SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

X	QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
	For the quarterly period ended December 31, 2001

OR

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

For the transition period from ______________ to ______________.

Commission File No. 0-18734

AVANIR PHARMACEUTICALS
(Exact name of registrant as specified in its charter)

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

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

(858) 622-5200
(Registrant’s telephone number, including area code)

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

The number of shares of Common Stock of the Registrant issued and outstanding as of February 1, 2002:

Class A Common stock, no par value	58,211,381
Class B Common stock, no par value	36,500

TABLE OF CONTENTS

		CONSOLIDATED BALANCE SHEETS (UNAUDITED)
		CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
		CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
		NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
	Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
PART II OTHER INFORMATION
	Item 6. EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURES

AVANIR PHARMACEUTICALS

FORM 10-Q

For the Quarter Ended December 31, 2001

INDEX

		Page
PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Balance Sheets	3
	Consolidated Statements of Operations	4
	Consolidated Statements of Cash Flows	5
	Notes to Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	21
PART II.	OTHER INFORMATION
Item 6.	Exhibits and Reports on Form 8-K	21

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AVANIR PHARMACEUTICALS
CONSOLIDATED BALANCE SHEETS (UNAUDITED)

				December 31,			September 30,
				2001			2001
ASSETS
Current assets:
	Cash and cash equivalents			$	12,546,173		$	16,542,545
	Restricted investment				388,122			388,122
	Short-term investments				24,038			23,179
	Receivables				1,249,555			898,676
	Inventory				222,585			222,585
	Prepaid				404,856			581,298
			Total current assets		14,835,329			18,656,405
	Property and equipment, net				2,400,907			2,217,094
	Intangible costs, net				1,290,605			1,174,928
	Investments				11,297,318			4,897,390
	Other assets				106,715			108,136
			TOTAL ASSETS	$	29,930,874		$	27,053,953
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
	Accounts payable			$	764,486		$	734,701
	Accrued expenses and other liabilities				919,002			858,991
	Accrued compensation and payroll taxes				325,978			355,526
	Loan payable				124,451			186,122
	Current portion of capital lease obligation				113,954			105,366
			Total current liabilities		2,247,871			2,240,706
	Capital lease obligation, net of current portion				422,179			351,784
			Total liabilities		2,670,050			2,592,490
COMMITMENTS
REDEEMABLE CONVERTIBLE PREFERRED STOCK
	Series D — no par value, 500 shares authorized; 50 shares issued and outstanding				507,512			502,903
SHAREHOLDERS’ EQUITY
	Preferred stock — no par value, 9,999,500 shares authorized:
		Series C Junior Participating — 1,000,000 shares authorized, no shares issued or outstanding			—			—
	Common stock — no par value:
		Class A — 99,288,000 shares authorized; 58,056,381 and 57,976,381 issued and outstanding			86,754,960			86,626,355
		Class B — 712,000 shares authorized; 36,500 shares issued and outstanding (convertible into Class A Common Stock)			19,895			19,895
	Accumulated deficit				(59,974,174	)		(62,735,080	)
	Accumulated other comprehensive income (loss)				(47,369	)		47,390
		Total shareholders’ equity			26,753,312			23,958,560
		TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY		$	29,930,874		$	27,053,953

See notes to consolidated financial statements.

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AVANIR PHARMACEUTICALS
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

			Three Months Ended
			December 31,
			2001			2000
REVENUES:
	Contract and license revenues		$	5,066,667		$	5,010,000
	Grant revenue			—			55,732
	Royalties			1,063,548			—
		Total revenues		6,130,215			5,065,732
EXPENSES:
	Research and development			2,346,859			1,308,125
	General and administrative			954,068			772,695
	Sales and marketing			320,032			214,319
		Total operating expenses		3,620,959			2,295,139
INCOME FROM OPERATIONS			$	2,509,256		$	2,770,593
	Interest income			187,915			335,370
	Other income			82,940			—
	Interest expense			(14,602	)		(2,859	)
NET INCOME			$	2,765,509		$	3,103,104
NET INCOME ATTRIBUTABLE TO COMMON SHAREHOLDERS:
	Net income		$	2,765,509		$	3,103,104
	Dividends on redeemable convertible preferred stock			(6,250	)		(6,301	)
	Accretion of discount related to redeemable convertible preferred stock			(4,609	)		(4,659	)
NET INCOME ATTRIBUTABLE TO COMMON SHAREHOLDERS			$	2,754,650		$	3,092,144
NET INCOME PER SHARE:
	BASIC		$	0.05		$	0.05
	DILUTED		$	0.04		$	0.05
WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING:
	BASIC			58,029,403			57,216,732
	DILUTED			61,455,499			65,516,875

