##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549


FORM 10-Q

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

For the Quarterly period ended September 30, 2003.

or

|  |  |                                                                                                                                                     
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------
|o |  | 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 |  | (I.R.S. Employer   
|incorporation or organization)  |  | Identification No.)

3520 Dunhill Street

San Diego, California 92121

(Address of principal executive offices and zip code)

(858) 597-4990

(Registrants telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

YES x    NO o

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).

YES x    NO o

20,968,700 shares of the Registrants Common Stock were outstanding as of
September 30, 2003.





---

TABLE OF CONTENTS



|                           |                                                                                               |                                            |  |  |  |  |  | 
|-------------------------- | --------------------------------------------------------------------------------------------- | ------------------------------------------ |  |  |  |  |  | 
|                           |                                                                                               | CONSOLIDATED BALANCE SHEETS               
|                           |                                                                                               | CONSOLIDATED STATEMENTS OF OPERATIONS     
|                           |                                                                                               | CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                           |                                                                                               | NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|                           | ITEM 2: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|                           | ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                           
|                           | ITEM 4: CONTROLS AND PROCEDURES                                                              
|PART II: OTHER INFORMATION
|                           | ITEM 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                
|EXHIBIT 10.35             
|EXHIBIT 10.36             
|EXHIBIT 10.37             
|EXHIBIT 10.38             
|EXHIBIT 10.39             
|EXHIBIT 31.1              
|EXHIBIT 31.2              
|EXHIBIT 32.1              
|EXHIBIT 32.2              



---



##### Table of Contents



APPLIED MOLECULAR EVOLUTION, INC.
FORM 10-Q INDEX

|                              |                                                                                               |                                                                                                                   |    |      |   | 
|----------------------------- | --------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------- | -- | ---- | - | 
|                              |                                                                                               |                                                                                                                   |    | PAGE
|                              |                                                                                               |                                                                                                                   |    |     
|PART I: FINANCIAL INFORMATION |                                                                                               |                                                                                                                   |    |     
|                              | ITEM 1: Financial Statements                                                                  |                                                                                                                   |    | 3    |  
|                              |                                                                                               | Consolidated Balance Sheets at September 30, 2003 (unaudited), and
December 31, 2002                              |    |      | 3 | 
|                              |                                                                                               | Consolidated Statements of Operations for the three and nine months ended
September 30, 2003 and 2002 (unaudited) |    |      | 4 | 
|                              |                                                                                               | Consolidated Statements of Cash Flows for the nine months ended
September 30, 2003
and 2002 (unaudited)           |    |      | 5 | 
|                              |                                                                                               | Notes to Consolidated Financial Statements (unaudited)                                                            |    |      | 6 | 
|                              | ITEM 2: Managements Discussion and Analysis of Financial Condition and
Results of Operations |                                                                                                                   |    | 8    |  
|                              | ITEM 3: Quantitative and Qualitative Disclosures About Market Risk                            |                                                                                                                   |    | 15   |  
|                              | ITEM 4: Controls and Procedures                                                               |                                                                                                                   |    | 15   |  
|PART II: OTHER INFORMATION    |                                                                                               |                                                                                                                   |    |     
|                              | ITEM 1: Legal Proceedings                                                                     |                                                                                                                   |    | 15   |  
|                              | ITEM 2: Changes in Securities and Use of Proceeds                                             |                                                                                                                   |    | 16   |  
|                              | ITEM 3: Defaults Upon Senior Securities                                                       |                                                                                                                   |    | 16   |  
|                              | 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   |  
|SIGNATURES                    |                                                                                               |                                                                                                                   | 18 |     
|EXHIBITS                      |                                                                                               |                                                                                                                   | 19 |     

