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SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

|  |  |                                                                                  
|- |  | ---------------------------------------------------------------------------------
|X |  | QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF
1934.
| 
|  |  | For the quarterly period ended December 31, 2001                                 

OR

| |  |                                                                                         
| |  | ----------------------------------------------------------------------------------------
| |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE 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
(State or other jurisdiction of
incorporation or organization) |  | 33-0314804
(IRS Employer Identification No.)

|                                                                                                     |  |                 
|---------------------------------------------------------------------------------------------------- |  | ----------------
|11388 Sorrento Valley Road, Suite 200,San Diego, California
(Address of principal executive offices) |  | 92121
(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 February 1, 2002:

|                                   |  |  |            | 
|---------------------------------- |  |  | ---------- | 
|Class A Common stock, no par value |  |  | 58,211,381 | 
|Class B Common stock, no par value |  |  | 36,500     | 



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TABLE OF CONTENTS



|                          |                                                                                               |                                                   |  |  |  |  |  | 
|------------------------- | --------------------------------------------------------------------------------------------- | ------------------------------------------------- |  |  |  |  |  | 
|                          |                                                                                               | CONSOLIDATED BALANCE SHEETS (UNAUDITED)          
|                          |                                                                                               | CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
|                          |                                                                                               | CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
|                          |                                                                                               | 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               



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AVANIR PHARMACEUTICALS

FORM 10-QFor the Quarter Ended December 31, 2001

INDEX

|         |  |                                                                                       |  |      |  | 
|-------- |  | ------------------------------------------------------------------------------------- |  | ---- |  | 
|         |  |                                                                                       |  | 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                            |  | 21   |  | 
|        
|PART II. |  | OTHER INFORMATION                                                                     |  |      |  | 
|        
|Item 6.  |  | Exhibits and Reports on Form 8-K                                                      |  | 21   |  | 

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AVANIR PHARMACEUTICALS
CONSOLIDATED BALANCE SHEETS (UNAUDITED)

|                                       |                                                                                  |                                                                                                                   |                           |             |              |            |               |             |            |            | 
|-------------------------------------- | -------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------- | ------------------------- | ----------- | ------------ | ---------- | ------------- | ----------- | ---------- | ---------- | 
|                                       |                                                                                  |                                                                                                                   |                           |             | December 31, |            | September 30,
|                                       |                                                                                  |                                                                                                                   |                           |             | 2001         |            | 2001         
|                                       |                                                                                  |                                                                                                                   |                           |             |              |            |              
|ASSETS                                 |                                                                                  |                                                                                                                   |                           |             |              |            |               |            
|Current assets:                        |                                                                                  |                                                                                                                   |                           |             |              |            |               |            
|                                       | Cash and cash equivalents                                                        |                                                                                                                   | $                         | 12,546,173  |              |            | $             | 16,542,545  |           
|                                       | Restricted investment                                                            |                                                                                                                   |                           | 388,122     |              |            |               | 388,122     |           
|                                       | Short-term investments                                                           |                                                                                                                   |                           | 24,038      |              |            |               | 23,179      |           
|                                       | Receivables                                                                      |                                                                                                                   |                           | 1,249,555   |              |            |               | 898,676     |           
|                                       | Inventory                                                                        |                                                                                                                   |                           | 222,585     |              |            |               | 222,585     |           
|                                       | Prepaid                                                                          |                                                                                                                   |                           | 404,856     |              |            |               | 581,298     |           
|                                       |                                                                                  |                                                                                                                   |                           |             |              |            |               |            
|                                       |                                                                                  |                                                                                                                   | Total current assets      |             |              | 14,835,329 |               |             |            | 18,656,405 | 
|                                       | Property and equipment, net                                                      |                                                                                                                   |                           | 2,400,907   |              |            |               | 2,217,094   |           
|                                       | Intangible costs, net                                                            |                                                                                                                   |                           | 1,290,605   |              |            |               | 1,174,928   |           
|                                       | Investments                                                                      |                                                                                                                   |                           | 11,297,318  |              |            |               | 4,897,390   |           
|                                       | Other assets                                                                     |                                                                                                                   |                           | 106,715     |              |            |               | 108,136     |           
|                                       |                                                                                  |                                                                                                                   |                           |             |              |            |               |            
|                                       |                                                                                  |                                                                                                                   | TOTAL ASSETS              |             | $            | 29,930,874 |               |             | $          | 27,053,953 | 
|                                       |                                                                                  |                                                                                                                   |                           |             |              |            |               |            
|LIABILITIES AND SHAREHOLDERS EQUITY   |                                                                                  |                                                                                                                   |                           |             |              |            |               |            
|Current liabilities:                   |                                                                                  |                                                                                                                   |                           |             |              |            |               |            
|                                       | Accounts payable                                                                 |                                                                                                                   | $                         | 764,486     |              |            | $             | 734,701     |           
|                                       | Accrued expenses and other liabilities                                           |                                                                                                                   |                           | 919,002     |              |            |               | 858,991     |           
|                                       | Accrued compensation and payroll taxes                                           |                                                                                                                   |                           | 325,978     |              |            |               | 355,526     |           
|                                       | Loan payable                                                                     |                                                                                                                   |                           | 124,451     |              |            |               | 186,122     |           
|                                       | Current portion of capital lease obligation                                      |                                                                                                                   |                           | 113,954     |              |            |               | 105,366     |           
|                                       |                                                                                  |                                                                                                                   |                           |             |              |            |               |            
|                                       |                                                                                  |                                                                                                                   | Total current liabilities |             |              | 2,247,871  |               |             |            | 2,240,706  | 
|                                       | Capital lease obligation, net of current portion                                 |                                                                                                                   |                           | 422,179     |              |            |               | 351,784     |           
|                                       |                                                                                  |                                                                                                                   |                           |             |              |            |               |            
|                                       |                                                                                  |                                                                                                                   | Total liabilities         |             |              | 2,670,050  |               |             |            | 2,592,490  | 
|COMMITMENTS                            |                                                                                  |                                                                                                                   |                           |             |              |            |               |            
|REDEEMABLE CONVERTIBLE PREFERRED STOCK |                                                                                  |                                                                                                                   |                           |             |              |            |               |            
|                                       | Series D  no par value, 500 shares authorized;
50 shares issued and outstanding |                                                                                                                   |                           | 507,512     |              |            |               | 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; 58,056,381 and
57,976,381 issued and outstanding                          |                           |             | 86,754,960   |            |               |             | 86,626,355 |           
|                                       |                                                                                  | Class B  712,000 shares authorized; 36,500 shares
issued and outstanding (convertible into Class A Common
Stock) |                           |             | 19,895       |            |               |             | 19,895     |           
|                                       | Accumulated deficit                                                              |                                                                                                                   |                           | (59,974,174 | )            |            |               | (62,735,080 | )         
|                                       | Accumulated other comprehensive income (loss)                                    |                                                                                                                   |                           | (47,369     | )            |            |               | 47,390      |           
|                                       |                                                                                  |                                                                                                                   |                           |             |              |            |               |            
|                                       |                                                                                  | Total shareholders equity                                                                                        |                           |             | 26,753,312   |            |               |             | 23,958,560 |           
|                                       |                                                                                  |                                                                                                                   |                           |             |              |            |               |            
|                                       |                                                                                  | TOTAL LIABILITIES AND SHAREHOLDERS EQUITY                                                                        |                           | $           | 29,930,874   |            |               | $           | 27,053,953 |           
|                                       |                                                                                  |                                                                                                                   |                           |             |              |            |               |            

