##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON, DC 20549
 FORM 10-Q
  þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
  OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
 
  AVANIR PHARMACEUTICALS
  California
(State or other jurisdiction of
incorporation or organization)
    
    33-0314804
(I.R.S. Employer Identification No.)
 11388 Sorrento Valley Road, San Diego, California
(Address of principal executive offices)
    
    92121
(Zip Code)
 (858) 622-5200
 þ o
  Large Accelerated Filer o
    
    Accelerated Filer þ
    
    Non-Accelerated Filer o
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Table of Contents
 PagePART I. FINANCIAL INFORMATIONItem 1.
    
    Financial Statements (Unaudited)Report of Independent Registered Public Accounting Firm
    
    
    3Condensed Consolidated Balance Sheets
    
    
    4Condensed Consolidated Statements of Operations
    
    
    5Condensed Consolidated Statements of Cash Flows
    
    
    6Notes to Condensed Consolidated Financial Statements
    
    
    7Item 2.
    
    Managements Discussion and Analysis of Financial Condition and
Results of Operations
    
    
    24Item 3.
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    41Item 4.
    
    Controls and Procedures
    
    
    41PART II. OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    42Item 1A.
    
    Risk Factors
    
    
    42Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    47Item 3.
    
    Defaults Upon Senior Securities
    
    
    47Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    47Item 5.
    
    Other Information
    
    
    48Item 6.
    
    Exhibits
    
    
    48Signatures
    
    
    49EXHIBIT 10.1EXHIBIT 10.2EXHIBIT 10.3EXHIBIT 15.1EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
   
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PART I. FINANCIAL INFORMATION
 
 Item 1. FINANCIAL STATEMENTS
 
 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 Avanir
 Avanir
   Avanir
  
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##### Table of Contents



Avanir Pharmaceuticals
 
 CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
 March 31,
    
    
    September 30,2006
    
    
    2005ASSETSCurrent assets:Cash and cash equivalents
    
    $
    10,912,580
    
    
    $
    8,620,143Short-term investments in securities
    
    
    38,738,504
    
    
    
    14,215,005Receivables, net
    
    
    1,482,674
    
    
    
    1,169,654Inventory
    
    
    271,375
    
    
    
    27,115Prepaid expenses
    
    
    1,566,671
    
    
    
    2,370,801Total current assets
    
    
    52,971,804
    
    
    
    26,402,718Investments in securities
    
    
    2,446,575
    
    
    
    3,845,566Restricted investments in securities
    
    
    856,597
    
    
    
    856,872Property and equipment, net
    
    
    6,111,449
    
    
    
    6,004,527Intangible assets, net
    
    
    3,726,164
    
    
    
    3,665,086Long-term inventory
    
    
    522,508
    
    
    
    347,424Other assets
    
    
    350,125
    
    
    
    279,797TOTAL ASSETS
    
    $
    66,985,222
    
    
    $
    41,401,990LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    3,252,387
    
    
    $
    6,751,781Accrued expenses and other liabilities
    
    
    7,220,922
    
    
    
    4,094,295Accrued compensation and payroll taxes
    
    
    1,223,772
    
    
    
    1,272,231Current portion of deferred revenue
    
    
    2,316,118
    
    
    
    1,970,989Current portion of notes payable
    
    
    333,317
    
    
    
    317,667Current portion of capital lease obligations
    
    
    22,816
    
    
    
    26,305Total current liabilities
    
    
    14,369,332
    
    
    
    14,433,268Deferred revenue, net of current portion
    
    
    16,683,843
    
    
    
    17,187,221Notes payable, net of current portion
    
    
    466,625
    
    
    
    637,285Capital lease obligations, net of current portion
    
    
    
    
    
    
    9,337Total liabilities
    
    
    31,519,800
    
    
    
    32,267,111COMMITMENTS AND CONTINGENCIES(Note 14)SHAREHOLDERS EQUITY:Preferred stock  no par value, 10,000,000 shares
authorized, no shares issued and outstanding as of
March 31, 2006 and September 30, 2005
    
    
    
    
    
    
    Common stock  no par value, Class A, 200,000,000
shares authorized, 31,653,236 and 27,341,732
shares issued and outstanding as of March 31, 2006
and September 30, 2005, respectively (Note 2)
    
    
    209,862,878
    
    
    
    167,738,303Unearned compensation
    
    
    
    
    
    
    (3,477,144
    )Accumulated deficit
    
    
    (174,092,311
    )
    
    
    (155,012,466
    )Accumulated other comprehensive loss
    
    
    (305,145
    )
    
    
    (113,814
    )Total shareholders equity
    
    
    35,465,422
    
    
    
    9,134,879TOTAL LIABILITIES AND SHAREHOLDERS EQUITY
    
    $
    66,985,222
    
    
    $
    41,401,990
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AVANIR Pharmaceuticals
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
 
 Three Months Ended
    
    
    Six Months EndedMarch 31,
    
    

March
31,2006
    
    
    2005
    
    
    2006
    
    
    2005REVENUES:Research and development services
    
    $
    1,956,565
    
    
    $
    
    
    
    $
    4,434,583
    
    
    $
    Royalties and sales of royalty rights
    
    
    427,259
    
    
    
    419,816
    
    
    
    1,009,304
    
    
    
    930,130Government research grants
    
    
    75,862
    
    
    
    124,917
    
    
    
    160,687
    
    
    
    285,568Licenses
    
    
    9,342
    
    
    
    100,000
    
    
    
    5,009,342
    
    
    
    300,000Product sales
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    17,400Total revenues
    
    
    2,469,028
    
    
    
    644,733
    
    
    