2



---



##### Table of Contents






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

|                                                             |                                                                                                                                                                 |                                            |        |               |        |              |        |         |        | 
|------------------------------------------------------------ | --------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------ | ------------- | ------ | ------------ | ------ | ------- | ------ | 
|                                                             |                                                                                                                                                                 |                                            |        | SEPTEMBER 30, |        | DECEMBER 31,
|                                                             |                                                                                                                                                                 |                                            |        | 2003          |        | 2002        
|                                                             |                                                                                                                                                                 |                                            |        |               |        |             
|                                                             |                                                                                                                                                                 |                                            |        | (UNAUDITED)   |        |              |        |        
|ASSETS                                                       |                                                                                                                                                                 |                                            |        |               |        |              |        |        
|Current assets:                                              |                                                                                                                                                                 |                                            |        |               |        |              |        |        
|                                                             | Cash and cash equivalents                                                                                                                                       |                                            | $      | 7,637         |        |              | $      | 6,336   |       
|                                                             | Short-term investments                                                                                                                                          |                                            |        | 36,021        |        |              |        | 44,783  |       
|                                                             | Prepaid expenses                                                                                                                                                |                                            |        | 318           |        |              |        | 448     |       
|                                                             | Other current assets                                                                                                                                            |                                            |        | 2,772         |        |              |        | 922     |       
|                                                             |                                                                                                                                                                 |                                            |        |               |        |              |        |        
|                                                             |                                                                                                                                                                 | Total current assets                       |        |               | 46,748 |              |        |         | 52,489 | 
|Restricted cash, cash equivalents and short-term investments |                                                                                                                                                                 |                                            |       |               |        |              | 10,500 |        
|Property and equipment, net                                  |                                                                                                                                                                 |                                            | 16,659 |               |        |              | 14,490 |        
|Patents, net                                                 |                                                                                                                                                                 |                                            | 2,131  |               |        |              | 1,985  |        
|Other assets                                                 |                                                                                                                                                                 |                                            | 327    |               |        |              | 507    |        
|                                                             |                                                                                                                                                                 |                                            |        |               |        |              |        |        
|                                                             |                                                                                                                                                                 | Total assets                               |        | $             | 65,865 |              |        | $       | 79,971 | 
|                                                             |                                                                                                                                                                 |                                            |        |               |        |              |        |         |       
|LIABILITIES AND STOCKHOLDERS EQUITY                         |                                                                                                                                                                 |                                            |        |               |        |              |        |        
|Current liabilities:                                         |                                                                                                                                                                 |                                            |        |               |        |              |        |        
|                                                             | Accounts payable                                                                                                                                                |                                            | $      | 1,477         |        |              | $      | 958     |       
|                                                             | Accrued liabilities                                                                                                                                             |                                            |        | 2,449         |        |              |        | 1,613   |       
|                                                             | Current portion of long-term debt                                                                                                                               |                                            |        | 1,707         |        |              |        |        |       
|                                                             | Current portion of long-term lease obligations                                                                                                                  |                                            |        | 125           |        |              |        |        |       
|                                                             | Current portion of deferred revenue                                                                                                                             |                                            |        | 287           |        |              |        | 1,214   |       
|                                                             |                                                                                                                                                                 |                                            |        |               |        |              |        |        
|                                                             |                                                                                                                                                                 | Total current liabilities                  |        |               | 6,045  |              |        |         | 3,785  | 
|Deferred revenue                                             |                                                                                                                                                                 |                                            | 1,250  |               |        |              | 158    |        
|Deferred rent                                                |                                                                                                                                                                 |                                            | 224    |               |        |              | 86     |        
|Long-term debt, net of current                               |                                                                                                                                                                 |                                            | 4,293  |               |        |              | 10,000 |        
|Long-term lease obligation, net of current portion           |                                                                                                                                                                 |                                            | 490    |               |        |              |       |        
|Minority interest                                            |                                                                                                                                                                 |                                            | 100    |               |        |              |       |        
|Stockholders equity:                                        |                                                                                                                                                                 |                                            |        |               |        |              |        |        
|                                                             | Preferred stock, $.001 par value, 5,000,000 shares
authorized, none issued                                                                                      |                                            |        |              |        |              |        |        |       
|                                                             | Common stock, $.001 par value, 45,000,000 shares
authorized, 24,041,811 and 23,661,477 shares issued at
September 30, 2003, and December 31, 2002, respectively |                                            |        | 24            |        |              |        | 24      |       
|                                                             | Additional paid-in capital                                                                                                                                      |                                            |        | 161,612       |        |              |        | 160,588 |       
|                                                             | Deferred compensation                                                                                                                                           |                                            |        | (198          | )      |              |        | (1,213  | )     
|                                                             | Notes receivable from employees                                                                                                                                 |                                            |        | (994          | )      |              |        | (941    | )     
|                                                             | Accumulated other comprehensive income                                                                                                                          |                                            |        | 327           |        |              |        | 761     |       
|                                                             | Accumulated deficit                                                                                                                                             |                                            |        | (85,622       | )      |              |        | (71,591 | )     
|                                                             | Less: Treasury stock at cost, 3,073,111 shares                                                                                                                  |                                            |        | (21,686       | )      |              |        | (21,686 | )     
|                                                             |                                                                                                                                                                 |                                            |        |               |        |              |        |        
|                                                             |                                                                                                                                                                 | Total stockholders equity                 |        |               | 53,463 |              |        |         | 65,942 | 
|                                                             |                                                                                                                                                                 |                                            |        |               |        |              |        |        
|                                                             |                                                                                                                                                                 | Total liabilities and stockholders equity |        | $             | 65,865 |              |        | $       | 79,971 | 
|                                                             |                                                                                                                                                                 |                                            |        |               |        |              |        |         |       

See accompanying notes.

