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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549


FORM 10-Q

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(Mark One)

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

For the quarterly period ended December 31, 2003

OR

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

For the transition period from __________to __________.

Commission File No. 0-18734

AVANIR PHARMACEUTICALS

(Exact name of registrant as specified in its charter)


|                                                  |  |                                     
|------------------------------------------------- |  | ------------------------------------
|California                                        |  | 33-0314804                          
|(State or other jurisdiction of                   |  | (I.R.S. Employer Identification No.)
|incorporation or organization)                    |  |                                     
|                                                  |  |                                     
|11388 Sorrento Valley Road, San Diego, California |  | 92121                               
|(Address of principal executive offices)          |  | (Zip Code)                          

(858) 622-5200
(Registrants telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities and Exchange Act
of 1934 during the preceding 12 months (or for such shorter periods that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES [X] NO [   ]

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

As of February 4, 2004, the registrant had 71,266,550 shares of Class A common
stock issued and outstanding.



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TABLE OF CONTENTS



|                              |                                                                                               |                                            |  |  |  |  |  | 
|----------------------------- | --------------------------------------------------------------------------------------------- | ------------------------------------------ |  |  |  |  |  | 
|PART I. FINANCIAL INFORMATION
|                              | Item 1. FINANCIAL STATEMENTS                                                                 
|                              |                                                                                               | INDEPENDENT ACCOUNTANTS REPORT           
|                              |                                                                                               | CONSOLIDATED BALANCE SHEETS               
|                              |                                                                                               | CONSOLIDATED STATEMENTS OF OPERATIONS     
|                              |                                                                                               | CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                              |                                                                                               | NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|                              | Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|                              | Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                           
|                              | Item 4. CONTROLS AND PROCEDURES                                                              
|PART II OTHER INFORMATION    
|                              | Item 6. EXHIBITS AND REPORTS ON FORM 8-K                                                     
|SIGNATURES                   
|EXHIBIT INDEX                
|EXHIBIT 15.0                 
|EXHIBIT 31.1                 
|EXHIBIT 31.2                 
|EXHIBIT 32.1                 
|EXHIBIT 32.2                 



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Table of Contents

|         |  |                                                                                       |  |     
|-------- |  | ------------------------------------------------------------------------------------- |  | ----
|         |  |                                                                                       |  | Page
|         |  |                                                                                       |  |     
|PART I.  |  | FINANCIAL INFORMATION                                                                 |  |     
|Item 1.  |  | Financial Statements                                                                  |  |     
|         |  | Independent Accountants Report                                                       |  | 3   
|         |  | Consolidated Balance Sheets                                                           |  | 4   
|         |  | Consolidated Statements of Operations                                                 |  | 5   
|         |  | Consolidated Statements of Cash Flows                                                 |  | 6   
|         |  | Notes to Consolidated Financial Statements                                            |  | 7   
|Item 2.  |  | Managements Discussion and Analysis of Financial Condition
and Results of Operations |  | 13  
|Item 3.  |  | Quantitative and Qualitative Disclosures about Market Risk                            |  | 29  
|Item 4.  |  | Controls and Procedures                                                               |  | 30  
|PART II. |  | OTHER INFORMATION                                                                     |  |     
|Item 6.  |  | Exhibits and Reports on Form 8-K                                                      |  | 31  

2



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PART I. FINANCIAL INFORMATION




Item 1. FINANCIAL STATEMENTS




INDEPENDENT ACCOUNTANTS REPORT

Board of Directors and Shareholders
Avanir Pharmaceuticals

We have reviewed the accompanying consolidated balance sheet of Avanir
Pharmaceuticals (the Company) and subsidiary as of December 31, 2003 and the
related consolidated statements of operations and cash flows for the
three-month periods ended December 31, 2003 and 2002. These interim financial
statements are the responsibility of the Companys management.

We conducted our review in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures to
financial data and of making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an audit conducted
in accordance with auditing standards generally accepted in the United States
of America, the objective of which is the expression of an opinion regarding
the financial statements taken as a whole. Accordingly, we do not express such
an opinion.

Based on our review, we are not aware of any material modifications that should
be made to such consolidated interim financial statements for them to be in
conformity with accounting principles generally accepted in the United States
of America.

We have previously audited, in accordance with auditing standards generally
accepted in the United States of America, the consolidated balance sheet of the
Company as of September 30, 2003 and the related consolidated statements of
operations, shareholders equity and cash flows for the year then ended (not
presented herein); and in our report dated December 19, 2003, we expressed an
unqualified opinion on those financial statements. In our opinion, the
information set forth in the accompanying consolidated balance sheet as of
September 30, 2003 is fairly stated, in all material respects, in relation to
the consolidated balance sheet from which it has been derived.

DELOITTE & TOUCHE LLP

San Diego, California
February 13, 2004

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Avanir Pharmaceuticals




CONSOLIDATED BALANCE SHEETS (UNAUDITED)

|                                                  |                                                              |                           |                                                                                                                                                                                          |                                            |            |              |            |               |            |            |            | 
|------------------------------------------------- | ------------------------------------------------------------ | ------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ---------- | ------------ | ---------- | ------------- | ---------- | ---------- | ---------- | 
|                                                  |                                                              |                           |                                                                                                                                                                                          |                                            |            | December 31, |            | September 30,
|                                                  |                                                              |                           |                                                                                                                                                                                          |                                            |            | 2003         |            | 2003         
|                                                  |                                                              |                           |                                                                                                                                                                                          |                                            |            |              |            |              
|ASSETS                                            |                                                              |                           |                                                                                                                                                                                          |                                            |            |              |            |              
|Current assets:                                   |                                                              |                           |                                                                                                                                                                                          |                                            |            |              |            |              
|                                                  | Cash and cash equivalents                                    |                           | $                                                                                                                                                                                        | 12,989,511                                 |            |              | $          | 12,198,408    |           
|                                                  | Short-term investments in securities                         |                           |                                                                                                                                                                                          | 4,559,631                                  |            |              |            | 3,888,798     |           
|                                                  | Accounts receivable                                          |                           |                                                                                                                                                                                          | 1,093,508                                  |            |              |            | 271,681       |           
|                                                  | Inventory                                                    |                           |                                                                                                                                                                                          | 12,404                                     |            |              |            | 210,854       |           
|                                                  | Prepaid expenses                                             |                           |                                                                                                                                                                                          | 1,116,984                                  |            |              |            | 1,564,315     |           
|                                                  |                                                              |                           |                                                                                                                                                                                          |                                            |            |              |            |              
|                                                  |                                                              | Total current assets      |                                                                                                                                                                                          |                                            | 19,772,038 |              |            |               | 18,134,056 |           
|Investments in securities                         |                                                              |                           | 103,694                                                                                                                                                                                  |                                            |            |              | 513,486    |              
|Restricted investments in securities              |                                                              |                           | 856,597                                                                                                                                                                                  |                                            |            |              | 856,597    |              
|Property and equipment, net                       |                                                              |                           | 7,434,759                                                                                                                                                                                |                                            |            |              | 7,742,005  |              
|Intangible assets, net                            |                                                              |                           | 2,351,595                                                                                                                                                                                |                                            |            |              | 2,131,209  |              
|Other assets                                      |                                                              |                           | 267,904                                                                                                                                                                                  |                                            |            |              | 267,904    |              
|                                                  |                                                              |                           |                                                                                                                                                                                          |                                            |            |              |            |              
|                                                  |                                                              |                           |                                                                                                                                                                                          | TOTAL ASSETS                               |            | $            | 30,786,587 |               |            | $          | 29,645,257 | 
|                                                  |                                                              |                           |                                                                                                                                                                                          |                                            |            |              |            |               |           
|LIABILITIES AND SHAREHOLDERS EQUITY              |                                                              |                           |                                                                                                                                                                                          |                                            |            |              |            |              
|Current liabilities:                              |                                                              |                           |                                                                                                                                                                                          |                                            |            |              |            |              
|                                                  | Accounts payable                                             |                           | $                                                                                                                                                                                        | 2,695,765                                  |            |              | $          | 2,853,604     |           
|                                                  | Accrued expenses and other liabilities                       |                           |                                                                                                                                                                                          | 2,402,701                                  |            |              |            | 1,806,058     |           
|                                                  | Accrued compensation and payroll taxes                       |                           |                                                                                                                                                                                          | 542,000                                    |            |              |            | 626,154       |           
|                                                  | Notes payable                                                |                           |                                                                                                                                                                                          | 295,916                                    |            |              |            | 244,805       |           
|                                                  | Current portion of deferred revenue                          |                           |                                                                                                                                                                                          | 2,005,016                                  |            |              |            | 1,841,865     |           
|                                                  | Current portion of capital lease obligations                 |                           |                                                                                                                                                                                          | 146,279                                    |            |              |            | 142,354       |           
|                                                  |                                                              |                           |                                                                                                                                                                                          |                                            |            |              |            |              
|                                                  |                                                              | Total current liabilities |                                                                                                                                                                                          |                                            | 8,087,677  |              |            |               | 7,514,840  |           
|Deferred revenue, net of current portion          |                                                              |                           | 20,252,020                                                                                                                                                                               |                                            |            |              | 20,900,776 |              
|Capital lease obligations, net of current portion |                                                              |                           | 154,301                                                                                                                                                                                  |                                            |            |              | 192,410    |              
|                                                  |                                                              |                           |                                                                                                                                                                                          |                                            |            |              |            |              
|                                                  |                                                              | Total liabilities         |                                                                                                                                                                                          |                                            | 28,493,998 |              |            |               | 28,608,026 |           
|                                                  |                                                              |                           |                                                                                                                                                                                          |                                            |            |              |            |              
|Contingencies (Note 13)                           |                                                              |                           |                                                                                                                                                                                          |                                            |            |              |            |              
|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; 71,208,750
and 65,816,434 shares issued and outstanding as of
December 31, 2003 and September 30, 2003,
respectively                             |                                            |            | 104,858,602  |            |               |            | 97,286,433 |           
|                                                  |                                                              |                           | Class B - 712,000 shares authorized; 3,500 and 13,500
shares issued and outstanding as of December 31, 2003
and September 30, 2003, respectively (convertible
into Class A common stock) |                                            |            | 3,395        |            |               |            | 8,395      |           
|                                                  | Accumulated deficit                                          |                           |                                                                                                                                                                                          | (102,531,261                               | )          |              |            | (96,251,049   | )         
|                                                  | Accumulated other comprehensive loss                         |                           |                                                                                                                                                                                          | (38,147                                    | )          |              |            | (6,548        | )         
|                                                  |                                                              |                           |                                                                                                                                                                                          |                                            |            |              |            |              
|                                                  |                                                              |                           | Total shareholders equity                                                                                                                                                               |                                            |            | 2,292,589    |            |               |            | 1,037,231  |           
|                                                  |                                                              |                           |                                                                                                                                                                                          |                                            |            |              |            |              
|                                                  |                                                              |                           |                                                                                                                                                                                          | TOTAL LIABILITIES AND SHAREHOLDERS EQUITY |            | $            | 30,786,587 |               |            | $          | 29,645,257 | 
|                                                  |                                                              |                           |                                                                                                                                                                                          |                                            |            |              |            |               |           

See notes to consolidated financial statements.

