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

FORM 10-Q

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

For the Quarterly period ended June 30, 2002.

or

[   ]

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ______________ to ______________.

Commission File No. 000-31101

APPLIED MOLECULAR EVOLUTION, INC.

3520 Dunhill Street
San Diego, California 92121

(858) 597-4990

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

YES [X]  NO [    ]

As of June 30, 2002, 23,627,116 shares of the Registrant’s Common Stock were issued and outstanding.

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APPLIED MOLECULAR EVOLUTION, INC.
FORM 10-Q INDEX

PAGE

PART I: FINANCIAL INFORMATION

ITEM 1:

Financial Statements

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Consolidated Balance Sheets at June 30, 2002 (unaudited) and December 31, 2001

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Consolidated Statements of Operations for the three and six months ended June 30, 2002 and 2001 (unaudited)

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Consolidated Statements of Cash Flows for the six months ended June 30, 2002 and 2001 (unaudited)

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Notes to Consolidated Financial Statements (unaudited)

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ITEM 2:

Management's Discussion and Analysis of Financial Condition and Results of Operations

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ITEM 3:

Quantitative and Qualitative Disclosures About Market Risk

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PART II: OTHER INFORMATION

ITEM 1:

Legal Proceedings

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ITEM 2:

Changes in Securities and Use of Proceeds

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ITEM 3:

Defaults Upon Senior Securities

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ITEM 4:

Submission of Matters to a Vote of Security Holders

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ITEM 5:

Other Information

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ITEM 6:

Exhibits and Reports on Form 8-K

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SIGNATURES

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

				JUNE 30,				DECEMBER 31,
				2002				2001
				(UNAUDITED)
ASSETS
Current assets:
	Cash and cash equivalents			$	12,019			$	25,927
	Short-term investments				52,232				54,269
	Prepaid expenses				291				429
	Other current assets				1,262				3,385
		Total current assets			65,804				84,010
Restricted cash, cash equivalents, and short-term investments					12,163				—
Property and equipment, net					13,824				3,223
Patents, net					1,939				1,865
Other assets					459				1,584
		Total assets		$	94,189			$	90,682
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable			$	1,493			$	1,128
	Accrued liabilities				1,753				1,173
	Current portion of deferred revenue				1,244				1,967
	Short-term loan				56				—
		Total current liabilities			4,546				4,268
Deferred revenue					276				394
Deferred rent					68				84
Long-term obligation					10,000				—
Minority interest					—				—
Stockholders’ equity:
	Preferred stock, $.001 par value, 5,000,000 shares authorized, none issued				—				—
	Common stock, $.001 par value, 45,000,000 shares authorized, 23,627,116 and 23,607,058 shares issued and outstanding at June 30, 2002, and December 31, 2001, respectively				24				24
	Additional paid-in capital				159,256				159,126
	Deferred compensation				(2,494	)			(4,373	)
	Notes receivable from employees				(910	)			(880	)
	Accumulated other comprehensive income				329				587
	Accumulated deficit				(62,506	)			(54,148	)
	Less: Treasury stock at cost — 1,200,000 shares				(14,400	)			(14,400	)
		Total stockholders’ equity			79,299				85,936
		Total liabilities and stockholders’ equity		$	94,189			$	90,682

See accompanying notes.

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

			THREE MONTHS ENDED JUNE 30,								SIX MONTHS ENDED JUNE 30,
			2002				2001				2002				2001
Revenues:
	Contract revenue from collaborations		$	824			$	320			$	2,780			$	570
	Other revenue			756				444				1,415				1,046
	Total revenue			1,580				764				4,195				1,616
Operating expenses:
	Research and development			3,725				2,592				7,091				4,831
	General and administrative			2,397				1,095				5,201				2,221
	Stock-based compensation			865				1,820				1,904				4,112
	Total operating expenses			6,987				5,507				14,196				11,164
Loss from operations				(5,407	)			(4,743	)			(10,001	)			(9,548	)
Minority interest				—				147				—				134
Interest income, net				719				1,239				1,643				2,755
Net loss			$	(4,688	)		$	(3,357	)		$	(8,358	)		$	(6,659	)
Net loss per share, basic and diluted			$	(0.21	)		$	(0.16	)		$	(0.38	)		$	(0.31	)
Weighted average shares outstanding, basic and diluted				21,954				21,355				21,898				21,240

See accompanying notes.

