APPLIED MOLECULAR EVOLUTION INC - 10-K Annual Report

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 than the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes þ No o

The aggregate market value of the shares of Common Stock held by non-affiliates of the Company, based upon the closing price of the Common Stock on June 30, 2002, as reported on the Nasdaq National Market, was approximately $93,612,620. Shares of Common Stock held by each executive officer and director and by each person who owned 10% or more of the outstanding shares of Common Stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

There were 20,589,191 shares outstanding of the registrant’s Common Stock as of February 20, 2003.

Registrant’s Proxy Statement to be filed with the Securities and Exchange Commission in connection with the solicitation of proxies for the Registrant’s Annual Meeting of Stockholders to be held in 2003, is incorporated by reference in Part III, Items 10, 11, 12 and 13 on this Form 10-K.

This Form 10-K contains, in addition to historical information, forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from the results discussed in any such forward-looking statements. Factors that could cause or contribute to such differences include those discussed in “Risk Factors” as well as those discussed elsewhere in this Form 10-K. These forward-looking statements represent our judgment as of the date of the filing of this Form 10-K. We disclaim, however, any intent or obligation to update these forward-looking statements.

Applied Molecular Evolution, Inc. (the “Company” or “AME”), a Delaware corporation, was incorporated on August 14, 1989. 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 for optimizing genes and proteins for specific commercial purposes. Our technology has been validated by, among other things, the ongoing clinical trials of Vitaxin^TM, a humanized and optimized therapeutic monoclonal antibody candidate, that AME licensed to MedImmune, Inc. (“MedImmune”), the successful creation of Numax^TM 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^TM 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.

The graphic above depicts a protein being produced from DNA as described in the text below.

DNA is a molecule found in all living cells and is responsible for determining the inherited characteristics of all living organisms. The entire DNA content of an organism is called its genome. The human genome is

organized into 46 chromosomes, and each chromosome contains a DNA molecule. Each DNA molecule consists of two complementary strands comprised of four different chemical bases called nucleotides, commonly referred to as A, C, G and T. Each set of three adjacent nucleotides (e.g., CAG or GAG) is referred to as a codon, and codons are organized into discrete units called genes. Genes direct the cell to make proteins, and the sequence of codons within a gene determines the protein that will be made by the cell.

Scientific evidence amassed to date suggests that the human genome contains approximately 30,000 genes, with each gene consisting of anywhere from tens to millions of codons. Genes are critically involved in the regulation of almost all aspects of human biology and disease because they serve as the blueprints for the production of proteins that control virtually all of a cell’s normal biological functions. For an organism to be healthy, genes must produce specific proteins at the right time in the appropriate amounts in the correct cells, a process known as gene expression. When a gene is expressed, its DNA directs the production of a specific protein.

Human proteins are composed of combinations of 20 different subunits called amino acids which are linked together like beads on a string. The specific sequence and types of amino acids in a protein determine the ultimate structure and function of the protein. Each codon in a gene specifies a corresponding amino acid in a protein. Therefore, the specific sequence of codons contained in the gene determines the amino acid composition and function of the protein. Any change in any of the three nucleotides in a codon could result in the incorporation of a different amino acid into the protein. This type of alteration may lead to the production of a protein with altered biological properties. Consequently, changes in nucleotides, e.g., if C is replaced by G within a codon, can have a significant functional impact on the inherited biological characteristics of an organism.

Evolution is the process by which living organisms adapt to their environment. There are two fundamental steps in the evolutionary process. The first step is the creation of genetic diversity through random events. The second step is the natural selection of organisms which possess beneficially adaptive characteristics that will be passed to the next generation.

The following critical limitations preclude natural evolution from efficiently developing proteins optimized for specific commercial purposes:


	•	It is extremely slow, often requiring the passage of thousands to millions of years.

	•	Natural evolution creates only a portion of the possible protein diversity because it introduces changes at the nucleotide level. Changes in individual nucleotides within a gene may or may not alter the amino acid sequence of the resulting protein. Therefore, a change that occurs at the nucleotide level may not alter the functional characteristics of the protein that is eventually produced. In contrast, by changing individual codons, it is possible to explore the full range of possible amino acid changes in a protein. Consequently, natural evolution is much less efficient at exploring the full range of protein diversity than a process which introduces change at the codon level.

	•	Selection occurs at the level of the whole organism, therefore individual proteins are not necessarily optimized.

These limitations create an opportunity to improve natural proteins for commercial purposes.

A segment of the biotechnology industry aims to discover genes from natural sources and subsequently develop proteins with important commercial applications from these genes.

Genomics, as it relates to healthcare, is the study of all the genetic information of a species and its relationship to disease. Recent technological advances in molecular biology and in scientific instrumentation have greatly increased the ability of researchers to identify genes and subsequently determine their functions. These developments are ultimately expected to lead to the identification of all the genes in the human genome.

To date, tens of thousands of genes have already been identified. In spite of these recent successes, genomics companies have been limited in their ability to develop commercially successful protein products. As described above, a major reason for this limitation is that naturally occurring genes produce proteins that have not been evolved for specific commercial purposes, and they typically yield proteins that may be deficient with respect to characteristics including safety, efficacy, potency, convenience (e.g. serum half-life and route of administration), manufacturing cost and intellectual property.

Traditionally, the biotechnology industry has attempted to modify genes for commercial purposes by employing two different strategies: random mutagenesis and rational design. Random mutagenesis involves inducing random mutations in genes in an effort to produce commercially viable proteins. Empirical evidence suggests that random mutagenesis offers a low probability of improving a protein and usually results in changes which are detrimental to the function of the protein. Rational design involves deliberately modifying a gene in an effort to change the structure of the resultant protein. This approach is predicated on the theory that analyzing the structure and shape of a protein will provide an understanding of its function. Consequently, once the structure of a protein is known, it may be possible to modify the underlying gene to improve the function of the protein. The major drawbacks to rational design are that it is expensive, time-consuming and, most significantly, imprecise.

The goal of directed molecular evolution is to optimize proteins for specific commercial purposes. Protein optimization generally involves improving the functional characteristics of a particular protein by changing its amino acids. For example, a particular protein may have an initial amino acid sequence that makes it susceptible to degradation at temperatures approximating that of the human body. Consequently, its utility as a therapeutic agent would be severely limited. By using directed molecular evolution, the stability of this protein could be dramatically improved by introducing changes in the amino acid sequence of the protein, and then screening for those changes that allow the protein to survive at higher temperatures while retaining its other important characteristics. Because the sequence of amino acids in a protein determines the protein’s structure and function, and the sequence of amino acids is specified in genes, proteins can be modified by altering the genes that produce them.

There are three fundamental steps in the process of directed molecular evolution. In the first step, a library, or collection, of genes is created by introducing changes in the initial gene that produces the protein of interest. Ideally, this library of genes should contain the optimal amount of genetic diversity. If the process introduces too much genetic diversity, the efficiency of directed molecular evolution may be significantly reduced because excessive change in the genes of interest is likely to destroy the function of most resulting proteins. Conversely, the creation of an insufficient amount of genetic diversity significantly reduces the probability of producing an optimized protein. The second step involves expressing proteins from all the different genes that were produced in the first step to create a library of diverse proteins. The third step in the process entails screening, or evaluating, this library to identify those proteins with improvements in the desired characteristics. The process is then repeated until a sufficiently improved protein is identified.

We believe that directed molecular evolution potentially offers several advantages over natural evolution and traditional biotechnology approaches to improve proteins. The entire process can be rapidly completed, efficiently and cost-effectively accomplishing in months what it takes traditional methods years to achieve. Because directed molecular evolution does not require any knowledge of the structure of the protein being optimized, it is much more rapid than conventional approaches such as rational design, which are based on time-consuming modeling techniques.

Directed molecular evolution represents a significant step forward in the optimization of proteins. There are currently a number of different competing approaches for conducting directed molecular evolution, including gene shuffling. We believe that these competing approaches do not take full advantage of the potential of directed molecular evolution to optimize proteins, particularly biotherapeutics, our primary target market.

Gene shuffling involves cleaving a collection of genes into fragments and then recombining the fragments to create new gene variants. Gene shuffling does not control the extent or precise location of changes introduced into the gene of interest nor does it explore the full range of protein diversity. These shortcomings significantly limit the usefulness of this approach in developing improved proteins:


	•	Completeness of Diversity: Gene shuffling generally lacks the ability to substitute each of the 20 human amino acids at a particular location in a protein. For example, if all the various genes in a gene family have the same codon ATG, that codes for the amino acid methionine, at a certain position, they will each produce a protein that contains a methionine at that same position. If this family of genes is then shuffled in an effort to create genetic diversity, all the gene variants that are produced will still have the same codon ATG at the same position. Therefore, in this particular situation, shuffling fails to introduce any of the other 19 possible human amino acids at the same position in the protein. If modifying that particular amino acid is necessary to enhancing the protein’s function, gene shuffling will be unable to produce an optimized protein.

	•	Extent of Change: The very nature of gene shuffling requires the cleavage of a collection of genes in multiple locations. Consequently, the shuffling process cannot precisely control the number of changes introduced into the genes. The greater the number of changes, the more likely it is that harmful changes will be introduced. Furthermore, extensive change requires the screening of larger libraries, which is more time-consuming and expensive.

	•	Location of Change: The gene shuffling approach lacks the ability to precisely control where changes are introduced into a gene. This limitation severely curtails the application of this technology to developing biotherapeutics because changing just a single amino acid at an inappropriate location can adversely impact the safety, efficacy, potency, convenience, manufacturing costs and intellectual property of a biotherapeutic.

Extremophile isolation attempts to identify previously undiscovered genetic diversity in nature by collecting unusual organisms that have adapted through natural selection to be able to survive in extreme environments. We believe that this approach has limited application to the biotherapeutic market. It has taken over two decades to transform mouse proteins, which are closely related to human proteins, into biotherapeutics that the human immune system will not reject. We expect it to be even more challenging to convert proteins from organisms that are extremely different from humans into biotherapeutics which will not be rejected by the human immune system.

We use our proprietary AMEsystem technology to improve the function of a target protein in order to enhance its commercial potential. The components of our AMEsystem are precise and efficient methods for conducting the three fundamental steps of directed molecular evolution and address the limitations of alternative directed molecular evolution approaches. There are three components to our AMEsystem technology:


	•	DirectAME ^TM: DirectAME is a gene synthesis process that enables the rapid production of a library of variant genes based on an initial gene.

	•	ExpressAME ^TM: ExpressAME consists of gene expression systems that efficiently produce proteins from the genes generated using DirectAME.

	•	ScreenAME ^TM: ScreenAME is a series of tests or assays which facilitate the identification of proteins with the optimal, desired commercial properties from the protein libraries produced using ExpressAME.

Our patented DirectAME technology addresses the limitations of competing directed molecular evolution approaches by rapidly and precisely generating the appropriate amount of genetic diversity, thereby significantly increasing the probability of creating and identifying functionally improved proteins. In contrast to some alternative directed molecular evolution approaches, our DirectAME approach has the following strengths:


	•	Completeness of Diversity: When optimizing the function of a protein by applying directed molecular evolution technology, it is critical that all 20 possible human amino acids be evaluated at each position of interest in the protein. By changing codons as opposed to single nucleotides, our patented DirectAME technology ensures that all 20 possible human amino acids are expressed at each position of interest within the protein. Competing approaches which cannot achieve such complete and focused diversity produce enormous protein libraries that are not economically feasible to screen.

	•	Extent of Change: The simultaneous introduction of a large number of amino acid changes in each protein in a library is undesirable because most amino acid changes are detrimental to the function of a protein. If multiple changes are made at once, the majority of the proteins produced will not possess the desired function, necessarily complicating the subsequent screening process. We can use our DirectAME technology to create a diverse library of proteins that differ from the initial target protein by a specific number of amino acids. In doing so, we significantly increase the probability of preserving the desired characteristics while keeping the number of proteins at a level that is efficient to express and screen. As we repeat the process, we introduce additional changes into the protein and retain only those changes that combine to produce a protein with improved function.

	•	Location of Change: Our DirectAME technology has the ability to change specific, carefully targeted areas of a gene and ultimately a protein. This ability to precisely alter a specific region of a target protein greatly facilitates the synthesis of more focused libraries, significantly increasing the likelihood of identifying improved proteins. The ability to change specific regions of a protein in a deliberate and precise manner while leaving all other regions unchanged has profound implications for the development of new biotherapeutics as well as for improving FDA-approved, currently marketed biopharmaceuticals. Optimizing monoclonal antibodies demonstrates the importance of having the ability to change amino acids only at specific locations. While antibodies are relatively large proteins


		consisting of hundreds of amino acids, the crucial sites on an antibody that determine its affinity or ability to bind to a particular target, constitute less than 5% of the overall protein. These sites consist of six different stretches of amino acids that are separated from one another. Therefore, antibody affinity optimization requires the ability to precisely confine amino acid changes to these six specific regions while leaving the remainder of the antibody unchanged.

Our ExpressAME technology encompasses a number of proprietary gene expression systems that we use to produce protein libraries. A unique feature of our ExpressAME system is that it enables us to apply our directed molecular evolution technology to virtually any protein, including those that cannot be functionally expressed in bacteria. A significant shortcoming of certain competing technologies is that they rely primarily on bacterial expression systems. However, many FDA-approved, currently marketed, biopharmaceuticals cannot be expressed in their functional, properly folded states by bacteria, and thus require expression in mammalian cells. ExpressAME has been developed specifically to address the technical challenges of conducting directed molecular evolution in both bacterial and mammalian cells.