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Avanir Pharmaceuticals




CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

|                                                      |                                                                         |                          |            |                    |           |      |            |            |           | 
|----------------------------------------------------- | ----------------------------------------------------------------------- | ------------------------ | ---------- | ------------------ | --------- | ---- | ---------- | ---------- | --------- | 
|                                                      |                                                                         |                          |            | Three Months Ended
|                                                      |                                                                         |                          |            | December 31,      
|                                                      |                                                                         |                          |            |                   
|                                                      |                                                                         |                          |            | 2003               |           | 2002
|                                                      |                                                                         |                          |            |                    |           |     
|REVENUES:                                             |                                                                         |                          |            |                    |           |      |            |           
|                                                      | Product sales                                                           |                          | $          | 769,938            |           |      | $          | 17,400     |          
|                                                      | Royalties and sale of royalty rights                                    |                          |            | 538,496            |           |      |            | 593,295    |          
|                                                      | Government research grants                                              |                          |            | 198,211            |           |      |            | 158,411    |          
|                                                      | Research contracts and licenses                                         |                          |            | 3,000              |           |      |            | 50,000     |          
|                                                      |                                                                         |                          |            |                    |           |      |            |            |          
|                                                      |                                                                         | Total revenues           |            |                    | 1,509,645 |      |            |            | 819,106   | 
|                                                      |                                                                         |                          |            |                    |           |      |            |            |          
|OPERATING EXPENSES:                                   |                                                                         |                          |            |                    |           |      |            |           
|                                                      | Research and development                                                |                          |            | 5,363,683          |           |      |            | 3,611,622  |          
|                                                      | General and administrative                                              |                          |            | 1,407,896          |           |      |            | 1,078,946  |          
|                                                      | Sales and marketing                                                     |                          |            | 858,511            |           |      |            | 425,129    |          
|                                                      | Cost of product sales                                                   |                          |            | 210,090            |           |      |            | 3,102      |          
|                                                      |                                                                         |                          |            |                    |           |      |            |            |          
|                                                      |                                                                         | Total operating expenses |            |                    | 7,840,180 |      |            |            | 5,118,799 | 
|                                                      |                                                                         |                          |            |                    |           |      |            |            |          
|LOSS FROM OPERATIONS                                  |                                                                         |                          | (6,330,535 | )                  |           |      | (4,299,693 | )         
|                                                      | Interest income                                                         |                          |            | 55,542             |           |      |            | 68,022     |          
|                                                      | Other income                                                            |                          |            | 7,647              |           |      |            | 5,846      |          
|                                                      | Interest expense                                                        |                          |            | (10,808            | )         |      |            | (10,574    | )        
|                                                      |                                                                         |                          |            |                    |           |      |            |            |          
|LOSS BEFORE INCOME TAXES                              |                                                                         |                          | (6,278,154 | )                  |           |      | (4,236,399 | )         
|                                                      | Provision for income taxes                                              |                          |            | (2,058             | )         |      |            | (1,600     | )        
|                                                      |                                                                         |                          |            |                    |           |      |            |            |          
|NET LOSS                                              |                                                                         | $                        | (6,280,212 | )                  |           | $    | (4,237,999 | )         
|                                                      |                                                                         |                          |            |                    |           |      |            |            |          
|NET LOSS ATTRIBUTABLE TO COMMON SHAREHOLDERS:         |                                                                         |                          |            |                    |           |      |            |           
|                                                      | Net loss                                                                |                          | $          | (6,280,212         | )         |      | $          | (4,237,999 | )        
|                                                      | Dividends on redeemable convertible preferred stock                     |                          |            |                   |           |      |            | (6,250     | )        
|                                                      | Accretion of discount related to redeemable
convertible preferred stock |                          |            |                   |           |      |            | (4,609     | )        
|                                                      |                                                                         |                          |            |                    |           |      |            |            |          
|NET LOSS ATTRIBUTABLE TO COMMON SHAREHOLDERS          |                                                                         | $                        | (6,280,212 | )                  |           | $    | (4,248,858 | )         
|                                                      |                                                                         |                          |            |                    |           |      |            |            |          
|NET LOSS PER SHARE:                                   |                                                                         |                          |            |                    |           |      |            |           
|                                                      | BASIC AND DILUTED                                                       |                          | $          | (0.09              | )         |      | $          | (0.07      | )        
|                                                      |                                                                         |                          |            |                    |           |      |            |            |          
|WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING: |                                                                         |                          |            |                    |           |      |            |           
|                                                      | BASIC AND DILUTED                                                       |                          |            | 67,804,604         |           |      |            | 58,296,555 |          
|                                                      |                                                                         |                          |            |                    |           |      |            |            |          

See notes to consolidated financial statements.

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Avanir Pharmaceuticals




CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

|                                                   |                                                                                            |                                        |                                                      |            |                    |            |            |            |            |            |  
|-------------------------------------------------- | ------------------------------------------------------------------------------------------ | -------------------------------------- | ---------------------------------------------------- | ---------- | ------------------ | ---------- | ---------- | ---------- | ---------- | ---------- | -
|                                                   |                                                                                            |                                        |                                                      |            | Three Months Ended
|                                                   |                                                                                            |                                        |                                                      |            | December 31,      
|                                                   |                                                                                            |                                        |                                                      |            |                   
|                                                   |                                                                                            |                                        |                                                      |            | 2003               |            | 2002      
|                                                   |                                                                                            |                                        |                                                      |            |                    |            |           
|OPERATING ACTIVITIES:                              |                                                                                            |                                        |                                                      |            |                    |            |            |           
|                                                   | Net loss                                                                                   |                                        | $                                                    | (6,280,212 | )                  |            | $          | (4,237,999 | )         
|                                                   | Adjustments to reconcile net loss to net cash provided by
(used for) operating activities: |                                        |                                                      |            |                    |            |            |            |           
|                                                   | Depreciation and amortization                                                              |                                        |                                                      | 393,495    |                    |            |            | 186,900    |           
|                                                   | Compensation paid with stock options                                                       |                                        |                                                      | 14,543     |                    |            |            | 46,435     |           
|                                                   | Loss on disposal of assets                                                                 |                                        |                                                      |           |                    |            |            | 212        |           
|                                                   | Changes in assets and liabilities:                                                         |                                        |                                                      |            |                    |            |            |            |           
|                                                   |                                                                                            | Accounts receivable                    |                                                      |            | (821,827           | )          |            |            | 866,216    |           
|                                                   |                                                                                            | Inventory                              |                                                      |            | 198,450            |            |            |            | 3,102      |           
|                                                   |                                                                                            | Prepaid expenses and other assets      |                                                      |            | 447,331            |            |            |            | (5,208     | )         
|                                                   |                                                                                            | Accounts payable                       |                                                      |            | (157,839           | )          |            |            | (770,595   | )         
|                                                   |                                                                                            | Accrued expenses and other liabilities |                                                      |            | 596,643            |            |            |            | (18,452    | )         
|                                                   |                                                                                            | Accrued compensation and payroll taxes |                                                      |            | (84,154            | )          |            |            | (53,641    | )         
|                                                   |                                                                                            | Deferred revenue                       |                                                      |            | (485,605           | )          |            |            | 20,068,308 |           
|                                                   |                                                                                            |                                        |                                                      |            |                    |            |            |            |           
|                                                   |                                                                                            |                                        | Net cash provided by (used for) operating activities |            |                    | (6,179,175 | )          |            |            | 16,085,278 |  
|                                                   |                                                                                            |                                        |                                                      |            |                    |            |            |            |           
|INVESTING ACTIVITIES:                              |                                                                                            |                                        |                                                      |            |                    |            |            |           
|                                                   | Investments in securities                                                                  |                                        |                                                      | (992,640   | )                  |            |            | (699,040   | )         
|                                                   | Proceeds from sales and maturities of investments in securities                            |                                        |                                                      | 700,000    |                    |            |            | 1,800,000  |           
|                                                   | Patent costs                                                                               |                                        |                                                      | (238,249   | )                  |            |            | (123,682   | )         
|                                                   | Purchases of property and equipment                                                        |                                        |                                                      | (68,386    | )                  |            |            | (2,003,630 | )         
|                                                   |                                                                                            |                                        |                                                      |            |                    |            |            |            |           
|                                                   |                                                                                            |                                        | Net cash used for investing activities               |            |                    | (599,275   | )          |            |            | (1,026,352 | )
|                                                   |                                                                                            |                                        |                                                      |            |                    |            |            |            |           
|FINANCING ACTIVITIES:                              |                                                                                            |                                        |                                                      |            |                    |            |            |           
|                                                   | Proceeds from issuance of common stock and warrants                                        |                                        |                                                      | 7,552,626  |                    |            |            | 25,500     |           
|                                                   | Dividends paid on preferred stock                                                          |                                        |                                                      |           |                    |            |            | (6,250     | )         
|                                                   | Proceeds from issuance of notes payable                                                    |                                        |                                                      | 159,918    |                    |            |            |           |           
|                                                   | Payments on notes and capital lease obligations                                            |                                        |                                                      | (142,991   | )                  |            |            | (140,362   | )         
|                                                   |                                                                                            |                                        |                                                      |            |                    |            |            |            |           
|                                                   |                                                                                            |                                        | Net cash provided by (used for) financing activities |            |                    | 7,569,553  |            |            |            | (121,112   | )
|                                                   |                                                                                            |                                        |                                                      |            |                    |            |            |            |           
|Net increase in cash and cash equivalents          |                                                                                            |                                        | 791,103                                              |            |                    |            | 14,937,814 |           
|Cash and cash equivalents at beginning of period   |                                                                                            |                                        | 12,198,408                                           |            |                    |            | 8,630,547  |           
|                                                   |                                                                                            |                                        |                                                      |            |                    |            |            |            |           
|Cash and cash equivalents at end of period         |                                                                                            | $                                      | 12,989,511                                           |            |                    | $          | 23,568,361 |           
|                                                   |                                                                                            |                                        |                                                      |            |                    |            |            |            |           
|SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: |                                                                                            |                                        |                                                      |            |                    |            |            |           
|Interest paid                                      |                                                                                            | $                                      | 10,808                                               |            |                    | $          | 10,574     |           
|Income taxes paid                                  |                                                                                            | $                                      | 2,058                                                |            |                    | $          | 1,600      |           

See notes to consolidated financial statements.

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Avanir Pharmaceuticals




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. BASIS OF PRESENTATION

Avanir Pharmaceuticals (Avanir, we or the Company) has prepared the
unaudited consolidated financial statements in this quarterly report in
accordance with the instructions to Form 10-Q adopted under the Securities
Exchange Act of 1934. Certain information and footnote disclosures normally
included in consolidated financial statements prepared in accordance with
accounting principles generally accepted in the United States have been
condensed or omitted pursuant to such rules and regulations. These unaudited
consolidated financial statements should be read with our audited consolidated
financial statements and the accompanying notes included in our Annual Report
on Form 10-K for the fiscal year ended September 30, 2003. In our opinion, all
adjustments (consisting only of normal recurring adjustments) necessary to
present a fair statement of our financial position as of December 31, 2003 and
September 30, 2003, and the results of operations for the three months ended
December 31, 2003 and 2002, have been made. The results of operations for the
three months ended December 31, 2003 are not necessarily indicative of the
results for the fiscal year ending September 30, 2004 or any future periods.

2. STOCK-BASED COMPENSATION

Statement of Financial Accounting Standards No. 123 (SFAS No. 123)
encourages, but does not require, companies to record compensation cost for
stock-based employee compensation at fair value. The Company has chosen to
continue to account for stock-based compensation using the intrinsic value
method prescribed in Accounting Principles Board (APB) Opinion No. 25,
Accounting for Stock Issued to Employees, and related interpretations for all
periods presented. Accordingly, compensation cost for stock options is
measured as the excess, if any, of the fair value of the Companys stock at the
date of the grant over the amount an employee must pay to acquire the stock.

If compensation cost had been determined based upon the fair value at the grant
date for awards under the stock option plans consistent with the methodology
prescribed under SFAS No. 123, the Companys net loss would have been higher by
$291,002 and $485,679 for the three months ended December 31, 2003 and 2002,
respectively, as summarized in the following table.

|                                                                                                                |                                 |                                                        |            |                                 |            |      |            |       |            |  
|--------------------------------------------------------------------------------------------------------------- | ------------------------------- | ------------------------------------------------------ | ---------- | ------------------------------- | ---------- | ---- | ---------- | ----- | ---------- | -
|                                                                                                                |                                 |                                                        |            | Three Months Ended December 31,
|                                                                                                                |                                 |                                                        |            |                                
|                                                                                                                |                                 |                                                        |            | 2003                            |            | 2002
|                                                                                                                |                                 |                                                        |            |                                 |            |     
|Net loss attributable to common
shareholders, as reported                                                       |                                 | $                                                      | (6,280,212 | )                               |            | $    | (4,248,858 | )    
|Add: Stock-based employee
compensation included in reported
net loss attributable to common
shareholders        |                                 |                                                        | 11,842     |                                 |            |      | 30,173     |      
|Deduct: Total stock-based employee
compensation expense determined
under fair value based method for
all awards |                                 |                                                        | (302,844   | )                               |            |      | (515,852   | )    
|                                                                                                                |                                 |                                                        |            |                                 |            |      |            |      
|                                                                                                                |                                 | Pro forma net loss
attributable to common
shareholders |            | $                               | (6,571,214 | )    |            | $     | (4,734,537 | )
|                                                                                                                |                                 |                                                        |            |                                 |            |      |            |      
|Net loss per share:                                                                                             |                                 |                                                        |            |                                 |            |      |            |      
|                                                                                                                | Basic and diluted  as reported |                                                        | $          | (0.09                           | )          |      | $          | (0.07 | )         
|                                                                                                                | Basic and diluted  pro forma   |                                                        | $          | (0.10                           | )          |      | $          | (0.08 | )         

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

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value
of the consideration received or the fair value of the equity instruments
issued, whichever is more reliably measurable. For the purpose of determining
compensation expense for stock options granted to non-employees, all of the
Companys directors are considered to be employees.

3. RECLASSIFICATIONS

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

4. BALANCE SHEET DETAILS

The following tables provide details of selected balance sheet items.

