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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 September 30, 2002.

or

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

Commission File No. 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

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(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 November 1, 2002, 20,580,566 shares of the Registrants Common Stock
were 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                           
|                              | ITEM 4: CONTROLS AND PROCEDURES                                                              
|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                   
|CERTIFICATIONS               
|EXHIBIT 10.28                



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APPLIED MOLECULAR EVOLUTION, INC.
FORM 10-Q INDEX

|                             |         |                                                                                                                                   |                                                                                               |      |   
|---------------------------- | ------- | --------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------- | ---- | --
|                             |         |                                                                                                                                   |                                                                                               | PAGE
|                             |         |                                                                                                                                   |                                                                                               |     
|PART I:FINANCIAL INFORMATION |         |                                                                                                                                  
|                            
|                            
|                            
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|                            
|                            
|                            
|                             | ITEM 1: |                                                                                                                                   | Financial Statements                                                                          |      | 3 
|                            
|                            
|                            
|                            
|                            
|                            
|                            
|                            
|                             |         | Consolidated Balance Sheets
        at September 30, 2002 (unaudited) and December 31, 2001                                       |                                                                                               | 3   
|                            
|                            
|                            
|                            
|                            
|                            
|                            
|                            
|                             |         | Consolidated Statements of
        Operations for the three and nine months ended September 30, 2002
        and 2001 (unaudited) |                                                                                               | 4   
|                            
|                            
|                            
|                            
|                            
|                            
|                            
|                            
|                             |         | Consolidated Statements of
        Cash Flows for the nine months ended September 30, 2002 and 2001
        (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                            |      | 15
|                            
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|                            
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|                             | ITEM 4: |                                                                                                                                   | Controls and Procedures                                                                       |      | 15
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|PART II:                     |         | OTHER INFORMATION                                                                                                                 |                                                                                               |     
|                            
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|                             | ITEM 1: |                                                                                                                                   | Legal Proceedings                                                                             |      | 15
|                            
|                            
|                            
|                            
|                            
|                            
|                            
|                            
|                             | ITEM 2: |                                                                                                                                   | Changes in Securities and
        Use of Proceeds                                             |      | 16
|                            
|                            
|                            
|                            
|                            
|                            
|                            
|                            
|                             | ITEM 3: |                                                                                                                                   | Defaults Upon Senior Securities                                                               |      | 16
|                            
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|                            
|                            
|                            
|                            
|                            
|                            
|                             | ITEM 4: |                                                                                                                                   | Submission of Matters to a
        Vote of Security Holders                                   |      | 16
|                            
|                            
|                            
|                            
|                            
|                            
|                            
|                            
|                             | ITEM 5: |                                                                                                                                   | Other Information                                                                             |      | 16
|                            
|                            
|                            
|                            
|                            
|                            
|                            
|                            
|                             | ITEM 6: |                                                                                                                                   | Exhibits and Reports on Form 8-K                                                              |      | 16
|                            
|                            
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|                            
|                            
|                            
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|SIGNATURES                   |         | 17                                                                                                                               
|                            
|                            
|                            
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|                            
|                            
|                            
|CERTIFICATIONS               |         | 18                                                                                                                               

