury. Pseudobulbar affect is a condition for which no FDA-approved
drug is indicated. Our
preclinical research and drug discovery programs are directed primarily toward
large therapeutic areas, including allergies and asthma, inflammatory diseases
and cholesterol reduction.

Licensing our products and partnering with other companies represent important
sources of funds for us to achieve cash inflows and pursue development of
several potential drugs and technology platforms. We intend to fund our
current preclinical development programs, if successful, at least until we are
able

11



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##### Table of Contents



to obtain Investigational New Drug (IND) status and begin clinical trials.
Thereafter, our strategy is to seek partners for co-development or
grant licenses to develop and market our potential new drugs. Co-development would
allow us to share development costs. Licensing would provide an opportunity to
receive license fees and milestone payments as the product is developed and
royalties on product sales if a product were to be successfully launched.

We also expect that Xenerex will help establish new research collaborations as
it produces human monoclonal antibodies to selected targets. Xenerex has three
collaborative research agreements in place for generating fully human
monoclonal antibodies to target antigens provided by research partners.
Xenerex now has contracts to generate antibodies to eight target antigens
provided by its partners and has a federal research grant to produce antibodies
to the Anthrax virus. Xenerex is also producing antibodies to targets
identified internally for future research and development by the Company.

Revenue-generating Contracts

As of August 6, 2002, we had nine active commercial contracts and three active
government-funded research grants that are generating or could generate
important revenues in the future to help fund our research and development
programs. Five of the commercial contracts are in the form of Abreva or
docosanol 10% cream license agreements, one contract is for the
commercialization of Neurodex, and three other contracts are through Xenerex
and are in the form of antibody research service agreements. AVANIRs
government-funded research totals $1.2 million and is for developing a
potential docosanol-based genital herpes product and an antibody to anthrax.

We expect that substantially all of our revenues for the next two quarters will
be earned from license fees, milestone payments, sales of the raw material
docosanol, research fees, grants and royalties under existing contracts and
research grants. GlaxoSmithKline continues to be our most significant revenue
source, representing over 95% of the Companys revenues for the first nine
months of fiscal 2002. A list of our revenue-generating contractual
arrangements is set forth as follows.

Revenue-generating Contracts

|                                 |  |                       |  |                   |  |                    
|-------------------------------- |  | --------------------- |  | ----------------- |  | -------------------
|                                 |  | Type of Agreement     |  | Date of Agreement |  | Product License,   
|Company or Research Grant        |  | or Grant Award        |  | Or Grant Award    |  | Service or Research
|                                 |  |                       |  |                   |  |                    
|GlaxoSmithKline                  |  | License of Abreva    |  | March 31, 2000    |  | Cold sore product  
|                                 |  | (U.S. and Canada)     |  |                   |  | license            
|                                 |  |                       |  |                   |  |                    
|CTS Chemical Industries, LTD     |  | Docosanol license     |  | July 6, 1993      |  | Cold sore product  
|                                 |  | (Israel)              |  |                   |  | license            
|                                 |  |                       |  |                   |  |                    
|Boryung Pharmaceuticals Co., LTD |  | Docosanol license     |  | March 11, 1994    |  | Cold sore product  
|                                 |  | (South Korea)         |  |                   |  | license            
|                                 |  |                       |  |                   |  |                    
|BioPharm Group                   |  | Docosanol license     |  | January 11, 2002  |  | Cold sore product  
|                                 |  | (Egypt)               |  |                   |  | license            
|                                 |  |                       |  |                   |  |                    
|Bruno Farmaceutici S.p.A.        |  | Docosanol license     |  | July 29, 2002     |  | Cold sore product  
|                                 |  | (Italy)               |  |                   |  | license            
|                                 |  |                       |  |                   |  |                    
|Medison Pharma, Ltd.             |  | Neurodex research and |  | August 6, 2002    |  | Pseudobulbar Affect
|                                 |  | commercialization     |  |                   |  | research and       
|                                 |  | (Israel)              |  |                   |  | commercialization  
|                                 |  |                       |  |                   |  |                    
|Eos Biotechnology, Inc.          |  | Antibody research by  |  | December 21, 2001 |  | Antibody generation
|                                 |  | Xenerex               |  |                   |  | services           
|                                 |  |                       |  |                   |  |                    
|Peregrine Pharmaceuticals        |  | Antibody research by  |  | June 7, 2001      |  | Antibody generation
|                                 |  | Xenerex               |  |                   |  | services           

12



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|                                       |  |                            |  |                    |  |                                 
|-------------------------------------- |  | -------------------------- |  | ------------------ |  | --------------------------------
|                                       |  | Type of Agreement          |  | Date of Agreement  |  | Product License,                
|Company or Research Grant              |  | or Grant Award             |  | Or Grant Award     |  | Service or Research             
|                                       |  |                            |  |                    |  |                                 
|DNAX Research, Inc.                    |  | Antibody research by       |  | January 21, 2002   |  | Antibody generation             
|                                       |  | Xenerex                    |  |                    |  | services                        
|                                       |  |                            |  |                    |  |                                 
|Small Business Innovative Research     |  | Federal research grant and |  | March 12, 2002 and |  | Pre-clinical research of        
|(SBIR) Grant and California Technology |  | State research grant       |  | April 26, 2002     |  | potential genital herpes product
|Investment Partnership Program         |  |                            |  |                    |  |                                 
|                                       |  |                            |  |                    |  |                                 
|                                       |  |                            |  |                    |  |                                 
|California Center for Advanced         |  | State grant                |  | June 19, 2002      |  | Pre-clinical anthrax            
|Technology (CCAT)                      |  |                            |  |                    |  | antibody research               

Research and Development Programs and Products in Clinical Development

We are currently conducting research on a number of potential therapeutic
products and technology platforms that are in various phases of clinical and
pre-clinical development. Pharmaceutical research and development (R&D)
programs, by their very nature, require a substantial amount of financial and
human resources and there is no assurance that they will be approved for
marketing by domestic and/or foreign regulatory agencies. The cost to develop
all of AVANIRs potential drugs through all clinical phases would cost
substantially in excess of funds currently available to the Company. As a
result, we do not intend to complete all clinical development stages ourselves
for several of our programs. We intend to use our own funds to develop
Neurodex through all clinical phases for the treatment of pseudobulbar affect
(emotional lability). Our strategy for our other drug development programs is
to use our own funds in the preclinical and early clinical stages and then
partner or license our technology when our research has been validated either
by Phase I or Phase II clinical data.

