##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

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

For the Quarterly period ended June 30, 2001.

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. 000-31101

APPLIED MOLECULAR EVOLUTION, INC.

(Exact name of registrant as specified in its charter)


|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 33-0374014                          
|                                                               |  |                                     
|(State or other jurisdiction of
incorporation or organization) |  | (I.R.S. Employer
Identification No.)

3520 Dunhill Street
San Diego, California 92121

(Address of principal executive offices and zip code)


(858) 597-4990

(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 Exchange Act of
1934 during the preceding 12 months (or for such shorter period 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 [   ]

As of July 31, 2001, 23,602,663 shares of the Registrants Common Stock were
issued and outstanding.





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TABLE OF CONTENTS



|                              |                                                                                               |                                            |  |  |  |  |  | 
|----------------------------- | --------------------------------------------------------------------------------------------- | ------------------------------------------ |  |  |  |  |  | 
|PART I: FINANCIAL INFORMATION
|                              | ITEM 1: Financial Statements                                                                 
|                              |                                                                                               | CONSOLIDATED BALANCE SHEETS               
|                              |                                                                                               | CONSOLIDATED STATEMENTS OF OPERATIONS     
|                              |                                                                                               | CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                              |                                                                                               | NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|                              | ITEM 2: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
|                              | ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                           
|PART II: OTHER INFORMATION   
|                              | ITEM 1: LEGAL PROCEEDINGS                                                                    
|                              | ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS                                            
|                              | ITEM 3: DEFAULTS UPON SENIOR SECURITIES                                                      
|                              | ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                  
|                              | ITEM 5: OTHER INFORMATION                                                                    
|                              | ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K                                                     
|SIGNATURES                   



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##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.
FORM 10-Q INDEX

|                               |                                                                                                |                                                                                                             |    |      |   | 
|------------------------------ | ---------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------- | -- | ---- | - | 
|                               |                                                                                                |                                                                                                             |    | PAGE
|                               |                                                                                                |                                                                                                             |    |     
|PART I:  FINANCIAL INFORMATION |                                                                                                |                                                                                                             |    |     
|                              
|                              
|                              
|                              
|                               | ITEM 1:  Financial Statements                                                                  |                                                                                                             |    | 3    |  
|                              
|                              
|                              
|                              
|                               |                                                                                                | Consolidated Balance Sheets at June 30, 2001 (unaudited) and December 31, 2000                              |    |      | 3 | 
|                              
|                              
|                              
|                              
|                               |                                                                                                | Consolidated Statements of Operations for the three and six months ended June 30, 2001 and 2000 (unaudited) |    |      | 4 | 
|                              
|                              
|                              
|                              
|                               |                                                                                                | Consolidated Statements of Cash Flows for the six months ended June 30, 2001 and 2000 (unaudited)           |    |      | 5 | 
|                              
|                              
|                              
|                              
|                               |                                                                                                | Notes to Consolidated Financial Statements (unaudited)                                                      |    |      | 6 | 
|                              
|                              
|                              
|                              
|                               | ITEM 2:  Managements Discussion and Analysis of Financial Condition and Results of Operations |                                                                                                             |    | 7    |  
|                              
|                              
|                              
|                              
|                               | ITEM 3:  Quantitative and Qualitative Disclosures About Market Risk                            |                                                                                                             |    | 12   |  
|                              
|                              
|                              
|                              
|PART II:  OTHER INFORMATION    |                                                                                                |                                                                                                             |    |     
|                              
|                              
|                              
|                              
|                               | ITEM 1:  Legal Proceedings                                                                     |                                                                                                             |    | 12   |  
|                              
|                              
|                              
|                              
|                               | ITEM 2:  Changes in Securities and Use of Proceeds                                             |                                                                                                             |    | 13   |  
|                              
|                              
|                              
|                              
|                               | ITEM 3:  Defaults Upon Senior Securities                                                       |                                                                                                             |    | 13   |  
|                              
|                              
|                              
|                              
|                               | ITEM 4:  Submission of Matters to a Vote of Security Holders                                   |                                                                                                             |    | 13   |  
|                              
|                              
|                              
|                              
|                               | ITEM 5:  Other Information                                                                     |                                                                                                             |    | 13   |  
|                              
|                              
|                              
|                              
|                               | ITEM 6:  Exhibits and Reports on Form 8-K                                                      |                                                                                                             |    | 13   |  
|                              
|                              
|                              
|                              
|SIGNATURES                     |                                                                                                |                                                                                                             | 15 |     

2



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APPLIED MOLECULAR EVOLUTION, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