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

|                                     |                                                                                                                                                                 |                                            |        |               |        |              |       |         |        | 
|------------------------------------ | --------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------ | ------------- | ------ | ------------ | ----- | ------- | ------ | 
|                                     |                                                                                                                                                                 |                                            |        | SEPTEMBER 30, |        | DECEMBER 31,
|                                     |                                                                                                                                                                 |                                            |        | 2002          |        | 2001        
|                                     |                                                                                                                                                                 |                                            |        |               |        |             
|                                     |                                                                                                                                                                 |                                            |        | (UNAUDITED)   |        |              |       |        
|ASSETS                               |                                                                                                                                                                 |                                            |        |               |        |              |       |        
|Current assets:                      |                                                                                                                                                                 |                                            |        |               |        |              |       |        
|                                     | Cash and cash equivalents                                                                                                                                       |                                            | $      | 3,506         |        |              | $     | 25,927  |       
|                                     | Short-term investments                                                                                                                                          |                                            |        | 51,865        |        |              |       | 54,269  |       
|                                     | Prepaid expenses                                                                                                                                                |                                            |        | 358           |        |              |       | 429     |       
|                                     | Other current assets                                                                                                                                            |                                            |        | 1,340         |        |              |       | 3,385   |       
|                                     |                                                                                                                                                                 |                                            |        |               |        |              |       |        
|                                     |                                                                                                                                                                 | Total current assets                       |        |               | 57,069 |              |       |         | 84,010 | 
|Restricted cash                      |                                                                                                                                                                 |                                            | 10,541 |               |        |              |      |        
|Property and equipment, net          |                                                                                                                                                                 |                                            | 14,051 |               |        |              | 3,223 |        
|Patents, net                         |                                                                                                                                                                 |                                            | 1,973  |               |        |              | 1,865 |        
|Other assets                         |                                                                                                                                                                 |                                            | 460    |               |        |              | 1,584 |        
|                                     |                                                                                                                                                                 |                                            |        |               |        |              |       |        
|                                     |                                                                                                                                                                 | Total assets                               |        | $             | 84,094 |              |       | $       | 90,682 | 
|                                     |                                                                                                                                                                 |                                            |        |               |        |              |       |        
|LIABILITIES AND STOCKHOLDERS EQUITY |                                                                                                                                                                 |                                            |        |               |        |              |       |        
|Current liabilities:                 |                                                                                                                                                                 |                                            |        |               |        |              |       |        
|                                     | Accounts payable                                                                                                                                                |                                            | $      | 1,758         |        |              | $     | 1,128   |       
|                                     | Accrued liabilities                                                                                                                                             |                                            |        | 2,238         |        |              |       | 1,173   |       
|                                     | Current portion of deferred revenue                                                                                                                             |                                            |        | 619           |        |              |       | 1,967   |       
|                                     |                                                                                                                                                                 |                                            |        |               |        |              |       |        
|                                     |                                                                                                                                                                 | Total current liabilities                  |        |               | 4,615  |              |       |         | 4,268  | 
|Deferred revenue                     |                                                                                                                                                                 |                                            | 217    |               |        |              | 394   |        
|Deferred rent                        |                                                                                                                                                                 |                                            | 59     |               |        |              | 84    |        
|Long-term obligation                 |                                                                                                                                                                 |                                            | 10,000 |               |        |              |      |        
|Minority interest                    |                                                                                                                                                                 |                                            |       |               |        |              |      |        
|Stockholders equity:                |                                                                                                                                                                 |                                            |        |               |        |              |       |        
|                                     | Preferred stock, $.001 par value, 5,000,000 shares authorized, none issued                                                                                      |                                            |        |              |        |              |       |        |       
|                                     | Common stock, $.001 par value, 45,000,000 shares authorized, 23,648,677
and 23,607,058 shares issued at September 30, 2002, and December 31,
2001, respectively |                                            |        | 24            |        |              |       | 24      |       
|                                     | Additional paid-in capital                                                                                                                                      |                                            |        | 160,453       |        |              |       | 159,126 |       
|                                     | Deferred compensation                                                                                                                                           |                                            |        | (1,781        | )      |              |       | (4,373  | )     
|                                     | Notes receivable from employees                                                                                                                                 |                                            |        | (925          | )      |              |       | (880    | )     
|                                     | Accumulated other comprehensive income                                                                                                                          |                                            |        | 729           |        |              |       | 587     |       
|                                     | Accumulated deficit                                                                                                                                             |                                            |        | (67,611       | )      |              |       | (54,148 | )     
|                                     | Less: Treasury stock at cost - 3,073,111 and 1,200,000 shares at
September 30, 2002, and December 31, 2001, respectively                                        |                                            |        | (21,686       | )      |              |       | (14,400 | )     
|                                     |                                                                                                                                                                 |                                            |        |               |        |              |       |        
|                                     |                                                                                                                                                                 | Total stockholders equity                 |        |               | 69,203 |              |       |         | 85,936 | 
|                                     |                                                                                                                                                                 |                                            |        |               |        |              |       |        
|                                     |                                                                                                                                                                 | Total liabilities and stockholders equity |        | $             | 84,094 |              |       | $       | 90,682 | 
|                                     |                                                                                                                                                                 |                                            |        |               |        |              |       |        

See accompanying notes.