See notes to consolidated financial statements.

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AVANIR PHARMACEUTICALS
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

|                                                      |                                                                         |                          |           |                    |           |      |           |            |           | 
|----------------------------------------------------- | ----------------------------------------------------------------------- | ------------------------ | --------- | ------------------ | --------- | ---- | --------- | ---------- | --------- | 
|                                                      |                                                                         |                          |           | Three Months Ended
|                                                      |                                                                         |                          |           | December 31,      
|                                                      |                                                                         |                          |           |                   
|                                                      |                                                                         |                          |           | 2001               |           | 2000
|                                                      |                                                                         |                          |           |                    |           |     
|REVENUES:                                             |                                                                         |                          |           |                    |           |      |           |           
|                                                      | Contract and license revenues                                           |                          | $         | 5,066,667          |           |      | $         | 5,010,000  |          
|                                                      | Grant revenue                                                           |                          |           |                   |           |      |           | 55,732     |          
|                                                      | Royalties                                                               |                          |           | 1,063,548          |           |      |           |           |          
|                                                      |                                                                         |                          |           |                    |           |      |           |           
|                                                      |                                                                         | Total revenues           |           |                    | 6,130,215 |      |           |            | 5,065,732 | 
|                                                      |                                                                         |                          |           |                    |           |      |           |           
|EXPENSES:                                             |                                                                         |                          |           |                    |           |      |           |           
|                                                      | Research and development                                                |                          |           | 2,346,859          |           |      |           | 1,308,125  |          
|                                                      | General and administrative                                              |                          |           | 954,068            |           |      |           | 772,695    |          
|                                                      | Sales and marketing                                                     |                          |           | 320,032            |           |      |           | 214,319    |          
|                                                      |                                                                         |                          |           |                    |           |      |           |           
|                                                      |                                                                         | Total operating expenses |           |                    | 3,620,959 |      |           |            | 2,295,139 | 
|                                                      |                                                                         |                          |           |                    |           |      |           |           
|INCOME FROM OPERATIONS                                |                                                                         | $                        | 2,509,256 |                    |           | $    | 2,770,593 |           
|                                                      | Interest income                                                         |                          |           | 187,915            |           |      |           | 335,370    |          
|                                                      | Other income                                                            |                          |           | 82,940             |           |      |           |           |          
|                                                      | Interest expense                                                        |                          |           | (14,602            | )         |      |           | (2,859     | )        
|                                                      |                                                                         |                          |           |                    |           |      |           |           
|NET INCOME                                            |                                                                         | $                        | 2,765,509 |                    |           | $    | 3,103,104 |           
|                                                      |                                                                         |                          |           |                    |           |      |           |           
|NET INCOME ATTRIBUTABLE TO COMMON SHAREHOLDERS:       |                                                                         |                          |           |                    |           |      |           |           
|                                                      | Net income                                                              |                          | $         | 2,765,509          |           |      | $         | 3,103,104  |          
|                                                      | Dividends on redeemable convertible preferred stock                     |                          |           | (6,250             | )         |      |           | (6,301     | )        
|                                                      | Accretion of discount related to redeemable
convertible preferred stock |                          |           | (4,609             | )         |      |           | (4,659     | )        
|                                                      |                                                                         |                          |           |                    |           |      |           |           
|NET INCOME ATTRIBUTABLE TO COMMON SHAREHOLDERS        |                                                                         | $                        | 2,754,650 |                    |           | $    | 3,092,144 |           
|                                                      |                                                                         |                          |           |                    |           |      |           |           
|NET INCOME PER SHARE:                                 |                                                                         |                          |           |                    |           |      |           |           
|                                                      | BASIC                                                                   |                          | $         | 0.05               |           |      | $         | 0.05       |          
|                                                      |                                                                         |                          |           |                    |           |      |           |           
|                                                      | DILUTED                                                                 |                          | $         | 0.04               |           |      | $         | 0.05       |          
|                                                      |                                                                         |                          |           |                    |           |      |           |           
|WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING: |                                                                         |                          |           |                    |           |      |           |           
|                                                      | BASIC                                                                   |                          |           | 58,029,403         |           |      |           | 57,216,732 |          
|                                                      |                                                                         |                          |           |                    |           |      |           |           
|                                                      | DILUTED                                                                 |                          |           | 61,455,499         |           |      |           | 65,516,875 |          
|                                                      |                                                                         |                          |           |                    |           |      |           |           

See notes to the financial statements.

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AVANIR PHARMACEUTICALS
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