For many of our programs in large therapeutic areas, the higher costs of the
later stages of clinical development requires that we license our technology or
partner with other pharmaceutical companies that have substantially greater
financial resources. Our licensees would continue to develop and fund those
projects and pay us up-front license fees, milestone payments, and royalties on
product sales if those products are successfully developed and approved for
marketing by the FDA and other foreign regulatory approval agencies. We
caution that many of our development efforts could experience delays, setbacks
and failures, with no assurance that any of our clinical research or our
potential licensees or partners will ever reach the stage of a new drug
application (NDA) with the FDA or that the NDA will be approved. The following
table sets forth the status of our proprietary research and clinical
development programs.

13



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##### Table of Contents



Research and Development Projects and Other Research Programs Expense

|                                                                                                                                                                                                                                                                                        |       |   |                             |           |                            |   |           |           |           |   |           |           |         |   |           |           |  |   |           |            |  |                 |   |  | 
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----- | - | --------------------------- | --------- | -------------------------- | - | --------- | --------- | --------- | - | --------- | --------- | ------- | - | --------- | --------- |  | - | --------- | ---------- |  | --------------- | - |  | 
|                                                                                                                                                                                                                                                                                        |       |   |                             |           |                            |   | Inception |           | Estimated
|                                                                                                                                                                                                                                                                                        |       |   | Three
Months Ended June 30, |           | Nine
Months Ended June 30, |   | Through   |           | Cost to  
|                                                                                                                                                                                                                                                                                        |       |   |                             |           |                            |   | June
30,  |           | Complete 
|                                                                                                                                                                                                                                                                                        |       |   | 2002                        |           | 2001                       |   | 2002      |           | 2001      |   | 2002(2)   |           | Project
|                                                                                                                                                                                                                                                                                        |       |   |                             |           |                            |   |           |           |           |   |           |           |        
|Company-Funded Projects(1):                                                                                                                                                                                                                                                             |       |   |                             |           |                            |   |           |           |           |   |           |           |         |   |           |           |  |   |           |            |  |                 |   | 
|Develop Neurodex for FDA                                                                                                                                                                                                                                                                |       | $ | 877,846                     |           |                            | $ | 253,807   |           |           | $ | 1,975,746 |           |         | $ | 996,875   |           |  | $ | 3,966,179 |            |  | $7-9 million   
|marketing approval in
treating emotional
lability. Initial Phase
II/III clinical trial has
been completed and a Phase
III clinical trial and
open-label study are
planned. Estimated timing
to complete all phases of
project: second quarter of
calendar year 2004.                    |       |   |                             |           |                            |   |           |           |           |   |           |           |         |   |           |           |  |   |           |            |  |                 |   | 
|                                                                                                                                                                                                                                                                                       
|Develop Neurodex for                                                                                                                                                                                                                                                                    |       |   | 514,797                     |           |                            |   | 63,333    |           |           |   | 1,009,387 |           |         |   | 654,052   |           |  |   | 2,091,025 |            |  | $2-5 million   
|licensing as potential
treatment for neuropathic
pain at end of Phase II
clinical trials. Phase II
dose-ranging trial is
currently underway.
Estimated timing to
complete project: second
quarter of calendar year
2003.                                                                |       |   |                             |           |                            |   |           |           |           |   |           |           |         |   |           |           |  |   |           |            |  |                 |   | 
|                                                                                                                                                                                                                                                                                       
|Develop IgE Regulator for                                                                                                                                                                                                                                                               |       |   | 1,415,967                   |           |                            |   | 173,219   |           |           |   | 2,617,349 |           |         |   | 938,657   |           |  |   | 6,614,982 |            |  | $2-4 million   
|licensing as treatment for
allergy and asthma after
filing and obtaining
investigational new drug
status with FDA.
Preclinical toxicology work
is underway. Estimated
timing to complete project
is second quarter 2003.                                                                |       |   |                             |           |                            |   |           |           |           |   |           |           |         |   |           |           |  |   |           |            |  |                 |   | 
|                                                                                                                                                                                                                                                                                       
|Government-Funded
Projects:                                                                                                                                                                                                                                                             |       |   |                             |           |                            |   |           |           |           |   |           |           |         |   |           |           |  |   |           |            |  |                 |   | 
|Pre-clinical research is                                                                                                                                                                                                                                                                |       |   | 31,732                      |           |                            |   |          |           |           |   | 32,858    |           |         |   | 80,567    |           |  |   | 147,540   |            |  | $1.1 million(3)
|for potential treatments
for genital herpes and
anthrax. Estimated timing
to complete the various
projects varies from one to
two years.                                                                                                                                                |       |   |                             |           |                            |   |           |           |           |   |           |           |         |   |           |           |  |   |           |            |  |                 |   | 
|                                                                                                                                                                                                                                                                                       
|Other Pre-clinical Research
Projects:                                                                                                                                                                                                                                                   |       |   |                             |           |                            |   |           |           |           |   |           |           |         |   |           |           |  |   |           |            |  |                 |   | 
|We use proprietary drug                                                                                                                                                                                                                                                                 |       |   | 684,877                     |           |                            |   | 498,043   |           |           |   | 2,356,826 |           |         |   | 1,331,007 |           |  |   | 5,325,979 |            |  |                 |  | 
|discovery and technology
platforms (CCM, monoclonal
antibody technology) to
pursue potential treatments
for anti-inflammation and
cholesterol reduction. The
costs and timing to
complete our pre-clinical
research are unpredictable
because of the
unpredictability of our research. |       |   |                             |           |                            |   |           |           |           |   |           |           |         |   |           |           |  |   |           |            |  |                 |   | 
|                                                                                                                                                                                                                                                                                       
|Other(4)                                                                                                                                                                                                                                                                                |       |   | 594,307                     |           |                            |   | 406,330   |           |           |   | 1,639,128 |           |         |   | 1,164,664 |           |  |   | 8,475,046 |            |  |                 |  | 
|                                                                                                                                                                                                                                                                                        |       |   |                             |           |                            |   |           |           |           |   |           |           |         |   |           |           |  |   |           |            |  |                 |   | 
|                                                                                                                                                                                                                                                                                        | Total |   | $                           | 4,119,526 |                            |   | $         | 1,394,732 |           |   | $         | 9,631,294 |         |   | $         | 5,165,822 |  |   | $         | 26,620,751 |  |                 |   |  | 
|                                                                                                                                                                                                                                                                                        |       |   |                             |           |                            |   |           |           |           |   |           |           |         |   |           |           |  |   |           |            |  |                 |   | 



|1. |  | At June 30, 2002, 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 R&D programs.
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  
|2. |  | Inception dates are on or after October 1, 1998, at which time we began
identifying and tracking costs for these research programs.                                                      
|  
|3. |  | The Companys research in
this field is funded by $1.2 million in state and federal
research grants.                                                                                     
|  
|4. |  | Other includes primarily laboratory occupancy costs and scientific
management.                                                                                                         

