AVANIR PHARMACEUTICALS - 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 and Exchange Act of 1934 during the preceding 12 months (or for such shorter periods that 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 statement incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ

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

As of December 11, 2003, the issuer had outstanding 70,753,482 shares of Class A and Class B common stock held by non-affiliates and the aggregate market value of these shares on that date was $116,036,000. For purposes of the foregoing disclosure and without admitting whether any person is an affiliate of the registrant, all shares owned directly or indirectly by officers and directors of the registrant have been treated as owned by an affiliate.

The number of shares of Common Stock of the registrant issued and outstanding as of December 11, 2003:

The registrant’s definitive Proxy Statement, which will be filed with the Securities and Exchange Commission on or before January 28, 2004 in connection with the registrant’s Annual Meeting of Shareholders to be held on March 18, 2004, is incorporated by reference into Part III of this report.

This Annual Report on Form 10-K contains forward-looking statements concerning future events and performance of our company. You should not rely excessively on these forward-looking statements, because they are only predictions based on our current expectations and assumptions. Forward-looking statements often contain words like “estimate,” “anticipate,” “believe,” “plan” or “expect.” Many known and unknown risks and uncertainties may cause our actual results to differ materially from those indicated in these forward-looking statements. You should review carefully the risks and uncertainties identified in this report. We disclaim any obligation to update or announce revisions to any forward-looking statements to reflect actual events or developments. Except as otherwise indicated herein, all dates referred to in this Report represent periods or dates fixed with reference to the calendar year, rather than our fiscal year ending September 30.

AVANIR Pharmaceuticals, based in San Diego and incorporated in California in 1988, is a drug discovery and development company focused on treatments for central nervous system disorders and inflammatory diseases. The Company’s lead product candidate, Neurodex^TM, is in a Phase III clinical trial for pseudobulbar affect, also known as emotional lability, and in Phase II clinical development for neuropathic pain. An internally discovered small molecule, AVP-13358, is being developed as a potential treatment of asthma and is in Phase I clinical development. AVANIR has established itself as a company that is capable of developing a drug through all preclinical and clinical phases of development and experienced in preparing and submitting new drug applications. The Company’s first commercialized product, Abreva®, has been approved by the U.S. Food and Drug Administration (FDA) and is marketed in North America by GlaxoSmithKline Consumer Healthcare (GlaxoSmithKline). Abreva is the leading over-the-counter (OTC) product for the treatment of cold sores.

AVANIR’s preclinical research and drug discovery programs are focused primarily on small molecules that can be taken orally as therapeutic treatments. Using its proprietary Xenerex^TM technology, AVANIR is also conducting research to develop injectable human monoclonal antibody products for infectious diseases, such as anthrax and cytomegalovirus, and for other therapeutic applications.

Partnering, licensing and research collaborations have been, and will continue to be, an important part of AVANIR’s business development strategy. We intend to partner with pharmaceutical companies that can help fund AVANIR’s research in exchange for sharing in the rights to commercialize new drugs resulting from this research. We have licensed and continue to seek licensees for docosanol 10% cream and other potential products in our pipeline. Research collaborations also represent an important way to achieve our development goals, by sharing in the risks and the opportunities that come from such development efforts.

AVANIR’s offices and research facilities are located at 11388 Sorrento Valley Road, San Diego, California 92121. Our telephone number is (858) 622-5200 and our e-mail address is info@AVANIR.com. Additional information about AVANIR can be found on our website, at www.AVANIR.com, and in our periodic and current reports filed with the Securities and Exchange Commission (“SEC”). Copies of our current and periodic reports filed with the SEC are available at the SEC Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549, and online at www.sec.gov and our website at www. AVANIR.com.

AVANIR has continued to commercialize docosanol 10% cream (known as Abreva in the U.S. and Canada) by pursuing regulatory approvals and license arrangements in several foreign countries. In November 2003, the Swedish Medical Products Agency approved docosanol 10% cream for marketing as a non-prescription, OTC topical treatment for cold sores. Sweden will act as the Reference Member State during the mutual recognition process for obtaining further regulatory approvals of docosanol 10% cream in the European Union. AVANIR has foreign license agreements for docosanol 10% cream in the Republic of Korea, Israel, Italy and Egypt, and is seeking additional licensees for the rest of Europe and Japan. AVANIR has assisted its

partners in obtaining OTC marketing approvals with regulatory agencies in Korea, Israel and Canada. For the last three years, substantially all of AVANIR’s revenues have come from milestone payments and royalties on product sales in the U.S. by GlaxoSmithKline and from sale of an undivided interest in the GlaxoSmithKline license agreement to Drug Royalty USA.

GlaxoSmithKline and Drug Royalty USA. GlaxoSmithKline launched Abreva in the U.S. in October 2000. Under the license agreement with GlaxoSmithKline subsidiary, SB Pharmco Puerto Rico, Inc., AVANIR has received milestone payments and royalties totaling $31 million. Abreva sales are somewhat seasonal, as the incidences of cold sores increase during the winter months. We expect that GlaxoSmithKline will launch Abreva in Canada in 2004, however, the timing of such launch is outside our control.

During fiscal 2003, AVANIR sold an undivided interest in the GlaxoSmithKline license agreement to Drug Royalty USA for $24.1 million. AVANIR retained the right to receive 50% of all royalties under the GlaxoSmithKline license agreement for annual sales of Abreva in excess of $62 million. AVANIR also retained its rights to develop and license docosanol 10% cream outside North America for the treatment of cold sores and to develop and license docosanol 10% cream in all jurisdictions for all other indications other than cold sore treatment.

Boryung Pharmaceuticals Company, Ltd. (“Boryung”). Boryung launched docosanol 10% cream as an OTC product under the trade name Herepair in the Republic of Korea in June 2002. The Boryung license agreement, initially signed in July 1994, gives Boryung the exclusive rights to manufacture, market and sell docosanol 10% cream in Korea. The agreement requires that Boryung purchase its supply of docosanol from AVANIR and pay us a royalty on product sales.

CTS Chemical Industries, Ltd. (“CTS”). CTS launched docosanol 10% cream as an OTC product under the trade name Abrax in Israel in January 2003. The CTS license agreement, initially signed in July 1993, gives CTS the exclusive rights to manufacture, market and sell docosanol 10% cream in Israel. The agreement requires that CTS purchase its supply of docosanol from AVANIR and pay us a royalty on product sales.

Bruno Farmaceutici (“Bruno”). The Bruno license agreement, signed in July 2002, gives Bruno the exclusive rights to manufacture, market and sell docosanol 10% cream in Italy. The Bruno license agreement requires that Bruno purchase its entire supply of docosanol from AVANIR and pay us a royalty on product sales. Marketing and sales of docosanol 10% cream is anticipated to begin in 2004, subject to Italian regulatory agency approval, which will be sought using the mutual recognition process.

Biopharm Group (“Biopharm”). The Biopharm license agreement, signed in January 2002 gives Biopharm the exclusive rights to manufacture, market and sell docosanol 10% cream in Egypt and select countries in the Middle East. Biopharm is currently going through the regulatory approval process in Egypt. The agreement requires that Biopharm purchase its supply of docosanol from AVANIR and pay us a royalty on product sales.

Commercial development strategy in other countries. We are pursuing licensing opportunities for docosanol 10% cream in other countries in Europe and in Japan. Further, in Japan, we intend to have the licensee seek approval as an OTC product, similar to the regulatory status of the product in the United States, Canada, Korea, Israel and Sweden. However, we can provide no assurance that any of our licensees will be able to obtain regulatory approval, either as an OTC product or as a prescription product, in Japan or in other countries that do not participate in the mutual recognition process.

Additional potential uses of docosanol 10% cream. During fiscal 2003, AVANIR continued to conduct preclinical research on potential topical formulations of docosanol in the treatment of genital herpes and other research related to the market for topical treatments. Our genital herpes research during the past two years has been funded by a $1.0 million SBIR Phase II grant from the National Institutes of Health and an aggregate of $150,000 in grants from the San Diego Regional Technology Alliance.

Neurodex is a patented orally administered formulation of dextromethorphan (DM) and quinidine (Q), which helps to sustain elevated levels of dextromethorphan in the human body. We believe this patented formulation can provide therapeutic benefits if DM is present at higher levels in the bloodstream. AVANIR has the rights to develop Neurodex for the treatment of pseudobulbar affect (“PBA” or emotional lability), neuropathic pain, weaning from narcotics and anti-depressants, and chronic cough. We are currently developing Neurodex for the treatment of PBA and neuropathic pain.

Neurodex for the treatment of pseudobulbar affect. PBA affects a diverse population of patients with neurologic disorders, including those with Alzheimer’s disease, multiple sclerosis (MS), Lou Gehrig’s disease (amyotrophic lateral sclerosis or ALS) and Parkinson’s disease, and those with neuronal damage following stroke and traumatic brain injury. PBA is typically characterized by periodic episodes of laughing or crying out of proportion or context to, or incongruent to, the basic social setting. We expect the market for PBA to reach $450 million by 2005 and could reach $700 million by the year 2010. Currently, no drug is approved for the treatment of PBA. Further, we are not aware of any other drugs in development that specifically address the condition of PBA.

In fiscal 2003, AVANIR initiated the second of two required Phase III clinical trials of Neurodex to examine the safety and efficacy of the drug in the treatment of PBA. The second Phase III clinical trial is being conducted at 23 sites in patients with MS, whereas the first Phase III clinical trial was in patients with ALS. The study parameters for the Phase III clinical trial in MS patients include a goal of the same number of study patients and use of the same CNS-LS scale (described below) that was used in the Phase III clinical trial in ALS patients. Since January 2003, AVANIR has also been engaged in an open-label study of PBA at 33 sites in a diverse population of patients with various neurologic disorders. We expect to complete the Phase III clinical trial of Neurodex for the treatment of PBA in MS patients and submit a new drug application (NDA) to the FDA for that indication in the second half of the 2004 calendar year.

In fiscal 2002, we completed a Phase III clinical trial of Neurodex in the treatment of PBA in patients suffering from ALS. A total of 140 patients with ALS who also suffer from PBA were enrolled at 17 academic study sites throughout the U.S. in the double blind, controlled Phase III study. The patients received capsules containing either Neurodex, or DM alone, or Q alone, twice daily for four weeks. The Neurodex arm showed statistically and clinically greater improvements than the DM-only arm (p=0.001) and the Q-only arm (p=0.0002) in the primary efficacy end point: change in the CNS-Lability Scale (CNS-LS). CNS-LS is a validated scale that measures the severity and frequency of a subject’s episodes of pathological laughing and/or crying. In the intent-to-treat population, the adjusted mean improvement in CNS-LS for patients treated with Neurodex was approximately twice the improvement in patients treated with either DM only or Q only.

Neurodex’s side effects reported in the Phase III clinical trial of Neurodex in ALS patients in fiscal 2002 were as anticipated, based on the pharmacology of DM. Four serious adverse events (including one death attributed to the progression of ALS) were reported during the Phase III clinical trial. All four events were considered to be unrelated to the test articles by the investigator who reported them. Early withdrawal due to adverse events occurred in 24% of Neurodex patients, 6% of DM-only patients, and 8% of Q-only patients. Adverse events reported for Neurodex included nausea, dizziness, somnolence, and diarrhea. All of these types of adverse events resolved when therapy was discontinued.

Neurodex for the treatment of neuropathic pain. In June 2003, we completed a four-week open label dose escalation study of Neurodex in patients with painful diabetic neuropathy. Results from the study indicated that Neurodex was well tolerated up to the highest target dose in the non-placebo controlled study. Patients in the study reported decreased pain intensity that was significantly different from baseline (p<0.0001). Additionally, 91% and 97% of the patients reported pain relief by Day 8 and Day 15, respectively, compared to baseline. The pain relief reported by the patients during the study improved with the duration of the study.

The clinical trial was conducted at five U.S. sites in 36 adult volunteers with diabetic neuropathy who experienced pain on a daily basis in the lower extremities for at least the previous three months. The study was designed to evaluate the safety and tolerability of escalating doses of Neurodex for future clinical trials. Various pain assessments were included as a preliminary evaluation of pain relief. Three patients did not complete the study, two due to adverse events (one serious and not related, one serious and possibly related) and one due to inability to comply with the protocol. Commonly reported adverse events (reported by three or more individuals) included nausea, constipation, diarrhea, dry mouth, fatigue, dizziness, insomnia, headache, upper respiratory tract infection and somnolence. Most adverse events were either mild or moderate in intensity, and 92% of the participants completed the study. There was minimal need for rescue pain medication; rescue medications were taken on a mean of 1.3 days during the four-week study.

At least half of the 15.7 million Americans who have diabetes are estimated to suffer from nerve damage caused by the disease, according to the American Diabetes Association. The damaged nerves can alter the sensitivity of pain centers in the spinal cord and consequently intensify pain transmission within the central nervous system. Diabetic neuropathic pain currently is most commonly treated with tricyclic antidepressants, anticonvulsants, opioid analgesics and local anesthetics. Most of these treatments have limited effectiveness or undesirable side effects. There is no drug approved in the U.S. specifically for diabetic neuropathic pain. AVANIR intends to develop Neurodex as a viable competitor in the $1 billion plus neuropathic pain market.

Commercialization strategy. We are currently evaluating alternatives for commercialization of Neurodex for PBA and neuropathic pain. Such alternatives include, among others, developing our own sales force for certain market segments, and co-promotion or licensing arrangements, possibly with a partner that could contribute to the development costs of the program. There can be no assurances as to the timing of a license or co-promotion arrangement, if any.

We are currently engaged in a Phase I clinical trial program for AVP-13358. In December 2002, following an evaluation of results of toxicology studies conducted on AVP-13358, AVANIR submitted an Investigational New Drug (IND) application to the FDA to begin Phase I testing of the drug. In October 2003, we announced that AVP-13358 was well tolerated at single rising doses up to five milligrams in a randomized, placebo-controlled Phase I clinical trial. Presence of the drug in the bloodstream, or exposure, was demonstrated at all four oral dose levels tested between one and five milligrams. Preclinical studies of AVP-13358 in animal models demonstrated the compound is capable of suppressing the synthesis of immunoglobulin epsilon (IgE) as well as other critical mediators of the allergic response. Also, in-vitro studies have demonstrated that AVP-13358 is capable of down-regulating IgE and suppressing the antigen-stimulated IL-4 and IL-5 receptor (IL-4Ra) on leukocytes. No inhibitory effects on antigen-specific IgG responses were observed. AVP-13358 is orally active and appears to be selective for the suppression of antigen specific IgE and Th2 cytokine-mediated diseases.

Both allergies and asthma are respiratory diseases caused by agents called allergens. Allergens trigger the initial phase of an asthma or allergy attack, and symptoms such as sneezing, coughing, stuffy nose, itching, chest tightness, wheezing, tingling and shortness of breath soon develop. In allergy-prone people, the presence of invading allergens triggers the immune system to produce an extra amount of the antibody known as IgE. IgE binds to mast cells, found in the mucosal lining of our airways. IgE and the allergen bind together or cross link on the surface of the mast cell, causing the mast cell to degranulate and release histamine and other chemical mediators that cause the symptoms of allergy and asthma. We believe that if IgE overproduction can be addressed, then the allergic response, which can range from mild sneezing to a serious asthmatic attack, may be reduced or prevented.

We estimate the worldwide market for sales of products that treat allergy and asthma is over $10 billion a year. The FDA’s recent approval of Xolair^TM, an injectible antibody that neutralizes the target IgE, helps validate IgE as a target in the treatment of patients with asthma. Presently, no small-molecule drugs (ones that can be taken orally) have been approved by the FDA for the down-regulation of IgE, either via neutralization or suppression of its synthesis or release. We believe our new small molecule agent,

AVP-13358, is an attractive candidate for developing as a treatment for allergy and asthma. There can be no assurances that AVP-13358 will successfully complete all of the rising doses planned for testing the safety and bioavailability in the Phase I clinical trials, nor that it will successfully complete all of the other clinical trials required to successfully obtain the FDA’s approval of the drug.

MIF inhibitor technology. AVANIR has continued to conduct research on drug candidates that appear capable of regulating the target, MIF (macrophage migration inhibitory factor), a protein believed to be a significant causal factor in several inflammatory diseases. Modulation of MIF activity may offer a novel therapeutic intervention in rheumatoid arthritis, sepsis, ulcerative colitis, Crohn’s disease, inflammatory neurological diseases, glomerulonephritis and asthma. MIF is known to regulate the synthesis and/or release of TNFa — validated target for inflammatory diseases. We believe these diseases still have unmet therapeutic needs. Sales of current drugs for these diseases exceed several billion dollars in the United States alone. Examples of successful commercialization of injectable drugs that target pro-inflammatory proteins are Enbrel® by Immunex Corporation and Remicade® by Johnson & Johnson, both of which target TNFa by binding to TNFa or the TNFa receptor, respectively. AVANIR’s research is focused on developing an oral small molecule that targets MIF. Our research program is at an early stage of development and will take several years of development effort to determine whether or not it will be successful.

Cholesterol reduction (CCM^TM Technology). We are engaged in research focused on certain types of small molecules for the treatment and prevention of hyper-cholesterolemia (high cholesterol). Cholesterol is transported in the blood in large cholesterol-rich particles called lipoproteins. Generally, low-density lipoproteins (LDL) deliver the cholesterol to peripheral tissues including aorta and coronary arteries, whereas high-density lipoproteins (HDL) remove excess cholesterol from peripheral tissues, and transport it to the liver for elimination. We are evaluating compounds that may be capable of accelerating the removal of excess cholesterol from peripheral tissues and transporting it to the liver for elimination. Because our research is at the preclinical stage of development, we are unable to predict the cost and timing for development of a drug.

Cancer research. AVANIR has developed an experimental compound, AVP-893, that has showed selective growth inhibition against a variety of cancer cell lines in preclinical testing and early compound screening performed by the National Cancer Institute (NCI). Early compound screening by NCI indicated AVP-893 and other AVANIR compounds appear to be unlike any existing drugs that have been screened by NCI for anti-cancer activity, either in terms of structure, tumor activity profile, or apparent mechanism of action. We expect that NCI will continue testing the compounds in their assays. If the compounds show favorable outcomes through additional testing, AVANIR will seek to out-license the compounds.

AVANIR’S Xenerex^TM technology is a patented technology in the early stages of development that is used to develop human monoclonal antibodies for the treatment of infectious diseases and other therapeutic applications. Our technology enables the generation of fully human antibodies from human lymphoid cells engrafted into severe combined immunodeficient (SCID) mice. We stimulate engrafted human cells in the mice with the antigenic target to which the cells respond by producing antibodies specific to the target. We identify the human cells that are producing antibodies of interest and then rescue the antibody DNA by standard recombinant technology. The Xenerex technology mimics the in vivo human antibody response as it generates multiple antibodies with various combinations of affinity and specificity characteristics to an antigenic target.

We have used the Xenerex technology in three R&D collaborations with other biotechnology companies that have their own proprietary antigen targets. The research collaborations provided the opportunity to earn research fees during the antibody generation effort and milestone payments if we were able to provide an antibody product candidate that is attractive for development by the research partner. In 2003 we changed our R&D strategy to put more emphasis on internal development programs, particularly those related to infectious diseases, an area we believe represents a better fit for our technology.

During 2003, we were awarded a total of $350,000 in government grants related to our research using our Xenerex technology. The Center for the Commercialization of Advanced Technology (CCAT) provided us with $150,000 in grants to develop an antibody to the anthrax toxin and a blood donor program. CCAT is a public/ private partnership between the U.S. Department of Defense and the San Diego State University Foundation to provide seed monies for promising technologies in the area of bio-defense. We also received government grants of $100,000 to develop antibodies to cytomegalovirus (CMV) and $100,000 to continue development of our antibody to the anthrax toxin. There can be no assurance that we will be successful in any of our development efforts using the Xenerex technology.