Our ScreenAME technology is a set of broadly applicable proprietary tests or assays that are highly sensitive and capable of characterizing thousands to millions of proteins simultaneously. In selecting a screen for use in the directed molecular evolution process, there is often a trade-off between the speed of throughput, the rate at which proteins can be screened, and the ability to predict the functional performance of the protein in the human body. We believe that using the most predictive screen available, regardless of its throughput, is essential for identifying the most improved proteins. By using our AMEsystem technology, we have the flexibility to create libraries of proteins which are appropriately matched to the throughput of the particular screen that is being used. If the most predictive screen that is available is low throughput, we can use DirectAME to create smaller, more focused libraries containing proteins that have each been changed at only one or two amino acid positions. Alternatively, when a high throughput and highly predictive screen is available, DirectAME can be used to generate larger protein libraries with multiple amino acid substitutions. In contrast, certain competing technologies that do not have the control and precision of DirectAME, and which therefore produce larger, less focused protein libraries, predominantly rely on high throughput screens, which are often less predictive.

We repeat the process starting with one or more of the improved proteins produced by our AMEsystem to further improve the function of the target protein. We can also combine beneficial amino acid changes identified in the initial protein library as a second strategy to achieve the same objective.

While virtually any product or process that utilizes or could utilize DNA or proteins might be improved though the application of our technology, we focus our efforts on the biotherapeutic market, the largest and most profitable target market for directed molecular evolution. We believe that the level of technological sophistication and precision required to improve FDA-approved, currently marketed, biopharmaceuticals as well as to develop novel biotherapeutic candidates is significantly greater than that required by other potential target markets for directed molecular evolution technologies. Since our inception, we have focused on developing and optimizing our AMEsystem technology to address the multibillion-dollar market opportunities in human biotherapeutics.

Proteins are essential to all cellular processes and have tremendous commercial value, particularly in the pharmaceutical industry. The worldwide sales of therapeutic proteins are projected to approach $24.0 billion by 2010. The biotherapeutic market encompasses four major classes of compounds, each with tremendous potential to improve human health:


	•	Antibodies: Antibodies currently represent the fastest growing biotherapeutic product category in dollar and percentage terms, due to the application of recently developed, novel approaches for generating, modifying and manufacturing antibodies. In 2002, worldwide sales for Synagis, a therapeutic antibody marketed by MedImmune, totaled more than $600.0 million. As demonstrated with our corporate collaborations and by our own internal development projects, our proprietary AMEsystem technology enables us to optimize antibodies with respect to safety, efficacy, potency, convenience, manufacturing cost and intellectual property.

	•	Cytokines: Cytokines are proteins secreted by cells that regulate the body’s immune system as well as its responses to inflammation. Cytokines have been implicated in a wide variety of diseases such as rheumatoid arthritis, sepsis and lupus that afflict millions of individuals. A well-studied cytokine is granulocyte-colony- stimulating factor, commonly known as G-CSF, which acts on the bone marrow to increase its production of white blood cells.

	•	Hormones: Hormones are proteins that are critical to the daily function and normal growth and development of the human body. Many of the most debilitating and chronic human diseases are due to hormone deficiencies. Human growth hormone, for example, is a naturally occurring human protein produced in the pituitary gland that regulates metabolism and is responsible for growth in children.

	•	Enzymes: Enzymes constitute the majority of proteins in all cells. These proteins speed up cellular processes and are therefore critical to the normal function of cells. Enzymatic deficiencies are often fatal. Gaucher’s disease, for example, is a seriously debilitating, sometimes fatal, genetic disorder caused by a deficiency in an important enzyme called glucocerebrosidase. Administration of the synthetic form of this enzyme, called Cerezyme®, is currently the only treatment available to these patients. As demonstrated through our work on our product candidate AME-359, an optimized version of the human serum enzyme butyrylcholinesterase (“BChE”), that is funded by the National Institutes of Health, (“NIH”), our proprietary AMEsystem technology enables us to optimize enzymes with respect to catalytic activity.

By applying our proprietary AMEsystem technology, we have successfully addressed many significant challenges involved in the biopharmaceutical development process. We believe that our technology platform has been validated through its successful application to critical, time-sensitive projects for MedImmune, Eli Lilly and Company (“Lilly”), Chiron Corporation (“Chiron”), Bristol-Myers Squibb Company (“Bristol-Myers Squibb”), Seattle Genetics, Inc. (“Seattle Genetics”) and CancerVax, Inc. (“CancerVax”).

The use of Synagis, MedImmune’s monoclonal antibody against Respiratory Syncytial Virus (“RSV”), is limited to the treatment of high-risk infants due to the biopharmaceutical’s high cost and requirement for intramuscular administration. By using our directed molecular evolution technology, we created several new product candidates for MedImmune that have been demonstrated in disease models to be at least 10 times more potent than Synagis. MedImmune is expected to initiate clinical trials with one of these candidates, and if successful, market it as Numax^TM. If Numax’s significantly increased potency is confirmed in human clinical trials, MedImmune could develop Numax for increased efficacy, additional indications, reduce production costs and pursue various delivery forms to broaden the product’s use.

A significant manufacturing problem was encountered during the development of Vitaxin^TM, a monoclonal antibody (“MAb”) product candidate designed to treat diseases including cancer and arthritis by inhibiting new blood vessel formation, a process known as anti-angiogenesis. A particular structural feature in the first-generation antibody made it susceptible to significant degradation during the manufacturing process, resulting in a loss of over 70% of the product yield. By applying our AMEsystem technology to Vitaxin, we successfully created a second-generation version of the antibody that is significantly more stable than its predecessor. Our directed molecular evolution technology decreased manufacturing costs by improving the yield by more than 300% and also increased the affinity of the antibody for its target by 90-fold. Second-generation Vitaxin entered two Phase I clinical trials for cancer and one Phase I clinical trial for rheumatoid arthritis with MedImmune during 2001, and may enter Phase II clinical trails in 2003.

AME-527 is a humanized and optimized version of Remicade, a chimeric (part-human, part-mouse) anti-Tumor Necrosis Factor alpha (“TNF alpha”) antibody which the FDA has approved for treatment of rheumatoid arthritis and Crohn’s disease. AME 527 is currently in preclinical development at AME for the treatment of rheumatoid arthritis. A potential limitation of Remicade stems from the mouse component of this antibody which renders it immunogenic. Certain patients develop antibodies to the mouse portion which may not only decrease the efficacy of Remicade, but also increase the probability of patients experiencing an adverse effect, such as an infusion reaction. By applying our frAMEworks^TM germline humanization and optimization technology to Remicade, we created AME-527. Our humanized and optimized, higher-affinity anti-TNF alpha MAb has the potential to reduce the immunogenicity issues associated with Remicade while potentially improving its efficacy as well.

AME-133 is a humanized and optimized anti-CD20 MAb in preclinical development for the treatment of non-Hodgkin’s Lymphoma (“NHL”). In AME’s head-to-head comparisons, this next-generation anti-CD20 MAb displayed superior potency in vitro to Rituxan, an FDA-approved, currently marketed anti-CD20 therapeutic MAb. AME-133 exhibited higher affinity than Rituxan in in vitro models and greater than 10-fold improved killing of human cancer cells in comparison to Rituxan as demonstrated in ex vivo cell-based assays. This increased potency could lead to a more convenient subcutaneous route of administration than the time-consuming and inconvenient intravenous administration required for Rituxan.

Subtractive immunization is a novel approach to discover antibodies that recognize unique therapeutic targets. However, this approach usually results in low-affinity antibodies that are unlikely to be commercially successful. By applying our AMEsystem technology to this problem, we can increase the affinity of antibodies produced by this process. For Cell-Matrix, Inc. (“Cell-Matrix”), we optimized HUI77 and HUIV26, anti-angiogenic mouse antibodies discovered using subtractive immunization, which could enable the commercialization of these antibodies. CancerVax acquired Cell-Matrix in January 2002 and is in preclinical development with these optimized antibodies.

We are a leader in applying directed molecular evolution to the optimization and development of human biotherapeutics. We have selected biotherapeutics as our primary target market because it is the largest and highest margin market for directed molecular evolution. We are using our proprietary AMEsystem technology to significantly improve important characteristics of established biopharmaceuticals, acting independently or in collaboration with the initial developer. Our business strategy includes four basic elements:


	•	Optimize Currently Marketed Biopharmaceuticals. We have optimized FDA-approved, currently marketed biopharmaceuticals to create improved versions of these biotherapeutics with potentially


		broader patent protection, including product candidates AME-527 and AME-133, optimized versions of Remicade and Rituxan, respectively. We believe that focusing on approved products with known therapeutic profiles and proven markets represent an attractive, lower risk development strategy. We plan to optimize and develop product candidates that we believe have lower development risks and target large, highly profitable markets.

	•	Develop Novel Biotherapeutics. We plan to access and develop novel human biotherapeutic candidates from a wide variety of sources including leading academic institutions and corporate collaborations. We also expect genomics and the sequencing of the human genome to yield an expanding number of novel proteins to optimize and commercially develop.

	•	Leverage Corporate Collaborations. We plan to continue to expand the number of our corporate collaborations with leading pharmaceutical and biotechnology companies that are facing technical challenges to the development and commercialization of their therapeutic protein candidates and to leverage these corporate collaborations to expand our pipeline of product candidates. Our goal is to combine our expertise with that of our collaborators. We believe that we can add the greatest value to a project by applying our AMEsystem technology early on in the development process while relying on our collaborators to further develop and commercialize the improved product candidates. Corporate collaborators provide financial support for research and development, potential milestone payments and royalties on the sale of any products resulting from the collaboration.

	•	Enhance Our AMEsystem Technology. We plan to continue to develop our AMEsystem technology by investing significantly in research and development while simultaneously protecting and expanding our leading intellectual property position in directed molecular evolution. We plan to license and acquire from others technologies that complement and expand our core capabilities.

Since inception, we have entered into numerous corporate collaborations and have pursued our own internal development projects. We expect that corporate collaborations will continue to be an important element of our business strategy. Unless specifically mentioned, we do not have commercialization rights to the intellectual property of products developed from our collaborations. The following is a summary of our development programs and related corporate collaborations:

In February 1999, we entered into a four-antibody corporate collaboration with MedImmune. The agreement covers the licensing of Vitaxin to MedImmune as well as the optimization of three additional antibodies, including Synagis and an antibody against IL-9. Licenses granted under this agreement are exclusive and worldwide covering the right to research, develop, sell and sublicense. The business terms of the agreement includes research and development support, potential milestone payments, royalties on the sales of products resulting from the collaboration and an equity investment. The duration of the research and development aspect of this agreement was extended through February 2004.

Synagis, MedImmune’s monoclonal antibody against RSV, is limited to the treatment of high-risk infants due to the biopharmaceutical’s high cost and requirement for intramuscular administration. By using our directed molecular evolution technology, we created several new product candidates for MedImmune that have been demonstrated in disease models to be at least 10 times more potent than Synagis. MedImmune is expected to initiate clinical trials with one of these candidates, and if successful, market it as Numax. This more potent version of Synagis could enable MedImmune to increase efficacy, address additional indications, reduce production costs and pursue additional methods for administering the protein therapeutic in order to broaden the product’s use.

Vitaxin is an anti-angiogenic antibody with potential applications in cancer and arthritis. We licensed LM609, the mouse antibody from which Vitaxin was derived, from The Scripps Research Institute. We then optimized LM609 to overcome a potential immune reaction in humans and licensed it to MedImmune.

MedImmune is now in clinical development with a second-generation version of Vitaxin that we developed using our AMEsystem technology. This version of the antibody has significantly improved affinity as well as decreased manufacturing costs. MedImmune initiated Phase I clinical trials for cancer and rheumatoid arthritis with this antibody during 2001, and may enter Phase II clinical trails in 2003.

Anti-IL-9 is an antibody with potential applications in respiratory disease including asthma.

In December 2001, we entered into a corporate collaboration covering the optimization of an antibody and a non-antibody protein therapeutic candidate with Lilly. Under the terms of the agreement, AME received an upfront signing fee and may receive milestone payments and royalties on the sales of products resulting from the collaboration. In February 2002, an additional agreement was entered into by AME and Lilly to include the optimization of an additional antibody therapeutic candidate.

In December 2001, we entered in to a corporate collaboration covering the optimization of a non-antibody protein therapeutic candidate with Chiron. Under the terms of the agreement, AME received an upfront signing fee and may receive milestone payments and royalties on the sales of products resulting from the collaboration.

In May 2002, we entered into a corporate collaboration covering the optimization of an antibody protein therapeutic candidate with Centocor. Under the terms of the agreement, AME received an upfront signing fee and may receive milestone payments and royalties on the sales of products resulting from the collaboration.

In November 1999, we entered into a corporate collaboration covering up to four novel antibody therapeutic candidates with Cell-Matrix. During 2000, we completed the optimization of the first two compounds, and the agreement was not extended to include the remaining two potential compounds. Under the terms of the agreement, AME may receive milestone payments and royalties on the sales of products resulting from the collaboration. CancerVax acquired Cell-Matrix in January 2002. Research under this collaboration has been completed.

In December 2000, we entered into a corporate collaboration covering the optimization of an antibody therapeutic candidate, HU96-110, with Biosynexus. During 2001 we completed the optimization of HU96-110, which is being developed for the treatment of staphylococcal bacterial infections. Under the terms of the agreement AME received research and development support and may receive milestone payments and royalties on the sale of products resulting from the collaboration. Research under this collaboration has been completed.

We have entered into two separate agreements with Bristol-Myers Squibb. We have completed our optimization work under these agreements and may receive milestone payments and royalties on the sale of products resulting from the collaboration. Under the terms of the agreement, portions of the milestone payments may be creditable against royalties.

In June 1993, we entered into our initial corporate collaboration with Bristol-Myers Squibb to optimize their BR96 anti-solid tumor antibody and to develop a discovery technology program to treat tumors. Bristol-Myers Squibb renewed this collaboration in 1995. As discussed below, hBR96, our improved version of BR96, is currently in preclinical development with Seattle Genetics, a biotechnology company founded by former Bristol-Myers Squibb scientists. Based on the success of our initial collaborations, Bristol-Myers Squibb amended our agreement in 1998 to include the optimization of its anti-CD40 antibody for treating inflammatory disease. Bristol-Myers Squibb is in preclinical development with the optimized anti-CD40 antibody. Research under this collaboration has been completed.