    10,613,916
    
    
    
    1,533,098OPERATING EXPENSES:Research and development
    
    
    7,919,847
    
    
    
    11,428,170
    
    
    
    17,283,249
    
    
    
    16,482,411Selling, general and administrative
    
    
    8,492,115
    
    
    
    3,372,183
    
    
    
    13,260,858
    
    
    
    6,323,186Cost of product sales
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,102Total operating expenses
    
    
    16,411,962
    
    
    
    14,800,353
    
    
    
    30,544,107
    
    
    
    22,808,699LOSS FROM OPERATIONS
    
    
    (13,942,934
    )
    
    
    (14,155,620
    )
    
    
    (19,930,191
    )
    
    
    (21,275,601
    )Interest income
    
    
    564,422
    
    
    
    125,147
    
    
    
    892,588
    
    
    
    246,979Interest expense
    
    
    (21,403
    )
    
    
    (25,324
    )
    
    
    (44,841
    )
    
    
    (46,945
    )Other income (expense), net
    
    
    (5,492
    )
    
    
    4,850
    
    
    
    5,020
    
    
    
    (62,071
    )LOSS BEFORE INCOME TAXES
    
    
    (13,405,407
    )
    
    
    (14,050,947
    )
    
    
    (19,077,424
    )
    
    
    (21,137,638
    )Provision for income taxes
    
    
    (4
    )
    
    
    
    
    
    
    (2,421
    )
    
    
    (1,898
    )NET LOSS
    
    $
    (13,405,411
    )
    
    $
    (14,050,947
    )
    
    $
    (19,079,845
    )
    
    $
    (21,139,536
    )NET LOSS PER SHARE:BASIC AND DILUTED (Note 2)
    
    $
    (0.43
    )
    
    $
    (0.57
    )
    
    $
    (0.64
    )
    
    $
    (0.87
    )WEIGHTED AVERAGE NUMBER OF COMMON SHARES
OUTSTANDING:BASIC AND DILUTED (Note 2)
    
    
    31,086,874
    
    
    
    24,565,682
    
    
    
    29,819,338
    
    
    
    24,261,024
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AVANIR Pharmaceuticals
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
 
 Six Months Ended March 31,2006
    
    
    2005OPERATING ACTIVITIES:Net loss
    
    $
    (19,079,845
    )
    
    $
    (21,139,536
    )Adjustments to reconcile net loss to net cash used for
operating activities:Depreciation and amortization
    
    
    965,679
    
    
    
    913,363Share-based compensation expense
    
    
    1,219,733
    
    
    
    5,402Issuance of common stock in connection with the acquisition
of additional contractual rights to Neurodex
    
    
    
    
    
    
    5,300,000Other-than-temporary impairment of investment
    
    
    
    
    
    
    78,012Loss on disposal of assets
    
    
    8,994
    
    
    
    2,827Intangible assets abandoned and impaired
    
    
    134,405
    
    
    
    177,965Changes in operating assets and liabilities:Receivables
    
    
    (313,020
    )
    
    
    (81,118
    )Inventory
    
    
    (419,344
    )
    
    
    3,102Prepaid expenses and other assets
    
    
    723,863
    
    
    
    (611,219
    )Accounts payable
    
    
    (3,476,650
    )
    
    
    (253,261
    )Accrued expenses and other liabilities
    
    
    3,116,777
    
    
    
    1,281,301Accrued compensation and payroll taxes
    
    
    (48,459
    )
    
    
    90,531Deferred revenue
    
    
    (158,249
    )
    
    
    (1,028,145
    )Net cash used for operating activities
    
    
    (17,326,116
    )
    
    
    (15,260,776
    )INVESTING ACTIVITIES:Investments in securities
    
    
    (46,165,564
    )
    
    
    (4,339,986
    )Proceeds from sales and maturities of investments in securities
    
    
    22,850,000
    
    
    
    7,914,365Patent costs
    
    
    (328,672
    )
    
    
    (551,777
    )Purchases of property and equipment
    
    
    (951,362
    )
    
    
    (151,289
    )Net cash (used for) provided by investing activities.
    
    
    (24,595,598
    )
    
    
    2,871,313FINANCING ACTIVITIES:Proceeds from issuance of common stock, net
    
    
    44,381,987
    
    
    
    7,196,498Proceeds from issuance of notes payable
    
    
    
    
    
    
    136,438Payments on notes and capital lease obligations
    
    
    (167,836
    )
    
    
    (231,070
    )Net cash provided by financing activities
    
    
    44,214,151
    
    
    
    7,101,866Net increase (decrease) in cash and cash equivalents
    
    
    2,292,437
    
    
    
    (5,287,597
    )Cash and cash equivalents at beginning of period
    
    
    8,620,143
    
    
    
    13,494,083Cash and cash equivalents at end of period
    
    $
    10,912,580
    
    
    $
    8,206,486SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:Interest paid
    
    $
    44,841
    
    
    $
    46,945Income taxes paid
    
    $
    2,421
    
    
    $
    1,898NONCASH INVESTING AND FINANCING ACTIVITIES:Accounts payable and accrued expenses for purchases of
property and equipment
    
    $
    229,319
    
    
    $
    93,532Elimination of unearned compensation against common stock
    
    $
    3,477,144
    
    
    $
    
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Avanir Pharmaceuticals
 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 1.     BASIS OF PRESENTATION
 Avanir Avanir
  Avanir
 2. REVERSE STOCK SPLIT
  3. SIGNIFICANT ACCOUNTING POLICIES
 Change in Accounting Method for Share-Based Compensation
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Three Months Ended
    