We purchase the drug substance, docosanol, from a large supplier in Western Europe. This manufacturing source was inspected by the FDA in 1998 and found to be operating under current good manufacturing practices (cGMP). Both AVANIR and GlaxoSmithKline have relied on this supplier for purchases of the raw material. We believe GlaxoSmithKline maintains reserves of the raw material as a precautionary measure in the event of a delay or problem in the manufacture of docosanol. We also maintain a certain quantity of the active ingredient for sale to our licensees. We currently store our raw material in the United States. Any material disruption in manufacturing could cause a delay in shipments and possible loss of sales, which would be outside our control.

The pharmaceutical industry is characterized by rapidly evolving technology and intense competition. Many companies of all sizes, including major pharmaceutical companies and specialized biotechnology companies, engage in activities similar to our activities. Many of our competitors have substantially greater financial and other resources and larger research and development and clinical and regulatory affairs staffs. In addition, colleges, universities, governmental agencies and other public and private research organizations continue to conduct research and are becoming more active in seeking patent protection and licensing arrangements to collect royalties for use of technologies that they have developed. Some of our competitors’ products and technologies are in direct competition with ours. We also must compete with these institutions in recruiting highly qualified scientific personnel.

Docosanol 10% cream. As the international product launch for docosanol 10% cream (Abreva® in the United States and Canada) progresses, the drug will face intense worldwide competition from the following products:


	•	OTC monograph preparations, including Carmex®, Zilactin®, Campho®, Orajel®, Herpecin® and others;

	•	Zovirax® acyclovir (oral and topical) and Valtrex® valacyclovir (oral) prescription products marketed by Biovail Corporation and GlaxoSmithKline, respectively, and

	•	Famvir® famciclovir (oral) and Denavir® penciclovir (topical) prescription products marketed by Novartis.

Neurodex. If approved by the FDA for the treatment of neuropathic pain, Neurodex will compete with other drug products that are currently prescribed by physicians, including narcotic products, non-narcotic products, and off-label uses of other drugs, such as anticonvulsants.

IgE down-regulation program. Our IgE down-regulation program competes with several research approaches and numerous compounds under development by large pharmaceutical and biotechnology companies. One such example is the anti-IgE therapy using rhuMAB-E25 (Xolair®), a recombinant humanized monoclonal antibody developed in a collaboration between Genentech, Tanox and Novartis. The injectable antibody Xolair was approved for marketing by the FDA in 2003. Other competitive and successful products already established in the marketplace include non-sedative antihistamine products, such as Shering-Plough’s Claritin® loratadine ($3 billion in annual sales) and Aventis’ Allegra®/ Telfast® ($1 billion in annual sales).

Antibody generation technology. Several companies, including Abgenix, Medarex, Inc., and Cambridge Antibody Technology, have human antibody generation technologies and have been in business longer and have substantially greater financial resources and personnel than we have.

Patents. AVANIR presently owns or has the rights to 82 issued patents (25 U.S. and 57 foreign) and 213 applications pending (21 U.S. and 192 foreign). Patents and patent applications owned by the Company are for docosanol-related products and technologies, Xenerex technologies for developing monoclonal antibodies, Neurodex, compounds capable of down-regulating the target IgE in controlling symptoms of allergy and asthma, compounds capable of down-regulating the target MIF in the treatment of several inflammatory diseases, and compounds for lowering cholesterol.

Docosanol-related technologies. These patents and patent applications pending cover both medical and veterinary uses of topical and systemic formulations of docosanol 10% cream in the U.S. and in foreign countries. We also have been granted rights under selected U.S. and foreign patents and patent applications related to docosanol 10% cream held by a third party.

Xenerex proprietary antibody generation technologies. We own the rights to several issued patents related to our Xenerex antibody generation technology.

IgE down-regulation technology. Our patents and patent applications are for the use of various small molecules and related general structures currently under development or being used in clinical and preclinical research for the regulation of IgE in the treatment of various inflammatory diseases.

Neurodex. We have in-licensed the rights to develop, manufacture and sell a drug combination of dextromethorphan and an enzyme inhibitor for the treatment of several central nervous system disorders.

MIF inhibitor technology. The patent applications pending for our MIF inhibitor technology are in regard to the use of one or more of a series of small molecule compounds that target MIF as a potential novel therapeutic intervention in rheumatoid arthritis, sepsis, ulcerative colitis, Crohn’s disease, inflammatory neurological diseases, glomerulonephritis and asthma.

Cholesterol reduction. The patent application pending in the United States for our cholesterol reduction technology relates to the general structures currently under development in preclinical research.

We cannot assure you that the claims in our pending patent applications will be issued as patents, that any issued patents will provide us with significant competitive advantages, or that the validity or enforceability of any of our patents will not be challenged or, if instituted, that these challenges will not be successful. The cost of litigation to uphold the validity and prevent infringement of our patents could be substantial. Furthermore, we cannot assure you that others will not independently develop similar technologies or duplicate our technologies or design around the patented aspects of our technologies. We can provide no assurance that our proposed technologies will not infringe patents or other rights owned by others, the licenses

to which might not be available to us. In addition, the National Institutes of Health regulations provide that, if federally funded entities do not pursue patent applications for patentable inventions in a timely manner, then the government may exercise its right to own these inventions.

In addition, the approval process for patent applications in foreign countries may differ significantly from the process in the U.S. The patent authorities in each country administer that country’s laws and regulations relating to patents independently of the laws and regulations of any other country and the patents must be sought and obtained separately. Therefore, approval in one country does not necessarily indicate that approval can be obtained in other countries.

Proprietary rights. In some cases, we may rely on trade secrets and confidentiality agreements to protect our innovations. We can provide no assurance that:


	•	our trade secrets will be maintained;

	•	secrecy obligations will be honored; or

	•	others will not independently develop similar or superior technology.

If consultants, key employees or other third parties apply technological information independently developed by them or by others to our projects, we may be subject to disputes regarding the proprietary rights to this information that may not be resolved in our favor.

Information regarding the status of our various research and development programs, and the amounts spent on major programs through the last two fiscal years, can be found under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

The FDA and comparable regulatory agencies in foreign countries regulate extensively the manufacture and sale of the pharmaceutical products that we have developed or currently are developing. The FDA has established guidelines and safety standards that are applicable to the nonclinical evaluation and clinical investigation of therapeutic products and stringent regulations that govern the manufacture and sale of these products. The process of obtaining regulatory approval for a new therapeutic product usually requires a significant amount of time and substantial resources. The steps typically required before a product can be produced and marketed for human use include:


	•	animal pharmacology studies to obtain preliminary information on the safety and efficacy of a drug; and

	•	nonclinical evaluation in vitro and in vivo including extensive toxicology studies.

The results of these nonclinical studies may be submitted to the FDA as part of an investigational new drug (IND) application. The sponsor of an IND application may commence human testing of the compound 30 days after submission of the IND, unless notified to the contrary by the FDA.


	•	Phase 1 investigations are generally conducted in healthy subjects. In certain instances, subjects with a terminal disease, such as cancer, may participate in Phase 1 studies that determine the maximum tolerated dose and initial safety of the product;

	•	Phase 2 studies are conducted in limited numbers of subjects with the disease or condition to be treated and are aimed at determining the most effective dose and schedule of administration, evaluating both safety and whether the product demonstrates therapeutic effectiveness against the disease; and

	•	Phase 3 studies involve large, well-controlled investigations in diseased subjects and are aimed at verifying the safety and effectiveness of the drug.

Data from all clinical studies, as well as all nonclinical studies and evidence of product quality, typically are submitted to the FDA in a New Drug Application (NDA).

The FDA’s Center for Drug Evaluation and Research (CDER) or the Center for Biologics Evaluation and Research (CBER) must approve a new drug application or biologics license application for a drug before the drug may be marketed in the U.S. At the time, if ever, that we begin to market our proposed products for commercial sale in the U.S., any manufacturing operations that may be established in or outside the U.S. will be subject to rigorous regulation, including compliance with current good manufacturing practices. We also may be subject to regulation under the Occupational Safety and Health Act, the Environmental Protection Act, the Toxic Substance Control Act, the Export Control Act and other present and future laws of general application. In addition, the handling, care and use of laboratory mice, including the hu-PBL-SCID mice and rats, are subject to the Guidelines for the Humane Use and Care of Laboratory Animals published by the National Institutes of Health.

Regulatory obligations continue post-approval, and include the reporting of adverse events when a drug is utilized in the broader commercial population. Promotion and marketing of drugs is also strictly regulated, with penalties imposed for violations of FDA regulations, the Federal Trade Commission’s Lanham Act, and other federal and state laws, including the federal anti-kickback statute.

We currently intend to continue to seek approval to market docosanol 10% cream and other proposed products in foreign countries, which may have regulatory processes that differ materially from those of the FDA. We anticipate that we will rely upon pharmaceutical or biotechnology companies to license our proposed products or independent consultants to seek approvals to market our proposed products in foreign countries. We cannot assure you that approvals to market any of our proposed products can be obtained in any country. Approval to market a product in any one foreign country does not necessarily indicate that approval can be obtained in other countries.

As of December 11, 2003, we employed 63 persons, including 46 engaged in research and development activities, clinical and regulatory affairs, and commercial development, and 17 engaged in administrative functions such as human resources, finance, accounting, purchasing and investor relations. Our staff includes 24 employees with Ph.D. or M.D. degrees. We believe that our relationship with our employees is good.

We expect that we will need to raise additional capital to fund ongoing operations. If we cannot raise additional capital, we may be forced to curtail operations. If we succeed in raising additional capital, it may affect our stock price and future revenues.

In order to maintain sufficient cash and investments for future operations, we will need to raise additional capital. We expect to seek to raise additional capital over the next twelve months through various alternatives, including licensing or sales of our technologies and drug candidates and sale of shares of our Class A common stock.


	•	If we raise capital through licensing or sales of one or more of our technologies and drug candidates, then we may lose an opportunity for product sales if a product is successfully developed, approved by the FDA and marketed. If we license any of our technologies or drug candidates, then the development of the product or technology will no longer be in our control. A licensee might not ever reach any of the milestones in a license agreement and we would not earn any additional payments in such an event. Further, if we sell any of our technologies or drug candidates, there can be no assurance that the sales price will cover our investment in such technology or drug candidate.

	•	If we raise capital by issuing additional shares of Class A common stock at a price per share less than the then-current market price per share, then the value of the shares of Class A common stock outstanding will be diluted or reduced. Further, even if we were to sell shares of common stock at


		prices equal to or higher than the current market price, the issuance of additional shares may depress the market price of our common stock and dilute your voting rights in the Company.

	•	We may not be able raise capital on terms that we find acceptable, if at all. If we are unable to raise additional capital to fund future operations, then we might have to reduce operations or defer or abandon one or more of our clinical or preclinical research programs. Any of these actions could be expected to have an adverse effect on our stock price.

AVANIR and its licensees may not be successful in obtaining regulatory approval of docosanol 10% cream immediately as an over-the-counter (“OTC”) product in the rest of the world or in licensing, marketing and selling the product in foreign countries.

AVANIR and its licensees face a wide variety of risks in foreign countries in obtaining regulatory approval and in marketing and selling docosanol 10% cream, including:


	•	Regulatory approval requirements differ by country, and obtaining approvals to market the drug in foreign countries may be difficult to obtain, may require additional costly and time consuming clinical trials, or may require prescription status first before obtaining sufficient experience to warrant approval as an OTC product;

	•	Building product awareness of a new drug, whether prescription or OTC, among customers or retail store decision makers may require a substantial amount of product promotion, which does not guarantee success;

	•	Consumers may not perceive that docosanol 10% cream is superior to existing and potentially new OTC products for oral herpes;

	•	Acceptance of docosanol 10% cream in the OTC consumer market may not be widespread; and

	•	Potential price erosion could occur due to competitive products and responses to our product’s introduction.

Developing and testing a drug candidate is a very expensive and time-consuming process that may not ultimately lead to a marketable product.

We may spend millions of dollars in preclinical studies researching the potential safety and efficacy of our drug candidates. If any such drug candidate fails to demonstrate the desired safety and efficacy, we may abandon the development of the compound, in which event we would not recover our expenditures incurred to date for that compound. If a compound appears to be safe and effective in preclinical studies, we may decide to proceed with human clinical trials. The full complement of clinical trials required to obtain regulatory approval for a new drug may involve several million dollars. Because of the Company’s limited financial resources, we may be required to license the compound to a pharmaceutical company with greater financial resources in order to complete development of the drug. There is no assurance that we will be able to find a large pharmaceutical company interested in licensing the drug or, if we do locate such a licensee, that the proposed license terms will be acceptable to the Company. In the event that we are unable to find a large pharmaceutical partner or licensee on acceptable terms, we may be forced to abandon one or more of our drug candidates.

We expect our quarterly operating results to fluctuate significantly from period-to-period for a number of reasons.

Future operating results will continue to be subject to significant quarterly fluctuations based on a variety of factors, including:


	•	Limited rights to future Abreva royalties — In December 2002 we sold to Drug Royalty USA the rights to a substantial portion of our future royalty revenues from sales of Abreva by GlaxoSmithKline. We will not receive any future royalty payments unless and until annual Abreva sales exceed $62 million, at which time we will receive one-half of the stated royalty rate on any excess sales. We


		expect that any royalty payments on these excess sales, if any, would occur only once a year, after the end of each calendar year.

	•	Concentration of significant customers, suppliers and industries — Milestone payments, royalties earned, and revenues recognized from the sale of rights to royalties from a single licensee (GlaxoSmithKline) accounted for approximately 73% and 95% of our fiscal 2003 and 2002 revenues, respectively. We have now received all of the milestone payments from GlaxoSmithKline for North America. With the sale of our Abreva royalty rights to Drug Royalty USA, future royalty payments from GlaxoSmithKline will come exclusively from our remaining 50% share of Abreva royalties on contract sales in excess of $62 million a year. Additionally, we purchase our raw materials from a sole foreign supplier that has been approved for manufacture by the FDA. Any disturbances or delays in the manufacture of the raw materials could seriously and adversely affect our business.

	•	Achievement of milestones under license agreements may be outside our control — Recognition of revenue under several of our license agreements may depend solely on the efforts and performance of our licensees in reaching milestones outside of our control. Such milestones may include specific events, such as regulatory approval, product launch, the passage of time, or reaching a sales threshold.

	•	Acquisitions/alliances — If, in the future, we acquire technologies, products, or businesses, or we form alliances with companies requiring technology investments or commitments, we will face a number of risks to our business. The risks that we may encounter include those associated with integrating operations, personnel, and technologies acquired or licensed, and the potential for unknown liabilities of the acquired business. Our business and operating results on a quarterly basis could be adversely affected if any of our acquisition or alliance activities are not successful.

Foreign sales of docosanol 10% cream and other potential products are subject to various foreign trade risks.

Our license agreement with GlaxoSmithKline is for the United States and Canada only. We also have exclusive license agreements for docosanol 10% cream for Israel, South Korea, Italy and Egypt. We are holding discussions with other potential licensees for marketing and selling docosanol 10% cream in other countries not already licensed. However, we may not finalize any license or distribution arrangements for other territories on a timely basis or on favorable terms, if at all. Further, our foreign licensees expose us to various foreign trade risks relating to development and marketing of docosanol 10% cream. We may arrange for contracts in the future for the manufacture, marketing and distribution of docosanol 10% cream overseas by foreign licensees, which will be substantially outside our control. Even if we are able to obtain experienced licensees in foreign markets, specific risks that could impact significantly our ability to deliver products abroad include:


	•	difficulties in obtaining regulatory approval of docosanol 10% cream in foreign countries;

	•	changes in the regulatory and competitive environments in foreign countries;

	•	changes in a specific country’s or region’s political or economic conditions;

	•	difficulty in finding foreign partners with sufficient capital to effectively launch, market and promote the product;

	•	shipping delays;

	•	difficulties in managing operations across disparate geographic areas;

	•	fluctuations in foreign currency exchange rates;

	•	prices of competitive products;

	•	difficulties associated with enforcing agreements through foreign legal systems;

	•	trade protection measures, including customs duties and export quotas; and

	•	foreign tax withholding laws.

Our research and development programs face intense competition and rapid technological change. If we fail to develop products that keep pace with competitive products and new technologies, our products and technologies could become obsolete.

The biotechnology industry is highly competitive and subject to significant and rapid technological change. We compete with hundreds of companies that develop and market products and technologies in similar areas as our research. Each competitor may have specific expertise and technologies that are better than ours. Many of these companies, either alone or together with their research partners, have substantially greater financial resources, larger research and development staffs, and substantially greater experience than we do.

Our failure or inability to comply with government regulations regarding the development, production, testing, manufacturing and marketing of our products may adversely affect our operations.

Governmental authorities in the U.S., including the FDA, and other countries highly regulate the development, production, testing, manufacturing and marketing of pharmaceutical products. The clinical testing and regulatory approval process can take a number of years and requires the expenditure of substantial resources. Failure to obtain, or delays in obtaining, these approvals will adversely affect our business operations, including our ability to commence marketing of any proposed products. We may find it necessary to use a significant portion of our financial resources for research and development and the clinical trials necessary to obtain these approvals for our proposed products. We will continue to incur costs of development without any assurance that we will ever obtain regulatory approvals for any of our products under development. Additionally, we cannot predict the extent to which adverse governmental regulation might arise from future U.S. or foreign legislative or administrative action. Moreover, we cannot predict with accuracy the effects of any future changes in the regulatory approval process and in the domestic health care system for which we develop our products. Future changes could affect adversely the time frame required for regulatory review, our financial resources, and the sale prices of our proposed products, if approved for sale.

Unsuccessful or lengthy research and development programs for proposed new products could negatively affect our business.

The drug development process is lengthy and capital intensive. Our drug development programs are exposed to all of the risks inherent in product development based on innovative technologies, including unanticipated development problems and the possible lack of funding or collaborative partners. Any of a number of problems in the development process could result in the abandonment or substantial change in the development of a specific product. Our Phase III clinical trial of Neurodex for the treatment of pseudobulbar affect in multiple sclerosis patients may experience setbacks or failures for reasons we have not anticipated. Our Phase I clinical trial of our lead compound for treating allergy and asthma may not demonstrate the efficacy of, or have the safety profile necessary for, a proposed product for human use. Unsuccessful clinical trial results for our proposed products could affect materially and adversely our future business operations and financial condition.

Our financial results could be affected by potential changes in the accounting rules governing the recognition of stock-based compensation expense.

We measure compensation expense for our employee stock compensation plans under the intrinsic value method of accounting prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” In addition, we provide pro forma disclosures of our operating results in our Notes to Consolidated Financial Statements as if the fair value method of accounting had been applied in accordance with SFAS No. 123, “Accounting for Stock-based Compensation.” Had we accounted for our compensation expense under the fair value method of accounting prescribed by SFAS No. 123, the charges would have been significantly higher, by approximately $1,554,000, $2,176,000, and $1,540,000 during fiscal 2003, 2002, and 2001, respectively. Currently, the U.S. Congress, the Securities and Exchange Commission and the Financial Accounting Standards Board are considering changes to accounting rules concerning the recognition of stock option compensation expense. If one or more of these proposals are implemented, we and other companies may be required to measure compensation expense using the fair value method, which would adversely affect

Our operations are vulnerable to interruption by fire, earthquake, power loss, telecommunications failure, and other events beyond our control. For example, during 2001 and again in 2003, we experienced “blackouts,” where there were periods of time lasting several hours in which our utility provider was unable to provide us with electrical power. The loss of electrical power or “blackouts” for any significant periods of time could adversely affect our ability to conduct experiments and could also harm our vendors. Further, we could lose valuable data made to date in experiments currently underway. We have mitigated the severity of power losses by installing on our premises emergency power equipment, which we have used on several occasions to supply electricity in the areas that we consider to be the most critical to our operations. However, the emergency power unit does not cover all of our electrical needs and, further, it might not operate properly in the event of a power loss.

