UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-K

 

 

 

Commission File No. 1-15803

 

Avanir Pharmaceuticals, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

(949) 389-6700

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

 

 

 

Securities registered pursuant to Section 12(g) of the Act:

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  YES o     NO þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15 (d) of the Act.  YES o     NO þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  YES þ     NO o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  YES o     NO o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  YES o     NO þ

 

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of March 31, 2010 was approximately $158.3 million, based upon the closing price on the NASDAQ Global Market reported for such date. Shares of common stock held by each officer and director and by each person who is known to own 10% or more of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates of the Company. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

 

120,982,441 shares of the registrant’s Common Stock were issued and outstanding as of December 1, 2010.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain information required to be disclosed in Part III of this report is incorporated by reference from the registrant’s definitive Proxy Statement for the 2011 Annual Meeting of Stockholders, which will be held on February 8, 2011 and which proxy statement will be filed not later than 120 days after the end of the fiscal year covered by this report.

 

 

Table of Contents

 

 

 

This Annual Report on Form 10-K contains forward-looking statements concerning future events and performance of our Company. When used in this report, the words “intend,” “estimate,” “anticipate,” “believe,” “plan,” “goal” and “expect” and similar expressions as they relate to AVANIR Pharmaceuticals, Inc. are included to identify forward-looking statements. These forward-looking statements are based on our current expectations and assumptions and many factors could cause our actual results to differ materially from those indicated in these forward-looking statements. Risks that could cause actual results to differ significantly from our forward-looking statements include, but are not limited to, risks relating to our product sales, capital resources, commercial market estimates, safety of NUEDEXTA, future development efforts, patent protection, effects of healthcare reform, reliance on third parties, and other risks set forth below under Item 1A, “Risk Factors.” We disclaim any intent to update or announce revisions to any forward-looking statements to reflect actual events or developments.

 

References in this report to AVANIR, the Company, we, our and us refer to AVANIR Pharmaceuticals, Inc. and its subsidiaries, on a consolidated basis. “AVANIR” and “NUEDEXTA” are trademarks of AVANIR Pharmaceuticals, Inc. or its subsidiaries in the U.S. and/or other countries. Other trademarks or service marks appearing in this report may be trademarks or service marks of other owners.

 

Executive Overview

 

AVANIR is a pharmaceutical company focused on developing and commercializing novel therapeutic products for the treatment of central nervous system disorders. In October 2010, the U.S. Food and Drug Administration (“FDA”) approved NUEDEXTA^tm (formerly referred to as AVP-923 or its previously proposed trade name Zenvia), a unique proprietary combination of dextromethorphan/quinidine, for the treatment of pseudobulbar affect (“PBA”). NUEDEXTA has also successfully completed a Phase III trial for the treatment of patients with diabetic peripheral neuropathic pain (“DPN pain”). We plan to commercially launch NUEDEXTA in the second quarter of fiscal 2011.

 

In addition to our focus on products for the central nervous system, we also have a number of partnered programs in other therapeutic areas that may generate future revenue for us. Our first commercialized product, docosanol 10% cream, (sold in the United States and Canada as Abreva^® by our marketing partner GlaxoSmithKline Consumer Healthcare) is the only over-the-counter treatment for cold sores that has been approved by the FDA. In 2008, we out-licensed all of our monoclonal antibodies and we remain eligible to receive milestone payments and royalties related to the sale of these assets. AVANIR was incorporated in California in August 1988 and was reincorporated in Delaware in March 2009.

 

Drug Candidates and Marketed Products

 

NUEDEXTA for the treatment of PBA

 

NUEDEXTA^tm is the first and only FDA-approved treatment for PBA, which occurs secondary to a variety of otherwise unrelated neurological conditions, and is characterized by involuntary, sudden, and frequent episodes of laughing and/or crying. PBA episodes typically occur out of proportion or incongruent to the patient’s underlying emotional state.

 

NUEDEXTA is an innovative combination of two well-characterized components: dextromethorphan hydrobromide (20 mg), the ingredient active in the central nervous system, and quinidine sulfate (10 mg), a metabolic inhibitor enabling therapeutic dextromethorphan concentrations. NUEDEXTA acts on sigma-1 and N-Methyl-D-aspartic acid, or NMDA, receptors in the brain, although the mechanism by which NUEDEXTA exerts therapeutic effects in patients with PBA is unknown.

 

Studies to support the effectiveness of NUEDEXTA in PBA were performed in patients with amyotrophic lateral sclerosis, or ALS, and multiple sclerosis, or MS. NUEDEXTA has not been shown to be safe and effective in other types of emotional lability that can commonly occur, for example, in Alzheimer’s disease and other

dementias. The primary outcome measure, laughing and crying episodes, was significantly lower in the NUEDEXTA cohort compared to placebo. The secondary outcome measure, the Center for Neurologic Studies Lability Scale (CNS-LS), demonstrated a significantly greater mean decrease in CNS-LS score from baseline for the NUEDEXTA cohort compared to placebo.

 

NUEDEXTA safety information

 

NUEDEXTA can interact with other medications causing significant changes in blood levels of those medications and/or NUEDEXTA. NUEDEXTA is contraindicated in patients receiving drugs that both prolong QT interval and are metabolized by CYP2D6 (e.g., thioridazine and pimozide) and should not be used concomitantly with other drugs containing quinidine, quinine, or mefloquine. NUEDEXTA is contraindicated in patients taking monoamine oxidase inhibitors (MAOIs) or in patients who have taken MAOIs within the preceding 14 days. NUEDEXTA is contraindicated in patients with a known hypersensitivity to its components.

 

NUEDEXTA may cause serious side effects, including possible changes in heart rhythm. NUEDEXTA is contraindicated in patients with a prolonged QT interval, congenital long QT syndrome or a history suggestive of torsades de pointes, in patients with heart failure as well as patients with, or at risk of, complete atrioventricular (AV) block, unless the patient has an implanted pacemaker. NUEDEXTA causes dose-dependent QTc prolongation. When initiating NUEDEXTA in patients at risk of QT prolongation and torsades de pointes, electrocardiographic (ECG) evaluation of QT interval should be conducted at baseline and 3-4 hours after the first dose.

 

The most common adverse reactions in patients taking NUEDEXTA are diarrhea, dizziness, cough, vomiting, weakness, swelling of feet and ankles, urinary tract infection, flu, elevated liver enzymes, and flatulence.

 

NUEDEXTA may cause dizziness. Precautions to reduce the risk of falls should be taken, particularly for patients with motor impairment affecting gait or a history of falls.

 

PBA indication and market

 

PBA is a distinct neurologic syndrome that is characterized by a lack of control of emotional expression, typically involving episodes of involuntary or exaggerated motor expression of emotion such as laughing, crying or other emotional displays.

 

There are an estimated 18 to 20 million people in the United States who suffer from the underlying neurological conditions that can give rise to PBA. These underlying neurologic conditions include but are not limited to ALS, MS, Alzheimer’s disease, Parkinson’s disease, stroke and traumatic brain injury. Extrapolating from the epidemiologic medical literature, physician estimates and an AVANIR-sponsored patient survey, which surveyed a total of 2,464 patients and caregivers of patients with underlying neurologic conditions associated with PBA (including ALS, Alzheimer’s disease/dementias, MS, Parkinson’s disease, stroke and traumatic brain injury), we estimate that approximately 10% of people in the United States who suffer from neurological disease or injury suffer from moderate to severe PBA, with many more suffering from mild PBA.

 

Other than NUEDEXTA, there are no approved therapies indicated to treat PBA. Currently, some physicians treat PBA using a range of drugs off-label, including: selective serotonin reuptake inhibitors/serotonin-norepinephrine reuptake inhibitors, or SSRIs/SNRIs, antidepressants and atypical antipsychotics. According to our market research, physicians are generally only moderately satisfied with these off-label therapies as a treatment for PBA. We conducted this market research through an Internet-based survey of 215 physicians, consisting of Neurologists, Internal Medicine/Geriatrics, Psychiatrists and Physical Medicine and Rehabilitation specialists.

 

We believe that NUEDEXTA represents a more attractive treatment option for patients suffering from PBA. In our Phase III STAR trial that was completed in 2009 with patients suffering from either ALS or MS as the underlying neurological condition, patients treated with NUEDEXTA reported an average overall 80% reduction in episodes at the end of the 12-week study compared to baseline, with an average 50% reduction in episodes in the first week of treatment. Over the course of the 12-week study, patients receiving NUEDEXTA experienced significantly lower PBA episode rates versus placebo (P<0.0001). Over the final two weeks of the STAR trial, one-half of patients treated with NUEDEXTA achieved episode-free remission.

Our market research, conducted pursuant to the physician survey described above, indicates that 85% of surveyed physicians within targeted physician specialties would likely or very likely prescribe NUEDEXTA to treat their patients suffering from PBA. Of the surveyed physicians, the highest use was expected to be in PBA patients who have underlying conditions of either stroke or traumatic brain injury, but physicians expect to treat all PBA patient populations with NUEDEXTA. Among those physicians expressing an intent to prescribe NUEDEXTA, 78% indicated that NUEDEXTA would likely be used as a first-line therapy or an add-on therapy.

 

NUEDEXTA Commercialization Strategy

 

We intend to market NUEDEXTA initially to approximately 14,000 physicians who primarily specialize in psychiatry and neurology. Our commercialization strategy for NUEDEXTA includes the following elements: increase awareness of PBA, promote trial and adoption of NUEDEXTA, increase brand awareness of NUEDEXTA and minimize payment and distribution barriers.

 

AVP-923 for the Treatment of Neuropathic Pain Indications

 

AVP-923 for the treatment of diabetic neuropathic pain

 

Diabetic peripheral neuropathic pain (“DPN pain”), which arises from nerve injury, can result in a chronic and debilitating form of pain that has historically been poorly diagnosed and treated. It is often described as burning, tingling, stabbing, or pins and needles in the feet, legs, hands or arms. An estimated 3.5 million people in the United States experience DPN pain according to the American Diabetes Association. DPN pain currently is most commonly treated with antidepressants, anticonvulsants, opioid analgesics and local anesthetics. Most of these treatments have limited effectiveness or undesirable side effects resulting in a high degree of unmet medical need. The neuropathic pain market is continuing to grow rapidly, and in 2006, was estimated to be worth $2.6 billion in sales among the seven largest markets, consisting of the United States, Japan, France, Germany, Italy, Spain and the United Kingdom.

 

AVANIR has successfully completed a Phase III clinical trial for AVP-923 in the treatment of patients with DPN pain. In April 2007, we announced positive top-line data from our first Phase III clinical trial of AVP-923 for the treatment of patients with DPN pain. The primary endpoint of the trial was based on the daily diary entries for the Pain Rating Scale as defined in the SPA with the FDA. In the trial, two doses of AVP-923, 45/30 mg DMQ dosed twice daily (“AVP-923 45/30”) and 30/30 mg DMQ dosed twice daily (“AVP-923 30/30”), were compared to placebo based on daily patient diary entries for the Pain Rating Scale. Both AVP-923 treatment groups had lower pain ratings than placebo patients (p <0.0001 in both cases). In the AVP-923 45/30 patient group, average reductions were significantly greater than placebo patients at Days 30, 60, and 90 (p <0.0001 at each time point). In the AVP-923 30/30 patient group, average reductions were also significantly greater than placebo patients at Days 30 and 60 (p <0.0001) and Day 90 (p=0.007).

 

AVP-923 also demonstrated statistically significant improvements in a number of key secondary endpoints including the Pain Relief Ratings Scale and the Pain Intensity Ratings Scale. The secondary endpoints compared the baseline value to the average rating values at each study visit after randomization. The average pain relief reductions, as measured on the Pain Relief Rating Scale, were greater for the AVP-923 45/30 patient group (p=0.0002) and for the AVP-923 30/30 patient group (p=0.0083), compared with placebo. In addition, the DMQ 45, but not the DMQ 30, patient group demonstrated statistically significant improvements in the Pain Intensity Rating Scale compared with placebo (p=0.029). Although not powered to detect differences in the secondary endpoint of the Peripheral Neuropathy Quality of Life Scale Composite score and thus not achieving statistical significance, the AVP-923 45/30 patients showed a greater improvement than placebo patients (p=0.05) and the AVP-923 30/30 patients showed a trend towards greater improvement than placebo patients (p=0.08).

 

The most commonly reported adverse events from this Phase III study were dizziness, nausea, diarrhea, fatigue and somnolence, which were mild to moderate in nature. A higher number of patients in the AVP-923 45/30 and AVP-923 30/30 treatment groups (25.2% and 21.0%, respectively) discontinued due to an adverse event than compared to placebo (11.4%). There were no statistically significant differences in serious adverse event with 7.6%, 4.8% and 4.1% reported in the AVP-923 45/30, AVP-923 30/30 and placebo groups, respectively, and no deaths occurred during the study.

Due to safety concerns raised by the FDA in our October 2006 approvable letter for AVP-923, we conducted a formal pharmacokinetic (“PK”) study to identify a lower quinidine dose formulation that may have similar efficacy to the doses tested in the Phase III study. In May 2008, we reported a positive outcome of the formal PK study and announced that we identified alternative lower quinidine dose formulations of AVP-923 for the next DPN pain phase III clinical trial. The new dose is intended to deliver similar efficacy and improved safety/tolerability versus the formulations previously tested in DPN pain.

 

In September 2008, we submitted our Phase III protocol and related program questions for AVP-923 in the treatment of patients with DPN pain to the FDA under the SPA process. In subsequent communications regarding the continued development of AVP-923 for DPN pain, the FDA has indicated that it may be necessary to test a lower quinidine dose formulation in the DPN pain indication, such as the formulation that was identified in our PK study. Additionally, based on feedback from the FDA, we believe that it is likely that two large well controlled Phase III trials utilizing a new lower quinidine dose formulation would be needed to support a New Drug Application (“NDA”) filing for this indication. Due to our limited capital resources and focus on the commercialization of NUEDEXTA, we do not expect that we will be able to initiate the trials needed for this indication without additional capital or a development partner for AVP-923. Accordingly, we are evaluating our options to fund this program, including the potential for a development partner.