Seattle Genetics is in preclinical development with hBR96 for the potential treatment of cancers. After we optimized BR96 for Bristol-Myers Squibb, Seattle Genetics licensed this product candidate from Bristol-Myers Squibb. Under our original agreement with Bristol-Myers Squibb and an agreement among Bristol-Myers Squibb, Seattle Genetics and AME, we may receive milestone payments and royalties on the sale of products resulting from the collaboration. Research under this collaboration has been completed.

AME’s majority-owned subsidiary, Novasite Pharmaceuticals, Inc. (“Novasite”), applies directed molecular evolution to small-molecule drug discovery and optimization. Novasite’s proprietary Expanded Target Drug Discovery^TM (“ETDD”) technology works to address a limiting factor in drug discovery by simultaneously screening libraries of small molecules against libraries of drug target variants created through directed molecular evolution. Novasite’s ETDD technology enables the concurrent screening of hundreds of targets. This contrasts with a conventional method of screening compound libraries against only a single receptor target at a time. Novasite’s novel approach has the potential to screen a billion individual ligand-receptor combinations per day.

During 2002, Novasite raised approximately $1.3 million, including the conversion of approximately $550,000 of debt, from a Series B Preferred Stock financings which occurred in September and November of 2002. In January 2003, Novasite raised an additional $750,000 from Series B Preferred stock financing. Following the financings, AME held a 54% interest in Novasite, and Crabtree Ventures LP, a venture firm and previous investor in Novasite, held a 40% interest in Novasite. John F. Richards, one of our directors and a director of Novasite, is the Managing Member of Crabtree Ventures, L.L.C., the general partner of Crabtree Ventures, L.P. An additional $750,000 is expected to be raised in 2003 from Series B Preferred Stock financing. The funds from the financings are expected to be used to commercialize the ETDD technology for the discovery of highly selective small-molecule drugs.

William D. Huse, our President, Chief Executive Officer and one of our directors, is the President, Chief Executive Officer and a director of Novasite. Dr. Huse has been granted options to purchase up to 800,000 shares of Novasite common stock with an exercise price equal to $0.05 per share, of which he has exercised options to purchase 16,800 shares of Novasite common stock. Approximately 70% of the total options are fully vested. Additionally, Lawrence E. Bloch, our Chief Financial Officer and Secretary, is a director of Novasite.

In March 2002, Novasite was awarded a $2.4 million grant from the National Institutes of Health (“NIH”) to support the discovery of anti-obesity drug candidates with ETDD. The grant awards $2.4 million over two years to Novasite under Phase II of the Small Business Innovation Research Program of the National Institute of Diabetes and Digestive and Kidney Diseases branch of the NIH. Novasite plans to apply

In September 2000 Novasite received a grant from the NIH of $3.2 million over three years for research to develop Novasite’s proprietary technology platform. The grant was awarded to Novasite under the Bioengineering Research Partnership Program of the National Institute of Allergy and Infectious Diseases.

In July 2001, Novasite entered into an agreement with Aventis Pharmaceuticals, Inc. (“Aventis”) to conduct a pilot-screening project using Novasite’s proprietary ETDD technology platform. Research under this collaboration has not been completed.

We are using our AMEsystem technology to develop both improved versions of currently marketed biopharmaceuticals and novel human protein therapeutic candidates. We are working on improving multiple FDA-approved, currently marketed biopharmaceuticals that are already marketed by third parties and in their first-generation forms are expected to each have sales in excess of $100.0 million in 2002. We have retained full commercialization rights to these internal development projects.

AME-527 is a humanized and optimized anti-TNF alpha MAb, in preclinical development for the treatment of rheumatoid arthritis. AME-527 binds to and neutralizes human TNF alpha, which is believed to contribute to inflammatory diseases, including rheumatoid arthritis. In AME’s head-to-head comparisons of affinity, protection from cell killing and potency, this next-generation MAb demonstrated superiority to Remicade, an FDA-approved, currently marketed anti-TNF alpha therapeutic MAb. AME-527 demonstrated greater than 15-fold higher affinity than Remicade in in vitro assays and provided greater than 10-fold increased protection from TNF alpha-mediated cell killing than Remicade in cell-based assays. Additionally, AME-527 demonstrated increased potency when compared with Remicade in a transgenic human TNF alpha polyarthritic murine model, as measured by the prevention of disease progression, or joint swelling.

AME-133 is a humanized and optimized anti-CD20 MAb in preclinical development for the treatment of NHL. AME-133 binds to and induces death of cells expressing the CD20 antigen. In AME’s head-to-head comparisons of affinity and tumor cell killing potency, this next-generation MAb displayed superiority to Rituxan, an FDA-approved, currently marketed anti-CD20 therapeutic MAb. AME-133 exhibited greater than 10-fold higher affinity than Rituxan in in vitro models and greater than 10-fold improved killing of human cancer cells in comparison to Rituxan as demonstrated in ex vivo cell-based assays.

In September 2001, we announced the award of a $1.0 million grant from the NIH to support the development of AME-359, a therapeutic enzyme BChE we licensed from the University of Nebraska Medical Center in March 2000 and the Mayo Clinic in January 2001, for the potential treatment of acute cocaine toxicity and chronic cocaine addiction. BChE is a naturally occurring human serum enzyme that inefficiently breaks down cocaine to inactive byproducts. Using the AMEsystem, AME has developed AME-359 demonstrating over 100-fold increased activity compared with naturally occurring BChE and has taken the resulting product candidate into preclinical development. AME has conducted animal models demonstrating engineered improvements in AME-359’s catalytic rate that improve the enzyme’s ability to neutralize the toxic effects of cocaine in vivo by greater than 250-fold in comparison to the naturally occurring enzyme.

We hold patents and rights to patents within the field of directed molecular evolution with an extensive portfolio that includes 23 issued U.S. patents related to our proprietary technology and the resultant compositions of matter. 41 counterpart patents to these U.S. patents are issued in other major industrialized countries. We have an additional 45 pending U.S. patent applications and 68 pending foreign and international counterpart applications relating to our AMEsystem technology and the application of this technology to diverse industries including protein pharmaceuticals and industrial enzymes.

Our intellectual property portfolio includes trade secrets, know-how, trademarks, patents and patent applications related to DirectAME gene synthesis, ExpressAME protein expression and ScreenAME protein screening as well as the exclusive license to the Kauffman patents.


	•	DirectAME: The DirectAME gene synthesis patents are directed to methods for generating genetic diversity which can be used for conducting directed molecular evolution. They claim methods for introducing changes at the codon level to generate genetic diversity.

	•	ExpressAME: ExpressAME is a system used for conducting directed molecular evolution in both bacterial and mammalian cells. This system enables the expression of many therapeutic proteins in their functional, properly folded states, a feature that cannot always be achieved by relying exclusively on bacterial expression systems.

	•	ScreenAME: We have a number of issued patents and pending patent applications relating to our ScreenAME technologies for assaying protein libraries. The patents and patent applications describe methods for evaluating protein function.

	•	Kauffman Patents: The Kauffman patent family comprises six issued U.S. patents with claims covering methods of randomly generating proteins, which we believe is required by many directed molecular evolution technologies. We were granted an exclusive license to the Kauffman patent family in 1994. The first Kauffman patent application was filed in 1985, and the first U.S. Kauffman patent issued in 1998 with a term extending into 2015. Their patent prosecution history includes a successful defense to an opponent’s challenge in Japan as well as being issued in Europe with no challenge.

We are fully committed to investing in the further development, expansion and enforcement of our leading intellectual property position in directed molecular evolution.

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 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 AG and its wholly owned subsidiary MorphoSys USA, Inc. 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.

We are a leader in the application of directed molecular evolution to the optimization and development of biotherapeutics. We are aware that companies such as Maxygen, Inc., Diversa Corporation and Genencor International, Inc., rely on alternative methods such as gene shuffling and extremophile isolation for obtaining or generating genetic diversity. Some or all of these companies will compete against us to develop novel human biotherapeutic products and to improve FDA-approved, currently marketed protein therapeutics. Academic institutions such as the California Institute of Technology and the University of Washington are also working in this field. In the future, we expect the field to become highly competitive and that companies

and academic and research institutions will seek to develop technologies that could be competitive with our AMEsystem technology. Any products that we may develop through our AMEsystem technology will compete in highly competitive markets, especially our improved versions of FDA-approved, currently marketed biopharmaceuticals.

Many of our potential competitors have substantially greater financial, technical and personnel resources than we do, and we cannot be certain that they will not succeed in developing technologies and products that would render our technology and products or those of our collaborators obsolete or noncompetitive. In addition, many of those competitors have significantly greater experience than we do in their respective fields. Our ability to compete successfully will depend, in part, on:


	•	our ability to demonstrate the applicability of our technology to optimizing a broad range of proteins

	•	the cost-effectiveness of our optimization approach

	•	our ability to develop products that reach the market first

	•	our ability to develop products that are technologically superior to other products in the market

	•	our ability to obtain and enforce patents covering our technology

The development of new therapeutic products is a complex, lengthy, expensive, highly regulated process, and is subject to substantial uncertainty and risk. Any product candidates that we or our collaborators may develop for use in the United States will be subject to regulation by the FDA, and may be subject to local or regional regulatory agencies in other countries if developed for use there. Biotherapeutic products are regulated by the Federal Food, Drug and Cosmetic Act and the Public Health Service Act. The two statutes, and a large body of related regulations govern, among other things, product-related testing, manufacturing, safety, efficacy, labeling, storage, record keeping, advertising and other promotional practices. FDA approval is required prior to marketing a pharmaceutical product in the United States.

New biotherapeutics typically advance from research testing, involving laboratory and animal studies, through preclinical pharmacology and toxicology testing, and finally through several phases of clinical testing in humans. Before a new product candidate may be tested in humans, preclinical studies must be conducted in the laboratory and in animal model systems to gain preliminary information on the product candidate’s efficacy and to give indication of any potential safety concerns. The results of these studies are submitted as a part of an Investigational New Drug (“IND”) application in the United States, or its equivalent elsewhere in the world. The IND application must be reviewed by the FDA and become effective pursuant to FDA regulations before human clinical trials may commence, and the trials may be halted by a clinical hold at any time. The IND includes a detailed description of the product, its manufacture and the proposed clinical investigations. A company must sponsor and file an IND for each proposed product candidate, and usually a separate IND for each clinical indication. The FDA may require the modification, suspension or termination of clinical trials at any time if an unwarranted risk is presented to patients involved in the clinical trials.

Once the IND is active, biopharmaceutical product candidates undergo clinical testing in several phases. Human clinical trials typically are conducted in three phases and are subject to detailed protocols. Each protocol regulates how the clinical trial is to be conducted and must be submitted to the FDA as part of the IND. In typical Phase I clinical trials, small numbers of patients or healthy volunteers are treated to determine a preliminary safety profile, pharmacokinetics and sometimes preliminary evidence of efficacy of the product candidate. In typical Phase II clinical trials, larger groups of patients afflicted with a target disease are treated with the investigational product at various doses in order to determine preliminary evidence of efficacy, optimal dosages and expanded evidence of safety. Typical Phase III clinical trials are large scale, multicenter, controlled, comparative trials conducted in the afflicted patient population intended for registration. In selected cases, a given clinical trial may contain elements of more than one typical testing phase. In some cases, initial human testing is done in patients rather than healthy volunteers. These studies may provide results traditionally obtained in Phase II clinical trials and can be referred to as “Phase I/ II” trials.

Furthermore, pivotal trials, studies that provide significant evidence of safety and efficacy in support of registration, are usually Phase III clinical trials, but may be Phase II clinical trials in serious, life-threatening diseases.

Upon successful completion of clinical trials, the pharmaceutical sponsor prepares an application requesting approval to market the biotherapeutic for a particular patient population. This application, a New Drug Application (“NDA”) or Biologic License Application (“BLA”) in the United States, contains a large amount of information on the manufacturing and characterization of the medicinal product candidate, its preclinical testing and all completed phases of clinical testing, as well as any treatment experience outside of clinical trials. Submission of a BLA does not assure FDA approval for marketing. The FDA has recently announced a major reorganization in which most non-vaccine, non-gene therapy biotheropeutic candidates will be regulated by its CDER division, and it is not clear whether either the NDA or the BLA applications will be used in the future.

Applications submitted to the FDA are subject to an unpredictable and potentially prolonged review process. The FDA may require additional preclinical information, manufacturing information or clinical information. Additional preclinical, manufacturing or clinical studies may be required, and the additional studies may take years to complete. External reviews, including FDA Advisory Committees, may be required. The FDA may and at time does ultimately decide that the application does not satisfy its criteria for approval. Even if FDA regulatory clearances are obtained, a marketed product is subject to continual review. Post-approval discovery of previously unknown problems or failure to comply with the applicable regulatory requirements may result in restrictions placed on the marketing of a product or may result in withdrawal of marketing approval. In this case, the FDA or its international counterparts may order the product to be withdrawn from the market and recalled from distribution. Failure to comply with the applicable regulatory requirements may also result in fines, other civil sanctions or criminal sanctions.

Before marketing clearance is secured, the manufacturing facility must be inspected for compliance with current Good Manufacturing Practices (“GMP”) by FDA inspectors. The manufacturing facility must satisfy current GMP requirements prior to marketing clearance. In addition, if marketing clearance is secured, the manufacturing facility will be inspected periodically for GMP compliance by FDA inspectors, and, if the facility is located in California, by inspectors from the Food and Drug Branch of the California Department of Health Services. In complying with the GMP regulations, manufacturers must continue to expend time, money and effort in production, recordkeeping and other requirements. Failure to comply with the GMP regulations subjects the manufacturer to possible FDA regulatory action, such as the suspension of manufacturing, product recall or seizure, injunction, fines and criminal prosecution.