3



---



##### Table of Contents






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

|                                                       |                                      |   |                    |       |                   |   |        |       |      |   |         |        |  |   |         |        | 
|------------------------------------------------------ | ------------------------------------ | - | ------------------ | ----- | ----------------- | - | ------ | ----- | ---- | - | ------- | ------ |  | - | ------- | ------ | 
|                                                       |                                      |   | THREE MONTHS ENDED |       | NINE MONTHS ENDED
|                                                       |                                      |   | SEPTEMBER 30,      |       | SEPTEMBER 30,    
|                                                       |                                      |   |                    |       |                  
|                                                       |                                      |   | 2003               |       | 2002              |   | 2003   |       | 2002
|                                                       |                                      |   |                    |       |                   |   |        |       |     
|Revenues:                                              |                                      |   |                    |       |                   |   |        |       |      |   |         |        |  |   |         |       
|                                                       | Contract revenue from collaborations |   | $                  | 626   |                   |   | $      | 1,199 |      |   | $       | 3,332  |  |   | $       | 3,979  | 
|                                                       | Other revenue                        |   |                    | 838   |                   |   |        | 258   |      |   |         | 2,789  |  |   |         | 1,673  | 
|                                                       |                                      |   |                    |       |                   |   |        |       |      |   |         |        |  |   |         |       
|                                                       | Total revenue                        |   |                    | 1,464 |                   |   |        | 1,457 |      |   |         | 6,121  |  |   |         | 5,652  | 
|                                                       |                                      |   |                    |       |                   |   |        |       |      |   |         |        |  |   |         |       
|Operating expenses:                                    |                                      |   |                    |       |                   |   |        |       |      |   |         |        |  |   |         |       
|                                                       | Research and development             |   |                    | 5,919 |                   |   |        | 3,315 |      |   |         | 15,446 |  |   |         | 10,406 | 
|                                                       | General and administrative           |   |                    | 1,361 |                   |   |        | 2,972 |      |   |         | 5,582  |  |   |         | 8,173  | 
|                                                       | Stock-based compensation             |   |                    | 237   |                   |   |        | 711   |      |   |         | 1,023  |  |   |         | 2,615  | 
|                                                       |                                      |   |                    |       |                   |   |        |       |      |   |         |        |  |   |         |       
|                                                       | Total operating expenses             |   |                    | 7,517 |                   |   |        | 6,998 |      |   |         | 22,051 |  |   |         | 21,194 | 
|                                                       |                                      |   |                    |       |                   |   |        |       |      |   |         |        |  |   |         |       
|Loss from operations                                   |                                      |   | (6,053             | )     |                   |   | (5,541 | )     |      |   | (15,930 | )      |  |   | (15,542 | )     
|Minority interest                                      |                                      |   | 106                |       |                   |   | 402    |       |      |   | 709     |        |  |   | 402     |       
|Interest income, net                                   |                                      |   | 240                |       |                   |   | 638    |       |      |   | 1,190   |        |  |   | 2,281   |       
|Other financing charges                                |                                      |   |                   |       |                   |   | (604   | )     |      |   |        |        |  |   | (604    | )     
|                                                       |                                      |   |                    |       |                   |   |        |       |      |   |         |        |  |   |         |       
|Net loss                                               |                                      | $ | (5,707             | )     |                   | $ | (5,105 | )     |      | $ | (14,031 | )      |  | $ | (13,463 | )     
|                                                       |                                      |   |                    |       |                   |   |        |       |      |   |         |        |  |   |         |        | 
|Net loss per share, basic and diluted                  |                                      | $ | (0.27              | )     |                   | $ | (0.24  | )     |      | $ | (0.68   | )      |  | $ | (0.62   | )     
|Weighted average shares outstanding, basic
and diluted |                                      |   | 20,921             |       |                   |   | 21,227 |       |      |   | 20,760  |        |  |   | 21,672  |       

See accompanying notes.

4



---



##### Table of Contents






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

|                                                                            |                                                     |   |                                 |        |      |   |         |        |  
|--------------------------------------------------------------------------- | --------------------------------------------------- | - | ------------------------------- | ------ | ---- | - | ------- | ------ | -
|                                                                            |                                                     |   | NINE MONTHS ENDED SEPTEMBER 30,
|                                                                            |                                                     |   |                                
|                                                                            |                                                     |   | 2003                            |        | 2002
|                                                                            |                                                     |   |                                 |        |     
|OPERATING ACTIVITIES                                                        |                                                     |   |                                 |        |      |   |         |       
|Net loss                                                                    |                                                     | $ | (14,031                         | )      |      | $ | (13,463 | )     
|Adjustments to reconcile net loss to net cash
used in operating activities: |                                                     |   |                                 |        |      |   |         |       
|                                                                            | Depreciation and amortization                       |   |                                 | 1,051  |      |   |         | 1,082  |  
|                                                                            | Amortization of stock-based compensation            |   |                                 | 1,007  |      |   |         | 2,583  |  
|                                                                            | Compensation related to consultant stock options    |   |                                 | 15     |      |   |         | 33     |  
|                                                                            | Deferred revenue                                    |   |                                 | 165    |      |   |         | (1,526 | )
|                                                                            | Deferred rent                                       |   |                                 | 138    |      |   |         | (25    | )
|                                                                            | Minority interest                                   |   |                                 | (709   | )    |   |         | (402   | )
|                                                                            | Realized gain on short-term investments             |   |                                 | (141   | )    |   |         | (133   | )
|                                                                            | Accrued interest on notes receivable from employees |   |                                 | (53    | )    |   |         | (45    | )
|                                                                            | Other financing charges                             |   |                                 |       |      |   |         | 604    |  
|Changes in operating assets and liabilities:                                |                                                     |   |                                 |        |      |   |         |       
|                                                                            | Prepaid expenses and other assets                   |   |                                 | (1,540 | )    |   |         | 3,239  |  
|                                                                            | Accounts payable and accrued expenses               |   |                                 | 1,355  |      |   |         | 1,696  |  
|                                                                            |                                                     |   |                                 |        |      |   |         |       
|Net cash used in operating activities                                       |                                                     |   | (12,743                         | )      |      |   | (6,357  | )     
|                                                                            |                                                     |   |                                 |        |      |   |         |       
|INVESTING ACTIVITIES                                                        |                                                     |   |                                 |        |      |   |         |       
|Restricted cash, cash equivalents and short-term investments                |                                                     |   | 10,500                          |        |      |   | (10,541 | )     
|Purchase of property and equipment                                          |                                                     |   | (3,098                          | )      |      |   | (11,802 | )     
|Purchase of short-term investments                                          |                                                     |   | (21,456                         | )      |      |   | (57,390 | )     
|Proceeds from sale of short-term investments                                |                                                     |   | 29,925                          |        |      |   | 60,071  |       
|Patents                                                                     |                                                     |   | (268                            | )      |      |   | (217    | )     
|                                                                            |                                                     |   |                                 |        |      |   |         |       
|Net cash provided by (used in) investing activities                         |                                                     |   | 15,603                          |        |      |   | (19,879 | )     
|                                                                            |                                                     |   |                                 |        |      |   |         |       
|FINANCING ACTIVITIES                                                        |                                                     |   |                                 |        |      |   |         |       
|Proceeds from long-term obligations                                         |                                                     |   | 6,615                           |        |      |   | 10,000  |       
|Payments
on long-term obligations                                           |                                                     |   | (10,000                         | )      |      |   |        |       
|Proceeds from issuance of convertible notes                                 |                                                     |   |                                |        |      |   | 406     |       
|Issuance of common stock, net                                               |                                                     |   | 342                             |        |      |   | 213     |       
|Purchase of treasury stock                                                  |                                                     |   |                                |        |      |   | (7,286  | )     
|Investment in subsidiary by minority investors, net                         |                                                     |   | 1,484                           |        |      |   | 482     |       
|                                                                            |                                                     |   |                                 |        |      |   |         |       
|Net cash (used in) provided by financing activities                         |                                                     |   | (1,559                          | )      |      |   | 3,815   |       
|                                                                            |                                                     |   |                                 |        |      |   |         |       
|Net increase (decrease) in cash and cash equivalents                        |                                                     |   | 1,301                           |        |      |   | (22,421 | )     
|Cash and cash equivalents at the beginning of the period                    |                                                     |   | 6,336                           |        |      |   | 25,927  |       
|                                                                            |                                                     |   |                                 |        |      |   |         |       
|Cash and cash equivalents at the end of the period                          |                                                     | $ | 7,637                           |        |      | $ | 3,506   |       
|                                                                            |                                                     |   |                                 |        |      |   |         |       
|Supplemental non-cash disclosure                                            |                                                     |   |                                 |        |      |   |         |       
|Conversion of notes payable to equity in subsidiary                         |                                                     | $ |                                |        |      | $ | (406    | )     
|                                                                            |                                                     |   |                                 |        |      |   |         |       