 

AVP-923 for the Treatment of MS Pain

 

In September 2009, we reported on secondary efficacy endpoints from the double-blind phase of the AVP-923 STAR trail in PBA, including an endpoint measuring reduction of pain in patients with underlying MS. AVP-923 30/10 mg demonstrated statistically significant relief of MS-related pain compared to placebo in the subset of MS patients with moderate-to-severe pain. Based on these data and the previous proof of concept pain data in MS patients with PBA, we are conducting a strategic assessment of the optimal clinical development path for AVP-923 to obtain an MS pain indication.

 

Other Programs

 

Docosanol 10% Cream — Cold Sore Treatment

 

Docosanol 10% cream is a topical treatment for cold sores. In 2000, we received FDA approval for marketing docosanol 10% cream as an over-the-counter product. Since that time, docosanol 10% cream has been approved by regulatory agencies in Asia, North America, and Europe. In March 2000, we granted a subsidiary of GlaxoSmithKline, SB Pharmco Puerto Rico, Inc. (“GSK”), the exclusive rights under a license to market docosanol 10% cream in the United States and Canada (“GSK License Agreement”). GSK markets the product under the name Abreva^® in these markets. Under the terms of the GSK License Agreement, GSK is responsible for all sales and marketing activities and the manufacturing and distribution of docosanol 10% cream. Under the GSK license agreement, the Company received a total of $25 million in milestone payments from GSK and the Company was entitled to receive an 8% royalty on net sales of Abreva by GSK.

 

In November 2002, the Company sold to Drug Royalty USA an undivided interest in the Company’s rights to receive future Abreva royalties under the GSK License Agreement for $24.1 million (the “Drug Royalty Agreement”). Under the Drug Royalty Agreement, Drug Royalty USA has the right to receive royalties from GSK on sales of Abreva until December 2013. The Company retained the right to receive 50% of all royalties (a net of 4%) under the GSK License Agreement for annual net sales of Abreva in the U.S. and Canada in excess of $62 million. From the effective date of the GSK License Agreement up to the 2002 sale of the Company’s royalty rights to Drug Royalty USA, Inc. (“DRC”) the Company received a total of approximately $5.9 million in royalty payments from GSK attributed to the 8% royalty on net sales by GSK.

 

Under the terms of our docosanol license agreements, our partners are generally responsible for all regulatory approvals, sales and marketing activities, and manufacturing and distribution of the product in the licensed territories. The terms of the license agreements typically provide for us to receive a data transfer fee, potential milestone payments and royalties on product sales. We purchase the active pharmaceutical ingredient (“API”), docosanol, from a large supplier in Western Europe and have, on occasion, sold material to our licensees. We

currently store our API in the United States. Any material disruption in manufacturing could cause a delay in shipments and possible loss of sales.

 

Xenerex Human Antibody Technology — Anthrax/Other Infectious Diseases

 

In March 2008, we entered into an Asset Purchase and License Agreement with Emergent Biosolutions for the sale of our anthrax antibodies and license to use our proprietary Xenerex Technology platform, which was used to generate fully human antibodies to target antigens. Under the terms of the Agreement, we completed the remaining work under our NIH/NIAID grant (“NIH grant”) and transferred all materials to Emergent. Under the terms of the agreement, we are eligible to receive milestone payments and royalties on any product sales generated from this program. In connection with the sale of the anthrax antibody program, we also ceased all ongoing research and development work related to other infectious diseases on June 30, 2008.

 

In September 2008, we entered into an Asset Purchase Agreement with a San Diego based biotechnology company for the sale of our non-anthrax related antibodies as well as the remaining equipment and supplies associated with the Xenerex Technology platform. In connection with this sale, we received an upfront payment of $210,000 and are eligible to receive future royalties on potential product sales, if any.

 

Competition

 

The pharmaceutical industry is characterized by rapidly evolving technology and intense competition. A large number of 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 available to them. 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 personnel.

 

NUEDEXTA for Pseudobulbar Affect.  Although NUEDEXTA is the first product to be marketed for the treatment of PBA, we are aware that physicians may prescribe other products in an off-label manner for the treatment of this disorder. For example, NUEDEXTA may face competition from the following products:

 

 

While it is also possible that compounding pharmacies could combine the components of NUEDEXTA in an unauthorized fashion, it is inconsistent with the policies of the Pharmacy Compounding Accreditation Board.

 

AVP-923 for DPN pain.  We anticipate that AVP-923 for the treatment of DPN pain, if further developed by us and approved by the FDA for marketing, would compete with other drug products that are currently prescribed by physicians, including those identified below. Additionally, many other companies are developing drug candidates for this indication and we expect competition for AVP-923, if approved to treat DPN pain, to be intense. Current approved competitors include:

 

 

Docosanol 10% cream.  Abreva faces intense competition in the U.S. and Canada from the following established products:

 

 

Manufacturing

 

We currently have no manufacturing or production facilities and, accordingly, rely on third parties for clinical production of our products and product candidates. We obtain the API for NUEDEXTA from one of several available commercial suppliers. Further, we licensed to various pharmaceutical companies the exclusive rights to manufacture and distribute docosanol 10% cream.

 

Patents and Proprietary Rights

 

As of September 30, 2010, we owned or had the rights to 136 issued patents (41U.S. and 95 foreign) and 60 pending applications (5 U.S. and 55 foreign). Patents and patent applications owned or licensed by us include NUEDEXTA and other technologies, including but not limited to docosanol-related products and technologies and MIF inhibitor technologies.

 

 

In June 2008, the European Patent Office (“EPO”) granted a new patent which extends the period of commercial exclusivity for NUEDEXTA into 2023. The new European patent expands the available NUEDEXTA dose ranges under prior patent protection and encompasses a range of indications, including PBA, DPN pain, and other neurologic conditions.

 

In February 2010, the United States Patent and Trademark Office (“USPTO”) granted a new patent which extends the period of commercial exclusivity for NUEDEXTA into 2025. Subsequent to February 2010, the period of commercial exclusively for NUEDEXTA was extended an additional year to 2026. The new U.S. patent expands the available NUEDEXTA dose ranges under prior patent protection and encompasses our current clinical development programs in PBA and other neurologic conditions. A divisional application containing claims in support of the DPN pain program was filed and is pending with the USPTO.

 

In addition to this newly allowed U.S. patent, we have exclusive rights under a royalty-bearing license granted from the Center for Neurologic Study (“CNS”) to a family of patents and patent applications that claim methods of treating PBA, chronic pain, as well as other neurologic conditions, using combinations of dextromethorphan and quinidine, the two active agents in NUEDEXTA.

 

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 in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Government Regulations

 

The FDA and comparable regulatory agencies in foreign countries extensively regulate the manufacture and sale of the pharmaceutical products that we have developed or are currently 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 tested in humans include:

 

 

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.

 

The clinical testing program for a new drug typically involves three phases:

 

 

Data from all clinical studies, as well as all nonclinical studies and evidence of product quality, typically are submitted to the FDA in a NDA. Although the FDA’s requirements for clinical trials are well established and we believe that we have planned and conducted our clinical trials in accordance with the FDA’s applicable regulations and guidelines, these requirements, including requirements relating to testing the safety of drug candidates, may be subject to change or new interpretation. Additionally, we could be required to conduct additional trials beyond what we had planned due to the FDA’s safety and/or efficacy concerns or due to differing interpretations of the meaning of our clinical data. (See Item 1A, “Risk Factors”).

 

The FDA’s Center for Drug Evaluation and Research must approve a NDA for a drug before it may be marketed in the U.S. If 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 also 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.

 

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 Lanham Act (trademark statute), and other federal and state laws, including the federal anti-kickback statute.

 

We currently intend to continue to seek, directly or through our partners, approval to market our products and product candidates 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.

 

Product Liability Insurance

 

We maintain product liability insurance on our products and clinical trials that provides coverage in the amount of $10 million per incident and $10 million in the aggregate. We may increase our product liability insurance coverage when we commence marketing NUEDEXTA.

Executive Officers and Key Employees of the Registrant

 

Information concerning our executive officers and key employees, including their names, ages and certain biographical information can be found in Part III, Item 10 under the caption, “Executive Officers and Key Employees of the Registrant.” This information is incorporated by reference into Part I of this report.

 

Employees

 

As of December 1, 2010, we employed 128 persons, including 14 engaged in research and development activities, including clinical development, medical and regulatory affairs, and 114 in selling, general and administrative functions such as human resources, finance, accounting, business development, sales, marketing, and investor relations. Of the selling, general and administrative positions, approximately 94 are field based.

 

Financial Information about Segments

 

We operate in a single accounting segment — the development and commercialization of novel treatments that target the central nervous system. Refer to Note 15, “Segment Information” in the Notes to the Consolidated Financial Statements.

 

General Information

 

Our principal executive offices are located at 101 Enterprise, Suite 300, Aliso Viejo, California 92656. Our telephone number is (949) 389-6700 and our e-mail address is info@avanir.com. Our Internet website address is www.avanir.com. No portion of our website is incorporated by reference into this Annual Report on Form 10-K.

 

You are advised to read this Annual Report on Form 10-K in conjunction with other reports and documents that we file from time to time with the Securities and Exchange Commission (“SEC”). In particular, please read our Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K that we may file from time to time. You may obtain copies of these reports after the date of this annual report directly from us or from the SEC at the SEC’s Public Reference Room at 100 F Street, N.E. Washington, D.C. 20549. In addition, the SEC maintains information for electronic filers (including AVANIR) at its website at www.sec.gov. The public may obtain information regarding the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. We make our periodic and current reports available on our internet website, free of charge, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC.

 

 

This Annual Report on Form 10-K contains forward-looking information based on our current expectations. Because our actual results may differ materially from any forward-looking statements that we make or that are made on our behalf, this section includes a discussion of important factors that could affect our actual future results, including, but not limited to, our product sales, capital resources, commercial market estimates, safety of NUEDEXTA, future development efforts, patent protection, effects of healthcare reform, reliance on third parties, and other risks set forth below.

 

Risks Relating to Our Business

 

Our near-term prospects are dependent on NUEDEXTA. If we are unable to successfully commercialize NUEDEXTA, including successfully maintaining adequate sales, marketing or distribution capabilities or entering into agreements with third parties to perform some of these functions, we will not be able to commercialize NUEDEXTA effectively and our ability to generate significant revenue or achieve profitability will be adversely affected.

 

Although NUEDEXTA has been approved for marketing, our ability to generate significant revenue in the near to medium term is entirely dependent upon our ability to commercialize NUEDEXTA. As we prepare for the launch of NUEDEXTA, we may not be able to adequately build or maintain the necessary sales, marketing, supply chain management or reimbursement capabilities on our own or enter into arrangements with third parties to perform these functions in a timely manner or on acceptable terms. Additionally, maintaining sales, marketing and

distribution capabilities may be more expensive than we anticipate, requiring us to divert capital from other intended purposes or preventing us from building our sales, marketing and distribution capabilities to the desired levels. To be successful we must:

 

 

The commercialization of NUEDEXTA requires us to manage relationships with an increasing number of collaborative partners, suppliers and third-party contractors. If we are unable to successfully establish and maintain the required infrastructure, either internally or through third parties, and successfully manage an increasing number of relationships, we will have difficulty growing our business. In addition, we may enter into co-promotion or out-licensing arrangements with other pharmaceutical or biotechnology partners where necessary to reach customers in domestic or foreign market segments and when deemed strategically and economically advisable. To the extent that we enter into co-promotion or other licensing arrangements, our product revenues are likely to be lower than if we directly marketed and sold NUEDEXTA, and some or all of the revenues we receive will depend upon the efforts of third parties, which may not be successful. If we are unable to develop and maintain adequate sales, marketing and distribution capabilities, independently or with others, we may not be able to generate significant product revenue or become profitable.

 

We have a history of net losses and an accumulated deficit, and we may never generate sufficient revenue to achieve or maintain profitability in the future.

 

We have experienced significant net losses and negative cash flows from operations and we expect our negative cash flow from operations to continue until we are able to generate significant revenues from sales of NUEDEXTA. As of September 30, 2010, we had an accumulated deficit of approximately $304.7 million. We have incurred these losses principally from costs incurred in funding the research, development and clinical testing of our drug candidates and from our general and administrative expenses. We may continue incurring net losses for the foreseeable future and we expect our operating losses to increase for at least the short term as we increase our total expenditures in preparation for the commercial launch of NUEDEXTA.

 

Our ability to generate revenue and achieve profitability is dependent on our ability, alone or with partners, to successfully manufacture and market NUEDEXTA for the treatment of patients with PBA. We expect to continue to spend substantial amounts on preparing for the commercial launch of NUEDEXTA in PBA, as well as seeking regulatory approvals for use of NUEDEXTA in other geographic markets and indications. As a result, we may never generate sufficient revenue from product sales to become profitable or generate positive cash flows.

 

PBA is a new market and estimates vary significantly over the potential market size and our anticipated revenues over the near and long term.

 

Our drug is being made available to patients to treat PBA, an indication for which there is no established pharmaceutical market. Industry sources and equity research analysts have a wide divergence of estimates for the near- and long-term market potential of our product. A variety of assumptions directly impact the estimates for our drug’s market potential, including estimates of underlying neurologic condition prevalence, severity of PBA prevalence among these conditions, rates of physician adoption of our drug for treatment of PBA among these populations, drug pricing assumptions, and patient adherence and compliance rates within each underlying neurologic condition. Small differences in these assumptions can lead to widely divergent estimates of the market potential of our product. Accordingly, investors are cautioned not to place undue reliance on any particular estimates of equity research analysts or industry sources.

We have limited capital resources and may need to raise additional funds to support our operations.

 

We have experienced significant operating losses in funding the research, development and clinical testing of our drug candidates and we expect to continue to incur substantial operating losses for the foreseeable future as we commence commercial operations. Although we had approximately $122.3 million in cash and cash equivalents and restricted investments in marketable securities as of December 1, 2010, we currently do not have any meaningful sources of recurring revenue or cash flow from operations and may not be able to achieve profitability with our current capital resources.