|                                                                         |                                                                                   |                                        |                                                      |            |                    |            |            |           |          |           |  
|------------------------------------------------------------------------ | --------------------------------------------------------------------------------- | -------------------------------------- | ---------------------------------------------------- | ---------- | ------------------ | ---------- | ---------- | --------- | -------- | --------- | -
|                                                                         |                                                                                   |                                        |                                                      |            | Three Months Ended
|                                                                         |                                                                                   |                                        |                                                      |            | December 31,      
|                                                                         |                                                                                   |                                        |                                                      |            |                   
|                                                                         |                                                                                   |                                        |                                                      |            | 2001               |            | 2000      
|                                                                         |                                                                                   |                                        |                                                      |            |                    |            |           
|OPERATING ACTIVITIES:                                                    |                                                                                   |                                        |                                                      |            |                    |            |            |          
|                                                                         | Net income                                                                        |                                        | $                                                    | 2,765,509  |                    |            | $          | 3,103,104 |         
|                                                                         | Adjustments to reconcile net income to net cash provided
by operating activities: |                                        |                                                      |            |                    |            |            |           |         
|                                                                         | Depreciation and amortization                                                     |                                        |                                                      | 129,816    |                    |            |            | 69,872    |         
|                                                                         | Compensation paid with common stock and stock options                             |                                        |                                                      | 44,860     |                    |            |            | 13,622    |         
|                                                                         | Loss on sale or disposal of assets                                                |                                        |                                                      | 28         |                    |            |            | 670       |         
|                                                                         | Changes in assets and liabilities:                                                |                                        |                                                      |            |                    |            |            |           |         
|                                                                         |                                                                                   | Accounts receivable                    |                                                      |            | (350,879           | )          |            |           | (38,953  | )        
|                                                                         |                                                                                   | Inventory                              |                                                      |            |                   |            |            |           | (3,980   | )        
|                                                                         |                                                                                   | Prepaid and other                      |                                                      |            | 177,863            |            |            |           | (83,311  | )        
|                                                                         |                                                                                   | Accounts payable                       |                                                      |            | 29,785             |            |            |           | (139,527 | )        
|                                                                         |                                                                                   | Accrued expenses and other liabilities |                                                      |            | 60,011             |            |            |           | (278,166 | )        
|                                                                         |                                                                                   | Accrued compensation and payroll taxes |                                                      |            | (29,548            | )          |            |           | 9,673    |          
|                                                                         |                                                                                   |                                        |                                                      |            |                    |            |            |          
|                                                                         |                                                                                   |                                        | Net cash provided by operating activities:           |            |                    | 2,827,445  |            |           |          | 2,653,004 |  
|INVESTING ACTIVITIES:                                                    |                                                                                   |                                        |                                                      |            |                    |            |            |          
|                                                                         | Investments in securities                                                         |                                        |                                                      | (7,695,545 | )                  |            |            |          |         
|                                                                         | Proceeds from sales and maturities of investments                                 |                                        |                                                      | 1,200,000  |                    |            |            | 95,164    |         
|                                                                         | Patent costs                                                                      |                                        |                                                      | (127,577   | )                  |            |            | (227,981  | )       
|                                                                         | Capital expenditures                                                              |                                        |                                                      | (188,721   | )                  |            |            | (289,887  | )       
|                                                                         |                                                                                   |                                        |                                                      |            |                    |            |            |          
|                                                                         |                                                                                   |                                        | Net cash used for investing activities               |            |                    | (6,811,843 | )          |           |          | (422,704  | )
|FINANCING ACTIVITIES:                                                    |                                                                                   |                                        |                                                      |            |                    |            |            |          
|                                                                         | Proceeds from issuance of common stock, net                                       |                                        |                                                      | 90,000     |                    |            |            | 929,583   |         
|                                                                         | Dividends paid on preferred stock                                                 |                                        |                                                      | (6,250     | )                  |            |            |          |         
|                                                                         | Repayment of notes payable                                                        |                                        |                                                      | (95,724    | )                  |            |            | (61,230   | )       
|                                                                         |                                                                                   |                                        |                                                      |            |                    |            |            |          
|                                                                         |                                                                                   |                                        | Net cash provided by (used for) financing activities |            |                    | (11,974    | )          |           |          | 868,353   |  
|                                                                         |                                                                                   |                                        |                                                      |            |                    |            |            |          
|Net increase (decrease) in cash and cash equivalents                     |                                                                                   |                                        | (3,996,372                                           | )          |                    |            | 3,098,653  |          
|Cash and cash equivalents at beginning of period                         |                                                                                   |                                        | 16,542,545                                           |            |                    |            | 19,699,768 |          
|                                                                         |                                                                                   |                                        |                                                      |            |                    |            |            |          
|Cash and cash equivalents at end of period                               |                                                                                   | $                                      | 12,546,173                                           |            |                    | $          | 22,798,421 |          
|                                                                         |                                                                                   |                                        |                                                      |            |                    |            |            |          
|SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:                       |                                                                                   |                                        |                                                      |            |                    |            |            |          
|Interest paid                                                            |                                                                                   | $                                      | 14,602                                               |            |                    | $          | 2,859      |          
|                                                                         |                                                                                   |                                        |                                                      |            |                    |            |            |          
|SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND FINANCING
ACTIVITIES: |                                                                                   |                                        |                                                      |            |                    |            |            |          
|Acquisition of equipment with capital leases                             |                                                                                   | $                                      | 113,036                                              |            |                    | $          |           |          

See notes to the financial statements.

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AVANIR PHARMACEUTICALS

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

We (also referred to as AVANIR or the Company) 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. In our opinion, we have
presented the consolidated financial statements, including all adjustments
consisting only of normal recurring accruals that are necessary to summarize
fairly our financial position as of December 31, 2001, and the results of
operations for the three months ended December 31, 2001 and December 31, 2000.
The results of operations for the three months ended December 31, 2001 may not
be indicative of the results that may be expected for the year ending September
30, 2002.

2. RECLASSIFICATIONS

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

3. BALANCE SHEET DETAIL

The following tables provide details of selected balance sheet items.

|                             |                                                 |                             |           |              |           |               |           |           |           | 
|---------------------------- | ----------------------------------------------- | --------------------------- | --------- | ------------ | --------- | ------------- | --------- | --------- | --------- | 
|                             |                                                 |                             |           | December 31, |           | September 30,
|                             |                                                 |                             |           | 2001         |           | 2001         
|                             |                                                 |                             |           |              |           |              
|Receivables:                 |                                                 |                             |           |              |           |               |           |          
|                             | Total receivables                               |                             | $         | 1,249,555    |           |               | $         | 898,676   |          
|                             | Allowance for doubtful accounts                 |                             |           |             |           |               |           |          |          
|                             |                                                 |                             |           |              |           |               |           |          
|                             |                                                 | Receivables                 |           | $            | 1,249,555 |               |           | $         | 898,676   | 
|                             |                                                 |                             |           |              |           |               |           |          
|Property and equipment, net: |                                                 |                             |           |              |           |               |           |          
|                             | Leasehold improvements                          |                             | $         | 769,156      |           |               | $         | 753,824   |          
|                             | Computer equipment and related software         |                             |           | 350,392      |           |               |           | 296,862   |          
|                             | Research and development equipment              |                             |           | 2,062,364    |           |               |           | 1,831,645 |          
|                             | Office equipment, furniture, and fixtures       |                             |           | 220,945      |           |               |           | 218,796   |          
|                             |                                                 |                             |           |              |           |               |           |          
|                             |                                                 |                             | 3,402,857 |              |           |               | 3,101,127 |          
|                             | Less, accumulated depreciation and amortization |                             |           | (1,001,950   | )         |               |           | (884,033  | )        
|                             |                                                 |                             |           |              |           |               |           |          
|                             |                                                 | Property and equipment, net |           | $            | 2,400,907 |               |           | $         | 2,217,094 | 
|                             |                                                 |                             |           |              |           |               |           |          
|Intangible costs, net:       |                                                 |                             |           |              |           |               |           |          
|                             | Intangible costs                                |                             | $         | 1,441,281    |           |               | $         | 1,313,704 |          
|                             | Less, accumulated amortization                  |                             |           | (150,676     | )         |               |           | (138,776  | )        
|                             |                                                 |                             |           |              |           |               |           |          
|                             |                                                 | Intangible costs, net       |           | $            | 1,290,605 |               |           | $         | 1,174,928 | 
|                             |                                                 |                             |           |              |           |               |           |          