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Neurodex Research Projects

Neurodex is a patented, orally administered combination of dextromethorphan
(DM) and an enzyme inhibitor that sustains elevated levels of dextromethorphan
on a proposed twelve-hour dosing schedule. AVANIR is developing Neurodex for
use in two indications: emotional lability and neuropathic pain.

Treatment of emotional lability. In May 2002, AVANIR successfully completed a
pivotal Phase II/III clinical trial for the treatment of pseudobulbar affect in
patients with ALS. Preliminary results reported in June showed the endpoint of
the study was statistically significant in favor of Neurodex when compared to
either of the other two treatment arms. Additional statistical analysis of the
study results has confirmed efficacy in the primary endpoint as well as
efficacy in pre-specified secondary endpoints. As expected, based on its
pharmacology, adverse events including nausea, drowsiness and dizziness were
reported with greater frequency in the Neurodex group. An abstract has been
submitted to the American Neurological Association conference scheduled for
October 2002. If accepted, detailed data on the clinical trials will be
presented at that meeting.

AVANIR plans to initiate a second Phase III trial for Neurodex that will be
conducted in MS patients later in 2002. AVANIR also intends to initiate in
calendar year 2002 an open-label safety study in patients with symptoms of pseudobulbar
affect. If we are successful in completing the remaining studies prior to the
end of 2003, we intend to file an NDA with the FDA in early 2004. Assuming the
FDA approves Neurodex for marketing under normal FDA review guidelines, the
drug would be available for sale by mid-2005 and we would expect to begin
receiving revenue from sales of the drug in the third
calendar quarter of 2005.

Treatment of Neuropathic Pain. In July 2002, we initiated a Phase II,
open-label dose-ranging clinical trial of Neurodex for the treatment of pain in
patients with diabetic neuropathy. Assuming we are successful in completing
the open-label dose-ranging trial and other Phase II clinical studies, as
planned, we intend to license the drug to another company that would continue
to carry out clinical development, including paying for development costs and
paying us license fees, milestone payments and/or royalties on product sales if
the drug is successfully developed and approved for marketing by the FDA.
There can be no assurances that the dose-ranging trial will be successful or
that we will be successful in obtaining a licensee for the drug. We intend to
complete our development efforts by the second calendar quarter 2003. We anticipate
finding a licensee and begin receiving material net cash inflows from payments
by the licensee by the third calendar quarter 2003.

We caution that many of our development efforts related to Neurodex could
experience delays, setbacks and failures, with no assurance that our clinical
research for either emotional lability or neuropathic pain will ever reach
completion in the timeframes planned, if at all, that we will be successful in
finding a licensee, or that the licensee will be successful in carrying out the
remainder of the clinical development, file an NDA or obtain approval from the
FDA for marketing the drug. If we or our licensee were to experience one or
more setbacks or failures in the development of the drug, we or our licensee
may have to repeat the research at additional cost or abandon of development
program.

Allergy and Asthma Preclinical Research (IgE Regulator) Project

A key component in the pathophysiology of both allergy and asthma is the
overproduction of immunoglobulin epsilon (IgE) antibodies. We have identified
a family of orally active small molecules that selectively inhibit or prevent
the production of IgE antibodies. As of June 30, 2002, we were in the
preclinical stage of development, engaged in toxicology studies of our lead
compound. We intend to file for an IND application for our lead compound with
the FDA before December 31, 2002. Assuming we are successful in filing an IND
for the product, we intend to begin shortly thereafter the process of

15



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##### Table of Contents



seeking a licensee for continued development of the drug. We expect that
clinical trials for this drug in the large therapeutic area of allergy and
asthma would require substantially more financial resources than we anticipate
will be available to us for the foreseeable future. Therefore, our strategy is
to license the drug for further development by another company and receive
license fees, milestone payments and/or royalties if the drug is successfully
developed. Assuming we are successful in our toxicology studies and we file
with the FDA for an IND and the IND is approved, we intend by the second
calendar quarter of 2003 to license the drug to another company that has the
resources to carry out and pay for the development program, including license
fees and milestone payments to us and royalties on product sales if
successfully developed and approved for marketing by the FDA.

We caution that many of our development efforts related to IgE could experience
delays, setbacks and failures, with no assurance that our research will ever
reach completion of our intended plan, that we will be successful in finding a
licensee, or that the licensee will be successful in carrying out the remainder
of the clinical development, file an NDA or obtain approval from the FDA. If
we or our licensee were to experience one or more setbacks or failures in the
development of the drug, we or our licensee may have to repeat the research at
additional cost or abandon the development program.

Government-funded Research Projects

We currently have three government-funded research grants totaling $1.2
million that are intended to reimburse us for the cost of certain preclinical
research related to a potential treatment for genital herpes and antibodies for
anthrax. Our $1 million Phase II Small Business Innovative Research (SBIR)
grant and $150,000 California Technology Investment Partnership (CalTIP) grant
are for pre-clinical research related to the development of a topical treatment
for genital herpes (HSV-2) over a two-year period. We are using the SBIR grant
to fund certain pre-clinical research related to genital herpes. We are using
the CalTIP funds for defining and assessing the market including assessment of
competitive landscape, product opportunities, brand identification and possible
brand names for a potential genital herpes product. Additionally, we recently
received a $75,000 grant from the California Center for Advanced Technology for
research and development during approximately the next twelve months related to
finding an antibody to anthrax.

Other Pre-clinical Research Projects

Anti-Inflammatory Research (MIF Inhibitor) In mid-2001 we acquired a
proprietary series of compounds that appear to inhibit or block the activity of
macrophage migration inhibitory factor (MIF). MIF is a protein that plays a
central role in inflammation pathways. Our research indicates that MIF may
serve as a potential drug target in a variety of diseases, including rheumatoid
arthritis, Crohns disease, colitis, asthma and sepsis. Our goal is to identify
and develop an orally administered compound that can be developed as an
innovative therapy for the treatment of inflammatory diseases. Our MIF
technology platform is currently in the early preclinical stage of development
and is at too early of a stage of development to predict the cost and timing to
complete the project.