 

In light of our substantial long-term capital needs, we may need to partner (either in the U.S. or outside the U.S.) or raise additional capital in the future to finance our long-term operations, until we expect to be able to generate meaningful amounts of revenue from product sales. Based on our current loss rate and existing capital resources as of the date of this report, we estimate that we have sufficient funds to sustain our operations at their current and anticipated levels through at least the next 24 months, which includes the planned launch of NUEDEXTA for PBA in the first calendar quarter of fiscal 2011. Although we expect to be able to raise additional capital, there can be no assurance that we will be able to do so or that the available terms of any financing would be acceptable to us. If we are unable to raise additional capital to fund future operations, then we may be unable to fully execute our development and commercialization plans for NUEDEXTA. This may result in significant delays or cutbacks in the commercialization of NUEDEXTA and may force us to further curtail our operations or seek to raise additional capital.

 

If we raise additional capital, we may do so through various financing alternatives, including licensing or sales of our technologies, drugs and/or drug candidates, selling shares of common or preferred stock, through the acquisition of other companies, or through the issuance of debt. Each of these financing alternatives carries certain risks. Raising capital through the issuance of common stock may depress the market price of our stock. Any such financing will dilute our existing stockholders and, if our stock price is relatively depressed at the time of any such offering, the levels of dilution would be greater. In addition, debt financing, to the extent available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as making capital expenditures or entering into licensing transactions. If we seek to raise capital through licensing transactions or sales of one or more of our technologies, drugs or drug candidates, as we have previously done with certain investigational compounds and docosanol 10% cream, then we will likely need to share a significant portion of future revenues from these drug candidates with our licensees. Additionally, the development of any drug candidates licensed or sold to third parties will no longer be in our control and thus we may not realize the full value of any such relationships.

 

Significant safety or drug interaction problems could arise with respect to NUEDEXTA, which could result in restrictions in NUEDEXTA’s label, recalls, withdrawal of NUEDEXTA from the market, an adverse impact on potential sales of NUEDEXTA, or cause us to alter or terminate current or future NUEDEXTA clinical development programs, any of which would adversely impact our future business prospects.

 

Discovery of previously unknown safety or drug interaction problems with an approved product may result in a variety of adverse regulatory actions. Under the Food and Drug Administration Amendments Act of 2007, the FDA has broad authority to force drug manufacturers to take any number of actions if previously unknown safety or drug interaction problems arise, including, but not limited to: (i) requiring manufacturers to conduct post-approval clinical studies to assess known risks or signals of serious risks, or to identify unexpected serious risks; (ii) mandating labeling changes to a product based on new safety information; or (iii) requiring manufacturers to implement a Risk Evaluation Mitigation Strategy, or REMS, where necessary to assure safe use of the drug. In addition, previously unknown safety or drug interaction problems could result in product recalls, restrictions on the product’s permissible uses, or withdrawal of the product from the market.

 

The combination of dextromethorphan and quinidine has never been marketed for the treatment of any condition until the approval of NUEDEXTA. NUEDEXTA has only been studied in a limited number of patients in clinical studies and the data submitted to the FDA as part of our New Drug Application was obtained in controlled clinical trials of limited duration. In connection with the approval of NUEDEXTA, the FDA has required that we conduct certain post-approval studies, which include both non-clinical studies and a pediatric development plan. New safety or drug interaction issues may arise from these studies or as NUEDEXTA is used over longer periods of

time by a wider group of patients. In addition, as we conduct other clinical trials for NUEDEXTA in other indications, new safety problems may be identified which could negatively impact both our ability to successfully complete these studies and the use and/or regulatory status of NUEDEXTA for the treatment of PBA. New safety or drug interaction issues may result in product liability lawsuits and may require us to, among other things, provide additional warnings and/or restrictions on the NUEDEXTA package insert, including a boxed warning, directly alert healthcare providers of new safety information, narrow our approved indications, or alter or terminate current or planned trials for additional uses of NUEDEXTA, any of which could have a significant adverse impact on potential sales of NUEDEXTA.

 

In addition, if we are required to conduct additional post-approval clinical studies, implement a REMS, or take other similar actions, such requirements or restrictions could have a material adverse impact on our ability to generate revenues from sales of NUEDEXTA, or require us to expend significant additional funds.

 

We have out-licensed or sold most of our non-core drug development programs and related assets and these and other possible future dispositions carry certain risks.

 

We have entered into agreements for the out-licensing or sale of our non-core assets, including FazaClo, our anthrax antibody program, and other antibodies in our infectious disease program, as well as docosanol in the U.S. and other markets worldwide. As a result, we do not currently have a diversified pipeline of product candidates and our long-term success is currently dependent on NUEDEXTA. From time to time, we have been and will continue to be engaged in discussions with potential licensing or development partners for NUEDEXTA for PBA and/or other indications and we may choose to pursue a partnership or license involving NUEDEXTA, if the terms are attractive. However, these transactions involve numerous risks, including:

 

 

Transactions such as these carry significant risks where a large portion of the total consideration is contingent upon post-closing events, such as commercialization or sales milestones. We may not exercise control over whether these milestones are met and, if they are not met, then a potentially large portion of the value of the transaction may not be realized. Disputes may also develop over these and other terms, such as representations and warranties, indemnities, earn-outs, and other provisions in the transaction agreements. If disputes are resolved unfavorably, our financial condition and results of operations may be adversely affected and we may not realize the anticipated benefits from the transactions.

 

Disputes relating to these transactions can lead to expensive and time-consuming litigation and may subject us to unanticipated liabilities or risks, disrupt our operations, divert management’s attention from day-to-day operations, and increase our operating expenses.

 

The FDA’s safety concerns regarding our prior formulation of AVP-923 for the treatment of PBA extend to other clinical indications that we have been pursuing, including DPN pain. Due to these concerns, any future development of AVP-923 for other indications is expected to use an alternative lower-dose quinidine formulation, which may negatively affect efficacy.

 

We have successfully completed a single Phase III trial for AVP-923 in the treatment of DPN pain. In communications regarding the continued development of AVP-923 for this indication, the FDA has expressed that the safety concerns and questions raised in the PBA approvable letter necessitate the testing of a low-dose quinidine formulation in the DPN pain indication as well. Additionally, based on feedback we have received from the FDA on the proposed continued development of AVP-923 for this indication, we believe it is likely that two large well-controlled Phase III trials would be needed to support a supplemental NDA filing for this indication. Due to our limited capital resources, we do not expect that we will be able to conduct the trials needed for this indication without additional capital or a development partner for NUEDEXTA. Moreover, although we achieved positive results in our initial Phase III trial, an alternative low-dose quinidine formulation may not yield the same levels of

efficacy as seen in the earlier trials or as predicted based on our subsequent pharmacokinetic study. Any decrease in efficacy may be so great that the drug does not demonstrate a statistically significant improvement over placebo or an active comparator. Additionally, any alternative low-dose quinidine formulation that we develop may not sufficiently satisfy the FDA’s safety concerns. If this were to happen, we may not be able to pursue the development of AVP-923 for other indications or may need to undertake significant additional clinical trials, which would be costly and cause potentially substantial delays.

 

We rely on market research to evaluate the potential commercial acceptance of NUEDEXTA.

 

Based on the results of our market research, we believe that physicians are likely to support the use and adoption of NUEDEXTA for the treatment of PBA. We conducted market research in accordance with Good Marketing Research Practices and we concluded that they may not be indicative of the response we might receive from a broader selection of physicians. Moreover, these results are based on physicians’ impressions formed from a description of the product, and not actual results from prescription of the product, which could result in different responses from those same or other physicians.

 

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

 

We have invested in an extensive patent portfolio and we rely substantially on the protection of our intellectual property through our ownership or control of issued patents and patent applications. Because of the competitive nature of the biopharmaceutical industry, we cannot assure you that:

 

 

Even if we successfully secure our intellectual property rights, third parties, including other biotechnology or pharmaceutical companies, may allege that our technology infringes on their rights or that our patents are invalid or not enforceable. Intellectual property litigation is costly, and even if we were to prevail in such a dispute, the cost of litigation could adversely affect our business, financial condition, and results of operations. Litigation is also time consuming and would divert management’s attention and resources away from our operations and other activities. If we were to lose any litigation, in addition to any damages we would have to pay, we could be required to stop the infringing activity or obtain a license. Any required license might not be available to us on acceptable terms, or at all. Some licenses might be non-exclusive, and our competitors could have access to the same technology licensed to us. If we were to fail to obtain a required license or were unable to design around a competitor’s patent, we would be unable to sell or continue to develop some of our products, which would have a material adverse effect on our business, financial condition and results of operations.

 

It is unclear whether we would be eligible for patent-term restoration in the U.S. under applicable law and we therefore do not know whether our patent-term can be extended.

 

Some of our U.S. patents may be eligible for limited patent term extension under the Drug Price Competition and Patent Term Restoration Act of 1984, referred to as the Hatch-Waxman Amendments. Due to receipt of approval for NUEDEXTA, the Hatch-Waxman Amendments permit a patent restoration term of up to five years for one of our patents covering NUEDEXTA as compensation for the patent term lost during product development and the regulatory review process. The patent term restoration period is generally one-half the time between the

effective date of an IND and the submission date of an NDA, plus the time between the submission date of an NDA and the approval of that application with a maximum of five years. We intend to apply for patent term restoration. However, because NUEDEXTA is not a new chemical entity, but is a combination of two previously approved products, it is uncertain whether NUEDEXTA will be granted any patent term restoration under the U.S. Patent and Trademark Office guidelines. In addition, the patent term restoration cannot extend the remaining term of a patent beyond a total of 14 years after the product’s approval date.

 

Market exclusivity provisions under the Federal Food, Drug and Cosmetic Act, or the FDCA, also may delay the submission or the approval of certain applications for competing product candidates. The FDCA provides three years of non-patent marketing exclusivity for an NDA if new clinical investigations, other than bioavailability studies, that were conducted or sponsored by the applicant are deemed by the FDA to be essential to the approval of the application. This three-year exclusivity covers only the conditions associated with the new clinical investigations and does not prohibit the FDA from approving abbreviated NDAs (ANDA) for drugs containing the original active agent.

 

Once the three-year FDCA exclusivity period has passed and after the patents (including the patent restoration term, if any) that cover NUEDEXTA expire or have been invalidated, generic drug companies would be able to introduce competing versions of the drug. If we are unsuccessful in defending our patents against generic competition, our long-term revenues from NUEDEXTA sales may be less than expected, we may have greater difficulty finding a development partner or licensee for NUEDEXTA and the costs to defend the patents would be significant.

 

NUEDEXTA may face competition from lower cost generic or follow-on products.

 

NUEDEXTA is approved under the provisions of the FDCA, which renders it susceptible to potential competition from generic manufacturers via the ANDA procedure. Generic manufacturers pursuing ANDA approval are not required to conduct costly and time-consuming clinical trials to establish the safety and efficacy of their products; rather, they are permitted to rely on the innovator’s data regarding safety and efficacy. Thus, generic manufacturers can sell their products at prices much lower than those charged by the innovative pharmaceutical or biotechnology companies who have incurred substantial expenses associated with the research and development of the drug product.

 

The ANDA procedure includes provisions allowing generic manufacturers to challenge the innovator’s patent protection by submitting “Paragraph IV” certifications to the FDA in which the generic manufacturer claims that the innovator’s patent is invalid or will not be infringed by the manufacture, use, or sale of the generic product. A patent owner who receives a Paragraph IV certification may choose to sue the generic applicant for patent infringement. In recent years, generic manufacturers have used Paragraph IV certifications extensively to challenge the applicability of patents listed in the FDA’s Approved Drug Products List with Therapeutic Equivalence Evaluations, commonly referred to as the Orange Book, on a wide array of innovative therapeutic products. We expect this trend to continue and to implicate drug products with even relatively modest revenues.

 

If an ANDA filer were to receive approval to sell a generic version of NUEDEXTA, NUEDEXTA would become subject to increased competition and our revenue would be adversely affected. Additionally, it is possible that compounding pharmacies could formulate a generic version of NUEDEXTA in violation of our patent rights, which could also adversely affect our revenues.

 

We may be unable to protect our unpatented proprietary technology and information.

 

In addition to our patented intellectual property, we also rely on trade secrets and confidential information. We may be unable to effectively protect our rights to such proprietary technology or information. Other parties may independently develop or gain access to equivalent technologies or information and disclose it for others to use. Disputes may arise about inventorship and corresponding rights to know-how and inventions resulting from the joint creation or use of intellectual property by us and our corporate partners, licensees, scientific and academic collaborators and consultants. In addition, confidentiality agreements and material transfer agreements we have entered into with these parties and with employees and advisors may not provide effective protection of our proprietary technology or information or, in the event of unauthorized use or disclosure, may not provide adequate remedies.

If we fail to obtain regulatory approval in foreign jurisdictions, we would not be able to market our products abroad and our revenue prospects would be limited.

 

We may seek to have our products or product candidates marketed outside the United States. In order to market our products in the European Union and many other foreign jurisdictions, we must obtain separate regulatory approvals and comply with numerous and varying regulatory requirements. The approval procedure varies among countries and jurisdictions and can involve additional testing. The time required to obtain approval may differ from that required to obtain FDA approval. The foreign regulatory approval processes may include all of the risks associated with obtaining FDA approval. We may not obtain foreign regulatory approvals on a timely basis, if at all. For example, our development partner in Japan encountered significant difficulty in seeking approval of docosanol in that country and was forced to abandon efforts to seek approval in that country. Approval by the FDA does not ensure approval by regulatory authorities in other countries or jurisdictions, and approval by one foreign regulatory authority does not ensure approval by regulatory authorities in other foreign countries or jurisdictions or by the FDA. We may not be able to file for regulatory approvals and may not receive necessary approvals to commercialize our products in any market. The failure to obtain these approvals could materially adversely affect our business, financial condition and results of operations.