Property and equipment.Property and equipment consist of the following:

|                                          |                              |   |                   |            |                    |   |            |            |       |   |              |           |             |   |           |            |  |   |            |            |   |   |           |           | 
|----------------------------------------- | ---------------------------- | - | ----------------- | ---------- | ------------------ | - | ---------- | ---------- | ----- | - | ------------ | --------- | ----------- | - | --------- | ---------- |  | - | ---------- | ---------- | - | - | --------- | --------- | 
|                                          |                              |   | December 31, 2003 |            | September 30, 2003
|                                          |                              |   |                   |            |                   
|                                          |                              |   | Gross             |            |                    |   |            |            |       |   |              |           | Gross       |   |           |            |  |   |            |            |  
|                                          |                              |   | Carrying          |            | Accumulated        |   |            |            |       |   | Carrying     |           | Accumulated |   |           |            | 
|                                          |                              |   | Value             |            | Depreciation       |   | Net        |            | Value |   | Depreciation |           | Net        
|                                          |                              |   |                   |            |                    |   |            |            |       |   |              |           |            
|Research and
development
equipment        |                              | $ | 3,590,040         |            |                    | $ | (1,491,428 | )          |       | $ | 2,098,612    |           |             | $ | 3,544,343 |            |  | $ | (1,331,544 | )          |   | $ | 2,212,799 |          
|Computer equipment
and related
software   |                              |   | 1,001,911         |            |                    |   | (425,233   | )          |       |   | 576,678      |           |             |   | 1,000,206 |            |  |   | (383,512   | )          |   |   | 616,694   |          
|Leasehold
improvements                    |                              |   | 5,018,345         |            |                    |   | (595,447   | )          |       |   | 4,422,898    |           |             |   | 5,000,147 |            |  |   | (445,435   | )          |   |   | 4,554,712 |          
|Office equipment,
furniture, and
fixtures |                              |   | 552,650           |            |                    |   | (216,079   | )          |       |   | 336,571      |           |             |   | 549,864   |            |  |   | (192,064   | )          |   |   | 357,800   |          
|                                          |                              |   |                   |            |                    |   |            |            |       |   |              |           |             |   |           |            |  |   |            |            |   |   |           |          
|                                          | Total property
and equipment |   | $                 | 10,162,946 |                    |   | $          | (2,728,187 | )     |   | $            | 7,434,759 |             |   | $         | 10,094,560 |  |   | $          | (2,352,555 | ) |   | $         | 7,742,005 | 
|                                          |                              |   |                   |            |                    |   |            |            |       |   |              |           |             |   |           |            |  |   |            |            |   |   |           |          

Intangible assets.Intangible assets with indefinite useful lives consist of
costs of trademarks for Avanir and Xenerex and similar names intended for use
or potential use in the United States and the rest of the world. The Company
reviews intangible assets with indefinite useful lives at least annually for
impairment, following the guidelines established in Statement of Financial
Standards No. 142, Goodwill and Other Intangible Assets, (SFAS No. 142).
There were no impairments to trademarks during the three months ended December
31, 2003 and 2002. Intangible assets with finite lives are amortized over
their useful lives and are evaluated for impairment whenever events or changes
in circumstances indicate that their carrying value may not be recoverable
under SFAS No. 144, Accounting for Impairment or Disposal of Long-lived
Assets. Avanirs amortizable intangible assets consist of the costs of
patents, patent applications, and licenses.

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Intangible assets, consisting of both intangible assets with finite and
indefinite useful lives, are as follows.

|                                               |                             |   |                   |           |                    |   |          |          |       |   |              |           |             |   |           |           |  |   |          |          |   |   |           |           | 
|---------------------------------------------- | --------------------------- | - | ----------------- | --------- | ------------------ | - | -------- | -------- | ----- | - | ------------ | --------- | ----------- | - | --------- | --------- |  | - | -------- | -------- | - | - | --------- | --------- | 
|                                               |                             |   | December 31, 2003 |           | September 30, 2003
|                                               |                             |   |                   |           |                   
|                                               |                             |   | Gross             |           |                    |   |          |          |       |   |              |           | Gross       |   |           |           |  |   |          |          |  
|                                               |                             |   | Carrying          |           | Accumulated        |   |          |          |       |   | Carrying     |           | Accumulated |   |           |           | 
|                                               |                             |   | Value             |           | Amortization       |   | Net      |          | Value |   | Amortization |           | Net        
|                                               |                             |   |                   |           |                    |   |          |          |       |   |              |           |            
|Intangible assets with
finite lives:           |                             |   |                   |           |                    |   |          |          |       |   |              |           |             |   |           |           |  |   |          |          |   |   |           |          
|                                               | Patent applications
pending |   | $                 | 1,695,107 |                    |   | $        |         |       |   | $            | 1,695,107 |             |   | $         | 1,464,859 |  |   | $        |         |   |   | $         | 1,464,859 | 
|                                               | Patents                     |   |                   | 863,057   |                    |   |          | (271,954 | )     |   |              | 591,103   |             |   |           | 855,799   |  |   |          | (254,657 | ) |   |           | 601,142   | 
|                                               | Licenses                    |   |                   | 42,461    |                    |   |          | (13,949  | )     |   |              | 28,512    |             |   |           | 42,461    |  |   |          | (13,383  | ) |   |           | 29,078    | 
|                                               |                             |   |                   |           |                    |   |          |          |       |   |              |           |             |   |           |           |  |   |          |          |   |   |           |           | 
|Total intangible
assets with finite
lives      |                             |   | 2,600,625         |           |                    |   | (285,903 | )        |       |   | 2,314,722    |           |             |   | 2,363,119 |           |  |   | (268,040 | )        |   |   | 2,095,079 |          
|Intangible assets with
indefinite useful
lives |                             |   | 36,873            |           |                    |   |         |          |       |   | 36,873       |           |             |   | 36,130    |           |  |   |         |          |   |   | 36,130    |          
|                                               |                             |   |                   |           |                    |   |          |          |       |   |              |           |             |   |           |           |  |   |          |          |   |   |           |           | 
|Total intangible assets                        |                             | $ | 2,637,498         |           |                    | $ | (285,903 | )        |       | $ | 2,351,595    |           |             | $ | 2,399,249 |           |  | $ | (268,040 | )        |   | $ | 2,131,209 |          
|                                               |                             |   |                   |           |                    |   |          |          |       |   |              |           |             |   |           |           |  |   |          |          |   |   |           |           | 

Amortization expense related to amortizable intangible assets was approximately
$18,000 and $16,000 for the three months ended December 31, 2003 and 2002,
respectively. Based solely on the amortizable intangible assets as of December
31, 2003, the estimated annual amortization expense of intangible assets for
the fiscal years ending September 30 is shown in the following table. Actual
amortization expense to be reported in future periods could differ from these
estimates as a result of acquisitions, divestitures, and other relevant
factors.

|                                 |          |   |           |           | 
|-------------------------------- | -------- | - | --------- | --------- | 
|Amortization Expense             |          |   |           |          
|Fiscal year ending September 30, |          |   |           |          
|2004                             |          | $ | 52,456    |          
|2005                             |          |   | 69,710    |          
|2006                             |          |   | 69,103    |          
|2007                             |          |   | 67,269    |          
|2008                             |          |   | 66,608    |          
|Thereafter                       |          |   | 294,469   |          
|                                 |          |   |           |          
|                                 | Subtotal |   |           | 619,615   | 
|Patent applications pending      |          |   | 1,695,107 |          
|                                 |          |   |           |          
|                                 | Total    |   | $         | 2,314,722 | 
|                                 |          |   |           |          

5. USE OF ESTIMATES

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities as of the date
of the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.

6. INVENTORY

Inventory is stated at the lower of cost (first-in, first-out) or market.
Inventory consists primarily of the raw material docosanol, which is the active
ingredient in docosanol 10% cream. Docosanol in its present form as stored by
the Company has a substantial shelf life, a relatively stable value and
long-term use, and carries a low risk of becoming excess inventory or obsolete.
Avanir does not own or store any docosanol 10% cream in its finished product
form. The Company and one of its licensees receive raw materials from
a single supplier. Avanir also supplies several other licensees with raw
materials from

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the same supplier. The inability of a sole supplier to fulfill
supply requirements of the Company or its licensees could materially impact
future operating results.

7. DEFERRED REVENUE

On December 24, 2002, Avanir sold an undivided interest in its Abreva®
license agreement with SB Pharmco Puerto Rico, Inc. (SB or GlaxoSmithKline)
to Drug Royalty USA, Inc. (Drug Royalty USA) for $24.1 million. We recorded
the net proceeds of the transaction as deferred revenue, to be recognized as
revenue over the life of the license agreement, because of our ongoing
involvement in earning future revenues under our license agreement with SB.
The following table sets forth the deferred revenue balances for the Drug
Royalty USA agreement and other agreements as of December 31, 2003 and
September 30, 2003. The portion of deferred revenue classified as a current
liability represents the amount Avanir expects to realize as revenue within the
next 12 months.

|                                          |                                          |                        |            |               |            |            |         |         |         |   |            |            |            | 
|----------------------------------------- | ---------------------------------------- | ---------------------- | ---------- | ------------- | ---------- | ---------- | ------- | ------- | ------- | - | ---------- | ---------- | ---------- | 
|                                          |                                          |                        |            | Drug Royalty  |            | Other      |         |         |         |  
|                                          |                                          |                        |            | USA Agreement |            | Agreements |         | Total  
|                                          |                                          |                        |            |               |            |            |         |        
|Deferred revenue as of September 30, 2003 |                                          | $                      | 22,509,308 |               |            | $          | 233,333 |         |         | $ | 22,742,641 |           
|Changes during period:                    |                                          |                        |            |               |            |            |         |         |         |   |            |           
|                                          | Additions to deferred revenue            |                        |            |              |            |            |         | 50,000  |         |   |            | 50,000     |           
|                                          | Recognized as revenue during period      |                        |            | (535,605      | )          |            |         |        |         |   |            | (535,605   | )         
|                                          |                                          |                        |            |               |            |            |         |         |         |   |            |           
|Deferred revenue as of December 31, 2003  |                                          | $                      | 21,973,703 |               |            | $          | 283,333 |         |         | $ | 22,257,036 |           
|                                          |                                          |                        |            |               |            |            |         |         |         |   |            |           
|Classified as:                            |                                          |                        |            |               |            |            |         |         |         |   |            |           
|                                          | Current portion of deferred revenue      |                        | $          | 1,721,683     |            |            | $       | 283,333 |         |   | $          | 2,005,016  |           
|                                          | Deferred revenue, net of current portion |                        |            | 20,252,020    |            |            |         |        |         |   |            | 20,252,020 |           
|                                          |                                          |                        |            |               |            |            |         |         |         |   |            |           
|                                          |                                          | Total deferred revenue |            | $             | 21,973,703 |            |         | $       | 283,333 |   |            | $          | 22,257,036 | 
|                                          |                                          |                        |            |               |            |            |         |         |         |   |            |           

8. REVENUE RECOGNITION

Performance-based license fees.We recognize revenues from license fees when
the performance requirements have been met, the fee is fixed or determinable,
and collection of fees is probable. We defer revenues and recognize them
ratably over the life of the agreement when we have continuing obligations to
perform under the agreement.

Royalty revenues.We recognize royalty revenues from license agreements when
earned. Net sales figures used for calculating royalties due the Company can
often include deductions for costs of unsaleable returns, managed care
charge-backs, cash discounts, freight and warehousing, and miscellaneous
write-offs, which may vary over the course of the license agreement.

Revenues from sale of royalty rights.In agreements where we have sold our
rights to future royalties under license agreements and we maintain continuing
involvement in earning such royalties, we defer revenues and recognize them
over the life of the license agreement. For example, in the sale of an
undivided interest of our Abreva license agreement to Drug Royalty USA, revenue
recognition is being determined under the units-of-revenue method. Under this
method, the amount of deferred revenue to be recognized as revenue in each
period is calculated by multiplying (i) the ratio of the royalty payments due
to Drug Royalty USA for the period to the total remaining royalties that we
expect SB will pay Drug Royalty USA over the term of the agreement, by (ii) the
unamortized deferred revenue amount.

Revenue arrangements with multiple deliverables.In certain circumstances, we
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

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antibody generation
services, the allocation is based on objective, customer-specific evidence of
fair value. We recognize revenue related to the delivered products or services
only if: (i) the above performance or service criteria are met; (ii) any
undelivered products or services are not essential to the functionality of the
delivered products or services; (iii) payment for the delivered products or
services is not contingent upon delivery of the remaining products or services;
(iv) we have an enforceable claim to receive the amount due in the event we do
not deliver the undelivered products or services; and (v) as discussed above,
there is evidence of the fair value for each of the undelivered products or
services.

Government research grant revenues.We recognize revenues from government
research grants during the period in which the related expenditures are
incurred.