Cholesterol Reduction (CCM Technology)  Our research on cholesterol lowering
agents is a very early stage drug discovery program that has been implemented
to discover agents that will be valuable in the treatment and prevention of
hyper-cholesterolemia (high cholesterol). Cholesterol is transported in the
blood in large cholesterol-rich particles called lipoproteins. Generally,
low-density lipoproteins (LDL) deliver the cholesterol to peripheral tissues
including aorta and coronary arteries, whereas high-density lipoproteins (HDL)
remove excess cholesterol from peripheral tissues, and transport it to the
liver for elimination. We have a proprietary technology, code-named CCM, that
we are using to identify peptides that may be capable of accelerating the
removal of excess cholesterol from peripheral tissues and transporting it to
the liver for elimination. Because our CCM technology platform is at a very
early stage of research, we are unable to predict the cost and timing for
development of a drug.

16



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##### Table of Contents



Monoclonal Antibodies Research As of June 30, 2002, we were engaged in
research collaborations with three companies that desire to use our proprietary
technology to produce fully human monoclonal antibodies to potential disease
targets. These research collaborations typically provide us with advance
payments to conduct research and provide for milestone payments in the event
that we are successful in meeting certain predetermined stages of development.
Xenerex is also conducting research on developing antibodies to targets
identified by AVANIR and itself for possible addition to the Companys own drug
discovery and development programs. Because all of our research is at a very early preclinical stage of development and
is unpredictable in terms of the outcome, we are unable to predict the cost and
timing for development of any antibody or drug.

Other Collaborative Research Programs  On January 15, 2002, we entered into a
collaborative research and development agreement with Shanghai New Asiatic
Pharmaceutical Company, Ltd., a division of Shanghai Pharmaceutical Co., Ltd.
Under the agreement, Shanghai New Asiatic is exploring other indications or uses for
docosanol 10% cream beyond cold sores and fever blisters. These additional
indications include genital herpes or HSV-2 and herpes zoster, also known as
shingles. Terms of the agreement provide for Shanghai New Asiatic to conduct
and finance all aspects of product development deemed necessary for regulatory
approvals for all three indications. We are responsible for providing all
pertinent clinical, pre-clinical, regulatory and manufacturing information,
along with related know-how and assistance, for their product
development and regulatory efforts. AVANIR will retain sole and exclusive
title to all products that may be developed within the scope of the agreement.

CRITICAL ACCOUNTING POLICIES

Because of the significance of our revenue recognition policies to our
financial statements, we believe it is appropriate to include our revenue
recognition policies as critical accounting policies.

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.

Our largest and most significant license agreement is with GlaxoSmithKline. On
March 31, 2000, we transferred the rights to GlaxoSmithKline to manufacture,
use, and sell Abreva in the United States and Canada 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 that territory. As of December 31, 2001,
GlaxoSmithKline had achieved all of the performance milestones under the
agreement and we had earned all of the $25 million in license fees and
milestone payments. We have no further obligations to perform any future
services, deliver any product, or perform any marketing or sales of the
product. Future revenues 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
reasonable assured.

Royalties on Licensed Products

We recognize royalty revenues from our licensed products based on the reported
sales by our licensee and computed in accordance with the specific terms of the
license agreement. Since the launch of Abreva in October 2000, 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.

Research Contracts

In certain circumstances, we may enter into research contracts or
collaborations where we are obligated to deliver to the customer multiple
products and/or services (multiple deliverables) in exchange for fees or
milestone payments. Such contracts could include antibody generation services
agreements and other forms of research collaborations.

As of June 30, 2002, Xenerex had entered into three research collaboration
arrangements, all of which have research initiation fees. In these agreements,
the customer provides antigens to Xenerex. Xenerex performs research to
develop potential antibodies for those antigens (initial phase). If, after a
reasonable commercial effort is made to develop an antibody, it is determined
that none exists, the contract is complete and the initiation fee is
recognized. If antibodies are developed, they are provided to the customer and
a determination is made by the customer to have Xenerex perform further
research or terminate the remaining contract. If the customer decides to have
Xenerex continue research on the developed antibodies, there exists in the
contract milestones that are tied to the completion of the different phases of
effort such as when the customer files the Biologics License Application and
when the customer obtains regulatory approval.

The research collaboration agreements also define the amount of royalties on
product sales by the licensee, if the licensee successfully develops and
obtains approval for marketing a product. The license fees and royalty rates,
while defined as part of the research collaboration agreement, would still be
subject to completion of a definitive license agreement with the customer.

Xenerex Research Initiation Fees  Xenerex defers research initiation fees and
recognizes the revenue once Xenerex has completed its efforts to create
antibodies. Under the three agreements at June 30, 2002, if Xenerex fails to
create antibodies, then the remaining contract may be terminated and the
research initiation fees are not refundable, indicating that the earnings
process is complete, provided Xenerex has made a commercially reasonable effort
to create antibodies. The status of Xenerex three existing collaborative
agreements are as follows:



| |  |  | Peregrine Pharmaceuticals The Peregrine contract provides
for the creation of antibodies to three target antigens provided by
Peregrine. As of June 30, 2002, Xenerex had advanced to the second
stage of the research collaboration agreement for one of the three
target antigens. The second stage is intended to provide Peregrine
with more information on selected panels of the antibodies that meet
the antibody characteristics desired by Peregrine. We earned and
recognized a pro-rata portion of the research initiation fee as
revenue associated with our efforts and included the amount in our
contract and license fee revenues for the nine months ended June 30,
2002. We have not completed the performance associated with stage
two or other milestones in the agreement and have not earned or
recognized any other revenues in the nine months ended June 30,
2002.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Eos Biotechnology, Inc. The Eos contract provides for the
creation of antibodies to three target antigens provided by Eos. As
of June 30, 2002, Xenerex had advanced to the second stage of the
research collaboration agreement for two of the three target
antigens. The second stage is intended to provide Eos with more
information on selected panels of the antibodies that meet the
antibody characteristics desired by Eos. We earned and recognized
the research initiation fee as revenue associated with our
commercial efforts on all three antigens and included the amount in
our contract and license fee revenues in the prior fiscal year ended
September 30, 2001. We have not completed the performance
associated with stage two or other milestones in the agreement and
have not earned or recognized any revenues in the nine months ended
June 30, 2002.           
|
| |  |  | DNAX Research, Inc. The DNAX contract provides for the
creation of antibodies to two target antigens provided by DNAX. We
have not completed the commercial efforts associated with the
research initiation fees or achieved any of the milestones in the
agreement. Therefore, as of June 30, 2002, we had not earned or
recognized any revenues under the agreement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      

Xenerex Receipt of Milestone Payments 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). Xenerex recognizes 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              
|
| |  |  | We have an enforceable claim to receive the amount due in the event
we do not deliver the remaining undelivered products or services.