 

We face challenges recruiting and retaining members of management and other key personnel.

 

The industry in which we compete has a high level of employee mobility and aggressive recruiting of skilled employees. This type of environment creates intense competition for qualified personnel, particularly in commercial, clinical and regulatory affairs, research and development and accounting and finance. Because we have a relatively small organization, the loss of any executive officers, including the Chief Executive Officer, key members of senior management or other key employees, could adversely affect our operations. For example, if we were to lose one or more of the senior members of our sales and marketing team, the success of the NUEDEXTA launch could be adversely affected.

 

Our operations might be interrupted by the occurrence of a natural disaster or other catastrophic event.

 

Our principal operations are located in Aliso Viejo, California. We depend on our facilities and on our partners, contractors and vendors for the continued operation of our business. Natural disasters or other catastrophic events, interruptions in the supply of natural resources, political and governmental changes, wildfires and other fires, floods, explosions, actions of animal rights activists, earthquakes and civil unrest could disrupt our operations or those of our partners, contractors and vendors. Even though we believe we carry commercially reasonable business interruption and liability insurance, and our contractors may carry liability insurance that protect us in certain events, we might suffer losses as a result of business interruptions that exceed the coverage available under our and our contractors’ insurance policies or for which we or our contractors do not have coverage. Any natural disaster or catastrophic event could have a significant negative impact on our operations and financial results. Moreover, any such event could impact the commercialization of NUEDEXTA and our research and development programs.

 

Future acquisitions could disrupt our business and harm our financial condition.

 

In order to augment our product pipeline or otherwise strengthen our business, we may decide to acquire additional businesses, products and technologies. As we have limited experience in evaluating and completing acquisitions, our ability as an organization to make such acquisitions is unproven. Acquisitions could require significant capital infusions and could involve many risks, including, but not limited to, the following:

 

 

 

If any of these risks occurred, it could adversely affect our business, financial condition and operating results. We cannot assure you that we will be able to identify or consummate any future acquisitions on acceptable terms, or at all. If we do pursue any acquisitions, it is possible that we may not realize the anticipated benefits from such acquisitions or that the market will not view such acquisitions positively.

 

Risks Relating to Our Industry

 

There are a number of difficulties and risks associated with clinical trials and our trials may not yield the expected results.

 

There are a number of difficulties and risks associated with conducting clinical trials. For instance, we may discover that a product candidate does not exhibit the expected therapeutic results, may cause harmful side effects or have other unexpected characteristics that may delay or preclude regulatory approval or limit commercial use if approved. It typically takes several years to complete a late-stage clinical trial and a clinical trial can fail at any stage of testing. If clinical trial difficulties or failures arise, our product candidates may never be approved for sale or become commercially viable.

 

In addition, the possibility exists that:

 

 

It is possible that earlier clinical and pre-clinical trial results may not be predictive of the results of subsequent clinical trials. If earlier clinical and/or pre-clinical trial results cannot be replicated or are inconsistent with subsequent results, our development programs may be cancelled or deferred. In addition, the results of these prior clinical trials may not be acceptable to the FDA or similar foreign regulatory authorities because the data may be incomplete, outdated or not otherwise acceptable for inclusion in our submissions for regulatory approval.

 

Additionally, the FDA has substantial discretion in the approval process and may reject our data or disagree with our interpretations of regulations or draw different conclusions from our clinical trial data or ask for additional

information at any time during their review. For example, the use of different statistical methods to analyze the efficacy data from our Phase III trial of AVP-923 in DPN pain results in significantly different conclusions about the efficacy of the drug. Although we believe we have legitimate reasons to use the methods that we have adopted as outlined in our SPA with the FDA, the FDA may not agree with these reasons and may disagree with our conclusions regarding the results of these trials.

 

Although we would work to be able to fully address any such FDA concerns, we may not be able to resolve all such matters favorably, if at all. Disputes that are not resolved favorably could result in one or more of the following:

 

 

If we do not receive regulatory approval to sell our product candidates or cannot successfully commercialize our product candidates, we would not be able to generate meaningful levels of sustainable revenues.

 

The pharmaceutical industry is highly competitive and most of our competitors have larger operations and have greater resources. As a result, we face significant competitive hurdles.

 

The pharmaceutical and biotechnology industries are highly competitive and subject to significant and rapid technological change. We compete with hundreds of companies that develop and market products and technologies in areas similar to those in which we are performing our research. For example, we expect that NUEDEXTA will face competition from antidepressants, atypical anti-psychotic agents and other agents in the treatment of PBA. Additionally, NUEDEXTA may face challenges from “generic” drug companies, as described above.

 

Our competitors may have specific expertise and development technologies that are better than ours and many of these companies, which include large pharmaceutical companies, either alone or together with their research partners, have substantially greater financial resources, larger research and development capabilities and substantially greater experience than we do. Accordingly, our competitors may successfully develop competing products. We are also competing with other companies and their products with respect to manufacturing efficiencies and marketing capabilities, areas where we have limited or no direct experience.

 

If we fail to comply with regulatory requirements, regulatory agencies may take action against us, which could significantly harm our business.

 

Marketed products, along with the manufacturing processes, post-approval clinical data, labeling, advertising and promotional activities for these products, are subject to continual requirements and review by the FDA and other regulatory bodies. In addition, regulatory authorities subject a marketed product, its manufacturer and the manufacturing facilities to ongoing review and periodic inspections. We will be subject to ongoing FDA requirements, including required submissions of safety and other post-market information and reports, registration requirements, current Good Manufacturing Practices (“cGMP”) regulations, requirements regarding the distribution of samples to physicians and recordkeeping requirements.

 

The cGMP regulations also include requirements relating to quality control and quality assurance, as well as the corresponding maintenance of records and documentation. We rely on the compliance by our contract manufacturers with cGMP regulations and other regulatory requirements relating to the manufacture of products. We are also subject to state laws and registration requirements covering the distribution of our products. Regulatory agencies may change existing requirements or adopt new requirements or policies. We may be slow to adapt or may not be able to adapt to these changes or new requirements.

We face uncertainty related to healthcare reform, pricing and reimbursement, which could reduce our revenue.

 

In the United States, President Obama signed in March 2010 the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Affordability Reconciliation Act (collectively, “PPACA”), which is expected to substantially change the way health care is financed by both governmental and private payors. PPACA provides for changes to extend medical benefits to those who currently lack insurance coverage, encourages improvements in the quality of health care items and services, and significantly impacts the U.S. pharmaceutical industry in a number of ways, further listed below. By extending coverage to a larger population, PPACA may substantially change the structure of the health insurance system and the methodology for reimbursing medical services, drugs and devices. These structural changes could entail modifications to the existing system of private payors and government programs, such as Medicare, Medicaid and State Children’s Health Insurance Program, as well as the creation of a government-sponsored healthcare insurance source, or some combination of both. Such restructuring of the coverage of medical care in the United States could impact the extent of reimbursement for prescribed drugs, including our product candidates, biopharmaceuticals, and medical devices. Some of the specific PPACA provisions, among other things:

 

 

If future reimbursement for NUEDEXTA or any other approved product candidates, if any, is substantially less than we project, or rebate obligations associated with them are substantially increased, our business could be materially and adversely impacted.

 

Sales of NUEDEXTA for treatment of patients with PBA will depend in part on the availability of coverage and reimbursement from third-party payors such as government insurance programs, including Medicare and Medicaid, private health insurers, health maintenance organizations and other health care related organizations. Accordingly, coverage and reimbursement may be uncertain. Adoption of NUEDEXTA by the medical community may be limited if third-party payors will not offer coverage. Cost control initiatives may decrease coverage and payment levels for NUEDEXTA and, in turn, the price that we will be able to charge. We are unable to predict all changes to the coverage or reimbursement methodologies that will be applied by private or government payors to NUEDEXTA. Any denial of private or government payor coverage or inadequate reimbursement for procedures performed using NUEDEXTA could harm our business and reduce our revenue.

 

In addition, both the federal and state governments in the United States and foreign governments continue to propose and pass new legislation affecting coverage and reimbursement policies, which are designed to contain or reduce the cost of health care. Further federal and state proposals and healthcare reforms are likely, which could limit the prices that can be charged for the product candidates that we develop and may further limit our commercial opportunity. There may be future changes that result in reductions in current coverage and reimbursement levels for our products, if commercialized, and we cannot predict the scope of any future changes or the impact that those changes would have on our operations.

We rely on insurance companies to mitigate our exposure for business activities, including developing and marketing pharmaceutical products for human use.

 

The conduct of our business, including the testing, marketing and sale of pharmaceutical products, involves the risk of liability claims by consumers, stockholders, and other third parties. Although we maintain various types of insurance, including product liability and director and officer liability, claims can be high and our insurance may not sufficiently cover our actual liabilities. If liability claims were made against us, it is possible that our insurance carriers may deny, or attempt to deny, coverage in certain instances. If a lawsuit against us is successful, then the lack or insufficiency of insurance coverage could materially and adversely affect 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 and the imposition of higher insurance requirements could impose additional costs on us. Additionally, we are potentially at risk if our insurance carriers become insolvent. Although we have historically obtained coverage through highly rated and capitalized firms, the ongoing financial crisis may affect our ability to obtain coverage under existing policies or purchase insurance under new policies at reasonable rates.

 

If we market products in a manner that violates health care fraud and abuse laws, we may be subject to civil or criminal penalties.

 

We are also subject to healthcare fraud and abuse regulation and enforcement by both the federal government and the states in which we conduct our business. The laws that may affect our ability to operate include:

 

 

If our operations are found to be in violation of any of the laws described above or any other governmental regulations that apply to us, we may be subject to penalties, including civil and criminal penalties, damages, fines, exclusion from governmental health care programs, and the curtailment or restructuring of our operations, any of which could adversely affect our ability to operate our business and our financial results. The risk of our being found in violation of these laws is increased by the fact that many of them have not been fully interpreted by the regulatory authorities or the courts, and their provisions are open to a variety of interpretations. Further, the recently enacted PPACA, among other things, amends the intent requirement of the federal anti-kickback and criminal health care fraud statutes. A person or entity no longer needs to have actual knowledge of this statute or specific intent to violate it. In addition, the PPACA provides that the government may assert that a claim including items or services resulting from a violation of the federal anti-kickback statute constitutes a false or fraudulent claim for purposes of the false claims statutes. Moreover, some states, such as California, Massachusetts and Vermont, mandate implementation of commercial compliance programs to ensure compliance with these laws. Any action against us for violation of these laws, even if we successfully defend against it, could cause us to incur significant legal expenses and divert our management’s attention from the operation of our business.

 

In addition, there has been a recent trend of increased federal and state regulation of payments made to physicians for marketing, including the tracking and reporting of gifts, compensation, and other remuneration to

physicians. The shifting commercial compliance environment and the need to build and maintain robust and expandable systems to comply with multiple jurisdictions with different compliance and/or reporting requirements increases the possibility that a healthcare company may run afoul of one or more of the requirements.

 

The PPACA also imposes new reporting and disclosure requirements on drug manufacturers for any “transfer of value” made or distributed to prescribers and other healthcare providers, effective March 30, 2013. Such information will be made publicly available in a searchable format beginning September 30, 2013. In addition, drug manufacturers will also be required to report and disclose any investment interests held by physicians and their immediate family members during the preceding calendar year. Failure to submit required information may result in civil monetary penalties of up to an aggregate of $150,000 per year (and up to an aggregate of $1 million per year for “knowing failures”), for all payments, transfers of value or ownership or investment interests not reported in an annual submission. Finally, under PPACA, effective April 1, 2012, pharmaceutical manufacturers and distributors must provide the U.S. Department of Health and Human Services with an annual report on the drug samples they provide to physicians.

 

We may incur significant liability if it is determined that we are promoting the “off-label” use of drugs.

 

Companies may not promote drugs for “off-label” uses — that is, uses that are not described in the product’s labeling and that differ from those approved by the FDA, TPD or other applicable regulatory agencies. Physicians may prescribe drug products for off-label uses, and such off-label uses are common across medical specialties. Although the FDA, TPD and other regulatory agencies do not regulate a physician’s choice of treatments, the FDA, TPD and other regulatory agencies do restrict communications by pharmaceutical companies or their sales representatives on the subject of off-label use. The FDA, TPD and other regulatory agencies actively enforce regulations prohibiting promotion of off-label uses and the promotion of products for which marketing clearance has not been obtained. A company that is found to have improperly promoted off-label uses may be subject to significant liability, including civil and administrative remedies as well as criminal sanctions. Notwithstanding the regulatory restrictions on off-label promotion, the FDA, TPD and other regulatory authorities allow companies to engage in truthful, non-misleading, and non-promotional speech concerning their products. Although we believe that all of our communications regarding all of our products are in compliance with the relevant regulatory requirements, the FDA, TPD or another regulatory authority may disagree, and we may be subject to significant liability, including civil and administrative remedies, as well as criminal sanctions. In addition, management’s attention could be diverted from our business operations and our reputation could be damaged. Our distribution partners may also be the subject of regulatory investigations involving, or remedies or sanctions for, off-label uses of products we have licensed to them, which may have an adverse impact on sales of such licensed products, which may, in turn, have a material adverse effect on our business, financial condition and results of operations and could cause the market value of our common shares to decline.

 

Risks Related to Reliance on Third Parties

 

We depend on third parties to manufacture, package and distribute compounds for our drugs and drug candidates. The failure of these third parties to perform successfully could harm our business.