See accompanying notes.

5



---



##### Table of Contents






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

1. Organization and Business

Applied Molecular Evolution, Inc. (the Company or AME), a Delaware
corporation, was incorporated on August 14, 1989. The Company has a broad
technology platform termed the AMEsystem, which the Companys management
believes will provide AME with a valuable and efficient solution to optimizing
proteins with commercial potential. The Company applies its proprietary
technology to optimize proteins from all major classes of therapeutic proteins
including antibodies, cytokines, hormones, enzymes and growth factors. AMEs
majority-owned subsidiary, Novasite Pharmaceuticals, Inc. (Novasite), applies
directed molecular evolution to small-molecule drug discovery and optimization.

2. Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared
in accordance with accounting principles generally accepted in the United
States 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, 2002.

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, its
majority-owned subsidiary, Novasite, and its wholly owned subsidiary AME Torrey
View, LLC (Torrey View). As of September 30, 2003,
Novasite was 51% owned by
AME. All significant intercompany accounts and transactions have been
eliminated.

3. Notes Payable

During the third quarter, the Company entered into an equipment term loan for
$6.0 million. This note bears interest at an annual rate of 6.5% and is
payable over 36 months. This note is collateralized by specific underlying
property and equipment with a book value of $3.6 million. The loan is subject
to certain covenants including maintaining a minimum cash balance of
$9.0 million.

The Company also entered into a leaseline whereby the Company may draw up to
$4.0 million for qualifying equipment purchases. As of September 30, 2003,
the Company had utilized $615,000 of the available amount and has
approximately $3.4 million available for future equipment
purchases. This lease bears an
effective annual interest rate of 6.9% and is payable over 48 months.

4. Commitments

During the third quarter, the Company amended its current operating lease
agreement for its primary operating facilities. The amended terms provide for
the facilities to be leased through December 2008, with specific rent
escalations. Rent expense will continue to be recorded on a straight-line
basis.

On August 17, 2001, the Company entered into an Operating Agreement with Torrey
View Phase II, L.P., (TV), 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 may develop
this property over the next few years as its corporate headquarters. The
Company could also seek alternative uses for the property or sell the property
if development would be inconsistent with the Companys liquidity and cash
resource needs.

In connection with the purchase, the Company borrowed approximately $10.0
million, under a $15.0 million credit facility, from Merrill Lynch Business
Financial Services to fund the purchase price and certain development costs. As
of June 30, 2003, the Company had repaid the outstanding loan balance under the
credit facility, and all restricted cash which had collateralized the
outstanding loan balance had been released.

6



---



##### Table of Contents



On June 16, 2003, the Company entered into an agreement with TV to purchase
TVs interest in Torrey View for $3,169,000, of which $3,000,000 had been
previously advanced to TV and accounted for as a project cost. The remaining
$169,000 was expensed. This payment was in lieu of TVs contractual right to
receive a $3,750,000 payment for termination of TVs economic interest in
Torrey View. The Company is now the sole member of Torrey View.