9. INVESTMENTS

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

|                         |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |           |           |  |  | 
|------------------------ | ------------------------------- | -------------------------------- | --------------------- | --------- | --------- | --------- | --------- | ---------- | ------ | ---------- | - | ------- | ------- | - | - | --------- | --------- |  |  | 
|                         |                                 |                                  |                       |           |           |           |           |            |        | Gross      |   | Gross   |         |   |   |          
|                         |                                 |                                  |                       |           |           | Amortized |           | Unrealized |        | Unrealized |   | Fair   
|                         |                                 |                                  |                       |           |           | Cost      |           | Gains (1)  |        | Losses (1) |   | Value  
|                         |                                 |                                  |                       |           |           |           |           |            |        |            |   |        
|As of December 31, 2003: |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          
|                         | Certificates of deposit         |                                  | $                     | 1,356,597 |           |           | $         | 11,799     |        |            | $ |        |         |   | $ | 1,368,396 |          
|                         | Adjustable rate mutual fund (2) |                                  |                       | 3,014,365 |           |           |           |           |        |            |   | (37,446 | )       |   |   | 2,976,919 |          
|                         | Government debt securities      |                                  |                       | 1,187,107 |           |           |           |           |        |            |   | (12,500 | )       |   |   | 1,174,607 |          
|                         |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |           |          
|                         |                                 | Total                            |                       | $         | 5,558,069 |           |           | $          | 11,799 |            |   | $       | (49,946 | ) |   | $         | 5,519,922 | 
|                         |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |           |          
|Reported as:             |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          
|                         | Short-term investments:         |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |           |          
|                         |                                 | Classified as available-for-sale |                       | $         | 4,559,631 |           |           |            |        |            |   |         |         |   |   |           |           | 
|                         |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          
|                         | Long-term investments:          |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |           |          
|                         |                                 | Classified as available-for-sale |                       |           | 103,694   |           |           |            |        |            |   |         |         |   |   |           |           | 
|                         |                                 | Restricted investments (3)       |                       |           | 856,597   |           |           |            |        |            |   |         |         |   |   |           |           | 
|                         |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          
|                         |                                 |                                  | Long-term investments |           |           | 960,291   |           |            |        |            |   |         |         |   |   |           |           |  | 
|                         |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          
|                         |                                 |                                  |                       | Total     |           | $         | 5,519,922 |            |        |            |   |         |         |   |   |           |           |  |  | 
|                         |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          

|                          |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |           |           |  |  | 
|------------------------- | ------------------------------- | -------------------------------- | --------------------- | --------- | --------- | --------- | --------- | ---------- | ------ | ---------- | - | ------- | ------- | - | - | --------- | --------- |  |  | 
|                          |                                 |                                  |                       |           |           |           |           |            |        | Gross      |   | Gross   |         |   |   |          
|                          |                                 |                                  |                       |           |           | Amortized |           | Unrealized |        | Unrealized |   | Fair   
|                          |                                 |                                  |                       |           |           | Cost      |           | Gains (4)  |        | Losses (4) |   | Value  
|                          |                                 |                                  |                       |           |           |           |           |            |        |            |   |        
|As of September 30, 2003: |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          
|                          | Certificates of deposit         |                                  | $                     | 2,056,597 |           |           | $         | 15,575     |        |            | $ |        |         |   | $ | 2,072,172 |          
|                          | Adjustable rate mutual fund (2) |                                  |                       | 3,014,365 |           |           |           |           |        |            |   | (18,723 | )       |   |   | 2,995,642 |          
|                          | Government debt securities      |                                  |                       | 194,467   |           |           |           |           |        |            |   | (3,400  | )       |   |   | 191,067   |          
|                          |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |           |          
|                          |                                 | Total                            |                       | $         | 5,265,429 |           |           | $          | 15,575 |            |   | $       | (22,123 | ) |   | $         | 5,258,881 | 
|                          |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |           |          
|Reported as:              |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          
|                          | Short-term investments:         |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |           |          
|                          |                                 | Classified as available-for-sale |                       | $         | 3,888,798 |           |           |            |        |            |   |         |         |   |   |           |           | 
|                          |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          
|                          | Long-term investments:          |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |           |          
|                          |                                 | Classified as available-for-sale |                       |           | 513,486   |           |           |            |        |            |   |         |         |   |   |           |           | 
|                          |                                 | Restricted investments (3)       |                       |           | 856,597   |           |           |            |        |            |   |         |         |   |   |           |           | 
|                          |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          
|                          |                                 |                                  | Long-term investments |           |           | 1,370,083 |           |            |        |            |   |         |         |   |   |           |           |  | 
|                          |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          
|                          |                                 |                                  |                       | Total     |           | $         | 5,258,881 |            |        |            |   |         |         |   |   |           |           |  |  | 
|                          |                                 |                                  |                       |           |           |           |           |            |        |            |   |         |         |   |   |          



|(1) |  | Gross unrealized gains of $11,799 and gross unrealized losses of
$49,946 on government securities, the adjustable rate mutual fund, and
certificates of deposit represent an accumulated net unrealized loss of
$38,147, which is reported as accumulated other comprehensive loss on
the consolidated balance sheet as of December 31, 2003.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) |  | Represents an investment in a mutual fund that invests primarily in
adjustable rate mortgage-backed securities.                                                                                                                                                                                                                                

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|(3) |  | Restricted investments amounting to $856,597 as of both December
31, 2003 and September 30, 2003 represent amounts pledged to our bank
as collateral for letters of credit issued in connection with our
leases of office and laboratory space.                                                                                                
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(4) |  | Gross unrealized gains of $15,575 and gross unrealized losses of
$22,123 on government securities, the adjustable rate mutual fund, and
certificates of deposit represent an accumulated net unrealized loss of
$6,548, which is reported as accumulated other comprehensive loss on
the consolidated balance sheet as of September 30, 2003.

10. COMPUTATION OF NET LOSS PER COMMON SHARE

We compute basic net loss per common share by dividing the net loss
attributable to common shareholders by the weighted-average number of common
shares outstanding during the period (Basic EPS Method). We compute diluted
net loss per common share by dividing the net loss attributable to common
shareholders by the weighted-average number of common and dilutive common
equivalent shares outstanding during the period (Diluted EPS Method).
Dilutive common equivalent shares consist of shares issuable upon exercise of
stock options and warrants and conversion of preferred stock. In the
accompanying consolidated statements of operations, we have presented our net
loss per share for the three-month periods ended December 31, 2003 and 2002
using the Basic EPS Method and the Diluted EPS Method. The shares of common
stock issuable upon exercise of stock options and warrants and conversion of
preferred stock under the Diluted EPS Method were excluded from the three-month
periods ended December 31, 2003 and 2002, as the inclusion of such shares would
have been anti-dilutive.

The following table provides a reconciliation from the basic to the diluted EPS
computations for the three months ended December 31, 2003 and 2002:

|                                                                                      |                                                                         |                                                                                         |            |                                 |            |      |            |            |            |  
|------------------------------------------------------------------------------------- | ----------------------------------------------------------------------- | --------------------------------------------------------------------------------------- | ---------- | ------------------------------- | ---------- | ---- | ---------- | ---------- | ---------- | -
|                                                                                      |                                                                         |                                                                                         |            | Three Months Ended December 31,
|                                                                                      |                                                                         |                                                                                         |            |                                
|                                                                                      |                                                                         |                                                                                         |            | 2003                            |            | 2002
|                                                                                      |                                                                         |                                                                                         |            |                                 |            |     
|Numerator:                                                                            |                                                                         |                                                                                         |            |                                 |            |      |            |           
|                                                                                      | Net loss                                                                |                                                                                         | $          | (6,280,212                      | )          |      | $          | (4,237,999 | )         
|Less:                                                                                 |                                                                         |                                                                                         |            |                                 |            |      |            |           
|                                                                                      | Dividends on redeemable convertible preferred stock                     |                                                                                         |            |                                |            |      |            | (6,250     | )         
|                                                                                      | Accretion of discount related to redeemable convertible preferred stock |                                                                                         |            |                                |            |      |            | (4,609     | )         
|                                                                                      |                                                                         |                                                                                         |            |                                 |            |      |            |            |           
|                                                                                      |                                                                         | Net loss attributable to common shareholders for basic earnings per
share computation   |            |                                 | (6,280,212 | )    |            |            | (4,248,858 | )
|Effect of dilutive securities:                                                        |                                                                         |                                                                                         |            |                                 |            |      |            |           
|                                                                                      | Stock options, warrants and convertible preferred stock (1)(2)          |                                                                                         |            |                                |            |      |            |           |           
|                                                                                      |                                                                         |                                                                                         |            |                                 |            |      |            |            |           
|                                                                                      |                                                                         | Net loss attributable to common shareholders for diluted earnings
per share computation |            | $                               | (6,280,212 | )    |            | $          | (4,248,858 | )
|                                                                                      |                                                                         |                                                                                         |            |                                 |            |      |            |            |           
|Denominator:                                                                          |                                                                         |                                                                                         |            |                                 |            |      |            |           
|Shares for basic and diluted net loss per share  weighted average shares
outstanding |                                                                         |                                                                                         | 67,804,604 |                                 |            |      | 58,296,555 |           
|                                                                                      |                                                                         |                                                                                         |            |                                 |            |      |            |            |           
|Basic and diluted net loss per share                                                  |                                                                         | $                                                                                       | (0.09      | )                               |            | $    | (0.07      | )         
|                                                                                      |                                                                         |                                                                                         |            |                                 |            |      |            |            |           



|(1) |  | For the three months ended December 31, 2003 and 2002, options to
purchase 5,285,588 and 5,758,176 shares of common stock, respectively,
were excluded from the computation of diluted net loss per share, as
the inclusion of such shares would be antidilutive. 
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) |  | For the three months ended December 31, 2003 and 2002, warrants to
purchase 5,680,759 and 1,084,550 shares of common stock, respectively,
were excluded from the computation of diluted net loss per share, as
the inclusion of such shares would be antidilutive.

11. SHAREHOLDERS EQUITY

Preferred stock. Preferred stock consists of Series C Junior Participating
Preferred Stock, of which none is outstanding.

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Class A common stock.On December 5, 2003, we sold and issued 5,382,316 shares
of Class A common stock and five-year warrants to purchase an additional 3,229,389 shares
of Class A common stock to several accredited investors and received $8,019,652
in gross proceeds. The exercise price of the warrants is $1.75 per share. The
financing transaction was made pursuant to the terms of a securities purchase
agreement that provided each investor with a five-year warrant to purchase six-tenths of
a share of Class A common stock for every share of Class A common stock
purchased under the agreement. The effect of the financing transaction was an
increase in cash and shareholders equity in the amount of $7,552,626, after
taking into effect the costs of the transaction. The placement agent was paid
$415,000 in fees and expenses, and was issued a five-year warrant to purchase 161,470
shares of the Companys Class A common stock at $1.75 per share, in connection
with this transaction.

Class B common stock conversions.As of December 31, 2003 and September 30,
2003 there were 3,500 and 13,500 shares of Class B common stock outstanding,
respectively. During the three-month period ended December 31, 2003, 10,000
shares of Class B common stock were converted to 10,000 shares of Class A
common stock. On January 16, 2004 the remaining 3,500 shares of Class B common
stock were converted to 3,500 shares of Class A common stock.

12.     RECENT ACCOUNTING PRONOUNCEMENTS

In January 2003, the Financial Accounting Standards Board (FASB) issued FASB
Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities,
an Interpretation of ARB No. 51. FIN 46 requires the consolidation of certain
variable interest entities by the primary beneficiary of the entity if the
equity investment at risk is not sufficient to permit the entity to finance its
activities without additional subordinated financial support from other parties
or if the equity investors lack the characteristics of a controlling financial
interest. FIN 46 is effective immediately for variable interest entities
created or acquired after January 31, 2003. For variable interest entities
created or acquired prior to February 1, 2003, the provisions of FIN 46, as
amended, were applicable to entities deemed special purpose entities effective
on December 31, 2003 and will be applicable to entities not deemed special
purpose entities effective on March 31, 2004. The application of the
provisions of FIN 46 that became effective on December 31, 2003 did not have a
material impact on the Companys financial statements. The effect, if any, on
the Companys financial statements of the remaining provisions of FIN 46 has
not yet been determined.

13.     CONTINGENCIES

In the ordinary course of business, we may face various claims brought by third
parties, including claims relating to the safety or efficacy of our products.
Any of these claims could subject us to costly litigation and, while we
generally believe that we have adequate insurance to cover many different types
of liabilities, our insurance carriers may deny coverage or our policy limits
may be inadequate to fully satisfy any damage awards or settlements. If this
were to happen, the payment of any such awards could have a material adverse
effect on our operations and financial position. Additionally, any such claims,
whether or not successful, could damage our reputation and business. Management
believes the outcome of currently identified claims and lawsuits will not have
a material adverse effect on the Companys operations or financial position.




Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

This quarterly report on Form 10-Q contains forward-looking statements
concerning future events and performance of our company. You should not rely
excessively on these forward-looking statements, because they are only
predictions based on our current expectations and assumptions. When used in
this report, the words intend, estimate, anticipate, believe, plan or
expect and similar expressions as they related to Avanir are included to
identify forward-looking statements. Many factors

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could cause our actual
results to differ materially from those indicated in these forward-looking
statements. You should review carefully the factors identified in this report
under the caption, Risk Factors that Might Affect Future Results, and in our
most recent annual report on Form 10-K filed with the Securities and
Exchange Commission (SEC). We disclaim any obligation to update or announce
revisions to any forward-looking statements to reflect actual events or
developments.