Commercial Phase of Xenerex Research Contracts  Xenerex research collaboration
agreements provide that a final license agreement will be executed to
incorporate the terms and conditions for the commercial phase of the contract.
We will evaluate revenue recognition for the commercial phase once a license
agreement is executed and the commercial phase has commenced.

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. Regardless of when we receive
the payment associated with a research phase, we defer the revenue recognition
until the service is completed or product is delivered.

RESULTS OF OPERATIONS 
THREE MONTHS ENDED JUNE 30, 2002

Revenues

Revenues for the third quarter of fiscal 2002 were $819,000, compared to
revenues of $514,000 for the same period last year. Revenues in both periods
consisted primarily of royalties on Abreva sales, which increased by 50% over
the same period in the prior year. Consumer demand for Abreva continued to
increase, represented by sales and growth in share of the market for
over-the-counter lip remedies. Based on recent sales trends for the product,
we expect to earn royalties of about $1 million during the fiscal
quarter ending September 30, 2002, and about $1.2 million during the fiscal
quarter ending December 31, 2002, assuming product promotion continues at
present levels.

One of our licensees, Boryung Pharmaceuticals, launched docosanol 10% cream
under the brand name Herepair in South Korea on June 22, 2002; however, it is
too soon for us to make any predictions about product sales or royalties at
this time. South Korea represents the first foreign market in which docosanol
10% cream has been launched and represents a new milestone for us in beginning
to diversify our sources of royalty revenues from the product. We expect that
Abreva product launch in Canada will begin in the second calendar quarter of
2003. Our ability to earn license fees, milestone payments and royalties from
international sources will depend substantially on the timing of foreign
regulatory approvals and the timing of product launch by our licensees, which
are substantially outside of our control.

We expect that our subsidiary, Xenerex Biosciences,
will gradually improve as a source of revenue through its antibody generation services. Revenues from research collaborations are intended to help fund a portion of
Xenerexs research, but the larger milestone payments that typically accompany
these collaborations will depend on the progress that Xenerex makes
and progress by its partners in
evaluating, selecting and advancing our antibodies through the development
pipeline. Progress by Xenerex and its research partners is largely unpredictable and will
take years of development before an antibody reaches the market, if ever,
assuming it is selected for further development.

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Our revenues for the next several quarters will depend substantially on the
amount of royalties earned from Abreva product sales, the amount of license fees, royalties and milestone payments from international licensees of
docosanol 10% cream, the achievement of milestones in providing human
antibodies at Xenerex, and whether or not we license or sell to other companies
the rights to any of our drugs in development or currently marketed.

Operating Expenses

Total Operating Expenses Total operating expenses amounted to $5.9 million in
the third quarter of fiscal 2002, compared to $2.8 million in the same period
in fiscal 2001. The $3.1 million increase in operating expenses compared to
the same period a year ago was primarily caused by a $2.7 million increase in
research and development (R&D) project spending and a $544,000 increase in
general and administrative costs, partially offset by a $236,000 reduction in
Abreva product launch costs. Spending on R&D programs accounted for 70% and
50% of total operating expenses for the fiscal quarters ended June 30, 2002 and
2001, respectively. General and administrative expenses accounted for 23% and
29% of total operating expenses for the fiscal quarters ended June 30, 2002 and
2001, respectively. Sales and marketing expenses accounted for 7% and 13% of
total operating expenses for the fiscal quarters ended June 30, 2002 and 2001,
respectively. These and other costs are more fully described below and in the
table, Research and Development Projects and Other Research
Programs Expense provided
earlier.

Research and Development Expenses R&D expenses increased to $4.1 million in
the third fiscal quarter 2002, compared to $1.4 million in the same period a
year ago. The growth in R&D expenses reflected the Companys expanded product
development pipeline and advances in clinical and preclinical development,
including accelerated patient enrollments in the recently completed Phase
II/III clinical trial for Neurodex (formerly AVP-923) for the treatment of
emotional lability. Also during fiscal 2002, AVANIR initiated toxicology work
on its novel lead compound for treating allergy and asthma.

We plan to continue spending on our clinical development programs for Neurodex
and our other preclinical research through the next several quarters. In July
2002, we initiated a Phase II open-label dose escalation clinical trial for the
treatment of neuropathic pain. We intend to initiate in the third fiscal
quarter 2002 a Phase III clinical trial of emotional lability in patients with
multiple sclerosis and an open-label clinical trial of emotional lability. We
also intend to continue toxicology work during the next two quarters and other
advanced preclinical research on our lead compound for treating allergy and
allergic asthma and other preclinical research in the areas of
anti-inflammation, cholesterol reduction and drug discovery through antibody
generation research.

General and Administrative Expenses  General and administrative expenses
amounted to $1.3 million in the third fiscal quarter 2002 compared to expenses
of $799,000 in the same period in the prior year. General and administrative
expenses continued to grow as a result of higher administrative staff levels
necessary to support primarily increased headcount in the research and
development and clinical and regulatory affairs departments, employee training
and development programs, and increased cost of building occupancy including
utilities, insurance and maintenance.

Sales and Marketing Expenses  During the third fiscal quarter 2002, sales and
marketing expenses were $393,000, compared with $361,000 in the same period a
year ago. The small increase in expenses was due primarily to legal and
consulting costs of outlicensing docosanol 10% cream, negotiating and
establishing license agreements outside North America, and increasing
commercial development activity at Xenerex.

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Other Income and Expenses

Interest Income  In the third fiscal quarter 2002, interest income amounted to
$151,000, compared to $285,000 for the same period a year ago. The decrease in
interest income during the third fiscal quarter 2002 was primarily due to lower
interest rates on investments and money market funds compared with the same
period a year ago.