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

|                                                       |                                      |   |                                  |       |                                 |   |        |       |      |   |         |        |  |   |         |        | 
|------------------------------------------------------ | ------------------------------------ | - | -------------------------------- | ----- | ------------------------------- | - | ------ | ----- | ---- | - | ------- | ------ |  | - | ------- | ------ | 
|                                                       |                                      |   | THREE MONTHS ENDED SEPTEMBER 30, |       | NINE MONTHS ENDED SEPTEMBER 30,
|                                                       |                                      |   |                                  |       |                                
|                                                       |                                      |   | 2002                             |       | 2001                            |   | 2002   |       | 2001
|                                                       |                                      |   |                                  |       |                                 |   |        |       |     
|Revenues:                                              |                                      |   |                                  |       |                                 |   |        |       |      |   |         |        |  |   |         |       
|                                                       | Contract revenue from
collaborations |   | $                                | 1,199 |                                 |   | $      | 474   |      |   | $       | 3,979  |  |   | $       | 1,044  | 
|                                                       | Other revenue                        |   |                                  | 258   |                                 |   |        | 398   |      |   |         | 1,673  |  |   |         | 1,444  | 
|                                                       |                                      |   |                                  |       |                                 |   |        |       |      |   |         |        |  |   |         |       
|                                                       | Total revenue                        |   |                                  | 1,457 |                                 |   |        | 872   |      |   |         | 5,652  |  |   |         | 2,488  | 
|                                                       |                                      |   |                                  |       |                                 |   |        |       |      |   |         |        |  |   |         |       
|Operating expenses:                                    |                                      |   |                                  |       |                                 |   |        |       |      |   |         |        |  |   |         |       
|                                                       | Research and development             |   |                                  | 3,315 |                                 |   |        | 2,834 |      |   |         | 10,406 |  |   |         | 7,665  | 
|                                                       | General and administrative           |   |                                  | 2,972 |                                 |   |        | 1,145 |      |   |         | 8,173  |  |   |         | 3,366  | 
|                                                       | Stock-based compensation             |   |                                  | 711   |                                 |   |        | 1,473 |      |   |         | 2,615  |  |   |         | 5,585  | 
|                                                       |                                      |   |                                  |       |                                 |   |        |       |      |   |         |        |  |   |         |       
|                                                       | Total operating expenses             |   |                                  | 6,998 |                                 |   |        | 5,452 |      |   |         | 21,194 |  |   |         | 16,616 | 
|                                                       |                                      |   |                                  |       |                                 |   |        |       |      |   |         |        |  |   |         |       
|Loss from operations                                   |                                      |   | (5,541                           | )     |                                 |   | (4,580 | )     |      |   | (15,542 | )      |  |   | (14,128 | )     
|Minority interest                                      |                                      |   | 402                              |       |                                 |   | 180    |       |      |   | 402     |        |  |   | 314     |       
|Interest income, net                                   |                                      |   | 638                              |       |                                 |   | 1,263  |       |      |   | 2,281   |        |  |   | 4,018   |       
|Other financing charges                                |                                      |   | (604                             | )     |                                 |   |       |       |      |   | (604    | )      |  |   |        |       
|                                                       |                                      |   |                                  |       |                                 |   |        |       |      |   |         |        |  |   |         |       
|Net loss                                               |                                      | $ | (5,105                           | )     |                                 | $ | (3,137 | )     |      | $ | (13,463 | )      |  | $ | (9,796  | )     
|                                                       |                                      |   |                                  |       |                                 |   |        |       |      |   |         |        |  |   |         |       
|Net loss per share, basic and diluted                  |                                      | $ | (0.24                            | )     |                                 | $ | (0.15  | )     |      | $ | (0.62   | )      |  | $ | (0.46   | )     
|Weighted average shares outstanding,
basic and diluted |                                      |   | 21,227                           |       |                                 |   | 21,440 |       |      |   | 21,672  |        |  |   | 21,308  |       

See accompanying notes.

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

|                                                                            |                                                     |   |                                 |        |      |   |         |       |  
|--------------------------------------------------------------------------- | --------------------------------------------------- | - | ------------------------------- | ------ | ---- | - | ------- | ----- | -
|                                                                            |                                                     |   | NINE MONTHS ENDED SEPTEMBER 30,
|                                                                            |                                                     |   |                                
|                                                                            |                                                     |   | 2002                            |        | 2001
|                                                                            |                                                     |   |                                 |        |     
|OPERATING ACTIVITIES                                                        |                                                     |   |                                 |        |      |   |         |      
|Net loss                                                                    |                                                     | $ | (13,463                         | )      |      | $ | (9,796  | )    
|Adjustments to reconcile net loss to net cash
used in operating activities: |                                                     |   |                                 |        |      |   |         |      
|                                                                            | Depreciation and amortization                       |   |                                 | 1,082  |      |   |         | 623   |  
|                                                                            | Amortization of stock-based compensation            |   |                                 | 2,583  |      |   |         | 5,260 |  
|                                                                            | Compensation related to consultant stock options    |   |                                 | 33     |      |   |         | 325   |  
|                                                                            | Deferred revenue                                    |   |                                 | (1,526 | )    |   |         | (167  | )
|                                                                            | Deferred rent                                       |   |                                 | (25    | )    |   |         | (12   | )
|                                                                            | Minority interest                                   |   |                                 | (402   | )    |   |         | (314  | )
|                                                                            | Realized gain on short-term investments             |   |                                 | (133   | )    |   |         | (392  | )
|                                                                            | Accrued interest on notes receivable from employees |   |                                 | (45    | )    |   |         | (40   | )
|                                                                            | Other financing charges                             |   |                                 | 604    |      |   |         |      |  
|Changes in operating assets and liabilities:                                |                                                     |   |                                 |        |      |   |         |      
|                                                                            | Prepaid expenses and other assets                   |   |                                 | 3,239  |      |   |         | 299   |  
|                                                                            | Accounts payable and accrued expenses               |   |                                 | 1,696  |      |   |         | 316   |  
|                                                                            |                                                     |   |                                 |        |      |   |         |      
|Net cash used in operating activities                                       |                                                     |   | (6,357                          | )      |      |   | (3,898  | )    
|                                                                            |                                                     |   |                                 |        |      |   |         |      
|INVESTING ACTIVITIES                                                        |                                                     |   |                                 |        |      |   |         |      
|Restricted cash                                                             |                                                     |   | (10,541                         | )      |      |   |        |      
|Purchase of property and equipment                                          |                                                     |   | (11,802                         | )      |      |   | (2,711  | )    
|Purchase of short-term investments                                          |                                                     |   | (57,390                         | )      |      |   | (52,721 | )    
|Proceeds from sale of short-term investments                                |                                                     |   | 60,071                          |        |      |   | 51,547  |      
|Patents                                                                     |                                                     |   | (217                            | )      |      |   | (222    | )    
|                                                                            |                                                     |   |                                 |        |      |   |         |      
|Net cash used in investing activities                                       |                                                     |   | (19,879                         | )      |      |   | (4,107  | )    
|                                                                            |                                                     |   |                                 |        |      |   |         |      
|FINANCING ACTIVITIES                                                        |                                                     |   |                                 |        |      |   |         |      
|Proceeds from (payments on) long-term obligations                           |                                                     |   | 10,000                          |        |      |   | (14     | )    
|Proceeds from issuance of convertible notes                                 |                                                     |   | 406                             |        |      |   |        |      
|Issuance of common stock                                                    |                                                     |   | 213                             |        |      |   | 76      |      
|Purchase of treasury stock                                                  |                                                     |   | (7,286                          | )      |      |   |        |      
|Investment in subsidiary by minority investors, net                         |                                                     |   | 482                             |        |      |   |        |      
|                                                                            |                                                     |   |                                 |        |      |   |         |      
|Net cash provided by financing activities                                   |                                                     |   | 3,815                           |        |      |   | 62      |      
|                                                                            |                                                     |   |                                 |        |      |   |         |      
|Net decrease in cash and cash equivalents                                   |                                                     |   | (22,421                         | )      |      |   | (7,943  | )    
|Cash and cash equivalents at the beginning of the period                    |                                                     |   | 25,927                          |        |      |   | 36,865  |      
|                                                                            |                                                     |   |                                 |        |      |   |         |      
|Cash and cash equivalents at the end of the period                          |                                                     | $ | 3,506                           |        |      | $ | 28,922  |      
|                                                                            |                                                     |   |                                 |        |      |   |         |      
|Supplemental non-cash disclosure                                            |                                                     |   |                                 |        |      |   |         |      
|Conversion of notes payable to equity in subsidiary                         |                                                     | $ | (406                            | )      |      | $ |        |      
|                                                                            |                                                     |   |                                 |        |      |   |         |      