In both domestic and foreign markets, sales of any approved products depends on reimbursement decisions from governmental agencies and/or third-party payers, including government and private insurance plans. Third-party payers are increasingly requiring evidence from controlled clinical trials that includes safety, efficacy, quality of life and pharmacoeconomic endpoints. Reimbursers are also increasingly recommending generic treatments first and challenging the prices charged for medical products and services. If we, or our collaborators, succeed in bringing one or more product candidates to market, these products may not be considered cost-effective, reimbursement may not be available, or reimbursement policies may adversely affect our ability to sell our products on a profitable basis.

We also are subject to various federal, state and local laws, regulations and recommendations relating to safe working conditions, laboratory and manufacturing practices, the experimental use of animals and the use and disposal of hazardous or potentially hazardous substances, including radioactive compounds and infectious disease agents, used in connection with our research. The extent of government regulation which might result from any future legislation or administrative action cannot be accurately predicted.

Second-generation Vitaxin, optimized by us, entered Phase I clinical testing with MedImmune during 2001, and may enter Phase II clinical trails in 2003. Our corporate collaborators control all aspects of the clinical testing of product candidates we optimized for them. We do not have any internal development product candidates in human clinical trials.

As of December 31, 2002, we had 106 full-time employees, 48 of whom hold advanced degrees. 83 of our full-time employees were engaged in research and development, and 23 were engaged in business development, finance and general administration. None of our employees is represented by labor unions or covered by collective bargaining agreements. We have not experienced any work stoppages and consider our employee relations to be good.

Remicade® is a registered trademark of Centocor; Rituxan® is a registered trademark of IDEC Pharmaceuticals, Inc.; Numax^TM and Vitaxin^TM are trademarks of MedImmune; and Synagis® is a registered trademark of MedImmune.

The Company’s Internet address is www.AME.biz. The Company makes available free of charge on www.AME.biz its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports, as soon as reasonably practical after the Company electronically files such material with, or furnishes it to, the SEC. The information found on the Company’s website shall not be deemed incorporated by reference by any general statement incorporating by reference this report into any filing under the Securities Act of 1933 or under the Securities Exchange Act of 1934, except to the extent the Company specifically incorporates the information found on the Company’s website by reference, and shall not otherwise be deemed filed under such Acts.

We are at an early stage of development. We incurred a net loss of $17.4 million for the twelve months ended December 31, 2002, and our revenue for the same period was $7.9 million. Additionally, we have had net losses each year since inception and as of December 31, 2002, had an accumulated deficit of $71.6 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

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 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 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 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 (“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 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 subsidiary, Novasite Pharmaceuticals, Inc. (“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 December 31, 2002, our officers and directors and their affiliates, in the aggregate, owned beneficially approximately 26% 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.

Our executive officers and key employees, and their ages and positions as of March 4, 2003, are:

William D. Huse, M.D., Ph.D., founded our Company in 1989, has been our Chief Executive Officer since January 1999 and the Chairman of the Board of Directors since May of 2002. Dr. Huse was affiliated with The Scripps Research Institute from 1989 to 1990. Prior to joining Scripps, Dr. Huse was Vice President, Research and Development at Stratagene, Inc., a private biotechnology company, from 1986 to 1989. Dr. Huse was an Assistant Professor at Yale University School of Medicine, Section of Molecular Neurobiology, from 1984 to 1986. Dr. Huse received his M.D. and Ph.D. in Neurosciences from the Albert Einstein School of Medicine. Dr. Huse completed his postdoctoral work at Cold Spring Harbor Laboratory.

Lawrence E. Bloch, M.D., J.D., has been our Chief Financial Officer since March 2000 and our Secretary since April 2000. From 1999 to 2002, he held the position of Vice President of Business Development in our Company. From 1998 to 1999, he served as a consultant to several private biotechnology companies, including our Company and U.S. Genomics, Inc. In 1995, Dr. Bloch co-founded CareCom, Inc., a developer of patient-oriented bioinformatics applications, and served as its President from 1995 to 1999. Dr. Bloch received a J.D. from Harvard Law School, an M.D. from Harvard Medical School and an M.B.A. from Harvard Business School.

James B. Breitmeyer, M.D., Ph.D., has been our Chief Medical Officer since December 2001. From 2000 to 2001, Dr. Breitmeyer was President and CEO of the Harvard Clinical Research Institute. From 1991 to 2000, Dr. Breitmeyer held a variety of positions at Serono Laboratories, Inc., including Chief Medical Officer and Senior Vice President of Research and Development. Prior to Serono, Dr. Breitmeyer served as a consultant to Immunogen, Inc., and held clinical and teaching positions at the Dana Farber Cancer Institute and Harvard Medical School. Dr. Breitmeyer received his M.D. and Ph.D. from Washington University School of Medicine and is board certified in Internal Medicine and Oncology.

Keith S. Manchester, M.D., has been our Vice President of Business Development since January 2002. From 2000 to 2002 he held the position of Director of Business Development in our Company. From 1999 to 2000, Dr. Manchester was an associate at Vestar Capital Partners, a private equity firm specializing in management buyouts. From 1997 to 1999, Dr. Manchester was an investment banker in the healthcare group at Goldman, Sachs & Co. He completed his surgical internship at Parkland Medical Hospital in Dallas, Texas. Dr. Manchester received an A.B. from Harvard College and an M.D. from Harvard Medical School.

William L. Respess, J.D., Ph.D., has been our Vice President and General Counsel since July 2002 and has been a member of our Board of Directors since September 2002. From 2000 to 2002, Dr. Respess served as Senior Vice President and General Counsel of Graviton Inc. From 1988 to 2000, Dr. Respess served as Senior Vice President and General Counsel of Ligand Pharmaceuticals Inc. Dr. Respess’ experience also includes positions as Vice President and General Counsel of Gen-Probe Inc., Vice President and General Counsel of Hybritech Inc. and Partner at Lyon & Lyon. Dr. Respess received a Ph.D. in Organic Chemistry from the Massachusetts Institute of Technology and a J.D. from George Washington University before serving as Law Clerk and Technical Advisor to the Honorable J. Lindsay Almond, Jr., on the United States Court of Customs and Patent Appeals. He is a member of the American Intellectual Property Law Association and has been a frequent lecturer on intellectual property and licensing law.

Jeffry D. Watkins, Ph.D., has been our Chief Scientific Officer since January 2002. From 1998 to 2002, he served as our Vice President of Research. From 1993 to 1998, Dr. Watkins held a variety of research positions in our Company. From 1992 to 1993, he was a research scientist at Hybritech, Inc., a public biotechnology company focused on diagnostics. Dr. Watkins received a Ph.D. in Biochemistry from Purdue University. He completed his postdoctoral research at The Scripps Research Institute and at Purdue University. He is also the recipient of a National Institutes of Health Postdoctoral Fellowship. Dr. Watkins has authored multiple scientific peer-reviewed articles, is named inventor on numerous directed molecular evolution patents and has been the principal investigator on multiple federal grants.

Our executive office and research facilities are located in San Diego, California, and comprise approximately 43,000 square feet of space. The leases on these facilities expire in December 2004 and 2008. We believe that our existing facilities and equipment are well maintained and in good working condition and that our current facilities will provide adequate capacity through the term of the leases.

On August 17, 2001, the Company entered into an Operating Agreement with Torrey View Phase II, L.P., to establish AME Torrey View, LLC (“Torrey View”), a 99% owned subsidiary of the Company, which is consolidated in our financial statements. On March 4, 2002, Torrey View purchased a 10.73-acre parcel of undeveloped land in San Diego County from a third party at a cost of approximately $8.0 million. The Company 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 Bank USA to fund the purchase price and certain development costs, and as of December 31, 2002, we had approximately $5.0 million available for future financing needs under this credit facility. This loan was transferred to Merrill Lynch Business Financial Services during 2002 with substantially the same terms as the original loan from Merrill Lynch Bank USA. As of December 31, 2002, restricted cash of approximately $10.5 million collateralized the outstanding loan balance. The Company also entered into a $3.0 million loan and a development and management agreement with a group, that is not affiliated with the Company, but that is affiliated with the 1% owner of Torrey View, who may assist 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 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.

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

Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters

(a) Our common stock has been traded on the Nasdaq National Market since our initial public offering on July 27, 2000, under the symbol AMEV. Prior to such time, there was no public market for our common stock. The following table sets forth the range of the high and low closing sale prices for our common stock, as reported on the Nasdaq National Market, for the two most recent fiscal years:

We have never declared or paid any cash dividends on our capital stock. We currently intend to retain future earnings, if any, for development of our business and, therefore, do not anticipate that we will declare or pay cash dividends on our capital stock in the foreseeable future.

(b) 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, $6.3 million for purchases of property and equipment, and approximately $19.3 million to fund our net losses. The balance of the proceeds was applied towards the purchase of temporary investments

The following table presents our selected historical financial data. The selected data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements included elsewhere in this Form 10-K, including the notes to the consolidated financial statements. The selected data in this section is not intended to replace the consolidated financial statements.


(1)	Amounts include the results of Novasite Pharmaceuticals, Inc. (“Novasite”), our majority-owned subsidiary, from July 13, 1999, its date of incorporation (see Note 1 of Notes to Consolidated Financial Statements).


(2)	Amounts include the results of AME Torrey View, LLC (“Torrey View”), our majority-owned subsidiary, from August 17, 2001, its date of incorporation (see Note 1 of Notes to Consolidated Financial Statements).

The following discussion of the financial condition and results of our operations should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in our Annual Report on Form 10-K. This discussion contains forward-looking statements concerning the Company’s operating results and timing of anticipated expenditures. Such statements involve risks and uncertainties that could cause actual results to differ materially from those projected. Factors that could cause or contribute to such differences are described in the “Risk Factors” and elsewhere in the Form 10-K. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect our analysis only as of the date hereof. We assume no obligation to update these forward-looking statements to reflect actual results or changes in factors or assumptions affecting such forward-looking statements.

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. We focus principally on applying our technology to human biotherapeutics, the largest and most profitable target market for directed molecular evolution. 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^TM technology and the development of Vitaxin^TM, 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, 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 (“Biosite”), 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 December 31, 2002, we had an accumulated deficit of $71.6 million. These losses and this accumulated deficit resulted from the significant costs incurred in the development of our technology platform and the preclinical and clinical development of Vitaxin. We expect these losses to increase as we continue to invest in our AMEsystem technology and internal development projects.

Services during 2002 with substantially the same terms as the original loan from Merrill Lynch Bank USA. As of December 31, 2002, restricted cash of approximately $10.5 million collateralized the outstanding loan balance. The Company also entered into a $3.0 million loan and a development and management agreement with a group, that is not affiliated with the Company, but that is affiliated with the 1% owner of Torrey View, who may assist the Company with the development of the project. The $3.0 million loan from the Company to the group is collateralized by a perfected security interest in the 1% owner’s membership rights in Torrey View and is due in 2004. Torrey View also entered into an engagement letter and compensation agreement with a third party to act as a broker and co-development manager, on behalf of Torrey View, in connection with the purchase and development of the land.

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

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 (see Note 1 to our financial statements on page F-7).

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 (“SAB101”), Revenue Recognition, 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 and technology license fees under multiple-element arrangements are deferred and recognized over the period of such services or performance if such arrangements require on-going 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.

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 December 31, 2002, capitalized costs related to issued patents total approximately $508,000 (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.

We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.

Revenue. Revenue was $7.9 million for the year ended December 31, 2002, compared to $3.6 million for the year ended December 31, 2001, an increase of $4.3 million. Revenues from corporate collaborators increased to $5.6 million for the year ended December 31, 2002, from $1.5 million for the year ended December 31, 2001. This increase was primarily due to contract research and milestone revenue received under our corporate collaborations. Other revenue, related to licenses and grants, was $2.3 million for the year ended December 31, 2002, and $2.1 million for the year ended December 31, 2001.

Research and development. Research and development expenses consist primarily of compensation and other expenses related to research and development personnel, costs associated with preclinical development of our internal development product candidates and facilities expenses. We generally do not track our research and development costs by projects, therefore we cannot accurately estimate with any degree of certainty what our costs have been for particular research and development projects. Research and development expenses were $15.1 million for the year ended December 31, 2002, compared to $10.9 million for the year ended December 31, 2001, an increase of $4.2 million. This increase was primarily attributable to salaries and other personnel related expenses and additional supplies and equipment, due to an increase in scientific staffing to support our internal development projects, corporate collaborations and grants.

General and administrative. General and administrative expenses increased to $9.7 million for the year ended December 31, 2002, from $4.4 million for the year ended December 31, 2001, an increase of

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 options were granted. Deferred compensation is included as a component of stockholders’ equity and is being amortized in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 28 over the vesting periods of the related options, which is generally three or four years. Amortization of deferred compensation, which is reported as stock-based compensation in the statement of operations, was approximately $3.2 million for the year ended December 31, 2002 ($1.0 million related to research and development and $2.2 million related to general and administrative), and $6.8 million for the year ended December 31, 2001 ($2.1 million related to research and development and $4.7 million related to general and administrative).

Interest income, net. Net interest income decreased to $2.8 million for the year ended December 31, 2002, from $4.9 million for the year ended December 31, 2001, a decrease of $2.1 million. The decrease was due primarily to our lower average cash and investment balances and lower interest earned on investment balances during 2002 compared to 2001.

Other financing charges. We incurred other financing charges of $604,000 for the year ended December 31, 2002, compared to no charges for the year ended December 31, 2001. The increase is due to a non-cash finance charge related to the issuance and conversion of convertible debt at below market price and the issuance of warrants by our subsidiary, Novasite, to one of its minority investors (see Note 12).

Revenue. Revenue was $3.6 million for the year ended December 31, 2001, compared to $2.7 million for the year ended December 31, 2000, an increase of $900,000. Revenues from corporate collaborators were $1.5 million for each of the years ended December 31, 2001 and 2000. Other revenue increased to $2.1 million for the year ended December 31, 2001, from $1.2 million for the year ended December 31, 2000, an increase of approximately $900,000. This increase was primarily due to additional grant revenue earned in 2001.