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

			SIX MONTHS ENDED JUNE 30,
			2002				2001
OPERATING ACTIVITIES
Net loss			$	(8,358	)		$	(6,659	)
Adjustments to reconcile net loss to net cash used in operating activities:
	Depreciation and amortization			687				345
	Amortization of stock-based compensation			1,879				3,806
	Compensation related to consultant stock options			25				306
	Deferred revenue			(841	)			(138	)
	Deferred rent			(16	)			(8	)
	Minority interest			—				(134	)
	Realized gain on short-term investments			(121	)			(155	)
	Accrued interest on notes receivable from employees			(30	)			(27	)
Changes in operating assets and liabilities:
	Prepaid expenses and other assets			3,386				955
	Accounts payable and accrued expenses			945				(150	)
Net cash used in operating activities				(2,444	)			(1,859	)
INVESTING ACTIVITIES
Restricted cash, cash equivalents, and short-term investments				(12,163	)			—
Purchase of property and equipment				(11,216	)			(2,233	)
Purchase of short-term investments				(30,342	)			(37,901	)
Proceeds from sale of short-term investments				32,242				28,494
Patents				(146	)			(125	)
Net cash used in investing activities				(21,625	)			(11,765	)
FINANCING ACTIVITIES
Proceeds from (payments on) long-term obligations				10,000				(9	)
Proceeds from short-term loan				56				—
Issuance of common stock, net				105				76
Net cash provided by financing activities				10,161				67
Net decrease in cash and cash equivalents				(13,908	)			(13,557	)
Cash and cash equivalents at the beginning of the period				25,927				36,865
Cash and cash equivalents at the end of the period			$	12,019			$	23,308

See accompanying notes.

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

1. Organization and Business

Applied Molecular Evolution, Inc. (“Company” or “AME”), a Delaware corporation, was incorporated on August 14, 1989. The Company has a broad technology platform termed AMEsystem™, which the Company’s management believes will provide AME with a valuable and efficient solution to optimizing proteins with commercial potential. To date, the Company has successfully utilized its proprietary technology to optimize protein therapeutic candidates for pharmaceutical and biotechnology companies as well as for the Company’s own internal development projects.

2. Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and disclosures required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The results of operations for the interim period are not necessarily indicative of results to be expected for any other interim period or for the year as a whole. These unaudited consolidated financial statements and disclosures thereto should be read in conjunction with the audited financial statements and disclosures thereto contained in the Company’s annual report on Form 10-K for the year ended December 31, 2001.

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

The consolidated financial statements include the accounts of the Company and its majority owned subsidiaries, Novasite Pharmaceuticals, Inc. (“Novasite”), and AME Torrey View, LLC (“Torrey View”). Novasite and Torrey View are 72% and 99% owned by AME, respectively. All significant intercompany accounts and transactions have been eliminated.

3. Commitments

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

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

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

4. Comprehensive Loss

Total comprehensive loss was $8,616,000 for the six months ended June 30, 2002, and $6,340,000 for the six months ended June 30, 2001. The difference between net loss and comprehensive loss is primarily due to the difference between market value and cost basis of the Company’s short-term marketable securities.

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5. Computation of Net Loss Per Share

Basic and diluted net loss per share are presented in conformity with Statement of Financial Accounting Standards No. 128, Earnings per Share (SFAS No. 128). In accordance with SFAS No. 128, basic and diluted net loss per share has been computed using the weighted average number of shares of common stock outstanding during the period, less shares subject to repurchase. To the extent common stock equivalents (stock options) are dilutive, they would be included in diluted per share amounts.

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

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

The following information should be read in conjunction with the consolidated financial statements and the notes thereto included in Item 1 of this quarterly report. We also urge readers to review and consider our disclosures describing various factors that affect our business, including the disclosures under Management’s Discussion and Analysis of Financial Condition and Results of Operations and Risk Factors and the audited financial statements and notes thereto contained in our annual report on Form 10-K for the year ended December 31, 2001.

OVERVIEW

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

Since our formation, we have expended considerable resources on the development of our AMEsystem™ technology and the development of Vitaxin™, a product candidate engineered from an antibody we licensed from The Scripps Research Institute. Much of our research and development from 1995 to 1999 was allocated to preclinical development and initial clinical trials of Vitaxin. In 1999, we licensed Vitaxin to MedImmune, Inc. (“MedImmune”), which is responsible for future clinical development expenses and commercialization.