See accompanying notes.

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

1. Organization and Business

Applied Molecular Evolution, Inc. (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 protein
therapeutic candidates for pharmaceutical and biotechnology companies as
well as for the Companys own internal development projects.

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 disclosures 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
disclosures thereto should be read in conjunction with the audited
financial statements and disclosures thereto contained in the Companys
annual report on Form 10-K for the year ended December 31, 2001.

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 disclosures. Changes in the estimates may affect
amounts reported in future periods.

The consolidated financial statements include the accounts of the Company
and its majority owned subsidiaries, Novasite Pharmaceuticals, Inc.
(Novasite), and AME Torrey View, LLC (Torrey View). Novasite and
Torrey View are 61% and 99% owned by AME. All significant intercompany
accounts and transactions have been eliminated.

3. Commitments

On August 17, 2001, we entered into an Operating Agreement with Torrey
View Phase II, L.P., to establish Torrey View. On March 4, 2002, Torrey
View purchased a 10.73-acre parcel of undeveloped land in San Diego County
from a third party at a cost of approximately $8.0 million. The Company
intends to develop this property over the next few years as its corporate
headquarters.

In connection with the purchase, the Company borrowed approximately $10.0
million, under a $15.0 million credit facility, from Merrill Lynch Bank
USA to fund the purchase price and certain development costs, and as of
September 30, 2002, we had approximately $5.0 million available for future
financing needs under this credit facility. As of September 30, 2002,
restricted cash of approximately $10.5 million collateralized the
outstanding loan balance. The Company also entered into a $3.0 million
loan and a development and management agreement with a group, that is not
affiliated with the Company, but that is affiliated with the 1% owner of
Torrey View, who is assisting the Company with the development of the
project. The $3.0 million loan from the Company to the group is
collateralized by a perfected security interest in the 1% owners
membership rights in Torrey View and is due in 2004. Torrey View also
entered into an engagement letter and compensation agreement with a third
party to act as a broker and co-development manager, on behalf of Torrey
View, in connection with the purchase and development of the land.

On July 25, 2002, a petition was filed in the Superior Court of the State
of California, County of San Diego, by the Torrey Hills Community
Coalition, et al. against the City of San Diego, et al. seeking to compel
the City of San Diego to revoke the approval which was previously issued
with respect to the development of our corporate headquarters. A petition
was also filed by the Del Mar Union School District on October 25, 2002,
seeking a similar legal remedy. These petitions assert that the City of
San Diego failed to comply with or violated various legal requirements in
connection with its approval of that development, but they do not seek
monetary relief from the Company. We understand that the City of San
Diego believes

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that it has complied with all legal requirements for this project and
therefore intends to vigorously oppose these petitions. The Company is
named as a real party in interest, and we also intend to vigorously oppose
these petitions and believe that they will not have a material adverse
effect on our business.

4. Comprehensive Loss

Total comprehensive loss was $13,321,000 for the nine months ended
September 30, 2002, and $9,202,000 for the nine months ended September 30,
2001. The difference between net loss and comprehensive loss is primarily
due to the difference between market value and cost basis of the Companys
short-term marketable securities.