Research and development. Research and development expenses consist primarily of compensation and other expenses related to research and development personnel, costs associated with preclinical development of our internal development product candidates and facilities expenses. We generally do not track our research and development costs by projects, therefore we cannot accurately estimate with any degree of certainty what our costs have been for particular research and development projects. Research and development expenses were $10.9 million for the year ended December 31, 2001, compared to $4.5 million for the year ended December 31, 2000, an increase of $6.4 million. This increase was primarily attributable to salaries and other personnel related expenses, expansion of facilities and additional supplies and equipment, due to an increase in scientific staffing to support our internal development projects, collaborations and grants.

General and administrative. General and administrative expenses increased to $4.4 million for the year ended December 31, 2001, from $2.8 million for the year ended December 31, 2000, an increase of $1.6 million. The increase was due primarily to the expansion of our administrative infrastructure, including increases in salaries and other personnel related expenses, expansion of facilities and travel and professional fees to support our growth and increased business development efforts.

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 options were granted. Deferred compensation is included as a component of stockholders’ equity and is being amortized in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 28 over the vesting periods of the related options, which is generally three or four years. Amortization of deferred compensation, which is reported as stock-based compensation in the statement of operations, was approximately $6.8 million for the year ended December 31, 2001 ($2.1 million related to research and development and $4.7 million related to general and administrative), and $12.2 million for the year ended December 31, 2000 ($3.9 million related to research and development and $8.3 million related to general and administrative).

Interest income, net. Net interest income increased to $4.9 million for the year ended December 31, 2001, from $3.1 million for the year ended December 31, 2000, an increase of $1.8 million. The increase was due primarily to our higher average cash and investment balances during 2001 as a result of the cash proceeds from the initial public offering, which closed in the third quarter of 2000.

In July 2000, we sold approximately 5.3 million shares of common stock in an initial public offering, resulting in net proceeds to the Company of approximately $92.9 million. Prior to the initial public offering, we had financed our operations primarily through private placements of equity securities, with aggregate net proceeds of approximately $39.6 million. In addition, we had generated $24.8 million of cash from research collaborations through December 31, 2002.

In December 2000, we repurchased 1.2 million shares of our common stock at a cost to us of $14.4 million. In August 2002, we repurchased approximately 1.9 million shares of our common stock at a cost to us of approximately $7.3 million.

As of December 31, 2002, we had approximately $51.1 million in unrestricted cash, cash equivalents, and short-term investments, compared to $80.2 million of unrestricted cash, cash equivalents, and short-term investments as of December 31, 2001. In addition, we had restricted cash of $10.5 million as of December 31, 2002, which has been pledged as collateral for the $10.0 million credit facility from Merrill Lynch.

For the year ended December 31, 2002, we used cash of approximately $10.0 million in operating activities primarily to fund our net losses of $17.4 million, offset by non-cash charges for stock-based compensation totaling $3.2 million and a decrease in prepaid expenses and other assets of $3.5 million. We used approximately $6.6 million of cash for operations in 2001 and $2.9 million in 2000.

For the year ended December 31, 2002, we used cash of approximately $13.6 million in investing activities compared to the use of cash of approximately $4.4 million for the year ended December 31, 2001. For the year ended December 31, 2000, we used cash of approximately $51.8 million in investing activities. Our investing activities consisted primarily of purchases and sales of short-term investments, and capital expenditures for property and equipment. We expect to continue to make investments in our infrastructure, including purchasing property and equipment to support our operations.

For the year ended December 31, 2002, we generated approximately $4.0 million of cash from financing activities, primarily from the proceeds of the Merrill Lynch loan of $10.0 million, offset by the repurchase of 1.9 million shares of our common stock for $7.3 million, compared to $71,000 of cash generated for the year ended December 31, 2001. For the year ended December 31, 2000, we generated $89.5 million of cash from financing activities, primarily from the net proceeds of approximately $92.9 million from the initial public offering, $10.0 million of net proceeds from the sale of Series F preferred stock, and $583,000 from the private placement of equity securities in Novasite, offset by the repurchase of 1.2 million shares of our common stock for $14.4 million.

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 99% 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 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. Further, any additional equity financing may be dilutive to stockholders, and debt financing, if available,

We incurred net operating losses in 2002, 2001 and 2000, and consequently did not pay any federal or state income taxes. As of December 31, 2002, we had federal net operating loss carryforwards of approximately $39.8 million, which begin to expire in 2006. At December 31, 2002, the net operating loss carryforwards for state tax purposes were approximately $4.0 million, which will continue to expire in 2004. We also had federal and state research and development tax credit carryforwards at December 31, 2002, of $1.0 million and $653,000, respectively, which begin to expire in 2006, unless previously utilized.

In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS No. 144”), which establishes one accounting model to be used for long-lived assets to be disposed of by sale and broadens the presentation of discontinued operations to include more disposal transactions. SFAS No. 144 supercedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, and the accounting and reporting provisions of Accounting Principles Board (“APB”) Opinion No. 30. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. The adoption of SFAS No. 144 in January 2002 did not have a material impact the Company’s consolidated financial position or results of operations, and we do not expect any impact in the foreseeable future.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (“SFAS No. 146”). This statement supercedes Emerging Issues Task Force (“EITF”) Issue No. 94-3 Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring (“EITF 94-3”). SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF 94-3, a liability was recognized at the date an entity committed to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. The provisions of SFAS No. 146 will be effective for any exit and disposal activities initiated after December 31, 2002.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure — an amendment of FASB Statement No. 123 (“SFAS No. 148”). This statement amends SFAS No. 123, Accounting for Stock Based Compensation (“SFAS No. 123”) to provide alternative methods of voluntarily transitioning to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also amends the disclosure requirements of SFAS No. 123 to require disclosure of the method used to account for stock-based employee compensation and the effect of the method on reported results in both annual and interim financial statements. The disclosure provisions will be effective for the Company beginning with the Company’s year ended December 31, 2003. The Company has not yet completed the final evaluation of the options presented by SFAS No. 148. However, within this fiscal year, the

Company expects to reach a determination of whether and, if so, when to change the Company’s existing accounting for stock-based compensation to the fair value method in accordance with the transition alternatives of SFAS No. 148.

In November 2002, the EITF reached consensus on EITF Issue 00-21, Accounting for Revenue Arrangements with Multiple Deliverables (“EITF 00-21”), which addresses how to account for arrangements that may involve the delivery or performance of multiple products, services, and/or rights to use assets. The final consensus of EITF 00-21 will be applicable to agreements entered into in fiscal periods beginning after June 15, 2003, with early adoption permitted. Additionally, companies will be permitted to apply the consensus guidance to all existing arrangements as the cumulative effect of a change in accounting principle in accordance with APB Opinion No. 20, Accounting Changes. Management is currently evaluating the effect that the adoption of EITF 00-21 will have on its results of operations and financial position.

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 and the then-prevailing interest rate 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 in 2002 was approximately two years. Due to the short-term nature of these investments, we believe that we have no material exposure to interest rate fluctuations 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.

The consolidated financial statements and supplementary data of the Company required by this item are set forth at the pages indicated in Item 15(a)(1).

Information regarding directors is incorporated by reference to the section entitled “Election of Directors” in the Proxy Statement. Information regarding executive officers is contained in Part I of this Form 10-K. Information regarding Section 16 reporting compliance is incorporated by reference to the Proxy Statement under the heading “Section 16 Beneficial Ownership Reporting Compliance.”

The information required by this item is incorporated by reference to the Proxy Statement under the heading “Executive Compensation.”

Certain of the information required by this item is incorporated by reference to the Proxy Statement under the heading “Security Ownership of Certain Beneficial Owners and Management.”

The following table sets forth information as of the end of December 31, 2002, with respect to compensation plans under which equity securities of the Company are authorized for issuance.


(1)	The table does not include information for employee benefit plans of the Company and its subsidiaries intended to meet the qualification requirements of Section 401(a) of the Internal Revenue Code and foreign employee benefit plans which are similar to Section 401(a) plans.

(2)	Consists of four plans: the 1992 Stock Plan, the 2000 Stock Plan, the 2001 Stock Incentive Plan and the 2000 Employee Stock Purchase Plan.

(3)	This category consists of one plan: the 2002 New Employee Stock Incentive Plan.

The Company’s 2002 New Employee Stock Incentive Plan provides for the grant of options to purchase shares of the Company’s common stock, restricted shares of the common stock, stock appreciation rights or awards of units based on the value of share of the Company’s common stock to new non-officer employees of the Company as an inducement to accept an offer of employment with the Company. Only new non-officer employees who were not previously employed by the Company or a parent, a subsidiary or an affiliate of the Company may be eligible for a grant under the 2002 New Employee Stock Incentive Plan. A maximum of 200,000 shares of common stock may be issued under the 2002 New Employee Stock Incentive Plan, subject to adjustment in the number of shares of common stock that may be issued for changes in the Company’s capital structure.

The information required by this item is incorporated by reference to the Proxy Statement under the heading “Certain Transactions.”

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

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

The financial statements of the Company are included herein as required under Item 8 of this Annual Report on Form 10-K. See Index on page F-l.

Schedules have been omitted because information required to be set forth therein is not applicable or is included in the financial statements or notes thereto.

The exhibits listed below are required by Item 601 of Regulation S-K. Each management contract or compensatory plan or arrangement required to be filed as an exhibit to the Form 10-K has been identified. See paragraph (c).

On November 5, 2002, we filed a current report on Form 8-K, with exhibits attached thereto, reporting under Item 5 Amendment No. 1 to the Rights Agreement dated as of May 10, 2001, between the Company and EquiServe Trust Company, N.A.


	(1)	Incorporated by reference to Exhibit 3(i).2 filed with the Company’s Registration Statement on Form S-1 (No. 333-36830) filed on May 12, 2000.

	(2)	Incorporated by reference to Exhibit 3(ii).2 filed with the Company’s Registration Statement on Form S-1 (No. 333-36830) filed on May 12, 2000.

	(3)	Incorporated by reference to Exhibit 3(i).2 filed with the Company’s Registration Statement on Form 8-A (File No. 000-31101) filed on May 11, 2001.

	(4)	Incorporated by reference to the exhibits of the same number filed with the Company’s Registration Statement on Form S-1 (No. 333-36830) filed on May 12, 2000.

	(5)	Incorporated by reference to the exhibits of the same number filed with the Company’s Annual Report on Form 10-K (No. 000-31101) filed on March 19, 2001.

	(6)	Incorporated by reference to Exhibit 4.1 filed with the Company’s Registration Statement on Form 8-A (File No. 000-31101) filed on May 11, 2001.

	(7)	Incorporated by reference to Exhibit 4.1 filed with the Company’s Current Report on Form 8-K (File No. 000-31101) filed on August 21, 2002.

	(8)	Incorporated by reference to Exhibit 4.2 filed with the Company’s Registration Statement on Form 8-A (File No. 000-31101) filed on November 5, 2002.

	(9)	Incorporated by reference to Exhibit A filed with the Company’s Proxy Statement on Schedule 14A (File No. 000-31101) filed on April 23, 2001.


(10)	Incorporated by reference to the exhibits of the same number filed with the Company’s Annual Report on Form 10-K (File No. 000-31101) filed on March 5, 2002.

(11)	Incorporated by reference to Exhibit 10.28 filed with the Company’s Quarterly Report on Form 10-Q (File No. 000-31101) filed on May 7, 2002.

(12)	Incorporated by reference to Exhibit 10.28 filed with the Company’s Quarterly Report on Form 10-Q (File No. 000-31101) filed on November 5, 2002.

(13)	Incorporated by reference to Exhibit 10.1 filed with the Company’s Registration Statement on Form S-8 (File No. 333-102317) filed on January 2, 2003.

†	The Company has received confidential treatment of certain portions of these agreements.

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of San Diego, State of California, on the fourth day of March, 2003.


	By:	/s/ WILLIAM D. HUSE



	William D. Huse, M.D., Ph.D.
	President, Chief Executive Officer
	and Chairman of the Board

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints William D. Huse, M.D., Ph.D., and Lawrence E. Bloch, M.D., J.D., and each of them, his or her true and lawful attorneys-in-fact and agents, each with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments, including post-effective amendments, to this Report on Form 10-K, and to file the same, with all exhibits thereto and other documents in connection herewith, with the Securities and Exchange Commission, granting unto the attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that the attorneys-in-fact and agents, or either of them, or their, his or her substitutes or substitute, may lawfully do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Report on Form 10-K has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

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

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

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

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


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

	b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and

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

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


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

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

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


	/s/ WILLIAM D. HUSE

	William D. Huse, M.D., Ph.D.
	President, Chief Executive Officer and
	Chairman of the Board

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


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

	b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and

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


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

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


	/s/ LAWRENCE E. BLOCH

	Lawrence E. Bloch, M.D., J.D.
	Chief Financial Officer and Secretary

We have audited the accompanying consolidated balance sheets of Applied Molecular Evolution, Inc., as of December 31, 2002 and 2001, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Applied Molecular Evolution, Inc. at December 31, 2002 and 2001, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States.

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 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 announced that it has successfully utilized its proprietary technology to optimize proteins from all major classes of therapeutic proteins for corporate collaborators and the Company’s internal development projects. AME’s majority owned subsidiary, Novasite applies directed molecular evolution to small-molecule drug discovery and optimization.

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”). All significant intercompany accounts and transactions have been eliminated.

At December 31, 2002, 2001 and 2000, AME’s ownership interest in Novasite was 59%, 72% and 72%, respectively. Prior to December 2000, AME had a 78% ownership interest in Novasite. The net loss of Novasite ($2,566,000, $1,522,000 and $567,000 in 2002, 2001 and 2000, respectively) is allocated to the minority interests based on their ownership percentage of Novasite. The amounts ($1,218,000, $0 and $308,000 in 2002, 2001 and 2000, respectively) by which AME’s ownership interest in Novasite’s equity exceeded AME’s cost basis in its investment has been recorded as additional paid-in capital of AME.