 

We have utilized, and intend to continue utilizing, third parties to manufacture, package and distribute NUEDEXTA and the API for docosanol 10% cream and to provide clinical supplies of our drug candidates. We have no experience in manufacturing and do not have any manufacturing facilities. Currently, we have sole suppliers for the API for docosanol and NUEDEXTA, and a sole manufacturer for the finished form of NUEDEXTA. In addition, these materials are custom and available from only a limited number of sources. Any material disruption in manufacturing could cause a delay in shipments and possible loss of sales. We do not have any long-term agreements in place with our current docosanol supplier or NUEDEXTA supplier. If we are required to change manufacturers, we may experience delays associated with finding an alternate manufacturer that is properly qualified to produce supplies of our products and product candidates in accordance with FDA requirements and our specifications. Any delays or difficulties in obtaining APIs or in manufacturing, packaging or distributing NUEDEXTA could delay our clinical trials of this product candidate for DPN pain, MS-related pain or other potential indications. The third parties we rely on for manufacturing and packaging are also subject to regulatory review, and any regulatory compliance problems with these third parties could significantly delay or

disrupt our commercialization activities. Additionally, the ongoing economic crisis creates risk for us if any of these third parties suffer liquidity or operational problems. If a key third party vendor becomes insolvent or is forced to lay off workers assisting with our projects, our results and development timing could suffer.

 

Because we depend on clinical research centers and other contractors for clinical testing and for certain research and development activities, the results of our clinical trials and such research activities are, to a certain extent, beyond our control.

 

The nature of clinical trials and our business strategy of outsourcing a substantial portion of our research require that we rely on clinical research centers and other contractors to assist us with research and development, clinical testing activities, patient enrollment and regulatory submissions to the FDA. As a result, our success depends partially on the success of these third parties in performing their responsibilities. Although we pre-qualify our contractors and we believe that they are fully capable of performing their contractual obligations, we cannot directly control the adequacy and timeliness of the resources and expertise that they apply to these activities. Additionally, the current global economic slowdown may affect our development partners and vendors, which could adversely affect their ability to timely perform their tasks. If our contractors do not perform their obligations in an adequate and timely manner, the pace of clinical development, regulatory approval and commercialization of our drug candidates could be significantly delayed and our prospects could be adversely affected.

 

We generally do not control the development of compounds licensed to third parties and, as a result, we may not realize a significant portion of the potential value of any such license arrangements.

 

Under our typical license arrangement we have no direct control over the development of drug candidates and have only limited, if any, input on the direction of development efforts. These development efforts are made by our licensing partner, and if the results of their development efforts are negative or inconclusive, it is possible that our licensing partner could elect to defer or abandon further development of these programs. We similarly rely on licensing partners to obtain regulatory approval for docosanol in foreign jurisdictions. Because much of the potential value of these license arrangements is contingent upon the successful development and commercialization of the licensed technology, the ultimate value of these licenses will depend on the efforts of licensing partners. If our licensing partners do not succeed in developing the licensed technology for whatever reason, or elect to discontinue the development of these programs, we may be unable to realize the potential value of these arrangements. If we were to license NUEDEXTA to a third party or a development partner, it is likely that much of the long-term success of that drug will similarly depend on the efforts of the licensee.

 

We expect to rely entirely on third parties for international registration, sales and marketing efforts.

 

In the event that we attempt to enter into international markets, we expect to rely on collaborative partners to obtain regulatory approvals and to market and sell our product(s) in those markets. We have not yet entered into any collaborative arrangement with respect to marketing or selling NUEDEXTA, with the exception of one such agreement relating to Israel. We may be unable to enter into any other arrangements on terms favorable to us, or at all, and even if we are able to enter into sales and marketing arrangements with collaborative partners, we cannot assure you that their sales and marketing efforts will be successful. If we are unable to enter into favorable collaborative arrangements with respect to marketing or selling NUEDEXTA in international markets, or if our collaborators’ efforts are unsuccessful, our ability to generate revenues from international product sales will suffer.

 

Risks Relating to Our Stock

 

Our stock price has historically been volatile and we expect that this volatility will continue for the foreseeable future.

 

The market price of our common stock has been, and is likely to continue to be, highly volatile. This volatility can be attributed to many factors independent of our operating results, including the following:

 

 

 

If a substantial number of shares are sold into the market at any given time, particularly following any significant announcements or large swings in our stock price (whether sales are under our existing “shelf” registration statements, from an existing stockholder, or the result of warrant or stock options exercised), there may not be sufficient demand in the market to purchase the shares without a decline in the market price for our common stock. Moreover, continuous sales into the market of a number of shares in excess of the typical trading volume for our common stock, or even the availability of such a large number of shares, could depress the trading market for our common stock over an extended period of time.

 

Additionally, our stock price has been volatile as a result of announcements of regulatory actions and decisions relating to NUEDEXTA, and periodic variations in our operating results. We expect that our operating results will continue to vary from quarter to quarter, particularly as we commercially launch NUEDEXTA. Our operating results and prospects may also vary depending on the status of our partnering arrangements.

 

As a result of these factors, we expect that our stock price may continue to be volatile and investors may be unable to sell their shares at a price equal to, or above, the price paid. Additionally, any significant drops in our stock price could give rise to stockholder lawsuits, which are costly and time consuming to defend against and which may adversely affect our ability to raise capital while the suits are pending, even if the suits are ultimately resolved in favor of the Company. We have, from time to time, been a party to such suits and although none have been material to date, there can be no assurance that any such suit will not have an adverse effect on the Company.

 

If our internal controls over financial reporting are not considered effective, our business and stock price could be adversely affected.

 

Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate the effectiveness of our internal controls over financial reporting as of the end of each fiscal year, and to include a management report assessing the effectiveness of our internal controls over financial reporting in our annual report on Form 10-K for that fiscal year. Section 404 also requires our independent registered public accounting firm to attest to, and report on, management’s assessment of our internal controls over financial reporting, and we again became subject to these requirements starting with the year ended September 30, 2010.

 

Our management, including our chief executive officer and principal financial officer, does not expect that our internal controls over financial reporting will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud involving a company have been, or will be, detected. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and we cannot assure you that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become ineffective because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. We cannot assure you that we or our independent registered public accounting firm will not identify a material weakness in our internal controls in the future. A material weakness in our internal controls over financial reporting would require management and our independent registered public accounting firm to consider our internal controls as ineffective. If our internal controls over financial reporting are not considered effective, we may experience a loss of public confidence, which could have an adverse effect on our business and on the market price of our common stock.

Because we do not expect to pay dividends in the foreseeable future, you must rely on stock appreciation for any return on your investment.

 

We have paid no cash dividends on our common stock to date, and we currently intend to retain our future earnings, if any, to fund the development and growth of our business. As a result, we do not expect to pay any cash dividends in the foreseeable future, and payment of cash dividends, if any, will also depend on our financial condition, results of operations, capital requirements and other factors and will be at the discretion of our board of directors. Furthermore, we may in the future become subject to contractual restrictions on, or prohibitions against, the payment of dividends. Accordingly, the success of your investment in our common stock will likely depend entirely upon any future appreciation. There is no guarantee that our common stock will appreciate in value or even maintain the price at which you purchased your shares, and you may not realize a return on your investment in our common stock.

 

Our corporate governance documents, rights agreement and Delaware law may delay or prevent an acquisition of us that stockholders may consider favorable, which could decrease the value of our common stock.

 

Our certificate of incorporation and bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us without the consent of our board of directors. These provisions include restrictions on the ability of our stockholders to remove directors and supermajority voting requirements for stockholders to amend our organizational documents and a classified board of directors. In addition, our board of directors has the right to issue preferred stock without stockholder approval, which could be used to dilute the stock ownership of a potential hostile acquirer. Delaware law, for instance, also imposes some restrictions on mergers and other business combinations between any holder of 15% or more of our outstanding common stock and us. Although we believe these provisions protect our stockholders from coercive or otherwise unfair takeover tactics and thereby provide for an opportunity to receive a higher bid by requiring potential acquirers to negotiate with our board of directors, these provisions apply even if the offer may be considered beneficial by some stockholders. We have also adopted a stockholder rights agreement intended to deter hostile or coercive attempts to acquire us. Under the agreement, if a person becomes an “acquiring person,” each holder of a right (other than the acquiring person) will be entitled to purchase, at the then-current exercise price, such number of shares of our preferred stock which are equivalent to shares of common stock having twice the exercise price of the right. If we are acquired in a merger or other business combination transaction after any such event, each holder of a right will then be entitled to purchase, at the then-current exercise price, shares of the acquiring company’s common stock having a value of twice the exercise price of the right. Our stockholder rights agreement could make it more difficult for a third party to acquire, or could discourage a third party from acquiring, us or a large block of our common stock without the support of our board of directors. Therefore, the agreement makes an acquisition much more costly to a potential acquirer.

 

 

None.

 

 

Our headquarters and commercial and administrative offices are located in Aliso Viejo, California, where we currently occupy approximately 17,000 square feet. The Aliso Viejo office lease expires in June 2011. With the organizational growth anticipated following the October 2010 FDA approval of NUEDEXTA, we have determined that we will need to increase our current office space capacity. We may or may not renew the Aliso Viejo office lease as we identify other suitable properties.

 

We lease approximately 30,370 square feet in two buildings in San Diego. The terms of the leases for the San Diego facilities end in January 2013. The San Diego buildings are sublet through January 2013.

 

 

In the ordinary course of business, we may face various claims brought by third parties and we may, from time to time, make claims or take legal actions to assert our rights, including intellectual property rights as well as claims

relating to employment matters and 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, may be inadequately capitalized to pay on valid claims, 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 consolidated operations, cash flows and financial position. Additionally, any such claims, whether or not successful, could damage our reputation and business. Management believes the outcome of currently pending claims or lawsuits will not likely have a material effect on our operations or financial position.

 

 

 

The following table sets forth the high and low prices for our common stock in each of the quarters over the past two fiscal years, as quoted on the NASDAQ Global Market.

 

 

On December 1, 2010, the closing sales price of our common stock was $4.18 per share.

 

As of November 27, 2010, we had approximately 29,344 stockholders, including 371 holders of record and an estimated 28,973 beneficial owners. We have not paid any dividends on our common stock since our inception and do not expect to pay dividends on our common stock in the foreseeable future.

The following graph compares the cumulative 5-year return provided stockholders on AVANIR Pharmaceutical, Inc.’s common stock relative to the cumulative total returns of the NASDAQ Composite index and the NASDAQ Biotechnology index. An investment of $100 (with reinvestment of all dividends) is assumed to have been made in our common stock and in each of the indexes on October 1, 2005 and its relative performance is tracked through November 30, 2010.

 

 

Information About Our Equity Compensation Plans

 

Information regarding our equity compensation plans is incorporated by reference in Item 12 of Part III of this annual report on Form 10-K.

 

 

The selected consolidated financial data set forth below at September 30, 2010 and 2009, and for the fiscal years ended September 30, 2010, 2009, and 2008, 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 with “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The selected consolidated financial data set forth below at September 30, 2008, 2007 and 2006, and for the years ended September 30, 2007 and 2006, are derived from our audited consolidated financial statements that are contained in reports previously filed with the SEC, not included herein. The quarterly consolidated financial data are derived from unaudited consolidated financial statements included in our Quarterly Reports on Form 10-Q. All share and per share information herein (including shares outstanding, earnings per share and warrant and stock option exercise prices) reflect the retrospective adjustment for a one-for-four reverse stock split implemented in January 2006.

The following tables include selected consolidated financial data for each of our last five fiscal years and quarterly data for the last two fiscal years and include adjustments to reflect the classification of our FazaClo Business as discontinued operations.

 

Summary Financial Information

 

 

 

 

 

 

 

 

This Annual Report on Form 10-K contains forward-looking statements concerning future events and performance of the Company. When used in this report, the words “intend,” “estimate,” “anticipate,” “believe,” “plan” or “expect” and similar expressions are included to identify forward-looking statements. These forward-looking statements are based on our current expectations and assumptions and 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 in Item 1A, “Risk Factors”. We disclaim any intent 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.

 

Executive Overview

 

We are a pharmaceutical company focused on acquiring, developing and commercializing novel therapeutic products for the treatment of central nervous system disorders. In October 2010, the U.S. Food and Drug Administration (“FDA”) approved NUEDEXTA (formerly referred to as AVP-923 or its previously proposed trade name Zenvia), a unique proprietary combination of dextromethorphan/quinidine, for the treatment of pseudobulbar affect (“PBA”). NUEDEXTA has also successfully completed a Phase III trial for the treatment

of patients with diabetic peripheral neuropathic pain (“DPN pain”). We plan to commercially launch NUEDEXTA in the second quarter of fiscal 2011.

 

In addition to our focus on products for the central nervous system, we also have a number of partnered programs in other therapeutic areas which may generate future revenue for us. Our first commercialized product, docosanol 10% cream, (sold in the United States and Canada as Abreva^® by our marketing partner GlaxoSmithKline Consumer Healthcare) is the only over-the-counter treatment for cold sores that has been approved by the FDA. In 2008, we out-licensed all of our monoclonal antibodies and we remain eligible to receive milestone payments and royalties related to the sale of these assets. AVANIR was incorporated in California in August 1988 and was reincorporated in Delaware in March 2009.

 

The following is a summary of significant accomplishments in fiscal 2010 and subsequent to the end of fiscal 2010 through the date of this filing that have materially affected our operations, financial condition and prospects:

 

 

Our principal focus is on the commercial launch of NUEDEXTA for the PBA indication. We believe that cash and cash equivalents and restricted investments of approximately $39.4 million at September 30, 2010, as well as the proceeds raised from the common stock offering completed in November 2010 totaling approximately $83.0 million in net proceeds, will be sufficient to fund our operations, for at least the next 24 months. For additional information about the risks and uncertainties that may affect our business and prospects, please see Item 1A, “Risk Factors.”

 

Critical Accounting Policies and Estimates

 

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make a number of assumptions and estimates that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reported periods. Significant estimates and assumptions are required in the determination of revenue

recognition in certain royalties. Significant estimates and assumptions are also required in the appropriateness of amounts recognized for inventories, income taxes, contingencies, estimates on the net working capital adjustment and stock-based compensation. We base our estimates on historical experience and various other assumptions that are available at that time and that we believe to be reasonable under the circumstances. Some of these judgments can be subjective and complex. For any given individual estimate or assumption made by us, there may also be other estimates or assumptions that are reasonable. These items are monitored and analyzed by management for changes in facts and circumstances, and material changes in these estimates could occur in the future. Changes in estimates are recorded in the period in which they become known. Actual results may differ from our estimates if past experience or other assumptions do not turn out to be substantially accurate.