5. 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). 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. To the extent common stock equivalents (stock options) are
dilutive, they would be included in diluted per share amounts.

6. Novasite Financing

In August 2002, the Companys subsidiary, Novasite, received $350,000 from
a private placement of 10% convertible notes with a minority investor of
Novasite. The notes plus accrued interest were converted at a discounted
price into preferred stock of Novasite in connection with a financing
which closed on September 30, 2002. Novasite recorded a debt discount of
$477,000 related to the beneficial conversion feature of the notes and the
full amount of the debt discount was recorded as other financing charges
as of September 30, 2002. John F. Richards, one of our directors, is the
President of Crabtree Ventures, L.L.C., the general partner of Crabtree
Ventures, L.P., which as the minority investor, provided the funding for
the private placement.

In connection with the issuance of these convertible notes, Novasite
issued warrants to purchase 350,000 shares of preferred stock. The
warrants are fully vested and expire in August 2006. Novasite recorded a
debt discount related to the warrants of $127,000 based upon a
Black-Scholes valuation, which was recorded as other financing charges as
of September 30, 2002, when the notes were converted.

In addition to the conversion of notes and related accrued interest, which
totaled $554,041, Novasite received cash of $500,000 and issued 1,430,304 shares of preferred stock.




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, 2001.

OVERVIEW

We are a leader in the application of directed molecular evolution to the
optimization and development of biotherapeutics. Directed molecular
evolution is a process by which genes and proteins are optimized for
specific commercial purposes. We

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focus principally on applying our technology to human biotherapeutics, the
largest and most profitable target market for directed molecular
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
to 1999 was allocated to preclinical development and initial clinical
trials of Vitaxin. In 1999, we licensed Vitaxin to MedImmune, Inc.
(MedImmune), which is responsible for future clinical development
expenses and commercialization.

To date we have generated revenue from corporate collaborations, product
candidate and technology licenses, royalties, and government grants. We
have corporate collaborations with MedImmune, Inc., Eli Lilly and Company,
Centocor, Inc., Chiron Corporation, CancerVax, Inc., Biosynexus Inc.,
Bristol-Myers Squibb Company, Seattle Genetics, Inc., and Aventis
Pharmaceuticals, Inc., the final one through our majority owned
subsidiary, Novasite. We have licensed intellectual property to Biosite
Incorporated, formerly Biosite Diagnostics, Inc., in exchange for a
nonrefundable, 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 September 30, 2002, we
had an accumulated deficit of $67.6 million. These losses and this
accumulated deficit resulted from the significant costs incurred in the
development of our AMEsystem technology and the preclinical and clinical
development of Vitaxin and our internal development projects. We expect
these losses to increase as we continue to invest in our AMEsystem
technology and internal development projects.

On August 17, 2001, we entered into an Operating Agreement with Torrey
View Phase II, L.P., to establish AME Torrey View, LLC (Torrey View).
Torrey View is a 99% owned subsidiary and is consolidated in the Companys
financial statements. On March 4, 2002, Torrey View purchased a 10.73-acre
parcel of undeveloped land in San Diego County from a third party at a
cost of approximately $8.0 million. The Company intends to develop this
property over the next few years as its corporate headquarters.

In connection with the purchase, the Company borrowed approximately $10.0
million, under a $15.0 million credit facility, from Merrill Lynch Bank
USA to fund the purchase price and certain development costs, and as of
September 30, 2002, we had approximately $5.0 million available for future
financing needs under this credit facility. As of September 30, 2002,
restricted cash of approximately $10.5 million collateralized the
outstanding loan balance. The Company also entered into a $3.0 million
loan and a development and management agreement with a group, that is not
affiliated with the Company, but that is affiliated with the 1% owner of
Torrey View, who is assisting the Company with the development of the
project. The $3.0 million loan from the Company to the group is
collateralized by a perfected security interest in the 1% owners
membership rights in Torrey View and is due in 2004. Torrey View also
entered into an engagement letter and compensation agreement with a third
party to act as a broker and co-development manager, on behalf of Torrey
View, in connection with the purchase and development of the land.

On July 25, 2002, a petition was filed in the Superior Court of the State
of California, County of San Diego, by the Torrey Hills Community
Coalition, et al. against the City of San Diego, et al. seeking to compel
the City of San Diego to revoke the approval which was previously issued
with respect to the development of our corporate headquarters. A petition
was also filed by the Del Mar Union School District on October 25, 2002,
seeking a similar legal remedy. These petitions assert that the City of
San Diego failed to comply with or violated various legal requirements in
connection with its approval of that development, but they do not seek
monetary relief from the Company. We understand that the City of San
Diego believes that it has complied with all legal requirements for this
project and therefore intends to vigorously oppose these petitions. The
Company is named as a real party in interest, and we also intend to
vigorously oppose these petitions and believe that they will not have a
material adverse effect on our business.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of
operations are based upon the Companys consolidated financial statements,
which have been prepared in accordance with accounting principles
generally accepted in the United States. The preparation of these
financial statements requires us to make estimates and judgments that
affect the reported amounts of assets, liabilities, revenues and expenses,
and related disclosure of contingent assets and liabilities. On an ongoing

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basis, we evaluate our estimates, including those related to revenue
recognition, patent costs, and income taxes. We base our estimates on
historical experience and on various other assumptions that are believed
to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual
results may differ from these estimates under different assumptions or
conditions.