4. INVENTORY

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

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5. REVENUE RECOGNITION

Performance-based license fees.We recognize revenues from license fees when
the performance requirements have been met, the fee is fixed or determinable,
and collection of fees is probable.

Royalty revenues.We recognize royalty revenues from our licensed products when
earned. Net sales figures used for calculating royalties due the Company can
often include deductions for estimated costs of unsaleable returns, managed
care chargebacks, cash discounts, freight and warehousing, and miscellaneous
write-offs, which may vary over the course of the license agreement.
Because of the aforementioned deductions, sales of
Abreva, if publicly reported by our licensee, GlaxoSmithKline, could differ
from net sales used in calculating the royalties
earned in accordance with the license agreement.

Revenue arrangements with multiple deliverables.In certain circumstances, we
may enter into revenue arrangements whereby we are obligated to deliver to the
customer multiple products and/or services (multiple deliverables). Such
arrangements could include antibody generation services agreements and other
forms of research collaborations. In these transactions, we allocate the total
revenue to be earned under the arrangement among the various elements based on
their relative fair value. In the case of antibody generation services, the
allocation is based on customer specific objective evidence of fair value. In
the case of other forms of research collaborations, milestone payments are
deferred and recognized ratably over the period of the obligation. We
recognize revenue related to the delivered products or services only if: (i)
the above performance or service criteria are met; (ii) any undelivered
products or services are not essential to the functionality of the delivered
products or services; (iii) payment for the delivered products or services is
not contingent upon delivery of the remaining products or services; (iv) we
have an enforceable claim to receive the amount due in the event we do not
deliver the undelivered products or services; and (v) as discussed above, there
is evidence of the fair value for each of the undelivered products or services.

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

6. INVESTMENTS

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

|                         |                         |                                  |                        |           |            |            |            |            |        |            |   |         |         |   |   |           |            |  |  | 
|------------------------ | ----------------------- | -------------------------------- | ---------------------- | --------- | ---------- | ---------- | ---------- | ---------- | ------ | ---------- | - | ------- | ------- | - | - | --------- | ---------- |  |  | 
|                         |                         |                                  |                        |           |            |            |            |            |        | Gross      |   | Gross   |         |   |   |          
|                         |                         |                                  |                        |           |            | Amortized  |            | Unrealized |        | Unrealized |   | Fair   
|                         |                         |                                  |                        |           |            | Cost       |            | Gain(2)    |        | Loss(2)    |   | Value  
|                         |                         |                                  |                        |           |            |            |            |            |        |            |   |        
|As of December 31, 2001: |                         |                                  |                        |           |            |            |            |            |        |            |   |         |         |   |   |          
|                         | Certificates of deposit |                                  | $                      | 1,612,160 |            |            |            |           |        |            | $ | (12,470 | )       |   | $ | 1,599,690 |           
|                         | Government securities   |                                  |                        | 9,975,000 |            |            | $          | 41,145     |        |            |   | (76,044 | )       |   |   | 9,940,101 |           
|                         | Commercial paper        |                                  |                        | 200,000   |            |            |            | 6,624      |        |            |   |        |         |   |   | 206,624   |           
|                         |                         |                                  |                        |           |            |            |            |            |        |            |   |         |         |   |   |          
|                         |                         | Total                            |                        | $         | 11,787,160 |            |            | $          | 47,769 |            |   | $       | (88,514 | ) |   | $         | 11,746,415 | 
|                         |                         |                                  |                        |           |            |            |            |            |        |            |   |         |         |   |   |          
|Reported as:             |                         |                                  |                        |           |            |            |            |            |        |            |   |         |         |   |   |          
|                         | Short-term investments: |                                  |                        |           |            |            |            |            |        |            |   |         |         |   |   |           |           
|                         |                         | Restricted investment(1)         |                        | $         | 388,122    |            |            |            |        |            |   |         |         |   |   |           |            | 
|                         |                         | Classified as held to maturity   |                        |           | 24,038     |            |            |            |        |            |   |         |         |   |   |           |            | 
|                         |                         |                                  |                        |           |            |            |            |            |        |            |   |         |         |   |   |          
|                         |                         |                                  | Short-term investments |           | $          | 412,160    |            |            |        |            |   |         |         |   |   |           |            |  | 
|                         | Long-term investments:  |                                  |                        |           |            |            |            |            |        |            |   |         |         |   |   |           |           
|                         |                         | Classified as available for sale |                        | $         | 11,097,318 |            |            |            |        |            |   |         |         |   |   |           |            | 
|                         |                         | Classified as held to maturity   |                        |           | 200,000    |            |            |            |        |            |   |         |         |   |   |           |            | 
|                         |                         |                                  |                        |           |            |            |            |            |        |            |   |         |         |   |   |          
|                         |                         |                                  | Long-term investments  |           | $          | 11,297,318 |            |            |        |            |   |         |         |   |   |           |            |  | 
|                         |                         |                                  |                        |           |            |            |            |            |        |            |   |         |         |   |   |          
|                         |                         |                                  |                        | Total     |            | $          | 11,709,478 |            |        |            |   |         |         |   |   |           |            |  |  | 
|                         |                         |                                  |                        |           |            |            |            |            |        |            |   |         |         |   |   |          