|                                     |                                                                                                                                                                           |                                            |       |             |        |              |       |         |        | 
|------------------------------------ | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ----- | ----------- | ------ | ------------ | ----- | ------- | ------ | 
|                                     |                                                                                                                                                                           |                                            |       | JUNE 30,    |        | DECEMBER 31,
|                                     |                                                                                                                                                                           |                                            |       | 2001        |        | 2000        
|                                     |                                                                                                                                                                           |                                            |       |             |        |             
|                                     |                                                                                                                                                                           |                                            |       | (UNAUDITED) |        |             
|ASSETS                               |                                                                                                                                                                           |                                            |       |             |        |              |       |        
|                                    
|                                    
|                                    
|                                    
|Current assets:                      |                                                                                                                                                                           |                                            |       |             |        |              |       |        
|                                    
|                                    
|                                    
|                                    
|                                     | Cash and cash equivalents                                                                                                                                                 |                                            | $     | 23,308      |        |              | $     | 36,865  |       
|                                    
|                                    
|                                    
|                                    
|                                     | Short-term investments                                                                                                                                                    |                                            |       | 62,566      |        |              |       | 52,685  |       
|                                    
|                                    
|                                    
|                                    
|                                     | Prepaid expenses                                                                                                                                                          |                                            |       | 242         |        |              |       | 552     |       
|                                    
|                                    
|                                    
|                                    
|                                     | Other current assets                                                                                                                                                      |                                            |       | 1,629       |        |              |       | 2,317   |       
|                                     |                                                                                                                                                                           |                                            |       |             |        |              |       |        
|                                     |                                                                                                                                                                           | Total current assets                       |       |             | 87,745 |              |       |         | 92,419 | 
|                                    
|                                    
|                                    
|                                    
|Property and equipment, net          |                                                                                                                                                                           |                                            | 2,800 |             |        |              | 851   |        
|                                    
|                                    
|                                    
|                                    
|Patents, net                         |                                                                                                                                                                           |                                            | 1,596 |             |        |              | 1,532 |        
|                                    
|                                    
|                                    
|                                    
|Other assets                         |                                                                                                                                                                           |                                            | 115   |             |        |              | 72    |        
|                                     |                                                                                                                                                                           |                                            |       |             |        |              |       |        
|                                     |                                                                                                                                                                           | Total assets                               |       | $           | 92,256 |              |       | $       | 94,874 | 
|                                     |                                                                                                                                                                           |                                            |       |             |        |              |       |        
|LIABILITIES AND STOCKHOLDERS EQUITY |                                                                                                                                                                           |                                            |       |             |        |              |       |        
|                                    
|                                    
|                                    
|                                    
|Current liabilities:                 |                                                                                                                                                                           |                                            |       |             |        |              |       |        
|                                    
|                                    
|                                    
|                                    
|                                     | Accounts payable and accrued liabilities                                                                                                                                  |                                            | $     | 1,429       |        |              | $     | 1,579   |       
|                                    
|                                    
|                                    
|                                    
|                                     | Current portion of deferred revenue                                                                                                                                       |                                            |       | 238         |        |              |       | 258     |       
|                                    
|                                    
|                                    
|                                    
|                                     | Current portion of long-term obligations                                                                                                                                  |                                            |       | 8           |        |              |       | 17      |       
|                                     |                                                                                                                                                                           |                                            |       |             |        |              |       |        
|                                     |                                                                                                                                                                           | Total current liabilities                  |       |             | 1,675  |              |       |         | 1,854  | 
|                                    
|                                    
|                                    
|                                    
|Deferred revenue                     |                                                                                                                                                                           |                                            | 513   |             |        |              | 631   |        
|                                    
|                                    
|                                    
|                                    
|Deferred rent                        |                                                                                                                                                                           |                                            | 92    |             |        |              | 100   |        
|                                    
|                                    
|                                    
|                                    
|Minority interest                    |                                                                                                                                                                           |                                            | 238   |             |        |              | 372   |        
|                                    
|                                    
|                                    
|                                    
|Stockholders equity:                |                                                                                                                                                                           |                                            |       |             |        |              |       |        
|                                    
|                                    
|                                    
|                                    
|                                     | Preferred stock, $.001 par value, 5,000,000 shares authorized, none issued                                                                                                |                                            |       |            |        |              |       |        |       
|                                    
|                                    
|                                    
|                                    
|                                     | Common stock, $.001 par value, 45,000,000 shares authorized,
23,601,963 and 23,592,264 shares issued and outstanding at
June 30, 2001 and December 31, 2000, respectively |                                            |       | 24          |        |              |       | 24      |       
|                                    
|                                    
|                                    
|                                    
|                                     | Additional paid-in-capital                                                                                                                                                |                                            |       | 159,158     |        |              |       | 158,776 |       
|                                    
|                                    
|                                    
|                                    
|                                     | Deferred compensation                                                                                                                                                     |                                            |       | (7,112      | )      |              |       | (10,918 | )     
|                                    
|                                    
|                                    
|                                    
|                                     | Notes receivable from employees                                                                                                                                           |                                            |       | (854        | )      |              |       | (827    | )     
|                                    
|                                    
|                                    
|                                    
|                                     | Accumulated other comprehensive income                                                                                                                                    |                                            |       | 499         |        |              |       | 180     |       
|                                    
|                                    
|                                    
|                                    
|                                     | Accumulated deficit                                                                                                                                                       |                                            |       | (47,577     | )      |              |       | (40,918 | )     
|                                    
|                                    
|                                    
|                                    
|                                     | Less: Treasury stock at cost - 1,200,000 shares                                                                                                                           |                                            |       | (14,400     | )      |              |       | (14,400 | )     
|                                     |                                                                                                                                                                           |                                            |       |             |        |              |       |        
|                                     |                                                                                                                                                                           | Total stockholders equity                 |       |             | 89,738 |              |       |         | 91,917 | 
|                                     |                                                                                                                                                                           |                                            |       |             |        |              |       |        
|                                     |                                                                                                                                                                           | Total liabilities and stockholders equity |       | $           | 92,256 |              |       | $       | 94,874 | 
|                                     |                                                                                                                                                                           |                                            |       |             |        |              |       |        

See accompanying notes.

3



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APPLIED MOLECULAR EVOLUTION, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)