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., (Coalition), 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, (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.

On June 18, 2003, following a hearing on the merits of the petition of
the Coalition, the Superior Court issued an order denying the petition and ruled in
favor of the City of San Diego and AME. The Coalition has appealed the order denying its petition to the California Court of
Appeals. The Company and the City of San Diego intend to oppose
the appeal.

On August 29, 2003, the Superior Court granted a demurrer by the Company and
dismissed the petition of the School District for failing to name Torrey View
as a necessary real party in interest. The School District has filed an
amended petition naming Torrey View as a real party in interest. The Company
intends to demur to the amended petition.

5. Comprehensive Loss

Total comprehensive loss was $14,465,000 for the nine months ended September
30, 2003, and $13,321,000 for the nine months ended September 30, 2002. The
difference between net loss and comprehensive loss is primarily due to the
difference between the market value and the cost basis of the Companys
short-term marketable securities.

6. Computation of Net Loss Per Share

Basic and diluted net loss per share are presented in conformity with Statement
of Financial Accounting Standards (SFAS) No. 128, Earnings per Share. 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.

7. Stock-based Compensation

The Company has in effect several stock-based plans under which nonqualified
and incentive stock options have been granted to employees, consultants and
directors. As required by SFAS No. 123, Accounting for Stock-Based Compensation
and SFAS No. 148, Accounting for Stock-Based Compensation Transition and
Disclosure,the pro forma effects of stock-based compensation on net income
(loss) and net earnings (loss) per common share are estimated at the date of
grant using the Black-Scholes option-pricing model. For purposes of pro forma
disclosures, the estimated fair value of the options is amortized as an expense
over the options vesting period. The Companys pro forma net loss information
is as follows (in thousands, except per share amounts):

7



---



##### Table of Contents



|                                                          |  |                            |        |                           |  |             |        |             |  |   |         |   |  |   |         |  
|--------------------------------------------------------- |  | -------------------------- | ------ | ------------------------- |  | ----------- | ------ | ----------- |  | - | ------- | - |  | - | ------- | -
|                                                          |  | For the Three Months Ended |        | For the Nine Months Ended
|                                                          |  | September 30,              |        | September 30,            
|                                                          |  |                            |        |                          
|                                                          |  | 2003                       |        | 2002                      |  | 2003        |        | 2002       
|                                                          |  |                            |        |                           |  |             |        |            
|                                                          |  | (Unaudited)                |        | (Unaudited)               |  | (Unaudited) |        | (Unaudited)
|                                                          |  |                            |        |                           |  |             |        |            
|Net loss attributable to
common stockholders, as
reported |  | $                          | (5,707 | )                         |  | $           | (5,105 | )           |  | $ | (14,031 | ) |  | $ | (13,463 | )
|Net loss attributable to
common stockholders, pro
forma   |  | $                          | (6,850 | )                         |  | $           | (6,180 | )           |  | $ | (17,351 | ) |  | $ | (16,469 | )
|Basic and diluted net
loss per share, as
reported         |  | $                          | (0.27  | )                         |  | $           | (0.24  | )           |  | $ | (0.68   | ) |  | $ | (0.62   | )
|Basic and diluted net
loss per share, pro
forma           |  | $                          | (0.33  | )                         |  | $           | (0.29  | )           |  | $ | (0.84   | ) |  | $ | (0.76   | )

8. MedImmune, Inc. (MedImmune)

In September 2003, the Company achieved two milestones as a result of the
initiation by MedImmune of Phase II trials for Vitaxin® in both rheumatoid
arthritis and melanoma. In accordance with the terms of the license agreement,
MedImmune has a certain period of time from the date of the milestone-triggering event
to elect to have the milestone payment treated as cash milestones or
as equity purchased at a
premium. If the milestone payment is recognized as an equity purchase, 20%
of the amount will be recorded as deferred royalty revenue. If the
milestone payment is recognized as a cash milestone, 35% of the payment will be recognized as milestone revenue, and
the remaining 65% will be recognized as deferred royalty revenue. The Company
received payment of the milestones in October 2003, however, because the election of
payment method described above has not been made, the entire amount
of the milestones is included as deferred revenue in the accompanying balance sheet.

9. Novasite Financing

In June 2003, the Companys subsidiary, Novasite, received $500,000 as
consideration for the issuance of 500,000 shares of preferred stock to Crabtree
Ventures, L.P. (Crabtree). John F. Richards, one of our directors, is the
President of Crabtree Ventures, L.L.C., the general partner of Crabtree, a
minority investor in Novasite. In addition, Novasite issued 221,000 shares of
preferred stock to AME in exchange for the cancellation of $221,000 of accounts
payable due to AME. In April 2003 and January 2003, Novasite received $250,000
and $750,000, respectively, as consideration for the issuance of 250,000 and
750,000 shares of preferred stock, respectively, to Crabtree.

In January 2002, Novasite received $200,000 from a private placement of 10%
convertible notes with AME and Crabtree. These notes, which did not have a
material beneficial conversion feature or include warrants, were converted into
preferred stock of Novasite in connection with the financing which closed on
September 30, 2002. In addition, in August 2002, Novasite received $350,000
from a private placement of 10% convertible notes with Crabtree. The notes plus
accrued interest were converted at a discounted price into preferred stock of
Novasite in connection with the 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. In connection
with the issuance of the August 2002 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 held by Crabtree and AME
and related accrued interest as of September 30, 2002, which totaled $554,041,
Novasite received cash proceeds of $500,000 and issued 1,430,304 shares of
preferred stock. In November 2002, Novasite received an additional $250,000 as
consideration for the issuance of 250,000 shares of preferred stock to
Crabtree.