EXECUTIVE OVERVIEW

We are a drug discovery and development company focused primarily on novel
treatments for chronic diseases. We have one product that has been approved by
the U.S. Food and Drug Administration (FDA) for the treatment of cold sores,
docosanol 10% cream (sold as Abreva® by our marketing partner, GlaxoSmithKline
Consumer Healthcare, in North America), and have several product candidates in
clinical development. Our most advanced product candidate, Neurodex, is in
Phase III clinical development for the treatment of pseudobulbar affect
(PBA), also known as emotional lability or pathological laughing or crying.
Neurodex is also in Phase II clinical development for the treatment of
neuropathic pain. A potential product for allergy and asthma, AVP-13358, is in
Phase I clinical development. We also have preclinical research programs
targeting inflammatory diseases, atherosclerosis, and cancer. The following
graph illustrates the development status of our product candidates.

(BAR CHART)

The continued development of these product candidates and the potential launch
of a new drug is capital intensive and we expect that our development and
operational costs will continue to exceed revenues from existing sources for at
least the next two years. Accordingly, we will need to raise significant
amounts of additional funds during this two-year period to finance our research
and development activities and operations. We may do so through licensing or
other collaboration arrangements, issuing equity or debt securities, or through
the sale of one or more of our platform technologies or new drug candidates.
If we are unable to license one or more of our new drug candidates, or raise
funds through other alternatives in a timely manner, we may have to slow the
rate of development of some of our early-stage programs or sell the rights to
one or more of our new drug candidates. We funded operations during fiscal
2003 and the first quarter of fiscal 2004 primarily through the sale of common
stock and warrants and the sale of an undivided interest in our Abreva® license
agreement with a GlaxoSmithKline subsidiary, SB Pharmco Puerto Rico, Inc.
(GlaxoSmithKline), which is described in the following paragraph.

Our most significant product license to date is with GlaxoSmithKline for the
right to sell Abreva in North America for the treatment of cold sores. In
December 2002, we sold an undivided

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interest in our license with GlaxoSmithKline to Drug Royalty USA for $24.1
million, under which we retained one-half of all royalties from GlaxoSmithKline
on annual Abreva sales in excess of $62 million. Although we have received the
$24.1 million in sale proceeds under this contract, the revenues have been
deferred in accordance with accounting principles generally accepted in the
United States and we are recognizing a portion of the revenue each quarter
through April 2014.

We are seeking additional licensees for docosanol 10% cream in Europe and Japan
and, in November 2003, the Swedish Medical Products Agency approved docosanol
10% cream for marketing as a non-prescription, over-the-counter (OTC) topical
treatment for cold sores. Sweden is acting as the Reference Member State for
obtaining further regulatory approvals of docosanol 10% cream in the European
Union. We expect that the Swedish approval will serve to facilitate regulatory
approval in additional countries in the European Union through what is known as
the mutual recognition process. We also believe that European regulatory
approvals will make the drug more attractive for licensing.

Our current Phase III clinical trial for Neurodex in the treatment of PBA has
achieved over 90% of planned patient enrollments as of February 6, 2004. We
expect to complete the remainder of enrollments by the end of March 2004. If
the results of the trial are favorable, we expect to submit a new drug
application (NDA) to the FDA for the drug in the second half of this calendar
year. We may license Neurodex for distribution in the United States and other
countries, or elect to market the drug directly with a co-promotion partner, if
the FDA approves the product. If we choose to market the drug directly, we
will need to raise additional capital to fund the creation of a sales force and
working capital related to manufacturing, promotion and sales of the product.
If we are able to obtain approval from the FDA in the second half of 2005 to
market Neurodex, and launch Neurodex shortly thereafter, we expect that
revenues from sales of the product will begin to contribute operating cash
flows in fiscal 2006.

Regarding our other clinical and preclinical development programs, we intend to
develop those programs to Phase II proof of concept and then license those
programs to major pharmaceutical companies. We are pursuing this strategy for
these programs because we do not have sufficient human or capital resources to
carry out all phases of clinical development.

RESULTS OF OPERATIONS 
THREE MONTHS ENDED DECEMBER 31, 2003

Revenues

Revenues in the first quarter of
fiscal 2004 amounted to $1.5 million, including $770,000 from sales of the active ingredient docosanol to
licensees, $536,000 from the recognition of deferred revenues relating to the
sale of an undivided interest in our Abreva® license agreement to Drug
Royalty USA (see Note 7, Deferred Revenue, in the
accompanying consolidated financial
statements), and $198,000 from government research grants. Revenues in the
first quarter of fiscal 2003 amounted to $819,000, including $589,000 from the recognition of
deferred revenues relating to the sale of an undivided interest in our Abreva
license agreement to Drug Royalty USA and $158,000 from government research
grants.

During fiscal 2004, we expect to recognize approximately $2.0 million in
revenues from the recognition of deferred revenues relating to the sale of an
undivided interest in our Abreva license agreement to Drug Royalty USA and
other contracts, approximately $800,000 in sales of the active
ingredient docosanol to licensees, and approximately $800,000 in revenues from government research grants.
Projected revenues from other sources, such as license fees, milestone
payments, and royalties on foreign sales of licensed products, will depend
substantially on the timing of approval decisions for docosanol 10% cream by
foreign regulatory agencies and our ability to enter into additional license
arrangements and achieve milestones under those arrangements. Such
arrangements could be in the form of licensing or partnering arrangements for
docosanol 10% cream or for our other product development programs for the
treatment of PBA, neuropathic pain, allergy and asthma, and cholesterol. Such
product programs could take years of additional development before they reach
the stage of licensing, if ever, by other pharmaceutical companies.

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Revenue-generating Contracts

In December 2003, we entered into a license agreement with Peregrine
Pharmacuticals, Inc. that licenses an antibody that we developed for a cancer
target provided by Peregrine. Other commercial contracts that remained active
during the first quarter of fiscal 2004 include five docosanol 10% cream (e.g.
Abreva) license agreements, one Neurodex sublicense, and two antibody research
service agreements. For the last three years, the GlaxoSmithKline license
arrangement has been our most significant revenue source, representing
approximately 95% of the Companys revenues during the last three fiscal years.

Expenses

Operating expenses. Total operating expenses were $7.8 million in the first
quarter of fiscal 2004, compared to $5.1 million in the same period in fiscal
2003. The 53% increase in operating expenses was primarily caused by a 49%
increase in spending on research and development programs and over a 100%
increase in spending on sales and marketing programs. Research and development
programs accounted for 68% and 71% of total operating expenses for the fiscal
quarters ended December 31, 2003 and 2002, respectively. Sales and marketing
expenses accounted for 11% and 8% of total operating expenses for the fiscal
quarters ended December 31, 2003 and 2002, respectively. These and other costs
are more fully described below.

|                    |                            |                          |  |                    |     |      |  |    |     |  
|------------------- | -------------------------- | ------------------------ |  | ------------------ | --- | ---- |  | -- | --- | -
|                    |                            |                          |  | Three Months Ended
|                    |                            |                          |  | December 31,      
|                    |                            |                          |  |                   
|                    |                            |                          |  | 2003               |     | 2002
|                    |                            |                          |  |                    |     |     
|Operating expenses: |                            |                          |  |                    |     |      |  |   
|                    | Research and development   |                          |  | 68                 | %   |      |  | 71 | %  
|                    | General and administrative |                          |  | 18                 | %   |      |  | 21 | %  
|                    | Sales and marketing        |                          |  | 11                 | %   |      |  | 8  | %  
|                    | Cost of product sales      |                          |  | 3                  | %   |      |  |   |    
|                    |                            |                          |  |                    |     |      |  |    |    
|                    |                            | Total operating expenses |  |                    | 100 | %    |  |    | 100 | %
|                    |                            |                          |  |                    |     |      |  |    |    

Research and development (R&D) expenses. R&D expenses were $5.4 million in
the first fiscal quarter of 2004, compared to $3.6 million in the same period a
year ago. The Phase III clinical trial for Neurodex in the treatment of PBA in
patients with MS accounted for 33% of all R&D spending in the
first quarter of fiscal 2004. Costs associated with completion of toxicology and other
preclinical research related to Avanirs lead compound for the treatment of
allergies and asthma accounted for 20% of total R&D spending in the first
quarter of fiscal 2004. The balance of R&D spending was for other programs,
including preclinical research related to inflammation and cholesterol-lowering
compounds and antibody research programs. We expect R&D spending will continue
at the current rate through the next several quarters as we continue the Phase
III clinical trial and open label study of Neurodex, the Phase I clinical
trials of AVP-13358, and preclinical research related to cholesterol reduction
and inflammation.

In the first quarter fiscal 2003, approximately one-third of R&D expenses were
related to completion of toxicology and other preclinical research related to
treatments for allergies and asthma. The Phase III clinical trial for Neurodex
in the treatment of PBA in patients with MS accounted for 16% of all R&D
spending. The balance of R&D spending was divided primarily among research
related to inflammation, cholesterol-lowering compounds, and antibody research
programs.

Pharmaceutical R&D programs, by their very nature, require a substantial amount
of financial and human resources and there is no assurance that any drug
candidate will be approved for marketing by domestic and/or foreign regulatory
agencies. The later stages of clinical development typically require
substantially greater funds for development than the earlier stages. Thus, for
many of our larger development programs, we intend to license our technology or
partner with other pharmaceutical companies that have substantially greater
financial resources. We expect that our licensees will continue

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to develop and
fund those projects and pay us up-front license fees, milestone payments, and
royalties on product sales if those products are successfully developed and
approved for marketing by the FDA and
foreign regulatory agencies. We caution that many of our development efforts
could experience delays, setbacks and failures, with no assurance that any of
our clinical research or our potential licensees or partners will ever reach
the stage of submitting an NDA to the FDA or that any NDA will be approved.
The following table sets forth the status of, and costs attributable to, our
proprietary research and clinical development programs.

Research and Development Projects and Expenses

|                                                                                                                                                                                                                           |       |   |                    |           |              |                |             |           |             |   |            |            |  |   |      |     | 
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----- | - | ------------------ | --------- | ------------ | -------------- | ----------- | --------- | ----------- | - | ---------- | ---------- |  | - | ---- | --- | 
|                                                                                                                                                                                                                           |       |   | Three Months Ended |           |              |                |             |           |             |   |           
|                                                                                                                                                                                                                           |       |   |                    |           | Inception    | Estimated Cost
|                                                                                                                                                                                                                           |       |   | December 31,       |           | Through      |                | To License 
|                                                                                                                                                                                                                           |       |   |                    |           | December 31, |                | or Complete
|                                                                                                                                                                                                                           |       |   | 2003 (1)           |           | 2002 (1)     |                | 2003(1)(2)  |           | Project (1)
|                                                                                                                                                                                                                           |       |   |                    |           |              |                |             |           |            
|Major Company-Funded Projects:                                                                                                                                                                                             |       |   |                    |           |              |                |             |           |             |   |            |            |  |   |      |    
|Develop Neurodex for FDA marketing
approval in treating PBA. Estimated
timing to complete remaining phases
of project necessary to submit an NDA
to FDA: 0.5 year                                                          |       | $ | 1,776,708          |           |              | $              | 577,072     |           |             | $ | 12,232,357 |            |  | $ | 5M   |    
|Develop Neurodex for neuropathic pain.
Phase II open-label study completed                                                                                                                                                 |       |   | 594,463            |           |              |                | 100,908     |           |             |   | 5,352,535  |            |  |   | (3   | )  
|Development program for allergy and
asthma (IgE regulator). Program was
expanded to include Phase IIa.
Estimated timing to complete Phase
IIa and license the product: up to 2
years                                       |       |   | 1,065,344          |           |              |                | 1,234,742   |           |             |   | 15,570,295 |            |  | $ | 16M  | (4)
|Preclinical anti-inflammatory
research program (MIF inhibitor).
Program was expanded to include Phase
IIa. Estimated timing to complete
Phase IIa and to license the product: up
to 4 years                                |       |   | 611,112            |           |              |                | 624,716     |           |             |   | 5,658,646  |            |  | $ | 23M  | (4)
|Preclinical cholesterol reduction
program. Estimated timing to
complete proof of concept and license
product: up to 3.5 years                                                                                              |       |   | 223,505            |           |              |                | 227,148     |           |             |   | 2,124,145  |            |  | $ | 27M  |    
|Government-Funded Projects:                                                                                                                                                                                                |       |   |                    |           |              |                |             |           |             |   |            |            |  |   |      |    
|Preclinical research, primarily for
potential treatments for genital
herpes and anthrax. Estimated timing
to complete the various projects
varies from one to two years                                                    |       |   | 226,991            |           |              |                | 170,874     |           |             |   | 1,308,887  |            |  | $ | 0.6M | (5)
|Other Research Projects:                                                                                                                                                                                                   |       |   |                    |           |              |                |             |           |             |   |            |            |  |   |      |    
|Other research projects are primarily
in the areas involving monoclonal
antibodies and docosanol. The costs
and timing to complete these projects
are unpredictable because of the
uncertainty of outcomes of our
research |       |   | 865,560            |           |              |                | 676,162     |           |             |   | 12,266,778 |            |  |   |      |    
|                                                                                                                                                                                                                           |       |   |                    |           |              |                |             |           |             |   |            |            |  |   |      |    
|                                                                                                                                                                                                                           | Total |   | $                  | 5,363,683 |              |                | $           | 3,611,622 |             |   | $          | 54,513,643 |  |   |      |     | 
|                                                                                                                                                                                                                           |       |   |                    |           |              |                |             |           |             |   |            |            |  |   |      |    



|(1) |  | Each project includes allocation of laboratory occupancy costs.
M refers to millions. Estimated costs and timing to complete the
projects are subject to the availability of funds.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) |  | Inception dates are on or after October 1, 1998, at which time we
began identifying and tracking costs for these research programs.                                                  

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|(3) |  | Clinical development, licensing and/or co-promotion strategies are
being evaluated. See Research and Development Program Status and
Plans. Program expenditures for Neurodex for the treatment of
neuropathic pain during each of the listed periods include allocated
costs of certain research programs that are shared with Neurodex for
PBA.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(4) |  | Timing and projected costs to license IgE and MIF programs have
been increased to include clinical development through Phase IIa.
Previously, estimated costs and timing included development only
through Phase I.                                                                                                                               
|   
|(5) |  | State and Federal research grants totaling $1.5 million are for
research related to genital herpes, anthrax, cytomegalovirus (CMV)
and a blood donor program.                                                                                                                                                                                   

Research and Development Program Status and Plans

Neurodex for the treatment of PBA.We are nearing completion of enrollment in
a 140-patient Phase III clinical trial of Neurodex for the treatment of PBA in
patients with MS. We are also engaged in a 300-patient open label study for
the treatment of PBA in a broader pool of patients who could have any one of
several neurodegenerative diseases. Prior to engaging in these studies, we had
completed the initial Phase III clinical trial of PBA in patients with ALS, in
May 2002. Our goal is to submit an NDA to the FDA in the second half of the
2004 calendar year.