|                                                                        |                                    |   |                             |       |                           |   |         |       |      |   |        |        |  |   |         |       | 
|----------------------------------------------------------------------- | ---------------------------------- | - | --------------------------- | ----- | ------------------------- | - | ------- | ----- | ---- | - | ------ | ------ |  | - | ------- | ----- | 
|                                                                        |                                    |   | THREE MONTHS ENDED JUNE 30, |       | SIX MONTHS ENDED JUNE 30,
|                                                                        |                                    |   |                             |       |                          
|                                                                        |                                    |   | 2001                        |       | 2000                      |   | 2001    |       | 2000
|                                                                        |                                    |   |                             |       |                           |   |         |       |     
|Revenue                                                                
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|                                                                        | Contract revenue                   | $ | 320                         |       |                           | $ | 318     |       |      | $ | 570    |        |  | $ | 1,039   |      
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|                                                                        | Other revenue                      |   |                             | 444   |                           |   |         | 59    |      |   |        | 1,046  |  |   |         | 169   | 
|                                                                        |                                    |   |                             |       |                           |   |         |       |      |   |        |        |  |   |         |      
|                                                                        | Total revenue                      |   |                             | 764   |                           |   |         | 377   |      |   |        | 1,616  |  |   |         | 1,208 | 
|                                                                        |                                    |   |                             |       |                           |   |         |       |      |   |        |        |  |   |         |      
|Operating expenses                                                     
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|                                                                        | Research and development           |   | 2,592                       |       |                           |   | 809     |       |      |   | 4,831  |        |  |   | 1,476   |      
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|                                                                        | General and administrative         |   |                             | 1,095 |                           |   |         | 502   |      |   |        | 2,221  |  |   |         | 921   | 
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|                                                                        | Non-cash, stock based compensation |   |                             | 1,820 |                           |   |         | 4,249 |      |   |        | 4,112  |  |   |         | 5,434 | 
|                                                                        |                                    |   |                             |       |                           |   |         |       |      |   |        |        |  |   |         |      
|                                                                        | Total operating expenses           |   |                             | 5,507 |                           |   |         | 5,560 |      |   |        | 11,164 |  |   |         | 7,831 | 
|                                                                        |                                    |   |                             |       |                           |   |         |       |      |   |        |        |  |   |         |      
|Loss from operations                                                    |                                    |   | (4,743                      | )     |                           |   | (5,183  | )     |      |   | (9,548 | )      |  |   | (6,623  | )    
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|Minority interest                                                       |                                    |   | 147                         |       |                           |   | 35      |       |      |   | 134    |        |  |   | 78      |      
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|Interest income, net                                                    |                                    |   | 1,239                       |       |                           |   | 84      |       |      |   | 2,755  |        |  |   | 123     |      
|                                                                        |                                    |   |                             |       |                           |   |         |       |      |   |        |        |  |   |         |      
|Net loss                                                                |                                    |   | (3,357                      | )     |                           |   | (5,064  | )     |      |   | (6,659 | )      |  |   | (6,422  | )    
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|Deemed dividend on Series F preferred stock                             |                                    |   |                            |       |                           |   | (10,100 | )     |      |   |       |        |  |   | (10,100 | )    
|                                                                        |                                    |   |                             |       |                           |   |         |       |      |   |        |        |  |   |         |      
|Net loss applicable to common stockholders                              |                                    | $ | (3,357                      | )     |                           | $ | (15,164 | )     |      | $ | (6,659 | )      |  | $ | (16,522 | )    
|                                                                        |                                    |   |                             |       |                           |   |         |       |      |   |        |        |  |   |         |      
|Net loss per share applicable to common stockholders, basic
and diluted |                                    | $ | (0.16                       | )     |                           | $ | (5.73   | )     |      | $ | (0.31  | )      |  | $ | (6.32   | )    
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|Net loss per share, basic and diluted                                   |                                    | $ | (0.16                       | )     |                           | $ | (1.91   | )     |      | $ | (0.31  | )      |  | $ | (2.46   | )    
|                                                                       
|                                                                       
|                                                                       
|                                                                       
|Weighted average shares outstanding, basic and diluted                  |                                    |   | 21,355                      |       |                           |   | 2,648   |       |      |   | 21,240 |        |  |   | 2,613   |      

See accompanying notes.

4



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APPLIED MOLECULAR EVOLUTION, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)

|                                                                            |                                                     |   |                           |       |      |   |        |       |  
|--------------------------------------------------------------------------- | --------------------------------------------------- | - | ------------------------- | ----- | ---- | - | ------ | ----- | -
|                                                                            |                                                     |   | SIX MONTHS ENDED JUNE 30,
|                                                                            |                                                     |   |                          
|                                                                            |                                                     |   | 2001                      |       | 2000
|                                                                            |                                                     |   |                           |       |     
|OPERATING ACTIVITIES                                                        |                                                     |   |                           |       |      |   |        |      
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Net loss                                                                    |                                                     | $ | (6,659                    | )     |      | $ | (6,422 | )    
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Adjustments to reconcile net loss to net cash
used in operating activities: |                                                     |   |                           |       |      |   |        |      
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Depreciation and amortization                       |   |                           | 345   |      |   |        | 122   |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Amortization of stock-based compensation            |   |                           | 3,806 |      |   |        | 5,096 |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Compensation related to consultant stock options    |   |                           | 306   |      |   |        | 338   |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Deferred revenue                                    |   |                           | (138  | )    |   |        | (118  | )
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Deferred rent                                       |   |                           | (8    | )    |   |        | (7    | )
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Minority interest                                   |   |                           | (134  | )    |   |        | (78   | )
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Realized gain on short-term investments             |   |                           | (155  | )    |   |        |      |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Accrued interest on notes receivable from employees |   |                           | (27   | )    |   |        |      |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Changes in operating assets and liabilities:                                |                                                     |   |                           |       |      |   |        |      
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Prepaid expenses and other assets                   |   |                           | 955   |      |   |        | (769  | )
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Accounts payable and accrued expenses               |   |                           | (150  | )    |   |        | 275   |  
|                                                                            |                                                     |   |                           |       |      |   |        |      
|Net cash flows used in operating activities                                 |                                                     |   | (1,859                    | )     |      |   | (1,563 | )    
|                                                                            |                                                     |   |                           |       |      |   |        |      
|INVESTING ACTIVITIES                                                        |                                                     |   |                           |       |      |   |        |      
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Purchase of property and equipment                                          |                                                     |   | (2,233                    | )     |      |   | (218   | )    
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Purchase of short-term investments                                          |                                                     |   | (37,901                   | )     |      |   | (1,907 | )    
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Proceeds from sale of short-term investments                                |                                                     |   | 28,494                    |       |      |   | 534    |      
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Patents                                                                     |                                                     |   | (125                      | )     |      |   | (196   | )    
|                                                                            |                                                     |   |                           |       |      |   |        |      
|Net cash flows used in investing activities                                 |                                                     |   | (11,765                   | )     |      |   | (1,787 | )    
|                                                                            |                                                     |   |                           |       |      |   |        |      
|FINANCING ACTIVITIES                                                        |                                                     |   |                           |       |      |   |        |      
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Payments on long-term obligations                                           |                                                     |   | (9                        | )     |      |   | (9     | )    
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Issuance of preferred stock, net                                            |                                                     |   |                          |       |      |   | 10,028 |      
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Issuance of common stock, net                                               |                                                     |   | 76                        |       |      |   | 288    |      
|                                                                            |                                                     |   |                           |       |      |   |        |      
|Net cash flows provided by financing activities                             |                                                     |   | 67                        |       |      |   | 10,307 |      
|                                                                            |                                                     |   |                           |       |      |   |        |      
|Net increase (decrease) in cash and cash equivalents                        |                                                     |   | (13,557                   | )     |      |   | 6,957  |      
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Cash and cash equivalents at the beginning of the period                    |                                                     |   | 36,865                    |       |      |   | 1,974  |      
|                                                                            |                                                     |   |                           |       |      |   |        |      
|Cash and cash equivalents at the end of the period                          |                                                     | $ | 23,308                    |       |      | $ | 8,931  |      
|                                                                            |                                                     |   |                           |       |      |   |        |      

See accompanying notes.