7



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|                          |                        |                         |                                  |                        |           |           |           |            |        |            |        |       |   |  |   |   |           |   |           | 
|------------------------- | ---------------------- | ----------------------- | -------------------------------- | ---------------------- | --------- | --------- | --------- | ---------- | ------ | ---------- | ------ | ----- | - |  | - | - | --------- | - | --------- | 
|                          |                        |                         |                                  |                        |           |           |           |            |        | Gross      |        | Gross |   |  |   |  
|                          |                        |                         |                                  |                        |           | Amortized |           | Unrealized |        | Unrealized |        | Fair 
|                          |                        |                         |                                  |                        |           | Cost      |           | Gain(3)    |        | Loss       |        | 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: |                                  |                        |           |           |           |            |        |            |        |       |   |  |   |   |           |  
|                          |                        |                         | Restricted investment(1)         |                        | $         | 388,122   |           |            |        |            |        |       |   |  |   |   |           |   |          
|                          |                        |                         | Classified as held to maturity   |                        |           | 23,179    |           |            |        |            |        |       |   |  |   |   |           |   |          
|                          |                        |                         |                                  |                        |           |           |           |            |        |            |        |       |   |  |   |  
|                          |                        |                         |                                  | Short-term investments |           | $         | 411,301   |            |        |            |        |       |   |  |   |   |           |   |           | 
|                          | Long-term investments: |                         |                                  |                        |           |           |           |            |        |            |        |       |   |  |   |   |          
|                          |                        |                         | Classified as available for sale |                        | $         | 4,497,390 |           |            |        |            |        |       |   |  |   |   |           |   |          
|                          |                        |                         | Classified as held to maturity   |                        |           | 400,000   |           |            |        |            |        |       |   |  |   |   |           |   |          
|                          |                        |                         |                                  |                        |           |           |           |            |        |            |        |       |   |  |   |  
|                          |                        |                         |                                  | Long-term investments  |           |           | 4,897,390 |            |        |            |        |       |   |  |   |   |           |   |           | 
|                          |                        |                         |                                  |                        |           |           |           |            |        |            |        |       |   |  |   |  
|                          |                        |                         |                                  | Total                  |           | $         | 5,308,691 |            |        |            |        |       |   |  |   |   |           |   |           | 
|                          |                        |                         |                                  |                        |           |           |           |            |        |            |        |       |   |  |   |  



---

|(1) |  | A restricted investment amounting to $388,122 as of December 31,
2001, 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 $41,145 on government securities and
gross unrealized losses of $88,514 on other investments represent an
accumulated net unrealized loss of $47,369, which is reported as
Accumulated other comprehensive loss on the consolidated balance
sheet as of December 31, 2001.
|   
|   
|   
|   
|(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. ESTIMATES

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the amounts reported
in the financial statements and accompanying notes.

8. COMPUTATION OF NET INCOME PER COMMON SHARE

We computed basic income per share by dividing the net income attributable to
common shareholders by the weighted average number of common shares outstanding
during the period (Basic EPS method). We compute diluted earnings per common
share by dividing the net income 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.

8



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##### Table of Contents



9. DILUTED WEIGHTED AVERAGE NUMBER OF SHARES

The following table is the reconciliation from the basic to the diluted
earnings per share computations for net income for the three months ended
December 31, 2001 and December 31, 2000:

|                                                                          |                                                                         |   |                                       |                                                                        |   |                                 |            |           |   |            |           | 
|------------------------------------------------------------------------- | ----------------------------------------------------------------------- | - | ------------------------------------- | ---------------------------------------------------------------------- | - | ------------------------------- | ---------- | --------- | - | ---------- | --------- | 
|                                                                          |                                                                         |   |                                       |                                                                        |   | Three Months Ended December 31,
|                                                                          |                                                                         |   |                                       |                                                                        |   |                                
|                                                                          |                                                                         |   |                                       |                                                                        |   | 2001                            |            | 2000     
|                                                                          |                                                                         |   |                                       |                                                                        |   |                                 |            |          
|Numerator:                                                                |                                                                         |   |                                       |                                                                        |   |                                 |            |          
|                                                                          | Net income                                                              |   | $                                     | 2,765,509                                                              |   |                                 | $          | 3,103,104 |  
|Less:                                                                     |                                                                         |   |                                       |                                                                        |   |                                 |            |          
|                                                                          | Dividends on redeemable convertible
preferred stock                     |   |                                       | (6,250                                                                 | ) |                                 |            | (6,301    | )
|                                                                          | Accretion of discount related to redeemable
convertible preferred stock |   |                                       | (4,609                                                                 | ) |                                 |            | (4,659    | )
|                                                                          |                                                                         |   |                                       |                                                                        |   |                                 |            |          
|                                                                          |                                                                         |   |                                       | Income available to common
shareholders for basic earnings per
share   |   |                                 | 2,754,650  |           |   |            | 3,092,144 | 
|Effect of dilutive securities:                                            |                                                                         |   |                                       |                                                                        |   |                                 |            |          
|                                                                          | Convertible preferred stock                                             |   |                                       | (23,857                                                                | ) |                                 |            | (42,090   | )
|                                                                          |                                                                         |   |                                       |                                                                        |   |                                 |            |          
|                                                                          |                                                                         |   |                                       | Income available to common
shareholders for diluted earnings per
share |   | $                               | 2,730,793  |           |   | $          | 3,050,054 | 
|                                                                          |                                                                         |   |                                       |                                                                        |   |                                 |            |          
|Denominator:                                                              |                                                                         |   |                                       |                                                                        |   |                                 |            |          
|Shares for basic earnings per share 
weighted average shares outstanding |                                                                         |   | 58,029,403                            |                                                                        |   |                                 | 57,216,732 |          
|Effect of dilutive securities:                                            |                                                                         |   |                                       |                                                                        |   |                                 |            |          
|                                                                          | Stock options(1)                                                        |   |                                       | 2,551,715                                                              |   |                                 |            | 6,679,919 |  
|                                                                          | Warrant shares                                                          |   |                                       | 687,452                                                                |   |                                 |            | 1,444,578 |  
|                                                                          | Convertible preferred stock                                             |   |                                       | 186,929                                                                |   |                                 |            | 175,646   |  
|                                                                          |                                                                         |   |                                       |                                                                        |   |                                 |            |          
|                                                                          |                                                                         |   | Shares for diluted earnings per share |                                                                        |   | 61,455,499                      |            |           |   | 65,516,875 |          
|                                                                          |                                                                         |   |                                       |                                                                        |   |                                 |            |          
|Basic earnings per share                                                  |                                                                         | $ | 0.05                                  |                                                                        |   | $                               | 0.05       |          
|                                                                          |                                                                         |   |                                       |                                                                        |   |                                 |            |          
|Diluted earnings per share                                                |                                                                         | $ | 0.04                                  |                                                                        |   | $                               | 0.05       |          
|                                                                          |                                                                         |   |                                       |                                                                        |   |                                 |            |          



---

|(1) |  | For the three months ended December 31, 2001, options to purchase 343,260
shares of common stock were excluded from the computation of diluted
earnings per share, as the inclusion of such shares would be antidilutive.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

10. SHAREHOLDERS EQUITY

Preferred Stock

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

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

Series D Redeemable Convertible Preferred Stock.At December 31, 2001 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.                                                                                                                                                                                                  

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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.