See notes to the financial statements.

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AVANIR PHARMACEUTICALS
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

				Three Months Ended
				December 31,
				2001			2000
OPERATING ACTIVITIES:
	Net income			$	2,765,509		$	3,103,104
	Adjustments to reconcile net income to net cash provided by operating activities:
	Depreciation and amortization				129,816			69,872
	Compensation paid with common stock and stock options				44,860			13,622
	Loss on sale or disposal of assets				28			670
	Changes in assets and liabilities:
		Accounts receivable			(350,879	)		(38,953	)
		Inventory			—			(3,980	)
		Prepaid and other			177,863			(83,311	)
		Accounts payable			29,785			(139,527	)
		Accrued expenses and other liabilities			60,011			(278,166	)
		Accrued compensation and payroll taxes			(29,548	)		9,673
			Net cash provided by operating activities:		2,827,445			2,653,004
INVESTING ACTIVITIES:
	Investments in securities				(7,695,545	)		—
	Proceeds from sales and maturities of investments				1,200,000			95,164
	Patent costs				(127,577	)		(227,981	)
	Capital expenditures				(188,721	)		(289,887	)
			Net cash used for investing activities		(6,811,843	)		(422,704	)
FINANCING ACTIVITIES:
	Proceeds from issuance of common stock, net				90,000			929,583
	Dividends paid on preferred stock				(6,250	)		—
	Repayment of notes payable				(95,724	)		(61,230	)
			Net cash provided by (used for) financing activities		(11,974	)		868,353
Net increase (decrease) in cash and cash equivalents					(3,996,372	)		3,098,653
Cash and cash equivalents at beginning of period					16,542,545			19,699,768
Cash and cash equivalents at end of period				$	12,546,173		$	22,798,421
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Interest paid				$	14,602		$	2,859
SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND FINANCING ACTIVITIES:
Acquisition of equipment with capital leases				$	113,036		$	—

See notes to the financial statements.

5

AVANIR PHARMACEUTICALS

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

We (also referred to as “AVANIR” or the “Company”) have prepared the unaudited consolidated financial statements in this quarterly report in accordance with the instructions to Form 10-Q adopted under the Securities Exchange Act of 1934. These statements should be read with our audited consolidated financial statements and the accompanying notes included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2001. In our opinion, we have presented the consolidated financial statements, including all adjustments consisting only of normal recurring accruals that are necessary to summarize fairly our financial position as of December 31, 2001, and the results of operations for the three months ended December 31, 2001 and December 31, 2000. The results of operations for the three months ended December 31, 2001 may not be indicative of the results that may be expected for the year ending September 30, 2002.

2. RECLASSIFICATIONS

Certain amounts from the prior period have been reclassified to conform to the current period presentation.

3. BALANCE SHEET DETAIL

The following tables provide details of selected balance sheet items.