We believe that the following critical accounting policies affect the
significant judgments and estimates used in the preparation of our
consolidated financial statements.

Revenue recognition

We recognize revenue when all four of the following criteria are met: (i)
persuasive evidence that an arrangement exists; (ii) delivery of the
products and/or services has occurred; (iii) the selling price is fixed or
determinable; and (iv) collectibility is reasonably assured. In addition,
we follow the provisions of the Securities and Exchange Commissions Staff
Accounting Bulletin No. 101 (SAB 101), Revenue Recognition in Financial
Statements, which sets forth guidelines in the timing of revenue
recognition based upon factors such as passage of title, installation,
payments, and customer acceptance. Amounts received for upfront product
candidate and technology license fees under multiple-element arrangements
are deferred and recognized over the period of such services or
performance if such arrangements require ongoing services or performance.
Amounts received for milestones are recognized upon achievement of the
milestone, unless the amounts received are creditable against royalties or
we have ongoing performance obligations. Royalty revenue will be
recognized upon sale of the related products, provided the royalty amounts
are fixed and determinable and collection of the related receivable is
probable. Any amounts received prior to satisfying our revenue recognition
criteria will be recorded as deferred revenue in the accompanying balance
sheets.

Patent costs

We capitalize the costs incurred to file patent applications. These costs
are amortized over a six-year estimated life from the date of patent
issuance. At September 30, 2002, capitalized costs related to issued
patents total approximately $451,000 (net of accumulated amortization) and
approximately $1.5 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.

Long-Lived Assets

In accordance with SFAS No. 144, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,if
indicators of impairment exist, we assess the recoverability of the
affected long-lived assets by determining whether the carrying value of
such assets can be recovered through the undiscounted future operating
cash flows. If impairment is indicated, we measure the amount of such
impairment by comparing the carrying value of the asset to the present
value of the expected future cash flows associated with the use of the
asset. While the Companys current and historical operating and cash flow
losses are indicators of impairment, we believe the future cash flows to
be received from the long-lived assets will exceed the assets carrying
value, and accordingly have not recognized any impairment losses through
September 30, 2002.

RESULTS OF OPERATIONS

Three Months Ended September 30, 2002, Compared to Three Months Ended
September 30, 2001

Revenues. Our revenue increased to $1.5 million for the quarter ended
September 30, 2002, from $872,000 for the same period in 2001, an increase
of approximately $628,000. The increase was primarily due to contract
revenue recognized under our corporate collaborations.

Research and development. Research and development expenses increased to
$3.3 million for the quarter ended September 30, 2002, from $2.8 million
for the same period in 2001, an increase of approximately $500,000. The
increase was primarily

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due to increased scientific staffing and the expansion of scientific
activities in support of our internal development projects and corporate
collaborations.

General and administrative. General and administrative expenses increased
to $3.0 million for the quarter ended September 30, 2002, from $1.1
million for the same period in 2001, an increase of $1.9 million. The
increase was primarily due to additional legal expenses incurred in our
litigation against MorphoSys.

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 on an accelerated basis 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 SFAS 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
the Emerging Issues Task Forces (EITF) No. 96-18, Accounting for Equity
Instruments That Are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services.

For the three months ended September 30, 2002, we recorded non-cash,
stock-based compensation of $711,000 ($229,000 and $482,000 related to
research and development and general and administrative, respectively),
compared to $1.5 million ($470,000 and $1.0 million related to research
and development and general and administrative, respectively) for the same
period in 2001.

Interest income, net. Net interest income decreased to $638,000 for the
quarter ended September 30, 2002, from $1.3 million for the same period in
2001, a decrease of approximately $662,000. The decrease was primarily due
to lower interest rates and lower cash, cash equivalent, and short-term
investment balances in 2002.

Other financing charges. We incurred other financing charges of $604,000
for the three-month period ended September 30, 2002, compared to no
charges for the three-month period ended September 30, 2001. The increase
is due to a non-cash finance charge related to the issuance and conversion
of convertible debt at below market price and the issuance of warrants by
our subsidiary, Novasite, to one of its minority investors (see note 6).

Nine Months Ended September 30, 2002, Compared to Nine Months Ended
September 30, 2001

Revenues. Our revenue increased to $5.7 million for the nine months ended
September 30, 2002, from $2.5 million for the same period in 2001, an
increase of approximately $3.2 million. The increase was
primarily due to contract revenue and milestones recognized under our
corporate collaborations.

Research and development. Research and development expenses increased to
$10.4 million for the nine months ended September 30, 2002, from $7.7
million for the same period in 2001, an increase of $2.7 million. The
increase was primarily related to additional scientific staffing and
expansion of facilities to support our internal development projects and
corporate collaborations.

General and administrative. General and administrative expenses increased
to $8.2 million for the nine months ended September 30, 2002, from $3.4
million for the same period in 2001, an increase of $4.8 million. The
increase was primarily due to additional legal expenses incurred in our
litigation against MorphoSys, the expansion of our administrative
infrastructure and additional staff.