11. RECENT ACCOUNTING PRONOUNCEMENTS

In December 1999, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial
Statements. SAB 101, as amended, summarizes certain of the SECs views in
applying accounting principles generally accepted in the United States of
America to revenue recognition in financial statements, including revenues
earned from collaborations between companies. We adopted SAB 101 in the fourth
quarter of the fiscal year ended September 30, 2001. The adoption of SAB 101
did not have a material impact on the Companys earnings.

In July 2001, the Financial Accounting Standards Board (FASB) approved three
statements, Statement of Financial Accounting Standards No. 141 (SFAS 141),
Business Combinations, SFAS 142, Goodwill and Other Intangible Assets, and
SFAS 143, Accounting for Asset Retirement Obligations.

SFAS 141 supersedes APB Opinion No. 16, Business Combinations, and eliminates
the pooling-of-interests method of accounting for business combinations, thus
requiring all business combinations be accounted for using the purchase method.
In addition, in applying the purchase method, SFAS 141 changes the criteria
for recognizing intangible assets apart from goodwill and states the following
criteria should be considered in determining the recognition of the intangible
assets: (1) the intangible asset arises from contractual or other legal
rights, or (2) the intangible asset is separable or dividable from the acquired
entity and capable of being sold, transferred, licensed, rented, or exchanged.
The requirements of SFAS 141 are effective for all business combinations
completed after June 30, 2001. The adoption of this new standard did not have
a material impact on the Companys financial statements.

SFAS 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 142 is required for the Company on October
1, 2002. We do not believe the adoption of SFAS 142 will have a significant
impact on the Companys financial statements.

SFAS 143 requires entities to record the fair value of a liability for an asset
retirement obligation in the period in which it is incurred. When the
liability is initially recorded, the entity capitalizes a cost by increasing
the carrying amount of the related long-lived asset. Over time, the liability
is accreted to its present value each period, and the capitalized cost is
depreciated over the useful life of the related asset. Upon settlement of the
liability, an entity either settles the obligation for its recorded amount or
incurs a gain or loss upon settlement. Application of SFAS 143 became
effective for AVANIR on October 1, 2001. The adoption of this standard did not
have a significant impact on the Companys financial statements.

In August 2001 the FASB issued SFAS 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

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No. 144
becomes effective for the Company on October 1, 2002. The effect, if any, of
SFAS 144 on the Companys financial statements has not yet been determined.




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. Forward-looking
statements often contain words like estimate, anticipate, believe, plan
or expect. Many known and unknown risks and uncertainties could cause our
actual results to differ materially from those indicated in these
forward-looking statements. You should review carefully the risks and
uncertainties identified in this report 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 engaged in research, development, commercialization, licensing and
sales of innovative drug products and antibody generation services. AVANIRs
subsidiary, Xenerex Biosciences, is engaged in research collaborations with
partner companies for developing and commercializing completely human antibody
products to target antigens.

AVANIR currently has a drug on the market that has been approved by the United
States Food and Drug Administration (FDA). 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 United States for the treatment of cold
sores. The consumer research group ranked Abreva number five among the top
selling new consumer healthcare products introduced in the twelve month period
ended September 2001. Under the license agreement with GlaxoSmithKline, AVANIR
has received $25 million in milestone payments, including the final $5 million
milestone payment received in November 2001.

AVANIR has completed other license agreements or is engaged in negotiations for
licensing of docosanol 10% cream to other international companies. AVANIR is
also assisting those companies in their efforts to obtain regulatory approvals
for manufacturing and marketing the drug. The Company currently has license
agreements with companies that have a presence in Canada, South Korea, Israel,
Egypt and other countries in the Middle East. The regulatory approval process
is underway in each of those countries. We are also preparing for an initial
filing for regulatory approval of docosonal in Europe and have made the
decision to prepare for filing in Japan as well.

AVANIRs drug development pipeline consists of clinical, pre-clinical and drug
discovery programs. Current clinical development programs are centered around
Neurodex, which could potentially provide a novel approach for the treatment
of several central nervous system disorders. AVANIR is currently developing
two of four known potential indications for Neurodex. The leading clinical
development program is for the treatment of emotional lability, a
neurodegenerative condition for which no FDA-approved drug exists. A Phase
II/III clinical trial for the treatment of emotional lability in patients with
Lou Gehrigs disease is underway. If the trial is successful, we plan to
follow with an additional Phase III clinical trial in patients with multiple sclerosis. Positive results will be
needed for both clinical trials for us to file a new drug application with the
FDA in late 2003 or early 2004. We also intend to enter a
Phase II dosing trial for Neurodex in the treatment of diabetic
neuropathic pain later in 2002. Our
preclinical research and drug discovery programs are at earlier stages of
development and are directed primarily

11



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toward large therapeutic areas, including allergies and asthma, inflammatory diseases and cholesterol
reduction.

Important parts of our development strategy include engaging in research
collaborations, acquisitions and licensing. For example, in January 2002 we
entered into a research collaboration with Shanghai New Asiatic Pharmaceutical
Company for the purposes of exploring other indications or uses for docosanol
10% cream, including genital herpes and herpes zoster, also known as shingles.
We intend to partner with more companies that can help fund AVANIRs research
in exchange for rights to commercialize new drugs coming from this research.
We also expect that Xenerex will play an important part in establishing new
research collaborations and in providing a source of revenues for its services
in generating human monoclonal antibodies for its partners. In January 2002,
Xenerex entered into its third collaborative research agreement for generating
fully human monoclonal antibodies to target antigens provided by its research
partner. Xenerex now has contracts to generate antibodies to eight target
antigens provided by its partners.

RESULTS OF OPERATIONS

Revenues

Revenues increased to $6.1 million for the first quarter of fiscal year 2002,
representing the three months ended December 31, 2001, compared to $5.1 million
in the same period a year ago. The 21% increase in revenues was due primarily
to royalties earned from sales of Abreva by GlaxoSmithKline. Royalties on
sales of Abreva continued to improve with increasing market penetration and
seasonally higher demand for cold sore products. In addition to $1.1 million
in royalties on product sales, revenues for the first fiscal quarter 2002
included the final $5 million milestone from GlaxoSmithKline when the company
reached the one-year anniversary of introduction of Abreva. Revenues for the
first fiscal quarter 2001 included earning $5 million in October 2000 when
GlaxoSmithKline achieved Abreva product launch.

