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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549


FORM 10-Q



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(Mark One)

|      |                                                                                         
|----- | ----------------------------------------------------------------------------------------
|[ X ] | QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.
|     
|      | For the quarterly period ended December 31, 2002                                        

OR

|       |                                                                                          
|------ | -----------------------------------------------------------------------------------------
|
|[    ] | TRANSITION REPORT PURSUANT TO
SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
|       |                                                                                          
|       | For the transition period from    to    .                                                

Commission File No. 0-18734

AVANIR PHARMACEUTICALS

(Exact name of registrant as specified in its charter)


|                                                                                                      |  |                                                
|----------------------------------------------------------------------------------------------------- |  | -----------------------------------------------
|California
(State or other jurisdiction of
incorporation or organization)                             |  | 33-0314804
(I.R.S. Employer Identification No.)
|                                                                                                      |  |                                                
|11388 Sorrento Valley Road, Suite 200, San Diego, California
(Address of principal executive offices) |  | 92121
(Zip Code)                               

(858) 622-5200

(Registrants telephone number, including area code)


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

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

The number of shares of Common Stock of the registrant issued and outstanding
as of
February 6, 2003:

|                                   |  |  |            | 
|---------------------------------- |  |  | ---------- | 
|Class A Common stock, no par value |  |  | 58,294,533 | 
|Class B Common stock, no par value |  |  | 13,500     | 



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TABLE OF CONTENTS



|                          |                                                                                                                    |                                            |  |  |  |  |  | 
|------------------------- | ------------------------------------------------------------------------------------------------------------------ | ------------------------------------------ |  |  |  |  |  | 
|                          |                                                                                                                    | 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                                                                          
|EXHIBIT 99.1             
|EXHIBIT 99.2             



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Table of Contents

|                                                                                              |                                            |      |    |   | 
|--------------------------------------------------------------------------------------------- | ------------------------------------------ | ---- | -- | - | 
|                                                                                              |                                            | Page
|                                                                                              |                                            |     
|PART I. FINANCIAL INFORMATION                                                                 |                                            |     
|Item 1. Financial Statements
Consolidated Balance Sheets                                      |                                            |      | 3  |  
|                                                                                              | Consolidated Statements of Operations      |      |    | 4 | 
|                                                                                              | Consolidated Statements of Cash Flows      |      |    | 5 | 
|                                                                                              | Notes to Consolidated Financial Statements |      |    | 6 | 
|Item 2. Managements Discussion and Analysis of Financial Condition
and Results of Operations |                                            |      | 14 |  
|Item 3. Quantitative and Qualitative Disclosures about Market Risk                            |                                            |      | 30 |  
|Item 4.
Controls and Procedures                                                               |                                            |      | 30 |  
|PART II. OTHER INFORMATION                                                                    |                                            |      |    |  
|Item 6. Exhibits and Reports on Form 8-K                                                      |                                            |      | 31 |  

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Avanir Pharmaceuticals

CONSOLIDATED BALANCE SHEETS (UNAUDITED)

|                                                |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |               |            |            |            | 
|----------------------------------------------- | -------------------------------------------------------------------------------- | ------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | ---------- | ------------ | --------- | ------------- | ---------- | ---------- | ---------- | 
|                                                |                                                                                  |                           |                                                                                                                                                                  |                            |            | December 31, |           | September 30,
|                                                |                                                                                  |                           |                                                                                                                                                                  |                            |            | 2002         |           | 2002         
|                                                |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|ASSETS                                          |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|Current assets:                                 |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|                                                | Cash and cash equivalents                                                        |                           | $                                                                                                                                                                | 23,568,361                 |            |              | $         | 8,630,547     |           
|                                                | Short-term investments in securities                                             |                           |                                                                                                                                                                  | 1,899,578                  |            |              |           | 695,840       |           
|                                                | Receivables, net                                                                 |                           |                                                                                                                                                                  | 232,738                    |            |              |           | 1,098,954     |           
|                                                | Inventory                                                                        |                           |                                                                                                                                                                  | 235,024                    |            |              |           | 238,126       |           
|                                                | Prepaid expenses                                                                 |                           |                                                                                                                                                                  | 688,319                    |            |              |           | 683,111       |           
|                                                |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|                                                |                                                                                  | Total current assets      |                                                                                                                                                                  |                            | 26,624,020 |              |           |               | 11,346,578 |           
|Investments in securities                       |                                                                                  |                           | 684,339                                                                                                                                                          |                            |            |              | 2,986,023 |              
|Restricted investments                          |                                                                                  |                           | 856,597                                                                                                                                                          |                            |            |              | 856,597   |              
|Property and equipment, net                     |                                                                                  |                           | 5,012,392                                                                                                                                                        |                            |            |              | 3,180,966 |              
|Intangible assets, net                          |                                                                                  |                           | 1,768,193                                                                                                                                                        |                            |            |              | 1,659,418 |              
|Other assets                                    |                                                                                  |                           | 303,347                                                                                                                                                          |                            |            |              | 303,347   |              
|                                                |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|                                                | TOTAL ASSETS                                                                     |                           | $                                                                                                                                                                | 35,248,888                 |            |              | $         | 20,332,929    |           
|                                                |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|LIABILITIES AND SHAREHOLDERS EQUITY            |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|Current liabilities:                            |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|                                                | Accounts payable                                                                 |                           | $                                                                                                                                                                | 1,935,011                  |            |              | $         | 2,705,606     |           
|                                                | Accrued expenses and other liabilities                                           |                           |                                                                                                                                                                  | 1,580,173                  |            |              |           | 1,598,625     |           
|                                                | Accrued compensation and payroll taxes                                           |                           |                                                                                                                                                                  | 408,477                    |            |              |           | 462,118       |           
|                                                | Loan payable                                                                     |                           |                                                                                                                                                                  | 180,392                    |            |              |           | 299,980       |           
|                                                | Current portion of deferred revenue                                              |                           |                                                                                                                                                                  | 2,171,470                  |            |              |           | 233,333       |           
|                                                | Current portion of capital lease obligations                                     |                           |                                                                                                                                                                  | 131,244                    |            |              |           | 128,833       |           
|                                                |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|                                                |                                                                                  | Total current liabilities |                                                                                                                                                                  |                            | 6,406,767  |              |           |               | 5,428,495  |           
|                                                | Deferred revenue, net of current portion                                         |                           |                                                                                                                                                                  | 18,130,171                 |            |              |           |              |           
|                                                | Capital lease obligations, net of current portion                                |                           |                                                                                                                                                                  | 300,579                    |            |              |           | 323,764       |           
|                                                |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|                                                |                                                                                  | Total liabilities         |                                                                                                                                                                  |                            | 24,837,517 |              |           |               | 5,752,259  |           
|                                                |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|CONTINGENCIES(Note 12)                          |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|REDEEMABLE CONVERTIBLE PREFERRED STOCK          |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|                                                | Series D  no par value, 500 shares authorized; 50 shares
issued and outstanding |                           |                                                                                                                                                                  | 525,798                    |            |              |           | 521,189       |           
|                                                |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|SHAREHOLDERS EQUITY                            |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|                                                | Preferred stock  no par value, 9,999,500 shares authorized:                     |                           |                                                                                                                                                                  |                            |            |              |           |               |           
|                                                |                                                                                  |                           | Series C Junior Participating - 1,000,000 shares
authorized; no shares issued or outstanding                                                                     |                            |            |             |           |               |            |           |           
|                                                | Common stock  no par value:                                                     |                           |                                                                                                                                                                  |                            |            |              |           |               |           
|                                                |                                                                                  |                           | Class A - 99,288,000 shares authorized; 58,294,533
and 58,270,533 shares issued and outstanding as of
December 31, 2002 and September 30, 2002,
respectively     |                            |            | 87,118,942   |           |               |            | 87,053,257 |           
|                                                |                                                                                  |                           | Class B - 712,000 shares authorized; 13,500 shares
issued and outstanding as of December 31, 2002 and
September 30, 2002 (convertible into Class A common
stock) |                            |            | 8,395        |           |               |            | 8,395      |           
|                                                | Accumulated deficit                                                              |                           |                                                                                                                                                                  | (77,245,485                | )          |              |           | (73,002,878   | )         
|                                                | Accumulated other comprehensive income                                           |                           |                                                                                                                                                                  | 3,721                      |            |              |           | 707           |           
|                                                |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|                                                |                                                                                  |                           |                                                                                                                                                                  | Total shareholders equity |            |              | 9,885,573 |               |            |            | 14,059,481 | 
|                                                |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|                                                | TOTAL LIABILITIES AND SHAREHOLDERS EQUITY                                       |                           | $                                                                                                                                                                | 35,248,888                 |            |              | $         | 20,332,929    |           
|                                                |                                                                                  |                           |                                                                                                                                                                  |                            |            |              |           |              
|                                               
|See notes to consolidated financial statements.