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, 2002.

8



---



##### Table of Contents



OVERVIEW

We are a leader in the application of directed molecular evolution to the
optimization and development of human biotherapeutics. Directed molecular
evolution is a process by which genes and proteins are optimized for specific
commercial purposes. Our technology has been validated by, among other things,
the ongoing clinical trials of Vitaxin, a humanized and optimized therapeutic
monoclonal antibody candidate, that AME licensed to MedImmune, Inc.
(MedImmune), the successful creation of Numax candidates by optimizing
Synagis® for MedImmune and the engineering of product candidates AME-527 and
AME-133, optimized versions of the FDA-approved, currently marketed monoclonal
antibodies Remicade® and Rituxan®, respectively. We use our proprietary
AMEsystem technology to rapidly create improvements in proteins that would be
less efficient and more expensive to achieve through conventional methods.
Since our inception, our principal focus has been on applying our technology to
human biotherapeutics, the largest and most profitable target market for
directed molecular evolution. We plan to use our directed molecular evolution
technology to develop improved versions of FDA-approved, currently marketed
biopharmaceuticals as well as novel human biotherapeutics. AMEs majority-owned
subsidiary, Novasite, applies directed molecular evolution to small-molecule
drug discovery and optimization.

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, which is responsible for current and 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 Incorporated,
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 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 (NIH).

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, 2003, we had
an accumulated deficit of $85.6 million. The losses and this accumulated
deficit resulted from the significant costs incurred in the development of our
proprietary AMEsystem technology platform, our internal development projects
and the preclinical and clinical development of Vitaxin. We expect these losses
to increase as we continue to invest in our AMEsystem technology and our
internal development projects, including AME-527 and AME-133.

See Note 4 of Notes to Consolidated Financial Statements and Item 1 of Part II
for matters related to the Companys wholly owned subsidiary, AME Torrey View,
LLC.

On June 25, 2001, we filed a complaint against MorphoSys AG and its wholly
owned subsidiary MorphoSys USA, Inc. (collectively, MorphoSys), 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 is willfully infringing the Kauffman patent family under which we
hold an exclusive license.

On January 6, 2003, we announced a report and recommendation from the
magistrate judge in the United States District Court for the District of
Massachusetts to the district judge in our legal action against MorphoSys that
MorphoSys motion for summary judgment of non-infringement be allowed and that
AMEs motion for partial summary judgment of infringement be denied and all
other motions be dismissed as moot. We have filed objections to the magistrate
judges report and recommendation. The district judge may adopt, reject or
modify the magistrate judges recommendation or instruct the magistrate judge
to reconsider the recommendation.

RESULTS OF OPERATIONS

Three Months Ended September 30, 2003, Compared to Three Months Ended September
30, 2002

Revenues. Our revenues were $1.5 million for the quarter ended September 30,
2003, and also $1.5 million for the same period in 2002.

9



---



##### Table of Contents



Research and development. Research and development expenses increased to $5.9
million for the quarter ended September 30, 2003, from $3.3 million for the
same period in 2002, an increase of approximately $2.6 million. The increase
was primarily due to increased research and development staffing and the expansion of
research and development activities in support of our internal development projects.

General and administrative. General and administrative expenses decreased to
$1.4 million for the quarter ended September 30, 2003, from $3.0 million for
the same period in 2002, a decrease of approximately $1.6 million. The decrease
was primarily due to the decrease in 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 Financial Accounting
Standards Board (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
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, 2003, we recorded non-cash,
stock-based compensation of $237,000 ($82,000 and $155,000 related to research
and development and general and administrative, respectively), compared to
$711,000 ($229,000 and $482,000 related to research and development and general
and administrative, respectively) for the same period in 2002.

Interest income, net. Net interest
income decreased to $240,000 for the quarter
ended September 30, 2003 from $638,000 for the same period in 2002, a decrease
of approximately $398,000. The decrease was primarily due to lower interest
rates and lower cash, cash equivalent and short-term investment balances in
2003.

Other financing charges. We incurred no other financing charges for the
three-month period ended September 30, 2003, compared to $604,000 for the
three-month period ended September 30, 2002. The decrease 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 majority-owned
subsidiary, Novasite, to one of its minority investors (See Note 9).

Nine Months Ended September 30, 2003, Compared to Nine Months Ended September
30, 2002

Revenues. Our revenues increased to $6.1 million for the nine months ended
September 30, 2003, from $5.7 million for the same period in 2002, an increase
of approximately $400,000. The increase was primarily due to revenue recognized
under our grants from the NIH.

Research and development. Research and development expenses increased to $15.4
million for the nine months ended September 30, 2003, from $10.4 million for
the same period in 2002, an increase of approximately $5.0 million. The
increase was primarily related to additional research and development staffing and expansion
of facilities to support our internal development projects.

General and administrative. General and administrative expenses decreased to
$5.6 million for the nine months ended September 30, 2003, from $8.2 million
for the same period in 2002, a decrease of approximately $2.6 million. The
decrease was primarily due to the decrease in legal expenses incurred in our
litigation against MorphoSys.