Our inability to attract and retain key management and scientific personnel could negatively affect our business.

Our success depends on the performance of a small core staff of key management and scientific employees with biotech experience. Given our small staff size and programs currently under development, we depend substantially on our ability to hire, train, retain and motivate high quality personnel, especially our scientists and management team in this field. If we were to lose one or more of our key scientists, then we would likely lose some portion of our institutional knowledge and technical know-how, potentially causing a substantial delay in one or more of our development programs until adequate replacement personnel could be hired and trained.

Our future success also depends on our continuing ability to identify, hire, train and retain highly qualified, technical, sales, marketing and customer service personnel. We presently employ approximately 63 people. Further, we might hire additional people over the next twelve months. Other than our chief executive officer, our executives do not have employment agreements. We do not have “key person” life insurance policies for any of our executives. The industry in which we compete has a high level of employee mobility and aggressive recruiting of skilled personnel. This type of environment creates intense competition for qualified personnel, particularly in product research and development, sales and marketing, and accounting and finance.

Our patents may be challenged and our pending patents may be denied. Either result would seriously jeopardize our ability to compete in the intended markets for our proposed products.

We rely substantially on the protection of our intellectual property through our ownership or control of issued patents and patent applications. Patents and patent applications owned or controlled by the Company are for docosanol-related products and technologies, Neurodex^TM, compounds capable of regulating the target IgE in controlling symptoms of allergy and asthma, compounds capable of regulating the target MIF in the treatment of several inflammatory diseases, and Xenerex technologies for developing monoclonal antibodies. Because of the competitive nature of the biopharmaceutical industry, we cannot assure you that:


	•	the claims in any pending patent applications will be allowed or that patents will be granted;

	•	present and future competitors will not develop similar or superior technologies independently, duplicate our technologies or design around the patented aspects of our technologies;

	•	our proposed technologies will not infringe other patents or rights owned by others, including licenses that may not be available to us;

	•	any of our issued patents will provide us with significant competitive advantages; or

	•	challenges will not be instituted against the validity or enforceability of any patent that we own or, if instituted, that these challenges will not be successful.

Our inability to obtain or maintain patent protections for our products in foreign markets may negatively affect our financial condition.

The process for the approval of patent applications in foreign countries may differ significantly from the process in the U.S. These differences may delay our plans to market and sell docosanol 10% cream and other products in the international marketplace. Approval in one country does not indicate that approval will be obtained in other countries. The patent authorities in each country administer that country’s laws and regulations relating to patents independently of the laws and regulations of any other country and we must seek and obtain the patents separately. Our inability to obtain or maintain patent protections for docosanol 10% cream and other products in foreign markets would severely hamper our ability to generate international sales from our first product and other products still under development.

If we do not protect our technical innovations, then our business may be negatively affected.

We rely substantially on confidentiality agreements to protect our innovations. We cannot assure you that secrecy obligations will be honored, or that others will not independently develop similar or superior technology. Additionally, if our consultants, key employees or other third parties apply technological information independently developed by them or by others to our projects, then disputes may arise as to the ownership rights of these innovations. It is costly to litigate these disputes and an unfavorable result could adversely affect our intellectual property portfolio as well as our business and financial condition.

Developing new pharmaceutical products for human use involves product liability risks, for which we currently have limited insurance coverage.

The testing, marketing, and sale of pharmaceutical products involves the risk of product liability claims by consumers and other third parties. We maintain product liability insurance coverage for our clinical trials in the amount of $5 million per incident and $5 million in the aggregate. However, product liability claims can be high in the pharmaceutical industry and our insurance may not sufficiently cover our actual liabilities. If a suit against our business or proposed products is successful, then the lack or insufficiency of insurance coverage could affect materially and adversely our business and financial condition. Furthermore, various distributors of pharmaceutical products require minimum product liability insurance coverage before their purchase or acceptance of products for distribution. Failure to satisfy these insurance requirements could impede our ability to achieve broad distribution of our proposed products.

In the ordinary course of business, we face various claims brought by third parties, including claims relating to the safety or efficacy of our products. Any of these claims could subject us to costly litigation and, while we generally believe that we have adequate insurance to cover many different types of liabilities, our insurance carriers may deny coverage or our policy limits may be inadequate to fully satisfy any damage awards or settlements. If this were to happen, the payment of any such awards could have a material adverse effect on our operations and financial position. Additionally, any such claims, whether or not successful, could damage our reputation and business.

Abreva faces competition from a number of existing and well-established products and the companies that market their products.

We have the opportunity to earn royalties on Abreva product wholesale sales if sales exceed $62 million a year. Abreva competes with several other products for oral-facial herpes currently on the market in the U.S., as well as other products or potential products that are or may be under development or undergoing FDA review. Most of the competing products are manufactured by companies having substantial financial resources, research and development facilities and manufacturing and marketing experience. Even with Abreva being marketed by one of the world’s largest consumer healthcare companies, GlaxoSmithKline, not all competitive responses and the impacts of those responses can be foreseen.

In connection with two lease agreements, we currently lease 57,582 square feet of laboratory and office space in three buildings located at 11388, 11404, and 11408 Sorrento Valley Road, San Diego, California for a combined base rental payment of approximately $137,000 per month in fiscal 2004. These two leases have scheduled rent increases each year and expire on August 31, 2008 and January 14, 2013, respectively. See Note 6, “Commitments and Contingencies,” to our financial statements annexed to this report and Exhibits 10.6 and 10.8.

We maintain irrevocable standby letters of credit to the lessors, totaling $857,000 to secure our performance under the leases. We also completed $4.1 million in tenant improvements in fiscal 2003 for the three buildings that we lease.

In the ordinary course of business, we face various claims brought by third parties, including claims relating to the safety or efficacy of our products. Any of these claims could subject us to costly litigation and, while we generally believe that we have adequate insurance to cover many different types of liabilities, our insurance carriers may deny coverage or our policy limits may be inadequate to fully satisfy any damage awards or settlements. If this were to happen, the payment of any such awards could have a material adverse effect on our results of operations and financial position. Additionally, any such claims, whether or not successful, could damage our reputation and business.

Our Class A common stock trades under the symbol “AVN” on The American Stock Exchange (the “AMEX”). The following table sets forth the high and low quarterly closing quotations for our Class A common stock over the past two fiscal years, as quoted on the AMEX.

On December 11, 2003, the closing sales price of Class A Common Stock was $1.64 per share.

As of December 11, 2003, we had approximately 1,060 holders of record and approximately 19,663 beneficial owners of our Class A Common Stock. We have not paid any dividends on our Class A or Class B common stock since our inception and do not expect to pay dividends on our common stock in the foreseeable future.

The selected consolidated financial data set forth below at September 30, 2003 and 2002, and for the fiscal years ended September 30, 2003, 2002 and 2001, are derived from our audited consolidated financial statements included elsewhere in this report. This information should be read in conjunction with those consolidated financial statements, the notes thereto, and the independent auditors’ report thereon, and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The selected consolidated financial data set forth below at September 30, 2001, 2000 and 1999, and for the years ended September 30, 2000 and 1999, are derived from our audited consolidated financial statements that are contained in reports previously filed with the SEC.

This annual report on Form 10-K contains forward-looking statements concerning future events and performance of our company. You should not rely excessively on these forward-looking statements, because they are only predictions based on our current expectations and assumptions. When used in this report, the words “intend,” “estimate,” “anticipate,” “believe,” “plan” and “expect” and similar expressions as they relate to AVANIR are included to identify forward-looking statements. Many factors could cause our actual results to differ materially from those indicated in these forward-looking statements. You should review carefully the factors identified in this report as set forth below and under the caption “Risk Factors that Might Affect Future Operations.” We disclaim any obligation to update or announce revisions to any forward-looking statements to reflect actual events or developments. Except as otherwise indicted herein, all dates referred to in this Report represent periods or dates fixed with reference to the calendar year, rather than our fiscal year ending September 30.

AVANIR Pharmaceuticals, based in San Diego and incorporated in California in 1988, is engaged in research, discovery, development and licensing of innovative drug products for several therapeutic areas, including herpes simplex, pseudobulbar affect (“PBA”), also known as emotional lability, neuropathic pain, allergy and asthma, cholesterol reduction, and other inflammatory diseases. Using our proprietary Xenerex^TM technology, we also develop human monoclonal antibodies for infectious diseases and other therapeutic applications.

AVANIR successfully developed the first over-the-counter (OTC) drug that has been approved by the United States Food and Drug Administration (FDA) for the treatment of cold sores. Marketed in the U.S. by GlaxoSmithKline Consumer Healthcare, Abreva® (docosanol 10% cream) was launched in late 2000 and has been the largest selling consumer healthcare product in the U.S. for the treatment of cold sores since

introduction. From inception of the license agreement with GlaxoSmithKline subsidiary, SB Pharmco Puerto Rico, through September 30, 2003, AVANIR has received over $55 million in license fees, milestone payments and royalties on Abreva contract sales and sale of certain interests in future royalties.

In fiscal 2003, AVANIR sold an undivided interest in its license agreement with GlaxoSmithKline to Drug Royalty USA for $24.1 million. AVANIR retained the right to receive 50% of all royalties under the GlaxoSmithKline license agreement for annual sales of Abreva in excess of $62 million. AVANIR also retained its rights to market and/or license the cold sore product outside North America and to develop docosanol 10% cream for other indications.

Outside the U.S., docosanol 10% cream is approved for OTC marketing in Sweden, Canada, the Republic of Korea and Israel. The Swedish Medical Products Agency (MPA) approved docosanol 10% cream for marketing in November 2003. The Swedish MPA is a reference state for the mutual recognition process for regulatory approvals by other states in the European Union. In addition to the GlaxoSmithKline license agreement, AVANIR has license agreements for docosanol 10% cream in Italy, the Republic of Korea, Israel and Egypt. The product is already being marketed under the trade names Herepair in Korea and Abrax in Israel.

AVANIR’s drug development pipeline consists of clinical, preclinical and earlier stage drug discovery programs. Neurodex is in Phase III clinical development for the treatment of PBA and should be ready for submission of a new drug application (NDA) with the FDA in 2004. PBA affects a diverse population of patients with neurologic disorders, such as Alzheimer’s disease, multiple sclerosis (MS), Lou Gehrig’s disease (amyotrophic lateral sclerosis or ALS), Parkinson’s disease, and those with neuronal damage following stroke and traumatic brain injury. We have successfully completed one Phase II study of Neurodex for the treatment of neuropathic pain. We are also engaged in a Phase I clinical trial of AVP-13358 for the treatment of allergy and asthma and have published interim results of single rising dose studies. Our preclinical research and drug discovery programs are directed primarily toward large therapeutic areas, including cholesterol reduction and other inflammatory diseases. We also are using our Xenerex^TM technology to produce human monoclonal antibodies for anthrax, cytomegalovirus, and other infectious diseases and selected targets for collaborative partners.

Licensing our products and partnering with other companies represent important sources of funds for us to achieve cash inflows and pursue development of several potential drugs and technology platforms. We intend to fund our current preclinical development programs, if successful, at least until we are able to obtain Investigational New Drug (IND) status and begin clinical trials. Thereafter, our strategy is to seek partners for co-development or to grant licenses to develop and market our potential new drugs. Co-development would allow us to share development costs and product revenues. Licensing would provide an opportunity to receive license fees and milestone payments as the product is developed and royalties on product sales if a product were to be successfully launched.

The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires that management make a number of assumptions and estimates that affect the reported amounts of assets, liabilities, revenues and expenses in our consolidated financial statements and accompanying notes. Management bases its estimates on historical information and assumptions believed to be reasonable. Although these estimates are based on management’s best knowledge of current events and circumstances that may impact the Company in the future, actual results may differ from these estimates.

Our critical accounting policies are those that affect our financial statements materially and involve a significant level of judgment by management. Our critical accounting policies regarding revenue recognition are in the following areas: milestone payments in license agreements, royalties on licensed products, sale of rights to future royalties, and recognition of revenues in research contracts. Our critical accounting policies regarding expense recognition are principally related to research contracts. Our critical accounting policies also include the valuation of long-lived and intangible assets.

We recognize revenues from license fees when the performance requirements have been met, the fee is fixed or determinable, and collection of fees is probable. We defer revenues and recognize them ratably over the life of the agreement when we have continuing obligations to perform under the agreement.

Our largest and most significant license agreement is with SB Pharmco Puerto Rico, Inc., a subsidiary of GlaxoSmithKline (“GlaxoSmithKline”). On March 31, 2000, we transferred the rights to manufacture, use, and sell Abreva in the United States and Canada to GlaxoSmithKline and gave them full control, authority and responsibility over research, development, registration including actions required to obtain appropriate government approvals, and commercialization of the product in those territories. GlaxoSmithKline has achieved and paid all of the performance milestones under the agreement. With regard to the milestones, we have no further performance obligations. Future revenues, if any, to be earned under the GlaxoSmithKline agreement will come solely from royalty revenues.

We expect to enter into additional license agreements in the future. We expect that each license agreement will have its own set of circumstances and terms of performance. We will consider the specific facts and circumstances of each license agreement to determine the appropriate revenue recognition for such items, including nonrefundable up-front fees and milestone payments and taking into consideration when the earnings process is complete and collection is reasonably assured.

We recognize royalty revenues from our licensed products based on the reported sales by our licensees and computed in accordance with the specific terms of the license agreements. Since the launch of Abreva in October 2000 through September 30, 2003, substantially all of our royalties have come from GlaxoSmithKline. We have entered into additional license agreements that contain royalties as a source of revenues, and we expect to enter into additional similar license agreements with foreign-based companies.

In December 2002, we sold an undivided interest in our license agreement with GlaxoSmithKline to Drug Royalty USA, Inc. (“Drug Royalty USA”) and received a payment of $20.5 million at closing and an additional $3.6 million in April 2003. Because of our ongoing involvement with GlaxoSmithKline in earning future royalty revenues, we have recorded the amounts received from Drug Royalty USA, net of costs of the transaction and after the forgiveness of certain advances, as deferred revenue. (See Note 5, “Asset Sale,” in the accompanying financial statements.) The amount recorded as deferred revenue is being recognized as revenue under the units-of-revenue method. Under this method, the amount of deferred revenue being recognized as revenue in each period is calculated by multiplying (i) the ratio of the royalty payments due to Drug Royalty USA for the period to the total remaining royalties that we expect GlaxoSmithKline will pay Drug Royalty USA over the term of the agreement, by (ii) the unamortized deferred revenue amount. The portion of deferred revenue classified as part of current liabilities represents the amount we expect to realize as revenue within the next 12 months.

In certain circumstances, we may enter into research contracts or collaborations having obligations to deliver to the customer multiple products and/or services (multiple deliverables) in exchange for fees or milestone payments. Such contracts could include antibody generation services agreements and other forms of research collaborations.

Antibody generation services. As of September 30, 2003, we were engaged in work on two research collaboration agreements, both of which have research initiation fees. In these agreements, the customer provides us with the target antigens. We then perform research services to develop potential antibodies for those antigens. If we are able to estimate the period of service in the contract in advance of beginning the work, then we recognize such research initiation fees ratably as revenue over the estimated period of service. If

we are unable to identify the period of service in the contract in advance of beginning the work, we defer research initiation fees and recognize such fees as revenue once we have completed our efforts to create the antibodies. In the research phases of the research collaboration agreement, we may receive payment either to start a research phase or to complete a research phase (including receipt by the customer of the deliverable). We recognize revenue once the product has been delivered, because the earning process would be complete and an exchange has been made. Factors taken into consideration in recognizing revenues include the following:


	•	The performance criteria have been met;

	•	Any undelivered products or services are not essential to the functionality of the delivered products or services; and

	•	Payment for the delivered products or services is not contingent on delivery of the remaining products or services.

Other research contracts. As with all our research contracts, including the up-front initiation fee, we defer revenue recognition until services have been rendered or products (e.g. developed antibodies) are delivered. The milestones established within the contract are set to approximate the effort associated with the completion of each phase.

Pursuant to management’s assessment of the progress that has been made on clinical trials and other research contracts, we recognize expenses related to such contracts as the services are provided.

We assess the impairment of identifiable intangible assets and long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important that could trigger an impairment review include the following:


	•	a significant underperformance relative to expected historical or projected future operating results;

	•	a significant change in the manner of our use of the acquired asset or the strategy for our overall business; and/or

	•	a significant negative industry or economic trend.

When we determine that the carrying value of intangible assets or long-lived assets are not recoverable based upon the existence of one or more of the above indicators of impairment, we may be required to record impairment charges for these assets that have not been previously recorded.

AVANIR’s operating expenses are influenced substantially by the amount of spending devoted to clinical development programs and drug discovery research. During the past three years, we have substantially expanded our drug development pipeline, which requires that we allocate significant amounts of our resources to research and development activities, which have increased substantially over the same period. Our spending on new business development and on general and administrative support staff tends to follow trends in our spending for research, but to a lesser extent. Other components of our operating costs include maintenance and operation of our laboratory and office facilities, depreciation, professional and consulting fees related to clinical trials and regulatory compliance, insurance, and investor relations. We expect spending on research and development to continue to represent approximately 70% of our operating expenses for fiscal 2004. Building rent amounting to approximately $1.6 million in fiscal 2004 has scheduled rent increases of approximately 4% a year for at least the next three years. Our business is exposed to significant risks, as discussed in the section entitled “Risk factors that might affect future operations,” which may result in

We believe the impact of inflation and changing prices on net sales revenues and on net income from continuing operations has been immaterial during the past three years. Prices for electricity increased in early fiscal 2001, however, our operations do not consume a substantial amount of electricity other than for providing lighting and air conditioning for our offices and laboratories.

Revenues in fiscal 2003 amounted to $2.4 million, compared to $8.9 million in fiscal 2002. Revenues for fiscal 2003 included $1.8 million in revenues that the Company recognized from the sale of Abreva® royalty rights to Drug Royalty USA and $587,000 from government research grants. Revenues for fiscal 2002 included a final $5.0 million milestone payment relating to the one-year anniversary of Abreva® product launch and $3.4 million in royalty revenues on Abreva product sales. Other revenues in fiscal 2002 included $160,000 in federal and state grant revenues, $41,000 in sales of docosanol, and $226,000 in research contracts and license fees from other areas.

During fiscal 2004, we expect to recognize approximately $1.8 million in revenues from the sale transaction to Drug Royalty USA, with a corresponding reduction in deferred revenue. Also during the fiscal year, we expect to earn approximately $800,000 from sales of docosanol to licensees and $500,000 in revenues from research being performed under government research grants. Potential revenues from license fees, milestone payments, and royalties on foreign sales of docosanol 10% cream will depend substantially on the timing of approvals by foreign regulatory agencies and our ability to enter into additional license arrangements. Potential revenues from licensing and/or selling products in clinical and preclinical development, including Neurodex for the treatment of PBA and neuropathic pain and treatments for inflammatory diseases and high cholesterol, are less predictable.

Partnering, licensing and research collaborations have been, and will continue to be, an important part of AVANIR’s business development strategy. We intend to partner with pharmaceutical companies that can help fund AVANIR’s research in exchange for sharing in the rights to commercialize new drugs resulting from this research. We have licensed and continue to seek licensees in other countries for docosanol 10% cream and other potential products in our development pipeline. Research collaborations also represent an important way to achieve our development goals, while sharing in the risks and the opportunities that come from such development efforts.

As of September 30, 2003, we had several contracts and grants that are generating or could generate revenues in the future to help fund our research and development programs. Five contracts are in the form of docosanol 10% cream license agreements, one contract is for a Neurodex license, and two contracts are in the form of antibody research service agreements. For the last three years, the GlaxoSmithKline license arrangement has been our most significant revenue source, representing approximately 95% of the Company’s cumulative revenues during the last three fiscal years. A list of our revenue-generating contracts is set forth in the following table.