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Avanir Pharmaceuticals

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

|                                                       |                                                                         |                          |            |                    |           |      |           |            |           | 
|------------------------------------------------------ | ----------------------------------------------------------------------- | ------------------------ | ---------- | ------------------ | --------- | ---- | --------- | ---------- | --------- | 
|                                                       |                                                                         |                          |            | Three Months Ended
|                                                       |                                                                         |                          |            | December 31,      
|                                                       |                                                                         |                          |            |                   
|                                                       |                                                                         |                          |            | 2002               |           | 2001
|                                                       |                                                                         |                          |            |                    |           |     
|REVENUES:                                              |                                                                         |                          |            |                    |           |      |           |           
|                                                       | Research contracts and licenses                                         |                          | $          | 50,000             |           |      | $         | 5,066,667  |          
|                                                       | Royalties and sale of royalty rights                                    |                          |            | 593,295            |           |      |           | 1,063,548  |          
|                                                       | Government research grants                                              |                          |            | 158,411            |           |      |           |           |          
|                                                       | Product sales                                                           |                          |            | 17,400             |           |      |           |           |          
|                                                       |                                                                         |                          |            |                    |           |      |           |            |          
|                                                       |                                                                         | Total revenues           |            |                    | 819,106   |      |           |            | 6,130,215 | 
|                                                       |                                                                         |                          |            |                    |           |      |           |           
|OPERATING EXPENSES:                                    |                                                                         |                          |            |                    |           |      |           |           
|                                                       | Cost of product sales                                                   |                          |            | 3,102              |           |      |           |           |          
|                                                       | Research and development                                                |                          |            | 3,611,622          |           |      |           | 2,346,859  |          
|                                                       | General and administrative                                              |                          |            | 1,080,546          |           |      |           | 954,068    |          
|                                                       | Sales and marketing                                                     |                          |            | 425,129            |           |      |           | 320,032    |          
|                                                       |                                                                         |                          |            |                    |           |      |           |            |          
|                                                       |                                                                         | Total operating expenses |            |                    | 5,120,399 |      |           |            | 3,620,959 | 
|                                                       |                                                                         |                          |            |                    |           |      |           |           
|INCOME (LOSS) FROM OPERATIONS                          |                                                                         |                          | (4,301,293 | )                  |           |      | 2,509,256 |           
|                                                       | Interest income                                                         |                          |            | 68,022             |           |      |           | 187,915    |          
|                                                       | Other income                                                            |                          |            | 5,846              |           |      |           | 82,940     |          
|                                                       | Interest expense                                                        |                          |            | (10,574            | )         |      |           | (14,602    | )        
|                                                       |                                                                         |                          |            |                    |           |      |           |           
|NET INCOME (LOSS)                                      |                                                                         | $                        | (4,237,999 | )                  |           | $    | 2,765,509 |           
|                                                       |                                                                         |                          |            |                    |           |      |           |           
|NET INCOME (LOSS) ATTRIBUTABLE TO COMMON SHAREHOLDERS: |                                                                         |                          |            |                    |           |      |           |           
|                                                       | Net income (loss)                                                       |                          | $          | (4,237,999         | )         |      | $         | 2,765,509  |          
|                                                       | Dividends on redeemable convertible preferred stock                     |                          |            | (6,250             | )         |      |           | (6,250     | )        
|                                                       | Accretion of discount related to redeemable
convertible preferred stock |                          |            | (4,609             | )         |      |           | (4,609     | )        
|                                                       |                                                                         |                          |            |                    |           |      |           |            |          
|NET INCOME (LOSS) ATTRIBUTABLE TO COMMON SHAREHOLDERS  |                                                                         | $                        | (4,248,858 | )                  |           | $    | 2,754,650 |           
|                                                       |                                                                         |                          |            |                    |           |      |           |           
|NET INCOME (LOSS) PER SHARE:                           |                                                                         |                          |            |                    |           |      |           |           
|                                                       | BASIC                                                                   |                          | $          | (0.07              | )         |      | $         | 0.05       |          
|                                                       |                                                                         |                          |            |                    |           |      |           |           
|                                                       | DILUTED                                                                 |                          | $          | (0.07              | )         |      | $         | 0.04       |          
|                                                       |                                                                         |                          |            |                    |           |      |           |           
|WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING:  |                                                                         |                          |            |                    |           |      |           |           
|                                                       | BASIC                                                                   |                          |            | 58,296,555         |           |      |           | 58,029,403 |          
|                                                       |                                                                         |                          |            |                    |           |      |           |           
|                                                       | DILUTED                                                                 |                          |            | 58,296,555         |           |      |           | 61,455,499 |          
|                                                       |                                                                         |                          |            |                    |           |      |           |           
|See notes to consolidated financial statements.       

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Avanir Pharmaceuticals

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

|                                                                         |                                                                                          |                                        |                                            |            |                    |            |            |            |          |            |  
|------------------------------------------------------------------------ | ---------------------------------------------------------------------------------------- | -------------------------------------- | ------------------------------------------ | ---------- | ------------------ | ---------- | ---------- | ---------- | -------- | ---------- | -
|                                                                         |                                                                                          |                                        |                                            |            | Three Months Ended
|                                                                         |                                                                                          |                                        |                                            |            | December 31,      
|                                                                         |                                                                                          |                                        |                                            |            |                   
|                                                                         |                                                                                          |                                        |                                            |            | 2002               |            | 2001      
|                                                                         |                                                                                          |                                        |                                            |            |                    |            |           
|OPERATING ACTIVITIES:                                                    |                                                                                          |                                        |                                            |            |                    |            |            |           
|                                                                         | Net income (loss)                                                                        |                                        | $                                          | (4,237,999 | )                  |            | $          | 2,765,509  |         
|                                                                         | Adjustments to reconcile net income (loss) to net cash
provided by operating activities: |                                        |                                            |            |                    |            |            |            |         
|                                                                         | Depreciation and amortization                                                            |                                        |                                            | 186,900    |                    |            |            | 129,816    |         
|                                                                         | Compensation paid with stock options                                                     |                                        |                                            | 46,435     |                    |            |            | 44,860     |         
|                                                                         | Loss on disposal of assets                                                               |                                        |                                            | 212        |                    |            |            | 28         |         
|                                                                         | Changes in assets and liabilities:                                                       |                                        |                                            |            |                    |            |            |            |         
|                                                                         |                                                                                          | Receivables, net                       |                                            |            | 866,216            |            |            |            | (350,879 | )         
|                                                                         |                                                                                          | Inventory                              |                                            |            | 3,102              |            |            |            |         |           
|                                                                         |                                                                                          | Prepaid expenses and other assets      |                                            |            | (5,208             | )          |            |            | 177,863  |           
|                                                                         |                                                                                          | Accounts payable                       |                                            |            | (770,595           | )          |            |            | 29,785   |           
|                                                                         |                                                                                          | Accrued expenses and other liabilities |                                            |            | (18,452            | )          |            |            | 51,678   |           
|                                                                         |                                                                                          | Accrued compensation and payroll taxes |                                            |            | (53,641            | )          |            |            | (29,548  | )         
|                                                                         |                                                                                          | Deferred revenue                       |                                            |            | 20,068,308         |            |            |            | 8,333    |           
|                                                                         |                                                                                          |                                        |                                            |            |                    |            |            |           
|                                                                         |                                                                                          |                                        | Net cash provided by operating activities: |            |                    | 16,085,278 |            |            |          | 2,827,445  |  
|                                                                         |                                                                                          |                                        |                                            |            |                    |            |            |           
|INVESTING ACTIVITIES:                                                    |                                                                                          |                                        |                                            |            |                    |            |            |           
|                                                                         | Investments in securities                                                                |                                        |                                            | (699,040   | )                  |            |            | (7,695,545 | )       
|                                                                         | Proceeds from sales and maturities of investments in securities                          |                                        |                                            | 1,800,000  |                    |            |            | 1,200,000  |         
|                                                                         | Patent costs                                                                             |                                        |                                            | (123,682   | )                  |            |            | (127,577   | )       
|                                                                         | Construction in progress                                                                 |                                        |                                            | (1,553,341 | )                  |            |            |           |         
|                                                                         | Purchases of property and equipment                                                      |                                        |                                            | (450,289   | )                  |            |            | (188,721   | )       
|                                                                         |                                                                                          |                                        |                                            |            |                    |            |            |           
|                                                                         |                                                                                          |                                        | Net cash used for investing activities     |            |                    | (1,026,352 | )          |            |          | (6,811,843 | )
|                                                                         |                                                                                          |                                        |                                            |            |                    |            |            |           
|FINANCING ACTIVITIES:                                                    |                                                                                          |                                        |                                            |            |                    |            |            |           
|                                                                         | Proceeds from issuance of common stock                                                   |                                        |                                            | 25,500     |                    |            |            | 90,000     |         
|                                                                         | Dividends paid on preferred stock                                                        |                                        |                                            | (6,250     | )                  |            |            | (6,250     | )       
|                                                                         | Payments on loans and capital lease obligations                                          |                                        |                                            | (140,362   | )                  |            |            | (95,724    | )       
|                                                                         |                                                                                          |                                        |                                            |            |                    |            |            |           
|                                                                         |                                                                                          |                                        | Net cash used for financing activities     |            |                    | (121,112   | )          |            |          | (11,974    | )
|                                                                         |                                                                                          |                                        |                                            |            |                    |            |            |           
|Net increase (decrease) in cash and cash equivalents                     |                                                                                          |                                        | 14,937,814                                 |            |                    |            | (3,996,372 | )         
|Cash and cash equivalents at beginning of period                         |                                                                                          |                                        | 8,630,547                                  |            |                    |            | 16,542,545 |           
|                                                                         |                                                                                          |                                        |                                            |            |                    |            |            |           
|Cash and cash equivalents at end of period                               |                                                                                          | $                                      | 23,568,361                                 |            |                    | $          | 12,546,173 |           
|                                                                         |                                                                                          |                                        |                                            |            |                    |            |            |           
|SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:                       |                                                                                          |                                        |                                            |            |                    |            |            |           
|Interest paid                                                            |                                                                                          | $                                      | 10,574                                     |            |                    | $          | 14,602     |           
|                                                                         |                                                                                          |                                        |                                            |            |                    |            |            |           
|SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND FINANCING
ACTIVITIES: |                                                                                          |                                        |                                            |            |                    |            |            |           
|Acquisition of equipment under capital leases                            |                                                                                          | $                                      |                                           |            |                    | $          | 113,036    |           
|                                                                        
|See notes to consolidated financial statements.                         

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AVANIR Pharmaceuticals

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

AVANIR Pharmaceuticals (AVANIR, we or the Company) has prepared the
unaudited consolidated financial statements in this quarterly report in
accordance with the instructions to Form 10-Q adopted under the Securities
Exchange Act of 1934. Certain information and footnote disclosures normally
included in consolidated financial statements prepared in accordance with
accounting principles generally accepted in the United States have been
condensed or omitted pursuant to such rules and regulations. These unaudited
consolidated financial statements should be read with our audited consolidated
financial statements and the accompanying notes included in our Annual Report
on Form 10-K for the fiscal year ended September 30, 2002. In our opinion, all
adjustments (consisting only of normal recurring adjustments) necessary to
present a fair statement of our financial position as of December 31, 2002 and
September 30, 2002, and the results of operations for the three months ended
December 31, 2002 and 2001, have been made. The results of operations for the
three months ended December 31, 2002 are not necessarily indicative of the
results for the fiscal year ending September 30, 2003 or any future periods.