5



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APPLIED MOLECULAR EVOLUTION, INC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1.    Organization and Business



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Applied Molecular Evolution, Inc., or the Company or AME, a Delaware
corporation, was incorporated on August 14, 1989. The Company has a broad
technology platform termed AMEsystem, which the Companys management
believes will provide AME with a valuable and efficient solution to
optimizing proteins with commercial potential. To date, the Company has
successfully utilized its proprietary technology to optimize monoclonal
antibodies for pharmaceutical and biotechnology companies.

2.    Basis of Presentation



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all the
information and footnotes required by generally accepted accounting
principles for complete financial statements. In the opinion of management,
all adjustments (consisting of normal recurring accruals) considered
necessary for a fair presentation have been included. The results of
operations for the interim period are not necessarily indicative of results
to be expected for any other interim period or for the year as a whole. These
unaudited consolidated financial statements and footnotes thereto should be
read in conjunction with the audited financial statements and footnotes
thereto contained in the Companys annual report on Form 10-K for the year
ended December 31, 2000.



| |                                                                                                                                                                                                                                                                                                                               
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The preparation of financial statements in accordance with generally accepted
accounting principles requires management to make estimates and assumptions
that affect amounts reported in the consolidated financial statements and
related footnotes. Changes in the estimates may affect amounts reported in
future periods.



| |                                                                                                                                                                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The consolidated financial statements include the accounts of the Company and
Novasite Pharmaceuticals, Inc., or Novasite, which is 72% owned by AME and
which was incorporated in July 1999. All significant intercompany accounts
and transactions have been eliminated.

3.    Comprehensive Loss



| |                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------
| | Total comprehensive loss was $6,340,000 for the six months ended June 30,
2001, and $6,418,000 for the six months ended June 30, 2000.

4.    Computation of Net Loss Per Share



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Basic and diluted net loss per share are presented in conformity with
Statement of Financial Accounting Standards No. 128 Earnings per Share
(SFAS No. 128) and Staff Accounting Bulletin 98 issued by the Staff of the
Securities and Exchange Commission (SAB 98), for all periods presented. Under
the provisions of SAB 98, common and preferred stock that has been issued or
granted for nominal consideration prior to the anticipated effective date of
the initial public offering must be included in the calculation of basic and
diluted net loss per share as if these shares had been outstanding for all
periods presented. To date, the Company has not issued or granted shares for
nominal consideration. In accordance with SFAS No. 128, basic and diluted net
loss per share has been computed using the weighted average number of shares
of common stock outstanding during the period, less shares subject to
repurchase.

5.    Recently Issued Accounting Pronouncements



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Company adopted SFAS No. 133, Accounting for Derivative Instruments and
Hedging Activities (SFAS No. 133), effective January 1, 2001. SFAS No. 133
establishes accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts
(collectively referred to as derivatives), and for hedging activities. It
requires that an entity recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those
instruments at fair value. The adoption of SFAS No. 133 had no effect on the
financial statements as the Company currently does not invest in derivative
instruments or engage in hedging activities.

6



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6.    Subsequent Events.



| |                                                                                                                                
| | -------------------------------------------------------------------------------------------------------------------------------
| | A description of certain litigation is described in Part II, Item 1, Legal
Proceedings of this Quarterly Report on Form 10-Q.







ITEM 2:   MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

The statements in this quarterly report that are not descriptions of historical
facts may be forward-looking statements that are subject to risks and
uncertainties. Actual results could differ materially from those currently
anticipated due to a number of factors, including those identified below and in
our other publicly available documents. We are under no obligation to update
any of these forward-looking statements after the filing of this quarterly
report to reflect actual results or changes in our expectations.

The following information should be read in conjunction with the consolidated
financial statements and the notes thereto included in Item 1 of this quarterly
report. We also urge readers to review and consider our disclosures describing
various factors that affect our business, including the disclosures under
Managements Discussion and Analysis of Financial Condition and Results of
Operations and Risk Factors and the audited financial statements and notes
thereto contained in our annual report on Form 10-K for the year ended December
31, 2000.

OVERVIEW

We are a leader in the application of directed evolution to the development of
biotherapeutics. Directed evolution is a process by which genes and proteins
are optimized for specific commercial purposes. We focus principally on
applying our technology to human biotherapeutics, the largest and most
profitable target market for directed evolution.

Since our formation, we have expended considerable resources on the development
of our AMEsystem technology and the development of Vitaxin, a product candidate
engineered from an antibody we licensed from The Scripps Research Institute.
Much of our research and development from 1995-1999 was allocated to
preclinical development and initial clinical trials for Vitaxin. In 1999 we
licensed Vitaxin to MedImmune, which is responsible for future clinical
development expenses and commercialization. To date, MedImmune has initiated
Phase I and Phase I/II clinical trials with an improved, second generation
version of Vitaxin that we enhanced using our AMEsystem technology.

To date we have generated revenue from research collaborations, product and
technology licenses, prepaid royalties and government grants. We have strategic
collaborations with MedImmune, Bristol-Myers Squibb, Seattle Genetics, Cell
Matrix, and Biosynexus. We have licensed intellectual property to Biosite
Incorporated, formerly Biosite Diagnostics Incorporated in exchange for a
non-refundable, prepaid, fixed royalty which is being recognized over six
years, the estimated useful lives of the related patents. Our government grants
have come from the National Institutes of Health. Research funding from
corporate collaborators and government grants is recognized as revenue when the
services are rendered.

We have incurred losses since our inception. As of June 30, 2001, we had an
accumulated deficit of $47.6 million. These losses and this accumulated deficit
resulted from the significant costs incurred in the development of our
technology platform and the clinical development of Vitaxin. We expect these
losses to increase as we continue to invest in our AMEsystem technology and
internal development projects.

We have capitalized the costs incurred to file patent applications. These costs
are amortized over a six-year estimated life from the date of patent issuance.
At June 30, 2001, we had capitalized costs related to issued patents totaling
approximately $338,000 (net of accumulated amortization) and approximately $1.3
million related to unissued patents. Our results of operations could be
materially impacted when we begin amortizing the costs related to unissued
patents. In addition, we expense all costs related to abandoned patent
applications. If we elect to abandon any of our currently issued or unissued
patents, the related expense could be material to our results of operations for
the period of the abandonment.