    
    Six Months EndedMarch 31, 2006
    
    
    March 31, 2006Research and development expense
    
    $
    185,990
    
    
    $
    262,337Selling, general and administrative expense
    
    
    571,730
    
    
    
    957,396Share-based compensation expense before taxes
    
    
    757,720
    
    
    
    1,219,733Related income tax benefits
    
    
    
    
    
    
    Share-based compensation expense
    
    $
    757,720
    
    
    $
    1,219,733Net share-based compensation expense per common
Share  basic and diluted
    
    $
    (0.02
    )
    
    $
    (0.04
    )Share-based compensation expense from:Stock options
    
    $
    400,356
    
    
    $
    647,054Restricted stock awards
    
    
    328,159
    
    
    
    543,474Restricted stock units
    
    
    29,205
    
    
    
    29,205Total
    
    $
    757,720
    
    
    $
    1,219,733
  8




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Three Months
    
    
    Six Months EndedEnded March 31, 2005
    
    
    March 31, 2005Net loss, as reported
    
    $
    (14,050,947
    )
    
    $
    (21,139,536
    )Add: Share-based employee
compensation expense included in
reported net loss
    
    
    
    
    
    
    Deduct: Total share-based
employee compensation expense
determined under fair value based
method for all awards expense
determined under fair value based
method for all awards
    
    
    (453,794
    )
    
    
    (732,457
    )Pro forma net loss
    
    $
    (14,504,741
    )
    
    $
    (21,871,993
    )Net loss per
share:Basic and diluted  as reported
    
    $
    (0.57
    )
    
    $
    (0.87
    )Basic and diluted  pro forma
    
    $
    (0.59
    )
    
    $
    (0.90
    )
   Revenue Recognition
  9




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Revenue Arrangements with Multiple Deliverables
 License Arrangements
  Royalty Revenues.
 Revenues from Sale of Royalty Rights . ®
 10




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Government Research Grant Revenue.
 Product Sales  Active Pharmaceutical Ingredient Docosanol.
 Recognition of Expenses in Outsourced Contracts
  Research and Development Expenses
   
    
    The technology is in the early stage of development and has no alternative uses;
    
    There is substantial uncertainty of the technology or product being successful;
    
    There will be difficulty in completing the remaining development; and
    
    There is substantial cost to complete the work.
 Acquired contractual rights
 11




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Capitalization and Valuation of Long-Lived and Intangible Assets
   
    
    A significant underperformance relative to expected historical or projected future
operating results;
    
    A significant change in the manner of our use of the acquired asset or the strategy for
our overall business; and/or
    
    A significant negative industry or economic trend.
  Stock Offering Costs
  4.      INVESTMENTS
  Amortized
    
    
    Gross Unrealized
    
    
    Gross
    
    
    FairCost
    
    
    Gains (1)
    
    

Unrealized
Losses (1)
    
    
    ValueAs of March 31, 2006:Certificates of deposit
    
    $
    856,597
    
    
    $
    
    
    
    $
    
    
    
    $
    856,597Government debt securities
    
    
    41,490,224
    
    
    
    
    
    
    
    (305,145
    )
    
    
    41,185,079Total
    
    $
    42,346,821
    
    
    $
    
    
    
    $
    (305,145
    )
    
    $
    42,041,676Classified and reported as:Short term investments:Classified as available-for-sale
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    38,738,504Long term investments:Classified as available-for-sale
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,446,575Restricted investments in
securities (2)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    856,597Long-term investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,303,172Total
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    42,041,676
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Gross Unrealized
    
    
    Gross Unrealized
    
    
    FairAmortized Cost
    
    
    Gains (3)
    
    
    Losses (3)
    
    
    ValueAs of September 30, 2005:Certificates of deposit
    
    $
    956,872
    
    
    $
    48
    
    
    $
    
    
    
    $
    956,920Government debt securities
    
    
    18,074,385
    
    
    
    
    
    
    
    (113,862
    )
    
    
    17,960,523Total
    
    $
    19,031,257
    
    
    $
    48
    
    
    $
    (113,862
    )
    
    $
    18,917,443Classified and reported as:Short term investments:Classified as available-for-sale
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    14,215,005Long term investments:Classified as available-for-sale
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,845,566Restricted investments in
securities (2)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    856,872Long-term investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,702,438Total
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    18,917,443
 (1)
    
    Gross unrealized losses of $305,145 on government debt securities are reported as
accumulated other comprehensive loss on the consolidated balance sheet as of March 31, 2006.
 (2)
    
    Represents amounts pledged to our bank as collateral for letters of credit issued in
connection with our leases of office and laboratory space.
 (3)
    
    Gross unrealized gains of $48 and gross unrealized losses of $113,862 on government
securities and certificates of deposit represent an accumulated net unrealized loss of
$113,814, which is reported as accumulated other comprehensive loss on the consolidated
balance sheet as of September 30, 2005.
 5. RECEIVABLES, NET
  March 31, 2006
    
    
    September 30, 2005Unbilled receivables
    
    $
    1,249,087
    
    
    $
    1,010,902Receivables
    
    
    261,686
    
    
    
    186,8511,510,773
    
    
    
    1,197,753Allowance for doubtful accounts
    
    
    (28,099
    )
    
    
    (28,099
    )Receivables, net
    
    $
    1,482,674
    
    
    $
    1,169,654
 6. INVENTORY
  March 31, 2006
    
    
    September 30, 2005Inventory
    
    $
    793,883
    
    
    $
    374,539Less: current portion
    
    
    271,375
    
    
    
    27,115Long-term portion
    
    $
    522,508
    
    
    $
    347,424
 13




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7. PROPERTY AND EQUIPMENT
  March 31, 2006
    