2. RECLASSIFICATIONS

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

3. BALANCE SHEET DETAILS

Receivables. Receivables consist of the following:

|            |  |                   |         |                    |  |     |        |       |  |                   |         |               |  |   |           |  |  |   |   |  |  |   |           | 
|----------- |  | ----------------- | ------- | ------------------ |  | --- | ------ | ----- |  | ----------------- | ------- | ------------- |  | - | --------- |  |  | - | - |  |  | - | --------- | 
|            |  | December 31, 2002 |         | September 30, 2002
|            |  |                   |         |                   
|            |  | Gross             |         |                    |  |     |        |       |  |                   |         | Gross         |  |   |           |  |  |   |   | 
|            |  | Carrying          |         | Allowance for      |  |     |        |       |  | Carrying          |         | Allowance for |  |   |           | 
|            |  | Value             |         | Doubtful Accounts  |  | Net |        | Value |  | Doubtful Accounts |         | Net          
|            |  |                   |         |                    |  |     |        |       |  |                   |         |              
|Receivables |  | $                 | 238,110 |                    |  | $   | (5,372 | )     |  | $                 | 232,738 |               |  | $ | 1,098,954 |  |  | $ |  |  |  | $ | 1,098,954 | 
|            |  |                   |         |                    |  |     |        |       |  |                   |         |               |  |   |           |  |  |   |   |  |  |   |           | 

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

|                                          |                              |   |                   |           |                    |   |          |            |       |   |              |           |             |   |           |           |  |   |          |            |   |   |           |           | 
|----------------------------------------- | ---------------------------- | - | ----------------- | --------- | ------------------ | - | -------- | ---------- | ----- | - | ------------ | --------- | ----------- | - | --------- | --------- |  | - | -------- | ---------- | - | - | --------- | --------- | 
|                                          |                              |   | December 31, 2002 |           | September 30, 2002
|                                          |                              |   |                   |           |                   
|                                          |                              |   | Gross             |           |                    |   |          |            |       |   |              |           | Gross       |   |           |           |  |   |          |            |  
|                                          |                              |   | Carrying          |           | Accumulated        |   |          |            |       |   | Carrying     |           | Accumulated |   |           |           | 
|                                          |                              |   | Value             |           | Depreciation       |   | Net      |            | Value |   | Depreciation |           | Net        
|                                          |                              |   |                   |           |                    |   |          |            |       |   |              |           |            
|Research and development
equipment        |                              | $ | 2,566,008         |           |                    | $ | (963,820 | )          |       | $ | 1,602,188    |           |             | $ | 2,420,028 |           |  | $ | (867,991 | )          |   | $ | 1,552,037 |          
|Computer equipment and related
software   |                              |   | 974,469           |           |                    |   | (273,511 | )          |       |   | 700,958      |           |             |   | 851,952   |           |  |   | (238,199 | )          |   |   | 613,753   |          
|Leasehold improvements                    |                              |   | 871,196           |           |                    |   | (204,966 | )          |       |   | 666,230      |           |             |   | 866,318   |           |  |   | (175,410 | )          |   |   | 690,908   |          
|Office equipment, furniture, and
Fixtures |                              |   | 274,706           |           |                    |   | (138,725 | )          |       |   | 135,981      |           |             |   | 254,731   |           |  |   | (128,557 | )          |   |   | 126,174   |          
|Construction in progress                  |                              |   | 1,907,035         |           |                    |   |         |            |       |   | 1,907,035    |           |             |   | 198,094   |           |  |   |         |            |   |   | 198,094   |          
|                                          |                              |   |                   |           |                    |   |          |            |       |   |              |           |             |   |           |           |  |   |          |            |   |   |           |          
|                                          | Total property and equipment |   | $                 | 6,593,414 |                    |   | $        | (1,581,022 | )     |   | $            | 5,012,392 |             |   | $         | 4,591,123 |  |   | $        | (1,410,157 | ) |   | $         | 3,180,966 | 
|                                          |                              |   |                   |           |                    |   |          |            |       |   |              |           |             |   |           |           |  |   |          |            |   |   |           |          

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Intangible Assets.Effective October 1, 2002, the Company adopted SFAS No.
142, Goodwill and Other Intangible Assets, which requires goodwill and other
intangible assets that have indefinite useful lives to no longer be amortized;
however, these assets must be reviewed at least annually for impairment.
Intangible assets with indefinite useful lives consist of costs of trademarks
for AVANIR and Xenerex and similar names intended for use or potential use in
the United States and rest of world. There were no impairments to trademarks
during the three months ended December 31, 2002. Intangible assets with finite
lives continue to be 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.

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

|                                               |                             |   |                   |           |                    |   |          |          |       |   |              |           |             |   |           |         |  |   |          |          |   |   |           |         | 
|---------------------------------------------- | --------------------------- | - | ----------------- | --------- | ------------------ | - | -------- | -------- | ----- | - | ------------ | --------- | ----------- | - | --------- | ------- |  | - | -------- | -------- | - | - | --------- | ------- | 
|                                               |                             |   | December 31, 2002 |           | September 30, 2002
|                                               |                             |   |                   |           |                   
|                                               |                             |   | Gross             |           |                    |   |          |          |       |   |              |           | Gross       |   |           |         |  |   |          |          |  
|                                               |                             |   | Carrying          |           | Accumulated        |   |          |          |       |   | Carrying     |           | Accumulated |   |           |         | 
|                                               |                             |   | Value             |           | Amortization       |   | Net      |          | Value |   | Amortization |           | Net        
|                                               |                             |   |                   |           |                    |   |          |          |       |   |              |           |            
|Intangible
assets with finite lives:           |                             |   |                   |           |                    |   |          |          |       |   |              |           |             |   |           |         |  |   |          |          |   |   |           |        
|                                               | Patent applications pending |   | $                 | 1,046,620 |                    |   | $        |         |       |   | $            | 1,046,620 |             |   | $         | 966,781 |  |   | $        |         |   |   | $         | 966,781 | 
|                                               | Patents                     |   |                   | 776,541   |                    |   |          | (207,097 | )     |   |              | 569,444   |             |   |           | 741,175 |  |   |          | (192,190 | ) |   |           | 548,985 | 
|                                               | Licenses                    |   |                   | 41,216    |                    |   |          | (7,530   | )     |   |              | 33,686    |             |   |           | 41,215  |  |   |          | (6,445   | ) |   |           | 34,770  | 
|                                               | Licenses pending            |   |                   | 22,618    |                    |   |          |         |       |   |              | 22,618    |             |   |           | 22,101  |  |   |          |         |   |   |           | 22,101  | 
|                                               |                             |   |                   |           |                    |   |          |          |       |   |              |           |             |   |           |         |  |   |          |          |   |   |           |        
|Total intangible
assets with finite lives      |                             |   | 1,886,995         |           |                    |   | (214,627 | )        |       |   | 1,672,368    |           |             |   | 1,771,272 |         |  |   | (198,635 | )        |   |   | 1,572,637 |        
|Intangible assets with
indefinite useful lives |                             |   | 95,825            |           |                    |   |         |          |       |   | 95,825       |           |             |   | 86,781    |         |  |   |         |          |   |   | 86,781    |        
|                                               |                             |   |                   |           |                    |   |          |          |       |   |              |           |             |   |           |         |  |   |          |          |   |   |           |         | 
|Total intangible assets                        |                             | $ | 1,982,820         |           |                    | $ | (214,627 | )        |       | $ | 1,768,193    |           |             | $ | 1,858,053 |         |  | $ | (198,635 | )        |   | $ | 1,659,418 |        
|                                               |                             |   |                   |           |                    |   |          |          |       |   |              |           |             |   |           |         |  |   |          |          |   |   |           |        

Amortization expense related to amortizable intangible assets was $16,000
for the three months ending December 31, 2002, compared to $12,000 for the same
period in the prior year. Based solely on the amortizable intangible assets as
of December 31, 2002, the estimated annual amortization expense of
intangible assets for the fiscal years ending September 30 is as follows.
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 for        
|Fiscal Year Ending September 30,
|                                
|2003                             |          | $ | 47,148    |          
|2004                             |          |   | 63,139    |          
|2005                             |          |   | 61,094    |          
|2006                             |          |   | 60,109    |          
|2007                             |          |   | 58,842    |          
|Thereafter                       |          |   | 312,798   |          
|                                 |          |   |           |          
|                                 | Subtotal |   |           | 603,130   | 
|Patent
applications pending      |          |   | 1,046,620 |          
|Licenses
pending                 |          |   | 22,618    |          
|                                 |          |   |           |          
|                                 | Total    |   | $         | 1,672,368 | 
|                                 |          |   |           |          

4. USE OF ESTIMATES

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

5. INVENTORY

Inventory is stated at the lower of cost (first-in, first-out) or market.
Inventory consists primarily of the raw material docosanol, which is the active
ingredient in docosanol 10% cream. Docosanol in its present form as stored by
the Company has a substantial shelf life, a relatively stable value and
long-term use, and carries a low risk of becoming excess inventory or obsolete.
Avanir does not own or store any docosanol 10% cream in its finished product
form. The Company and one of its licensees receive raw materials from a single
supplier. Avanir also supplies several other licensees with raw materials from
the same supplier. The inability of a sole supplier to fulfill supply
requirements of the Company or its licensees could materially impact future
operating results. Avanir also holds in inventory small quantities of
dextromethorphan and quinidine, compounds useful in the manufacture of
Neurodex. Avanir is developing Neurodex as a potential treatment for
pseudobulbar affect and neuropathic pain.

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6. ASSET SALE

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

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

In recording the sale transaction, Avanir increased cash by $20.4 million (net
of transaction costs), reduced accrued expenses by $301,000 in connection with
the forgiveness of a related advance, and recorded deferred revenue in the
amount of $20.7 million. We recorded the initial net proceeds of the
transaction as deferred revenue because of our ongoing involvement in earning
future revenues under our license agreement with SB. Avanir will recognize the
deferred revenue amount as revenue over the life of the Drug Royalty USA
agreement. Revenue recognition will be under the units-of-revenue method.
Under this method, the amount of deferred revenue to be recognized as revenue
in each period will be calculated by multiplying (i) the ratio
of the unamortized deferred revenue amount to the total remaining royalties that we expect SB will pay Drug
Royalty USA over the term of the agreement, by (ii) the royalty payments due to
Drug Royalty USA for the period. The portion of deferred revenue classified as
part of current liabilities represents the amount Avanir expects to realize as
revenue within the next 12 months.