Other Income  Other income for the third fiscal quarter 2002 primarily
consists of rental income for use of the Companys conference center and
emergency standby power generating equipment.

Interest Expense  In the third fiscal quarter 2002, interest expense amounted
to $14,000, compared to $870 for the same period a year ago. Increased levels
of interest expense will continue for the foreseeable future. Increased
interest expense for the third fiscal quarter 2002 was primarily related to
$568,000 in new capital equipment lease financing transactions for an emergency
power generator and various new pieces of laboratory equipment.

Net Loss Attributable To Common Shareholders

For the third fiscal quarter 2002, the net loss attributable to common
shareholders was $4.9 million, compared to $2 million for the same period a
year ago. Basic and diluted net loss per share was $0.08, compared to $0.03
for the same period a year ago. While opportunities for licensing or sales of
our drugs and technologies could arise over the next three months to one year,
it is difficult to predict the timing or fiscal impact of any such
opportunities. Therefore, we have excluded any materially significant
revenue-generating opportunities from our near-term outlook, other than current
licensing arrangements and research service agreements. Considering
established relationships only, we expect to incur a loss for the quarter
ending September 30, 2002 that is similar to our loss in the third quarter of
fiscal 2002.

We will continue to pursue our drug development strategy focused on large
market therapeutic areas with significant partnering and licensing potential
and will seek licensees and partners to further fund and develop our products.
Some of these potential license arrangements could materially change our
outlook for future revenues and costs. Given the unpredictability of such
potential arrangements beyond fiscal 2002, our outlook is that we may have
some quarterly periods of profitability and some quarterly periods of losses
through 2003 and 2004, depending on the amounts and timing of license fees and
milestone payments on licensed products and partnering arrangements for our R&D
programs.

RESULTS OF OPERATIONS 
NINE MONTHS ENDED JUNE 30, 2002

Revenues

Revenues for the first nine months of fiscal 2002 amounted to $7.7 million,
compared to $6.9 million for the same period a year ago. The 12% increase in
revenues was due primarily to increased royalties earned by AVANIR from Abreva
sales, which continue to show increased market penetration since product launch
began in October 2000. Revenues for the first nine months of fiscal 2002
included a $5 million milestone when Abreva reached the one-year anniversary
after product launch and $2.5 million in royalties on Abreva product sales.
Revenues for the first nine months of fiscal 2001 included a $5 million
milestone earned on the Abreva product launch and $1.8 million in royalties on
Abreva product sales. We have provided an outlook for revenues in future
quarters in our discussion of Results of Operations-Three Months Ended June
30, 2002.

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Operating Expenses

Total Operating Expenses  Total operating expenses amounted to $14.1 million
for the first nine months of fiscal 2002, compared to $9.4 million for the same
period of fiscal 2001. The $4.7 million increase in operating expenses was
primarily due to a $4.5 million increase in expenses related to R&D projects
and a $756,000 increase in general and administrative expenses, partially offset
by a $728,000 reduction in Abreva product launch costs. Expenditures on R&D
programs accounted for 68% and 55% of total operating expenses for the first
nine months of fiscal 2002 and 2001, respectively. General and administrative
expenses accounted for 24% and 28% of total operating expenses for the first
nine months of fiscal 2002 and 2001, respectively. Sales and marketing
expenses accounted for 8% and 9% of total operating expenses for the first nine
months of fiscal 2002 and 2001, respectively. These and other costs are more
fully described below.

Research and Development Expenses  Total R&D expenses amounted to $9.6 million
for the first nine months of fiscal 2002, compared to $5.2 million for the same
period a year ago. A breakdown of major R&D spending for the first nine months
of the current fiscal year included direct costs for Neurodex research ($3
million), allergy and asthma research ($2.6 million), and other preclinical
research related to Xenerex, inflammation and cholesterol reduction
($2.4 million). The balance of R&D spending primarily reflected routine costs
associated with operation and maintenance of laboratory facilities.

General and Administrative Expenses  General and administrative expenses
amounted to $3.4 million in the first nine months of fiscal 2002, compared to
expenses of $2.6 million in the same period in the prior year. Higher expenses
were attributable to an increase in administrative staff size to support
growing R&D and commercial development operations, and increased cost of
building occupancy including utilities, maintenance and insurance. General and
administrative expenses grew at a slower rate than R&D and sales and marketing
expenses as the Company concentrated its efforts on R&D programs.

Sales and Marketing Expenses  Sales and marketing expenses during the first
nine months of fiscal 2002 were $1.1 million, compared with $867,000 in the
same period a year ago. Increased expenses in the first nine months of fiscal
2002 were related to legal and consulting costs to out-license docosanol 10%
cream in Europe and the Middle East, establishing a research collaboration in
the Peoples Republic of China, and increasing commercial development activity
at Xenerex Biosciences. Sales and marketing activity for the same period in
fiscal year 2001 was relatively low while we directed most of our efforts
toward GlaxoSmithKlines launch of Abreva.

Other Income and Expenses

Interest Income  In the first nine months of fiscal 2002, interest income
amounted to $520,000, compared to $960,000 for the same period a year ago. The
decrease in interest income during the first nine months of fiscal 2002 was
primarily due to lower interest rates on investments compared with the same
period a year ago.

Other Income  Other income for the
first nine months of fiscal 2002 includes income from renting out the
conference center.

Interest Expense  In the first nine months of fiscal 2002, interest expense
amounted to $47,000, compared to $5,000 for the same period a year ago.
Increased levels of interest expense will continue for the foreseeable future.
Increased interest expense for the first nine months of fiscal 2002 was
primarily related to the addition of $568,000 in new capital equipment lease
financing transactions, primarily for an emergency power generator and various
new pieces of laboratory equipment.

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Net Loss Attributable To Common Shareholders

The net loss attributable to common shareholders for the first nine months of
fiscal 2002 was $5.9 million, compared to $1.6 million for the same period a
year ago. Basic and diluted net loss per share was $0.10 for the first nine
months of fiscal 2002, compared to $0.03 for the same period a year ago.

LIQUIDITY AND CAPITAL RESOURCES

At June 30, 2002, we had cash and investments of $17.5 million, including $7.5
million in cash and cash equivalents. At September 30, 2001, we had cash and
investments of $21.9 million, including $16.5 million in cash and cash
equivalents. Explanations of the changes in net cash provided by or used for
operating, investing and financing activities are provided below.