For the nine months ended September 30, 2003, we recorded non-cash, stock-based
compensation of $1.0 million ($337,000 and $686,000 related to research and
development and general and administrative, respectively), compared to $2.6
million ($845,000 and $1.8 million related to research and development and
general and administrative, respectively) for the same period in 2002.

Interest income, net. Net interest income decreased to $1.2 million for the
nine months ended September 30, 2003, from $2.3 million for the same period in
2002, a decrease of approximately $1.1 million. The decrease was primarily due
to lower interest rates and lower cash, cash equivalent and short-term
investment balances in 2003.

Other financing charges. We incurred no other financing charges for the
nine-month period ended September 30, 2003, compared to

10



---



##### Table of Contents



$604,000 for the nine-month period ended September 30, 2002. The decrease 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
majority-owned subsidiary, Novasite, to one of its minority investors (See Note
9).

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 $26.8 million of cash from corporate collaborations
through September 30, 2003.

As of September 30, 2003, we had approximately $43.7 million in unrestricted
cash, cash equivalents and short-term investments, compared to $51.1 million of
unrestricted cash, cash equivalents and short-term investments as of December
31, 2002. As of September 30, 2003, we had no restricted cash, reflecting full
repayment of the Merrill Lynch Business Financial Services Credit facility
which had a $10.5 million restricted cash balance as of December 31, 2002.

For the nine months ended September 30, 2003, we used cash of approximately
$12.7 million in operating activities, net of non-cash charges for depreciation
and patent amortization totaling $1.1 million, non-cash, stock based
compensation totaling $1.0 million, an increase in deferred
revenue of $165,000 and changes in operating assets and liabilities of $185,000.

For the nine months ended September 30, 2003, we generated cash of
approximately $15.6 million from investing activities. Our investing activities
consisted primarily of sales and maturities of short-term investments offset by
purchases of short-term investments and property and equipment. We expect to
continue to make investments in our infrastructure, including purchasing
property and equipment to support our operations.

For the nine months ended September 30, 2003, we used cash of approximately
$1.6 million for financing activities. Our financing activities consisted
primarily of the repayment of our Merrill Lynch Business Financial Services
credit facility of $10.0 million. This was offset by cash proceeds of $6.6
million received from our collateralized equipment financing facilities, a $1.5
million investment by a minority investor in our majority-owned subsidiary, Novasite, and
$342,000 received from the sale of common stock under our Employee Stock
Purchase Plan and from the exercise of stock options.

We expect our cash requirements to increase in 2003 as we continue our research
and development efforts, hire additional personnel and accommodate our future
facility needs. These facility needs include leased space at our current
facilities, and may include the development of the property purchased by Torrey
View, the Companys wholly owned subsidiary. The Company may develop this
property as its corporate headquarters over the next few years, which could
involve a substantial commitment. The Company could also seek alternative uses
for the property or sell the property if development would be inconsistent with
the Companys liquidity and cash resource needs. We believe that our current
cash, cash equivalents and short-term 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 guarantee that additional
funding, if sought, will be available on terms favorable to us. Furthermore,
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.

RISK FACTORS

11



---



##### Table of Contents



We have not achieved profitability and may never become profitable.

We are at an early stage of development. We incurred a net loss of $14.0
million for the nine months ended September 30, 2003, and our revenue for the
same period was $6.1 million. Additionally, we have had net losses each year
since inception and as of September 30, 2003, had an accumulated deficit of
$85.6 million. We expect to report a net loss for fiscal year 2003, 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
biotherapeutic candidates that we have optimized. Successful commercialization
of biotherapeutic candidates 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
candidate. 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 certain proteins, 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 certain 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 may call for
us to enter into contractual arrangements with collaborators. We may be
unsuccessful in attracting collaborators to develop and commercialize our
product candidates. Some

12



---



##### Table of Contents



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 or biologic
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 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. Our commercial success
might also become dependent on us not infringing valid, enforceable patents or
proprietary rights which might be developed by third parties in the future. 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
collaborators 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 work
will be critical to our

13



---



##### Table of Contents



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 protein therapeutics 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 (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 7,622,625 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 majority-owned 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, 2003, our officers and directors and their affiliates, in
the aggregate, owned beneficially approximately 29% 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
interests as a stockholder are different from their interests as both managers
and stockholders, you may not agree with their decisions.

14



---



##### Table of Contents






ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The primary objective of our investment activities is to preserve principal
while at the same time maximizing the income we receive from our investments
without significantly increasing risk. Some of the securities that we invest in
may have market risk. This means that a change in prevailing interest rates may
cause the principal amount of the investment to fluctuate. For example, if we
hold a security that was issued with a fixed interest rate at the
then-prevailing rate, and the prevailing interest rate later rises, the market
value of our investment will probably decline. To minimize this risk in the
future, we intend to maintain our portfolio of cash equivalents and short-term
investments in a variety of securities, including commercial paper, money
market funds and government and non-government debt securities. The average
duration of all of our investments as of September 30, 2003, 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