The following table sets forth the deferred revenue recorded from the sale to
Drug Royalty USA of rights to future Abreva royalties and the deferred revenue
balances as of December 31, 2002 and September 30, 2002.

|                                          |                                               |                               |            |               |            |            |         |         |         |   |            |            |            | 
|----------------------------------------- | --------------------------------------------- | ----------------------------- | ---------- | ------------- | ---------- | ---------- | ------- | ------- | ------- | - | ---------- | ---------- | ---------- | 
|                                          |                                               |                               |            | Drug Royalty  |            | Other      |         |         |         |  
|                                          |                                               |                               |            | USA Agreement |            | Agreements |         | Total  
|                                          |                                               |                               |            |               |            |            |         |        
|Deferred revenue as of September 30, 2002 |                                               | $                             |           |               |            | $          | 233,333 |         |         | $ | 233,333    |           
|                                          |                                               |                               |            |               |            |            |         |         |         |   |            |           
|Changes during period:                    |                                               |                               |            |               |            |            |         |         |         |   |            |           
|                                          | Proceeds from sale of future Abreva royalties |                               |            | 20,500,000    |            |            |         |        |         |   |            | 20,500,000 |           
|                                          | Less cost of transaction                      |                               |            | (143,982      | )          |            |         |        |         |   |            | (143,982   | )         
|                                          |                                               |                               |            |               |            |            |         |         |         |   |            |           
|                                          |                                               | Net proceeds                  |            |               | 20,356,018 |            |         |         |        |   |            |            | 20,356,018 | 
|                                          | Forgiveness of a related advance              |                               |            | 300,912       |            |            |         |        |         |   |            | 300,912    |           
|                                          |                                               |                               |            |               |            |            |         |         |         |   |            |           
|                                          |                                               | Additions to deferred revenue |            |               | 20,656,930 |            |         |         |        |   |            |            | 20,656,930 | 
|                                          |                                               |                               |            |               |            |            |         |         |         |   |            |           
|                                          | Recognized as revenues during period          |                               |            | (588,622      | )          |            |         |        |         |   |            | (588,622   | )         
|                                          |                                               |                               |            |               |            |            |         |         |         |   |            |           
|Deferred revenue as of December 31, 2002  |                                               | $                             | 20,068,308 |               |            | $          | 233,333 |         |         | $ | 20,301,641 |           
|                                          |                                               |                               |            |               |            |            |         |         |         |   |            |           
|Classified as:                            |                                               |                               |            |               |            |            |         |         |         |   |            |           
|                                          | Current portion of deferred revenue           |                               | $          | 1,938,137     |            |            | $       | 233,333 |         |   | $          | 2,171,470  |           
|                                          | Deferred revenue, net of current portion      |                               |            | 18,130,171    |            |            |         |        |         |   |            | 18,130,171 |           
|                                          |                                               |                               |            |               |            |            |         |         |         |   |            |           
|                                          |                                               | Total deferred revenue        |            | $             | 20,068,308 |            |         | $       | 233,333 |   |            | $          | 20,301,641 | 
|                                          |                                               |                               |            |               |            |            |         |         |         |   |            |           

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7. REVENUE RECOGNITION

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

Royalty revenues.We recognize royalty revenues from our licensed products when
earned. Net sales figures used for calculating royalties due to the Company
can often include deductions for costs of unsaleable returns, managed care

write-offs, which may vary over the course of the license agreement. Sales of
Abreva, if publicly reported by the licensees parent, GlaxoSmithKline, could
differ from net sales used in calculating royalties and in determining the
royalties earned in accordance with the license agreement. In agreements where
we have sold our rights to future royalties under license agreements and we
maintain continuing involvement in earning such royalties, we defer revenues
and recognize them ratably over the life of the license agreement.

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

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

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8. INVESTMENTS

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

|                         |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |           |           |  |  | 
|------------------------ | ----------------------- | -------------------------------- | ---------------------- | --------- | --------- | --------- | --------- | ---------- | ------ | ---------- | - | ------- | ------- | - | - | --------- | --------- |  |  | 
|                         |                         |                                  |                        |           |           |           |           |            |        | Gross      |   | Gross   |         |   |   |          
|                         |                         |                                  |                        |           |           | Amortized |           | Unrealized |        | Unrealized |   | Fair   
|                         |                         |                                  |                        |           |           | Cost      |           | Gains (2)  |        | Losses (2) |   | Value  
|                         |                         |                                  |                        |           |           |           |           |            |        |            |   |        
|As of December 31, 2002: |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          
|                         | Certificates of deposit |                                  | $                      | 2,256,597 |           |           | $         | 16,581     |        |            | $ |        |         |   | $ | 2,273,178 |          
|                         | Government securities   |                                  |                        | 980,196   |           |           |           |           |        |            |   | (12,860 | )       |   |   | 967,336   |          
|                         | Commercial paper        |                                  |                        | 200,000   |           |           |           | 4,418      |        |            |   |        |         |   |   | 204,418   |          
|                         |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          
|                         |                         | Total                            |                        | $         | 3,436,793 |           |           | $          | 20,999 |            |   | $       | (12,860 | ) |   | $         | 3,444,932 | 
|                         |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          
|Reported as:             |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          
|                         | Short-term investments: |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |           |          
|                         |                         | Classified as available-for-sale |                        | $         | 1,699,578 |           |           |            |        |            |   |         |         |   |   |           |           | 
|                         |                         | Classified as held-to-maturity   |                        |           | 200,000   |           |           |            |        |            |   |         |         |   |   |           |           | 
|                         |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          
|                         |                         |                                  | Short-term investments |           |           | 1,899,578 |           |            |        |            |   |         |         |   |   |           |           |  | 
|                         |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          
|                         | Long-term investments:  |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |           |          
|                         |                         | Classified as available-for-sale |                        |           | 684,339   |           |           |            |        |            |   |         |         |   |   |           |           | 
|                         |                         | Restricted investments (1)       |                        |           | 856,597   |           |           |            |        |            |   |         |         |   |   |           |           | 
|                         |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          
|                         |                         |                                  | Long-term investments  |           |           | 1,540,936 |           |            |        |            |   |         |         |   |   |           |           |  | 
|                         |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          
|                         |                         |                                  |                        | Total     |           | $         | 3,440,514 |            |        |            |   |         |         |   |   |           |           |  |  | 
|                         |                         |                                  |                        |           |           |           |           |            |        |            |   |         |         |   |   |          

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



|(1) |  | Restricted investments amounting to $856,597 as of December 31,
2002 and September 30, 2002 represent amounts that we pledged to our
bank as collateral for letters of credit that our bank issued in
connection with our leases of office and laboratory space.                                              
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) |  | Gross unrealized gains of $16,581 and gross unrealized losses of
$12,860 on government securities and certificates of deposit represent
an accumulated net unrealized gain of $3,721, which is reported as
Accumulated other comprehensive income on the consolidated balance
sheet as of December 31, 2002.
|   
|(3) |  | Gross unrealized gains of $13,607 and gross unrealized losses of
$12,900 on government securities and certificates of deposit represent
an accumulated net unrealized gain of $707, which is reported as
Accumulated other comprehensive income on the consolidated balance
sheet as of September 30, 2002. 

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9. COMPUTATION OF NET INCOME AND NET LOSS PER COMMON SHARE

We compute basic net income (loss) per common share by dividing the net income
and 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 income (loss) per common share by dividing the net income
and 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 income and net loss per share for the three-month
periods ended December 31, 2002 and 2001 using the Basic EPS Method and the
Diluted EPS Method.

The following table provides a reconciliation from the basic to the diluted EPS
computations for the three months ended December 31, 2002 and 2001:

|                                                                                    |                                 |                                                                         |                                                 |                                                                                                  |            |                                 |            |           |           |            |           | 
|----------------------------------------------------------------------------------- | ------------------------------- | ----------------------------------------------------------------------- | ----------------------------------------------- | ------------------------------------------------------------------------------------------------ | ---------- | ------------------------------- | ---------- | --------- | --------- | ---------- | --------- | 
|                                                                                    |                                 |                                                                         |                                                 |                                                                                                  |            | Three Months Ended December 31,
|                                                                                    |                                 |                                                                         |                                                 |                                                                                                  |            |                                
|                                                                                    |                                 |                                                                         |                                                 |                                                                                                  |            | 2002                            |            | 2001     
|                                                                                    |                                 |                                                                         |                                                 |                                                                                                  |            |                                 |            |          
|Numerator:                                                                          |                                 |                                                                         |                                                 |                                                                                                  |            |                                 |            |          
|                                                                                    |                                 | Net income (loss)                                                       |                                                 | $                                                                                                | (4,237,999 | )                               |            | $         | 2,765,509 |           
|Less:                                                                               |                                 |                                                                         |                                                 |                                                                                                  |            |                                 |            |          
|                                                                                    |                                 | Dividends on redeemable convertible preferred stock                     |                                                 |                                                                                                  | (6,250     | )                               |            |           | (6,250    | )         
|                                                                                    |                                 | Accretion of discount related to redeemable convertible preferred stock |                                                 |                                                                                                  | (4,609     | )                               |            |           | (4,609    | )         
|                                                                                    |                                 |                                                                         |                                                 |                                                                                                  |            |                                 |            |          
|                                                                                    |                                 |                                                                         |                                                 | Net income (loss) attributable to common shareholders for basic
earnings per share computation   |            |                                 | (4,248,858 | )         |           |            | 2,754,650 | 
|Effect of dilutive securities:                                                      |                                 |                                                                         |                                                 |                                                                                                  |            |                                 |            |          
|                                                                                    |                                 | Convertible preferred stock                                             |                                                 |                                                                                                  |           |                                 |            |           | (23,857   | )         
|                                                                                    |                                 |                                                                         |                                                 |                                                                                                  |            |                                 |            |          
|                                                                                    |                                 |                                                                         |                                                 | Net income (loss) attributable to common shareholders for diluted
earnings per share computation |            | $                               | (4,248,858 | )         |           | $          | 2,730,793 | 
|                                                                                    |                                 |                                                                         |                                                 |                                                                                                  |            |                                 |            |           |           |            |           | 
|Denominator:                                                                        |                                 |                                                                         |                                                 |                                                                                                  |            |                                 |            |          
|Shares for basic net income or loss per share  weighted average shares
outstanding |                                 |                                                                         | 58,296,555                                      |                                                                                                  |            |                                 | 58,029,403 |          
|Effect of dilutive securities:                                                      |                                 |                                                                         |                                                 |                                                                                                  |            |                                 |            |          
|                                                                                    | Stock options (1)               |                                                                         |                                                 |                                                                                                 |            |                                 |            | 2,551,715 |          
|                                                                                    | Stock warrants (2)              |                                                                         |                                                 |                                                                                                 |            |                                 |            | 687,452   |          
|                                                                                    | Convertible preferred stock (3) |                                                                         |                                                 |                                                                                                 |            |                                 |            | 186,929   |          
|                                                                                    |                                 |                                                                         |                                                 |                                                                                                  |            |                                 |            |          
|                                                                                    |                                 |                                                                         | Shares for diluted net income or loss per share |                                                                                                  |            | 58,296,555                      |            |           |           | 61,455,499 |          
|                                                                                    |                                 |                                                                         |                                                 |                                                                                                  |            |                                 |            |          
|Basic net income (loss) per share                                                   |                                 | $                                                                       | (0.07                                           | )                                                                                                |            | $                               | 0.05       |          
|                                                                                    |                                 |                                                                         |                                                 |                                                                                                  |            |                                 |            |          
|Diluted net income (loss) per share                                                 |                                 | $                                                                       | (0.07                                           | )                                                                                                |            | $                               | 0.04       |          
|                                                                                    |                                 |                                                                         |                                                 |                                                                                                  |            |                                 |            |          