Operating expenses. Our total operating expenses increased to $25.9 million in fiscal 2003, compared to $19.5 million in fiscal 2002. The 33% increase in operating expenses was primarily caused by a 36% increase in spending on research and development programs. Research and development programs accounted for 72% and 70% of total operating expenses for fiscal 2003 and 2002, respectively. General and administrative expenses accounted for 18% and 22% of total operating expenses for fiscal 2003 and 2002, respectively. Sales and marketing expenses accounted for 10% and 8% of total operating expenses for fiscal 2003 and 2002, respectively. These and other costs are more fully described below.

Research and development (R&D) expenses. R&D expenses totaled $18.6 million in fiscal 2003, compared to $13.6 million in fiscal 2002. We had four clinical trials and studies under way throughout most of fiscal 2003, compared to only one clinical trial in fiscal 2002. The Phase III clinical trial and open label study of Neurodex in the treatment of PBA accounted for $5.1 million, or 27%, of total R&D spending. Completion of toxicology, submitting an investigational new drug (IND) application to the FDA, and completion of the initial dose levels in Phase I clinical trials of our lead compound for the treatment of allergy and asthma accounted for $4.7 million, or 25%, of total R&D spending. An additional 11% of R&D spending was devoted to the development of Neurodex in the treatment of neuropathic pain, currently in Phase II clinical

development. Approximately 12% of spending was focused on research on a group of compounds targeting MIF as a potential treatment for inflammatory diseases. In fiscal 2002, preclinical research focused on a novel treatment for allergy and asthma, including toxicology studies, scaled-up manufacture of the lead compound, development of second generation compounds, and other related contract research, accounted for 36% of total R&D spending. Also in fiscal 2002, clinical development of Neurodex for the treatment of PBA, including a Phase III clinical trial in patients with Lou Gehrig’s disease, accounted for 22% of R&D spending. R&D related to the treatment of neuropathic pain and research on candidates for regulating MIF each accounted for 10% of total R&D spending. The balance of R&D activities in both fiscal 2003 and 2002 was primarily related to other preclinical programs addressing cholesterol reduction and programs funded by government research grants.

Pharmaceutical R&D programs, by their very nature, require a substantial amount of financial and human resources and there is no assurance that any drug candidate will be approved for marketing by domestic and/ or foreign regulatory agencies. The later stages of clinical development typically require substantially greater funds for development than the earlier stages. Thus, for many of our larger development programs, we intend to license our technology or partner with other pharmaceutical companies that have substantially greater financial resources. We expect that our licensees will continue to develop and fund those projects and pay us up-front license fees, milestone payments, and royalties on product sales if those products are successfully developed and approved for marketing by the FDA and foreign regulatory agencies. We caution that many of our development efforts could experience delays, setbacks and failures, with no assurance that any of our clinical research or our potential licensees or partners will ever reach the stage of an NDA with the FDA or that any NDA will be approved. The following table sets forth the status of, and costs attributable to, our proprietary research and clinical development programs.


(1)	At September 30, 2003, we held the worldwide rights to manufacture, market and sell all of the products in clinical development and any of the products that might come from our internal R&D programs. All dates in the schedule refer to calendar year.

(2)	Each project includes allocation of laboratory occupancy costs. “M” refers to millions. Estimated costs and timing to complete the projects are subject to the availability of funds.

(3)	Inception dates are on or after October 1, 1998, at which time we began identifying and tracking costs for these research programs.

(4)	Clinical development, licensing and/or co-promotion strategies are being evaluated. See “Research and Development Program Strategy.”

(5)	State and Federal research grants totaling $1.5 million are for research related to genital herpes, anthrax, cytomegalovirus (CMV) and a blood donor program.

We are pursuing an R&D program strategy that is intended to provide a stream of potential products in various stages of development as well as in several therapeutic areas and technology platforms. Our approach is not to rely on any one therapeutic area or technology platform, but to extend our development expertise across several therapeutic areas, technology platforms and research targets that each could lead to one or more products. To help conserve cash resources as we continue these R&D programs, we intend to use our own funds for clinical trials that are relatively small and license our products and technologies to others when we expect the development costs will exceed available cash resources. We are pursuing this strategy because the costs of pursuing all of our development programs through all clinical phases are beyond our available cash resources. There can be no assurances that we will be successful in licensing any of our products or technologies. If we are unable to license one or more of our products and technologies in a timely manner, then we may have to slow down the rate of development of some of our early-stage programs, which could allow competition to catch up or surpass our programs.

Neurodex for the treatment of PBA. We are currently engaged in a 140-patient Phase III clinical trial of Neurodex for the treatment of PBA in patients with multiple sclerosis. We are also engaged in a 300-patient open label study for the treatment of PBA in a broader pool of patients who could have any one of several neurodegenerative diseases. Prior to engaging in these studies, we had completed the initial Phase III clinical trial of PBA in patients with ALS, in May 2002. Our goal is to submit an NDA with the FDA in the second half of the 2004 calendar year.

Neurodex for the treatment of neuropathic pain. In June 2003, we announced the completion of a four-week open-label dose escalation study of Neurodex in patients with painful diabetic neuropathy. Results of the non-placebo controlled Phase II study indicated that Neurodex was well tolerated up to the highest target dose, and patients reported decreased pain intensity that was significantly different from baseline (p < 0.0001). Out of 36 adult patients with diabetic neuropathy who experience pain on a daily basis in the lower extremities, three did not complete the study. Of those patients not completing the study, two were due to adverse events (one serious and not related, one serious and possibly related) and one due to inability to comply with the protocol. Commonly reported adverse events (reported by three or more individuals) included nausea, constipation, diarrhea, dry mouth, fatigue, dizziness, insomnia, headache, upper respiratory tract infection, and somnolence. Most adverse events were either mild or moderate in intensity, and 92% of participants completed the study. This program remains in the Phase II stage of clinical development, while we evaluate alternatives for continued development of Neurodex in the treatment of neuropathic pain, including continuing development with our own expenditures or with the funding of a potential co-promotion partner or potential licensee.

Neurodex R&D spending strategy. We are currently evaluating alternatives for commercialization of Neurodex for PBA and neuropathic pain. Such alternatives include, among others, developing our own sales force for certain market segments, and co-promotion or licensing arrangements, possibly with a partner that could contribute to the development costs of the program. There can be no assurances as to the timing of a license or co-promotion arrangement, if any.

Development program for allergy and asthma (IgE regulator). In fiscal 2003, we increased the estimated costs to complete the project by $3.0 million and timing to complete the project by one year to allow for additional toxicology studies and more extensive Phase I testing that were required by the FDA. In October 2003, we announced that AVP-13358 was well tolerated at single rising doses up to five milligrams in a randomized, placebo-controlled Phase I clinical trial. Presence of the drug in the bloodstream, or exposure, was demonstrated at all four oral dose levels tested between one and five milligrams. AVP-13358 is a novel drug molecule discovered by AVANIR scientists that is intended to inhibit the production of IgE, a well-known mediator of allergy and asthma. Phase 1a trials are intended to establish safety of the drug in single rising doses in healthy volunteers and to assess the compound’s effect on certain disease biomarkers. These trials will be followed by Phase Ib clinical trials using rising multi-doses in healthy patients. Assuming the successful completion of Phase 1a clinical trials and adequate funds to continue development without a partner, we estimate that Phase Ib clinical trials for this compound will be completed 2004. Assuming these results are favorable, we expect to license the drug to a larger pharmaceutical company for further development.

Anti-inflammatory research program (MIF inhibitor). We are currently conducting research on several potential drug candidates capable of inhibiting or blocking the activity of macrophage migration inhibitory factor. Our research indicates that MIF may serve as a potential drug target in a variety of diseases, including rheumatoid arthritis, Crohn’s disease, colitis and asthma. Assuming we are successful in finding a lead compound and submitting an IND to the FDA, we intend to license the compound to another pharmaceutical company for further development. Any delays to our product development timeline or in submitting an IND could cause a similar delay in the timing of when we expect that we could license our MIF technology.

Government research contracts. AVANIR also is engaged in research funded by $1.5 million in government research grants. The government research grants are to be used for investigating the market potential for a topical genital herpes treatment, conducting research on various docosanol-based formulations for genital herpes, development of antibodies to anthrax toxins and cytomegalovirus, and development of a blood donor program intended to find high-affinity antibodies to infectious diseases. We expect the current government-funded research programs will continue through fiscal year 2004.

Cholesterol reduction — We are engaged in preclinical research focused on certain types of small molecules that can be taken orally as a potential treatment or means of prevention of hyper-cholesterolemia (high cholesterol). Cholesterol is transported in the blood in large cholesterol-rich particles called lipoproteins. Generally, low-density lipoproteins (LDL) deliver the cholesterol to peripheral tissues including aorta

and coronary arteries, whereas high-density lipoproteins (HDL) remove excess cholesterol from peripheral tissues, and transport it to the liver for elimination. We are evaluating certain compounds that may be capable of accelerating the removal of excess cholesterol from peripheral tissues. Because our research is at the preclinical stage of development, we are unable to predict the cost and timing for development of a drug.

Monoclonal antibodies research — In fiscal 2003, we collaborated with three other companies in efforts to use our Xenerex^TM technology to produce fully human monoclonal antibodies for potential disease targets provided by those companies. The research collaborations provided us with advance payments to conduct the research, and the possibility for milestone payments if any of the antibody products we developed reached further stages of development. If a product were eventually sold, we would receive royalties on product sales. In December 2003 we announced that we had entered into a license agreement with Peregrine Pharmaceuticals for one of the antibodies that we had developed for the treatment of solid tumor cancers. We changed our emphasis during the year to focus more on finding antibodies for our own disease targets, particularly infectious diseases. We successfully developed multiple antibodies that demonstrate high potency against anthrax toxins in vitroand in vivoand against anthrax spores in vivo. Much of our work targeting infectious diseases has been funded by government research grants. Because all of our research is at a very early preclinical stage of development and is unpredictable in terms of the outcome, we are unable to predict the cost and timing for development of any antibody or drug.

Other collaborative research programs — Under an agreement signed in 2002, we provided clinical and preclinical research information on docosanol 10% cream to Shanghai New Asiatic Pharmaceutical Company, Ltd. for the purposes of evaluating the regulatory approval requirements and size of the markets for the treatment of cold sores, genital herpes and herpes zoster (shingles) in the People’s Republic of China. In 2003 we terminated the collaboration with Shanghai New Asiatic, because of the lack of progress that they had made. Presently, we are not pursuing any further research collaborations in the People’s Republic of China.

General and administrative expenses. Our general and administrative expenses increased slightly to $4.7 million in fiscal 2003, compared to $4.2 million in fiscal 2002. These increased expenses primarily relate to:


	•	a $283,000 increase in building occupancy costs, including utilities, maintenance and insurance resulting from the increase in usable office space, which amounted to 57,625 square feet in fiscal 2003, compared to 27,195 square feet in fiscal 2002; and

	•	increased legal and consulting costs relating to compliance with the Sarbanes-Oxley Act of 2002 and related rules and regulations.

Sales and marketing expenses. Sales and marketing expenses increased to $2.6 million in fiscal 2003, compared to $1.6 million during fiscal 2002. Higher expenses in fiscal 2003 were related to market research and planning and preparation for product launch of Neurodex for the treatment of PBA. Fiscal 2002 expenses included legal, travel and consulting costs related to out-licensing docosanol 10% cream in Europe and the Middle East, establishing business relations in the People’s Republic of China, and additional licensing and other commercial development activities related to marketing our antibody generation services.

Interest income. Interest income decreased to $266,000 in fiscal 2003, compared to $664,000 million in fiscal 2002. The decrease in interest income during fiscal 2003 was primarily due to lower investment balances and lower average interest rates on investments compared with fiscal 2002.

Other Income. Other income for fiscal 2003, consisting of rental income, decreased to $27,000, compared to $130,000 in fiscal 2002. Fiscal 2002 included fees earned under a contract that provided a period of exclusivity in negotiations. AVANIR also received rental income from Healthscan Metabolic Imaging, LLC for sharing an emergency power generator under an equipment lease agreement.

Interest expense. Interest expense decreased to $45,000 in fiscal 2003, compared to $61,000 in fiscal 2002. Lower interest expense for fiscal 2003 was due to lower interest rates on extended payment plans for our

insurance policies and a reduction in the principal amounts due under capital leases initiated in fiscal 2002. Interest expense for fiscal 2002 was primarily related to the addition of $618,000 in new capital equipment lease financing transactions for an emergency power generator and various new pieces of laboratory equipment.

For fiscal 2003, the net loss attributable to common shareholders was $23.3 million, or $0.39 per share, compared to $10.3 million, or $0.18 per share in fiscal 2002.

We expect to continue to pursue our drug development strategy focused on the development of Neurodex, followed by other programs in earlier stages of development that are in large therapeutic areas and that have significant partnering and licensing potential. To help fund and develop our products, we intend to seek licensees and partners to share the costs of development. Some of these potential license arrangements could materially change our outlook for future revenues and costs. However, the timing of such potential arrangements is unpredictable. To reach the stage of partnering or licensing our product candidates or technologies or marketing our own products, we expect to continue to invest primarily in our clinical development programs, which we expect will contribute to a loss for fiscal 2004.

Revenues in fiscal 2002 decreased to $8.9 million, compared to $12.7 million in fiscal 2001. The $3.8 million decrease in revenues for fiscal 2002 resulted primarily from the completion of milestone payments under the license agreement with our licensee, GlaxoSmithKline, in October 2001. Revenues for fiscal 2002 included a final $5.0 million milestone payment upon reaching the one-year anniversary of Abreva® product launch and $3.4 million in royalty revenues on Abreva product sales. Other revenues in fiscal 2002 included $160,000 in federal and state grant revenues, $41,000 in sales of the active ingredient docosanol, and $226,000 in contract and license fees from other areas. Revenues in fiscal 2001 included $10.0 million in milestone payments and $2.5 million in royalty revenues on Abreva product sales. Other fiscal 2001 revenues included $73,000 in government grant revenues, and $70,000 in contract and license fees from other areas.

Operating expenses. Our total operating expenses increased to $19.5 million in fiscal 2002, compared to $13.3 million in fiscal 2001. Operating expenses in fiscal 2002 were higher than fiscal 2001 by $6.2 million. The net increase in operating expenses during fiscal 2002 is described below.

Research and development (R&D) expenses. R&D expenses totaled $13.6 million in fiscal 2002, compared to $8.1 million (including $917,000 in purchased in-process R&D expenses) in fiscal 2001. In fiscal 2002, we spent $3.0 million on clinical development of Neurodex in the treatment of PBA, including a Phase III clinical trial in patients who have Lou Gehrig’s disease. We also spent $1.3 million in R&D related to the treatment of neuropathic pain. We also spent $4.9 million in fiscal 2002 on preclinical research focused on a novel treatment for allergy and asthma, including toxicology studies, scaled-up manufacture of the lead compound, development of second-generation compounds, and other contract research. The balance of R&D activities was primarily related to other preclinical programs addressing inflammation and cholesterol reduction and antibody generation technology.

In fiscal 2001 we spent $2.3 million on Neurodex, including $1.5 million related to the Phase III clinical trial for the potential treatment of PBA in patients with Lou Gehrig’s disease and $800,000 related to the treatment of neuropathic pain. We also spent $1.4 million on preclinical research focused on a novel treatment for allergy and asthma. The balance of R&D activities was primarily related to other preclinical programs addressing inflammation and cholesterol reduction, and antibody generation technology.

General and administrative expenses. Our general and administrative expenses increased to $4.2 million in fiscal 2002, compared to $3.2 million during fiscal 2001. These increased expenses primarily relate to:


	•	increased staff size and higher administrative support costs for most of fiscal 2002 as the Company increased its level of operating activity in drug discovery, clinical development, and business development, and

	•	increased building occupancy costs including utilities, maintenance and insurance.

Sales and marketing expenses. Sales and marketing expenses increased to $1.6 million in fiscal 2002, compared to $1.2 million during fiscal 2001. Fiscal 2002 expenses included legal, travel and consulting costs related to out-licensing docosanol 10% cream in Europe and the Middle East, establishing business relations in the People’s Republic of China, and additional licensing and other commercial development activities related to marketing our antibody generation services. Fiscal 2001 expenses primarily reflected travel, legal and overall business development staff costs necessary to pursue international licensing of docosanol 10% cream.

Interest income. Interest income decreased to $664,000 in fiscal 2002, compared to $1.1 million in fiscal 2001. The decrease in interest income during fiscal 2002 was primarily due to lower investment balances and lower interest rates on investments compared with fiscal 2001.

Other Income. Other income for fiscal 2002 increased to $130,000, compared to $3,000 in fiscal 2001. The increase in other income during fiscal 2002 was primarily due to fees earned under a contract that provided a period of exclusivity in negotiations. AVANIR also received rental income from Healthscan Metabolic Imaging, LLC for sharing an emergency power generator under an equipment lease agreement.

Interest expense. Interest expense increased to $61,000 in fiscal 2002, compared to $7,000 in fiscal 2001. Increased interest expense for fiscal 2002 was primarily related to the addition of $618,000 in new capital equipment lease financing transactions for an emergency power generator and various new pieces of laboratory equipment.

For fiscal 2002, the net loss attributable to common shareholders was $10.3 million, or $0.18 per share, compared to $190,000 in net income attributable to common shareholders in fiscal 2001, or approximately breakeven on a per share basis.

As of September 30, 2003, we had cash, cash equivalents and investments in securities totaling $17.5 million, including cash and cash equivalents of $12.2 million, and a net working capital balance of $10.6 million. As of September 30, 2002, we had cash, cash equivalents and investments in securities of $13.2 million, including cash and cash equivalents of $8.6 million, and a net working capital balance of $5.9 million. Explanations of the changes in net cash provided by or used for operating, investing and financing activities are provided below.

Note 6, “Commitments and Contingencies,” of the financial statements filed with this report describes the Company’s material commitments for leasing obligations and is incorporated herein by reference. We anticipate being able to satisfy the obligations described in Note 6 out of cash, cash equivalents and investments in securities held by the Company as of September 30, 2003 and proceeds from the sale of Class A Common Stock in December 2003.

Operating activities. Net cash provided by operating activities in fiscal 2003 amounted to $1.1 million, compared to net cash used for operating activities of $6.9 million during fiscal 2002. On December 24, 2002, we sold to Drug Royalty USA an undivided interest in our Abreva® license agreement with GlaxoSmithKline and received $24.1 million. The net cash provided by operating activities in fiscal 2003 reflects the $24.1 million in total cash received from Drug Royalty USA (See Note 5, “Asset Sale” in the accompanying notes to the financial statements) and a royalty payment of $876,000 from GlaxoSmithKline that contributed substantially to the $827,000 reduction in receivables, partially offset by the $23.2 million net loss for the fiscal year and an $846,000 increase in prepaid expenses and other assets. Operating activities increased substantially in fiscal 2003, as we were engaged in four clinical trials and studies, compared with only one in the prior year. Prepaid expenses and other assets increased by $846,000 during the year, reflecting a number of payments that were made “up-front” on signing several contracts to engage in clinical trials and other services. Net cash used for operating activities for fiscal 2002 is attributable primarily to a $10.2 million net loss, partially offset by a $2.0 million increase in accounts payable, a $979,000 increase in accrued expenses and $603,000 in depreciation and amortization.

Investing activities. Net cash used for investing activities during the fiscal 2003 amounted to $6.9 million, including capital expenditures related to purchases of capital equipment and leasehold improvements totaling $5.5 million, patent costs of $616,000, and investments in securities totaling $3.7 million, partially offset by sales and maturities of investments totaling $3.0 million. The leasehold improvements were related to completion of construction of laboratory and office space at our three leased buildings in San Diego. Net cash used for investing activities during fiscal 2002 amounted to $1.2 million, including $9.0 million in investments in securities, $1.4 million in purchases of property and equipment and $538,000 in patent costs, partially offset by $9.7 million in proceeds from sales and maturities of investments in securities.