RESULTS OF OPERATIONS

Three Months Ended June 30, 2001, compared to Three Months Ended June 30, 2000

Revenue. Our revenue increased to $764,000 for the quarter ended June 30, 2001,
from $377,000 for the same period in 2000, an increase of approximately
$387,000. The increase was due to an increase in grant revenue.

7



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Research and development. Research and development expenses increased to $2.6
million for the quarter ended June 30, 2001, from $809,000 for the same period
in 2000, an increase of approximately $1.8 million. The increase was primarily
related to additional scientific staffing and expansion of facilities to
support our internal development projects, collaborations, and grants.

General and administrative. General and administrative expenses increased to
$1.1 million for the quarter ended June 30, 2001, from $502,000 for the same
period in 2000, an increase of approximately $600,000. The increase was
primarily due to the expansion of the administrative infrastructure, including
additional staff and expansion of facilities, to support our growth and
requirements as a public company.

Stock based compensation. Deferred compensation for options granted to
employees is the difference between the exercise price and the estimated fair
value of our common stock on the date the options were granted. Deferred
compensation is included as a component of stockholders equity and is being
amortized in accordance with FASB Interpretation No. 28 over the vesting
periods of the related options, which is generally four years.

Deferred compensation for options granted to consultants has been determined in
accordance with Statement of Financial Accounting Standards No. 123,
Accounting for Stock  Based Compensation, as the fair value of the equity
instruments issued, and is periodically remeasured as the underlying options
vest in accordance with EITF 96-18.

For the three months ended June 30, 2001, we recorded non-cash, stock based
compensation expenses of $1.8 million ($569,000 and $1.2 million related to
research and development and general and administrative, respectively),
compared to $4.2 million ($1.3 million and $2.9 million related to research and
development and general and administrative, respectively) for the same period
in 2000.

Interest income, net. Net interest income increased to $1.2 million for the
quarter ended June 30, 2001, from $84,000 for the same period in 2000. The
increase was primarily due to our higher average cash and investment balances
during 2001 as a result of the cash proceeds from our initial public offering,
which closed in the third quarter of 2000.

Six Months Ended June 30, 2001, compared to Six Months Ended June 30, 2000

Revenue. Our revenue increased to $1.6 million for the six months ended June
30, 2001, from $1.2 million for the same period in 2000, an increase of
approximately $400,000. The increase was due to an increase in grant revenue,
offset by a decrease in contract revenue.

Research and development. Research and development expenses increased to $4.8
million for the six months ended June 30, 2001, from $1.5 million for the same
period in 2000, an increase of approximately $3.3 million. The increase was
primarily related to additional scientific staffing and expansion of facilities
to support our internal development projects, collaborations, and grants.

General and administrative. General and administrative expenses increased to
$2.2 million for the six months ended June 30, 2001, from $921,000 for the same
period in 2000, an increase of approximately $1.3 million. The increase was
primarily due to the expansion of the administrative infrastructure, including
additional staff and expansion of facilities, to support the needs of a public
company, and professional fees in connection with the expansion of our business
development efforts.

For the six months ended June 30, 2001, we recorded non-cash, stock based
compensation expenses of $4.1 million ($1.3 million and $2.8 million related to
research and development and general and administrative, respectively),
compared to $5.4 million ($1.9 million and $3.5 million related to research and
development and general and administrative, respectively) for the same period
in 2000.

Interest income, net. Net interest income increased to $2.8 million for the six
months ended June 30, 2001, from $123,000 for the same period in 2000. The
increase was primarily due to our higher average cash and investment balances
during 2001 as a result of the cash proceeds from our initial public offering,
which closed in the third quarter of 2000.

LIQUIDITY AND CAPITAL RESOURCES

In July 2000, we sold 5.3 million shares of Common Stock in an initial public
offering resulting in net proceeds to the Company of approximately $94.5
million (excluding offering expenses). Prior to the initial public offering, we
had financed our operations

8



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primarily through private placements of equity securities, with aggregate net
proceeds of approximately $39.9 million. In addition, we have generated $18.1
million of cash from research collaborations through June 30, 2001.

As of June 30, 2001, we had approximately $85.9 million in cash, cash
equivalents and short-term investments, compared to $89.6 million of cash, cash
equivalents and short-term investments as of December 31, 2000.

For the six months ended June 30, 2001, we used cash of approximately $1.9
million in operating activities to fund our net losses of $6.7 million, offset
by non-cash charges for depreciation and patent amortization totaling $345,000,
non-cash, stock based compensation totaling $3.8 million, a decrease in
deferred revenue of $138,000, and changes in operating assets and liabilities
of $805,000.

For the six months ended June 30, 2001, we used cash of approximately $11.8
million in investing activities. Our investing activities consisted primarily
of purchases and sales of short-term investments, and capital expenditures for
property and equipment to be used in our business. We expect to continue to
make investments in our infrastructure, including purchasing property and
equipment to support our operations.

We expect our cash requirements to increase significantly in 2001 as we
continue our research and development efforts, hire additional personnel, grow
our administrative support activities and expand our facilities. We believe
that our current cash, cash equivalents and investments and interest earned
thereon, together with funding received from collaborators and government
grants will be sufficient to satisfy our anticipated cash needs for working
capital and capital expenditures for approximately two years. However, it is
possible that we will seek additional financing within this timeframe. We may
raise additional funds through public or private financing, collaborative
relationships or other arrangements. We cannot assure you that additional
funding, if sought, will be available on terms favorable to us. Further, any
additional equity financing may be dilutive to stockholders, and debt
financing, if available, may involve restrictive covenants. Our failure to
raise capital when needed may harm our business and operating results.

On June 25, 2001, we filed a complaint against MorphoSys AG and its wholly
owned subsidiary MorphoSys USA, Inc. in the United States District Court for
the District of Massachusetts seeking injunctive relief and damages on behalf
of the Company. The complaint alleges that MorphoSys AG and MorphoSys USA,
Inc. are willfully infringing Kauffman patents under which we hold an exclusive
license.