    
    September 30, 2005Gross Carrying
    
    
    Accumulated
    
    
    
    
    
    
    Gross Carrying
    
    
    AccumulatedValue
    
    
    Depreciation
    
    
    Net
    
    
    Value
    
    
    Depreciation
    
    
    NetResearch and
development
equipment
    
    $
    3,976,257
    
    
    $
    (2,860,591
    )
    
    $
    1,115,666
    
    
    $
    3,903,735
    
    
    $
    (2,567,843
    )
    
    $
    1,335,892Computer equipment
and related
software
    
    
    1,273,804
    
    
    
    (661,122
    )
    
    
    612,682
    
    
    
    1,038,390
    
    
    
    (565,137
    )
    
    
    473,253Leasehold
improvements
    
    
    5,676,238
    
    
    
    (1,996,935
    )
    
    
    3,679,303
    
    
    
    5,583,177
    
    
    
    (1,641,485
    )
    
    
    3,941,692Office equipment,
furniture and
fixtures
    
    
    791,294
    
    
    
    (349,215
    )
    
    
    442,079
    
    
    
    558,911
    
    
    
    (305,221
    )
    
    
    253,690Manufacturing
equipment
    
    
    261,719
    
    
    
    
    
    
    
    261,719
    
    
    
    
    
    
    
    
    
    
    
    Total property
and equipment
    
    $
    11,979,312
    
    
    $
    (5,867,863
    )
    
    $
    6,111,449
    
    
    $
    11,084,213
    
    
    $
    (5,079,686
    )
    
    $
    6,004,527
  8. INTANGIBLE ASSETS
  March 31, 2006
    
    
    September 30, 2005Gross Carrying
    
    
    Accumulated
    
    
    
    
    
    
    Gross Carrying
    
    
    AccumulatedValue
    
    
    Depreciation
    
    
    Net
    
    
    Value
    
    
    Depreciation
    
    
    NetIntangible assets with
finite lives:Patent applications
pending (1)
    
    $
    3,068,996
    
    
    $
    (406,157
    )
    
    $
    2,662,839
    
    
    $
    3,029,127
    
    
    $
    (336,457
    )
    
    $
    2,692,670Patents (1)
    
    
    1,658,021
    
    
    
    (644,259
    )
    
    
    1,013,762
    
    
    
    1,429,532
    
    
    
    (506,144
    )
    
    
    923,388Licenses
    
    
    42,461
    
    
    
    (19,032
    )
    
    
    23,429
    
    
    
    42,461
    
    
    
    (17,904
    )
    
    
    24,557Total intangible
assets with finite
lives
    
    
    4,769,478
    
    
    
    (1,069,448
    )
    
    
    3,700,030
    
    
    
    4,501,120
    
    
    
    (860,505
    )
    
    
    3,640,615Intangible assets with
indefinite useful
lives:Trademarks (2)
    
    
    26,134
    
    
    
    
    
    
    
    26,134
    
    
    
    24,471
    
    
    
    
    
    
    
    24,471Total intangible assets
    
    $
    4,795,612
    
    
    $
    (1,069,448
    )
    
    $
    3,726,164
    
    
    $
    4,525,591
    
    
    $
    (860,505
    )
    
    $
    3,665,086
 
 (1)
    
    Patent applications pending include the net effect of $4,910 and $39,638 (net of
accumulated amortization of $0 and $3,409) in intangible assets abandoned during the
three-month and six-month periods ended March 31, 2006, respectively. Patent applications
pending include the net effect of $2,944 and $173,272 (net of accumulated amortization of
$68 and $18,389) in intangible assets abandoned during the three-month and six-month
periods ended 14




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##### Table of Contents



March 31, 2005, respectively. We abandoned certain patents pending related to docosanol 10%
cream in selected countries where we determined there are no viable markets.(2)
    
    Intangible assets with indefinite useful lives include the net effect of $4,693 in
trademarks abandoned during the three-month and six-month periods ended March 31, 2005.  Amortization Expense
 Fiscal year ending September 30:2006 (remaining six months)
    
    $
    136,0002007
    
    
    270,0002008
    
    
    270,0002009
    
    
    262,0002010
    
    
    234,000Thereafter
    
    
    2,528,000Total
    
    $
    3,700,000
 9. DEFERRED REVENUE
 ®
 Drug RoyaltyUSA Agreement
    
    
    Other Agreements
    
    
    TotalDeferred revenue as of September 30, 2005
    
    $
    19,049,877
    
    
    $
    108,333
    
    
    $
    19,158,210Changes during the period:Additions during period
    
    
    
    
    
    
    860,216
    
    
    
    860,216Recognized as revenue during period
    
    
    (1,009,123
    )
    
    
    (9,342
    )
    
    
    (1,018,465
    )Deferred revenue as of March 31, 2006
    
    $
    18,040,754
    
    
    $
    959,207
    
    
    $
    18,999,961Classified and reported as:Current portion of deferred revenue
    
    $
    1,998,638
    
    
    $
    317,480
    
    
    $
    2,316,118Deferred revenue, net of current portion
    
    
    16,042,116
    
    
    
    641,727
    
    
    
    16,683,843Total deferred revenue
    
    $
    18,040,754
    
    
    $
    959,207
    
    
    $
    18,999,961
 Drug Royalty Agreement ®
  15




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##### Table of Contents



®
 Docosanol License Agreement
   10. COMPUTATION OF NET LOSS PER COMMON SHARE
  16