In May 2003, we completed construction on approximately 30,400 square feet of existing leased laboratory and office space, located at 11404 and 11408 Sorrento Valley Road, San Diego, California. The facilities at 11404 and 11408 Sorrento Valley Road are subject to a lease between the Company and Sorrento Plaza, a California limited partnership, effective May 20, 2002. Leasehold improvements to the Sorrento Plaza facilities were necessary before we could take occupancy. The Company also made leasehold improvements to laboratory and office space at 11388 Sorrento Valley Road to accommodate the relocation of several departments. The expenditures at all three facilities are intended to accommodate current as well as potential future expanded business operations. (See Note 3, “Balance Sheet Details — Property and Equipment.”) As of December 11, 2003, the Company had 57,582 square feet of usable laboratory and office space and 63 employees, with the capacity to accommodate up to 100 employees.

Financing activities. Net cash provided by financing activities amounted to $9.3 million during fiscal 2003, compared to $222,000 in cash provided by financing activities for the same period a year ago. Financing activities in fiscal 2003 included $9.4 million in net proceeds from a private placement in common stock, after taking into effect $644,000 in costs related to the transaction. (See Note 7, “Shareholders’ Equity.”) Financing activities during fiscal 2002 reflected $261,000 in proceeds from issuances of common stock and

We believe that cash, cash equivalents, short and long-term investments in securities and restricted investments totaling $17.5 million as of September 30, 2003, together with the sale of Class A Common Stock that raised an additional $8.0 million in December 2003 before the costs of the financing (See Note 7, “Shareholders’ Equity — Common Stock”), plus anticipated future payments and revenues, should be sufficient to sustain our planned level of operations for at least the next twelve months. Additionally, to continue to enhance our capital base and liquidity and to continue to fund the development of our drug candidates and technology platforms, we expect to continue to pursue various alternatives for raising additional funds during the next twelve months, including partnering arrangements, issuance of debt or equity securities, and licensing or sales of any of our platform technologies or new drug candidates.

See Note 2, “Summary of Significant Accounting Policies — Recent Accounting Pronouncements” in the accompanying financial statements for a discussion of recent accounting pronouncements and their effect, if any, on the Company.

As described below, we are exposed to market risk related to changes in interest rates. Because substantially all our revenue, expenses, and capital purchasing activities are transacted in U.S. dollars, our exposure to foreign currency exchange rates is immaterial. However, in the future we could face increasing exposure to foreign currency exchange rates as we expand international distribution of docosanol 10% cream and purchase additional services from outside the U.S. Until such time as we are faced with material amounts of foreign currency exchange rate risks, we do not plan to use derivative financial instruments, which can be used to hedge such risks. We will evaluate the use of derivative financial instruments to hedge our exposures as the needs and risks should arise.

Our investment portfolio consists primarily of fixed income instruments with an average duration of 2.0 years as of September 30, 2003 (2.3 years as of September 30, 2002). The primary objective of our investments in debt securities is to preserve principal while achieving attractive yields, without significantly increasing risk. We classify our investments as of September 30, 2003 as available-for-sale. These available-for-sale securities are subject to interest rate risk. In general, we would expect that the volatility of this portfolio would decrease as its duration decreases.

The Company’s Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of the Company’s “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15(d)-15(e)), as of the end of the period covered by this report. Based on that evaluation, these officers have concluded that the Company’s disclosure controls and procedures were adequate and designed to ensure that material information relating to the Company and the Company’s consolidated subsidiary would be made known to them by others within those entities.

The information relating to our directors that are required by this item is incorporated by reference from the information under the caption “Election of Directors” contained in our definitive proxy statement (the “Proxy Statement”), which will be filed with the Securities and Exchange Commission in connection our Annual Meeting of Shareholders to be held on March 18, 2004.

The names of our executive officers and their ages as of December 11, 2003 are set forth below. The officers are elected annually by the Board of Directors and hold office until their respective successors are qualified and appointed or until their resignation, removal or disqualification.

Gerald J. Yakatan, Ph.D. Dr. Yakatan has served as President and Chief Executive Officer since March 1998 and as Vice President of Drug Development from July 1995 to February 1998. He also has served as a director of the Company since February 1998. Dr. Yakatan has extensive executive management experience in the pharmaceutical industry. In 1996, he founded IriSys Research & Development, LLC, a privately held company (“IriSys”) where he served as President and Chief Executive Officer until joining AVANIR. He still serves as Chairman of IriSys. Dr. Yakatan also founded Tanabe Research Laboratories, USA, Inc., in 1990 and served as President and Chief Executive Officer until 1995. Earlier in his career, Dr. Yakatan held various executive positions over a seven-year period at Warner-Lambert Co./ Parke-Davis, including Vice President of worldwide product development, and as a member of the Parke-Davis pharmaceutical research management team and the Executive Committee where he had significant exposure to all stages of R&D and the sales and marketing processes. Prior to joining Warner-Lambert/ Parke-Davis, Dr. Yakatan was a tenured faculty member of the University of Texas at the Austin College of Pharmacy where he was Chair of the Department of Pharmaceutics and Assistant Director of the Drug Dynamics Institute. He is a Fellow of the American Association of Pharmaceutical Scientists and the American College of Clinical Pharmacology. Dr. Yakatan received his B.S. in Pharmacy in 1963 and M.S. in Pharmaceutical Chemistry in 1965 from Temple University. In 1971, Dr. Yakatan received his Ph.D. in Pharmaceutical Sciences from the University of Florida.

James E. Berg. Mr. Berg has served as Vice President, Clinical and Regulatory Affairs, since March 1997. Mr. Berg led the team responsible for the clinical trials program for docosanol 10% cream and had the responsibility for working with the FDA and other regulatory agencies that led to the approvals of the product in the U.S., Canada and Sweden. From August 1992 to March 1997, Mr. Berg was Director of Clinical Affairs and Product Development at the Company. Earlier in his career, Mr. Berg held various sales and management positions at QUIDEL Corporation, San Diego, California, and at Krupp Bilstein Corporation of America, Inc., San Diego, California. Mr. Berg received his B.A. degree from the University of Wisconsin in 1973.

R. Martin Emanuele, Ph.D. Dr. Emanuele has served as Vice President, Licensing and Business Development, since August 2002. Dr. Emanuel is responsible for AVANIR’s partnering, licensing and related business development activities. From May 1988 to July 2002, Dr. Emanuele was employed by CytRx Corporation, where he held a number of R&D and business development positions and attained the position of Vice President of Research and Business Development. Prior to CytRx, Dr. Emanuele was a clinical research scientist with Dupont Critical Care. Dr. Emanuele holds a B.S. from Colorado State University, an M.S. from Northern Illinois University, and a Ph.D. in Pharmacology & Experimental Therapeutics from Loyola University of Chicago.

Gus Fernandez, Pharm.D. Dr. Fernandez has served as Vice President, Commercial Development since March 2003. In this capacity, Dr. Fernandez is responsible for the commercial development activities for the Company’s pipeline of products, which includes comprehensive pre-launch planning activities for Neurodex. From March 2002 to March 2003, he was Executive Director, Commercial Development where he was responsible for business development and licensing activities and from November 2002 to February 2002, he was Director, Commercial Development, where he worked in the same capacity. Prior to joining the Company, Dr. Fernandez held several senior management level positions at Dura Pharmaceuticals, San Diego, California, including Senior Manager, Medical Affairs, Director of Product Management, Regional Director of Sales and Director, Sales Operations. Prior to joining Dura Pharmaceuticals, he held a number of sales and marketing positions at Eli Lilly and Company, Indianapolis, Indiana. Dr. Fernandez graduated from the University of the Pacific with a Pharm.D. in pharmacy, where he graduated cum laude. He also has an M.B.A. degree from Webster University, San Diego, California.

Gregory P. Hanson, CMA. Mr. Hanson has served as Vice President, Finance and Chief Financial Officer (CFO) and Corporate Secretary since July 1998. Mr. Hanson also serves as the Corporate Compliance Officer. From September 1995 to July 1998, he was the Chief Financial Officer of XXsys Technologies Inc., a composite materials technology company; and from May 1993 to September 1995, he held a number of financial positions within The Titan Corporation, a diversified telecommunications and information technology company, including acting CFO and acting Controller for its subsidiary, Titan Information Systems. Earlier in his career, Mr. Hanson held various management positions at Ford Motor Company over a 14-year span and at Solar Turbines Incorporated, a subsidiary of Caterpillar Inc., over a three-year span. Mr. Hanson has a B.S. degree in Mechanical Engineering from Kansas State University and an M.B.A. degree with honors from the University of Michigan. He is a Certified Management Accountant and has passed the examination for Certified Public Accountants.

J. David Hansen. Mr. Hansen has served as Senior Vice President, Corporate Development, responsible for business development, licensing and product commercialization since March 2003. Mr. Hansen joined the Company in September 1998 as Vice President of Sales and Marketing. In addition, he became President of the Company’s subsidiary, Xenerex Biosciences, in March 2001. Prior to joining the Company, Mr. Hansen held various management positions at Dura Pharmaceuticals, San Diego, California, from December 1989 to September 1998, including Senior Director, Strategic Sales Systems; National Sales Director, Director of Business Development and Director of Marketing. Earlier in his career, he held various management positions at Immunetech Pharmaceuticals, San Diego, California; Schering/ Key Pharmaceuticals, Kennilworth, New Jersey; and E.R. Squibb & Sons, Princeton, New York. Mr. Hansen graduated with honors from the University of Oregon, with a B.S. degree in Chemistry in June 1974.

Jagadish Sircar, Ph.D. Dr. Sircar has served as our Vice President, Drug Discovery since November 2002. From November 1995 to March 2000, he held the position of Director of Chemistry at AVANIR and from April 2000 to November 2002 he was Executive Director, Drug Discovery of the Company. Before joining the Company, Dr. Sircar held the position of Senior Vice President, Research and Discovery for Biofor, Inc. from January 1992 to November 1995. From 1969 to 1991, Dr. Sircar was employed by Warner-Lambert/ Parke-Davis in its Research Division (currently Pfizer), where he attained the position of Associate Research Fellow and Chairman of the Immunoinflammatory Project Team. During his tenure at Warner-Lambert/ Parke-Davis, he was responsible for the discovery and preclinical development of six compounds. Dr. Sircar holds a Ph.D. in Organic Chemistry, an M.S. in Pure Chemistry and a B.S. (Honors) in Chemistry,

Victoria Smith. Ms. Smith has served as Vice President, Administration since March 2003. From March 2001 to March 2003, she held the position of Executive Director, Administration and from June 1998 to March 2001 she held the position of Director, Administrative Affairs. Prior to joining the Company, Ms. Smith held various management positions for Tanabe Research Laboratories, USA, Inc., San Diego, California, from 1990 to 1996, including Director, Administrative Affairs; Manager, R&D, Administration, and Human Resources. In June 1995 she completed the Leadership Education Awareness Development (LEAD) program in San Diego, California. Ms. Smith graduated from San Diego State University with a B.A. degree in Speech Communication in 1982 and from the University of Phoenix with a M.A. degree in Organizational Management in August 1992.

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

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

The information required by this item is incorporated by reference to the information under the caption “Certain Relationships and Related Transactions” contained in the proxy statement.

The information required by this item is incorporated by reference to the information under the caption “Fees for Independent Auditors” contained in the proxy statement.

On July 25, 2003, AVANIR filed a current report on Form 8-K under Items 5 and 7 regarding the closing of a private placement of the registrant’s Class A common stock.

On August 12, 2003, AVANIR filed a current report on Form 8-K under Items 7 and 12 furnishing a press release announcing the registrant’s results of operations for the three and nine months ended June 30, 2003.


	(1)	Incorporated by reference to the similarly described exhibit included with the Registrant’s Amendment No. 4 to the Registration Statement on Form S-1, File No. 33-32742, declared effective by the Commission on April 13, 1994.

	(2)	Incorporated by reference to the similarly described exhibit included with the Registrant’s Registration Statement on Form S-1, File No. 33-32742, declared effective by the Commission on May 8, 1990.

	(3)	Incorporated by reference to the similarly described exhibit included with the Registrant’s Current Report on Form 8-K, filed March 11, 1999.

	(4)	Incorporated by reference to the similarly described exhibit included with the Registrant’s Current Report on Form 8-K, filed April 1, 1999.

	(5)	Incorporated by reference to the similarly described exhibit included with the Registrant’s Current Report on Form 8-K, filed April 20, 1999.

	(6)	Incorporated by reference to the similarly described exhibit included with the Registrant’s Current Report on Form 8-K, filed December 3, 1999.

	(7)	Incorporated by reference to the similarly described exhibit included with the Registrant’s Current Report on Form 8-K, filed February 4, 2000.

	(8)	Incorporated by reference to the similarly described exhibit included with the Registrant’s Current Report on Form 8-K, filed May 4, 2000.

	(9)	Incorporated by reference to the similarly described exhibit included with the Registrant’s Quarterly Report on Form 10-Q, filed August 14, 2000.


(10)	Incorporated by reference to the similarly described exhibit included with the Registrant’s Annual Report on Form 10-K, filed December 21, 2001.

(11)	Incorporated by reference to the similarly described exhibit included with the Registrant’s Quarterly Report on Form 10-Q, filed August 13, 2002.

(12)	Incorporated by reference to the similarly described exhibit included with the Registrant’s Quarterly Report on Form 10-Q, filed May 13, 2003.

(13)	Incorporated by reference to the similarly described exhibit included with the Registrant’s Registration on From S-3, File No. 333-107820, declared effective by the Commission on August 19, 2003.

(14)	Incorporated by reference to the similarly described exhibit included with the Registrant’s Current Report on Form 8-K, filed December 11, 2003.

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


	By:	/s/ GERALD J. YAKATAN, PH.D.



	Gerald J. Yakatan, Ph.D.
	President and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.

We have audited the accompanying consolidated balance sheets of AVANIR Pharmaceuticals and subsidiary as of September 30, 2003 and 2002, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period ended September 30, 2003. 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 of America. 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, such consolidated financial statements present fairly, in all material respects, the financial position of AVANIR Pharmaceuticals and subsidiary as of September 30, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 2003, in conformity with accounting principles generally accepted in the United States of America.

AVANIR Pharmaceuticals (“AVANIR,” “we,” or the “Company”) is engaged in research, development, commercialization and licensing of innovative pharmaceutical products and in providing antibody generation services. AVANIR’s first product, Abreva® (chemical name is docosanol 10% cream), is the number one selling cold sore medication in the U.S. over-the-counter (OTC) market and the only OTC product in the cold sore category approved by the U.S. Food and Drug Administration (FDA). AVANIR is engaged in various stages of discussions and negotiations for licensing docosanol 10% cream to companies in various other countries and in obtaining regulatory approvals in those countries for marketing of the product. The Company is also engaged in research and development of several drugs in various phases of clinical and preclinical development. Through its wholly-owned subsidiary, Xenerex Biosciences, the Company develops and commercializes completely human antibody products for partner companies through research collaborations with those companies and for AVANIR.

AVANIR is subject to various risks and uncertainties frequently encountered by companies in the early stages of operations, particularly in the evolving market for small biotech and specialty pharmaceuticals companies. Such risks and uncertainties include, but are not limited to, timing and uncertainty of achieving milestones in clinical trials and in obtaining approvals by the FDA and regulatory agencies in other countries.

AVANIR’s ability to generate revenues in the future will depend substantially on the timing and success of filing and obtaining regulatory approvals and finding licensees for products for the rest of the world. AVANIR expects that its next product, Neurodex, for the treatment of pseudobulbar affect (PBA), will be available for sale in 2005, assuming the remaining clinical trials and other studies are successful and the FDA approves the drug for marketing. The Company’s operating expenses depend substantially on the level of expenditures for research and development programs and the rate of progress being made on such programs.

The consolidated financial statements include the accounts of AVANIR Pharmaceuticals and its subsidiary, Xenerex Biosciences. All significant intercompany accounts and transactions have been eliminated. Certain amounts from prior years have been reclassified to conform to the current year presentation.

The Company’s fiscal year ends on September 30 of each year. The years ended September 30, 2003, 2002, and 2001 may be referred to as fiscal 2003, fiscal 2002, and fiscal 2001, respectively.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Cash and cash equivalents consist of highly liquid investments with original maturities of three months or less at the date of acquisition. Substantially all cash and cash equivalents are under the custodianship of two major financial institutions.

Restricted investments in securities amounting to $856,597 as of both September 30, 2003 and 2002 represent amounts pledged to our bank as collateral for letters of credit issued in connection with our real estate lease agreements.

Investments (Note 4, “Investments”) are comprised of marketable securities consisting primarily of certificates of deposit, U.S. state and municipal government obligations, corporate bonds, and an investment in a mutual fund that invests primarily in asset-backed and mortgage-backed securities. All marketable securities are held in the Company’s name and primarily under the custodianship of two major financial institutions. The Company’s policy is to protect the value of its investment portfolio and minimize principal risk by earning returns based on current interest rates. Short-term investments are marketable securities with maturities of less than one year from the balance sheet date. The Company’s marketable securities are classified either as available-for-sale or held-to-maturity. The Company has no securities classified as trading. The marketable securities classified as held-to-maturity are carried at amortized cost and the marketable securities classified as available-for-sale are carried at fair market value. Unrealized gains or losses related to marketable securities classified as available-for-sale are included as part of shareholders’ equity, as “accumulated other comprehensive income (loss).”

Statement of Financial Accounting Standards No. 115 (SFAS 115), “Accounting for Certain Investments in Debt and Equity Securities,” requires companies to determine whether a decline in fair value below the amortized cost basis is other than temporary. If a decline in fair value is determined to be other than temporary, SFAS 115 requires the carrying value of the debt or equity security to be written down to its fair value. The Company does not have any investments that are impaired.

Carrying amounts of the Company’s financial instruments, including cash and cash equivalents, approximate fair value because of their short maturities. The fair values of investments are determined using quoted market prices for those securities or similar financial instruments.

Inventory is stated at the lower of cost (first-in, first-out) or market. Inventory consists of the raw material docosanol, which is the active ingredient in docosanol 10% cream. Docosanol in its present form as stored by the Company has a substantial shelf life, a relatively stable value and long-term use, and carries a low risk of becoming excess inventory or obsolete. AVANIR does not own or store any docosanol 10% cream in its finished product form. The Company and one of its licensees receive raw materials from a single supplier. AVANIR also supplies several other licensees with raw materials from the same supplier. The inability of this sole supplier to fulfill supply requirements of the Company or its licensees could materially impact future operating results.

Substantially all of AVANIR’s cash and cash equivalents are maintained with two major financial institutions in the United States. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and, therefore, bear minimal risk.

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of marketable securities and interest rate instruments. The counterparties to the Company’s investment securities and interest rate instruments are various major corporations and financial institutions of high credit standing. The Company does not believe there is significant risk of non-performance by these counterparties because the Company limits the amount of credit exposure to any one financial institution and any one type of investment.

The Company’s income from fiscal 2000 to 2002 was substantially from its license agreement with GlaxoSmithKline. The Company performs ongoing credit evaluations of its customers’ financial conditions and would limit the amount of credit extended if deemed necessary but usually requires no collateral.

The Company’s policy regarding long-lived assets is to review such long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If the review indicates that long-lived assets are not recoverable (i.e. the carrying amount is less than the future projected undiscounted cash flows), their carrying amount would be reduced to fair value. The Company carries no goodwill on its books at either September 30, 2003 or 2002. Further, during fiscal 2003 and 2002, the Company had no material impairments to property and equipment or intangible assets, which consist primarily of patents and trademarks.

We capitalize legal costs incurred in connection with patent applications, trademark applications and license agreements. We amortize costs of approved patents and license agreements over their useful lives, or terms of the agreements, whichever ones are shorter. For patent and trademark applications that we abandon, we charge the remaining unamortized accumulated costs to expense.