 

Share-Based Compensation

 

We grant options, restricted stock units and restricted stock awards to purchase our common stock to our employees, directors and consultants under our stock option plans. The benefits provided under these plans are share-based payments that we account for using the fair value method.

 

The fair value of each option award is estimated on the date of grant using a Black-Scholes-Merton option pricing model (“Black-Scholes model”) that uses assumptions regarding a number of complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends. Expected volatilities are based on historical volatility of our common stock and other factors. The expected terms of options granted are based on analyses of historical employee termination rates and option exercises. The risk-free interest rates are based on the U.S. Treasury yield in effect at the time of the grant. Since we do not expect to pay dividends on our common stock in the foreseeable future, we estimated the dividend yield to be 0%.

 

If factors change and we employ different assumptions in calculating the fair value in future periods, the compensation expense that we record may differ significantly from what we have recorded in the current period. There is a high degree of subjectivity involved when using option pricing models to estimate share-based compensation. Because changes in the subjective input assumptions can materially affect our estimates of fair values of our share-based compensation, in our opinion, existing valuation models, including the Black-Scholes and lattice binomial models, may not provide reliable measures of the fair values of our share-based compensation. Consequently, there is a risk that our estimates of the fair values of our share-based compensation awards on the grant dates may bear little resemblance to the actual values realized upon the exercise, early termination or forfeiture of those share-based payments in the future. Certain share-based payments, such as employee stock options, may expire worthless or otherwise result in zero intrinsic value as compared to the fair values originally estimated on the grant date and reported in our financial statements. For awards with a longer vesting period, such as the three-year cliff vesting awards issued to certain officers, the actual forfeiture rate and related expense may not be known for a longer period of time, which can result in more significant accounting adjustments once the awards are either vested or forfeited.

 

Alternatively, values may be realized from these instruments that are significantly in excess of the fair values originally estimated on the grant date and reported in our financial statements. There is no current market-based mechanism or other practical application to verify the reliability and accuracy of the estimates stemming from these valuation models, nor is there a means to compare and adjust the estimates to actual values. Although the fair value of employee share-based awards is determined using an option-pricing model, the value derived from that model may not be indicative of the fair value observed in a willing buyer/willing seller market transaction.

 

The application of the fair value method of accounting for share-based compensation may be subject to further interpretation and refinement over time. There are significant differences among valuation models, and there is a possibility that we will adopt different valuation models in the future. This may result in a lack of consistency in future periods and materially affect the fair value estimate of share-based payments. It may also result in a lack of comparability with other companies that use different models, methods and assumptions.

 

Theoretical valuation models and market-based methods are evolving and may result in lower or higher fair value estimates for share-based compensation. The timing, readiness, adoption, general acceptance, reliability and testing of these methods is uncertain. Sophisticated mathematical models may require voluminous historical

information, modeling expertise, financial analyses, correlation analyses, integrated software and databases, consulting fees, customization and testing for adequacy of internal controls. Market-based methods are emerging that, if employed by us, may dilute our earnings per share and involve significant transaction fees and ongoing administrative expenses. The uncertainties and costs of these extensive valuation efforts may outweigh the benefits to investors.

 

Share-based compensation expense recognized during a period is based on the value of the portion of share-based payment awards that is ultimately expected to vest amortized using the straight-line attribution method. As share-based compensation expense recognized in the consolidated statements of operations for fiscal 2010, 2009, and 2008 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. The fair value method requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We estimate forfeitures based on our historical experience. Changes to the estimated forfeiture rate are accounted for as a cumulative effect of change in the period the change occurred. During fiscal 2010, we reduced our estimated forfeiture rate on certain restricted stock unit awards from 12.6% to zero percent, as we expect all the awards to vest. This change in the estimated forfeiture rates resulted in an increase in share-based compensation expense of approximately $93,000 with no effect on loss per share for fiscal 2010. In the fourth quarter of fiscal 2009, we reviewed our estimated forfeiture rate considering then recent actual data resulting in a reduction to our estimated forfeiture rate from 30.0% to 12.6% in fiscal 2009. Additionally, we reduced our estimated forfeiture rate on certain restricted stock unit awards from 30.0% to zero percent, as we expected all the awards to vest. These changes in the estimated forfeiture rates during fiscal 2009 resulted in an increase in share-based compensation expense of $935,000 and an increase to the diluted loss per share of $0.01 for fiscal 2009.

 

Revenue Recognition

 

General.  We recognize revenue when all of the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) our price to the buyer is fixed or determinable; and (4) collectability is reasonably assured.

 

Certain product sales are subject to rights of return. For products sold where the buyer has the right to return the product, we recognize revenue at the time of sale only if (1) our price to the buyer is fixed or determinable; (2) the buyer has paid us, or the buyer is obligated to pay us and the obligation is not contingent on the resale of the product; (3) the buyer’s obligation to us would not be changed in the event of theft or physical destruction or damage of the product; (4) the buyer has economic substance apart from that provided by us; (5) we do not have significant obligations for future performance to directly bring about resale of the product by the buyer; and (6) the amount of future returns can be reasonably estimated.

 

Revenue Arrangements with Multiple Deliverables.  In the past, we have entered into revenue arrangements whereby we deliver to the customer multiple products and/or services. Such arrangements have generally included some combination of the following: antibody generation services; licensed rights to technology, patented products, compounds, data and other intellectual property; and research and development services. We analyze our multiple element arrangements to determine whether the elements can be separated. We perform our analysis at the inception of the arrangement and as each product or service is delivered. If a product or service is not separable, the combined deliverables will be accounted for as a single unit of accounting.

 

A delivered product or service (or group of delivered products or services) can be separated from other elements when it meets all of the following criteria: (1) the delivered item has value to the customer on a standalone basis; (2) there is objective and reliable evidence of the fair value of the undelivered item; and (3) if the arrangement includes a general right of return relative to the delivered item, delivery, or performance of the undelivered item is considered probable and substantially in our control. If an element can be separated, we allocate revenue based upon the relative fair values of each element. We determine the fair value of a separate deliverable using the price we charge other customers when we sell that product or service separately; however if we do not sell the product or service separately, we use third-party evidence of fair value. We consider licensed rights or technology to have standalone value to our customers if we or others have sold such rights or technology separately or our customers can sell such rights or technology separately without the need for our continuing involvement.

License Arrangements.  License arrangements may consist of non-refundable upfront license fees, data transfer fees, or research reimbursement payments and/or exclusive licensed rights to patented or patent pending compounds, technology access fees, various performance or sales milestones and future product royalty payments. Some of these arrangements are multiple element arrangements.

 

Non-refundable, up-front fees that are not contingent on any future performance by us, and require no consequential continuing involvement on our part, are recognized as revenue when the license term commences and the licensed data, technology and/or compound is delivered. Such deliverables may include physical quantities of compounds, design of the compounds and structure-activity relationships, the conceptual framework and mechanism of action, and rights to the patents or patents pending for such compounds. We defer recognition of non-refundable upfront fees if we have continuing performance obligations without which the technology, right, product or service conveyed in conjunction with the non-refundable fee has no utility to the licensee that is separate and independent of our performance under the other elements of the arrangement. In addition, if we have continuing involvement through research and development services that are required because our know-how and expertise related to the technology is proprietary to us, or can only be performed by us, then such up-front fees are deferred and recognized over the period of continuing involvement.

 

Payments related to substantive, performance-based milestones in a research and development arrangement are recognized as revenue upon the achievement of the milestones as specified in the underlying agreements when they represent the culmination of the earnings process.

 

Royalty Revenues.  We recognize royalty revenues from licensed products when earned in accordance with the terms of the license agreements. Net sales figures used for calculating royalties include deductions for returned product, pricing allowances, managed care charge backs, cash discounts, freight/warehousing, and miscellaneous write-offs.

 

Certain royalty agreements require that royalties are earned only if a sales threshold is exceeded. Under these types of arrangements, the threshold is typically based on annual sales. The company recognizes royalty revenue in the period in which the threshold is exceeded.

 

Revenues from Sale of Royalty Rights.  When we sell our rights to future royalties under license agreements and also maintain continuing involvement in earning such royalties, we defer recognition of any upfront payments and recognize them as revenue over the life of the license agreement. We recognize revenue for the sale of an undivided interest of our Abreva license agreement to Drug Royalty USA 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 the following: (1) the ratio of the royalty payments due to Drug Royalty USA for the period to the total remaining royalties that we expect GSK will pay Drug Royalty USA over the term of the agreement by (2) the unamortized deferred revenue amount.

 

Product Sales — Active Pharmaceutical Ingredient Docosanol (“API Docosanol”).  Revenue from sales of our API Docosanol is recorded when title and risk of loss have passed to the buyer and provided the criteria for revenue recognition are met. We sell the API Docosanol to various licensees upon receipt of a written order for the materials. Shipments generally occur fewer than three times a year. Our contracts for sales of the API Docosanol include buyer acceptance provisions that give our buyers the right of replacement if the delivered product does not meet specified criteria. That right requires that they give us notice within 30 days after receipt of the product. We have the option to refund or replace any such defective materials; however, we have historically demonstrated that the materials shipped from the same pre-inspected lot have consistently met the specified criteria and no buyer has rejected any of our shipments from the same pre-inspected lot to date. Therefore, we recognize revenue at the time of delivery without providing any returns reserve.

 

Cost of Revenues

 

Cost of revenues includes direct and indirect costs to manufacture product sold, including the write-off of obsolete inventory, reserves against inventory and to provide research and development services. We apply estimates or judgments in the valuation of inventory reserve.

Recognition of Expenses in Outsourced Contracts

 

Pursuant to management’s assessment of the services that have been performed on clinical trials and other contracts, we recognize expenses as the services are provided. Such management assessments include, but are not limited to: (1) an evaluation by the project manager of the work that has been completed during the period, (2) measurement of progress prepared internally and/or provided by the third-party service provider, (3) analyses of data that justify the progress, and (4) management’s judgment. Several of our contracts extend across multiple reporting periods, including our largest contract, representing a $7.1 million Phase III clinical trial contract that was entered into in the first fiscal quarter of fiscal 2008. Management bases its assessments on estimates that it considers reasonable in the circumstances. Other estimates could result in different assessments and different expense recognition.

 

Research and Development Expenses

 

Research and development expenses consist of expenses incurred in performing research and development activities including salaries and benefits, facilities and other overhead expenses, clinical trials, contract services and other outside expenses. Research and development expenses are charged to operations as they are incurred. Up-front payments to collaborators made in exchange for the avoidance of potential future milestone and royalty payments on licensed technology are also charged to research and development expense when the drug is still in the development stage, has not been approved by the FDA for commercialization and concurrently has no alternative uses.

 

We assess our obligations to make milestone payments that may become due under licensed or acquired technology to determine whether the payments should be expensed or capitalized. We charge milestone payments to research and development expense when:

 

 

Acquired contractual rights.  Payments to acquire contractual rights to a licensed technology or drug candidate are expensed as incurred when there is uncertainty in receiving future economic benefits from the acquired contractual rights. We consider the future economic benefits from the acquired contractual rights to a drug candidate to be uncertain until such drug candidate is approved by the FDA or when other significant risk factors are abated.

 

Effects of Inflation

 

We believe the impact of inflation and changing prices on net revenues and on operations has been minimal during the past three years.

 

Results of Operations

 

We operate our business on the basis of a single reportable segment, which is the business of development, acquisition and commercialization of novel therapeutics for chronic diseases. Our chief operating decision-maker is the Chief Executive Officer, who evaluates our company as a single operating segment.

 

We categorize revenues by type of revenue in five different categories: 1) royalties and royalty rights, 2) licensing, 3) government research grant services, 4) research and development services and 5) product sales.

 

All long-lived assets for fiscal 2010 and 2009 are located in the United States.

Comparison of Fiscal 2010 and 2009

 

Revenues and Cost of Revenues

 

 

Revenues

 

Revenues were $2.9 million for the fiscal year ended September 30, 2010 compared to $4.2 million for the fiscal year ended September 30, 2009. The decrease in revenues of approximately $1.3 million, or 31%, was primarily attributed to a decrease in the recognition of deferred royalty revenue, as well as a decrease in licensing revenue related to the license agreement with Kobayashi Pharmaceutical Co. Ltd. which was terminated in fiscal 2009.

 

In the fourth quarter of fiscal 2010, the Company recorded a cumulative non-cash adjustment to correct an immaterial error related to previously recorded deferred royalty revenue related to the GSK license agreement. The total cumulative non-cash adjustment recorded in the fourth quarter was a decrease in revenue of $797,000 which resulted in net revenues of ($71,000) in the fourth fiscal quarter of 2010 and $2.9 million for fiscal 2010.

 

For the fiscal years ended September 30, 2010 and 2009, we generated no product revenue from the sale of the active pharmaceutical ingredient docosanol.

 

Potential revenue-generating contracts that remained active as of September 30, 2010 include licensing revenue from our agreement with GSK, potential royalties from our agreements with Azur Pharma and Emergent Biosolutions, Inc. and modest revenue generated from various other licensing agreements. Partnering, licensing and research collaborations have been, and may continue to be, an important part of our business development strategy. We may continue to seek partnerships with pharmaceutical companies that can help fund our operations in exchange for sharing in the success of any licensed compounds or technologies. See Note 12 “Research, License, Supply and other Agreements” and Note 15 “Segment Information” in the Notes to Consolidated Financial Statements.

 

Cost of Revenues

 

In fiscal 2010, cost of revenues was $198,000 compared to $83,000 in fiscal 2009. The increase in cost of revenues was attributed to an increase in our inventory obsolescence reserve for docosanol.