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##### Table of Contents



11. COMPREHENSIVE LOSS
  Three Months Ended March 31,
    
    
    Six Months Ended March 31,2006
    
    
    2005
    
    
    2006
    
    
    2005Net loss
    
    $
    (13,405,411
    )
    
    $
    (14,050,947
    )
    
    $
    (19,079,845
    )
    
    $
    (21,139,536
    )Other comprehensive
loss, net of tax:Unrealized loss
on
available-for-sale
securities method
for all awards
    
    
    (131,994
    )
    
    
    (41,464
    )
    
    
    (191,331
    )
    
    
    (529
    )Total comprehensive loss
    
    $
    (13,537,405
    )
    
    $
    (14,092,411
    )
    
    $
    (19,271,176
    )
    
    $
    (21,140,065
    )
 12. SHAREHOLDERS EQUITY
 Unearned compensation
 Common stock
    17




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13. EQUITY INCENTIVE PLANS
   Stock Options
 a.
    
    25% of the option shares vest and become exercisable on the first anniversary of the
grant date and the remaining 75% of the option shares vest and become exercisable quarterly
in equal installments thereafter over three years;b.
    
    One-third of the option shares vest and become exercisable on the first anniversary of
the grant date and the remaining two-thirds of the option shares vest and become
exercisable daily or quarterly in equal installments thereafter over two years; orc.
    
    Options fully vest and become exercisable at the date of grant.
   Weighted averageWeighted average
    
    
    remaining
    
    
    Aggregate intrinsicexercise price per
    
    
    contractual term
    
    
    valueNumber of shares
    
    
    share
    
    
    (in years)
    
    
    (in millions)Outstanding, September 30, 2005
    
    
    1,600,034
    
    
    $
    8.76Granted
    
    
    361,812
    
    
    $
    11.00Exercised
    
    
    (455,304
    )
    
    $
    6.23Forfeited or expired expense
determined under fair value
based method for all awards
    
    
    (12,477
    )
    
    $
    11.94Outstanding, March 31, 2006
    
    
    1,494,065
    
    
    $
    10.62
    
    
    
    7.0
    
    
    $
    6.4Exercisable, March 31, 2006
    
    
    877,031
    
    
    $
    9.02
    
    
    
    5.2
    
    
    $
    5.1
 18




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Expected volatility
    
    78.4%-80.4%Weighted-average volatility
    
    79.0%Average expected term in years
    
    4.5Risk-fee interest rate (zero coupon U.S. Treasury Note)
    
    4.4%Expected dividend yield
    
    0%
 Restricted stock units.
 Weighted averagegrant dateNumber of shares
    
    

fair valueNonvested, September 30, 2005
    
    
    
    
    
    $
    Granted
    
    
    51,480
    
    
    $
    15.54Nonvested, March 31, 2006
    
    
    51,480
    
    
    $
    15.54
  Restricted stock awards
 Weighted averagegrant date fairNumber of shares
    
    
    valueNonvested, September 30, 2005
    
    
    250,000
    
    
    $
    14.22Granted
    
    
    30,000
    
    
    $
    15.12Nonvested, March 31, 2006
    
    
    280,000
    
    
    $
    14.32
 19




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##### Table of Contents



14. COMMITMENTS AND CONTINGENCIES
  15. LICENSE AGREEMENTS
 AstraZeneca UK Limited (AstraZeneca)
 20




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##### Table of Contents



Novartis International Pharmaceutical Ltd. (Novartis)
  Three Months
    
    
    Six Months EndedEnded March 31, 2006
    
    
    March 31, 2006Revenues:Milestone revenue
    
    $
    
    
    
    $
    5,000,000Research services and reimbursements
    
    
    1,956,565
    
    
    
    4,434,583Total
    
    $
    1,956,565
    
    
    $
    9,434,583
 16. MANUFACTURING SERVICES AGREEMENT
  17. SEGMENT INFORMATION
 ®
 21




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18. RECENT ACCOUNTING PRONOUNCEMENTS
 Financial Accounting Standards No. 151 (FAS 151).
 Financial Accounting Standards No. 154 (FAS 154).
 Financial Accounting Standards No. 155 (FAS 155).
 22




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19. SUBSEQUENT EVENTS
  23




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##### Table of Contents



Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
  EXECUTIVE OVERVIEW
 Avanir
  
    
    On April 4, 2006, we announced that the U.S. Federal Drug and Administration (FDA) had accepted
for filing and review our new drug application (NDA) for Neurodex for the treatment of
Involuntary Emotional Expression Disorder (IEED), also known as pseudobulbar affect (PBA) or
emotional lability. We were also informed by the FDA that the NDA would be granted priority review
status. The FDA grants priority review status to products that, if approved, would address an unmet
medical need or are considered to be potentially significant therapeutic advancements over existing
approved therapies in the treatment, diagnosis or prevention of a disease. We completed the
submission of the NDA on January 27, 2006 and we expect the FDA will take action on the NDA by July
30, 2006 (the PDUFA date), based on our estimates of the timing for the priority review. However,
the action may be delayed if there are questions from the FDA about our NDA.
    
    On April 3, 2006, the NASDAQ® approved our application for listing our common
stock for trading on the NASDAQ National Market System. On April 11, 2006, our stock began
trading on the NASDAQ under the stock symbol AVNR simultaneously with the discontinuation
of trading on the American Stock Exchange.
    
    On January 17, 2006, we implemented a one-for-four reverse stock split of our common
stock. Authorization to implement the reverse stock split had been previously approved on
March 17, 2005 by our shareholders at our annual meeting of shareholders. Our common stock
began trading on the American Stock Exchange on a split-adjusted basis on January 18, 2006,
and temporarily had a ticker symbol of AVN.R from January 18, 2006 through April 10,
2006. All share and per share information herein (including shares outstanding, earnings
per share and warrant and stock option exercise prices) reflect the adjustment of the
reverse stock split.
    