As of September 30, 2002, the Company had an obligation to redeem outstanding shares of Series D redeemable convertible preferred stock at the option of the holder. Therefore, the preferred stock has been classified separately from shareholders’ equity.

Performance-based license fees. We recognize revenues from license fees when the performance requirements have been met, the fee is fixed or determinable, and collection of fees is probable. We defer revenues and recognize them ratably over the life of the agreement when we have continuing obligations to perform under the agreement.

Royalty revenues. We recognize royalty revenues from our licensed products when earned. Net sales figures used for calculating royalties due the Company can often include deductions for costs of unsaleable returns, managed care charge-backs, cash discounts, freight and warehousing, and miscellaneous write-offs, which may vary over the course of the license agreement. Sales of Abreva®, if publicly reported by our licensee, GlaxoSmithKline, could differ from net sales used for calculating royalties and in determining the royalties earned in accordance with the license agreement. In agreements where we have sold our rights to future royalties under license agreements and we maintain continuing involvement in earning such royalties, we defer revenues and recognize them ratably over the life of the license agreement.

Revenue arrangements with multiple deliverables. In certain circumstances, we enter into revenue arrangements whereby we are obligated to deliver to the customer multiple products and/or services (multiple deliverables). Such arrangements could include antibody generation services agreements and other forms of research collaborations. In these transactions, we allocate the total revenue to be earned under the arrangement among the various elements based on their relative fair value. In the case of antibody generation services, the allocation is based on objective, customer-specific evidence of fair value. We recognize revenue related to the delivered products or services only if: (i) the above performance or service criteria are met; (ii) any undelivered products or services are not essential to the functionality of the delivered products or services; (iii) payment for the delivered products or services is not contingent upon delivery of the remaining products or services; (iv) we have an enforceable claim to receive the amount due in the event we do not deliver the undelivered products or services; and (v) as discussed above, there is evidence of the fair value for each of the undelivered products or services.

Government research grant revenues. We recognize revenues from government research grants during the period in which the related expenditures are incurred.

Property and equipment, net, is stated at cost less accumulated depreciation and amortization. Depreciation and amortization is computed using the straight-line method over the estimated useful life of the asset or the life of the project, whichever is less, if the equipment has been purchased for a particular use. Estimated useful lives of three to five years are used on computer equipment and related software. Office equipment, furniture and fixtures are depreciated over five years. Amortization of leasehold improvements is computed using the shorter of the remaining lease term or eight years.

We self-insure for portions of our insurance policies based on usual and customary deductibles offered by the insurance carriers, or other factors, such as historical loss experience, projected risk exposure, cost of insurance, and AVANIR’s ability to absorb potential losses that could arise based on the amounts of the deductibles.

Costs related to drug discovery and clinical development are charged to research and development expense as they are incurred.

In fiscal 2001, we charged $917,097 to in-process research and development expense, representing the cost of in-process technologies that we acquired from the Ciblex Corporation in fiscal 2001 that could assist us in discovering a drug capable of regulating macrophage migration inhibitory factor, a protein thought to play a central role in the early stages of development of several inflammatory diseases (MIF inhibitor technology). Included in the acquisition are all right, title and interest in and to the MIF inhibitor technology, including a provisional patent application, as well as any patent which may be issued upon AVANIR’s filing of a patent application regarding the use of certain compounds provided by Ciblex or similar compounds, in the treatment of autoimmune and inflammatory diseases. AVANIR also received as part of the application all preclinical data related to compounds provided by Ciblex, and all technology and know-how relating to the foregoing, including laboratory data and previous experimental results. In return for receiving the rights to develop the MIF inhibitor technology, AVANIR paid $50,000 in cash and issued 170,353 shares of the Company’s Class A common stock valued at $867,097, for a combined value of $917,097 in cash and common stock. If AVANIR achieves certain milestones in developing a product from the MIF inhibitor technology, then Ciblex would be entitled to certain payments upon reaching those milestones, and royalties on sales if the product is approved for marketing. We will recognize the expenses related to the achievement of the milestones if and when they are achieved.

AVANIR incurred certain costs related to the product launch phase for Abreva that were expensed in fiscal 2001. Our obligation to share product launch expenses with GlaxoSmithKline ceased after June 30, 2001.

We compute basic income (loss) per common share by dividing the net income and net loss attributable to common shareholders by the weighted average number of common shares outstanding during the period (“Basic EPS Method”). We compute diluted income (loss) per common share by dividing the net income and net loss attributable to common shareholders by the weighted-average number of common and dilutive

common equivalent shares outstanding during the period (“Diluted EPS Method”). Dilutive common equivalent shares consist of shares issuable upon exercise of stock options and warrants and conversion of preferred stock. In the accompanying consolidated statements of operations, we have presented our net income and net loss per share for fiscal 2003, 2002 and 2001 using both the Basic EPS Method and the Diluted EPS Method.

The following table is a reconciliation from the basic to the diluted EPS computations for fiscal 2003, 2002 and 2001:


(1)	For fiscal 2003, 2002, and 2001, options to purchase 5,308,604, 5,739,306, and 66,500 shares of common stock, respectively, were excluded from the computation of diluted net income (loss) per share as the inclusion of such shares would be antidilutive.

(2)	For fiscal 2003 and 2002, warrants to purchase 2,289,900 and 1,084,550 shares of common stock, respectively, were excluded from the computation of diluted net loss per share as the inclusion of such shares would be antidilutive.

(3)	For fiscal 2002, preferred stock that was convertible into 520,648 shares of common stock was excluded from the computation of diluted net loss per share as the inclusion of such shares would be antidilutive.

In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 148 (“SFAS No. 148”), “Accounting for Stock-based Compensation — Transition and Disclosure, an Amendment of FASB Statement No. 123.” SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial reports about the method of accounting for stock-based compensation and the effect of the method used on reported results. SFAS No. 123, as amended, encourages, but does not require, companies to record compensation cost for stock-based employee compensation at fair value. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations for all periods presented. Accordingly, compensation costs for stock options is measured as the excess, if any, of the fair value of the Company’s stock at the date of the grant over the amount an employee must pay to acquire the stock.

The following table summarizes the impact on the Company’s net income or loss had compensation costs been determined based upon the fair value at the grant date for awards under the stock option plans consistent with the methodology prescribed under SFAS No. 123.

We estimate the weighted average fair values per share of the options granted during fiscal 2003, 2002 and 2001 to be $0.96, $2.49 and $3.99, respectively, using the Black-Scholes option-pricing model and the following assumptions:

In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which addresses financial accounting and reporting for costs associated with exit or disposal activities and supersedes EITF Issue 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” 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 Issue 94-3, a liability for an exit cost as defined in EITF 94-3 was recognized at the date of an entity’s commitment to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. SFAS No. 146 became effective for the Company on January 1, 2003. The application of SFAS No. 146 did not have a material impact on the Company’s financial statements.

In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” which elaborates on the disclosures to be made by a guarantor about its obligation under certain guarantees issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The Interpretation expands on the accounting guidance of SFAS No. 5, “Accounting for Contingencies,” SFAS No. 57, “Related Party Disclosures,” and SFAS No. 107, “Disclosures about Fair Value of Financial Instruments.” It also incorporates without change the provisions of FASB Interpretation No. 34, “Disclosure of Indirect Guarantees of Indebtedness of Others.” FASB Interpretation No. 45 became effective for the Company on January 1, 2003. The application of FASB Interpretation No. 45 did not have a material impact on the Company’s financial statements.

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 provides alternative methods of transition for a voluntary change to the fair value-based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based compensation and the effect of the method used on reported results. The voluntary transition and amended disclosure requirements are effective for the Company for the fiscal year ended September 30, 2003. The interim reporting requirements became effective for the Company’s interim periods beginning January 1, 2003. The Company currently accounts for stock-based employee compensation under the intrinsic value method in accordance with APB No. 25. The Company does not plan to voluntarily change its method of accounting, but has implemented the amended disclosure requirements for the fiscal year ended September 30, 2003.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires the consolidation of certain variable interest entities by the primary beneficiary of the entity if the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties or if the equity investors lack the characteristics of a controlling financial interest. FIN 46 is effective for variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 were initially to have been applied in the first interim or annual period beginning after June 15, 2003. The FASB postponed implementation of FIN 46 in October 2003 and again in December 2003. Currently, the Company must apply the provisions of FIN 46 effective March 31, 2004. The effect, if any, of FIN 46 on the Company’s financial statements has not yet been determined.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). SFAS No. 150 is effective for financial instruments entered into or modified after May 15, 2003, and otherwise became effective for the Company on July 1, 2003. The adoption of SFAS No. 150 did not have a material impact on the Company’s financial statements.

Property and Equipment. During fiscal 2003, the Company completed construction on approximately 30,400 square feet of laboratory and office space, located at 11404 and 11408 Sorrento Valley Road, San Diego, CA. At the time of completion of construction, $4.1 million that was classified as construction in progress was reclassified as leasehold improvements. Property and equipment as of September 30, 2003 and September 30, 2002 consist of the following:

Intangible Assets. Effective October 1, 2002, the Company adopted SFAS No. 142, “Goodwill and Other Intangible Assets,” which requires goodwill and other intangible assets that have indefinite useful lives to no longer be amortized; however, these assets must be reviewed at least annually for impairment. Intangible assets with indefinite useful lives consist of costs of trademarks for AVANIR and Xenerex and similar names intended for use or potential use in the United States and the rest of the world. Intangible assets with finite lives continue to be amortized over their useful lives for the fiscal year ended September 30, 2003, and are evaluated for impairment whenever events or changes in circumstances indicate that their carrying value may not be recoverable under SFAS No. 144, “Accounting for Impairment or Disposal of Long-lived Assets.” AVANIR’s amortizable intangible assets consist of the costs of patents, patent applications, and licenses.

Intangible assets, consisting of both intangible assets with finite and indefinite useful lives, are as follows:

Amortization expense related to amortizable intangible assets was $69,405, $53,413, and $47,663 for fiscal years 2003, 2002 and 2001, respectively. During fiscal 2003, there were additions of $23,781 and an abandonment of $74,432 in intangible assets with indefinite useful lives. Based solely on the amortizable intangible assets as of September 30, 2003, the estimated annual amortization expense of intangible assets for the fiscal years ending September 30 is as shown in the following table. Actual amortization expense to be reported in future periods could differ from these estimates as a result of acquisitions, divestitures, asset impairments, and other relevant factors.

The following tables summarize the Company’s investments in securities, which are available for sale. Available-for-sale securities are those investments not intended for sale in the near term or held to maturity. The available-for-sale investments are carried at fair value with unrealized gains or losses reported in shareholders’ equity as accumulated other comprehensive income or loss. Investments classified as held-to-maturity are recorded at amortized cost.


(1)	Gross unrealized gains of $15,575 and gross unrealized losses of $22,123 on government securities, the adjustable rate mutual fund, and certificates of deposit represent an accumulated net unrealized loss of $6,548, which is reported as “accumulated other comprehensive loss” on the consolidated balance sheet as of September 30, 2003.

(2)	Represents an investment in a mutual fund that invests primarily in adjustable rate mortgage-backed securities.

(3)	Restricted investments amounting to $856,597 as of both September 30, 2003 and September 30, 2002 represent amounts pledged to our bank as collateral for letters of credit issued in connection with our leases of office and laboratory space.

(4)	Gross unrealized gains of $13,607 and gross unrealized losses of $12,900 on government securities and certificates of deposit represent an accumulated net unrealized gain of $707, which is reported as “accumulated other comprehensive income” on the consolidated balance sheet as of September 30, 2002.

On December 24, 2002, AVANIR sold an undivided interest in its Abreva® license agreement with SB Pharmco Puerto Rico, Inc. (“SB” or “GlaxoSmithKline”) to Drug Royalty USA, Inc. (“Drug Royalty USA”). Under the terms of the Drug Royalty USA agreement, Drug Royalty USA acquired the rights to all royalties accruing after September 30, 2002 from the sale of Abreva for cold sores in the United States and Canada payable under the Abreva license agreement, subject to AVANIR’s right to receive 50% of all such royalties payable on sales of Abreva over $62 million per year. Drug Royalty USA paid AVANIR $20.5 million at the closing and an additional $3.6 million in April 2003 upon AVANIR’s receipt from the United States Patent and Trademark Office of a grant of patent term extension for U.S. Patent Number 4,874,794. In connection with the sale, AVANIR and Drug Royalty USA entered into a security agreement pursuant to which AVANIR granted Drug Royalty USA a security interest in AVANIR’s United States and Canadian patents related to the treatment of cold sores.

AVANIR retains all rights to develop and license docosanol 10% cream (or Abreva, as marketed by SB’s parent, GlaxoSmithKline) outside the United States and Canada for the treatment of cold sores. AVANIR also retains all rights to develop and license docosanol 10% cream worldwide for all other indications, subject to certain rights of SB in the United States and Canada.

In recording the sale transaction in December 2002, AVANIR increased cash by $20.4 million (net of transaction costs), reduced accrued expenses by $301,000 in connection with the forgiveness of a related advance, and recorded deferred revenue in the amount of $20.7 million. We recorded the initial net proceeds of the transaction as deferred revenue because of our ongoing involvement in earning future revenues under our license agreement with SB. We also classified the additional $3.6 million received in April 2003 as deferred revenue, to be recognized ratably over the life of the license agreement.

The expiration date for U.S. Patent Number 4,874,794 has been extended from April 2009 to April 2014. The effect of extending the expiration of the patent from 2009 to 2014 is that it has extended the term of the patent royalty and the accounting period over which the deferred revenue relating to the patent royalty will be recognized as revenue. Thus, less deferred revenue has been recognized as revenue during the fiscal quarters ended June 30 and September 30, 2003 than the fiscal quarter ended March 31, 2003. Deferred revenues recognized as revenue for fiscal 2003 were $1.8 million. Abreva® royalties earned for fiscal 2002 were $3.4 million.

Revenue recognition is being determined under the units-of-revenue method. Under this method, the amount of deferred revenue to be recognized as revenue in each period is calculated by multiplying (i) the ratio of the royalty payments due to Drug Royalty USA for the period to the total remaining royalties that we

expect SB will pay Drug Royalty USA over the term of the agreement, by (ii) the unamortized deferred revenue amount. The portion of deferred revenue classified as part of current liabilities represents the amount AVANIR expects to realize as revenue within the next 12 months.

The following table sets forth the deferred revenue recorded from the sale to Drug Royalty USA of rights to future Abreva royalties and other deferred revenue balances as of September 30, 2003 and September 30, 2002.

Operating lease commitments. On March 20, 2000, the Company signed an eight-year lease for 27,047 square feet of office and lab space in a building located at 11388 Sorrento Valley Road, Suite 200, San Diego, California, commencing on September 1, 2000. On February 1, 2001, the Company signed an amendment to the lease for an additional 165 square feet of office and lab space. The lease has scheduled rent increases each year and expires on August 31, 2008. As of September 30, 2003, the financial commitment for the remainder of the term of the lease is $3,920,497. We delivered an irrevocable standby letter of credit to the lessor in the amount of $388,122, to secure our performance under the lease.

On May 20, 2002, we signed a ten-year lease for approximately 26,770 square feet of office and lab space in buildings adjacent to our existing facilities, commencing on January 15, 2003. On April 2, 2003, we signed an amendment to the lease for an additional 3,600 square feet of storage space in the building located at 11408 Sorrento Valley Road. The storage space is capable of being converted into either office or lab space, if needed in the future. The lease has scheduled rent increases each year and expires on January 14, 2013. As of September 30, 2003, the financial commitment for the remainder of the term of the lease is $9,832,756. We delivered an irrevocable standby letter of credit to the lessor in the amount of $468,475, to secure our performance under the lease.

Lease expenses for fiscal 2003, 2002 and 2001 were $1,724,403, $818,557 and $754,785, respectively. We have included $400,204 and $154,911 of deferred rent in accrued expenses and other liabilities as of September 30, 2003 and 2002, respectively. Future minimum payments under non-cancelable operating leases as of September 30, 2003 are as follows:

Capital lease commitments. On September 21, 2001, January 21, 2002 and May 1, 2002, the Company acquired several pieces of equipment under three-year, four-year and five-year capital lease obligations, respectively. Each of these capital leases provides the Company with the option at the expiration of the lease term to purchase all the equipment leased for a price of one dollar ($1.00).

Future minimum payments under the capital leases as of September 30, 2003 are as follows:

Legal contingencies. In the ordinary course of business, we face various claims brought by third parties, including claims relating to the safety or efficacy of our products. Any of these claims could subject us to costly litigation and, while we generally believe that we have adequate insurance to cover many different types of liabilities, our insurance carriers may deny coverage or our policy limits may be inadequate to fully satisfy any damage awards or settlements. If this were to happen, the payment of any such awards could have a material adverse effect on our operations and financial position. Additionally, any such claims, whether or not successful, could damage our reputation and business. Management believes the outcome of currently identified claims and lawsuits will not have a material adverse effect on the Company’s operations or financial position.

Preferred stock consists of Series C junior participating preferred stock and Series D redeemable convertible preferred stock. None of either series of preferred stock were issued or outstanding as of September 30, 2003.

Series C junior participating preferred stock. On March 2, 1999, our Board of Directors approved a shareholder rights plan (the “Plan”). The Plan features a dividend distribution of one preferred share purchase right (the “Right”) on each outstanding share of our Class A and Class B common stock, payable to shareholders of record on March 25, 1999. Subject to limited exceptions, the Rights would be exercisable if a person or group acquires 15% or more of our common stock or announces a tender offer for 15% or more of our common stock (a “Trigger Event”).

Under certain circumstances, each Right will entitle shareholders to buy one one-hundredth of a share of Series C junior participating preferred stock of AVANIR at an exercise price of $10.00 per share. Our Board of Directors will be entitled to redeem the Rights at $0.01 per Right at any time before a person has acquired 15% or more of the outstanding common stock. The Rights will expire on March 25, 2009.

If a Trigger Event occurs, each Right will entitle its owner, who is not an acquiring person, to purchase at the Right’s then current exercise price, a number of shares of Class A common stock having a market value at the time of twice the Right’s exercise price. Rights held by the acquiring person would become void and not be exercisable to purchase shares at the bargain purchase price. An acquiring person is defined as a person who acquires 15% or more of the outstanding shares of common stock.

Series D redeemable convertible preferred stock and Class J stock purchase warrants. As of September 30, 2003, none of the Series D redeemable convertible preferred stock (“Series D Shares”) remained outstanding. In May 2003, the holders of Series D Shares exercised their rights to convert all of the remaining 50 Series D Shares, representing $500,000 in redeemable convertible preferred stock and $36,630 in accrued and unpaid dividends, into 660,305 shares of Class A common stock, for an average price of $0.81 per share. The Series D Shares were issued in connection with a securities purchase agreement made with certain investors on March 22, 1999.

The securities purchase agreement between the investors and the Company provided for the sale of up to 500 shares of Series D redeemable convertible preferred stock (“Series D Shares”) and a corresponding number of Class J stock purchase warrants (“Class J Warrants”). The agreement required that one Class J Warrant be issued with each Series D Share for an aggregate purchase price per unit of $10,000. Each Series D Share carried an annual dividend of $500 payable on a quarterly basis in cash or, at our option, in stock at the applicable conversion rate. Each Class J Warrant that was issued as a part of each $10,000 unit was exercisable into 500 shares of Class A common stock. The Class J Warrants had an expiration date of five years from the date of issuance.

We estimated the value of the warrants issued in connection with the Series D Shares to be $106,000, based on the Black-Scholes method. We credited (added) $106,000 to Class A common stock and reported the same amount as a discount to the Series D redeemable convertible preferred stock. We accreted the discount over the three-year life of the Series D redeemable convertible preferred stock or upon conversion to Class A common stock. We estimated the value of the beneficial conversion feature of the Series D redeemable convertible preferred stock issued in February 2000 to be $140,000 based on the terms of the conversion price in the agreement, which is the lesser of $2.715 per share or 86% of market price as defined in the Certificate of Determination. In fiscal 2000, we recorded the effect of the beneficial conversion feature of $140,000 as a dividend paid, and charged the amount to the accumulated deficit and added the same amount to Class A common stock.