---

|(1) |  | For the three months ended December 31, 2002 and 2001, options to
purchase 5,758,176 and 343,260 shares of common stock, respectively,
were excluded from the computation of diluted earnings per share, as
the inclusion of such shares would be antidilutive.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(2) |  | For the three months ended December 31, 2002, warrants to purchase
1,084,550 shares of common stock were excluded from the computation of
diluted earnings per share, as the inclusion of such shares would be
antidilutive.                                   
|(3) |  | For the three months ended December 31, 2002, preferred stock
convertible into 668,920 shares of common stock was excluded from the
computation of diluted earnings per share, as the inclusion of such
shares would be anti-dilutive.                         

10. SHAREHOLDERS EQUITY

Preferred Stock

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

11



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##### Table of Contents



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

Series D Redeemable Convertible Preferred Stock.At December 31, 2002 and
September 30, 2002, 50 shares of Series D redeemable convertible preferred
stock (Series D Shares) remained outstanding in connection with a securities
purchase agreement made with certain investors on March 22, 1999. The Series
D holders may convert any or all of the remaining Series D Shares into shares
of Class A common stock at a conversion rate equal to $10,000 divided by a
conversion price equal to the lesser of:



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



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

Class A Common Stock

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

11. RECENT ACCOUNTING PRONOUNCEMENTS

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

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

In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities, which addresses financial accounting and
reporting for costs associated with exit or disposal activities and supersedes
EITF Issue 94-3, Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring). SFAS No. 146 requires that a liability for a cost
associated with an exit or disposal activity be recognized when the liability
is incurred. Under Issue 94-3, a liability for an exit cost as defined in EITF
94-3 was

12



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recognized at the date of an entitys commitment to an exit plan. SFAS
No. 146 also establishes that the liability should initially be measured and
recorded at fair value. The Company will adopt the provisions of SFAS No. 146
for exit or disposal activities that are initiated after December 31, 2002.

In November 2002, the FASB issued FASB Interpretation No. 45, Guarantors
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others, which elaborates on the disclosures to
be made by a guarantor about its obligation under certain guarantees issued.
It also clarifies that a guarantor is required to recognize, at the inception
of a guarantee, a liability for the fair value of the obligation undertaken in
issuing the guarantee. The Interpretation expands on the accounting guidance
of SFAS No. 5, Accounting for Contingencies, SFAS No. 57, Related Party
Disclosures, and SFAS No. 107, Disclosures about Fair Value of Financial
Instruments. It also incorporates without change the provisions of FASB
Interpretation No. 34, Disclosure of Indirect Guarantees of Indebtedness of
Others. Companies must implement the initial recognition and measurement
provision of Interpretation No. 45 for guarantees issued or modified after
December 31, 2002. The disclosures of Interpretation No. 45 are effective for
financial statements of interim or annual periods ending after December 31,
2002. The Company does not believe the adoption of Interpretation No. 45 will
have a material impact on the Companys financial statements.

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

compensation. In addition, SFAS No. 148 amends the disclosure requirements of
SFAS No. 123 to require prominent disclosures in both annual and interim
financial statements about the method of accounting for stock-based
compensation and the effect of the method used on reported results. The
voluntary transition and amended disclosure requirements are effective for the
Company for the fiscal year ending September 30, 2003. The interim reporting
requirements are effective for the Companys interim periods beginning January
1, 2003. The Company currently accounts for stock-based employee compensation
under the intrinsic value method in accordance with APB No. 25. The Company
does not plan to voluntarily change its method of accounting, but will
implement the amended disclosure requirements beginning in the quarter ending
March 31, 2003.

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

13



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

Overview

Avanir Pharmaceuticals, based in San Diego and incorporated in California in
1988, is a biopharmaceutical drug discovery and development company engaged in
research, development, commercialization, licensing and sales of innovative
drug products and antibody generation services. Avanirs first commercialized
product, docosanol 10% cream, is a topical treatment for cold sores. The
product is also known as Abreva in the United States and Canada, Herepair in
South Korea and Abrax in Israel. Avanir has out-licensed docosanol 10% cream
in the United States and in several foreign countries. Avanir is continuing to
expand its commercialization efforts for docosanol 10% cream while pursuing a
broader effort to discover new drugs and develop others that are already in our
development pipeline.

Avanirs product pipeline consists of programs in both clinical and
pre-clinical stages. Avanirs research is focused primarily on discovery and
development of small molecules that can be taken orally as potential treatments
for several central nervous system disorders, inflammatory diseases and
cholesterol reduction. Avanirs subsidiary, Xenerex Biosciences, is engaged in
research aimed at developing completely human antibody products to target
antigens, including antigens provided by partner companies.

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

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Both Avanirs and Xenerexs offices and research facilities are located at
11388 Sorrento Valley Road, Suite 200, San Diego, California 92121. Our
telephone number is (858) 622-5200 and our e-mail address is info@AVANIR.com.
Additional information about Avanir and Xenerex can be found on our website, at
www.AVANIR.com, and in our periodic and current reports filed with the SEC.
Copies of our current and periodic reports filed with the SEC are available at
the SEC Public Reference Room at 450 Fifth Street, N.W., Washington, D.C.
20549, and online at www.sec.govand our website at www. AVANIR.com.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

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

Our critical accounting policies are those that affect our financial statements
materially and involve a significant level of judgment by management. We
believe these policies are principally revenue recognition, as it relates to
milestone payments, royalties, the sale of rights to future royalties and
research contracts.

Milestone Payments in License Agreements

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

Our largest and most significant license agreement is with SB Pharmco Puerto
Rico, Inc., a subsidiary of GlaxoSmithKline (GlaxoSmithKline). On March 31,
2000, we transferred the rights to manufacture, use, and sell Abreva in the
United States and Canada to GlaxoSmithKline and gave them full control,
authority and responsibility over research, development, registration including
actions required to obtain appropriate government approvals, and
commercialization of the product in that territory. 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, 2002, substantially all of our royalties have come from
GlaxoSmithKline. We have entered into additional license agreements that
contain royalties as a source of revenues, and we expect to enter into
additional similar license agreements with foreign-based companies.

15



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Sale of Rights to Future Abreva Royalties

In December 2002, we sold an undivided interest in our license agreement with
SB Pharmco Puerto Rico, Inc. (SB or GlaxoSmithKline) to Drug Royalty USA,
Inc. (Drug Royalty USA) and received an initial payment of $20.5 million.
Because of our ongoing involvement with GlaxoSmithKline in earning future
royalty revenues, we have recorded the amount received from Drug Royalty USA,
net of costs of the transaction and after the forgiveness of certain advances,
as deferred revenue. (See Note 6, Asset Sale, in the accompanying financial
statements.) The amount recorded as deferred revenue will be recognized as
revenue under the units-of-revenue method. Under this method, the amount of
deferred revenue to be recognized as revenue in each period will be calculated
by multiplying (i) the ratio of the unamortized deferred revenue amount to the total
remaining royalties that we expect SB will pay Drug Royalty USA over the term of the
agreement, by (ii) the royalty payments due to Drug Royalty USA for the period.
The portion of deferred revenue classified as part of current liabilities
represents the amount Avanir expects to realize as revenue within the next 12
months.

Research Contracts

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

As of December 31, 2002, Xenerex Biosciences, our subsidiary, was engaged in
work on three research collaboration agreements, all of which have research
initiation fees. In these agreements, the customer provides antigens to
Xenerex. Xenerex then performs research to develop potential antibodies for
those antigens. If, after a reasonable commercial effort is made to develop an
antibody, it is determined that none exists, the contract is complete and the
initiation fee is recognized. If antibodies are developed, they are provided
to the customer and a determination is made by the customer whether to have
Xenerex perform further research or terminate the remaining contract. If the
customer decides to have Xenerex continue research on the developed antibodies,
there exists in the contract milestones that are tied to the completion of the
different phases of the project. Examples of milestones include when the
customer files the Biologics License Application and when the customer obtains
regulatory approval.

Recently, Xenerex completed its work under the research collaboration agreement
with Eos Biotechnology, Inc. (Eos). On January 31, 2003, Xenerex and Eos
mutually terminated the research collaboration agreement. Xenerex has been
paid in full for its research services and has no additional performance
obligations under the agreement. On February 4, 2003, Eos and Protein Design
Labs, Inc. (PDL), announced that they had entered into a definitive merger
agreement under which PDL, a competitor to Xenerex, would acquire Eos.

The research collaboration agreements also set forth the royalties payable to
Xenerex based on product sales by the customer, assuming the customer
successfully develops and obtains marketing approval for a given product. The
license fees and royalty rates, while set forth in each research collaboration
agreement, would still be subject to completion of a definitive license
agreement with the customer.