Neurodex for the treatment of neuropathic pain.This program remains in the
Phase II stage of clinical development while we evaluate alternatives for
continued development of Neurodex in the treatment of neuropathic pain,
including continuing development with our own expenditures or with the funding
of a potential co-promotion partner or potential licensee. In mid-2003, we
successfully completed a four-week open-label dose escalation study of Neurodex
in patients with painful diabetic neuropathy. There can be no assurances as to
the timing of a license or co-promotion arrangement, if any.

Development program for allergy and asthma (IgE regulator).In January 2004 we
changed our strategy to extend the program development timeline to include
Phase IIa clinical trials to enhance the programs value to potential
licensees. As a result, we increased the estimated costs by $8.0 million.
Previously, we included costs only through Phase I testing. In October 2003,
we announced that AVP-13358 was well tolerated at single rising doses up to
five milligrams in a randomized, placebo-controlled Phase I clinical trial.
Presence of the drug in the bloodstream, or exposure, was demonstrated at all
four oral dose levels tested between one and five milligrams. AVP-13358 is a
novel drug molecule discovered by Avanir scientists that is intended to inhibit
the production of IgE, a well-known mediator of allergy and asthma. Phase I
trials are intended to establish safety of the drug in single rising doses in
healthy volunteers. These trials will be followed by Phase Ib clinical trials
using rising multi-doses in healthy patients. Assuming the successful
completion of Phase I clinical trials and adequate funds to continue
development without a partner, we intend to continue development of the drug
through Phase IIa. Assuming the results of such additional studies are
favorable, we expect to license the drug to a larger pharmaceutical company for
further development.

Cholesterol reduction. We are engaged in preclinical research focused on
certain types of small molecules that can be taken orally as a potential
treatment of hyper-cholesterolemia (high cholesterol). Cholesterol is
transported in the blood in large cholesterol-rich particles called
lipoproteins. Generally, low-density lipoproteins (LDL) deliver the
cholesterol to peripheral tissues including aorta and coronary arteries,
whereas high-density lipoproteins (HDL) remove excess cholesterol from
peripheral tissues, and transport it to the liver for elimination. The process
is also known as reverse cholesterol transport (RCT). We are evaluating
certain compounds that may be capable of accelerating the removal of excess
cholesterol from peripheral tissues. We estimate the costs to develop selected
compounds to the stage of being able to demonstrate the proof of concept and to
license the compound to be $27 million.

Anti-inflammatory research program (MIF inhibitor). In January 2004 we changed
our strategy to extend the program development timeline to include Phase IIa
clinical trials, to enhance the programs value to potential licensees. As a
result, we increased the estimated costs by $12 million and timing to

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completion of Phase IIa and licensing the product by one year. Previously, we
included costs and timing only through Phase I. We are currently conducting
research on several potential drug candidates capable of inhibiting or blocking
the activity of macrophage migration inhibitory factor
(MIF). Our research indicates
that MIF may serve as a potential drug target in a variety of diseases,
including rheumatoid arthritis, Crohns disease, colitis and asthma. Assuming
we are successful in finding a lead compound and submitting an
investigational new drug (IND) application to the FDA,
and successfully completing some of the initial studies, we intend to license the compound to another pharmaceutical company for further
development. Any delays to our product development timeline or in submitting
an IND could cause a similar delay in the timing of when we expect that we
could license our MIF technology.

Government research contracts.Avanir also is engaged in research funded by
$1.5 million in government research grants. The government research grants are
to be used for investigating the market potential for a topical genital herpes
treatment, conducting research on various docosanol-based formulations for
genital herpes, development of antibodies to anthrax toxins and
cytomegalovirus, and development of a blood donor program intended to find
high-affinity antibodies to infectious diseases. We expect the current
government-funded research programs will continue through fiscal year 2004.

Monoclonal antibodies research. In December 2003 we announced that we had
entered into a license agreement with Peregrine Pharmaceuticals for one of the
antibodies that we had developed for the treatment of solid tumor cancers.
Also in December 2003, we presented positive new data on our panel of human
antibodies against the key toxin of the Class A biowarfare agent anthrax. Two
of Avanirs most potent anthrax antibodies, AVP 21D9 and AVP 22G12, appear
unique both in mechanism of action and in terms of the binding site on the
anthrax toxin. AVP 21D9 is currently in preclinical development for use as a
prophylactic and therapeutic drug to treat anthrax infections. Ultimately,
Avanir plans to submit an IND application seeking clearance
from the FDA to begin clinical trials to
evaluate the safety, tolerability, and pharmacology of AVP 21D9 in healthy
human subjects. Much of our work targeting infectious diseases has been funded
by government research grants. Because all of our research is at a very early
preclinical stage of development and is unpredictable in terms of the outcome,
we are unable to predict the cost and timing for development of any antibody or
drug.

General and administrative expenses. General and administrative expenses
amounted to $1.4 million in the first quarter of fiscal 2004, representing a
30% increase over expenses of $1.1 million in the same period in the prior
year. Higher expenses were primarily attributable to a $331,000 increase in
expenses related to human resource programs and an $87,000 increase in building
occupancy costs, including rent, utilities, maintenance and insurance resulting
from the addition of office space in January 2003, partially offset by a
$41,000 reduction in investor relations expenses due primarily to
discontinuation of outside contract services. The Company expects that general
and administrative expenses will remain about the same over the next two
quarters.

Sales and marketing expenses. During the first quarter of fiscal 2004, sales
and marketing expenses were $859,000, compared to $425,000 in the same period a
year ago. Higher expenses in the first fiscal quarter of 2004 were
related primarily to
the addition of approximately $374,000 in medical education and
awareness programs for PBA and pre-launch planning activities for
Neurodex, and $98,000 for market
research. We expect that sales and marketing expenses will continue at
the current rate for at least the next two quarters and increase thereafter if
Phase III clinical trial results for Neurodex are favorable.

Net Loss

For the first quarter of fiscal 2004, the net loss attributable to common
shareholders was $6.3 million, compared to $4.2 million for the same period a
year ago. The basic and diluted net loss per share was $0.09 for the first
quarter of fiscal 2004, compared to $0.07 for the same period a year ago. We
expect to continue to pursue our drug development strategy focused on the
development of Neurodex, followed by

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other programs in earlier stages of
development that are in large therapeutic areas and that have significant
partnering and licensing potential. To help fund and develop our products, we
intend to seek licensees and partners to share the costs of development. Some
of these potential license arrangements could materially change our outlook for future revenues and costs. However,
the timing of such potential arrangements is unpredictable.

LIQUIDITY AND CAPITAL RESOURCES

As of December 31, 2003, we had cash, cash equivalents, and investments in
securities totaling $18.5 million and a net working capital balance of $11.7
million. As of September 30, 2003, we had cash, cash equivalents and
investments in securities of $17.5 million and a net working capital balance of
$10.6 million. Explanations of net cash provided by or used for operating,
investing and financing activities are provided below.

|                                                     |  |               |            |               |  |               |             |   |  |   |            |  
|---------------------------------------------------- |  | ------------- | ---------- | ------------- |  | ------------- | ----------- | - |  | - | ---------- | -
|                                                     |  | December 31,  |            | Increase      |  | September 30,
|                                                     |  | 2003          |            | During Period |  | 2003         
|                                                     |  |               |            |               |  |              
|Cash, cash equivalents and investments in securities |  | $             | 18,509,433 |               |  | $             | 1,052,144   |   |  | $ | 17,457,289 |  
|Cash and cash equivalents                            |  | $             | 12,989,511 |               |  | $             | 791,103     |   |  | $ | 12,198,408 |  
|Net working capital                                  |  | $             | 11,684,361 |               |  | $             | 1,065,145   |   |  | $ | 10,619,216 |  
|                                                    
|                                                     |  | Quarter ended |            | Change        |  | Quarter ended
|                                                     |  | December 31,  |            | Between       |  | December 31, 
|                                                     |  | 2003          |            | Periods       |  | 2002         
|                                                     |  |               |            |               |  |              
|Net cash provided by (used for) operating activities |  | $             | (6,179,175 | )             |  | $             | (22,264,453 | ) |  | $ | 16,085,278 |  
|Net cash used for investing activities               |  |               | (599,275   | )             |  |               | 427,077     |   |  |   | (1,026,352 | )
|Net cash provided by (used for) financing activities |  |               | 7,569,553  |               |  |               | 7,690,665   |   |  |   | (121,112   | )
|                                                     |  |               |            |               |  |               |             |   |  |   |            |  
|Net increase in cash and cash equivalents            |  | $             | 791,103    |               |  | $             | (14,146,711 | ) |  | $ | 14,937,814 |  
|                                                     |  |               |            |               |  |               |             |   |  |   |            |  

Operating activities. Net cash used for operating activities amounted to $6.2
million in the first quarter of fiscal 2004, compared to $16.1 million in cash
provided by operating activities during the same period a year ago. For the
first quarter of fiscal 2004, the net loss of $6.3 million accounted for most
of the cash used for operating activities. Also during the period, accounts
receivable increased by $821,827, representing sales of the active ingredient
docosanol to licensees and services provided under government grants for which
payments were received after the quarter ended. Also, inventory declined by
$198,450, representing the cost of docosanol sold to various licensees. We
intend to replenish our docosanol inventory later in the year. The net cash
provided by operating activities in the first quarter of fiscal 2003 includes
$20.4 million in cash, net of transaction costs, received from Drug Royalty USA
on December 24, 2002, from the sale of an undivided interest in our Abreva®
license agreement with GlaxoSmithKline. The sale of rights to future Abreva
royalties was recorded as deferred revenue on the date of sale. (See Note 7,
Deferred Revenue in the accompanying notes to the consolidated financial
statements.)

Investing activities. Net cash used for investing activities during the first
quarter of fiscal 2004 amounted to $599,000, including investments in
securities totaling $993,000, purchases of property and equipment of $68,000
and patent costs of $238,000, partially offset by sales and maturities of
investments totaling $700,000. Net cash used for investing activities during
the first quarter fiscal 2003 amounted to $1.0 million, including investments
in securities totaling $699,000, purchases of property and equipment of $2.0
million and patent costs of $124,000, partially offset by sales and maturities
of investments totaling $1.8 million. Capital expenditures were substantially
lower in the first quarter of fiscal 2004, compared to the same period a year
ago when the Company was engaged in making leasehold improvements to additional
office and laboratory space.

Financing activities. Net cash provided by financing activities amounted to
$7.6 million during the first quarter of fiscal 2004, consisting primarily of
$7.6 million received from the sale of Class A common stock and warrants in
December 2003. Net cash used for financing activities amounted to $121,000 in

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the first quarter of fiscal 2003, consisting primarily of payments on notes and
capital lease obligations.

We believe that cash, cash equivalents, and
investments in securities totaling $18.5 million at December 31, 2003, plus
anticipated future revenues, should be sufficient to sustain our planned level
of operations for at least the next 12 months. However, to continue to fund the development
of our new drug candidates and technology platforms during at least the next
two years, we expect to continue to pursue various alternatives for raising
capital during this two-year period. Potential alternatives that we are
considering for raising capital include, but are not limited to, partnering
arrangements where partners share development costs, issuance of debt or equity
securities, and licensing or sales of any of our platform technologies or new
drug candidates.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements in accordance with accounting
principles generally accepted in the United States requires that management
make a number of assumptions and estimates that affect the reported amounts of
assets, liabilities, revenues and expenses in our consolidated financial
statements and accompanying notes. Management bases its estimates on
historical information and assumptions believed to be reasonable. Although
these estimates are based on managements best knowledge of current events and
circumstances that may impact the Company in the future, actual results may
differ from these estimates.