According to the Certificate of Determination, the Series D holders were able to convert any or all of the Series D Shares into shares of Class A common stock at a conversion rate equal to $10,000 divided by a conversion price equal to the lesser of:


	•	the fixed conversion price — an amount equal to $2.715 per share of Class A common stock; or

	•	the variable conversion price — an amount equal to 86% of the market price of our Class A common stock, defined as the lower of:


	•	the average of the five lowest trading prices per share of Class A common stock on The American Stock Exchange during the 25 trading days immediately preceding a given date of determination, where trading price is determined as the average of the high and low trading prices of our Class A common stock on a particular trading day; or

	•	the average of the high and low trading price per share of Class A common stock on The American Stock Exchange on the date of determination.

The following table summarizes the changes in Series D Shares and conversions into Class A common stock from October 1, 2000 to September 30, 2003:

We have both Class A and Class B common stock. Holders of Class A common stock have one vote for each share held of record and holders of Class B common stock have five votes for each share held of record on all matters to be voted on by the shareholders. The Class A common stock and the Class B common stock vote as one class on all matters requiring shareholder approval, except that under California law the affirmative vote of a majority of the outstanding shares of Class A common stock and a majority of the outstanding shares of Class B common stock, each voting separately as a class, is required for any amendment to our articles of incorporation that would alter or change the powers, preferences or special right of, or increase or decrease the number of shares of, or create a new class or series of shares having rights, preferences or privileges prior to, each respective class of the Company’s common stock.

Upon liquidation, holders of both classes of common stock would be entitled to share ratably in the net assets available for distribution subject to the rights, if any, of holders of any preferred stock then outstanding.

Shares of both classes of common stock are not redeemable and have no preemptive or similar rights. The Class B common stock may be converted into Class A common stock on a share-for-share basis at any time at the election of the holder and will automatically convert into Class A common stock upon the sale or other transfer to another holder of Class B common stock (including, without limitation, conveyance into a trust or transfer by the operation of any will or the laws of descent and distribution).

Class A common stock. On March 13, 2003, we awarded to each non-employee director 10,000 shares of restricted Class A common stock. The shares awarded to each director are held in escrow by the Secretary of the Company and will be released from escrow to a director upon his or her termination of service as a director of the Company. The value of the Class A common stock on the date of grant was $1.16 per share. We recorded compensation expense in the amount of $92,800 in connection with these awards.

On July 23, 2003, we sold and issued 6,728,396 shares of Class A common stock and warrants to purchase an additional 1,345,673 shares of Class A common stock to several accredited investors and received $10,025,320 in gross proceeds. The warrant exercise price is $2.23 per share. The financing transaction was made pursuant to the terms of a securities purchase agreement that provided each investor with a warrant to purchase one share of Class A common stock for every five shares of Class A common stock purchased under the agreement. The effect of the financing transaction was an increase in cash and shareholders’ equity in the amount of $9,381,317 after taking into effect the costs of the transaction.

Also during fiscal 2003, we issued an aggregate of 77,200 shares of Class A common stock in connection with the exercise of stock purchase warrants (53,200 shares) and employee stock options (24,000 shares) for cash in the aggregate amount of $85,350, representing a weighted average price per share of $1.11.

During fiscal 2002, we issued 191,152 shares of Class A common stock in connection with the exercise of employee stock options for $170,574. We also issued 80,000 shares of Class A common stock in connection with the exercise of stock purchase warrants for $90,000.

Details of common stock transactions during fiscal 2003 and 2002 are shown in the tables that follow.

Additionally, on December 5, 2003, we sold and issued 5,382,316 shares of Class A common stock and warrants to purchase an additional 3,229,389 shares of Class A common stock to several accredited investors and received approximately $8,020,000 in gross proceeds. The warrant exercise price is $1.75 per share. The financing transaction was made pursuant to the terms of a securities purchase agreement that provided each investor with a warrant to purchase six-tenths of a share of Class A common stock for every share of Class A

common stock purchased under the agreement. The effect of the financing transaction was an increase in cash and shareholders’ equity in the amount of $8,019,652 before taking into effect the costs of the transaction. The placement agent was paid $415,000 in fees and expenses, and issued a warrant to purchase 161,470 shares of the Company’s Class A common stock at $1.75 per share, in connection with this transaction.

Class B common stock conversions. As of September 30, 2003 there were 13,500 shares of Class B common stock outstanding. During fiscal 2003 there were no conversions of Class B common stock. During fiscal 2002, 23,000 shares of Class B common stock were converted to 23,000 shares of Class A common stock.

Class G warrants. As of September 30, 2003, a Class G warrant to purchase 757,050 shares of Class A common stock at an exercise price of $1.375 per share remained outstanding. The holder of the Class G warrant did not exercise any rights to purchase Class A common stock during fiscal 2003 or 2002. The Class G warrant was issued in connection with the conversion of a convertible note payable issued on February 26, 1997, which is no longer outstanding. The Class G warrant expires 60 days following the date of effectiveness of a registration statement with the Securities and Exchange Commission (SEC) that registers the resale of shares purchasable upon exercise of the warrant. The 757,050 shares underlying the Class G warrant have not been registered with the SEC for resale in public markets.

Class J warrants. As of September 30, 2003, Class J warrants to purchase 50,000 shares of Class A common stock at $2.71 per share and 50,000 shares of Class A common stock at $0.9144 per share remained outstanding. None of the Class J warrants were exercised in fiscal 2003. The Class J warrants were issued in connection with Series D redeemable convertible preferred stock that was issued in fiscal 2000 and 1999. The expiration dates for the warrants vary from March 31, 2004 to February 18, 2005.

Class K warrant. On February 12, 2003, the Class K warrant holder exercised its right to purchase 53,200 shares of Class A common stock at an exercise price of $1.125 per share, for cash in the aggregate amount of $59,850. As of September 30, 2003, a Class K warrant to purchase 54,300 shares of Class A common stock at $1.125 per share remained outstanding and fully vested. The Class K warrant was issued to an investor relations consultant in connection with services performed and milestones achieved in fiscal 2000 and fiscal 2001. The expiration date of the remaining warrant is March 31, 2004.

Class M warrants. On November 30, 2003, Class M warrants to purchase 87,123 shares of Class A common stock at $1.284 per share expired. None of the Class M warrants were exercised in either fiscal 2003 or fiscal 2002. During fiscal 2001, the holders exercised their rights to purchase 107,581 shares of Class A common stock for the aggregate amount of $138,134.

Class N warrants. As of September 30, 2003, Class N warrants to purchase 32,877 shares of Class A common stock at an exercise price of $2.44 per share remained outstanding in connection with a $6 million private placement in January 2000. None of the Class N warrants were exercised in either fiscal 2003, 2002 or 2001. The Class N warrants expire on January 31, 2004.

The following table summarizes all warrant activity for fiscal 2003, 2002 and 2001:


(1)	Warrant shares tendered represent the amount of warrant shares given up, in lieu of cash, for warrants exercised (“cashless exercise”).

Stock options to officers. In fiscal 2003, we issued incentive stock options under our 2000 Stock Option Plan to the officers of the Company for the purchase of 435,000 shares of Class A common stock at exercise prices ranging from $1.05 to $1.16 per share. The option prices represent the closing market price for the common stock on the date of grant.

Stock options to non-employee directors. On March 14, 2003, we issued to our non-employee directors stock options to purchase an aggregate of 70,000 shares of Class A common stock at an exercise price of $1.15 per share as part of a provision for an annual formula grant under our 1994 Stock Option Plan. Further, we issued to a new director an option to purchase up to 25,000 shares of Class A common stock at an exercise price of $1.15 per share as part of his joining the board of directors. The exercise price of each option represents the closing market price for the common stock on the date of grant.

2003 Equity Incentive Plan. On March 13, 2003, the board of directors approved the adoption of a 2003 equity incentive plan (the “2003 Equity Incentive Plan”) that provides for the issuance of up to 2,500,000 shares of Class A common stock. The 2003 Equity Incentive Plan allows us to grant options, restricted stock awards and stock appreciation rights to our directors, officers, employees and consultants. As of September 30, 2003, 2,500,000 shares of Class A common stock remained available for issuance under the 2003 Equity Incentive Plan.

2000 Stock Option Plan. On March 23, 2000, our shareholders approved the adoption of the 2000 Stock Option Plan (the “2000 Plan”), pursuant to which an aggregate of 2,300,000 shares of our Class A common stock have been reserved for issuance. On March 14, 2002, our shareholders approved an amendment to the Plan to increase the number of shares of Class A common stock issuable under the Plan by 1,000,000 shares, for an aggregate of 3,300,000 shares. On March 13, 2003, we amended the 2000 Plan to allow for the issuance of restricted stock awards. As of September 30, 2003, 666,240 shares of Class A common stock were available for grant under the 2000 Plan.

1998 Stock Option Plan. On February 19, 1999, our shareholders approved the 1998 Stock Option Plan (the “1998 Plan”). The 1998 Plan as amended in 2002 reserves for issuance an aggregate of 1,875,000 shares of Class A common stock. The 1998 Plan allows us to grant options to our directors, officers, employees and consultants. As of September 30, 2003, options to purchase 47,303 shares of Class A common stock were available for grant under the 1998 Plan.

1994 Stock Option Plan. In March 1994, our shareholders approved the adoption of the 1994 Stock Option Plan (the “1994 Plan”). The 1994 Plan as amended in 1995, 1996, 1997 and 2002 reserves for issuance an aggregate of 2,000,000 shares of Class A common stock. The 1994 Plan allows us to grant options to our officers, directors, employees and consultants. The 1994 Plan provides for an automatic annual grant of an option to purchase 10,000 shares to each director who is not also one of our employees. The 1994 Plan terminates on January 14, 2004. As of September 30, 2003, 10,076 shares of Class A common stock were available for grant under the 1994 Plan.

Canceled stock options. During fiscal 2003, options to purchase an aggregate of 1,093,255 shares of Class A common stock at prices ranging from $1.06 to $3.56 per share were canceled following their expiration dates. Also, options to purchase 50,947 shares at prices ranging from $1.16 to $4.15 per share were canceled due to voluntary and involuntary terminations. The weighted average price per share for all canceled options was $2.93.

The following table summarizes all common stock option activity for fiscal 2003, 2002 and 2001:

The following table summarizes information concerning outstanding and exercisable Class A and Class B stock options as of September 30, 2003:

GlaxoSmithKline. On March 31, 2000, we signed an exclusive license agreement with GlaxoSmithKline (NYSE: GSK) for rights to manufacture and market Abreva® (docosanol 10% cream) as an over the counter (“OTC”) product in the United States and Canada as a treatment for recurrent oral-facial herpes. Under the terms of the license agreement, GlaxoSmithKline Consumer Healthcare is responsible for all sales and marketing activities and the manufacturing and distribution of Abreva in North America. The terms of the license agreement provided for AVANIR to earn up to $25 million in milestone payments, and royalties on product sales. In October 2000, GlaxoSmithKline launched Abreva. We earned and received all milestones under the agreement. During fiscal 2003, we sold an undivided interest in the GlaxoSmithKline license agreement to Drug Royalty USA, and received $24.1 million. (See Note 5, “Asset Sale.”)

Boryung Pharmaceuticals Company Ltd (“Boryung”). In March 1994, we entered into a 12-year exclusive license and supply agreement with Boryung, for the manufacture and sale of docosanol 10% cream in the Republic of Korea. Under the terms of the agreement, Boryung is responsible for manufacturing, marketing and distribution of docosanol 10% cream, and paying a royalty to AVANIR on product sales. The agreement includes a supply provision under which Boryung will purchase its entire requirement of active ingredient for use in the manufacture of topical docosanol 10% cream from us directly. Boryung launched the product, Herepair, in June 2002.

CTS Chemical Industries, Ltd. (“CTS”). In July 1993, we entered into a license agreement with CTS for the manufacture, marketing and distribution of docosanol 10% cream as a topical cold sore treatment in Israel. The five-year period of the license began in June 2002, the date of approval of the product by regulatory agencies in Israel. Under the terms of the agreement, CTS is responsible for manufacturing, marketing and distribution of docosanol 10% cream in Israel, and paying a royalty to AVANIR on product sales. The agreement includes a supply provision under which CTS will purchase its entire requirement of active ingredient from AVANIR for use in the manufacture of topical docosanol 10% cream. CTS launched the product, Abrax, in January 2003.

Bruno Farmaceutici. In July 2002, we entered into an agreement with Bruno Farmacutici (“Bruno”) giving Bruno the rights to manufacture and market docosanol 10% cream in Italy, Europe’s fourth largest market for the topical treatment of cold sores. The agreement requires that Bruno purchase its entire

requirement of raw materials from AVANIR and pay us a royalty on product sales. Docosanol 10% cream is not yet approved for marketing in Italy.

Government Research Grants. AVANIR is also engaged in research funded by $1.5 million in government research grants. The government research grants are to be used for investigating the market potential for a topical genital herpes treatment, conducting research on various docosanol-based formulations for a potential genital herpes product, development of antibodies to anthrax toxins and cytomegalovirus, and development of a blood donor program intended to find high-affinity antibodies to infectious diseases.

License agreement. On August 1, 2000, we entered into an agreement with IriSys Research and Development, LLC (“IriSys”) to sublicense the exclusive worldwide rights to a patented drug formulation, Neurodex, to treat multiple central nervous system disorders. Our sublicense agreement includes rights to the patented technology and know-how for the development and potential marketing of products for treatments of pseudobulbar affect (PBA), neuropathic pain, symptoms of chronic and intractable cough, and patients being weaned from narcotics. If either (i) the FDA accepts the submission of a new drug application (NDA) or (ii) the FDA approves the NDA for marketing, we will be required to make milestone payments to IriSys.

We are currently developing Neurodex for the treatment of PBA and neuropathic pain. We have not made any payments to IriSys, nor have any been due under this agreement, from the date of entering into this agreement through September 30, 2003. However, if we successfully submit an NDA for PBA in 2004, we will pay IriSys $150,000 for achieving the milestone in 2004. Other payments, if any, will be subject to our achievement of the milestones indicated above. If we successfully complete the clinical trials and the FDA accepts our NDA, we will be required to pay a patent royalty to IriSys based on a percent of annual net sales revenue if we market the product ourselves. If we sublicense the product to someone else, we are required to share equally with IriSys any royalties that we receive from third parties. The agreement calls for certain minimum sales levels to be achieved in order for AVANIR to maintain exclusivity of the marketing rights in the sublicensed territories.

Dr. Yakatan, president and chief executive officer of AVANIR, is a founder, chairman and the majority shareholder of IriSys. IriSys is the exclusive licensee of certain patents as set forth under an Exclusive Patent License Agreement between IriSys and the Center for Neurologic Study, dated as of April 2, 1997. The Company believes that the terms of the sublicense agreement with IriSys are no less favorable to the Company than those that could have been obtained from an unrelated party.

Research and development. In June 2003, the Company engaged IriSys to continue Neurodex stability studies previously being carried out for AVANIR by another company that is no longer in the business of providing such services. The service arrangement was transferred to IriSys following termination with the other company because IriSys was already familiar with the stability protocol. During fiscal 2003, AVANIR paid IriSys $18,840 related to continuation of the stability testing.

In April 2002, we entered into an agreement for services with IriSys to manufacture one lot of Neurodex for clinical studies and prepare a written stability protocol for the same lot. AVANIR selected IriSys because of its familiarity with the product as the licensor to AVANIR. During fiscal 2002, the Company paid IriSys an aggregate of $55,000 for delivery of the manufactured material and the written stability protocol.

In June 1999, we entered into an agreement for services with IriSys to develop formulations for a potential drug candidate for the treatment of allergy and asthma. IriSys’ fees for services compared favorably to competitive bids submitted to us at that time. During fiscal 2001, the Company paid IriSys $17,800 for services rendered pursuant to this agreement.

Components of the income tax benefit (provision) are as follows for the fiscal years ended September 30:

A reconciliation of the federal statutory income tax rate and the effective income tax rate is as follows for the fiscal years ended September 30:

Deferred income taxes reflect the income tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our net deferred income tax balance were as follows:

We have provided a full valuation allowance against the net deferred income tax assets recorded as of September 30, 2003 and 2002 due to uncertainties as to their ultimate realization. The net operating loss and research credit carryforwards expire on various dates through 2023. In the event of certain ownership changes, the Tax Reform Act of 1986 imposes certain restrictions on the amount of net operating loss carry forwards that we may use in any year. As of September 30, 2003, we had $75,982,344 and $14,823,113 of Federal and California net operating loss carryforwards, respectively.

We have established an employee savings plan pursuant to Section 401(k) of the Internal Revenue Code. The plan allows participating employees to deposit into tax deferred investment accounts 2% to 20% of their salary, subject to annual limits. We are not required to make matching contributions under the plan. In fiscal 2003, we contributed $70,753 to the plan. We did not make a contribution in either of fiscal years 2002 and 2001, or in any prior period since inception of the plan.