RISK FACTORS

WE HAVE NOT ACHIEVED PROFITABILITY AND MAY NEVER BECOME PROFITABLE.

We are at an early stage of development. We incurred a net loss of $6.7 million
for the six months ended June 30, 2001, and our revenue for that same period
was $1.6 million. Additionally, we have had net losses each year since
inception and, as of June 30, 2001, had an accumulated deficit of $47.6
million. We expect to report a net loss for fiscal year 2001, and we expect to
report increasing net losses for the foreseeable future. We may never achieve
profitability. The size of our net losses will depend, in part, on the rate of
growth, if any, in our contract revenue and on the level of our expenses. To
date, we have derived most of our revenue from collaborations and expect to
continue to do so in the foreseeable future. Revenues from collaborations are
uncertain because our ability to secure future agreements will depend upon our
ability to address the needs of our potential collaborators. We expect to spend
significant amounts to fund research and development and enhance our core
technology. We expect that our operating expenses will increase significantly
in the near term, and consequently, we will need to generate significant
additional revenue to achieve profitability. Even if we do achieve
profitability, we may not be able to sustain or increase profitability on a
quarterly or annual basis.

WE MAY NEED ADDITIONAL CAPITAL IN THE FUTURE. IF ADDITIONAL CAPITAL IS NOT
AVAILABLE, WE MAY HAVE TO CURTAIL OR CEASE OPERATIONS.

We may need to raise more money to continue our operations. We may seek
additional funds from public and private stock offerings, corporate
collaborations, borrowings under lease lines of credit or other sources. If we
cannot raise more money, we may have to reduce our capital expenditures, scale
back our development of new products, reduce our workforce or license to others
products that we otherwise would seek to commercialize ourselves. We expect
that our current resources, together with future operating revenue, will be
sufficient to fund operations for approximately two years. The amount of money
we will need will depend on many factors, including:



| |  |  | the success of our research and development efforts
| | - |  | ---------------------------------------------------

9



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| |  |  | our ability to establish collaborative agreements
| | - |  | -------------------------------------------------
|
| |  |  | our costs of prosecuting and maintaining patents 
|
| |  |  | market and competing technological developments  

Additional capital may not be available on terms acceptable to us, or at all.
Any additional equity financing may be dilutive to stockholders, and debt
financing, if available, may include restrictive covenants.

THE COMMERCIAL UTILITY OF OUR AMESYSTEM TECHNOLOGY IS UNPROVEN AND MAY NEVER BE
REALIZED.

While we have met with initial success in applying our AMEsystem technology, to
prove the commercial value of our technology, we or our collaborators will need
to commercialize biotherapeutics that we have optimized. Successful
commercialization of biotherapeutics requires: preclinical testing, clinical
trials, regulatory approval and commercial manufacturing. It will take us or
our collaborators many years to complete these steps for any biotherapeutic. If
we or our collaborators do not undertake and successfully complete these
activities, then our AMEsystem technology will be of little commercial value,
and our ability to generate revenue will be limited. Currently, there is one
product, Vitaxin, in clinical trials that has been developed using our
technology.

WE HAVE OPTIMIZED ONLY ONE TYPE OF PROTEIN AND MAY NOT BE ABLE TO OPTIMIZE
OTHERS, THEREBY LIMITING OUR MARKET POTENTIAL.

To date we have optimized only antibodies for corporate collaborators. If we
are unable to apply our AMEsystem technology to other types of proteins, the
scope of our potential business will be significantly limited.

IF OUR COLLABORATORS ARE NOT SUCCESSFUL OR IF WE ARE UNABLE TO FIND
COLLABORATORS IN THE FUTURE, WE MAY NOT BE ABLE TO COMMERCIALIZE PRODUCT
CANDIDATES.

Our primary strategy for developing and commercializing product candidates
calls for us to enter into contractual arrangements with collaborators. We may
be unsuccessful in attracting collaborators to develop and commercialize our
products. Some collaborators may not perform their obligations as we expect, or
we may not derive any revenue from these arrangements. We do not know whether
these collaborators will successfully develop and market any products under
their respective agreements. Our success depends in part upon the performance
by these collaborators of their responsibilities under these arrangements. We
have no control over the resources that any collaborator may devote to the
development and commercialization of products under these collaborations. Our
collaborators may terminate their agreements with us or otherwise fail to
conduct their collaborative activities successfully and in a timely manner. Our
collaborators may elect not to develop products arising out of our
collaborative arrangements or not to devote sufficient resources to develop,
manufacture, market or sell these products. Moreover, some of our collaborators
may also be researching competing technologies and products targeted by our
collaborative programs.

IF PRODUCT CANDIDATES WE OPTIMIZE DO NOT RECEIVE REGULATORY APPROVAL, NEITHER
WE NOR OUR COLLABORATORS WILL BE ABLE TO COMMERCIALIZE THESE PRODUCTS.

The U.S. Food and Drug Administration, or FDA, must approve any therapeutic
product before it can be marketed in the United States. The regulatory process
is expensive and time-consuming. Before we or a collaborator can file a new
drug application with the FDA, the product candidate must undergo extensive
testing, including animal studies and human clinical trials that can take many
years and may require substantial expenditures. Data obtained from such testing
may be susceptible to varying interpretations which could delay, limit or
prevent regulatory approval. Changes in regulatory policy for product approval
may cause delays or rejections. Because our product candidates will be
developed in a novel way, government regulatory authorities may subject these
product candidates to greater scrutiny than those developed using more
conventional methods. Some of our collaborators are in early stages of the FDA
regulatory process for drugs we have optimized.

IF WE ARE UNABLE TO ADEQUATELY PROTECT OUR PROPRIETARY TECHNOLOGY, OUR
COMPETITIVE POSITION COULD BE HURT.

The patent positions of biopharmaceutical and biotechnology companies,
including our patent position, are generally uncertain and involve complex
legal and factual questions. We may be able to protect our proprietary rights
from infringement by third parties only

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to the extent that our proprietary technologies are covered by valid and
enforceable patents or are effectively maintained as trade secrets.
Furthermore, others may independently develop similar or alternative
technologies or design around our patented technologies. Litigation or other
proceedings to defend or enforce our intellectual property rights could require
us to spend significant time and money and could disrupt and harm our business.