To date we have generated revenue from corporate collaborations, product candidate and technology licenses, royalties, and government grants. We have corporate collaborations with MedImmune, Inc., Eli Lilly and Company, Centocor, Inc., Chiron Corporation, CancerVax, Inc., Biosynexus Inc., Bristol-Myers Squibb Company, Seattle Genetics, Inc., and Aventis Pharmaceuticals, Inc., the final one through our majority owned subsidiary, Novasite. We have licensed intellectual property to Biosite Incorporated, formerly Biosite Diagnostics, Inc., in exchange for a nonrefundable, prepaid, fixed royalty which is being recognized over six years, the estimated useful lives of the related patents. Our government grants have come from the National Institutes of Health. Research funding from corporate collaborators and government grants is recognized as revenue when the services are rendered.

We have incurred losses since our inception. As of June 30, 2002, we had an accumulated deficit of $62.5 million. These losses and this accumulated deficit resulted from the significant costs incurred in the development of our AMEsystem technology and the preclinical and clinical development of Vitaxin and our internal development projects. We expect these losses to increase as we continue to invest in our AMEsystem technology and internal development projects.

On August 17, 2001, we entered into an Operating Agreement with Torrey View Phase II, L.P., to establish AME Torrey View, LLC (“Torrey View”). Torrey View is a 99% owned subsidiary and is consolidated in the Company’s financial statements. On March 4, 2002, Torrey View purchased a 10.73-acre parcel of undeveloped land in San Diego County from a

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third party at a cost of approximately $8.0 million. The Company intends to develop this property over the next few years as its corporate headquarters.

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

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

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, patent costs, and income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

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

Revenue recognition

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

Patent costs

We capitalize the costs incurred to file patent applications. These costs are amortized over a six-year estimated life from the date of patent issuance. At June 30, 2002, capitalized costs related to issued patents total approximately $471,000 (net of accumulated amortization) and approximately $1.5 million related to unissued patents. Our results of operations could be materially impacted when we begin amortizing the costs related to unissued patents. In addition, we expense all costs related to abandoned patent applications. If we elect to abandon any of our currently issued or unissued patents, the related expense could be material to our results of operations for the period of the abandonment.

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Long-Lived Assets

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

RESULTS OF OPERATIONS

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

Revenues. Our revenue increased to $1.6 million for the quarter ended June 30, 2002, from $764,000 for the same period in 2001, an increase of approximately $836,000. The increase was primarily due to contract revenue recognized under our corporate collaborations.

Research and development. Research and development expenses increased to $3.7 million for the quarter ended June 30, 2002, from $2.6 million for the same period in 2001, an increase of $1.1 million. The increase was primarily related to additional scientific staffing and expansion of facilities to support our internal development projects and corporate collaborations.

General and administrative. General and administrative expenses increased to $2.4 million for the quarter ended June 30, 2002, from $1.1 million for the same period in 2001, an increase of $1.3 million. The increase was primarily due to additional legal expenses incurred in our litigation against MorphoSys.

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

Deferred compensation for options granted to consultants has been determined in accordance with SFAS No. 123, Accounting for Stock-Based Compensation, as the fair value of the equity instruments issued, and is periodically remeasured as the underlying options vest in accordance with the Emerging Issues Task Force’s (EITF) No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.

For the three months ended June 30, 2002, we recorded non-cash, stock-based compensation of $865,000 ($279,000 and $586,000 related to research and development and general and administrative, respectively), compared to $1.8 million ($569,000 and $1.2 million related to research and development and general and administrative, respectively) for the same period in 2001.

Interest income, net. Net interest income decreased to $719,000 for the quarter ended June 30, 2002, from $1.2 million for the same period in 2001, a decrease of approximately $481,000. The decrease was primarily due to lower interest rates and lower cash, cash equivalent, and short-term investment balances in 2002.

Six Months Ended June 30, 2002, Compared to Six Months Ended June 30, 2001

Revenues. Our revenue increased to $4.2 million for the six months ended June 30, 2002, from $1.6 million for the same period in 2001, an increase of approximately $2.6 million. The increase was primarily due to contract revenue and milestones recognized under our corporate collaborations.

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Research and development. Research and development expenses increased to $7.1 million for the six months ended June 30, 2002, from $4.8 million for the same period in 2001, an increase of $2.3 million. The increase was primarily related to additional scientific staffing and expansion of facilities to support our internal development projects and corporate collaborations.

General and administrative. General and administrative expenses increased to $5.2 million for the six months ended June 30, 2002, from $2.2 million for the same period in 2001, an increase of $3.0 million. The increase was primarily due to additional legal expenses incurred in our litigation against MorphoSys and the expansion of our corporate communication efforts.