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

		For the fiscal year ended September 30, 2003

OR

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

		For the transition period from to


California		33-0314804
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

11388 Sorrento Valley Road, Suite 200, San Diego, California		92121 (Zip Code)
(Address of principal executive offices)


Class A Common Stock, no par value		71,208,750
Class B Common Stock, no par value		3,500


PART I
	Item 1. Business
	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 Consolidated 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
	Item 9A. Controls and Procedures
PART III
	Item 10. Directors and Executive Officers
	Item 11. Executive Compensation
	Item 12. Security Ownership of Certain Beneficial Owners and Management
	Item 13. Certain Relationships and Related Transactions
	Item 14. Principal Accountant Fees and Services
PART IV
	Item 15. Exhibits, Financial Statements and Schedules and Reports on Form 8-K
SIGNATURES
AVANIR PHARMACEUTICALS CONSOLIDATED BALANCE SHEETS
AVANIR PHARMACEUTICALS CONSOLIDATED STATEMENTS OF OPERATIONS
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
CONSOLIDATED STATEMENTS OF CASH FLOWS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
EXHIBIT 4.2
EXHIBIT 10.4
EXHIBIT 21.1
EXHIBIT 23.1
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2



	Class A
	Common Stock

	High		Low

Fiscal 2002
First Quarter	$	4.88	$	2.82
Second Quarter	$	4.97	$	2.67
Third Quarter	$	3.00	$	1.30
Fourth Quarter	$	1.85	$	1.14
Fiscal 2003
First Quarter	$	1.24	$	0.90
Second Quarter	$	1.63	$	0.77
Third Quarter	$	2.22	$	0.91
Fourth Quarter	$	2.00	$	1.42



		Patents and Patent Applications


		United States						Foreign

Description:		Issued		Expiration Dates		Pending		Issued		Expiration Dates		Pending

Docosanol-related technologies			10		2009 to 2016		2		39		Various		46
Xenerex proprietary antibody
	generation technologies		5		2012 to 2015		4		14		Various		1
IgE down-regulation technology			4		2018 to 2019		10		4		Various		101
Neurodex			6		2010 to 2015		1		0		—		15
MIF inhibitor technology			0		—		3		0		—		29
Cholesterol			0		—		1		0				0

Total			25				21		57				192


Item 4.	*Submission of Matters to a Vote of Security Holders*


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



		Fiscal Years Ended September 30,

Statement of operations data:		2003			2002			2001		2000			1999

Revenues		$	2,438,733		$	8,853,742		$	12,678,602	$	10,252,818		$	—
Net income (loss)		$	(23,236,348	)	$	(10,249,512	)	$	233,122	$	(582,283	)	$	(8,554,036	)
Net income (loss) attributable to common shareholders		$	(23,264,293	)	$	(10,292,798	)	$	189,888	$	(801,806	)	$	(8,583,182	)
Basic net income (loss) per share		$	(0.39	)	$	(0.18	)	$	0.00	$	(0.02	)	$	(0.21	)
Diluted net income (loss) per share		$	(0.39	)	$	(0.18	)	$	0.00	$	(0.02	)	$	(0.21	)
Weighted average number of shares of common stock outstanding:
	Basic		59,896,135			58,206,969			57,475,748		51,784,214			41,704,265
	Diluted		59,896,135			58,206,969			61,130,415		51,784,214			41,704,265



		September 30,

Balance sheet data:		2003		2002		2001		2000		1999

Cash and cash equivalents		$	12,198,408	$	8,630,547	$	16,542,545	$	19,699,768	$	122,674
Investments in securities			5,258,881		4,538,460		5,308,691		1,568,474		—

	Total cash, cash equivalents and investments in securities	$	17,457,289	$	13,169,007	$	21,851,236	$	21,268,242	$	122,674
Working capital		$	10,619,216	$	5,918,083	$	16,027,577	$	18,774,423	$	(956,190	)
Total assets		$	29,645,257	$	20,332,929	$	27,053,953	$	23,519,237	$	1,765,215
Deferred revenues		$	22,742,641	$	233,333	$	125,000	$	—	$	—
Total liabilities		$	28,608,026	$	5,752,259	$	2,592,490	$	1,922,929	$	1,701,019
Convertible preferred stock		$	—	$	521,189	$	502,903	$	465,920	$	—
Shareholders’ equity		$	1,037,231	$	14,059,481	$	23,958,560	$	21,130,388	$	64,196



		Fiscal Quarters Ended
Quarterly statement of operations data
for fiscal 2003:		December 31, 2002			March 31, 2003			June 30, 2003			September 30, 2003

Revenues		$	819,106		$	621,643		$	398,222		$	599,762
Net loss		$	(4,237,999	)	$	(5,977,934	)	$	(6,029,428	)	$	(6,990,987	)
Net loss attributable to common shareholders		$	(4,248,858	)	$	(5,988,693	)	$	(6,035,755	)	$	(6,990,987	)
Basic net loss per share		$	(0.07	)	$	(0.10	)	$	(0.10	)	$	(0.11	)
Diluted net loss per share		$	(0.07	)	$	(0.10	)	$	(0.10	)	$	(0.11	)
Weighted average number of shares of common stock outstanding:
	Basic and diluted		58,296,555			58,352,406			58,741,635			64,147,835



		Fiscal Quarters Ended
Quarterly statement of operations data
for fiscal 2002:		December 31, 2001		March 31, 2002			June 30, 2002			September 30, 2002

Revenues		$	6,130,215	$	738,378		$	819,340		$	1,165,809
Net income (loss)		$	2,765,509	$	(3,699,588	)	$	(4,895,265	)	$	(4,420,168	)
Net income (loss) attributable to common shareholders		$	2,754,650	$	(3,710,347	)	$	(4,906,074	)	$	(4,431,027	)
Basic net income (loss) per share		$	0.05	$	(0.06	)	$	(0.08	)	$	(0.08	)
Diluted net income (loss) per share		$	0.04	$	(0.06	)	$	(0.08	)	$	(0.08	)
Weighted average number of shares of common stock outstanding:
	Basic		58,029,403		58,240,466			58,275,445			58,284,033
	Diluted		61,455,499		58,240,466			58,275,445			58,284,033


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


		Product License, Sale,
Company or Research Grant	Description	Service or Research

GlaxoSmithKline	Undivided interest in the license agreement for Abreva® (U.S. and Canada)	Cold sore product license
Drug Royalty USA	License Purchase Agreement with Drug Royalty USA represents an undivided interest in the Abreva license agreement (U.S. and Canada)	Sale of undivided interest in Abreva license agreement and royalties
Miscellaneous docosanol licenses outside North America	— Israel — CTS Chemical Industries, Ltd. — Republic of Korea — Boryung Pharmaceuticals Co., Ltd. — Egypt — BioPharm Group — Italy — Bruno Farmaceutici S.p.A	Cold sore product licenses
Medison Pharma, Ltd.	Neurodex license (Israel)	Research and commercialization agreement related to PBA
DNAX Research, Inc. and Peregrine Pharmaceuticals	Pre-funded antibody research currently totaling $233,000 and one antibody license	Antibody generation services and antibody license
Miscellaneous Federal and State Government grant awards	Represents five grant awards totaling approximately $1.5 million	Preclinical research related to genital herpes, anthrax, and cytomegalovirus



	Three Months Ended				Fiscal Year Ended				Inception		Estimated
	September 30,				September 30,				Through		Cost to
									September 30,		Complete
	2003(2)		2002(2)		2003(2)		2002(2)		2003(2)(3)		Project(2)

Company-funded Projects(1):
Develop Neurodex for FDA marketing approval in treating PBA. Estimated timing to complete remaining phases of project necessary to submit an NDA with FDA: Second Half, 2004	$	1,719,327	$	703,134	$	5,055,929	$	2,957,523	$	10,455,649	$	6M
Develop Neurodex for neuropathic pain. Phase II open-label study completed		792,823		173,621		2,093,097		1,323,465		4,758,072		—	(4)
Develop AVP-13358 as a treatment for allergy and asthma. Estimated timing to complete Phase I, bioanalytical work and license the product: 2005		1,223,059		1,855,389		4,709,587		4,851,325		14,504,951	$	8M
Research on regulating the target MIF as a potential treatment for inflammatory diseases. Estimated timing to complete Phase I and to license the product: 2006		610,231		278,817		2,222,095		1,300,153		5,047,534	$	11M


Item 1.	*Business*


Item 6.	*Selected Consolidated Financial Data*


	*Milestone Payments in License Agreements*


	*Royalties on Licensed Products*


	September 30,		Increase During		September 30,
	2003		Fiscal 2003		2002

Cash and cash equivalents	$	12,198,408	$	3,567,861	$	8,630,547
Cash and investments in securities	$	17,457,289	$	4,288,282	$	13,169,007
Net working capital	$	10,619,216	$	4,701,133	$	5,918,083


	Year Ended						Year Ended
	September 30,			Change During			September 30,
	2003			Fiscal 2003			2002

Net cash provided by (used for) operating activities	$	1,140,635		$	8,069,113		$	(6,928,478	)
Net cash used for investing activities		(6,853,933	)		(5,648,196	)		(1,205,737	)
Net cash provided by financing activities		9,281,159			9,058,942			222,217

Net increase (decrease) in cash and cash equivalents	$	3,567,861		$	11,479,859		$	(7,911,998	)


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*


Name	Age		Position

Gerald J. Yakatan, Ph.D.		61	President and Chief Executive Officer
James E. Berg		52	Vice President, Clinical and Regulatory Affairs
R. Martin Emanuele, Ph.D.		49	Vice President, Licensing and Business Development
Gus Fernandez, Pharm.D.		46	Vice President, Commercial Development
Gregory P. Hanson, CMA		57	Vice President, Finance; Chief Financial Officer and Secretary
J. David Hansen		52	Senior Vice President, Corporate Development
Jagadish C. Sircar, Ph.D.		68	Vice President, Drug Discovery
Victoria Smith		55	Vice President, Administration


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


Item 13.	*Certain Relationships and Related Transactions*


Item 15.	*Exhibits, Financial Statements and Schedules and Reports on Form 8-K*


	(1) Index to consolidated financial statements appears on page F-1.


	3.1			Restated Articles of Incorporation of the Registrant, dated April 4, 1994(1)
	3.2			Certificate of Amendment of the Articles of Incorporation of the Registrant, dated November 20, 1998(10)
	3.3			Certificate of Amendment of the Articles of Incorporation of the Registrant, dated February 19, 1999(10)
	3.4			Amended and Restated Bylaws of the Registrant(10)


	4.1			Forms of Class A and Class B Common Stock Certificates(2)
	4.2			Class G Stock Purchase Warrant
	4.3			Certificate of Determination with respect to Series C Junior Participating Preferred Stock of the Registrant(3)
	4.4			Rights Agreement, dated as of March 5, 1999, with American Stock Transfer & Trust Company(3)
	4.5			Form of Rights Certificate with respect to the Rights Agreement, dated as of March 5, 1999(3)
	4.6			Form of Class J Stock Purchase Warrant issued in connection with Series D redeemable convertible preferred stock(4)
	4.7			Class K Stock Purchase Warrant, dated as of April 1, 1999, issued to Redington, Inc.(5)
	4.8			Amendment No. 1 to Rights Agreement, dated November 30, 1999, with American Stock Transfer & Trust Company(6)
	4.9			Registration Rights Agreement, dated January 25, 2000, by and among (i) AVANIR Pharmaceuticals and (ii) Bayview LLC, The Endeavour Capital Fund, S.A. and Roseworth Group LTD(7)
	4.10			Form of Class N Stock Purchase Warrant, issued in connection with Common Stock Purchase Agreement dated January 25, 2000(7)
	4.11			Securities Purchase Agreement by and among AVANIR Pharmaceuticals and a group of investors dated July 21, 2003.(13)
	4.12			Form of Class A Stock Purchase Warrant, issued in connection with the Securities Purchase Agreement dated July 21, 2003(13)
	4.13			Securities Purchase Agreement by and among AVANIR Pharmaceuticals and a group of investors dated November 25, 2003(14)
	4.14			Form of Class A Stock Purchase Warrant, issued in connection with the Securities Purchase Agreement dated November 25, 2003(14)
	10.1			Amended and Restated 1998 Stock Option Plan(10)
	10.2			Amended and Restated 1994 Stock Option Plan(10)
	10.3			Employment Agreement with Gerald J. Yakatan, dated November 29, 2001(10)
	10.4			Form of Indemnification Agreement with certain Directors and Executive Officers of the Registrant
	10.5			License Agreement, dated March 31, 2000, by and between AVANIR Pharmaceuticals and SB Pharmco Puerto Rico, a Puerto Rico Corporation(8)
	10.6			Standard Industrial Net Lease by and between AVANIR Pharmaceuticals and BC Sorrento, LLC, effective September 1, 2000(9)
	10.7			License Agreement, dated August 1, 2000, by and between AVANIR Pharmaceuticals (“Licensee”) and Irisys Research and Development, LLC, a California limited liability company(9)
	10.8			Standard Industrial Net Lease by and between AVANIR Pharmaceuticals (“Tenant”) and Sorrento Plaza, a California limited partnership (“Landlord”), effective May 20, 2002(11)
	10.9			Amended and Restated 2000 Stock Option Plan(12)
	10.10			Form of Restricted Stock Grant Notice for use with Amended and Restated 2000 Stock Option Plan(12)
	10.11			2003 Equity Incentive Plan(12)
	10.12			Form of Non-qualified Stock Option Award Notice for use with 2003 Equity Incentive Plan(12)
	10.13			Form of Restricted Stock Grant for use with 2003 Equity Incentive Plan(12)
	10.14			Form of Restricted Stock Grant Notice (cash consideration) for use with 2003 Equity Incentive Plan(12)
	21.1			List of Subsidiaries


23.1		Independent Auditors’ Consent
31.1		Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002
31.2		Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002
32.1		Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2		Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002



Signature	Title	Date


/s/ GERALD J. YAKATAN, PH.D. Gerald J. Yakatan, Ph.D.	President and Chief Executive Officer (Principal Executive Officer)	December 22, 2003

/s/ GREGORY P. HANSON, CMA Gregory P. Hanson, CMA	Vice President, Finance, Chief Financial Officer (Principal Financial and Accounting Officer)	December 22, 2003

/s/ JAMES B. GLAVIN James B. Glavin	Chairman of the Board	December 22, 2003

/s/ STEPHEN G. AUSTIN, CPA Stephen G. Austin, CPA	Director	December 22, 2003

/s/ DENNIS J. CARLO, PH.D. Dennis J. Carlo, Ph.D.	Director	December 22, 2003

/s/ MICHAEL W. GEORGE Michael W. George	Director	December 22, 2003

/s/ SUSAN GOLDING Susan Golding	Director	December 22, 2003

/s/ CHARLES A. MATHEWS Charles A. Mathews	Director	December 22, 2003

/s/ HAROLD F. OBERKFELL Harold F. Oberkfell	Director	December 22, 2003

/s/ KENNETH E. OLSON Kenneth E. Olson	Director	December 22, 2003


	Page

INDEPENDENT AUDITORS’ REPORT		F-2
CONSOLIDATED FINANCIAL STATEMENTS
Consolidated Balance Sheets		F-3
Consolidated Statements of Operations		F-4
Consolidated Statements of Shareholders’ Equity		F-5
Consolidated Statements of Cash Flows		F-6
Notes to Consolidated Financial Statements		F-7



			Years Ended September 30,

			2003			2002			2001

REVENUES:
	Research contracts and licenses		$	53,000		$	5,226,167		$	10,070,350
	Royalties and sale of royalty rights			1,780,893			3,426,403			2,535,717
	Government research grants			587,440			160,412			72,535
	Product sales			17,400			40,760			—

		Total revenues		2,438,733			8,853,742			12,678,602

OPERATING EXPENSES:
	Research and development			18,558,017			13,602,484			7,227,488
	General and administrative			4,736,791			4,243,829			3,226,563
	Sales and marketing			2,621,320			1,640,812			1,234,604
	Cost of product sales			3,102			4,731			—
	Purchased in-process research and development			—			—			917,097
	Product launch expenses			—			—			728,148

		Total operating expenses		25,919,230			19,491,856			13,333,900

LOSS FROM OPERATIONS				(23,480,497	)		(10,638,114	)		(655,298	)
	Interest income			265,874			663,588			1,147,439
	Other income			26,801			129,514			2,700
	Interest expense			(44,927	)		(60,560	)		(6,547	)

INCOME (LOSS) BEFORE INCOME TAXES				(23,232,749	)		(9,905,572	)		488,294
	Provision for income taxes			(3,599	)		(343,940	)		(255,172	)

NET INCOME (LOSS)			$	(23,236,348	)	$	(10,249,512	)	$	233,122

NET INCOME (LOSS) ATTRIBUTABLE TO COMMON SHAREHOLDERS:
	Net income (loss)		$	(23,236,348	)	$	(10,249,512	)	$	233,122
	Dividends on redeemable convertible preferred stock			(16,122	)		(25,000	)		(24,948	)
	Accretion of discount related to redeemable convertible preferred stock			(11,823	)		(18,286	)		(18,286	)

NET INCOME (LOSS) ATTRIBUTABLE TO COMMON SHAREHOLDERS			$	(23,264,293	)	$	(10,292,798	)	$	189,888

NET INCOME (LOSS) PER SHARE:
	BASIC		$	(0.39	)	$	(0.18	)	$	0.00

	DILUTED		$	(0.39	)	$	(0.18	)	$	0.00

WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING:
	BASIC			59,896,135			58,206,969			57,475,748

	DILUTED			59,896,135			58,206,969			61,130,415



		Common Stock
																				Accumulated
														Receivables						Other
		Class A						Class B						for						Comprehensive			Total			Comprehensive
														Common			Accumulated			Income			Shareholders’			Income
		Shares			Amount			Shares			Amount			Stock			Deficit			(Loss)			Equity			(Loss)

BALANCE, OCTOBER 1, 2000			56,974,828		$	84,695,590			65,000		$	34,145		$	(649,431	)	$	(62,949,916	)				$	21,130,388
Net income															233,122			233,122						233,122		$	233,122
Issuance of Class A common stock in connection with:
	Exercise of warrants		254,716			304,697																		304,697
	Exercise of stock options, net of taxes		558,142			653,399																		653,399
	Acquisition of MIF technology		170,353			867,097																		867,097
	Acquisition of minority interests in Xenerex		25,000			97,250																		97,250
	Conversions of Class B common stock		28,500			14,250			(28,500	)		(14,250	)											—
	Retired shares		(35,158	)		(129,031	)																	(129,031	)
Collection of receivables for Class A common stock															649,431									649,431
Dividends on preferred stock						(24,948	)																	(24,948	)
Accretion of discount related to Series D redeemable convertible preferred stock																		(18,286	)					(18,286	)
Compensation expense related to valuation of stock options granted to employees and non-employees for services rendered						148,051																		148,051
Unrealized gains on investments in securities																				$	47,390			47,390			47,390

BALANCE, SEPTEMBER 30, 2001			57,976,381			86,626,355			36,500			19,895			—			(62,735,080	)		47,390			23,958,560		$	280,512

Net loss																		(10,249,512	)					(10,249,512	)	$	(10,249,512	)
Issuance of Class A common stock in connection with:
	Exercise of warrants		80,000			90,000																		90,000
	Exercise of stock options, net of taxes		191,152			170,574																		170,574
	Conversions of Class B common stock		23,000			11,500			(23,000	)		(11,500	)											—
Dividends on preferred stock						(25,000	)																	(25,000	)
Accretion of discount related to Series D redeemable convertible preferred stock																		(18,286	)					(18,286	)
Compensation expense related to valuation of stock options granted to employees and non-employees for services rendered						179,828																		179,828
Unrealized losses on investments in securities																					(46,683	)		(46,683	)		(46,683	)

BALANCE, SEPTEMBER 30, 2002			58,270,533			87,053,257			13,500			8,395		$	—			(73,002,878	)		707			14,059,481		$	(10,296,195	)

Net loss																		(23,236,348	)				$	(23,236,348	)	$	(23,236,348	)
Issuance of Class A common stock in connection with:
	Exercise of warrants		53,200			59,850																		59,850
	Exercise of stock options, net of taxes		24,000			25,500																		25,500
	Restricted stock granted to directors		80,000			92,800																		92,800
	Sale of stock and warrants		6,728,396			9,381,317																		9,381,317
	Conversions of Series D Redeemable convertible preferred stock		660,305			536,630																		536,630
Dividends on preferred stock						(16,120	)																	(16,120	)
Accretion of discount related to Series D redeemable convertible preferred stock																		(11,823	)					(11,823	)
Compensation expense related to valuation of stock options granted to employees and non-employees for services rendered						153,199																		153,199
Unrealized losses on investments in securities																					(7,255	)		(7,255	)		(7,255	)

BALANCE, SEPTEMBER 30, 2003			65,816,434		$	97,286,433			13,500		$	8,395		$	—		$	(96,251,049	)	$	(6,548	)	$	1,037,231		$	(23,243,603	)


	*Computation of net income and net loss per common share*



		Year Ended September 30,

		2003			2002			2001

Net income (loss) attributable to common shareholders, as reported		$	(23,264,293	)	$	(10,292,798	)	$	189,888
Add: Stock-based employee compensation included in reported net income (loss) attributable to common shareholders			234,638			172,071			128,638
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards			(1,788,674	)		(2,348,203	)		(1,668,376	)

	Pro forma net loss attributable to common shareholders	$	(24,818,329	)	$	(12,468,930	)	$	(1,349,850	)

Net loss per share:
	Basic and diluted — as reported	$	(0.39	)	$	(0.18	)	$	0.00
	Basic and diluted — pro forma	$	(0.41	)	$	(0.21	)	$	(0.02	)



		September 30, 2003							September 30, 2002

		Gross							Gross
		Carrying		Accumulated					Carrying		Accumulated
		Value		Depreciation			Net		Value		Depreciation			Net

Research and development equipment		$	3,544,343	$	(1,331,544	)	$	2,212,799	$	2,420,028	$	(867,991	)	$	1,552,037
Computer equipment and related software			1,000,206		(383,512	)		616,694		851,952		(238,199	)		613,753
Leasehold improvements			5,000,147		(445,435	)		4,554,712		866,318		(175,410	)		690,908
Office equipment, furniture, and fixtures			549,864		(192,064	)		357,800		254,731		(128,557	)		126,174
Construction in progress			—		—			—		198,094		—			198,094

	Total property and equipment	$	10,094,560	$	(2,352,555	)	$	7,742,005	$	4,591,123	$	(1,410,157	)	$	3,180,966