Having received the final $5 million milestone payment from GlaxoSmithKline
during the first fiscal quarter 2002, our revenues for the next several
quarters will depend substantially on the amount of royalties earned from sales
of Abreva, potential milestone payments from international licensees of
docosanol 10% cream, and making further progress at Xenerex in adding to its
customer base and in reaching additional milestones in providing human
antibodies.

We believe GlaxoSmithKlines launch of Abreva has been very successful to
date, as demonstrated by achieving market leadership in the first year of
introduction. We expect that sales of Abreva will generate royalties to AVANIR
in the range of $3.3 million to $4.5 million during fiscal 2002, depending on
GlaxoSmithKlines level of product promotion and the timing of regulatory
approval for marketing the product in Canada. We believe that future royalties
on sales of Abreva will provide an important source of funds for pursuing
development programs. However, we expect that royalties and milestone payments
from international licensing during the next two quarters will not be enough to
sustain the profitability levels that we have experienced during the past two
quarters.

We continue to make progress in outlicensing docosanol 10% cream in
international markets, which represent potential new sources of revenues for us
in the future. However, our ability to earn license fees and milestone
payments from international sources in the near term will be more
unpredictable, because the timing of foreign regulatory approvals and
marketing of our product will be substantially outside our control.

We expect that our subsidiary, Xenerex Biosciences, will gradually become a
significant source of revenues through its antibody generation services
business. Near-term revenues should help fund

12



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##### Table of Contents



Xenerexs growth, but the larger
milestone payments that typically accompany these collaborations will depend on
the progress made by our partners in evaluating, selecting and advancing our
antibodies through the development pipeline. Progress by our 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.

Expenses

Operating Expenses Total operating expenses increased to $3.6 million in the
first fiscal quarter 2002, compared to $2.3 million in the same period in
fiscal 2001. The 58% increase in operating expenses was primarily caused by a
79% increase in spending on research and development programs. Research and
development programs accounted for 65% and 57% of total operating expenses for
the fiscal quarters ended December 31, 2001 and 2000, respectively. General
and administrative expenses accounted for 26% and 34% of total operating
expenses for the fiscal quarters ended December 31, 2001 and 2000,
respectively. Sales and marketing expenses accounted for 9% of total operating
expenses for the fiscal quarters ended December 31, 2001 and 2000. These and
other costs are more fully described below.

Research and Development Expenses Research and development (R&D) expenses
increased to $2.3 million in the first fiscal quarter 2002, compared to $1.3
million in the same period a year ago. The Phase II/III clinical trial for
Neurodex (formerly AVP-923) in the treatment of emotional lability accounted
for 29% of all R&D spending in the first fiscal quarter 2002. The Phase II/III
clinical trial for Neurodex was approximately 66% completed at December 31,
2001. Toxicology and other preclinical research related to AVANIRs lead
compound for the treatment of allergies and allergic asthma accounted for 17%
and development of human antibody generation technology within Xenerex
Biosciences accounted for 14% of R&D spending in the first fiscal quarter 2002.
The balance of R&D spending was for other programs, including preclinical
research related to inflammation and cholesterol lowering compounds, and for
operating and maintaining laboratory facilities.

We plan to continue increasing our spending on established R&D programs in the
development pipeline. For example, through the next several quarters we intend
to expand our clinical development programs for Neurodex by initiating a Phase
II clinical trial for the treatment of diabetic neuropathic pain. We also
intend to continue toxicology work and other advanced preclinical research on
our lead compound for treating allergy and allergic asthma.

In the first fiscal quarter 2001, R&D expenses primarily related to initiating
the Phase II/III clinical trial for Neurodex in treating emotional lability and
development of the antibody generation technology. The Neurodex Phase II/III
clinical trial began in November 2000.

General and Administrative Expenses General and administrative expenses
amounted to $954,000 in the first fiscal quarter 2002, representing a 23%
increase over expenses of $773,000 in the same period in the prior year.
Higher expenses were attributable to increased staff size to support growing
R&D and commercial development programs. 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 and outlicensing of docosanol 10%
cream.

Sales and Marketing Expenses During the first fiscal quarter 2002, sales and
marketing expenses were $320,000, compared with $214,000 in the same period a
year ago. Higher expenses in the first fiscal quarter 2002 were related to
expanding efforts 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.

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Income from Operations

For the first fiscal quarter 2002, income from operations was $2.5 million,
compared to $2.8 million for the same period a year ago. Higher fiscal 2002
operating expenses were only partially offset by the $1 million increase in
revenues attributable to Abreva royalties. Higher operating expenses
were related to the greater number and extent of R&D programs, increased staff size in the general and
administrative areas, and increases in sales and marketing activities,
including licensing activities for docosanol 10% cream.

Other Income and Expenses

Interest Income In the first fiscal quarter 2002, interest income amounted to
$188,000, compared to $335,000 for the same period a year ago. The decrease in
interest income during the first fiscal quarter 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 fiscal quarter 2002 primarily
consists of one-time fees charged by the Company to potential licensees for
exclusive rights to negotiate license agreements for docosanol 10% cream and
rental income for use of the Companys conference center and emergency standby
power generating equipment.

Interest Expense In the first fiscal quarter 2002, interest expense amounted
to $15,000, compared to $3,000 for the same period a year ago. Higher levels
of interest expense will continue for the foreseeable future. Higher interest
expense for the first fiscal quarter 2002 was primarily related to $495,000 in
new capital equipment lease financing transactions for an emergency power
generator and various new pieces of laboratory equipment.

Net Income

For the first fiscal quarter 2002, net income attributable to common
shareholders was $2.8 million, compared to $3.1 million for the same period a
year ago. Basic net income per share was $0.05 and diluted net income per
share was $0.04, compared to basic and diluted net income per share of $0.05
for the same period a year ago. Given the uncertainty in the amounts and
timing of revenues other than Abreva royalties, and planned
increases in spending associated with an expanded drug development
pipeline, we expect to incur losses at
least through the next two quarters. Thereafter, for a period of at
least two years, we expect to have some quarterly periods of
profitability and some quarterly periods of losses, depending on the amounts and timing
of license fees and milestone payments.

LIQUIDITY AND CAPITAL RESOURCES

At December 31, 2001, we had cash and cash equivalents of $12.5 million, short
and long-term investments of $11.7 million and a net working capital balance of
$12.6 million. At September 30, 2001, we had cash and cash equivalents of
$16.5 million, short and long-term investments of $5.3 million and a net
working capital balance of $16.4 million. We use finance leases to fund
portions of our equipment purchases, but we do not maintain a line of credit
with any financial institution. Explanations of the changes in net cash
provided by operating and financing activities and net cash used for investing
activities are provided below.