Xenerex research initiation fees.The Company defers research initiation fees
and recognizes such fees as revenue once Xenerex has completed its efforts to
create antibodies. Under existing research agreements, if Xenerex fails to
create antibodies, then the contract may be terminated with no additional
performance obligations. At such time, the earnings process is considered
complete, provided Xenerex has made a commercially reasonable effort to create
antibodies. The status of Xenerexs two existing collaborative research
agreements, as of February 6, 2003, is as follows:

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| |  | Peregrine Pharmaceuticals. The Peregrine contract provides for the
creation of antibodies to three target antigens provided by Peregrine.
Xenerex is engaged in the second stage of the research collaboration
agreement for one of the three target antigens. The second stage is
intended to provide Peregrine with more information on selected panels
of the antibodies that meet the antibody characteristics desired by
Peregrine. In the first fiscal quarter 2002, we earned and recognized a
pro-rata portion of the research initiation fee as research contract
revenue. In the first fiscal quarter 2003, we completed other research
services for Peregrine and recognized the revenues after the work had
been completed to the customers satisfaction. We have not completed
the performance associated with stage two nor achieved any of the other
milestones in the research collaboration agreement.
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| 
| |  | DNAX Research, Inc. The DNAX contract provides for the creation of
antibodies to two target antigens provided by DNAX. We have not
completed the commercial efforts associated with the research initiation
fees or achieved any of the milestones in the agreement. Therefore, as
of December 31, 2002, we had not earned or recognized any revenues under
the agreement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

Xenerexs receipt of milestone
payments. In the research phases of the
research collaboration agreement, Xenerex may receive payment either to start a
research phase or to complete a research phase (including receipt by the
customer of the deliverable). Xenerex recognizes revenue once the product has
been delivered, because the earning process would be complete and an exchange
has been made. Factors taken into consideration in recognizing revenues include
the following:



| |  | The performance criteria have been met;                                                                                              
|- |  | -------------------------------------------------------------------------------------------------------------------------------------
| 
| |  | Any undelivered products or services are not essential to the
functionality of the delivered products or services;                   
| 
| |  | Payment for the delivered products or services is not contingent on
delivery of the remaining products or services; and              
| 
| |  | We have an enforceable claim to receive the amount due in the event we
do not deliver the remaining undelivered products or services.

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

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

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RESULTS OF OPERATIONS 
THREE MONTHS ENDED DECEMBER 31, 2002

Revenues

Revenues in the first quarter of fiscal 2003 amounted to $819,000, compared to
$6.1 million for the same period last year. Revenues in the first quarter of
fiscal year 2003 included $589,000 in revenues that the Company recognized from
the sale of certain rights to future Abreva royalties to Drug Royalty USA,
$158,000 from government research grants and $72,000 in other revenues. Other
revenues were from a research contract, sales of docosanol raw material, and
royalties on sales of Herepair (docosanol 10% cream) in South Korea. Revenues
in the first quarter of fiscal 2002 included $1.1 million in royalties on
Abreva product sales and the final $5 million milestone from GlaxoSmithKline
when Abreva reached the one-year anniversary of the product launch.

In recording the sale transaction to Drug Royalty USA, Avanir increased cash by
$20.4 million (net of transaction costs), reduced accrued
expenses by $301,000
in connection with the forgiveness of a related advance, and recorded deferred
revenue in the amount of $20.7 million. We will be recognizing the amount
received from Drug Royalty USA as revenues over approximately a twelve-year
period of the royalty rights sold. (See Note 6, Asset Sale, in the
accompanying financial statements for a detailed description of how the
payments under the agreement with Drug Royalty USA will be recognized.)

During fiscal 2003, we expect to recognize approximately $2.0 million in
revenues from the sale transaction to Drug Royalty USA, with a corresponding
reduction in deferred revenue. Also during the fiscal year, we expect to earn
approximately $600,000 in revenues from research being performed under
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.

Revenue-generating Contracts

As of February 6, 2003, we had eight commercial contracts, one license purchase
agreement, and three government-funded research grants that are generating or
could generate revenues in the future to help fund our research and development
programs. Five of the commercial contracts are in the form of docosanol 10%
cream (Abreva) license agreements, one contract is for a Neurodex license, and
two contracts are through Xenerex and are in the form of antibody research
service agreements. Avanir also is engaged in research funded by $1.2 million
in government research grants. The government research grants are to be used
for investigating the development of a potential docosanol-based genital herpes
product and an antibody to anthrax.

For the last three years, GlaxoSmithKline has been our most significant revenue
source, representing over 95% of the Companys revenues in fiscal 2002. A list
of our revenue-generating contractual arrangements is set forth in the
following table.

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##### Table of Contents



Revenue-generating Contracts

|                                                                                                                 |  |                                                                                                                  |  |                                   |  |                                                                     
|---------------------------------------------------------------------------------------------------------------- |  | ---------------------------------------------------------------------------------------------------------------- |  | --------------------------------- |  | --------------------------------------------------------------------
|                                                                                                                 |  | Type of Agreement                                                                                                |  | Date of Agreement                 |  | Product License, Sale,                                              
|Company or Research Grant                                                                                        |  | or Grant Award                                                                                                   |  | or Grant Award                    |  | Service or Research                                                 
|                                                                                                                 |  |                                                                                                                  |  |                                   |  |                                                                     
|GlaxoSmithKline                                                                                                  |  | Undivided interest in the
license agreement for
Abreva®
(U.S. and Canada)                                        |  | March 31, 2000                    |  | Cold sore product license                                           
|                                                                                                                 |  |                                                                                                                  |  |                                   |  |                                                                     
|Drug Royalty USA                                                                                                 |  | License Purchase Agreement,
representing an undivided
interest in the Abreva
license agreement (U.S.
and Canada) |  | November 22, 2002                 |  | Sale of undivided
interest in Abreva
license agreement and
royalties
|                                                                                                                 |  |                                                                                                                  |  |                                   |  |                                                                     
|CTS Chemical Industries, LTD                                                                                     |  | Docosanol license (known
as Abrax in Israel)                                                                     |  | July 6, 1993                      |  | Cold sore product license                                           
|                                                                                                                 |  |                                                                                                                  |  |                                   |  |                                                                     
|Boryung Pharmaceuticals Co., LTD                                                                                 |  | Docosanol license (known
as Herepair in South
Korea)                                                             |  | March 11, 1994                    |  | Cold sore product license                                           
|                                                                                                                 |  |                                                                                                                  |  |                                   |  |                                                                     
|BioPharm Group                                                                                                   |  | Docosanol license
(Egypt)                                                                                        |  | January 11, 2002                  |  | Cold sore product license                                           
|                                                                                                                 |  |                                                                                                                  |  |                                   |  |                                                                     
|Bruno Farmaceutici S.p.A                                                                                         |  | Docosanol license
(Italy)                                                                                        |  | July 29, 2002                     |  | Cold sore product license                                           
|                                                                                                                 |  |                                                                                                                  |  |                                   |  |                                                                     
|Medison Pharma, Ltd.                                                                                             |  | Neurodex license
(Israel)                                                                                        |  | August 6, 2002                    |  | Pseudobulbar Affect
research agreement and
license                  
|                                                                                                                 |  |                                                                                                                  |  |                                   |  |                                                                     
|Peregrine Pharmaceuticals                                                                                        |  | Antibody research                                                                                                |  | June 7, 2001                      |  | Antibody generation
services                                        
|                                                                                                                 |  |                                                                                                                  |  |                                   |  |                                                                     
|DNAX Research, Inc.                                                                                              |  | Antibody research                                                                                                |  | January 21, 2002                  |  | Antibody generation
services                                        
|                                                                                                                 |  |                                                                                                                  |  |                                   |  |                                                                     
|Small Business Innovative
Research (SBIR) Grant Program
and California Technology
Investment Partnership Program |  | Federal research grant and
State research grant                                                                  |  | March 12, 2002 and
April 26, 2002 |  | Pre-clinical research of
potential genital herpes
product           
|                                                                                                                 |  |                                                                                                                  |  |                                   |  |                                                                     
|California Center for Advanced
Technology (CCAT)                                                                 |  | Department of Defense
grant administered through
San Diego State University
Foundation                           |  | June 19, 2002                     |  | Pre-clinical anthrax
antibody research                              

Expenses

Operating Expenses. Total operating expenses were $5.1 million in the first
fiscal quarter 2003, compared to $3.6 million in the same period in fiscal
2002. The 41% increase in operating expenses was primarily caused by a 54%
increase in spending on research and development programs. Research and
development programs accounted for 71% and 65% of total operating expenses for
the fiscal quarters ended December 31, 2002 and 2001, respectively. General
and administrative expenses accounted for 21% and 26% of total operating
expenses for the fiscal quarters ended December 31, 2002 and 2001,
respectively. Sales and marketing expenses accounted for 8% and 9% of total
operating expenses for the fiscal quarters ended December 31, 2002 and 2001,
respectively. These and other costs are more fully described below.

Research and Development
Expenses. Research and development (R&D) expenses
were $3.6 million in the first fiscal quarter 2003, compared to $2.3 million in
the same period a year ago. Costs associated with completion of toxicology and
other pre-clinical research related to Avanirs lead compound for the treatment
of allergies and asthma accounted for 29% of total R&D spending in the first
fiscal quarter

19



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2003. The Phase III clinical trial for Neurodex in the treatment of
pseudobulbar affect (PBA) in patients with multiple sclerosis
accounted for 17% (including allocated laboratory occupancy costs)
of all R&D spending in the first fiscal quarter 2003. The Phase III clinical
trial program for Neurodex had reached approximately 15% of completion as of
December 31, 2002. The balance of R&D spending was for other programs,
including pre-clinical research related to inflammation and
cholesterol-lowering compounds and antibody research programs.

In the first fiscal quarter 2002, R&D expenses were primarily related to the
cost of initiating the Phase II/III clinical trial for Neurodex in treating
emotional lability and development of the antibody generation technology. The
Neurodex Phase II/III clinical trial began in November 2000.

We expect R&D spending will continue to increase through the next several
quarters as we expand our clinical development programs by initiating a Phase I
clinical trial for the treatment of allergy and allergic asthma.

A summary of our R&D spending by program is shown in the table that follows.