On August 17, 2001, the Company entered into an Operating Agreement with Torrey View Phase II, L.P., to establish AME Torrey View, LLC (“Torrey View”). In March 2002, Torrey View purchased a parcel of undeveloped land that the Company may develop over the next few years as its corporate headquarters. Torrey View is a 99% owned subsidiary and is consolidated in the Company’s financial statements.

Cash and cash equivalents consist primarily of highly liquid investments with original maturities of 90 days or less when purchased. Short-term investments consist of debt securities with maturities in excess of 90 days when purchased.

In accordance with Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities, management determines the appropriate classification of short-term investment securities at the time of purchase and reevaluates such designation as of each balance sheet date. All securities have been classified as available-for-sale and are carried at fair value, with unrealized gains and losses, if any, reported in comprehensive income (loss). Realized gains and losses on available-for-sale securities are included in interest income. The cost of securities sold is based on the specific identification method.

Cash and cash equivalents, accounts payable and accrued liabilities, are carried at cost, which management believes approximates fair value due to the short-term maturity of these instruments. Short-term investments are carried at fair value.

Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents. The Company limits its exposure to credit loss by placing its cash with high credit quality financial institutions.

Property and equipment are stated at cost and depreciated over the estimated useful lives of the assets (3 to 10 years) using the straight-line method. Leasehold improvements and assets under capital leases are stated at cost and amortized over the shorter of the estimated useful lives of the assets or the lease term. The Company capitalized the acquisition costs in connection with a land purchase and is capitalizing costs incurred in the development of the land.

In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, if indicators of impairment exist, the Company assesses 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, the Company measures the amount of such impairment by comparing the carrying value of the asset to the fair value of the asset and records the impairment as a reduction in the carrying value of the related asset and a charge to operating results. While the Company’s current and historical operating and cash flow losses are indicators of impairment, the Company believes the future cash flows to be received from the long-lived assets will exceed the assets’ carrying value, and accordingly the Company has not recognized any impairment losses through December 31, 2002.

Legal costs incurred in filing patent applications have been capitalized and, upon patent issuance, are amortized over the six-year estimated useful lives of the patents. Costs related to abandoned patent applications are expensed at the time of abandonment.

In accordance with SFAS No. 109, Accounting for Income Taxes, a deferred tax asset or liability is determined based on the difference between the financial statement and tax basis of assets and liabilities as measured by the enacted tax rates which will be in effect when these differences reverse. The Company has provided a full valuation allowance against any deferred tax assets.

Rent expense is recorded on a straight-line basis over the term of the lease. The difference between rent expense and amounts paid under the lease agreements is recorded as deferred rent in the accompanying consolidated balance sheets.

In accordance with SFAS No. 130, Reporting Comprehensive Income, all components of comprehensive income or loss, including net income or loss, are reported in the financial statements in the period in which they are recognized. Comprehensive income or loss is defined as the change in equity during a period from transactions and other events and circumstances from non-owner sources. Net income or loss and other comprehensive income or loss, including foreign currency translation adjustments and unrealized gains and losses on investments, shall be reported, net of their related tax effect, to arrive at comprehensive income or loss.

Basic and diluted net loss per common share are presented in conformity with SFAS No. 128, Earnings per Share. In accordance with SFAS No. 128, basic and diluted net loss per share have been computed using the weighted average number of shares of common stock outstanding during the period, less shares subject to repurchase.

The following table presents the calculation of net loss per share (in thousands, except per share data):

The Company has excluded all preferred stock, outstanding stock options and warrants, and shares subject to repurchase from the calculation of diluted loss per common share because all such securities are antidilutive for all periods presented. The total number of shares excluded from the calculation of diluted net loss per share, prior to the application of the treasury stock method for options and warrants, was 3,598,788, 3,097,273 and 2,509,716 for the years ended December 31, 2002, 2001 and 2000, respectively.

Contract revenue is recognized either (i) ratably over the term of the agreement, which approximates the performance of services, for contracts specifying payment for services over a given period, or (ii) as services are performed under the agreement, for contracts specifying payment on a per full-time employee basis. Contract revenue in 2002 includes amounts received under collaborative agreements with Eli Lilly and Company (“Lilly”), MedImmune, Inc. (“MedImmune”), Chiron Corporation (“Chiron”), Centocor Inc. (“Centocor”), CancerVax, Inc. (“CancerVax”) and Aventis Pharmaceuticals, Inc. (“Aventis”) (Note 7). Contract revenue in 2001 includes amounts received under collaborative agreements with Lilly, MedImmune, Biosynexus Incorporated (“Biosynexus”) and Aventis (Note 7). Contract revenue in 2000 includes amounts received under collaborative agreements with MedImmune and CancerVax (Note 7).

Other revenue consists principally of research grants from the National Institutes of Health (“NIH”), and a nonrefundable, prepaid royalty fee received from Biosite Incorporated (“Biosite”), which is being recognized ratably over the estimated useful lives of the related patents (Note 8). Grant revenue is recognized as the research expenses related to the grants are incurred. All amounts received under the collaborative research agreements or research grants are not refundable, regardless of the success of the underlying research.

Revenue earned related to up-front product and technology license fees is recognized in accordance with Staff Accounting Bulletin 101 issued by the Securities and Exchange Commission. Accordingly, amounts received under multiple-element arrangements requiring ongoing services or performance by the Company are recognized over the period of such services or performance.

Revenue from milestones are recognized when earned, as evidenced by written acknowledgement from the collaborator, provided that (i) the milestone event is substantive and its achievability was not reasonably assured at the inception of the agreement, and (ii) the Company’s performance obligations after the milestone achievement will continue to be funded by the collaborator at a comparable level to before the milestone achievement. If both of these criteria are not met, the milestone payment would be recognized over the remaining minimum period of the Company’s performance obligations under the arrangement. Royalties, if any, will be recognized as earned. Under the Company’s research agreement with MedImmune (Note 7),

MedImmune may make milestone payments in the form of either cash payment or a purchase of equity at a specified premium to the then-current fair value of the Company’s stock, and a portion of such milestones are creditable against future royalties. Upon receipt of a cash milestone payment, the amount creditable against future royalties will be recorded as deferred royalty revenue and recognized as royalties would otherwise be due to the Company. Upon receipt of an equity milestone payment, the specified premium will be recorded as deferred royalty revenue and recognized as royalties would otherwise be due to the Company. In the event the Company is notified by MedImmune that MedImmune is terminating the development of all products for which royalties could be due to the Company, any amount then recorded as deferred royalty revenue will be recognized in full.

Amounts received in excess of revenue recognized are recorded as deferred revenue.

Research and development costs are expensed as incurred. Such costs include: personnel expenses, contractor fees, laboratory supplies, facilities and allocation of corporate costs. These expenses are incurred during research and development activities for our internal development projects, corporate collaborations and grants.

The Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”) and related Interpretations, in accounting for its employee and director stock options. Under APB 25, when the purchase price of restricted stock or the exercise price of the Company’s employee stock options equals or exceeds the fair value of the underlying stock on the date of issuance or grant, no compensation expense is recognized.

In March 2000, the FASB issued Interpretation No. 44, (“FIN 44”), Accounting for Certain Transactions Involving Stock Compensation — An Interpretation of APB 25. This interpretation clarifies the definition of employee for purpose of applying APB 25, the criteria for determining whether a plan qualifies as a non-compensatory plan, the accounting consequence of various modifications to the terms of a previously fixed stock option or award, and the accounting for an exchange of stock compensation awards in a business combination. FIN 44 was effective, and the Company adopted the interpretation on July 1, 2000. The adoption did not have a material impact on the Company’s consolidated results of operations.

Options or stock awards issued to non-employees are recorded at their fair value as determined in accordance with SFAS No. 123, Accounting for Stock-Based Compensation, and the Emerging Issues Task Force’s (“EITF”) Issue 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, and recognized over the related service period.

As required under SFAS No. 123 and newly issued 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 per common share are estimated at the date of grant using the Black-Scholes option-pricing model and are disclosed herein.

SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, requires the use of a management approach in identifying segments of an enterprise. Management has determined that the Company operates in one business segment, which is scientific research and development activities.

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

In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which establishes one accounting model to be used for long-lived assets to be disposed of by sale and broadens the presentation of discontinued operations to include more disposal transactions. SFAS No. 144 supercedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, and the accounting and reporting provisions of Accounting Principle Board (“APB”) Opinion No. 30. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. The adoption of SFAS No. 144 in January 2002 did not have a material impact on the Company’s consolidated financial position or results of operations, and we do not expect any impact in the foreseeable future.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. This statement supercedes EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring) (“EITF 94-3”). SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF 94-3, a liability was recognized at the date an entity committed to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. The provisions of SFAS No. 146 will be effective for any exit and disposal activities initiated after December 31, 2002.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure — an amendment of FASB Statement No. 123. This statement amends SFAS No. 123, Accounting for Stock Based Compensation to provide alternative methods of voluntarily transitioning to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also amends the disclosure requirements of SFAS No. 123 to require disclosure of the method used to account for stock-based employee compensation and the effect of the method on reported results in both annual and interim financial statements. The disclosure provisions will be effective for the Company beginning with the Company’s year ended December 31, 2003. The Company has not yet completed the final evaluation of the options presented by SFAS No. 148. However, within this fiscal year, the Company expects to reach a determination of whether and, if so, when to change the Company’s existing accounting for stock-based compensation to the fair value method in accordance with the transition alternatives of SFAS No. 148.

In November 2002, the EITF reached consensus on EITF Issue 00-21, Accounting for Revenue Arrangements with Multiple Deliverables (“EITF 00-21”), which addresses how to account for arrangements that may involve the delivery or performance of multiple products, services, and/or rights to use assets. The final consensus of EITF 00-21 will be applicable to agreements entered into in fiscal periods beginning after June 15, 2003, with early adoption permitted. Additionally, companies will be permitted to apply the consensus guidance to all existing arrangements as the cumulative effect of a change in accounting principle in accordance with APB Opinion No. 20, Accounting Changes. Management is currently evaluating the effect that the adoption of EITF Issue 00-21 will have on its results of operations and financial position.

At December 31, 2002, short-term investments consisted of the following (in thousands):

At December 31, 2001, short-term investments consisted of the following (in thousands):

Short-term investments by contractual maturity at December 31, 2002, are as follows (in thousands):

Prior to the completion of the Company’s initial public offering, the Series F preferred stock was sold primarily to the affiliates of an independent accredited investor at $4.50 per share; however, the price was substantially below the Company’s initial public offering price. Accordingly, pursuant to EITF 98-5, Accounting for Convertible Securities with Beneficial Conversion Features, the Company recognized a deemed dividend on the Series F preferred stock of $10.1 million.

In July 2000, the Company completed its initial public offering of common stock under the Securities Act of 1933, resulting in gross proceeds of $101.6 million and net proceeds (less the underwriters’ discount and offering expenses) of $92.9 million. Upon completion of the initial public offering, all of the Company’s convertible preferred stock and series A, B, C, D, E and F preferred stock outstanding converted into 13,884,568 shares of common stock.

In December 2000, the Company repurchased 1.2 million shares of its common stock at a price of $12.00 per share. In August 2002, the Company repurchased approximately 1.9 million shares of its common stock at a price of $3.89 per share.

During 1996 and 1997, in connection with a short-term loan and security agreements, the Company issued warrants to purchase 26,667 shares and 40,000 shares, respectively, of Series E preferred stock at an exercise price of $5.625 per share. In September 2000, these warrants were converted, in accordance with the warrant agreements, into 55,015 shares of the Company’s common stock.

The Company has in effect several stock-based plans under which nonqualified and incentive stock options have been granted to employees, consultants and directors. At December 31, 2002, approximately 3.4 million stock options were outstanding and approximately 399,000 shares were available for future grant under these plans.

The Board of Directors has designated committees that determine eligibility, vesting schedules and exercise prices for options granted under these plans. Options and other stock awards expire not more than ten years from the date of grant and are either exercisable immediately after the date of grant and subject to certain repurchase rights by the Company until such ownership rights have vested or are exercisable upon vesting. Vesting generally occurs over three or four years. At December 31, 2002, 2001 and 2000, 188,479, 616,812 and 1,273,844 shares of common stock, respectively, were subject to repurchase at a weighted-average price of $0.75, $0.79 and $0.79, respectively. Options are generally granted at fair market value of the Company’s common stock on the date of grant.

Pro forma net loss information is required to be disclosed by SFAS No. 123 and has been determined as if the Company has accounted for its employee stock options under the fair value method prescribed in that statement.

The fair value for the 2002 options was estimated at the date of grant, using the Black-Scholes option pricing model with the following assumptions: risk-free interest rate of 4.5%; dividend yield of 0%; a weighted-average expected life of the option of five years; and a volatility factor of 106%. The fair value for the 2001 options was estimated at the date of grant, using the Black-Scholes option pricing model with the following assumptions: risk-free interest rate of 5%; dividend yield of 0%; a weighted-average expected life of the option of five years; and a volatility factor of 115%. The fair value for the 2000 options granted after the Company filed its initial registration statement relating to the IPO was estimated at the date of grant, using the Black-Scholes option pricing model with the following assumptions: risk-free interest rate of 5.5%; dividend yield of 0%; a weighted-average expected life of the option of two years; and a volatility factor of 136%. The fair value for the 2000 options granted before the Company filed its initial registration statement relating to the IPO was estimated at the date of grant, using the minimum value pricing model with the following weighted average assumptions: risk-free interest rate of 6%; dividend yield of 0%; and a weighted-average expected life of the option of two years.

The weighted average fair values of options granted in 2002, 2001 and 2000 were $6.07, $8.35 and $0.67, respectively.