For the six months ended June 30, 2002, we recorded non-cash, stock-based compensation of $1.9 million ($616,000 and $1.3 million related to research and development and general and administrative, respectively), compared to $4.1 million ($1.3 million and $2.8 million related to research and development and general and administrative, respectively) for the same period in 2001.

Interest income, net. Net interest income decreased to $1.6 million for the six months ended June 30, 2002, from $2.8 million for the same period in 2001, a decrease of $1.2 million. The decrease was primarily due to lower interest rates and lower cash, cash equivalent, and short-term investment balances in 2002.

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 $21.9 million of cash from corporate collaborations through June 30, 2002.

As of June 30, 2002, we had approximately $76.4 million in restricted and unrestricted cash, cash equivalents, and short-term investments, compared to $80.2 million of unrestricted cash, cash equivalents, and short-term investments as of December 31, 2001.

For the six months ended June 30, 2002, we used cash of approximately $2.4 million in operating activities, net of non-cash charges for depreciation and patent amortization totaling $687,000, non-cash, stock based compensation totaling $1.9 million, a decrease in deferred revenue of $841,000, and changes in operating assets and liabilities of $4.3 million.

For the six months ended June 30, 2002, we used cash of approximately $21.6 million in investing activities. Our investing activities consisted primarily of purchases and sales of short-term investments, purchase of land, preconstruction costs related to the development of our corporate headquarters and capital expenditures for other property and equipment to be used in our business. We expect to continue to make investments in our infrastructure, including development of our corporate headquarters, and purchasing other property and equipment to support our operations.

For the six months ended June 30, 2002, we generated cash of approximately $10.2 million from financing activities. Our financing activities consisted primarily of a collateralized loan from Merrill Lynch Bank USA. At June 30, 2002, we had approximately $5.0 million available for future financing needs under this credit facility. These funds are being used to finance expenses related to the Company’s new headquarters, which is under development.

We expect our cash requirements to increase significantly in 2002 as we continue our research and development efforts, hire additional personnel, grow our administrative support activities and develop our corporate headquarters. We believe that our current cash, cash equivalents, and investments and interest earned thereon, together with funding received from collaborators and government grants will be sufficient to satisfy our anticipated cash needs for working capital and capital expenditures for at least the next two years. However, it is possible that we will seek additional financing within this timeframe. We may raise additional funds through public or private financing, collaborative relationships, or other arrangements. We cannot ensure that additional funding, if sought, will be available on terms favorable to us. Further, any additional equity financing may be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants. Our failure to raise capital when needed may harm our business and operating results.

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

RISK FACTORS

We have not achieved profitability and may never become profitable.

We are at an early stage of development. We incurred a net loss of $8.4 million for the six months ended June 30, 2002, and our revenue for the same period was $4.2 million. Additionally, we have had net losses each year since inception and as of June 30, 2002, had an accumulated deficit of $62.5 million. We expect to report a net loss for fiscal year 2002, and we expect to report increasing net losses for the foreseeable future. We may never achieve profitability. The size of our net losses will depend, in part, on the rate of growth, if any, in our contract revenue and on the level of our expenses. To date, we have derived most of our revenue from corporate collaborations and expect to continue to do so for the foreseeable future. Revenue from corporate collaborations is uncertain because our ability to secure future agreements will depend upon our ability to address the needs of our potential collaborators. We expect to spend significant amounts to fund research and development and enhance our AMEsystem technology. We expect that our operating expenses will increase significantly in the near term, and consequently, we will need to generate significant additional revenue to achieve profitability. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis.

We may need additional capital in the future. If additional capital is not available, we may have to curtail or cease operations.

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

•		the success of our research and development efforts
•		our ability to establish collaborative agreements
•		our costs of prosecuting and maintaining patents
•		market and competing technological developments

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

The commercial utility of our AMEsystem technology is unproven and may never be realized.

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

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

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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 we are unable to apply our AMEsystem technology to other types of proteins, the scope of our potential business will be significantly limited.

If our collaborators are not successful or if we are unable to find collaborators in the future, we may not be able to commercialize product candidates.

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

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

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

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

The patent positions of pharmaceutical and biotechnology companies, including our patent position, are generally uncertain and involve complex legal and factual questions. We may be able to protect our proprietary rights from infringement by third parties only to the extent that our proprietary technologies are covered by valid and enforceable patents or are effectively maintained as trade secrets. Furthermore, others may independently develop similar or alternative technologies or design around our patented technologies. Litigation or other proceedings to defend or enforce our intellectual property rights could require us to spend significant time and money and could disrupt and harm our business.