For the nine months ended September 30, 2002, we recorded non-cash,
stock-based compensation of $2.6 million ($845,000 and $1.8 million
related to research and development and general and administrative,
respectively), compared to $5.6 million ($2.0 million and $3.6 million
related to research and development and general and administrative,
respectively) for the same period in 2001.

Interest income, net. Net interest income decreased to $2.3 million for
the nine months ended September 30, 2002, from $4.0 million for the same
period in 2001, a decrease of $1.7 million. The decrease was primarily due
to lower interest rates and lower cash, cash equivalent, and short-term
investment balances in 2002.

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Other financing charges. We incurred other financing charges of $604,000
for the nine-month period ended September 30, 2002, compared to no charges
for the nine-month period ended September 30, 2001. The increase is due
to a non-cash finance charge related to the issuance and conversion of
convertible debt at below market price and the issuance of warrants by our
subsidiary, Novasite, to one of its minority investors (see note 6).

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 primarily through private
placements of equity securities, with aggregate net proceeds of
approximately $39.9 million. In addition, we have generated $22.1 million
of cash from corporate collaborations through September 30, 2002.

As of September 30, 2002, we had approximately $55.4 million in
unrestricted cash, cash equivalents, and short-term investments, compared
to $80.2 million of unrestricted cash, cash equivalents, and short-term
investments as of December 31, 2001. In addition, we had restricted cash
of approximately $10.5 million as of September 30, 2002, which has been pledged as
collateral for the $10 million credit facility from Merrill
Lynch Bank USA.

For the nine months ended September 30, 2002, we used cash of
approximately $6.4 million in operating activities, net of non-cash
charges for depreciation and patent amortization totaling $1.1 million,
non-cash, stock based compensation totaling $2.6 million, a decrease in
deferred revenue of $1.5 million, and changes in operating assets and
liabilities of $4.9 million.

For the nine months ended September 30, 2002, we used cash of
approximately $19.9 million in investing activities. Our investing
activities consisted primarily of purchases and sales of short-term
investments, purchase of land, preconstruction costs related to the
development of our corporate headquarters and capital expenditures for
other property and equipment to be used in our business. We expect to
continue to make investments in our infrastructure, including development
of our proposed corporate headquarters, and purchasing other property and
equipment to support our operations.

For the nine months ended September 30, 2002, we generated cash of
approximately $3.8 million from financing activities. We generated cash of
approximately $10.0 million from a collateralized loan from Merrill Lynch
Bank USA, and from an investment by minority investors in our subsidiary
Novasite of $888,000, offset by the repurchase of approximately 1.9
million shares of our common stock for approximately $7.3 million. At
September 30, 2002, we had approximately $5.0 million available for future
financing needs under this Merrill Lynch Bank USA credit facility. These
funds are available to be used to finance the Companys headquarters.

We expect our cash requirements to increase significantly as we continue
our research and development efforts, hire additional personnel, grow our
administrative support activities and finance the development of the
Companys corporate headquarters. 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 at least the next 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 ensure 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 on patents under which we
hold an exclusive license.

RISK FACTORS

We have not achieved profitability and may never become profitable.

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We are at an early stage of development. We incurred a net loss of $13.5
million for the nine months ended September 30, 2002, and our revenue for
the same period was $5.7 million. Additionally, we have had net losses
each year since inception and as of September 30, 2002, had an accumulated
deficit of $67.6 million. We expect to report a net loss for fiscal year
2002, 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 corporate collaborations and expect to continue to do so
for the foreseeable future. Revenue from corporate collaborations is
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 AMEsystem 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 capital 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 capital, we may have to reduce our capital
expenditures, scale back our development of new products, reduce our
workforce or license to others product candidates or products that we
otherwise would seek to commercialize ourselves. We expect that our
current resources, together with future operating revenues, will be
sufficient to fund operations for at least the next two years. The amount
of capital we will need will depend on many factors, including:



| |  | the success of our research and development efforts
|- |  | ---------------------------------------------------
| 
| |  | our ability to establish collaborative agreements  
| 
| |  | our costs of prosecuting and maintaining patents   
| 
| |  | the 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 its commercial value, 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 candidate, Vitaxin, in clinical
trials that has been optimized using our technology.

We have announced the optimization of only two types of proteins and may
not be able to optimize others, thereby limiting our market potential.

To date we have announced the optimization of only proteins from the
classes of antibodies and enzymes for corporate collaborators and internal
development projects. If, through the application of our AMEsystem
technology we are unable to optimize 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 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 product candidates.

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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 product
candidates under their respective agreements. Moreover, some of our
collaborators may acquire or develop competing technologies and product
candidates targeted by our collaborative programs. 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
product candidates 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 product candidates arising out of
our collaborative arrangements or not to devote sufficient resources to
develop, manufacture, market, or sell these product candidates.

If product candidates we optimize do not receive regulatory approval,
neither we nor our collaborators will be able to commercialize these
product candidates.