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period. The Company’s pro forma net loss information is as follows (in thousands, except per share amounts):

Exercise prices and the weighted average remaining contractual life for options outstanding as of December 31, 2002, are as follows (shares in thousands):

During the years ended December 31, 2000 and 1999, in connection with the grant of certain stock options to employees, the Company recorded deferred stock compensation totaling approximately $21.2 million and $1.1 million, respectively, representing the difference between the exercise price and the estimated fair value of the Company’s common stock on the date such stock options were granted. Deferred

compensation is included as a reduction of stockholders’ equity and is being amortized to expense over the vesting period of the options in accordance with FASB Interpretation No. 28, which permits an accelerated amortization methodology. During the years ended December 31, 2002, 2001 and 2000, the Company recorded amortization of deferred stock compensation expense of approximately $3.2 million, $6.5 million and $10.9 million, respectively.

In addition to the stock option plans of the Company as disclosed above, the Company’s majority-owned subsidiary, Novasite, also has a stock option plan under which nonqualified and incentive stock option have been granted to employees, consultants and directors. Under the plan, Novasite is authorized to issue approximately 1.8 million stock options. At December 31, 2002, approximately 1.6 million stock options were outstanding and approximately 213,000 stock options were available for future grants under the plan. The options have been granted with the exercise price equal to the fair market value of Novasite’s common stock of $0.05 per share as determined by Novasite’s Board of Directors and generally vest over four years. The effect on the consolidated financial statements of options granted to non-employees through December 31, 2002, is not material.

The Company’s 2000 Employee Stock Purchase Plan (“ESPP”) was adopted by the board of directors on June 20, 2000, and was subsequently approved by the stockholders. The ESPP permits eligible employees to purchase common stock through payroll deductions at 85% of fair market value. The initial offering period commenced on January 1, 2001. The Company has reserved 750,000 shares of common stock for issuance under the ESPP. The number of shares reserved for issuance under the ESPP may be increased on the first day of each fiscal year. At December 31, 2002, 37,749 shares had been issued under the ESPP, and 712,251 shares were available for future issuance.

In conjunction with a collaborative research and development agreement entered into with MedImmune in February 1999 (Note 7), MedImmune paid the Company an aggregate of $6,350,000, before expenses of $40,000, for (i) 907,143 shares of common stock, (ii) a specified quantity of Vitaxin, and (iii) an exclusive license to Vitaxin. At MedImmune’s request the agreement did not allocate the total proceeds among the three elements of the agreement. Of the aggregate proceeds of $6,350,000, $1,200,000 was refundable if the Company did not deliver the specified quantity of Vitaxin. This amount approximates the Company’s actual cost to acquire the specified quantity of Vitaxin from a third-party manufacturer and provide it to MedImmune. Accordingly, the Company allocated such amount to the specified quantity of Vitaxin and recognized it as revenue in August 1999 when the Vitaxin was delivered to and accepted by MedImmune. While the Company believes a significant portion of the proceeds relate to the value of the license to Vitaxin, the Company concluded that the available objective evidence was not persuasive enough to support an allocation of the remaining proceeds ($5,110,000) between the license and equity elements of the agreement, and accordingly the entire remaining proceeds were allocated to common stock.

At December 31, 2002, the following shares of common stock were reserved for issuance upon the exercise of equity instruments (in thousands):

During 2002, the Company borrowed approximately $10.0 million, under a $15.0 million credit facility, from Merrill Lynch Bank USA to fund the purchase price and certain development costs in connection with a land purchase. The loan bears interest at a floating rate equal to LIBOR plus one percent, payable monthly, and the principal is due on June 23, 2004. This loan was transferred to Merrill Lynch Business Financial Services during 2002, with substantially the same terms as the original loan from Merrill Lynch Bank USA. As of December 31, 2002, restricted cash of approximately $10.5 million collateralized the outstanding loan balance. The Company capitalized all interest paid on this loan in 2002, and as of December 31, 2002, total capitalized interest was approximately $173,000.

The Company leases its facilities under operating leases, which expire in 2004 and 2008. The leases provide for escalating rent payments during the term. For financial reporting purposes, rent expense is recognized on a straight-line basis over the terms of the leases. Accordingly, rent expense recognized in excess of rent paid is reflected as deferred rent. Under the lease agreements, the Company is required to pay a percentage of operating expenses relating to the building. Rent expense was approximately $510,000, $519,000 and $415,000 for the three years ended December 31, 2002, 2001 and 2000, respectively.

The Company also leases certain office equipment under operating leases, which expire in 2005.

Annual future minimum lease payments as of December 31, 2002, are as follows (in thousands):

The Company subleased a portion of its facilities under a sublease that expired in December 2002. Sublease income was approximately $114,000, $78,000 and $86,000 for the years ended December 31, 2002, 2001 and 2000, respectively.

At December 31, 2002, the Company had federal and California tax net operating loss carryforwards of approximately $39.8 million and $4.0 million, respectively. The difference between the tax loss carryforwards for federal and California purposes is primarily attributable to the capitalization of research and development

expenses for California and the 50-60% limitation of California loss carryforwards. The federal tax loss carryforwards will begin expiring in 2006, unless previously utilized. The California tax loss carryforwards will continue to expire in 2004, unless previously utilized. The Company also has federal and California research and development tax credit carryforwards totaling $1.0 million and $653,000, respectively, which will expire beginning in 2006, unless previously utilized.

Pursuant to Internal Revenue Code Section 382 and 383, use of the Company’s net operating loss and tax credit carryforwards will be limited as a result of certain cumulative changes in the Company’s stock ownership that occurred during 1993. However, the Company believes that the limitation will not have a material impact on the utilization of the carryforwards.

Significant components of the Company’s deferred tax assets as of December 31, 2002 and 2001, are shown below. A valuation allowance of $25.0 million has been recognized to offset the deferred tax assets as realization of such assets is uncertain.

As of December 31, 2002, the Company’s collaborative research and development agreements included 14 projects with eight different corporate collaborators. Generally these agreements include research funding and milestones, as well as additional payments upon the achievement of certain clinical milestones and royalties on net sales of products developed. During the years ended December 31, 2002, 2001 and 2000, the Company recorded revenue of approximately $5.6 million, $1.5 million and $1.5 million, respectively, related to research activities performed and research milestones achieved under these agreements.

In February 1999, the Company entered into a collaboration agreement with MedImmune to produce optimized antibodies. In addition, Vitaxin, the Company’s angiogenesis inhibitor, was exclusively licensed to MedImmune in return for an equity investment, milestone payments and royalties related to the development and commercialization of resulting products. Pursuant to the terms of the research program under the collaboration agreement, MedImmune agreed to fund three research programs, each for a period of six months, extendable up to 24 months. In addition to program funding, MedImmune will pay royalties to AME

on net sales of products developed. The agreement also provides that MedImmune will make additional payments, either through cash payments or equity purchases at a specified premium to then-current fair value, to the Company upon the achievement of certain milestones. Under the terms of the agreement, MedImmune has the option to credit up to 65% of cash payments and 20% of equity purchases against future royalty payments. At the time of a cash payment, 35% of the payment will be recognized as milestone revenue, and the remaining 65% will be recorded as deferred royalty revenue. Additionally, if MedImmune makes the milestone payment through an equity purchase, 20% of the amount will be recorded as deferred royalty revenue.

In December 2001, the Company entered into a collaboration agreement with Lilly to create optimized versions of an antibody as well as a non-antibody protein therapeutic candidate. Pursuant to the terms of the research program under the collaboration agreement, Lilly agreed to fund two research programs, one for a period of up to one year and the other for a period of six months, extendable by mutual consent. In February 2002, an additional agreement was entered into by AME and Lilly for the optimization of an additional antibody. In addition to program funding, these agreements also provides that Lilly will make additional payments to the Company upon the achievement of certain milestones and pay royalties on its net sales of products developed.

In May 2002, the Company entered into a research agreement with Centocor to optimize a therapeutic antibody candidate. The research program of this agreement is for six months, extendable upon mutual written consent. In addition to program funding, the agreement also provides that Centocor will make additional payments to the Company upon the achievement of certain milestones and pay royalties on its net sales of products developed.

In December 2001, the Company entered into a research agreement with Chiron to optimize a non-antibody protein therapeutic candidate. The research program of this agreement is for six months, extendable upon mutual written consent. In addition to program funding, the agreement also provides that Chiron will make additional payments to the Company upon the achievement of certain milestones and pay royalties on its net sales of products developed.

In November 1999, the Company entered into a collaboration agreement with Cell-Matrix, Inc., which was acquired by CancerVax in January 2002, to optimize candidate molecules and to perform some preclinical development. Pursuant to the terms of the agreement, Cell-Matrix paid the Company for the optimization of each of the two candidate molecules, which was completed in 2000. In addition, Cell-Matrix made milestone payments to AME for each enhanced antibody in 2000. The agreement also provides that CancerVax will make additional payments to the Company upon the achievement of certain milestones and pay royalties on its net sales of products developed. Research under this collaboration has been completed.

In December 2000, the Company entered into a collaboration agreement with Biosynexus to optimize a candidate molecule and perform certain preclinical development. The research and development aspect of this collaboration was for six months. In addition to research and development funding, the agreement also provides that Biosynexus will make additional payments to the Company upon the achievement of certain

milestones and pay royalties on its net sales of products developed. Research under this collaboration has been completed.

In July 2001, Novasite entered into an agreement with Aventis to conduct a pilot-screening project using Novasite’s proprietary ETDD technology platform.

During 1994, the Company entered into a license agreement with The Scripps Research Institute of California (“TSRI”). TSRI granted the Company exclusive rights to certain technology relating to a murine monoclonal antibody and the use of the antibody as an inhibitor of angiogenesis. In exchange, the Company paid TSRI $100,000 and issued TSRI 20,000 shares of AME common stock. The Company also agreed to provide TSRI additional payments based on the completion of certain clinical and approval milestones. In addition, the Company has agreed to reimburse TSRI for a portion of its past and future patent costs related to the licensed technology and pay royalties to TSRI on net sales of each licensed product. The exclusive license will expire 10 years after the date of the first commercial sale of such licensed product.

During 1998, the Company entered into a license agreement with Biosite. The Company granted Biosite non-exclusive rights to certain AME patent technology in exchange for an up-front, nonrefundable royalty fee of approximately $1.5 million. The Company is recognizing the royalty fee as revenue over the estimated lives of the related patents. As of December 31, 2002, 2001 and 2000, approximately $394,000, $631,000 and $868,000, respectively, of the amount originally received are included in deferred revenue.

The Company and Novasite are currently performing research and preclinical development under three grants from the NIH. Other revenue includes approximately $1.9 million, $1.9 million and $748,000 related to these grants for the years ended December 31, 2002, 2001 and 2000, respectively.

In September 2001, the NIH awarded a grant to AME that provides $1.0 million over two years for the preclinical development of a therapeutic enzyme optimized by AME’s proprietary directed molecular evolution technology.

In March 2002, the NIH awarded a grant to Novasite that provides $2.4 million over two years for research to develop Novasite’s proprietary technology platform.

In September 2000, the NIH awarded a grant to Novasite that provides $3.2 million over three years for research to develop Novasite’s proprietary technology platform.

The Company maintains a 401(k) plan which allows substantially all employees to contribute up to 15% of their salary, subject to annual limitations and requirements set by the Company. The board of directors may, at its sole discretion, approve Company contributions. The Company contributed approximately $144,000, $73,000 and $0 under the plan for the years ended December 31, 2002, 2001 and 2000, respectively.

The following is a summary of the unaudited quarterly results of operations for the years ended December 31, 2002 and 2001 (in thousands, except per share data):

In January 2002, the Company’s subsidiary, Novasite, received $200,000 from a private placement of 10% convertible notes with AME and a minority investor of Novasite. These notes, which did not have a material beneficial conversion feature and did not 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 a minority investor of Novasite. 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 expensed as other financing charges as of September 30, 2002. John F. Richards, one of our directors, is the President of Crabtree Ventures, L.L.C., the general partner of Crabtree Ventures, L.P., which as a minority investor, provided the funding for the private placement.

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 expensed as other financing charges as of September 30, 2002, when the notes were converted.

In addition to the conversion of notes held by Crabtree Ventures, L.P. and AME and related accrued interest on September 30, 2002, which totaled $554,041, Novasite received cash from Crabtree Ventures, L.P. of $500,000 and issued 1,430,304 shares of preferred stock to AME and Crabtree Ventures, L.P.

In November 2002, Novasite received an additional $250,000 and issued 250,000 shares of preferred stock to Crabtree Ventures, L.P. In January 2003 Novasite received an additional $750,000 and issued 750,000 shares of preferred stock to Crabtree Ventures, L.P.