			December 31,			September 30,
			2001			2001
Receivables:
	Total receivables		$	1,249,555		$	898,676
	Allowance for doubtful accounts			—			—
		Receivables	$	1,249,555		$	898,676
Property and equipment, net:
	Leasehold improvements		$	769,156		$	753,824
	Computer equipment and related software			350,392			296,862
	Research and development equipment			2,062,364			1,831,645
	Office equipment, furniture, and fixtures			220,945			218,796
				3,402,857			3,101,127
	Less, accumulated depreciation and amortization			(1,001,950	)		(884,033	)
		Property and equipment, net	$	2,400,907		$	2,217,094
Intangible costs, net:
	Intangible costs		$	1,441,281		$	1,313,704
	Less, accumulated amortization			(150,676	)		(138,776	)
		Intangible costs, net	$	1,290,605		$	1,174,928

4. INVENTORY

Inventory is stated at the lower of cost (first-in, first-out) or market. Inventory consists of the raw material, docosanol, which is the active ingredient in docosanol 10% cream. Docosanol in its present form as stored by the Company has a substantial shelf life, a relatively stable value and long-term use, and carries a low risk of becoming excess inventory or obsolete. The Company does not own or store any product in its final form, such as docosanol 10% cream.

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5. REVENUE RECOGNITION

Performance-based license fees. We recognize revenues from license fees when the performance requirements have been met, the fee is fixed or determinable, and collection of fees is probable.

Royalty revenues. We recognize royalty revenues from our licensed products when earned. Net sales figures used for calculating royalties due the Company can often include deductions for estimated costs of unsaleable returns, managed care chargebacks, cash discounts, freight and warehousing, and miscellaneous write-offs, which may vary over the course of the license agreement. Because of the aforementioned deductions, sales of Abreva™, if publicly reported by our licensee, GlaxoSmithKline, could differ from net sales used in calculating the royalties earned in accordance with the license agreement.

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

Federal research grant revenue. We recognize revenues from federal research grants during the period in which the related expenditures are incurred.

6. INVESTMENTS

The following tables summarize the Company’s investments in securities:

							Gross		Gross
					Amortized		Unrealized		Unrealized			Fair
					Cost		Gain(2)		Loss(2)			Value
As of December 31, 2001:
	Certificates of deposit				$	1,612,160		—	$	(12,470	)	$	1,599,690
	Government securities					9,975,000	$	41,145		(76,044	)		9,940,101
	Commercial paper					200,000		6,624		—			206,624
		Total			$	11,787,160	$	47,769	$	(88,514	)	$	11,746,415
Reported as:
	Short-term investments:
		Restricted investment(1)			$	388,122
		Classified as held to maturity				24,038
			Short-term investments		$	412,160
	Long-term investments:
		Classified as available for sale			$	11,097,318
		Classified as held to maturity				200,000
			Long-term investments		$	11,297,318
				Total	$	11,709,478

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							Gross		Gross
					Amortized		Unrealized		Unrealized		Fair
					Cost		Gain(3)		Loss		Value
As of September 30, 2001:
		Certificates of deposit			$	411,301		—		—	$	411,301
		Government securities				4,650,000	$	48,952		—		4,698,952
		Commercial paper				200,000		8,862		—		208,862
				Total	$	5,261,301	$	57,814		—	$	5,319,115
Reported as:
		Short-term investments:
			Restricted investment(1)		$	388,122
			Classified as held to maturity			23,179
				Short-term investments	$	411,301
	Long-term investments:
			Classified as available for sale		$	4,497,390
			Classified as held to maturity			400,000
				Long-term investments		4,897,390
				Total	$	5,308,691

(1)	A restricted investment amounting to $388,122 as of December 31, 2001, and September 30, 2001, represents an amount that we pledged to our bank as collateral for a letter of credit that our bank issued in connection with our lease of office and laboratory space.
(2)	Gross unrealized gains of $41,145 on government securities and gross unrealized losses of $88,514 on other investments represent an accumulated net unrealized loss of $47,369, which is reported as “Accumulated other comprehensive loss” on the consolidated balance sheet as of December 31, 2001.
(3)	Includes government securities with maturities in excess of 90 days and having gross unrealized gains totaling $47,390, which has been reported as “Accumulated other comprehensive income” on the consolidated balance sheet as of September 30, 2001.

7. ESTIMATES

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

8. COMPUTATION OF NET INCOME PER COMMON SHARE

We computed basic income per share by dividing the net income attributable to common shareholders by the weighted average number of common shares outstanding during the period (“Basic EPS method”). We compute diluted earnings per common share by dividing the net income attributable to common shareholders by the weighted-average number of common and dilutive common equivalent shares outstanding during the period (“Diluted EPS method”). Dilutive common equivalent shares consist of shares issuable upon exercise of stock options and warrants and conversion of preferred stock.