    In January 2006, we signed an exclusive license agreement with Kobayashi Pharmaceutical
Co., Ltd. (Kobayashi) giving Kobayashi the rights to manufacture and sell docosanol 10%
cream as a treatment for cold sores in Japan.
 24




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##### Table of Contents




    
    In January 2006, we entered into a manufacturing services agreement with Patheon, Inc.
(Patheon) under which Patheon will initially serve as our sole provider of drug
manufacturing services for Neurodex (the Manufacturing Agreement). Under the terms of
the Manufacturing Agreement, Patheon will be responsible for manufacturing, quality
control, quality assurance and stability testing of Neurodex. The Manufacturing Agreement
is effective until December 31, 2011.
    
    During the quarter ended March 31, 2006, we continued to fill important new
management positions, including the two positions of Vice President of Medical Affairs and
Vice President of Sales.
    
    On May 4, 2006 our Board of Directors authorized a space restructuring plan and the relocation
of our commercial and general and administrative operations. We currently occupy three laboratory
buildings in San Diego, California, and plan on relocating all operations other than research and
development to Orange County and subleasing two of the buildings in San Diego after the
relocation. On May 5, 2006, we entered into a lease for the new Orange County facilities, which
will consist initially of approximately 11,000 square feet of office space, increasing to 17,000
square feet in the second quarter of 2007, leased for an initial term of five years. The aggregate
minimum payments over the initial term of the lease are expected to be approximately $2.8 million.
    
    On May 4, 2006, Michael J. Puntoriero joined us as Senior Vice President of Finance
and, effective May 15, 2006, will be appointed Chief Financial Officer. As a key member of
the senior executive team, Mr. Puntoriero will be responsible for the areas of finance,
treasury, business planning, investor relations, information technology, and corporate
development. Effective May 15, 2006, Gregory P. Hanson, who is currently our Vice President
and Chief Financial Officer, will assume the new position of Vice President and Chief
Accounting Officer.
  25




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®
  
  26




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##### Table of Contents



info@avanir.com Avanir www.avanir.com www.sec.gov .
 CRITICAL ACCOUNTING POLICIES AND ESTIMATES
  27




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##### Table of Contents



Share-based compensation expense
    28




---



##### Table of Contents



Revenue Recognition
  Revenue Arrangements with Multiple Deliverables .
 29




---



##### Table of Contents



License Arrangements
  Royalty Revenues.
 Revenues from Sale of Royalty Rights . ®
 30




---



##### Table of Contents



Government Research Grant Revenue.
 Product Sales  Active Pharmaceutical Ingredient Docosanol.
 Recognition of Expenses in Outsourced Contracts
  Research and Development Expenses
   
    
    The technology is in the early stage of development and has no alternative uses;
    
    There is substantial uncertainty of the technology or product being successful;
    
    There will be difficulty in completing the remaining development; and
    
    There is substantial cost to complete the work.
 Acquired contractual rights
 31




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##### Table of Contents



Capitalization and Valuation of Long-Lived and Intangible Assets
   
    
    A significant underperformance relative to expected historical or projected future
operating results;
    
    A significant change in the manner of our use of the acquired asset or the strategy for
our overall business; and/or
    
    A significant negative industry or economic trend.
  RESULTS OF OPERATIONS
 COMPARISON OF THREE MONTHS ENDED MARCH 31, 2006 AND 2005
 Revenues
 ®
  Operating Expenses
  Three Months Ended
    
    
    Six Months EndedMarch 31,
    
    
    March 31,2006
    
    
    2005
    
    
    2006
    
    
    2005Operating expenses:Research and development
    
    
    48
    %
    
    
    77
    %
    
    
    57
    %
    
    
    72
    %Selling, general and administrative
    
    
    52
    %
    
    
    23
    %
    
    
    43
    %
    
    
    28
    %Costs of sales
    
    
    
    %
    
    
    
    %
    
    
    
    %
    
    
    
    %Total operating expenses
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
 32




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##### Table of Contents



Research
and development (R&D) expenses .
  Research and Development Projects and Expenses
 Three Months Ended
    
    
    Six Months Ended
    
    
    Inception
    
    
    EstimatedMarch 31,
    
    
    March 31,
    
    
    Through
    
    
    Cost toMarch 31,
    
    
    License or Complete2006 (1)
    
    
    2005 (1)(4)
    
    
    2006 (1)
    
    
    2005 (1)(4)
    
    
    2006 (1)(2)(4)
    
    
    Project (1)(3)Company-funded Projects:Development programs for
Neurodex, selective
cytokine inhibitor and
other programs projected
through fiscal 2007 (3)
    
    $
    6,027,247
    
    
    $
    10,249,442
    
    
    $
    13,304,575
    
    
    $
    13,774,474
    
    
    $
    92,044,454
    
    
    $30M to $40MPartner-funded Projects:Reverse cholesterol
transport and MIF
inhibitor research
programs
    
    
    1,795,634
    
    
    
    1,049,067
    
    
    
    3,811,719
    
    
    
    2,429,819
    
    
    
    23,267,609
    
    
    Funded by PartnersGovernment-funded Projects:Preclinical research on
various projects.
Funding for the anthrax
research project has beencompleted
    
    
    96,966
    
    
    
    129,661
    
    
    
    166,955
    
    
    
    278,118
    
    
    