(Mark One)
þ		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

		For the fiscal year ended December 31, 2002

or

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


PART I
	Item 1. Business
RISK FACTORS
MANAGEMENT
	Item 2. Properties
	Item 3. Legal Proceedings
	Item 4. Submission of Matters to a Vote of Security Holders
PART II
	Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters
	Item 6. Selected Financial Data
	Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 7A. Quantitative and Qualitative Disclosures About Market Risk
	Item 8. Financial Statements and Supplementary Data
	Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
PART III
	Item 10. Directors and Executive Officers of the Registrant
	Item 11. Executive Compensation
	Item 12. Security Ownership of Certain Beneficial Owners and Management
	Item 13. Certain Relationships and Related Transactions
	Item 14. Controls and Procedures
PART IV
	Item 15. Exhibits, Financial Statement Schedules, and Report on Form 8-K
SIGNATURES
CERTIFICATIONS
EXHIBIT 10.31
EXHIBIT 10.33
EXHIBIT 10.33
EXHIBIT 10.34
EXHIBIT 21.1
EXHIBIT 23.1


	High		Low

Year Ended December 31, 2001
First Quarter	$	18.23	$	5.75
Second Quarter	$	14.06	$	6.18
Third Quarter	$	13.80	$	7.00
Fourth Quarter	$	12.80	$	7.00


	High		Low

Year Ended December 31, 2002
First Quarter	$	13.20	$	7.71
Second Quarter	$	8.30	$	5.00
Third Quarter	$	5.55	$	3.83
Fourth Quarter	$	3.50	$	1.91



			Years Ended December 31,

			2002(1)(2)			2001(1)(2)			2000(1)			1999(1)			1998


			(In thousands, except per share data)
Consolidated Statement of Operations Data:
Revenue			$	7,927		$	3,613		$	2,693		$	2,592		$	2,590
Operating expenses:
	Research and development			15,133			10,933			4,462			4,408			2,583
	General and administrative			9,714			4,361			2,834			1,363			1,975
	Stock-based compensation ($1,029, $2,120, $3,882 and $78 related to research and development and $2,158, $4,687, $8,343 and $377 related to general and administrative for 2002, 2001, 2000 and 1999, respectively)			3,187			6,807			12,225			455			—

		Total operating expenses		28,034			22,101			19,521			6,226			4,558

Loss from operations				(20,107	)		(18,488	)		(16,828	)		(3,634	)		(1,968	)
Minority interest				505			372			127			45			—
Interest income, net				2,763			4,886			3,142			213			101
Other financing charges				(604	)		—			—			—			—

Net loss				(17,443	)		(13,230	)		(13,559	)		(3,376	)		(1,867	)
Deemed dividend on Series F preferred stock				—			—			(10,100	)		—			—

Net loss applicable to common stockholders			$	(17,443	)	$	(13,230	)	$	(23,659	)	$	(3,376	)	$	(1,867	)

Basic and diluted net loss per common share			$	(0.82	)	$	(0.62	)	$	(2.17	)	$	(1.39	)	$	(1.13	)

Weighted average shares outstanding				21,332			21,394			10,910			2,429			1,659

Consolidated Balance Sheet Data:
Cash, cash equivalents and short-term investments			$	51,119		$	80,196		$	89,550		$	3,498		$	824
Working capital				48,704			79,742			90,565			3,225			313
Total assets				79,971			90,682			94,874			5,938			2,752
Long-term obligations				10,000			—			—			17			—
Minority interest				—			—			372			225			—
Stockholders’ equity				65,942			85,936			91,917			3,830			725


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


	*Enabling the Commercialization of a Discovery Technology*


	*Series B Preferred Stock Financing, Affiliates and Select Option Information*


Name	Age		Position

William D. Huse, M.D., Ph.D.		48	Chief Executive Officer, President and Chairman of the Board
Lawrence E. Bloch, M.D., J.D.		37	Chief Financial Officer and Secretary
James B. Breitmeyer, M.D., Ph.D.		49	Chief Medical Officer
Keith S. Manchester, M.D.		34	Vice President of Business Development
William L. Respess, J.D., Ph.D.		63	Vice President, General Counsel and Director
Jeffry D. Watkins, Ph.D.		41	Chief Scientific Officer


Item 7.	*Management’s Discussion and Analysis of Financial Condition and Results of Operations*


	*Year Ended December 31, 2002, Compared to Year Ended December 31, 2001*


	*Year Ended December 31, 2001, Compared to Year Ended December 31, 2000*


Item 8.	*Financial Statements and Supplementary Data*


Item 9.	*Changes in and Disagreements With Accountants on Accounting and Financial Disclosure*


Item 10.	*Directors and Executive Officers of the Registrant*


	*Decreased Manufacturing Costs*


	*Increased Safety*


	*Enhanced Convenience*


	*MedImmune*


Item 12.	*Security Ownership of Certain Beneficial Owners and Management*


Item 13.	*Certain Relationships and Related Transactions*


Exhibit
Number		Description of Document

	3(i)(1)	Restated Certificate of Incorporation, as filed with the Delaware Secretary of State on August 1, 2000.
	3(ii)(2)	Amended and Restated Bylaws of the Company.
	3(iii)(3)	Certificate of Designations specifying the terms of the Series A Participating Preferred Stock of Registrant, as filed with the Secretary of State of the State of Delaware on May 11, 2001.
	4.1(4)	Form of Common Stock Certificate.
	4.2(4)	Stock Purchase Agreement with MedImmune, Inc. dated as of February 24, 1999.
	4.3(4)	Stock Purchase Agreement with each of Hilal Capital Management LLC and Keith Manchester dated as of May 3, 2000.
	4.4(5)	Stock Purchase Agreement with Attenuon, L.L.C. dated as of November 30, 2000.
	4.5(6)	Rights Agreement dated as of May 10, 2001 between Applied Molecular Evolution, Inc. and EquiServe Trust Company, N.A., as Rights Agent.
	4.6(7)	Stock Purchase Agreement dated as of August 18, 2002, between Applied Molecular Evolution, Inc. and the Selling Stockholders listed on Annex A hereto.
	4.7(8)	Amendment No. 1 to Rights Agreement dated as of November 4, 2002 between Applied Molecular Evolution, Inc. and EquiServe Trust Company, N.A., as Rights Agent.
	10.1.1(4)	1992 Stock Plan.
	10.1.2(4)	Form of Stock Option Agreement under the 1992 Stock Plan.
	10.2.1(4)	2000 Stock Plan.
	10.2.2(4)	Form of Stock Option Agreement under the 2000 Stock Plan.
	10.3(4)	License Agreement with Stuart A. Kauffman, M.D. dated as of November 3, 1994.
	10.4†(4)	License Agreement with MedImmune, Inc. dated as of February 24, 1999.
	10.5†(4)	Research and Assignment and License Agreement with MedImmune, Inc. dated as of February 24, 1999.



Name	Title	Date


/s/ WILLIAM D. HUSE William D. Huse, M.D., Ph.D.	President, Chief Executive Officer and Chairman of the Board (Principal Executive Officer)	March 4, 2003

/s/ LAWRENCE E. BLOCH Lawrence E. Bloch, M.D., J.D.	Chief Financial Officer (Principal Financial and Accounting Officer)	March 4, 2003

/s/ RAYMOND V. DITTAMORE Raymond V. Dittamore	Director	March 4, 2003

/s/ N. COLEMAN OWEN N. Coleman Owen	Director	March 4, 2003


	Page

Report of Ernst & Young LLP, Independent Auditors		F-2
Consolidated Balance Sheets as of December 31, 2002 and 2001.		F-3
Consolidated Statements of Operations for the years ended December 31, 2002, 2001 and 2000.		F-4
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2002, 2001 and 2000		F-5
Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2001 and 2000.		F-6
Notes to Consolidated Financial Statements		F-7



			December 31,

			2002			2001


			(In thousands, except
			share and per share data)
ASSETS
Current assets:
	Cash and cash equivalents		$	6,336		$	25,927
	Short-term investments			44,783			54,269
	Prepaid expenses			448			429
	Other current assets			922			3,385

Total current assets				52,489			84,010
Restricted cash				10,500			—
Property and equipment, net				14,490			3,223
Patents, net				1,985			1,865
Other assets				507			1,584

Total assets			$	79,971		$	90,682


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payables		$	958		$	1,128
	Accrued liabilities			1,613			1,173
	Current portion of deferred revenue			1,214			1,967

Total current liabilities				3,785			4,268
Deferred revenue				158			394
Deferred rent				86			84
Long-term obligation				10,000			—
Minority interest				—			—
Commitments (Note 5)
Stockholders’ equity:
	Preferred stock, $0.001 par value:
		Authorized shares — 5,000,000, none issued and outstanding		—			—
	Common stock, $0.001 par value:
		Authorized shares — 45,000,000 at December 31, 2002;
		Issued shares — 23,661,477 and 23,607,058 at December 31, 2002 and 2001, respectively		24			24
	Additional paid-in capital			160,588			159,126
	Deferred compensation			(1,213	)		(4,373	)
	Notes receivable from employees			(941	)		(880	)
	Accumulated other comprehensive income			761			587
	Accumulated deficit			(71,591	)		(54,148	)
	Less: Treasury stock at cost — 3,073,111 shares and 1,200,000 shares at December 31, 2002 and 2001, respectively			(21,686	)		(14,400	)

Total stockholders’ equity				65,942			85,936

Total liabilities and stockholders’ equity			$	79,971		$	90,682


																					Accumulated
																		Notes			Other						Treasury Stock
	Preferred Stock						Common Stock					Additional						Receivable			Comprehensive						at Cost						Total
												Paid-in			Deferred			from			Income			Accumulated									Stockholders’
	Shares			Amount			Shares			Amount		Capital			Compensation			Employees			(Loss)			Deficit			Shares			Amount			Equity


	(In thousands, except share data)
Balance at December 31, 1999		11,640,124		$	12			2,569,846		$	3	$	31,831		$	(649	)	$	—		$	(8	)	$	(27,359	)		—		$	—		$	3,830
Exercise of stock options for cash and notes receivable		—			—			1,735,335			2		1,228			—			(799	)		—			—			—			—			431
Deferred compensation		—			—			—			—		21,220			(21,220	)		—			—			—			—			—			—
Amortization of deferred compensation		—			—			—			—		—			10,948			—			—			—			—			—			10,948
Issuance of stock options to consultants		—			—			—			—		4			(4	)		—			—			—			—			—			—
Compensation related to consultant stock options		—			—			—			—		1,270			7			—			—			—			—			—			1,277
Interest on notes receivable		—			—			—			—		—			—			(28	)		—			—			—			—			(28	)
Issuance of Series F preferred stock, net of issuance costs		2,244,444			2			—			—		10,006			—			—			—			—			—			—			10,008
Issuance of common stock at IPO, net of issuance costs		—			—			5,347,500			5		92,909			—			—			—			—			—			—			92,914
Issuance of common stock for conversion of preferred stock upon IPO		(13,884,568	)		(14	)		13,884,568			14		—			—			—			—			—			—			—			—
Issuance of common stock for exercise of warrants		—			—			55,015			—		—			—			—			—			—			—			—			—
Minority investor’s investment in Novasite		—			—			—			—		308			—			—			—			—			—			—			308
Purchase of treasury stock		—			—			—			—		—			—			—			—			—			(1,200,000	)		(14,400	)		(14,400	)
Unrealized gain on short-term investments		—			—			—			—		—			—			—			188			—			—			—			188
Net loss		—			—			—			—		—			—			—			—			(13,559	)		—			—			(13,559	)

Comprehensive loss		—			—			—			—		—			—			—			—			—			—			—			(13,371	)

Balance at December 31, 2000		—			—			23,592,264			24		158,776			(10,918	)		(827	)		180			(40,918	)		(1,200,000	)		(14,400	)		91,917
Exercise of stock options for cash		—			—			9,947			—		14			—			—			—			—			—			—			14
Issuance of common stock under employee stock purchase plan		—			—			7,036			—		75			—			—			—			—			—			—			75
Repurchase of restricted stock		—			—			(2,189	)		—		(1	)		—			—			—			—			—			—			(1	)
Amortization of deferred compensation		—			—			—			—		—			6,481			—			—			—			—			—			6,481
Elimination of deferred compensation related to stock options forfeited		—			—			—			—		(64	)		64			—			—			—			—			—			—
Compensation related to consultant stock options		—			—			—			—		326			—			—			—			—			—			—			326
Interest on notes receivable		—			—			—			—		—			—			(53	)		—			—			—			—			(53	)
Unrealized gain on short-term investments		—			—			—			—		—			—			—			407			—			—			—			407
Net loss		—			—			—			—		—			—			—			—			(13,230	)		—			—			(13,230	)

Comprehensive loss		—			—			—			—		—			—			—			—			—			—			—			(12,823	)

Balance at December 31, 2001		—			—			23,607,058			24		159,126			(4,373	)		(880	)		587			(54,148	)		(1,200,000	)		(14,400	)		85,936
Exercise of stock options for cash		—			—			23,706			—		15			—			—			—			—			—			—			15
Issuance of common stock under employee stock purchase plan		—			—			30,713			—		202			—			—			—			—			—			—			202
Amortization of deferred compensation		—			—			—			—		—			3,151			—			—			—			—			—			3,151
Elimination of deferred compensation related to stock options forfeited		—			—			—			—		(9	)		9			—			—			—			—			—			—
Compensation related to consultant stock options		—			—			—			—		36			—			—			—			—			—			—			36
Interest on notes receivable		—			—			—			—		—			—			(61	)		—			—			—			—			(61	)
Minority investor’s investment in Novasite		—			—			—			—		1,218			—			—			—			—			—			—			1,218
Purchase of treasury stock		—			—			—			—		—			—			—			—			—			(1,873,111	)		(7,286	)		(7,286	)
Unrealized gain on short-term investments		—			—			—			—		—			—			—			174			—			—			—			174
Net loss		—			—			—			—		—			—			—			—			(17,443	)		—			—			(17,443	)

Comprehensive loss		—			—			—			—		—			—			—			—			—			—			—			(17,269	)

Balance at December 31, 2002		—		$	—			23,661,477		$	24	$	160,588		$	(1,213	)	$	(941	)	$	761		$	(71,591	)		(3,073,111	)	$	(21,686	)	$	65,942


	Amortized		Market		Unrealized
	Cost		Value		Gain (Loss)

Obligations of U.S. government agencies	$	13,887	$	14,222	$	335
Corporate debt securities		22,917		23,292		375
Asset-backed securities		7,218		7,269		51

	$	44,022	$	44,783	$	761


Due in one year or less	$	15,051
Due after one year through two years		20,378
Due after two years		9,354

	$	44,783


					Weighted
		Number of			Average
		Shares			Exercise Price

Balance at December 31, 1999			1,302		$	0.41
	Granted		1,772		$	1.69
	Exercised		(1,735	)	$	0.71
	Canceled		(103	)	$	0.45

Balance at December 31, 2000			1,236		$	1.82
	Granted		1,315		$	9.71
	Exercised		(10	)	$	1.45
	Canceled		(60	)	$	11.77

Balance at December 31, 2001			2,481		$	5.76
	Granted		1,056		$	7.52
	Exercised		(24	)	$	0.64
	Canceled		(103	)	$	11.91

Balance at December 31, 2002			3,410		$	6.16


Stock options:
	Issued and outstanding	3,410
	Authorized for future grants	399
Stock purchase plan		712

		4,521


2003	$	606
2004		837
2005		475
2006		485
2007		505

Total minimum lease payments	$	2,908