Our critical accounting policies are those that affect our financial statements
materially and involve a significant level of judgment by management. Our
critical accounting policies regarding revenue recognition are in the following
areas: milestone payments in license agreements, royalties on licensed
products, sale of rights to future royalties, and recognition of revenues in
research contracts. Our critical accounting policies regarding expense
recognition are principally related to research contracts. Our critical
accounting policies also include the valuation of long-lived and intangible
assets.

Milestone Payments in License Agreements

We recognize revenues from license fees when the performance requirements have
been met, the fee is fixed or determinable, and collection of fees is probable.
We defer revenues and recognize them over the life of the agreement when we
have continuing obligations to perform under the agreement.

Our largest and most significant license agreement is with SB Pharmco Puerto
Rico, Inc., a subsidiary of GlaxoSmithKline (GlaxoSmithKline). On March 31,
2000, we transferred the rights to manufacture, use, and sell Abreva in the
United States and Canada to GlaxoSmithKline and gave them full control,
authority and responsibility over research, development, regulatory compliance
activities (including actions required to obtain appropriate government
approvals), and commercialization of the product in those territories.
GlaxoSmithKline has achieved and paid all of the performance milestones under
the agreement. With regard to the milestones, we have no further performance
obligations. Future revenues, if any, to be earned under the GlaxoSmithKline
agreement will come solely from royalty revenues.

We expect to enter into additional license agreements in the future. We expect
that each license agreement will have its own set of circumstances and terms of
performance. We will consider the specific facts and circumstances of each
license agreement to determine the appropriate revenue recognition for such
items, including nonrefundable up-front fees and milestone payments and taking
into consideration when the earnings process is complete and collection is
reasonably assured.

Royalties on Licensed Products

We recognize royalty revenues from our licensed products based on the reported
sales by our licensees and computed in accordance with the specific terms of
the license agreements. Since the launch of Abreva in October 2000 through
December 31, 2003, substantially all of our royalties have come from

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GlaxoSmithKline. We have entered into additional license agreements that
contain royalties as a source of revenues, and we expect to enter into
additional similar license agreements with foreign-based companies.

Sales of Rights to Future Royalties

In fiscal 2003, we sold an undivided interest in our license agreement with
GlaxoSmithKline to Drug Royalty USA for $24.1
million. Because of our ongoing involvement with GlaxoSmithKline in earning
future royalty revenues, we recorded the amount received from Drug Royalty USA,
net of costs of the transaction and forgiveness of certain advances, as
deferred revenue. The amount recorded as deferred revenue is being recognized
as revenue under the units-of-revenue method over the period from October 2002
through April 2014. The portion of deferred revenue classified as a current
liability represents the amount that we expect to realize as revenue within the
next 12 months. (See Note 7, Deferred Revenue, in
the accompanying consolidated financial
statements.)

Recognition of Revenues in Research Contracts

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

Antibody generation services.As of December 31, 2003, we were engaged in work
on two research collaboration agreements, both of which have research
initiation fees. In these agreements, the customer provides us with the target
antigens. We then perform research services to develop potential antibodies
for those antigens. If we are able to estimate the period of service in the
contract in advance of beginning the work, then we recognize such research
initiation fees ratably as revenue over the estimated period of service. If we
are unable to identify the period of service in the contract in advance of
beginning the work, we defer research initiation fees and recognize such fees
as revenue once we have completed our efforts to create the antibodies. In the
research phases of the research collaboration agreement, we may receive payment
either to start a research phase or to complete a research phase (including
receipt by the customer of the deliverable). We recognize revenue once the
product has been delivered, because the earnings process is then complete and
an exchange has been made. Factors taken into consideration in recognizing
revenues include the following:



| |  | The performance criteria have been met;                                                                               
|- |  | ----------------------------------------------------------------------------------------------------------------------
| 
| |  | Any undelivered products or services are not essential to the
functionality of the delivered products or services; and
| 
| |  | Payment for the delivered products or services is not contingent on
delivery of the remaining products or services.   

Other research contracts.As with all our research contracts, including the
up-front initiation fee, we defer revenue recognition until services have been
rendered or products (e.g. developed antibodies) are delivered. The milestones
established within the contract are typically set to approximate the effort
associated with the completion of each phase.

Recognition of Expenses in Research Contracts

Pursuant to managements assessment of the progress that has been made on
clinical trials and services provided in other research contracts, we recognize
expenses as the services are provided. Several of our contracts extend across
multiple reporting periods. For example, contracts with organizations that
conduct our Phase III clinical trial of Neurodex for the treatment of PBA in
patients with multiple

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sclerosis and our Neurodex open label study, extend
beyond one year. Such contracts require an assessment of the work that has
been completed during the period, including measurement of progress, analysis
of data that justifies the progress, and finally, managements judgment.

Valuation of Long-Lived and Intangible Assets

We assess the impairment of identifiable intangible assets and long-lived
assets whenever events or changes in circumstances indicate that the carrying
value may not be recoverable. Factors we consider important that could trigger
an impairment review include the following:



| |  |  | a significant underperformance relative to expected historical or
projected future operating results;               
| | - |  | --------------------------------------------------------------------------------------------------------------------
|
| |  |  | a significant change in the manner of our use of the acquired asset
or the strategy for our overall business; and/or
|
| |  |  | a significant negative industry or economic trend.                                                                  

When we determine that the carrying value of intangible assets or long-lived
assets are not recoverable based upon the existence of one or more of the above
indicators of impairment, we may be required to record impairment charges for
these assets that have not been previously recorded.

RECENT ACCOUNTING PRONOUNCEMENTS

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

RISK FACTORS THAT MIGHT AFFECT FUTURE OPERATIONS

We expect that we will need to raise additional capital to fund ongoing
operations through 2005. If we are unable to raise additional capital, we may
be forced to curtail operations. If we succeed in raising additional capital
through a licensing or financing transaction, it may affect our future revenues
and stock price.

In order to maintain sufficient cash and investments for future operations, we
will need to raise additional capital. We expect to seek to raise additional
capital over the next 12 to 24 months through various alternatives, including
licensing or sales of our technologies and drug candidates and sale of shares
of our Class A common stock.



| |  |  | If we raise capital through licensing or sales of one or more of our
technologies and drug candidates, then we may lose an opportunity for
product sales if a product is successfully developed, approved by the
FDA and marketed. If we license any of our technologies or drug
candidates, then the development of the product or technology will no
longer be in our control. A licensee might not ever reach any of the
milestones in a license agreement and we would not earn any additional
payments in such an event. Further, if we sell any of our technologies
or drug candidates, the sales price may not cover our investment in
such technology or drug candidate.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | If we raise capital by issuing additional shares of Class A common
stock at a price per share less than the then-current market price per
share, then the value of the shares of Class A common stock
outstanding will be diluted or reduced. Further, even if we were to
sell shares of common stock at prices equal to or higher than the
current market price, the issuance of additional shares may depress
the market price of our common stock and dilute your voting rights in
the Company.                                                                                                                                                                              
|
| |  |  | We may not be able raise capital on terms that we find acceptable, if
at all. If we are unable to                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

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| |  |  | raise additional capital to fund future
operations, then we might have to reduce operations or defer or
abandon one or more of our clinical or preclinical research programs.
Any of these actions could be expected to have an adverse effect on
our stock price.
| |  |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

We may spend millions of dollars in preclinical studies researching the
potential safety and efficacy of our drug candidates. If any such drug
candidate fails to demonstrate the desired safety and efficacy, we may abandon
the development of the compound, in which event we would not recover our
expenditures incurred to date for that compound. If a compound appears to be
safe and effective in preclinical studies, we may decide to proceed with human
clinical trials. The full complement of clinical trials required to obtain
regulatory approval for a new drug may involve several million dollars. Because
of the Companys limited financial resources, we may be required to license the
compound to a pharmaceutical company with greater financial resources in order
to complete development of the drug. We may be unable to find a large
pharmaceutical company interested in licensing the drug or, if we do locate
such a licensee, that the proposed license terms will be acceptable to the
Company. In the event that we are unable to find a large pharmaceutical partner
or licensee on acceptable terms, we may be forced to abandon one or more of our
drug candidates.

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

Avanir and its licensees face a wide variety of risks in foreign countries in
obtaining regulatory approval and in marketing and selling docosanol 10% cream,
including:



| |  |  | Regulatory approval requirements differ by country, and obtaining approvals to market
the drug in foreign countries may be difficult to obtain, may require additional
costly and time consuming clinical trials, or may require prescription status first
before obtaining sufficient experience to warrant approval as an OTC product;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | 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.                                                                                                                                                                                                                            

We expect our quarterly operating results to fluctuate significantly from
period-to-period for a number of reasons.

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



| |  |  | Limited rights to future Abreva royalties In December 2002 we sold
to Drug Royalty USA the
| | - |  | -------------------------------------------------------------------------------------------

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| |   |  | rights to a substantial portion of our future
royalty revenues from sales of Abreva by GlaxoSmithKline. We will not
receive any future royalty payments unless and until annual Abreva
sales exceed $62 million, at which time we will receive one-half of
the stated royalty rate on any excess sales. We expect that any
royalty payments on these excess sales, if any, would occur only once
a year, after the end of each calendar year.                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Concentration of significant
customers, suppliers and industries 
Milestone payments, royalties earned, and revenues recognized from the
sale of rights to royalties from a single licensee (GlaxoSmithKline)
accounted for approximately 73% and 95% of our fiscal 2003 and 2002
revenues, respectively. We have now received all of the milestone
payments from GlaxoSmithKline for North America. With the sale of our
Abreva royalty rights to Drug Royalty USA, future royalty payments
from GlaxoSmithKline will come exclusively from our remaining 50%
share of Abreva royalties on contract sales in excess of $62 million a
year. Additionally, we purchase our raw materials from a sole foreign
supplier that has been approved for manufacture by the FDA. Any
disturbances or delays in the manufacture of the raw materials could
seriously and adversely affect our business.
|
| |  |  | Achievement of milestones under license agreements may be outside our
control Recognition of revenue under several of our license
agreements may depend solely on the efforts and performance of our
licensees in reaching milestones outside of our control. Such
milestones may include specific events, such as regulatory approval,
product launch, the passage of time, or reaching a sales threshold.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|
| |  |  | Acquisitions/alliances If, in the future, we acquire technologies,
products, or businesses, or we form alliances with companies requiring
technology investments or commitments, we will face a number of risks
to our business. The risks that we may encounter include those
associated with integrating operations, personnel, and technologies
acquired or licensed, and the potential for unknown liabilities of the
acquired business. Our business and operating results on a quarterly
basis could be adversely affected if any of our acquisition or
alliance activities are not successful.                                                                                                                                                                                                                                                                                        

Foreign sales of docosanol 10% cream and other potential products are subject
to various foreign trade risks.

Our license agreement with GlaxoSmithKline is for the United States and Canada
only. We also have exclusive license agreements for docosanol 10% cream for
Israel, South Korea, Italy and Egypt. We are holding discussions with other
potential licensees for marketing and selling docosanol 10% cream in other
countries not already licensed. However, we may not finalize any license or
distribution arrangements for other territories on a timely basis or on
favorable terms, if at all. Further, our foreign licensees expose us to various
foreign trade risks relating to development and marketing of docosanol 10%
cream. We may arrange for contracts in the future for the manufacture,
marketing and distribution of docosanol 10% cream overseas by foreign
licensees, which will be substantially outside our control. Even if we are able
to obtain experienced licensees in foreign markets, specific risks that could
impact significantly our ability to deliver products abroad include:



| |  |  | difficulties in obtaining regulatory approval of docosanol 10% cream in foreign countries;      
| | - |  | ------------------------------------------------------------------------------------------------
|
| |  |  | changes in the regulatory and competitive environments in foreign countries;                    
|
| |  |  | changes in a specific countrys or regions political or economic conditions;                   
|
| |  |  | difficulty in finding foreign partners with sufficient capital to effectively launch,
market and

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| |   |  | promote the product;                                                            
| | - |  | --------------------------------------------------------------------------------
|
| |  |  | shipping delays;                                                                
|
| |  |  | difficulties in managing operations across disparate geographic areas;          
|
| |  |  | fluctuations in foreign currency exchange rates;                                
|
| |  |  | prices of competitive products;                                                 
|
| |  |  | difficulties associated with enforcing agreements through foreign legal systems;
|
| |  |  | trade protection measures, including customs duties and export quotas; and      
|
| |  |  | foreign tax withholding laws.                                                   

Our research and development programs face intense competition and rapid
technological change. If we fail to develop products that keep pace with
competitive products and new technologies, our products and technologies could
become obsolete.