The FDA must approve any therapeutic product candidate 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. Our collaborators are in
early stages of the FDA regulatory process for product candidates we have
optimized.

If we are unable to adequately protect our proprietary technology, our
competitive position could be hurt.

The patent positions of pharmaceutical 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 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 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 product candidates. 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 product candidates 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 product candidates 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, Chief Executive Officer and
Chairman of the Board, 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

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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 product candidates
through the application of our directed molecular 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 our technology or
the product candidates we develop cannot be marketed as a result, 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.

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 product candidates 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 our common stock by our stockholders under Rule 144 of the
Securities Act of 1933 (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 which are not
held by our affiliates 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 registered a total of 6,732,625
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, Novasite, 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
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.

As of September 30, 2002, our officers and directors and their affiliates,
in the aggregate, owned beneficially approximately 28% of our outstanding
shares of common stock. As a result, these stockholders, acting together,
would be able to effectively control most matters requiring approval by
our stockholders, including the election of a majority of the directors.
If your

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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 nongovernment debt securities. The average duration of all
of our investments as of September 30, 2002, was less than two years. 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.




ITEM 4: CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures.

Within the 90-day period prior to the date of this report, the Company
carried out an evaluation, under the supervision and with the
participation of the Companys management, including the Companys Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of the Companys disclosure controls and procedures
pursuant to Rule 13a-14 of the Securities Exchange Act of 1934 (the
Exchange Act). Based upon that evaluation, the Chief Executive Officer
and Chief Financial Officer concluded that the Companys disclosure
controls and procedures are effective in timely alerting them to material
information relating to the Company (including its consolidated
subsidiaries) required to be included in the Companys Exchange Act
filings.

Changes in Internal Controls.

There have been no significant changes in the Companys internal controls
or in other factors that could significantly affect internal controls
subsequent to the date the Company carried out its evaluation.




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 the Kauffman patent family
under which we hold an exclusive license.

On July 25, 2002, a petition was filed in the Superior Court of the State
of California, County of San Diego, by the Torrey Hills Community
Coalition, et al. against the City of San Diego, et al. seeking to compel
the City of San Diego to revoke the approval which was previously issued
with respect to the development of our corporate headquarters. A petition
was also filed by the Del Mar Union School District on October 25, 2002,
seeking a similar legal remedy. These petitions assert that the City of
San Diego failed to comply with or violated various legal requirements in
connection with its approval of that development, but they do not seek
monetary relief from the Company. We understand that the City of San
Diego believes that it has complied with all legal requirements for this
project and therefore intends to vigorously oppose these petitions. The
Company is named as a real party in interest, and we also intend to
vigorously oppose these petitions and believe that they will not have a
material adverse effect on our business.

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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, UBS
PaineWebber Incorporated, formerly known as 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 the
Company other than for reimbursement of expenses. Net proceeds to us,
after deducting these expenses, were approximately $92.9 million. We have
used approximately $10.9 million of the net offering proceeds for a
portion of the repurchase of approximately 3.1 million shares of our stock
for $21.7 million, $5.0 million for purchases of property and equipment,
and approximately $15.3 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

None.




ITEM 5: OTHER INFORMATION

None.




ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

10.28 Employment Agreement with William L. Respess, dated June 7, 2002.

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

On August 21, 2002, we filed a report on Form 8-K, with exhibits attached
thereto, reporting under Item 5 the repurchase of 1,873,111 shares of our
common stock.

On September 23, 2002, we filed a report on Form 8-K, with exhibits
attached thereto, reporting under Item 6 the resignations of three of our
directors.

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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: November 5, 2002 | By: | /s/ William D. Huse, M.D., Ph.D.                                                         
|---------------------- | --- | -----------------------------------------------------------------------------------------
|                       |     | William D. Huse, M.D., Ph.D.
President, Chief Executive Officer and Chairman of the Board



|Date: November 5, 2002 | By: | /s/ Lawrence E. Bloch, M.D., J.D.                                  
|---------------------- | --- | -------------------------------------------------------------------
|                       |     | Lawrence E. Bloch, M.D., J.D.
Chief Financial Officer and Secretary

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CERTIFICATIONS

I, William D. Huse, M.D., Ph.D., certify that:

1. I have reviewed this quarterly report on Form 10-Q of Applied Molecular
Evolution, Inc.;

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

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

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

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

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

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

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

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

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

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



|Date: November 5, 2002 | By: | /s/ William D. Huse, M.D., Ph.D.                                                         
|---------------------- | --- | -----------------------------------------------------------------------------------------
|                       |     | William D. Huse, M.D., Ph.D.
President, Chief Executive Officer and Chairman of the Board

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I, Lawrence E. Bloch, M.D., J.D., certify that:

1. I have reviewed this quarterly report on Form 10-Q of Applied Molecular
Evolution, Inc.;

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

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

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

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

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

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

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

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

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

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



|Date: November 5, 2002 | By: | /s/ Lawrence E. Bloch, M.D., J.D.                                  
|---------------------- | --- | -------------------------------------------------------------------
|                       |     | Lawrence E. Bloch, M.D., J.D.
Chief Financial Officer and Secretary

19