Operating Activities Net cash used for operating activities in the first nine
months of fiscal 2002 amounted to $3.1 million, compared to net cash used for
operating activities of $1.9 million during the comparable period in fiscal
year 2001. Net cash used for operating activities for the first nine months of
fiscal 2002 is attributable primarily to a $5.8 million net loss, partially
offset by a $1.3 million increase in accounts payable, a $784,000 increase in
accrued expenses and $424,000 in depreciation and amortization. Net cash used
in operating activities for the first nine months of fiscal 2001 is
attributable primarily to a $1.6 million net loss, a $465,000 increase in
accounts receivable and a $374,000 decrease in accounts payable, partially
offset by $517,000 in depreciation and amortization.

Investing Activities  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 of $694,000 and patent
costs of $456,000, partially offset by maturities of securities of $3.9
million. As short-term interest rates came down through most of 2002, we
sought to achieve higher yields on our available cash by investing in
securities that had maturities longer than one year. Our investment strategy
of seeking higher yields through longer maturities of government securities and
bank CDs primarily resulted in a $4.0 million net increase in long-term
investments in securities for the first nine months of fiscal 2002. Net cash
used for investing activities in the first nine months of fiscal 2001 amounted
to $5.4 million, including investments in securities of $4.5 million, capital
expenditures of $882,000 and patent costs of $386,000.

Financing Activities  Net cash used for financing activities during the first
nine months of fiscal 2002 amounted to $29,000 and reflected funds received
from issuances of common stock partially offset by repayment of short-term
financing of insurance premiums and payments of dividends on preferred stock.
During the same period a year ago, net cash provided by financing activities
amounted to $1.1 million, primarily from issuances of $1.2 million in Class A
common stock on exercises of stock options and stock purchase warrants,
partially offset by repayment of loans payable.

We believe that cash and short and long-term investments totaling $17.5 million
at June 30, 2002 provide us with sufficient liquidity to sustain our present
level of operations for at least the next 12 months. To enhance our capital base and liquidity and to fund
the development of a greater number of drug candidates and technology platforms
now available to us, we intend to pursue several 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, financing future
royalties, issuance of debt or equity securities, and licensing or sales of any
of our platform technologies or new drug candidates.

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Federal Research Grants

We recognize revenues from federal research grants over the period in which the
related expenditures are incurred.

RECENT ACCOUNTING PRONOUNCEMENTS

See Note 10, Recent Accounting Pronouncements, in the Notes to Consolidated
Financial Statements included in Part 1. Item 1. of this report for a discussion
of recent accounting pronouncements and their effect, if any, on the Company.

ADDITIONAL FACTORS THAT MIGHT AFFECT FUTURE RESULTS

We expect our quarterly revenues and operating results to fluctuate for a
number of reasons.

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



| |  |  | Seasonality Our sequential royalty revenues from sales of Abreva
by GlaxoSmithKline in the United States are expected to fluctuate
downward in the summer months based on historical industry sales data
for cold sore treatments, which indicates some seasonality.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Concentration of Significant Customers, Suppliers and Industries 
Milestone payments and royalties earned from a single licensee
(GlaxoSmithKline) accounted for approximately 91% and 93% of our fiscal
2001 and 2000 net revenues, respectively. We have now received all of
the milestone payments from GlaxoSmithKline. Future revenues from
GlaxoSmithKline will come exclusively from Abreva royalties. Our
business could be adversely affected if GlaxoSmithKline terminated its
business relationship with us or significantly reduced the amount of
marketing and promotion of Abreva. 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.
|
| |  |  | Achievement of Milestones Under License Agreements May 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.                                                                                                                                                                                                                                                                                                                                                                                                                                          

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| |  |  | 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 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.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

If GlaxoSmithKline experiences problems in manufacturing or reduces promotion
of the product, then our royalties from sales of Abreva will be materially and
adversely affected.

Our royalty revenues from sales of Abreva in the future will be substantially
influenced by the level of GlaxoSmithKlines marketing and promotion of the
product. Any problem or delay in manufacturing, or any material reduction in
product promotion could affect materially and adversely our business operations
and financial condition.

AVANIR and its licensees may not be successful in obtaining regulatory approval
of docosanol 10% cream immediately as an 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 our efforts to obtain
regulatory approval as an over-the-counter (OTC) product and to market and
sell docosanol 10% cream in foreign countries, including:



| |  |  | Regulatory approval requirements differ by country, and
obtaining approvals to market the drug in foreign countries may be
difficult to obtain or may require prescription status first before
obtaining sufficient experience to warrant approval as an OTC
product;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | building product awareness of a new drug, whether
prescription or OTC, among customers or retail store decision makers
may require a substantial amount of product promotion, which does
not guarantee success;                                                      
|
| |  |  | consumers may not perceive that docosanol 10% cream is
superior to existing and potentially new OTC products for oral
herpes;                                                                                                                                        
|
| |  |  | acceptance of docosanol 10% cream in the OTC consumer market
may not be widespread; and                                                                                                                                                                              
|
| |  |  | potential price erosion could occur due to competitive
products and responses to our products introduction.                                                                                                                                                         

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 those compounds, in which event we will be forced to
write-off the costs of patents that may exist 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 a potential 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.

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

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 Blistex, Inc., 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.

We may issue additional shares of our Class A common stock. These issuances may
dilute the value of our Class A common stock to current shareholders and may
adversely affect the market price of our Class A common stock.

We anticipate that we may raise additional capital in the next twelve months
through the sale of shares of our Class A common stock. 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 higher than the current market
price, the issuance of additional shares may depress our market price and
dilute earnings per share.

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, Korea, Egypt and other parts of the Middle East. 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 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. Further, 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; and                                 
|
| |  |  | trade protection measures, including customs duties and export quotas.                                               

Our antibody generation services subsidiary, Xenerex Biosciences, faces intense
competition and rapid technological change, and if we fail to provide services
that keep pace with new technologies and gain market acceptance, our services
and technologies could become obsolete.

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The biotechnology industry is highly competitive and subject to significant and
rapid technological change. We compete with several companies that offer
antibody generation services to other companies. These competitors have
specific expertise or technology related to antibody development and 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, 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 other
products may adversely affect our operations.

Governmental authorities in the U.S., including the FDA, and other countries
regulate significantly the development, production, testing, manufacturing and
marketing of pharmaceutical products. The clinical testing and regulatory
approval process can take a number of years and require 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. In addition, 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 effect of
unspecified, but possible, 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.