    2,688,949
    
    
    $
    $
    7,919,847
    
    
    $
    11,428,170
    
    
    $
    17,283,249
    
    
    $
    16,482,411
    
    
    $
    118,001,012
 
 (1)
    
    Each project includes an allocation of laboratory occupancy costs. M refers to
millions. Estimated costs and timing to complete the projects are subject to the
availability of funds. For each of the projects set forth in the table, other than
Neurodex for IEED/PBA (which we intend to market ourselves), the reverse cholesterol
transport and the MIF inhibitor programs (both of which we have partnered), we may seek
development partners or licensees to defray part or all of the ongoing development costs.(2)
    
    Inception dates are on or after October 1, 1998, at which time we began identifying
and tracking program costs.(3)
    
    Assumes completion of development of Neurodex in the treatment of IEED/PBA and for
one Phase III clinical trial in the treatment of painful diabetic neuropathy and
continuation of Phase I studies of our selective cytokine inhibitor program. Projected
spending thereafter will be subject to progress made in research that is currently
underway.(4)
    
    Includes expenses funded by us prior to partnering these projects in the amounts of
$1.0 million and $2.4 million for the three-month and six-month periods ended March 31,
2005, respectively, and $17.1 million since inception through March 31, 2006. 33




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##### Table of Contents



Status of R&D Programs and Plans  Company-funded Projects
 Neurodex for the treatment of Involuntary Emotional Expression Disorder/Pseudobulbar Affect.
 Neurodex for the treatment of painful diabetic neuropathy.
 Development program for selective cytokine inhibitor.
 34




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##### Table of Contents



Status of R&D Programs and Plans  Partner-funded Projects
 Development program for reverse cholesterol transport.
 Anti-inflammatory research program (MIF inhibitor).
 Status of R&D Programs and Plans  Government-Funded Projects
 .
  35




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Selling, general and administrative expenses .
 
    
    $2.0 million increase in expenses related to the continued expansion of our market
research and pre-launch planning activities for Neurodex for the treatment of IEED/PBA and
hiring of additional sales and marketing personnel;
    
    $1.5 million in continuing medical education grants for IEED;
    
    $604,000 increase in expenses related to increases in headcount and compensation levels
in general and administrative areas; and
    
    $572,000 share-based compensation expense.
  Share-Based Compensation
  Interest Income
  Net Loss
   36




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##### Table of Contents



COMPARISON OF SIX-MONTH PERIODS ENDED MARCH 31, 2006 AND 2005
 Revenues
 ®
 Operating Expenses
  Research
and development (R&D) expenses .
 Selling, general and administrative expenses .
 
    
    $2.8 million increase in expenses related to the continued expansion of our market
research and pre-launch planning activities for Neurodex for the treatment of IEED/PBA and
hiring of additional sales and marketing personnel;
    
    $1.5 million in continuing medical educational grants;
 37




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##### Table of Contents




    
    $1.1 million increase in expenses related to increases in headcount and compensation
levels in general and administrative areas; and
    
    $957,000 share-based compensation expense.
 Share-Based Compensation
  Interest Income
  Net Loss
  LIQUIDITY AND CAPITAL RESOURCES
  Increase (Decrease)
    
    
    September 30,March 31, 2006
    
    
    During Period
    
    
    2005Cash, cash equivalents, investment in
securities and restricted investments
    
    $
    52,954,256
    
    
    $
    25,416,670
    
    
    $
    27,537,586Cash and cash equivalents
    
    $
    10,912,580
    
    
    $
    2,292,437
    
    
    $
    8,620,143Net working capital
    
    $
    38,602,472
    
    
    $
    26,633,022
    
    
    $
    11,969,450
 ChangeSix Months Ended
    
    
    Between
    
    
    Six Months EndedMarch 31, 2006
    
    
    Periods
    
    
    March 31, 2005Net cash used for operating activities
    
    $
    (17,326,116
    )
    
    $
    (2,065,340
    )
    
    $
    (15,260,776
    )Net cash (used for) provided by investing activities
    
    
    (24,595,598
    )
    
    
    (27,466,911
    )
    
    
    2,871,313Net cash provided by financing activities
    
    
    44,214,151
    
    
    
    37,112,285
    
    
    
    7,101,866Net increase (decrease) in cash and cash equivalents
    
    $
    2,292,437
    
    
    $
    7,580,034
    
    
    $
    (5,287,597
    )
 Operating activities.
 38




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##### Table of Contents



Investing activities.
 Financing activities.
   39




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MANAGEMENT OUTLOOK
   40




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##### Table of Contents



RECENT ACCOUNTING PRONOUNCEMENTS
  
 Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
  Interest rate sensitivity
  
 Item 4. CONTROLS AND PROCEDURES
 Evaluation of Disclosure Controls and Procedures
  Changes in Internal Controls over Financial Reporting
  41




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##### Table of Contents



PART II OTHER INFORMATION
 
 Item 1. LEGAL PROCEEDINGS
  
 Item 1A. RISK FACTORS
 Risks Relating to Our Business
 We have a history of losses and we may never achieve or maintain profitability.
   Any adverse decisions in the regulatory review or approval process may harm our prospects and could
harm our stock price.
  We have yet to market or sell Neurodex or any of our other potential products.
   42




---



##### Table of Contents



We expect that we will need to raise additional capital to fund ongoing operations and support our
planned product launch. If we are unable to raise additional capital, we may be forced to curtail
operations. If we succeed in raising additional capital through a licensing or financing
transaction, it may affect our stock price and future revenues.
    Changes in board and management composition that are intended to strengthen the board and
management team could adversely disrupt our operations.
  Our inability to attract and retain key management and scientific personnel could negatively affect
our business.
   43




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##### Table of Contents



We generally do not control the development of compounds licensed to third parties and, as a
result, we may not realize a significant portion of the potential value of any such license
arrangements.
  Our patents may be challenged and our pending patents may be denied. Either result would
seriously jeopardize our ability to compete in the intended markets for our proposed products.
  