(a)  Evaluation of disclosure controls and procedures.We maintain disclosure
controls and procedures, as such term is defined in Rule 13a-15(e) under the
Securities Exchange Act of 1934 (the Exchange Act), that are designed to
ensure that information required to be disclosed by us in reports that we file
or submit under the Exchange Act is recorded, processed, summarized and
reported within the time periods specified in Securities and Exchange
Commission rules and forms, and that such information is accumulated and
communicated to our management, including our Chief Executive Officer and Chief
Financial Officer, as appropriate, to allow timely decisions regarding required
disclosure. In designing and evaluating our disclosure controls and procedures,
management recognizes that disclosure controls and procedures, no matter how
well conceived and operated, can provide only reasonable, not absolute,
assurance that the objectives of the disclosure controls and procedures are
met. Additionally, in designing disclosure controls and procedures, our
management necessarily was required to apply its judgment in evaluating
potential disclosure controls and procedures. The design of any disclosure
controls and procedures also is based in part upon certain assumptions about
the likelihood of future events, and there can be no assurance that any design
will succeed in achieving its stated goals under all potential future
conditions.

Based on their evaluation as of the end of the period covered by this Quarterly
Report on Form 10-Q, our Chief Executive Officer and Chief Financial Officer
have concluded that, subject to the limitations noted above, our disclosure
controls and procedures were effective to ensure that material information
relating to us, including our consolidated subsidiaries, was made known to them
by others within those entities, particularly during the period in which this
Quarterly Report on Form 10-Q was being prepared.

(b)  Changes in internal control over financial reporting.There were no
significant changes in our internal control over financial reporting or, to our
knowledge, in other factors that could significantly affect these controls
subsequent to the date of their evaluation, including any corrective actions
with regard to significant deficiencies and material weaknesses.




PART II: OTHER INFORMATION




ITEM 1: LEGAL PROCEEDINGS

On June 25, 2001, we filed a complaint against MorphoSys 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 is
willfully infringing the Kauffman patent family under which we hold an
exclusive license.

On January 6, 2003, we announced a report and recommendation from the
magistrate judge in the United States District Court for the District of
Massachusetts to the district judge in our legal action against MorphoSys that
MorphoSys motion for summary judgment of non-infringement be allowed and that
AMEs motion for partial summary judgment of infringement be denied and all
other motions be dismissed as moot. We have filed objections to the magistrate
judges report and recommendation. The district judge may adopt, reject or

modify the magistrate judges recommendation or instruct the magistrate judge
to reconsider the recommendation.

On July 25, 2002, a petition was filed in the Superior Court of the State of
California, County of San Diego, by the Coalition 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 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

15



---



##### Table of Contents



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.

On June 18, 2003, following a hearing on the merits of the petition of
the Coalition, the Superior Court issued an order denying the petition and ruled in
favor of the City of San Diego and AME. The Coalition has appealed the order denying its petition to the California Court of Appeals.
The Company and the City of San Diego intend to oppose the
appeal.

On August 29, 2003, the Superior Court granted a demurrer by the Company and
dismissed the petition of the School District for failing to name Torrey View
as a necessary real party in interest. The School District has filed an
amended petition naming Torrey View as a real party in interest. The Company
intends to demur to the amended petition.




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, $10.0 million
for purchases of property and equipment and approximately $33.3 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

|                                                                                                                       
|-----------------------------------------------------------------------------------------------------------------------
|10.35 Third Amendment to Lease Agreement for 11095 Flintkote Avenue, San
Diego, California dated as of March 14, 2003. 
|                                                                                                                       
|10.36 Fourth Amendment to Lease Agreement for 11095 Flintkote Avenue, San
Diego, California dated as of August 4, 2003.

16



---



##### Table of Contents



|                                                                                                                                                             
|-------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.37 Fifth Amendment to Lease Agreement for 3520 Dunhill Street, San Diego,
California dated as of August 20, 2003.                                         
|                                                                                                                                                             
|10.38 Master Lease Agreement with General Electric Capital Corporation dated
September 24, 2003.                                                             
|                                                                                                                                                             
|10.39 Loan and Security Agreement with Silicon Valley Bank dated September
29, 2003.                                                                         
|                                                                                                                                                             
|31.1 Certification of the Chief Executive Officer of Applied Molecular
Evolution, Inc., Pursuant to Rule 13a-14(a) under the Securities Exchange Act
of 1934.
|                                                                                                                                                             
|31.2 Certification of the Chief Financial Officer of Applied Molecular
Evolution, Inc., Pursuant to Rule 13a-14(a) under the Securities Exchange Act
of 1934.
|                                                                                                                                                             
|32.1 Certification furnished Pursuant to Section 1350 of Chapter 63 of 18
U.S.C. as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.       
|                                                                                                                                                             
|32.2 Certification furnished Pursuant to Section 1350 of Chapter 63 of 18
U.S.C. as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.       

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

On August 5, 2003, pursuant to Item 12 we filed a current report on Form 8-K,
with an exhibit attached thereto, furnishing information relating to the
Companys results of operations for the three and six months ended June 30,
2003.

17



---



##### Table of Contents






SIGNATURES

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

|                       |  |     |  |                                      
|---------------------- |  | --- |  | -------------------------------------
|Date: November 4, 2003 |  | 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 4, 2003 |  | By: |  | /s/ Lawrence E. Bloch, M.D., J.D.    
|                       |  |     |  |                                      
|                       |  |     |  | Lawrence E. Bloch, M.D., J.D.        
|                       |  |     |  | Chief Financial Officer and Secretary

18