We face substantial risks of failing to complete the development of our
research programs for the treatment of central nervous system disorders,
allergy and asthma, and other areas. Our Phase III clinical trial of Neurodex
for the treatment of emotional lability in MS patients may experience setbacks
or failures for reasons we have not anticipated. Our Phase II open-label dose
escalation clinical trial of Neurodex for the treatment of neuropathic pain may
not show proof of concept. Our observations during preclinical research of our
lead compound for treating allergy and asthma, while showing effectiveness in
several in-vitroand ex-vivoassays and in-vivoallergy models, may not be
relevant to the development of, indicate 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. The development process
for medical products 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, which could result in
the abandonment or substantial change in the development of a specific product.

Business interruptions could adversely affect our business.

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, California experienced shortages in
adequate supply of electricity, resulting in rolling blackouts, where certain
areas are not provided with any electricity for periods of up to two hours.
The immediate impact was a significant increase in power rates for most users,
including us. Additionally, the loss of electrical power or blackouts for
any significant periods of time could harm either our vendors or our ability to
conduct

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our experiments or to provide antibody research services for others. Further,
we could lose valuable progress made to date in experiments currently underway.
We have attempted to mitigate the severity of power losses by installing
emergency power equipment, which we intend to use for those electrical needs
that we consider to be the most critical to operating our business. However,
the emergency power unit does not cover all of our electrical needs.

Our acquisition and alliance activities could disrupt our ongoing business.

We intend to continue to make investments in products and technologies, acquire
or inlicense technologies, and, in the future, could acquire entire companies
to expand our product development pipeline and sales revenues. Acquisitions
and strategic alliances often involve risks, including: difficulty in
assimilating the acquired technologies, operations and employees, difficulty in
managing research collaborations, difficulty in retaining key employees of an
acquired operation, disruption of our ongoing business, inability to
successfully integrate the acquired technology and operations into our business
and lack of experience in developing the acquired technology.

Difficulties in acquiring inlicensed technologies that we believe are necessary
to fill our product development pipeline may restrict our growth.

Our business strategy for growth is not only through internal development, but
also through inlicensing of products, potential products and/or technologies at
various stages in the drug development pipeline. We will face intense
competition in attempting to inlicense other products and technologies. In
addition, we may not be able to locate suitable products and technologies to
fit our strengths, obtain rights to these products and technologies on
acceptable terms, or have the financial resources to develop products from the
inlicensed technology. If we are unable to add to our product development
pipeline, our growth may be limited and it may affect our business and stock
price negatively. Also, we must have the financial resources to acquire and/or
inlicense new products and technologies and develop and market the products, if
approved. We can provide no assurance that we will be successful in our
inlicensing strategy or that it will have the desired effect on our future
growth or stock price.

Our inability to 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 lose the history and their knowledge,
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 55 people in AVANIR and
our subsidiary, Xenerex Biosciences, and we expect to hire additional people
over the next twelve months. While we have employment and employee retention
agreements with certain key executives, they are limited in scope and provide
no real assurance that any of these people will continue their employment with
us. We do not have key person life insurance policies. The industry in
which we compete has a high level of employee mobility and aggressive
recruiting of skilled personnel, which creates intense competition for
qualified personnel, particularly in product research, development, sales and
marketing.

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.

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We rely substantially on the protection of our intellectual property for
docosanol, with 22 U.S. and foreign docosanol patents and 39 additional
docosanol-related patent applications pending. We also have patents and patent
applications pending on other products and technologies, and have in-licensed
the rights to market a potential product that treats multiple central nervous
system disorders that has six issued patents. Because of the competitive
nature of the biopharmaceutical industry, we cannot assure you that:



| |  |  | the claims in the pending patent applications will be
allowed or that we will even be issued additional patents;                                                                     
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | 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 issued patents will provide us with significant
competitive advantages; or                                                                                                       
|
| |  |  | challenges will not be instituted against the validity
or enforceability of any patent that we own or, if instituted,
that these challenges will not be successful.                  

Our inability to obtain or maintain patent protections for our products in
foreign markets may negatively affect our financial condition.

The process for the approval of patent applications in foreign countries may
differ significantly from the process in the U.S. These differences may delay
our plans to market and sell docosanol 10% cream and other products in the
international marketplace. Approval in one country does not necessarily
indicate that approval can 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 develop independently similar or superior technology. In addition, 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 proprietary rights to this information in which we
may not receive a favorable resolution.

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.

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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.




Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risk related to changes in interest rates. Because
substantially all our revenue, expense, and capital purchasing activities are
transacted in U.S. dollars, our exposure to foreign currency exchange rates is
insignificant. 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 insignificant
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 if the needs and risks should arise.

Interest Rate Sensitivity

Our investment portfolio consists primarily of fixed income instruments with an
average duration of 2.7 years as of June 30, 2002 (2.8 years as of September
30, 2001). 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.




PART II. OTHER INFORMATION

Items 1-5. NOT APPLICABLE




Item 6. EXHIBITS AND REPORTS ON FORM 8-K



|(a) |  | Current Reports on Form 8-K
|--- |  | ---------------------------
|   
|    |  | None                       
|   
|(b) |  | Exhibits                   

|     |  |   |  |                                                                                                                                                                         
|---- |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.1 |  |  |  | Standard Industrial Net Lease by and between AVANIR
Pharmaceuticals (Tenant) and Sorrento Plaza, a California limited
partnership (Landlord), effective May 20, 2002
|    
|99.1 |  |  |  | Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                  
|    
|99.2 |  |  |  | Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                  

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

|                                                |  |                                                                                                                          |  |                
|----------------------------------------------- |  | ------------------------------------------------------------------------------------------------------------------------ |  | ---------------
|Signature                                       |  | Title                                                                                                                    |  | Date           
|                                                |  |                                                                                                                          |  |                
|                                                |  |                                                                                                                          |  |                
|/s/ GERALD J. YAKATAN
        Gerald J. Yakatan |  | President and Chief
        Executive Officer
        (Principal Executive Officer)                                      |  | August 13, 2002
|                                                |  |                                                                                                                          |  |                
|/s/ GREGORY P. HANSON
        Gregory P. Hanson |  | Vice President,
        Finance and Chief
        Financial Officer
        (Principal Financial and Accounting Officer) |  | August 13, 2002

31