The biotechnology industry is highly competitive and subject to significant and
rapid technological change. We compete with hundreds of companies that develop
and market products and technologies in similar areas as our research. Each
competitor may have specific expertise and technologies that are better than
ours. Many of these companies, either alone or together with their research
partners, have substantially greater financial resources, larger research and
development staffs, and substantially greater experience than we do.

Our failure or inability to comply with government regulations regarding the
development, production, testing, manufacturing and marketing of our products
may adversely affect our operations.

Governmental authorities in the U.S., including the FDA, and other countries
highly regulate the development, production, testing, manufacturing and
marketing of pharmaceutical products. The clinical testing and regulatory
approval process can take a number of years and requires the expenditure of
substantial resources. Failure to obtain, or delays in obtaining, these
approvals will adversely affect our business operations, including our ability
to commence marketing of any proposed products. We may find it necessary to use
a significant portion of our financial resources for research and development
and the clinical trials necessary to obtain these approvals for our proposed
products. We will continue to incur costs of development without any assurance
that we will ever obtain regulatory approvals for any of our products under
development. Additionally, we cannot predict the extent to which adverse
governmental regulation might arise from future U.S. or foreign legislative or
administrative action. Moreover, we cannot predict with accuracy the effects of
any future changes in the regulatory approval process and in the domestic
health care system for which we develop our products. Future changes could
affect adversely the time frame required for regulatory review, our financial
resources, and the sale prices of our proposed products, if approved for sale.

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

The drug development process is lengthy and capital intensive. Our drug
development programs are exposed to all of the risks inherent in product
development based on innovative technologies, including unanticipated
development problems and the possible lack of funding or collaborative
partners. Any of a

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number of problems in the development process could result
in the abandonment or substantial change in the development of a specific
product. Our Phase III clinical trial of Neurodex for the treatment of
pseudobulbar affect in multiple sclerosis patients may experience setbacks or
failures for reasons we have not anticipated. Our Phase I clinical trial of
our lead compound for treating allergy and asthma may not demonstrate the
efficacy of, or have the safety profile necessary for, a proposed product for
human use. Unsuccessful clinical trial results for our proposed products could
affect materially and adversely our future business operations and financial
condition.

Our financial results could be affected by potential changes in the accounting
rules governing the recognition of stock-based compensation expense.

We measure compensation expense for our employee stock compensation plans under
the intrinsic value method of accounting prescribed by Accounting Principles
Board Opinion No. 25, Accounting for Stock Issued to Employees. In addition,
we provide pro forma disclosures of our operating results in our Notes to
Consolidated Financial Statements as if the fair value method of accounting had
been applied in accordance with SFAS No. 123, Accounting for Stock-based
Compensation. Had we accounted for our compensation expense under the fair
value method of accounting prescribed by SFAS No. 123, the charges would have
been significantly higher, by approximately $1,554,000, $2,176,000, and
$1,540,000 during fiscal 2003, 2002, and 2001, respectively. Currently, the
U.S. Congress, the Securities and Exchange Commission and the Financial
Accounting Standards Board are considering changes to accounting rules
concerning the recognition of stock option compensation expense. If one or
more of these proposals are implemented, we and other companies may be required
to measure compensation expense using the fair value method, which would
adversely affect our results of operations by reducing our income or increasing
our losses by an amount equal to the difference in the two measurement methods.

Business interruptions could adversely affect our business.

Our operations are vulnerable to interruption by fire, earthquake, power loss,
telecommunications failure, and other events beyond our control. For example,
during 2001 and again in 2003, we experienced blackouts, where there were
periods of time lasting several hours in which our utility provider was unable
to provide us with electrical power. The loss of electrical power or
blackouts for any significant periods of time could adversely affect our
ability to conduct experiments and could also harm our vendors. Further, we
could lose valuable data made to date in experiments currently underway. We
have mitigated the severity of power losses by installing on our premises
emergency power equipment, which we have used on several occasions to supply
electricity in the areas that we consider to be the most critical to our
operations. However, the emergency power unit does not cover all of our
electrical needs and, further, it might not operate properly in the event of a
power loss.

Our inability to attract and retain key management and scientific personnel
could negatively affect our business.

Our success depends on the performance of a small core staff of key management
and scientific employees with biotech experience. Given our small staff size
and programs currently under development, we depend substantially on our
ability to hire, train, retain and motivate high quality personnel, especially
our scientists and management team in this field. If we were to lose one or
more of our key scientists, then we would likely lose some portion of our institutional
knowledge and technical know-how, potentially causing a substantial delay in
one or more of our development programs until adequate replacement personnel
could be hired and trained.

Our future success also depends on our continuing ability to identify, hire,
train and retain highly qualified, technical, sales, marketing and customer
service personnel. We presently employ

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approximately 60 people. Further, we
might hire additional people over the next twelve months. Other than our chief
executive officer, our executives do not have employment agreements. We do not
have key person life insurance policies for any of our executives. The
industry in which we compete has a high level of employee mobility and
aggressive recruiting of skilled personnel. This type of environment creates
intense competition for qualified personnel, particularly in product research
and development, sales and marketing, and accounting and finance.

Our patents may be challenged and our pending patents may be denied. Either
result would seriously jeopardize our ability to compete in the intended
markets for our proposed products.

We rely substantially on the protection of our intellectual property through
our ownership or control of issued patents and patent applications. Patents and
patent applications owned or controlled by the Company are for
docosanol-related products and technologies, Neurodex, compounds capable of
regulating the target IgE in controlling symptoms of allergy and asthma,
compounds capable of regulating the target MIF in the treatment of several
inflammatory diseases, and Xenerex technologies for developing monoclonal
antibodies. Because of the competitive nature of the biopharmaceutical
industry, we cannot assure you that:



| |  |  | the claims in any pending patent applications will be allowed or that patents will be granted;                                                                                       
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | present and future competitors will not develop similar or superior technologies
independently, duplicate our technologies or design around the patented aspects of our
technologies;
|
| |  |  | our proposed technologies will not infringe other patents or rights owned by others,
including licenses that may not be available to us;                                             
|
| |  |  | any of our issued patents will provide us with significant competitive advantages; or                                                                                                
|
| |  |  | challenges will not be instituted against the validity or enforceability of any patent that
we own or, if instituted, that these challenges will not be successful.                  

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

The process for the approval of patent applications in foreign countries may
differ significantly from the process in the U.S. These differences may delay
our plans to market and sell docosanol 10% cream and other products in the
international marketplace. Approval in one country does not indicate that
approval will be obtained in other countries. The patent authorities in each
country administer that countrys laws and regulations relating to patents
independently of the laws and regulations of any other country and we must seek
and obtain the patents separately. Our inability to obtain or maintain patent
protections for docosanol 10% cream and other products in foreign markets would
severely hamper our ability to generate international sales from our first
product and other products still under development.

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

We rely substantially on confidentiality agreements to protect our innovations.
We cannot assure you that secrecy obligations will be honored, or that others
will not independently develop similar or superior technology. Additionally, if
our consultants, key employees or other third parties apply technological
information independently developed by them or by others to our projects, then
disputes may arise as to

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the ownership rights of these innovations. It is
costly to litigate these disputes and an unfavorable result could adversely
affect our intellectual property portfolio as well as our business and
financial condition.

Developing new pharmaceutical products for human use involves product liability
risks, for which we currently have limited insurance coverage.

The testing, marketing, and sale of pharmaceutical products involves the risk
of product liability claims by consumers and other third parties. We maintain
product liability insurance coverage for our clinical trials in the amount of
$5 million per incident and $5 million in the aggregate. However, product
liability claims can be high in the pharmaceutical industry and our insurance
may not sufficiently cover our actual liabilities. If a suit against our
business or proposed products is successful, then the lack or insufficiency of
insurance coverage could affect materially and adversely our business and
financial condition. Furthermore, various distributors of pharmaceutical
products require minimum product liability insurance coverage before their
purchase or acceptance of products for distribution. Failure to satisfy these
insurance requirements could impede our ability to achieve broad distribution
of our proposed products.

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

In the ordinary course of business, we face various claims brought by third
parties, including claims relating to the safety or efficacy of our products.
Any of these claims could subject us to costly litigation and, while we
generally believe that we have adequate insurance to cover many different types
of liabilities, our insurance carriers may deny coverage or our policy limits
may be inadequate to fully satisfy any damage awards or settlements. If this
were to happen, the payment of any such awards could have a material adverse
effect on our operations and financial position. Additionally, any such claims,
whether or not successful, could damage our reputation and business.

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

We have the opportunity to earn royalties on Abreva product wholesale sales if
sales exceed $62 million a year. Abreva competes with several other products
for oral-facial herpes currently on the market in the U.S., as well as other
products or potential products that are or may be under development or
undergoing FDA review. Most of the competing products are manufactured by
companies having substantial financial resources, research and development
facilities and manufacturing and marketing experience. Even with Abreva being
marketed by one of the worlds largest consumer healthcare companies,
GlaxoSmithKline, not all competitive responses and the impacts of those
responses can be foreseen.




Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK

We are exposed to market risks related to changes in interest rates. Because
substantially all of our revenue, expense, and capital purchasing activities
are transacted in U.S. dollars, our exposure to foreign currency exchange rates
is immaterial. However, in the future we could face increasing exposure to
foreign currency exchange rates as we expand international distribution of
docosanol 10% cream. Until such time as we are faced with material amounts of
foreign currency exchange rate risks, we do not plan to use derivative financial instruments,
which can be used to hedge such risks. We will evaluate the use of derivative
financial instruments to hedge our exposures as the needs and risks should
arise.

Interest rate sensitivity

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Our investment portfolio consists primarily of fixed income instruments with an
average duration of six-tenths of a year as of December 31, 2003 (2.0 years as
of September 30, 2003). The primary objective of our investments in debt
securities is to preserve principal while achieving attractive yields, without
significantly increasing risk. We carry some investments that we intend to
hold to maturity and others that we classify as available-for-sale. These
available-for-sale securities are subject to interest rate risk. In general,
we would expect that the volatility of this portfolio would increase as its
duration increases.




Item 4. CONTROLS AND PROCEDURES

We maintain disclosure controls and procedures designed to help ensure that
material information related to the Company, and its subsidiary, is made known
to our management and audit committee on a regular and current basis. We have
evaluated our controls and procedures within 90 days of the filing date of this
report and have concluded that our disclosure controls and procedures as of the
date of this filing are adequate to enable us to comply with our disclosure
obligations. No significant change to our internal controls was made during
the period covered by this report or subsequent to our evaluation.

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PART II OTHER INFORMATION

Items 1-5. NOT APPLICABLE




Item 6. EXHIBITS AND REPORTS ON FORM 8-K

| |  |     |  |                     |  |                                                                    
| |  | --- |  | ------------------- |  | -------------------------------------------------------------------
| |  | (a) |  | Exhibits           
| |  |     |  |                     |  |                                                                    
| |  |     |  | 15.0                |  | Letter on unaudited interim financial information                  
| |  |     |  |                     |  |                                                                    
| |  |     |  | 31.1                |  | Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002
| |  |     |  |                     |  |                                                                    
| |  |     |  | 31.2                |  | Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002
| |  |     |  |                     |  |                                                                    
| |  |     |  | 32.1                |  | Certification pursuant to Section 906 of Sarbanes-Oxley Act of 2002
| |  |     |  |                     |  |                                                                    
| |  |     |  | 32.2                |  | Certification pursuant to Section 906 of Sarbanes-Oxley Act of 2002
| |  |     |  |                     |  |                                                                    
| |  | (b) |  | Reports on Form 8-K

On December 11, 2003, the registrant filed a current report on Form 8-K
disclosing, under Items 5 and 7, the closing of a financing on December 5,
2003.

On December 17, 2003, the registrant filed a current report on Form 8-K
furnishing, under Items 7 and 12, a press release announcing the results of
operations for the quarter and year ended September 30, 2003.

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SIGNATURES

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

|                                                    |  |                                                                                                  |  |                  
|--------------------------------------------------- |  | ------------------------------------------------------------------------------------------------ |  | -----------------
|Signature                                           |  | Title                                                                                            |  | Date             
|                                                    |  |                                                                                                  |  |                  
|/s/Gerald J. Yakatan, Ph.D.Gerald J. Yakatan, Ph.D. |  | President and Chief
Executive Officer (Principal Executive
Officer)                              |  | February 13, 2004
|                                                   
|/s/Gregory P. Hanson, CMAGregory P. Hanson, CMA     |  | Vice President, Finance and Chief
Financial Officer
(Principal Financial and Accounting Officer) |  | February 13, 2004

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EXHIBIT INDEX

|            |  |                                                                    
|----------- |  | -------------------------------------------------------------------
|Exhibit No. |  | Description                                                        
|            |  |                                                                    
|15.0        |  | Letter on unaudited interim financial information                  
|31.1        |  | Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002
|31.2        |  | Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002
|32.1        |  | Certification pursuant to Section 906 of Sarbanes-Oxley Act of 2002
|32.2        |  | Certification pursuant to Section 906 of Sarbanes-Oxley Act of 2002

33