Operating Expenses

 

 

Research and Development Expenses

 

Research and development expenses decreased by approximately $2.5 million or 16% for the fiscal year ended September 30, 2010 compared to the fiscal year ended September 30, 2009. The decrease is primarily due to a reduction in clinical expenses resulting from the completion of the STAR trial in fiscal 2009 offset by costs incurred in support of the complete response to the FDA approvable letter for NUEDEXTA and other regulatory activities. The complete response was submitted to the FDA in the third fiscal quarter of 2010.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses increased by approximately $6.3 million or 62% for the fiscal year ended September 30, 2010, compared to the fiscal year ended September 30, 2009. The increase is primarily attributed to costs associated with preparation for commercial readiness for the launch of NUEDEXTA.

 

Share-Based Compensation

 

The Company re-examines forfeiture rates as they apply to stock-based compensation on an annual basis. We estimate forfeitures based on our historical experience. Changes to the estimated forfeiture rate are accounted for as a cumulative effect of change in the period the change occurred. During fiscal 2010, we reduced our estimated forfeiture rate on certain restricted stock unit awards from 12.6% to zero percent, as we expect all the awards to vest. This change in the estimated forfeiture rates resulted in an increase in share-based compensation expense of approximately $93,000 with no effect on loss per share for fiscal 2010. In the fourth quarter of fiscal 2009, we reviewed our estimated forfeiture rate considering then recent actual data resulting in a reduction to our estimated forfeiture rate from 30.0% to 12.6% in fiscal 2009. Additionally, we reduced our estimated forfeiture rate on certain restricted stock unit awards from 30.0% to zero percent, as we expected all the awards to vest. These changes in the estimated forfeiture rates during fiscal 2009 resulted in an increase in share-based compensation expense of $935,000 and an increase to the diluted loss per share of $0.01 for fiscal 2009. Future estimates may differ substantially from management’s current estimates.

 

Total compensation expense for our share-based payments in the fiscal years ended September 30, 2010 and 2009 was approximately $2.7 million and $2.9 million, respectively. Selling, general and administrative expense in the fiscal years ended September 30, 2010 and 2009 includes share-based compensation expense of approximately $2.2 million for each period. Research and development expense in the fiscal years ended September 30, 2010 and 2009 includes share-based compensation expense of approximately $578,000 and $664,000, respectively. As of September 30, 2010, approximately $4.6 million of total unrecognized compensation costs related to unvested awards is expected to be recognized over a weighted average period of 2.4 years. See Note 11, “Stockholders’ Equity -Employee Equity Incentive Plans” in the Notes to Consolidated Financial Statements for further discussion.

 

Interest Expense and Interest Income

 

We had no interest expense for the fiscal year ended September 30, 2010, compared to a nominal amount of $517 for the prior fiscal year.

 

For the fiscal year ended September 30, 2010, interest income was approximately $15,000, compared to approximately $204,000 for the prior fiscal year. The decrease is due to a lower investment yield in fiscal 2010 as compared to the prior fiscal year.

Other, net

 

Other, net was approximately $391,000 of income in fiscal 2010 compared to expense of approximately $272,000 in fiscal 2009. In fiscal year 2010, the Company recorded approximately $390,000 as Other, net under Other Income (Expenses) in connection with a legal settlement. (See Note 10, “Commitments and Contingencies” in the Notes to Consolidated Financial Statements). In fiscal 2009, the Company recognized a loss on disposal of fixed assets of approximately $266,000.

 

Net Loss

 

Net loss was approximately $26.7 million, or $0.30 per share, for the fiscal year ended September 30, 2010, compared to a net loss of approximately $22.0 million, or $0.28 per share for the fiscal year ended September 30, 2009. The increase in net loss is primarily attributed to costs incurred in preparation for the commercial launch of NUEDEXTA and regulatory costs associated with the complete response to the approvable letter and other regulatory activities.

 

Comparison of Fiscal 2009 and 2008

 

Revenues and Cost of Revenues

 

 

Revenues

 

For the fiscal year ended September 30, 2009, we generated no product revenues. In fiscal 2008, we received net product revenues of $130,000. Product revenues for that period were generated from the sale of the active pharmaceutical ingredient docosanol.

 

Revenues from research services and other were $4.2 million for the fiscal year ended September 30, 2009 compared to $6.8 million for the fiscal year ended September 30, 2008. The decrease in revenues is attributed to a one-time milestone payment received from HBI of $1.5 million in fiscal 2008 that was not repeated in 2009, and a

decline in grant revenue received from the NIH grant of $1.0 million due to the termination of the anthrax antibody program which ended in 2008, and accordingly, there are no comparable revenues in fiscal 2009.

 

Cost of Revenues

 

In fiscal 2009, cost of product revenues was $73,000 compared to $22,000 in fiscal 2008. Cost of product revenues in fiscal 2009 was primarily attributed to an inventory reserve amount of $69,000 established for docosanol.

 

Cost of research services and grants was $10,000 for the fiscal year ended September 30, 2009 compared to $1.2 million for the fiscal year ended September 30, 2008. The decline in cost of revenues is primarily attributable to the completion of the remaining work under the NIH grant and the termination of all future research and development work related to other infectious diseases in June 2008.

 

Operating Expenses

 

 

Research and Development Expenses

 

Research and development expenses increased by approximately $1.8 million or 12% for the fiscal year ended September 30, 2009 compared to the fiscal year ended September 30, 2008. The increase is primarily due to costs incurred for the confirmatory Phase III trial for the PBA indication of NUEDEXTA.

 

General and Administrative Expenses

 

General and administrative expenses decreased by approximately $448,000 or 4% for the fiscal year ended September 30, 2009, compared to the fiscal year ended September 30, 2008. The decrease is primarily attributed to a decrease in our overall general and administrative expenses as a result of the restructuring and the significant organizational changes that we made to our infrastructure. In addition, our general and administrative costs have decreased as a result of our focused efforts to contain costs and negotiate discounts with our principal vendors.

 

Share-Based Compensation

 

The Company re-examines forfeiture rates as they apply to stock-based compensation on an annual basis. We estimate forfeitures based on our historical experience. Changes to the estimated forfeiture rate are accounted for as a cumulative effect of change in the period the change occurred. In the fourth quarter of fiscal 2009, we reviewed our estimated forfeiture rate considering recent actual data resulting in a reduction to our estimated forfeiture rate from 30.0% to 12.6%. Additionally, we reduced our estimated forfeiture rate on certain restricted stock unit awards from 30.0% to zero percent, as we expect all the awards to vest. These changes in the estimated forfeiture rates resulted in an increase in share-based compensation expense of approximately $935,000 and an increase to the diluted loss per share of $0.01 for fiscal 2009. Future estimates may differ substantially from the Company’s current estimates.

 

Total compensation expense for our share-based payments in the fiscal year ended September 30, 2009, and 2008 was approximately $2.9 million and $1.6 million (excluding $14,000 included in discontinued operations), respectively. General and administrative expense in the fiscal years ended September 30, 2009 and 2008 includes share-based compensation expense of approximately $2.2 million and $1.1 million, respectively. Research and development expense in the fiscal years ended September 30, 2009 and 2008 includes share-based compensation expense of approximately $664,000 and $491,000, respectively. As of September 30, 2009, approximately $3.0 million of total unrecognized compensation costs related to unvested awards is expected to be recognized

over a weighted average period of 2.4 years. See Note 11, “Stockholders’ Equity — Employee Equity Incentive Plans” in the Notes to Consolidated Financial Statements for further discussion.

 

Interest Expense and Interest Income

 

For the fiscal year ended September 30, 2009, interest expense was $517, compared to approximately $541,000 for the prior fiscal year. The decrease in interest expense in 2009 is primarily due to a decrease in the balance on notes payable as compared to the prior year, mostly attributed to the accelerated repayment of the remaining outstanding principal in June 2008. The notes payable were issued in connection with the purchase of Alamo Pharmaceuticals, Inc.

 

For the fiscal year ended September 30, 2009, interest income was approximately $204,000, compared to approximately $1.3 million for the prior fiscal year. The decrease is due to an 18% decrease in the average cash balance of our investment accounts in fiscal 2009 as compared to the prior fiscal year, coupled with a lower investment yield in fiscal 2009.

 

Other, net

 

Other, net expense was approximately $272,000 in fiscal 2009 compared to income of approximately $1.2 million in fiscal 2008. In fiscal 2009, the company recognized a loss on disposal of fixed assets of approximately $268,000. In fiscal 2008, the Company received approximately $1.25 million in proceeds resulting from a settlement agreement with a former employee. The proceeds represented court awarded reimbursement of attorney’s fees incurred in connection with the Company’s defense. The proceeds were recorded as other income in the third fiscal quarter of 2008.

 

Loss from Discontinued Operations

 

There was no loss from discontinued operations for the fiscal year ended September 30, 2009. For the fiscal year ended September 30, 2008, approximately a $1.6 million loss from discontinued operations was recorded as a result of the final net working capital adjustment of approximately $1.4 million under our FazaClo asset purchase agreement with Azur, as well as additional trailing costs related to the operations of FazaClo.

 

Net Loss

 

Net loss was approximately $22.0 million, or $0.28 per share, for the fiscal year ended September 30, 2009, compared to a net loss of approximately $17.5 million, or $0.30 per share for the fiscal year ended September 30, 2008. The increase in net loss is primarily attributed to the following: 1) non-cash expenses of $1.9 million related to share-based compensation expense and other non-cash expenses, 2) increased spending in research and development and 3) the presence of two non-recurring revenue sources in 2008 totaling $2.5 million. In addition, in fiscal 2008, we recorded a gain on early extinguishment of debt and other income which together totaled approximately $2.2 million.

 

Liquidity and Capital Resources

 

We assess our liquidity based on our ability to generate cash to fund future operations. Key factors in the management of our liquidity are: cash required to fund operating activities including expected operating losses and the levels of inventories, accounts payable and capital expenditures; the timing and extent of cash received from milestone payments under license agreements; adequate credit facilities; and financial flexibility to attract long-term equity capital on favorable terms. Historically, cash required to fund on-going business operations has been provided by financing activities and used to fund operations, working capital requirements and investing activities.

Cash, cash equivalents and restricted investments, as well as net cash provided by or used in operating, investing and financing activities, are summarized in the table below.

 

 

 

Operating activities.  Net cash used in operating activities was approximately $23.8 million in fiscal year 2010 compared to approximately $20.3 million in fiscal year 2009. The increase is primarily due to expenses related to the Company’s regulatory and commercial readiness activities. Net cash used in operating activities was approximately $16.7 million in fiscal year 2008. The increase from fiscal year 2008 to 2009 was primarily due to expenses related to the confirmatory Phase III trial and additional pre-clinical and clinical studies in support of the response to the approvable letter.

 

Investing activities.  Net cash used in investing activities was approximately $346,000 in fiscal year 2010, compared to approximately $357,000 net cash provided by investing activities in fiscal year 2009. In fiscal year 2010, cash used in investing activities was primarily due to the purchase of property and equipment in support of our commercial readiness activities and investments in securities. In fiscal year 2009, cash provided by investing activities arose primarily from sales and maturities of investments. Net cash provided by investing activities was approximately $1.0 million in fiscal year 2008. In fiscal year 2008, proceeds from sales and maturities of investments of approximately $2.3 million were partially offset by payments of approximately $1.4 million related to the net working capital adjustment from our sale of FazaClo.

 

Financing activities.  Net cash provided by financing activities was approximately $31.4 million in fiscal year 2010 compared to approximately $10.0 million in fiscal year 2009. In fiscal 2010, we raised approximately $32.7 million in gross proceeds (approximately $31.6 million net of offering costs and commissions) from sales of common stock. In fiscal 2009, we raised approximately $10.8 million in gross proceeds (approximately $10.2 million net of offering costs and commissions) from sale of common stock. Net cash provided by financing activities was approximately $26.5 million in fiscal year 2008. In fiscal 2008, we raised gross proceeds of approximately $40.0 million from sales of our common stock through a registered common stock offering in April 2008 (approximately $37.9 million net of offering costs and commissions), offset by $11.3 million to reduce long-term debt.

 

In April 2009, we filed a shelf registration statement on Form S-3 with the SEC to sell an aggregate of up to $35.0 million in common stock, preferred stock, debt securities and warrants. On May 6, 2009, the registration statement was declared effective. On July 30, 2009 we entered into a financing facility with Cantor Fitzgerald & Co., providing for the sale of up to 12,500,000 shares of our common stock from time to time into the open market at prevailing prices. As of December 1, 2010, 7.6 million shares of common stock had been sold for total gross

proceeds of $21.5 million through this facility under our registration statement. Approximately $13.5 million remains on this shelf registration statement. We may or may not sell additional shares under this facility, depending on the volume and price of our common stock, as well as our capital needs and potential alternative sources of capital, such as a development partner for NUEDEXTA.

 

In September 2009, we filed a shelf registration statement on Form S-3 with the SEC to sell an aggregate of up to $75.0 million in common stock, preferred stock, debt securities and warrants. On September 23, 2009, the registration statement was declared effective.

 

In May 2010, we sold an aggregate of 10,000,000 shares of our common stock in an underwritten offering at a public offering price of $2.75 per share, resulting in $27.5 million in gross offering proceeds and approximately $26.6 million in net proceeds to us, after deducting underwriting discounts, commissions and estimated offering expenses. Approximately $34.5 million remains on this shelf registration statement.

 

In September 2010, we filed a shelf registration statement on Form S-3 with the SEC to sell an aggregate of up to $75.0 million in common stock, preferred stock, debt securities and warrants. As of December 1, 2010, there were no funds remaining on this shelf registration statement.

 

In November 2010, we completed an underwritten public offering of 20,000,000 shares of our common stock offered at a public offering price of $4.40 per share. Gross offering proceeds resulting from the offering were approximately $88,000,000, with net proceeds of approximately $83.0 million, after deducting offering discounts, costs and commissions.

 

As of September 30, 2010, we have contractual obligations for trade expenses and operating lease obligations, as summarized in the table that follows. We have no off-balance sheet arrangements.