Operating Activities. Net cash provided by operating activities amounted to
$2.8 million in the first fiscal quarter 2002, compared to $2.7 million during
the same period a year ago. Net income of $2.8 million and $3.1 million for
the fiscal quarters ended 2002 and 2001, respectively, accounted for most of
the net cash provided by operating activities. Net cash provided by operating
activities increased in the first fiscal
quarter 2002 over the same period a year ago because we obtained better
payment terms from a number of vendors, which enabled us to reduce the amount of prepayments
on our purchases of equipment and services.

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Investing Activities. Net cash used for investing activities during the first
fiscal quarter 2002, amounted to $6.8 million, including investments in
securities totaling $7.7 million, capital expenditures of $189,000 and patent
costs of $128,000, partially offset by sales and maturities of investments
totaling $1.2 million. As short-term interest rates came down through most of
2001, 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 million reduction in cash and cash
equivalents and a $6.4 million net increase in short and long-term investments.
Net cash used for investing activities in the first fiscal quarter 2001
amounted to $423,000, including capital expenditures of $290,000 and patent
costs of $228,000.

Financing Activities. During the first fiscal quarter 2002, net cash used for
financing activities amounted to $12,000. During the same period a year ago,
net cash provided by financing activities amounted to $868,000, primarily from
issuances of Class A common stock on exercises of stock options and stock
purchase warrants. Other financing activities in the fiscal quarters ended
2002 and 2001, related primarily to short-term financing of insurance premiums
and payments of dividends on preferred stock.

We believe that cash and short and long-term investments totaling $24.3 million
at December 31, 2001, provide us with sufficient liquidity to fund at least two
years of operating costs. However, given the uncertainty of the timing and
amounts of revenues from sources other than royalties and our plans for
expanding our drug development pipeline, it is more likely than not that we
will raise capital in the next twelve months to enhance our capital base and
liquidity.

RECENT ACCOUNTING PRONOUNCEMENTS

See Note 11, Recent Accounting Pronouncements for a discussion of recent
accounting pronouncements and their effect, if any, on the Company.

RISK FACTORS THAT MIGHT AFFECT FUTURE OPERATIONS

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 wide 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.                                                                                                                                                                                                                                                                                                                            
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | 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.
|
| |  |  | 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. All of the milestone
payments from GlaxoSmithKline have now been received. Future revenues
from GlaxoSmithKline will come exclusively from Abreva royalties. Our business could be adversely affected if GlaxoSmithKline                                                                                                                     

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| |  |  | 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.
| |  |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

If we experience any delays in obtaining regulatory approval for Abreva in
Canada or 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.

We have signed an exclusive license agreement with GlaxoSmithKline for
manufacturing and sales of Abreva in North America. Abreva is approved for
sale only in the United States at this time. We have completed the application
for regulatory approval for marketing in Canada and we are currently awaiting a
decision. We could experience problems or delays in obtaining regulatory
approval in Canada, which has a market size that is about 10% of the size of
the U.S. market. Further, our royalty revenues from sales of Abreva next year
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 could face the following risks in our efforts to
obtain regulatory approval as an OTC product and to market and sell docosanol
10% cream in foreign countries:



| |  |  | 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.                                                                                                                                                         

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.

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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.

If we raise additional capital by issuing additional shares of Class A common
stock at a price or a value per share less than the then-current price per
share of Class A common stock, 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 todays price, sales of such
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 distributorship 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 Canada, Israel, Korea and other 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 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

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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 II/III clinical trials of
Neurodex for the treatment of emotional lability in ALS and MS patients may
experience setbacks or failures for reasons we have not anticipated. Our Phase
II 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 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.

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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, be able to obtain them 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 failure 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 45 people in AVANIR and
our subsidiary, Xenerex Biosciences, and we expect to hire additional people
throughout the year. 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.

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 patent and patent
applications pending on other products and technologies, and have inlicensed
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 bio-pharmaceutical 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.                  

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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 cover sufficiently all of the possible 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.

The conversion or exercise of currently outstanding stock purchase warrants and
stock options, or conversion of redeemable convertible preferred stock
currently outstanding will have a dilutive effect on our Class A common stock.

As of February 1, 2002, the Company had outstanding stock options to purchase
an aggregate of 5,144,994 shares of Class A common stock at exercise prices
ranging from $0.30 to $6.44 per share and warrants to acquire up to 1,184,550
shares of Class A common stock at exercise prices ranging from $0.9144 to
$2.715 per share. The Company has other securities that may have a dilutive
effect, including 50 shares of Series D redeemable convertible preferred stock,
which at recent market prices may be converted into approximately 186,900
shares of Class A common stock at a fixed conversion price of $2.715 per share.

Sales in the public market of shares of Class A common stock acquired upon
exercise of stock options and warrants may affect adversely the prevailing
market prices for Class A common stock. Negative

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price movements in the shares
of Class A common stock likely would affect adversely our ability to obtain
additional equity capital on favorable terms, if at all.

We do not intend to declare or pay cash dividends in the foreseeable future.

We do not intend to declare or pay cash dividends on our Class A or Class B
common stock in the foreseeable future. We expect to retain any earnings, if
and when achieved, to finance our 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
immaterial. However, in the future we could face increasing exposure to
foreign currency exchange rates as we expand international distribution of
docosanol 10% cream. Until such time as we are faced with material amounts of
foreign currency exchange rate risks, we do not plan to use derivative
financial instruments, which can be used to hedge such risks. We will evaluate
the use of derivative financial instruments to hedge our exposures as the needs
and risks should arise.

Interest rate sensitivity

Our investment portfolio consists primarily of fixed income instruments with an
average duration of 3.1 years as of December 31, 2001 (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

Item 1-5. NOT APPLICABLE




Item 6. EXHIBITS AND REPORTS ON FORM 8-K

None.




SIGNATURES

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

|                                                    |  |                                                                                                  |  |                  
|--------------------------------------------------- |  | ------------------------------------------------------------------------------------------------ |  | -----------------
|Signature                                           |  | Title                                                                                            |  | Date             
|                                                    |  |                                                                                                  |  |                  
|                                                   
|/s/Gerald J. Yakatan, Ph.D.Gerald J. Yakatan, Ph.D. |  | President and Chief
Executive Officer
(Principal Executive Officer)                              |  | February 14, 2002
|                                                   
|/s/Gregory P. HansonGregory P. Hanson               |  | Vice President, Finance and Chief
Financial Officer
(Principal Financial and Accounting Officer) |  | February 14, 2002

21