    
    The claims in any pending patent applications will be allowed or that patents will be
granted;
    
    Competitors will not develop similar or superior technologies independently, duplicate
our technologies, or design around the patented aspects of our technologies;
    
    Our proposed technologies will not infringe other patents or rights owned by others,
including licenses that may be not be available to us;
    
    Any of our issued patents will provide us with significant competitive advantages; or
    
    Challenges will not be instituted against the validity or enforceability of any patent
that we own or, if instituted, that these challenges will not be successful.
  We depend on third parties to manufacture, package and distribute compounds for our drugs and drug
candidates. The failure of these third parties to perform successfully could harm our business.
  44




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##### Table of Contents



Because we depend on clinical research centers and other contractors for clinical testing and for
certain research and development activities, the results of our clinical trials and such research
activities are, to a certain extent, beyond our control.
  Accounting for material transactions can be very complex and we face risks if regulators disagree
with our accounting treatment for any of these transactions.
   Developing new pharmaceutical products for human use involves product liability risks, for which we
currently have limited insurance coverage.
  45




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##### Table of Contents



Risks Relating to Our Stock
 Our stock price has historically been volatile and we expect that this volatility may continue for
the foreseeable future.
  
    
    Comments made by securities analysts, including changes in their recommendations;
    
    Announcements by us of financing transactions and/or future sales of equity or debt
securities;
    
    Sales of our Class A common stock by our directors, officers, or significant
shareholders;
    
    Announcements by our competitors of clinical trial results or product approvals;
    
    Changes in operations and increases in operating expenses as we prepare for the
commercial launch of Neurodex, assuming it is approved by the FDA; and
    
    Market and economic conditions.
  
    
    Performance under partnering arrangements The recognition of the revenue under our
partnering arrangements, including our license agreements for our MIF and RCT
technologies, will partially depend on the efforts and performance of our licensees in
reaching milestones that are outside of our control, such as regulatory approval, product
launch, or reaching a sales threshold.
    
    Timing of FDA regulatory decisions We are in the process of building a sales force
for the planned commercialization of Neurodex. The timing and extent of these development
expenditures will vary depending on the FDAs review and decision on approval of our NDA
for Neurodex. As a result, our expenses could vary significantly from quarter-to-quarter
while we await regulatory decisions and complete this building process.
    
    Acquisitions Our acquisition of certain rights relating to Neurodex in fiscal 2005
resulted in charges of approximately $7.2 million. We may acquire other companies or
technologies, and if we do so, we will incur potentially significant charges in connection
with such acquisitions and may have ongoing charges after the closing of any such
transaction. Any such acquisitions could also be disruptive to our operations and may
adversely affect our results of operations.
  46




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##### Table of Contents



Risks Relating to Our Industry
 The pharmaceutical industry is highly competitive and most of our competitors are larger and have
greater resources. As a result, we face significant competitive hurdles.
   
 Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
  
 Item 3. DEFAULTS UPON SENIOR SECURITIES
  
 Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
  47




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Proposal No. 1: Election of Directors
 Directors
    
    For
    
    
    WithholdEric K. Brandt
    
    
    25,145,458
    
    
    
    142,215Charles A. Mathews
    
    
    24,609,101
    
    
    
    678,572Jonathan T. Silverstein
    
    
    24,689,824
    
    
    
    597,849
 Proposal No. 2: Amendment to 2005 Equity Incentive Plan
 For
    
    Against
    
    Abstain10,367,433

    
    2,900,387
    
    
    
    90,734
 Proposal No. 4: Ratification of Selection of Deloitte & Touche LLP as Independent Registered Public
Accounting Firm
 For
    
    Against
    
    Abstain24,841,661
    
    399,286
    
    
    
    46,726
   
 Item 5. OTHER INFORMATION
  
 Item 6. EXHIBITS
 Exhibits
 10.1
    
    Manufacturing Services Agreement between Patheon, Inc. and AVANIR
Pharmaceuticals, dated January 4, 2006.*10.2
    
    Quality Agreement between Patheon, Inc. and AVANIR
Pharmaceuticals, dated January 4, 2006.*10.3
    
    Docosanol License Agreement between Kobayashi Pharmaceutical Co.,
Ltd. and AVANIR Pharmaceuticals, dated January 5, 2006.*15.1
    
    Letter on unaudited interim financial information.31.1
    
    Certification of Principal Executive Officer Required Under Rule
13a-14(a) of the Securities Exchange Act of 1934, as amended.31.2
    
    Certification of Principal Financial Officer Required Under Rule
13a-14(a) of the Securities Exchange Act of 1934, as amended.32.1
    
    Certification of Principal Executive Officer Required Under Rule
13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18
U.S.C. 1350.32.2
    
    Certification of Principal Financial Officer Required Under Rule
13a-14(b) of the Securities Exchange Act of 1934, as amended, and 18
U.S.C. 1350.
 
 *
    
    Confidential treatment requested. 48




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SIGNATURES
  Signature
    
    Title
    
    Date/s/ Eric K. Brandt

Eric K. Brandt
    
    President and Chief Executive Officer
(Principal Executive Officer)
    
    May 10, 2006/s/ Gregory P. Hanson, CMA

Gregory P. Hanson, CMA
    
    Vice President, Finance and Chief
Financial Officer
(Principal Financial and Accounting Officer)
    
    May 10, 2006
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