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Research and Development Projects and Other Research Programs Expense

|                                                                                                                                                                                                                                                                                                                               |  |                    |  |               |  |                |  |                   
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------------ |  | ------------- |  | -------------- |  | ------------------
|                                                                                                                                                                                                                                                                                                                               |  | Three Months Ended |  | Inception     |  |               
|                                                                                                                                                                                                                                                                                                                               |  | December 31,       |  | Through       |  | Estimated Cost
|                                                                                                                                                                                                                                                                                                                               |  |                    |  | December 31,  |  | To Complete   
|Company-Funded Projects (1):                                                                                                                                                                                                                                                                                                   |  | 2002(2)            |  | 2001(2)       |  | 2002 (2)(3)    |  | Project(2)        
|Development of Neurodex for FDA
marketing approval in treating PBA.
Initial Phase II/III clinical trial
has been completed and a Phase III
clinical trial and open label study
are underway. Estimated timing to
complete all phases of project
necessary to file a New Drug
Application with the FDA: mid-calendar year 2004. |  | $   630,151        |  | $   557,233   |  | $   7,140,798  |  | $   7-9 million   
|                                                                                                                                                                                                                                                                                                                               |  |                    |  |               |  |                |  |                   
|Development of Neurodex for
partnering or licensing outside the
U.S. as potential treatment for
neuropathic pain at end of Phase II
clinical trials. Phase II
dose-ranging trial is currently
underway. Estimated timing to
complete project: second quarter of
calendar year
2003.                                            |  | 110,191            |  | 287,061       |  | 3,276,072      |  | $   1.0 million   
|                                                                                                                                                                                                                                                                                                                               |  |                    |  |               |  |                |  |                   
|Develop AVP-13358 as an IgE
Regulator for partnering or
licensing as treatment for allergy
and asthma after completion of Phase
I clinical trials. Estimated timing
to complete project: fourth quarter
of calendar year 2003.                                                                                                 |  | 1,348,312          |  | 612,420       |  | 13,086,872     |  | $   3-4 million   
|                                                                                                                                                                                                                                                                                                                               |  |                    |  |               |  |                |  |                   
|Government-Funded Projects:                                                                                                                                                                                                                                                                                                    |  |                    |  |               |  |                |  |                   
|Pre-clinical research for potential
treatments for genital herpes and
anthrax. Estimated timing to
complete the various projects varies
from one to two years.                                                                                                                                                                 |  | 184,054            |  |              |  | 562,133        |  | $   1.0
million(4)
|                                                                                                                                                                                                                                                                                                                               |  |                    |  |               |  |                |  |                   
|Other Pre-clinical Research
Projects:                                                                                                                                                                                                                                                                                          |  |                    |  |               |  |                |  |                   
|Use of proprietary drug discovery
and technology platforms (MIF, CCM,
monoclonal antibody technology) to
pursue potential treatments for
inflammation and high cholesterol.
The costs and timing to complete our
pre-clinical research are
unpredictable because of the
uncertainty of outcomes of our
research.               |  | 1,338,914          |  | 890,145       |  | 10,137,690     |  |                  
|                                                                                                                                                                                                                                                                                                                               |  |                    |  |               |  |                |  |                   
|                                                                                                                                                                                                                                                                                                                               |  |                    |  |               |  |                |  |                   
|                                                                                                                                                                                                                                                                                                                               |  |                    |  |               |  |                |  |                   
|Total                                                                                                                                                                                                                                                                                                                          |  | $3,611,622         |  | $   2,346,859 |  | $   34,203,565 |  |                   
|                                                                                                                                                                                                                                                                                                                               |  |                    |  |               |  |                |  |                   

| |    |  |                                                                                                                                                                                              
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. |  | At December 31, 2002, we held the worldwide rights to manufacture,
market and sell all of the products in clinical development and any of
the products that might come from our R&D programs.
| |    |  |                                                                                                                                                                                              
| | 2. |  | Each project
includes allocation of laboratory occupancy costs.                                                                                                                              
| |    | 
| | 3. |  | Inception dates are on or after October 1, 1998, at which time we
began identifying and tracking costs for these research programs.                                                          
| |    |  |                                                                                                                                                                                              
| | 4. |  | The Company was awarded $1.2 million in state and federal research
grants related to genital herpes and anthrax research.                                                                    
| |    | 

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General and Administrative Expenses. General and administrative expenses
amounted to $1.1 million in the first fiscal quarter 2003, representing a 13%
increase over expenses of $954,000 in the same period in the prior year.
Higher expenses were attributable to increased staff size to support growing
R&D and commercial development programs. General and administrative expenses
continued the trend established in fiscal 2002 of growing at a slower rate than
R&D and sales and marketing expenses. The Company continues to concentrate its
efforts on R&D programs and market research for Neurodex and expects that
near-term increases in general and administrative expenses will be moderate.

Sales and Marketing Expenses. During the first fiscal quarter 2003, sales and
marketing expenses were $425,000, compared to $320,000 in the same period a
year ago. Higher expenses in the first fiscal quarter 2003 were related to
market research and initial planning and preparation for product launch of
Neurodex for the treatment of peusdobulbar affect. Sales and marketing
activity for the same period in fiscal year 2002 was relatively low while we
directed most of our efforts toward licensing of docosanol 10% cream in
overseas markets.

Net Income (Loss) from Operations

For the first fiscal quarter 2003, the net loss from operations was $4.3
million, compared to $2.5 million in net income from operations for the same
period a year ago. Contributing to the $6.8 million period-to-period decline
in profitability were lower revenues from milestones and higher operating
expenses. Revenues in the first fiscal quarter 2002 included a $5 million
milestone payment from GlaxoSmithKline. Operating expenses, amounting to $5.1
million in the first fiscal quarter 2003, were higher by $1.5 million, compared
with the same period a year ago. Higher operating expenses reflected the
greater number and extent of R&D programs, increased staff size in the general
and administrative areas, and increases in sales and marketing activities,
including market research and planning the product launch of Neurodex for the
treatment of pseudobulbar affect.

Other Income and Expenses

Interest Income. In the first fiscal quarter 2003, interest income amounted to
$68,000, compared to $188,000 for the same period a year ago. The decrease in
interest income during the first fiscal quarter 2003 was primarily due to lower
interest rates on investments and lower average invested amounts compared with
the same period a year ago.

Other Income. Other income amounting to $6,000 in the first fiscal quarter
2003 represents rental income on emergency standby power generating equipment.
Other income, amounting to $83,000 in the first fiscal quarter 2002, represents
fees earned under a contract that provided for an exclusive negotiating period,
rental income for use of the Companys conference center and rental income on
emergency standby power generating equipment.

Interest Expense. In the first fiscal quarter 2003, interest expense amounted
to $11,000, compared to $15,000 for the same period a year ago. Lower interest
expense for the first fiscal quarter 2003 was due to lower interest rates on
extended payment plans for our insurance policies.

Net Income (Loss)

For the first fiscal quarter 2003, the net loss attributable to common
shareholders was $4.2 million, compared to net income attributable to common
shareholders of $2.8 million for the same period a year ago. The basic and
diluted net loss per share was $0.07 for the first fiscal quarter 2003,
compared to basic net income per share of $0.05 and diluted net income per
share of $0.04 for the same period a year ago.

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For the remainder of the 2003 fiscal year, we expect to continue our current
operating plan, which emphasizes clinical development of products intended for
the treatment of three different diseases. We intend to continue to develop
Neurodex for the treatment of both pseudobulbar affect (PBA) (Phase III status)
and neuropathic pain (Phase II status). We also intend to begin a Phase I
clinical trial of our lead compound for the treatment of allergy and asthma in
the next few months. We expect that our spending on clinical trials and
earlier stage R&D programs, combined with other operating costs, will exceed
our revenues for at least the next two quarters. We anticipate that we will
file a New Drug Application with the FDA in the first half of calendar year
2004 for Neurodex for the treatment of PBA.

LIQUIDITY AND CAPITAL RESOURCES

As of December 31, 2002, we had cash and cash equivalents of $23.6 million,
short and long-term investments of $2.6 million (excluding restricted
investments of $857,000) and a net working capital balance of $20.2 million,
compared to cash and cash equivalents of $8.6 million, short and long-term
investments of $3.7 million (excluding restricted investments of $857,000) and
a net working capital balance of $5.9 million as of September 30, 2002.
Explanations of the changes in cash balances related to operating, financing
and investing activities are provided below.

Operating Activities. Net cash provided by operating activities amounted to
$16.1 million in the first fiscal quarter 2003, compared to $2.8 million during
the same period a year ago. On December 24, 2002, we sold to Drug Royalty USA
an undivided interest in our Abreva license agreement with GlaxoSmithKline and
received $20.4 million, net of transaction costs. The net cash provided by
operating activities in the first fiscal quarter 2003 reflects the $20.4
million in cash received from Drug Royalty USA, partially offset by the $4.2
million net loss for the quarter. The sale of rights to future Abreva
royalties was recorded as deferred revenue on the date of sale. (See Note 6,
Asset Sale in the accompanying notes to the financial statements.) For the
first fiscal quarter 2002, net income of $2.8 million accounted for most of the
net cash provided by operating activities.

Investing Activities. Net cash used for investing activities during the first
fiscal quarter 2003 amounted to $1.0 million, including investments in
securities totaling $700,000, capital expenditures of $2.0 million and patent
costs of $124,000, partially offset by sales and maturities of investments
totaling $1.8 million. Net cash used for investing activities during the first
fiscal quarter 2002 amounted to $6.8 million, including investments in
securities totaling $7.7 million, capital expenditures of $189,000 and patent
costs of $128,000, partially offset by sales and maturities of investments
totaling $1.2 million.

Financing Activities. Net cash used for financing activities amounted to
$121,000 during the first fiscal quarter 2003, compared to $12,000 for the same
period a year ago. We believe that cash and short and long-term investments
totaling $26.2 million at December 31, 2002, plus anticipated future revenues,
should be sufficient to sustain our planned level of operations for at least
the next 12 months. Additionally, to continue to enhance our capital base and
liquidity and to continue to fund the development of our drug candidates and
technology platforms, we expect to continue to pursue various alternatives for
raising additional funds during the next twelve months. Potential alternatives
that we are considering for raising capital include, but are not limited to,
partnering arrangements where partners share development costs, issuance of
debt or equity securities, and licensing or sales of any of our platform
technologies or new drug candidates.

RECENT ACCOUNTING PRONOUNCEMENTS

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

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RISK FACTORS THAT MIGHT AFFECT FUTURE OPERATIONS

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

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



| |  |  | Limited rights to future Abreva royalties  In December 2002 we sold
to Drug Royalty USA the rights to a substantial portion of 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 we would not receive
any royalty payments on these excess sales until after the end of each
calendar year.                                                                                                                                                                                                                                                                                              
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Concentration of significant customers, suppliers and industries 
Milestone payments and royalties earned from a single licensee
(GlaxoSmithKline) accounted for approximately 95% and 99% of our fiscal
2002 and 2001 revenues, respectively. We have now received all of the
milestone payments from GlaxoSmithKline. With the sale of our Abreva
royalty rights to Drug Royalty USA, future royalty revenues 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.                                                                                                                                                                                                          

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

Avanir and its licensees face a wide variety of risks in 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;                                                                                                                         

24



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| |  |  | consumers may not perceive that docosanol 10% cream is superior to
existing and potentially new OTC products for oral herpes;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------
|
| |  |  | acceptance of docosanol 10% cream in the OTC consumer market may not
be widespread; and                                      
|
| |  |  | potential price erosion could occur due to competitive products and
responses to our products introduction.                 