We also rely upon trade secrets, technical know-how and continuing inventions
to develop and maintain our competitive position. Others may independently
develop substantially equivalent proprietary information and techniques or
otherwise gain access to our trade secrets or discover or disclose our
technology, and we may not be able to meaningfully protect our trade secrets or
be capable of protecting our rights to our trade secrets.

IF WE INFRINGE THIRD-PARTY PATENTS OR BREACH OUR LICENSE AGREEMENTS, LITIGATION
MAY DEPLETE OUR RESOURCES AND UNDERMINE OUR ABILITY TO USE OUR AMESYSTEM
TECHNOLOGY.

Our commercial success also depends in part on neither infringing valid,
enforceable patents or proprietary rights of third parties, nor breaching any
licenses that may relate to our technology and products. We are aware of
third-party patents that may relate to our technology. It is possible that we
may unintentionally infringe these patents or other patents or proprietary
rights of third parties. Any legal action taken against us or our collaborative
partners claiming damages and seeking to enjoin commercial activities relating
to our products and processes affected by third-party rights may require us or
our collaborators to obtain licenses in order to continue to manufacture or
market the affected products and processes. In addition, these actions may
subject us to potential liability for damages. We or our collaborators may not
prevail in an action, and any license required under a patent may not be made
available on commercially acceptable terms, or at all. Litigation could result
in substantial costs and the diversion of managements efforts, regardless of
the result of the litigation.

IF WE LOSE OUR KEY PERSONNEL OR ARE UNABLE TO ATTRACT AND RETAIN ADDITIONAL
PERSONNEL, WE MAY BE UNABLE TO SUCCESSFULLY DEVELOP OUR TECHNOLOGY.

We are highly dependent on the principal members of our management and
scientific staff, particularly our President and Chief Executive Officer,
William D. Huse, M.D., Ph.D. If we lose their services we may not achieve our
objectives. In addition, recruiting and retaining qualified scientific
personnel to perform future research and development work will be critical to
our success. We do not have sufficient personnel to fully execute our business
plan, and there is currently a shortage of skilled executives and scientists,
which is likely to continue. As a result, competition for experienced
executives and scientists from numerous companies and academic and other
research institutions may limit our ability to hire or retain personnel on
acceptable terms. If we fail to attract and retain sufficient personnel, we may
not be able to develop or implement our technology.

PUBLIC PERCEPTION OF ETHICAL AND SOCIAL ISSUES MAY LIMIT THE USE OF OUR
TECHNOLOGY, WHICH COULD REDUCE OUR REVENUE.

Our success will depend upon our ability to develop products through the
application of our proprietary AMEsystem directed evolution technology.
Governmental authorities could, for social or other purposes, limit the use of
genetic modification or prohibit the practice of our technology. Ethical and
other concerns about the use of products derived from modified genes could
adversely affect their market acceptance. If, as a result, our technology or
the products we develop cannot be marketed, we would lose our core business.

WE USE HAZARDOUS CHEMICALS AND RADIOACTIVE AND BIOLOGICAL MATERIALS IN OUR
BUSINESS. ANY CLAIMS RELATING TO IMPROPER HANDLING, STORAGE OR DISPOSAL OF
THESE MATERIALS COULD BE TIME-CONSUMING AND COSTLY.

We use hazardous materials, including chemicals, and radioactive and biological
materials. These materials include o-phenylenediamine dihydrochloride, ethidium
bromide, and acrylamide. Our operations also produce hazardous waste products.
We cannot eliminate the risk of accidental contamination or discharge and any
resultant injury from these materials. We could be subject to civil damages in
the event of an improper or unauthorized release of, or exposure of individuals
to, hazardous materials. In addition, claimants may sue us for injury or
contamination that results from the use of these materials. Federal, state and
local laws and regulations govern the use, manufacture, storage, handling and
disposal of these materials. Compliance with environmental laws and regulations
may be expensive, and current or future environmental regulations may impair
our research, development, or production efforts.

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IF PEOPLE ARE HARMED BY DRUGS DEVELOPED USING OUR AMESYSTEM TECHNOLOGY, WE MAY
BE SUED FOR PRODUCT LIABILITY.

We may be sued for product liability and other claims if our technology or
products developed from our technology are alleged to have caused harm. We may
not be able to avoid significant liability exposure. We maintain product
liability insurance, but we may not have sufficient coverage. If we are sued
for any injury caused by our products and found liable, our financial
condition, reputation and ability to find collaborators may be harmed.

SUBSTANTIAL SALES OF OUR COMMON STOCK BY OUR EXISTING STOCKHOLDERS COULD CAUSE
OUR STOCK PRICE TO FALL.

Future sales of common stock by our stockholders under Rule 144 of the
Securities Act of 1933 or the Securities Act, or through the exercise of
outstanding registration rights or otherwise could have an adverse effect on
the price of our common stock. Shares of our common stock are eligible for sale
in the public market in reliance on Rule 144(k) or Rule 701 under the
Securities Act, without any volume restrictions. Additionally, we have
registered a total of 5,450,000 shares of common stock reserved for issuance
under our stock plans. Some of our existing stockholders have rights to require
us to register their shares for future sale.

OUR FINANCIAL CONDITION COULD BE AFFECTED BY OFFERINGS OF OUR SUBSIDIARYS
STOCK.

We could engage in future offerings or other sales of the common or preferred
stock of our subsidiary if our board determines that it is in the best
interests of the stockholders to pursue that course of action. This could
adversely affect our business, financial condition and results of operations.
For example, any offering or other sale of a minority portion of our
subsidiarys stock could reduce the subsidiarys contribution to our gross
revenues.

WE ARE SUBJECT TO INFLUENCE FROM OUR EXECUTIVE OFFICERS AND DIRECTORS WHO MAY
VOTE IN WAYS WITH WHICH YOU DISAGREE BECAUSE THEY HAVE INTERESTS BOTH AS
MANAGERS AND STOCKHOLDERS.

Our officers and directors and their affiliates, in the aggregate, own
beneficially approximately 30.8% of our outstanding shares of common stock. As
a result, these stockholders, acting together, could be able to effectively
control most matters requiring approval by our stockholders, including the
election of a majority of the directors. If your interests as a stockholder are
different from their interests as both managers and stockholders, you may not
agree with their decisions.







ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The primary objective of our investment activities is to preserve principal
while at the same time maximizing the income we receive from our investments
without significantly increasing risk. Some of the securities that we invest in
may have market risk. This means that a change in prevailing interest rates may
cause the principal amount of the investment to fluctuate. For example, if we
hold a security that was issued with a fixed interest rate at the
then-prevailing rate and the prevailing interest rate later rises, the market
value of our investment will probably decline. To minimize this risk in the
future, we intend to maintain our portfolio of cash equivalents and short-term
investments in a variety of securities, including commercial paper, money
market funds, and government and non government debt securities. The average
duration of all of our investments as of June 30, 2001, was approximately one
year. Due to the short-term nature of these investments, we believe that we
have no material exposure to interest rates arising from our investments. A
hypothetical 100 basis point adverse move in interest rates along the entire
interest rate yield curve would not materially affect the fair value of our
interest sensitive financial instruments. Declines in interest rates over time
will, however, reduce our investment income while increases in interest rates
over time will increase our interest expense.







PART II: OTHER INFORMATION







ITEM 1: LEGAL PROCEEDINGS

On June 25, 2001, we filed a complaint against MorphoSys AG and its wholly
owned subsidiary MorphoSys USA, Inc. in the United States District Court for
the District of Massachusetts seeking injunctive relief and damages on behalf
of the Company. The complaint alleges that MorphoSys AG and MorphoSys USA,
Inc. are willfully infringing Kauffman patents under which we hold an exclusive
license.

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ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS



| | (a) |  | Not applicable.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | --- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | (b) |  | Not applicable.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|
| | (c) |  | Not applicable.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|
| | (d) |  | The effective date of our first registration statement, filed on Form
S-1 under the Securities Act of 1933 (No. 333-36830) relating to our
initial public offering of common stock, was July 26, 2000. A total of
5,347,500 shares of our common stock were sold at a price of $19.00 per
share to an underwriting syndicate led by CIBC World Markets,
PaineWebber Incorporated and SG Cowen. Of these 5,347,500 shares,
697,500 shares were issued upon exercise of the underwriters
over-allotment option. The offering commenced on July 27, 2000 and
closed on August 2, 2000. The initial public offering resulted in gross
proceeds of $101.6 million, $7.1 million of which was applied toward the
underwriting discount. Expenses related to the offering totaled
approximately $1.6 million. No direct or indirect payments were made to
any directors, officers, owners of ten percent or more of any class of
our equity securities, or other affiliates of ours other than for
reimbursement of expenses. Net proceeds to us, after deducting these
expenses, were approximately $92.9 million. We have used approximately
$3.6 million of the net offering proceeds for a portion of the
repurchase of 1.2 million shares of our stock for $14.4 million, $2.3
million for purchases of property and equipment and approximately $1.8
million to fund our net losses. The balance of the proceeds was applied
towards the purchase of temporary investments consisting of U.S.
government agencies obligations, corporate bonds, asset-backed
securities, and cash and cash equivalents.







ITEM 3: DEFAULTS UPON SENIOR SECURITIES

Not applicable.







ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

On May 31, 2001 the Company held its Annual Meeting of Stockholders. The
following actions were taken at the Annual Meeting. As of April 16, 2001, the
record date, 22,394,927 shares were entitled to vote at the Annual Meeting.



| | 1. |  | The following Class I Directors were elected:
| | -- |  | ---------------------------------------------



| | a. |  | Peter K. Hilal 18,659,195 shares voted in favor of the nominee,
119,975 shares withheld their vote;                             
| | -- |  | --------------------------------------------------------------------------------------------------------------------------------
|
| | b. |  | William D. Huse 18,282,035 shares voted in favor of the
nominee, 497,135 shares withheld their vote;                            
|
| | c. |  | The following directors continue in office for their existing
terms:
Costa G. Sevastopoulos
John F. Richards
James J. Bochnowski



| | 2. |  | The adoption of the Companys 2001 Stock Incentive Plan was approved.
15,367,149 shares voted in favor of the proposal, 3,023,272 shares voted
against the proposal, 388,749 shares abstained and no shares were broker
non-votes.
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | 3. |  | The selection of Ernst & Young LLP as the Companys independent auditor
was ratified. 18,719,889 shares voted in favor of the proposal, 59, 281
shares voted against the proposal and no shares abstained.                        







ITEM 5: OTHER INFORMATION

Not Applicable.







ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K



| | (a) |  | Exhibits
| | --- |  | --------

| |        |  |                                                                                                                                                                                             
| | ------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 3(i)2* |  | Certificate of Designations specifying the terms of the Series A
Participating Preferred Stock of Registrant, as filed with the
Secretary of State of the State of Delaware on May 11, 2001.

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##### Table of Contents



| |        |  |                                                                                                                                           
| | ------ |  | ------------------------------------------------------------------------------------------------------------------------------------------
|
|
|
|
| | 10.1** |  | Rights Agreement dated as of May 10, 2001 between Applied Molecular
Evolution, Inc. and EquiServe Trust Company, N.A.                     
|
|
|
|
| | *      |  | Incorporated by reference to Exhibit 3(i)2 to the Companys
registration statement on Form 8-A (File No. 000-31101) filed on May 11, 2001.
|
|
|
|
| | **     |  | Incorporated by reference to Exhibit 4.1 to the Companys
Registration Statement on Form 8-A (File No. 000-31101) filed on May 11, 2001.  



|(b) |  | Reports on Form 8-K during the second quarter
|--- |  | ---------------------------------------------

On May 11, 2001 we filed a report on Form 8-K to disclose the Shareholder Rights
Plan approved by the Board of Directors on April 16, 2001.

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##### Table of Contents









SIGNATURES

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

|                     |  |                                                                                                        |  | 
|-------------------- |  | ------------------------------------------------------------------------------------------------------ |  | 
|Date: August 7, 2001 |  | By: /s/ William D. Huse                                                                                |  | 
|                     |  |                                                                                                       
|                     |  | William D. Huse, M.D., Ph.D.,
President and Chief Executive Officer                                   
|                    
|                    
|                    
|                    
|Date: August 7, 2001 |  | By: /s/ Lawrence E. Bloch                                                                              |  | 
|                     |  |                                                                                                       
|                     |  | Lawrence E. Bloch, M.D., Chief
Financial Officer, Vice President
of Business Development and Secretary

15