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

If we infringe third-party patents or breach our license agreements, litigation may deplete our resources and undermine our ability to use our AMEsystem technology.

Our commercial success also depends in part on neither infringing valid, enforceable patents or proprietary rights of third parties, nor breaching any licenses that may relate to our technology and product candidates. We are aware of third-party patents that may relate to our technology. It is possible that we may unintentionally infringe these patents or other patents or proprietary rights of third parties. Any legal action taken against us or our collaborative partners claiming damages and seeking to enjoin commercial activities relating to our product candidates and processes affected by third-party rights may require us or our collaborators to obtain licenses in order to continue to manufacture or market the affected product candidates and processes. In addition, these actions may subject us to potential liability for damages. We or our collaborators

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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 success. We do not have sufficient personnel to fully execute our business plan, and there is currently a shortage of skilled executives and scientists, which is likely to continue. As a result, competition for experienced executives and scientists from numerous companies and academic and other research institutions may limit our ability to hire or retain personnel on acceptable terms. If we fail to attract and retain sufficient personnel, we may not be able to develop or implement our technology.

Public perception of ethical and social issues may limit the use of our technology, which could reduce our revenue.

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

We use hazardous chemicals and radioactive and biological materials in our business. Any claims relating to improper handling, storage or disposal of these materials could be time-consuming and costly.

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

If people are harmed by drugs developed using our AMEsystem technology, we may be sued for product liability.

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

Substantial sales of our common stock by our existing stockholders could cause our stock price to fall.

Future sales of our common stock by our stockholders under Rule 144 of the Securities Act of 1933 (“the Securities Act”), or through the exercise of outstanding registration rights or otherwise could have an adverse effect on the price of our common stock. Shares of our common stock which are not held by our affiliates are eligible for sale in the public market in reliance on Rule 144(k) or Rule 701 under the Securities Act, without any volume restrictions. Additionally, we registered a total of 6,732,625 shares of common stock reserved for issuance under our stock plans. Some of our existing stockholders have rights to require us to register their shares for future sale.

Our financial condition could be affected by offerings of our subsidiary’s stock.

We could engage in future offerings or other sales of the common or preferred stock of our subsidiary, Novasite, if our board determines that it is in the best interests of the stockholders to pursue that course of action. This could adversely affect our

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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 June 30, 2002, our officers and directors and their affiliates, in the aggregate, owned beneficially approximately 30% 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.

ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we invest in may have market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the market value of our investment will probably decline. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, and government and nongovernment debt securities. The average duration of all of our investments as of June 30, 2002, was less than two years. Due to the short-term nature of these investments, we believe that we have no material exposure to interest rates arising from our investments. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest sensitive financial instruments. Declines in interest rates over time will, however, reduce our investment income, while increases in interest rates over time will increase our interest expense.

PART II: OTHER INFORMATION

ITEM 1: LEGAL PROCEEDINGS

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

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

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

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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 $3.6 million of the net offering proceeds for a portion of the repurchase of 1.2 million shares of our stock for $14.4 million, $3.7 million for purchases of property and equipment, and approximately $10.8 million to fund our net losses. The balance of the proceeds was applied towards the purchase of temporary investments consisting of U.S. government agencies’ obligations, corporate bonds, asset-backed securities, and cash and cash equivalents.

ITEM 3: DEFAULTS UPON SENIOR SECURITIES

Not applicable.

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

On May 29, 2002, the Company held its Annual Meeting of Stockholders. The following actions were taken at the Annual Meeting. As of April 22, 2002, the record date, 22,424,616 shares were entitled to vote at the Annual Meeting.

1.

The following Class II Director was elected:

	a.		John F. Richards: 18,754,711 shares voted in favor of the nominee, and 21,124 shares withheld their vote;
	b.		The following directors continue in office for their existing terms: Stanley T. Crooke Peter K. Hilal William D. Huse Clive A. Meanwell

2.

The selection of Ernst & Young LLP as the Company’s independent auditor was ratified. 18,712,232 shares voted in favor of the proposal, 63,443 shares voted against the proposal, and 160 shares abstained.

ITEM 5: OTHER INFORMATION

None.

ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K

(a)  Exhibits

None.

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

None.

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SIGNATURES

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

Date: August 14, 2002	By:	/s/William D. Huse, M.D., Ph.D.
		William D. Huse, M.D., Ph.D.Z President, Chief Executive Officer and Chairman of the Board

Date: August 14, 2002	By:	/s/Lawrence E. Bloch, M.D., J.D.
		Lawrence E. Bloch, M.D., J.D. Chief Financial Officer and Secretary

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