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

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

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

Abreva competes with several other products for oral-facial herpes currently on
the market in the U.S., as well as other products or potential products that
are or may be under development or undergoing FDA review. Most of our
competitors, including such companies as Bayer Corp. and Schering Plough, have
substantial financial resources, research and development facilities and
manufacturing and marketing experience. Even with Abreva being marketed by one
of the worlds largest consumer healthcare companies, GlaxoSmithKline, not all
competitive responses and the impacts of those responses can be foreseen.

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

In order to maintain sufficient cash and investments for future operations, we
anticipate that we may raise additional capital in the next twelve months
through the sale of shares of our Class A common stock. If we raise capital by
issuing additional shares of Class A common stock at a price per share less
than the then-current market price per share, then the value of the shares of
Class A common stock outstanding will be diluted or reduced. Further, even if
we were to sell shares of common stock at prices higher than the current market
price, the issuance of additional shares may depress the market price of our
common stock. If we are unable to raise additional capital to fund future
operations, then we might have to reduce operations or defer or abandon one or
more of our clinical research programs. Any abandonment or program deferral
could be viewed negatively by the marketplace.

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

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



| |  |  | difficulties in obtaining regulatory approval of docosanol 10% cream in foreign countries;                           
| | - |  | ---------------------------------------------------------------------------------------------------------------------
|
| |  |  | changes in the regulatory and competitive environments in foreign countries;                                         
|
| |  |  | changes in a specific countrys or regions political or economic conditions;                                        
|
| |  |  | difficulty in finding foreign partners with sufficient capital to
effectively launch, market and promote the product;
|
| |  |  | shipping delays;                                                                                                     
|
| |  |  | difficulties in managing operations across disparate geographic areas;                                               
|
| |  |  | fluctuations in foreign currency exchange rates;                                                                     
|
| |  |  | prices of competitive products;                                                                                      
|
| |  |  | difficulties associated with enforcing agreements through foreign legal systems;                                     
|
| |  |  | trade protection measures, including customs duties and export quotas; and                                           
|
| |  |  | foreign tax withholding laws.                                                                                        

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

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

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

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

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

The drug development process is lengthy and capital intensive. Our drug
development programs are exposed to all of the risks inherent in product
development based on innovative technologies, including unanticipated
development problems and the possible lack of funding or collaborative
partners. Any of a number of problems in the development process could result
in the abandonment or substantial change in the development of a specific
product. Our Phase III clinical trial of Neurodex for the treatment of
pseudobulbar affect in MS patients may experience setbacks or failures for
reasons we have not anticipated. Our Phase II open-label dose escalation
clinical trial of Neurodex for the treatment of neuropathic pain may not show
proof of concept. Our observations during pre-clinical research of our lead
compound for treating allergy and asthma may not be relevant to the development
of, indicate the efficacy of, or have the safety profile necessary for, a
proposed product for human use. Unsuccessful clinical trial results for our
proposed products could affect materially and adversely our future business
operations and financial condition.

Business interruptions could adversely affect our business.

Our operations are vulnerable to interruption by fire, earthquake, power loss,
telecommunications failure, terrorist attacks and other events beyond our
control. For example, during 2001, California experienced shortages in
adequate supply of electricity, resulting in rolling blackouts, where certain
areas were not provided with any electricity for periods of up to two hours.
The immediate impact was a significant increase in power rates. Additionally,
the loss of electrical power or blackouts for any significant periods of time
could harm our vendors and our ability to conduct experiments and provide
services. Further, we could lose valuable data made to date in experiments
currently underway. We have attempted to mitigate the severity of power losses
by installing emergency power equipment, which we intend to use for those
electrical needs that we consider to be the most critical to operating our
business. However, the emergency power unit does not cover all of our
electrical needs and, further, it might not operate properly in the event of a
power loss.

Our acquisition and alliance activities, if any, could disrupt our ongoing
business.

We intend to continue to make investments in new products and technologies. We
also intend to continue to acquire or in-license technologies. Further, we
could merge with another company to expand our product development pipeline and
sales revenues. Acquisitions and strategic alliances often involve risks,
including: difficulty in assimilating the acquired technologies, operations
and employees, difficulty in managing research collaborations, difficulty in
retaining key employees of an acquired operation,

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disruption of our ongoing business, inability to successfully integrate the acquired technology and
operations into our business and lack of experience in developing the acquired
technology.

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

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

Our future success also depends on our continuing ability to identify, hire,
train and retain highly qualified, technical, sales, marketing and customer
service personnel. We presently employ approximately 60 people. Further, we
expect to hire additional people over the next twelve months. Other than our
chief executive officer, our executives do not have employment agreements. We
do not have key person life insurance policies for any of our executives.
The industry in which we compete has a high level of employee mobility and
aggressive recruiting of skilled personnel. This type of environment creates
intense competition for qualified personnel, particularly in product research
and development, sales and marketing, and accounting and finance.

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

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



| |  |  | the claims in the pending patent applications will be allowed or that
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.                  

Additionally, we have applied for a five-year extension for one of our key
docosanol patents. If the patent extension is granted, we will receive
approximately $3.6 million from Drug Royalty USA in connection with the sale of
our future Abreva royalty rights. There can be no assurance, however, that the
patent extension will be granted or that we will receive this payment.

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

The process for the approval of patent applications in foreign countries may
differ significantly from the process in the U.S. These differences may delay
our plans to market and sell docosanol 10% cream and other products in the
international marketplace. Approval in one country does not 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 develop independently similar or superior technology. Additionally,
if our consultants, key employees or other third parties apply technological
information independently developed by them or by others to our projects, then
disputes may arise as to the ownership rights of these innovations. It is
costly to litigate these disputes and an unfavorable result could adversely
affect our intellectual property portfolio as well as our business and
financial condition.

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

The testing, marketing, and sale of pharmaceutical products involves the risk
of product liability claims by consumers and other third parties. We maintain
product liability insurance coverage for our clinical trials in the amount of
$2 million per incident and $2 million in the aggregate. However, product
liability claims can be high in the pharmaceutical industry and our insurance
may not sufficiently cover our actual liabilities. If a suit against our
business or proposed products is successful, then the lack or insufficiency of
insurance coverage could affect materially and adversely our business and
financial condition. Furthermore, various distributors of pharmaceutical
products require minimum product liability insurance coverage before their
purchase or acceptance of products for distribution. Failure to satisfy these
insurance requirements could impede our ability to achieve broad distribution
of our proposed products.

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

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

The conversion of redeemable convertible preferred stock currently outstanding
will have a dilutive effect on our Class A common stock.

As of February 6, 2003, the Company had outstanding 50 shares of Series D
redeemable convertible preferred stock. The Series D stock can be converted at
any time into shares of our Class A common stock at a price equal to 86% of the
then-current market price. Based on our stock price as of December 31, 2002,
these shares would convert into 668,920 shares of Class A common stock. If our

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stock price were to drop, the number of shares that may be acquired upon conversion of the Series D
stock would proportionately increase.

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

We do not intend to declare or pay cash dividends on our Class A or Class B
common stock in the foreseeable future. We expect to retain any earnings, if
and when achieved, to finance our business.




Item 3.            QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK

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

Interest rate sensitivity

Our investment portfolio consists primarily of fixed income instruments with an
average duration of 1.6 years as of December 31, 2002 (2.3 years as of
September 30, 2002). The primary objective of our investments in debt
securities is to preserve principal while achieving attractive yields, without
significantly increasing risk. We carry some investments that we intend to
hold to maturity and others that we classify as available-for-sale. These
available-for-sale securities are subject to interest rate risk. In general,
we would expect that the volatility of this portfolio would increase as its
duration increases.




Item 4.            CONTROLS AND PROCEDURES

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) |  |  | 99.1  |  |  | Certification pursuant to Section 906 of Sarbanes-Oxley Act of 2002
|    |  |  | 99.2  |  |  | Certification pursuant to Section 906 of Sarbanes-Oxley Act of 2002
|    |  |  |       |  |  |                                                                    
|(b) |  |  | None. |  |  |                                                                    

SIGNATURES

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

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

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CERTIFICATIONS

I, Gregory P. Hanson, certify that:

1.     I have reviewed this quarterly report on Form 10-Q of Avanir
Pharmaceuticals;

2.     Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this report;

3.     Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;

4.     The registrants other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a)        designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;

b)        evaluated the effectiveness of the registrants disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the Evaluation Date); and

c)        presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;

5.     The registrants other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrants auditors and the audit committee of
the registrants board of directors (or persons performing the equivalent
functions):

a)        all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrants ability to record,
process, summarize, and report financial data and have identified for the
registrants auditors any material weaknesses in internal controls; and

b)        any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrants internal controls;
and

6.     The registrants other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.

|                        |  |                        
|----------------------- |  | -----------------------
|Date: February 14, 2003 |  | /s/ Gregory P. Hanson  
|                        |  |                        
|                        |  | Gregory P. Hanson      
|                        |  | Chief Financial Officer

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I, Gerald J. Yakatan, certify that:

1.     I have reviewed this quarterly report on Form 10-Q of Avanir
Pharmaceuticals;

2.     Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this report;

3.     Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;

4.     The registrants other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a)         designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;

b)         evaluated the effectiveness of the registrants disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the Evaluation Date); and

c)         presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;

5.     The registrants other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrants auditors and the audit committee of
the registrants board of directors (or persons performing the equivalent
functions):

a)         all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrants ability to record,
process, summarize, and report financial data and have identified for the
registrants auditors any material weaknesses in internal controls; and

b)         any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrants internal controls;
and

6.     The registrants other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.

|                        |  |                        
|----------------------- |  | -----------------------
|Date: February 14, 2003 |  | /s/ Gerald J. Yakatan  
|                        |  |                        
|                        |  | Gerald J. Yakatan      
|                        |  | Chief Executive Officer

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EXHIBIT INDEX

|            |  |                                                                    
|----------- |  | -------------------------------------------------------------------
|Exhibit No. |  | Description                                                        
|            |  |                                                                    
|99.1        |  | Certification pursuant to Section 906 of Sarbanes-Oxley Act of 2002
|99.2        |  | Certification pursuant to Section 906 of Sarbanes-Oxley Act of 2002

34