 

 

 

 

In connection with our acquisition of Alamo, in May 2006, we agreed to pay up to an additional $39,450,000 in revenue-based earn-out payments, based on future sales of FazaClo. These earn-out payments are based on FazaClo sales in the U.S. from the closing date of the acquisition through December 31, 2018 (the “Contingent Payment Period”). We sold the FazaClo product line to Azur in August 2007. (See Note 3, “Sale of FazaClo” in the Notes to Consolidated Financial Statements.) Our future earn-out obligations that would have been payable to the prior owner of Alamo Pharmaceuticals upon the achievement of certain milestones were assumed by Azur, although we may remain liable for these payments if Azur defaults on these obligations.

 

NUEDEXTA License Milestone Payments.  We hold the exclusive worldwide marketing rights to NUEDEXTA for certain indications pursuant to an exclusive royalty-bearing license agreement with the Center for Neurologic Study (“CNS”). We will be obligated to pay CNS up to $400,000 in the aggregate in milestones to continue to develop NUEDEXTA for both PBA and DPN pain, assuming they are both approved for marketing by the FDA. We are not currently developing, nor do we have an obligation to develop, any other indications under the CNS license agreement. We paid a $75,000 milestone upon FDA approval of NUEDEXTA for the treatment of PBA. In addition, we are obligated to pay CNS a royalty on commercial sales of NUEDEXTA with respect to each indication, if the drug is approved by the FDA for commercialization. Under certain circumstances, we may have the obligation to pay CNS a portion of net revenues received if we sublicense NUEDEXTA to a third party. Under

the agreement with CNS, we are required to make payments on achievements of up to a maximum of ten milestones, based upon five specific clinical indications. Maximum payments for these milestone payments could total approximately $1.1 million if we pursued the development of NUEDEXTA for all of the licensed indications. Of the clinical indications that we currently plan to pursue, expected milestone payments could total approximately $400,000. In general, individual milestones range from approximately $75,000 to $125,000 for each accepted new drug application (“NDA”) and a similar amount for each approved NDA. In addition we are obligated to pay CNS a royalty ranging from approximately 5% to 8% of net GAAP revenues.

 

Management Outlook

 

We believe that cash, cash equivalents and restricted investments of approximately $39.4 million at September 30, 2010 and net proceeds of approximately $83.0 million raised under common stock offering completed in November 2010, will be sufficient to sustain our planned level of operations for at least the next 24 months. However, we cannot provide assurances that our plans will not change, or that changed circumstances will not result in the depletion of capital resources more rapidly than anticipated.

 

For information regarding the risks associated with our need to raise capital to fund our ongoing and planned operations, please see Item 1A, “Risk Factors.”

 

Recent Authoritative Guidance

 

See Note 2, “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements for a discussion of recently issued authoritative guidance and its effect, if any, on us.

 

 

As described below, we are exposed to market risks related to changes in interest rates. Because substantially all of 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 if 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 exposure as the needs and risks should arise.

 

Interest Rate Sensitivity

 

Our investment portfolio consists primarily of cash equivalent fixed income instruments invested in government money market funds. The primary objective of our investments in these securities is to preserve principal. We classify our restricted investments, which are primarily certificates of deposit, as of September 30, 2010 as held-to-maturity. These held-to-maturity securities are subject to interest rate risk. Based on the average duration of our investments as of September 30, 2010 and 2009, an increase of one percentage point in the interest rates would have resulted in increases in interest income of approximately $388,000 and $343,000, respectively.

 

As of September 30, 2010, $25.2 million of our cash and cash equivalents were maintained in four separate money market mutual funds, and approximately $13.6 million of our cash and cash equivalents were maintained at three major financial institutions in the United States. At times, deposits held with financial institutions may exceed the amount of insurance provided by the Federal Deposit Insurance Corporation. At September 30, 2010, such uninsured deposits totaled approximately $37.7 million. Generally, these deposits may be redeemed upon demand and, therefore, bear minimal risk.

 

Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash and cash equivalents. Our cash and cash equivalents are placed at various money market mutual funds and financial institutions of high credit standing.

 

We perform ongoing credit evaluations of our customers’ financial conditions and would limit the amount of credit extended if deemed necessary but usually we have required no collateral.

 

Our consolidated financial statements are annexed to this report beginning on page F-1.

 

 

None.

 

 

Evaluation of Disclosure Controls and Procedures

 

We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Vice President, Finance, of the effectiveness of our “disclosure controls and procedures” as of the end of the period covered by this report, pursuant to Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended.

 

In connection with that evaluation, our CEO and Vice President, Finance concluded that our disclosure controls and procedures were effective and designed to provide reasonable assurance that the information required to be disclosed is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms as of September 30, 2010. For the purpose of this review, disclosure controls and procedures means controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. These disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit is accumulated and communicated to management, including our principal executive officer, principal financial officer and principal accounting officer, as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

 

Management’s Report on Internal Control Over Financial Reporting

 

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and related COSO guidance. Based on our evaluation under this framework, our management concluded that our internal control over financial reporting was effective as of September 30, 2010.

 

Our assessment of the effectiveness of our internal control over financial reporting as of September 30, 2010 has been audited by KMJ Corbin & Company LLP, an independent registered public accounting firm, as stated in their report, which is set forth at F-3.

 

Changes in Internal Control over Financial Reporting

 

There has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) during our fourth fiscal quarter ended September 30, 2010, that has materially affected, or is reasonably likely to materially affect our internal control over financial reporting.

 

 

None.

 

 

The information relating to our directors that is required by this item is incorporated by reference from the information under the captions “Election of Directors,” “Corporate Governance,” and “Board of Directors and Committees” contained in our definitive proxy statement (the “Proxy Statement”), which will be filed with the Securities and Exchange Commission in connection with our 2011 Annual Meeting of Stockholders.

 

Additionally, information relating to reporting of insider transactions in Company securities is incorporated by reference from the information under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement.

 

Executive Officers and Key Employees of the Registrant

 

The names of our executive officers and other key employees and their ages as of December 1, 2010 are set forth below. 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.

 

 

Executive Officers

 

Keith Katkin.  Mr. Katkin joined AVANIR in July of 2005 as Senior Vice President of Sales and Marketing. In March 2007, Mr. Katkin was appointed President and Chief Executive Officer and was elected as a member of the Board of Directors. Prior to joining AVANIR, Mr. Katkin previously served as Vice President, Commercial Development for Peninsula Pharmaceuticals, playing a key role in the management and ultimate sale of the company to Johnson & Johnson in 2005. Additionally, Mr. Katkin’s employment experience includes leadership roles at InterMune, Inc., Amgen, Inc., and Abbott Laboratories. Mr. Katkin also served as strategic advisor to Cerexa, a pharmaceutical company that was sold to Forest Laboratories in 2007. Mr. Katkin received a B.S. degree in Business and Accounting from Indiana University and an M.B.A. degree in Finance from the Anderson School of Management at UCLA, graduating with honors. Mr. Katkin became a licensed Certified Public Accountant in 1995.

 

Randall E. Kaye, M.D.  Dr. Kaye joined AVANIR in January 2006 as Vice President of Clinical and Medical Affairs and assumed the role of Senior Vice President Clinical Research and Medical Affairs and Chief Medical Officer in February 2007. Immediately prior to joining AVANIR, from 2004 to 2006, Dr. Kaye was the Vice President of Medical Affairs for Scios Inc., a division of Johnson & Johnson. From 2002 to 2004, Dr. Kaye recruited and managed the Medical Affairs department for InterMune Inc. Previously, Dr. Kaye served for nearly a decade in a variety of Medical Affairs and Marketing positions for Pfizer Inc. Dr. Kaye earned his Doctor of Medicine, Masters in Public Health and Bachelor of Science degrees at George Washington University in Washington, D.C. and was a Research Fellow in Allergy and Immunology at Harvard Medical School.

 

Christine G. Ocampo, CPA.  Ms. Ocampo joined AVANIR in March 2007 as Corporate Controller and was promoted to Vice President, Finance in February 2008. Prior to joining AVANIR, Ms. Ocampo served as Senior Vice President, Chief Financial Officer, Chief Accounting Officer, Treasurer and Secretary of Cardiogenesis Corporation from November 2003 until April 2006. From 2001 to November 2003, Ms. Ocampo served in the role of Vice President and Corporate Controller at Cardiogenesis. Prior to first joining Cardiogenesis in April 1997, Ms. Ocampo held a management position in Finance at Mills-Peninsula Health Systems in Burlingame, CA, and

spent three years as an auditor for Ernst & Young LLP. Ms. Ocampo graduated with a Bachelors of Science in Accounting from Seattle University and became a licensed Certified Public Accountant in 1996.

 

Key Employees

 

Eric S. Benevich.  Mr. Benevich joined AVANIR in July 2005 as Senior Director of Marketing. In August 2007, he was promoted to Vice President of Communications. Prior to joining AVANIR, Mr. Benevich previously served as the Senior Director of Marketing for Peninsula Pharmaceuticals. Prior to his tenure at Peninsula Pharmaceuticals, Mr. Benevich held several Marketing positions with Amgen Inc., a global biotechnology company. In addition, Mr. Benevich held several commercial roles at Astra Merck in Sales, Market Research and Brand Marketing. Mr. Benevich graduated from Washington State University with a degree in International Business.

 

Gregory J. Flesher.  Mr. Flesher joined AVANIR in June 2006 as Senior Director of Commercial Strategy and in November 2006 assumed the additional responsibility for Business Development and Portfolio Planning. In August 2007 he was promoted to Vice President of Business Development. Prior to joining AVANIR, he served as a Sales Director from 2004 to 2006 and as Director of Pulmonary & Infectious Disease Marketing from 2002 to 2004 at InterMune, Inc., a biopharmaceutical company. Prior to his tenure at InterMune, Mr. Flesher held Oncology and Nephrology marketing positions with Amgen Inc., a global biotechnology company. Mr. Flesher also held roles in global marketing and clinical development at Eli Lilly and Company. Mr. Flesher graduated from Purdue University with a degree in Biology and has completed his doctorate coursework in Biochemistry and Molecular Biology at Indiana University School of Medicine.

 

Michael McFadden.  Mr. McFadden joined AVANIR in May 2010 as Vice President of U.S. Sales and Managed Markets. In this role, Mr. McFadden is responsible for staffing, training and leading the planned NUEDEXTA specialty sales force as well as leading the development of all strategies and activities related to managed markets; including national health plans, pharmacy benefit managers, state Medicaid, trade relations, long term care, government affairs, and contract administration. Mr. McFadden’s 20 years of pharmaceutical commercial experience includes the selling and marketing of several successful blockbuster prescription products. Prior to joining AVANIR, Mr. McFadden served in various leadership roles in sales and managed care at Amylin Pharmaceuticals where he was responsible for building and leading sales and managed markets teams and launching two first-in-class diabetes products. Prior to his tenure at Amylin, Mr. McFadden held commercial roles at Pharmacia and Eli Lilly and Company. Mr. McFadden graduated from University of Louisiana at Monroe with a degree in Business Administration.

 

Code of Ethics

 

We have adopted a code of Business Conduct and Ethics for directors, officers (including our principal executive officer, principal financial officer, and principal accounting officer and controller), and employees. This code is available on our website at www.avanir.com. Any waivers from or amendments to the code of ethics will be filed with the SEC on Form 8-K. You may also request a printed copy of our code of ethics, without charge, by writing to us at 101 Enterprise, Suite 300, Aliso Viejo, California 92656, Attn: Investor Relations.

 

 

The information required by this item is incorporated by reference to the information under the captions “Executive Compensation” and “Compensation Committee Interlocks and Insider Participation” contained in the Proxy Statement.

 

 

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

 

The information required by this item is incorporated by reference to the information under the captions “Certain Relationships and Related Party Transactions,” “Director Independence” and “Board Committees” contained in the Proxy Statement.

 

 

The information required by this item is incorporated by reference to the information under the caption “Fees for Independent Registered Public Accounting Firm” contained in the Proxy Statement.

 

 

(a) Financial Statements and Schedules

 

See index to the financial statements on page F-1.

 

(b) Exhibits

 

The following exhibits are incorporated by reference or filed as part of this report.

 

 

 

 

Pursuant to the requirements of Section 13 or 15(d) 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.

 

Avanir Pharmaceuticals, INC.

 

Keith A. Katkin

President and Chief Executive Officer

 

Date: December 7, 2010

 

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.

 

Avanir Pharmaceuticals, Inc.

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

 

To the Board of Directors and Stockholders of

Avanir Pharmaceuticals, Inc.

 

We have audited the accompanying consolidated balance sheets of Avanir Pharmaceuticals, Inc. and subsidiaries (the “Company”) as of September 30, 2010 and 2009, and the related consolidated statements of operations, stockholders’ equity and comprehensive loss and cash flows for each of the three years in the period ended September 30, 2010. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

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

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Avanir Pharmaceuticals, Inc. and subsidiaries as of September 30, 2010 and 2009, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 2010, in conformity with accounting principles generally accepted in the United States of America.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of September 30, 2010, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated December 7, 2010 expressed an unqualified opinion on the Company’s internal control over financial reporting.

 

/s/ KMJ Corbin & Company LLP

 

Costa Mesa, California

December 7, 2010

 

To the Board of Directors and Stockholders of

Avanir Pharmaceuticals, Inc.

 

We have audited the internal control over financial reporting of Avanir Pharmaceuticals, Inc. and subsidiaries (the “Company”) as of September 30, 2010, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting included in Item 9A. Our responsibility is to express an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit of internal controls over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness of the internal control over financial reporting to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, Avanir Pharmaceuticals, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of September 30, 2010, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Avanir Pharmaceuticals, Inc. and subsidiaries as of September 30, 2010 and 2009, and the related consolidated statements of operations, stockholders’ equity and comprehensive loss and cash flows for each of the three years in the period ended September 30, 2010 and our report dated December 7, 2010 expressed an unqualified opinion on those consolidated financial statements.

 

/s/ KMJ Corbin & Company LLP

 

Costa Mesa, California

December 7, 2010

Avanir Pharmaceuticals, Inc.

CONSOLIDATED BALANCE SHEETS

 

 

See notes to consolidated financial statements.

Avanir Pharmaceuticals, Inc.

 

CONSOLIDATED STATEMENTS OF OPERATIONS