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9. DILUTED WEIGHTED AVERAGE NUMBER OF SHARES

The following table is the reconciliation from the basic to the diluted earnings per share computations for “net income” for the three months ended December 31, 2001 and December 31, 2000:

				Three Months Ended December 31,
				2001			2000
Numerator:
	Net income			$	2,765,509		$	3,103,104
Less:
	Dividends on redeemable convertible preferred stock				(6,250	)		(6,301	)
	Accretion of discount related to redeemable convertible preferred stock				(4,609	)		(4,659	)
			Income available to common shareholders for basic earnings per share		2,754,650			3,092,144
Effect of dilutive securities:
	Convertible preferred stock				(23,857	)		(42,090	)
			Income available to common shareholders for diluted earnings per share	$	2,730,793		$	3,050,054
Denominator:
Shares for basic earnings per share — weighted average shares outstanding					58,029,403			57,216,732
Effect of dilutive securities:
	Stock options(1)				2,551,715			6,679,919
	Warrant shares				687,452			1,444,578
	Convertible preferred stock				186,929			175,646
		Shares for diluted earnings per share			61,455,499			65,516,875
Basic earnings per share				$	0.05		$	0.05
Diluted earnings per share				$	0.04		$	0.05

(1) For the three months ended December 31, 2001, options to purchase 343,260 shares of common stock were excluded from the computation of diluted earnings per share, as the inclusion of such shares would be antidilutive.

10. SHAREHOLDERS’ EQUITY

Preferred Stock

Preferred stock consists of Series C Junior Participating Preferred Stock and Series D Redeemable Convertible Preferred Stock.

Series C Junior Participating Preferred Stock. None of the Series C Junior Participating Preferred Stock is outstanding.

Series D Redeemable Convertible Preferred Stock. At December 31, 2001 and September 30, 2001, 50 shares of Series D redeemable convertible preferred stock (“Series D Shares”) remained outstanding in connection with a securities purchase agreement made with certain investors on March 22, 1999. The Series D holders may convert any or all of the remaining Series D Shares into shares of Class A common stock at a conversion rate equal to $10,000 divided by a conversion price equal to the lesser of:

• the Fixed Conversion Price — an amount equal to $2.715 per share of Class A common stock; or

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

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

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

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Class A Common Stock

On December 12, 2001, the holder of Class K Warrants exercised its right to purchase 80,000 shares of Class A common stock at an exercise price of $1.125 per share, for cash in the aggregate amount of $90,000.

11. RECENT ACCOUNTING PRONOUNCEMENTS

In December 1999, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements.” SAB 101, as amended, summarizes certain of the SEC’s views in applying accounting principles generally accepted in the United States of America to revenue recognition in financial statements, including revenues earned from collaborations between companies. We adopted SAB 101 in the fourth quarter of the fiscal year ended September 30, 2001. The adoption of SAB 101 did not have a material impact on the Company’s earnings.

In July 2001, the Financial Accounting Standards Board (“FASB”) approved three statements, Statement of Financial Accounting Standards No. 141 (“SFAS 141”), “Business Combinations,” SFAS 142, “Goodwill and Other Intangible Assets,” and SFAS 143, “Accounting for Asset Retirement Obligations.”

SFAS 141 supersedes APB Opinion No. 16, “Business Combinations,” and eliminates the pooling-of-interests method of accounting for business combinations, thus requiring all business combinations be accounted for using the purchase method. In addition, in applying the purchase method, SFAS 141 changes the criteria for recognizing intangible assets apart from goodwill and states the following criteria should be considered in determining the recognition of the intangible assets: (1) the intangible asset arises from contractual or other legal rights, or (2) the intangible asset is separable or dividable from the acquired entity and capable of being sold, transferred, licensed, rented, or exchanged. The requirements of SFAS 141 are effective for all business combinations completed after June 30, 2001. The adoption of this new standard did not have a material impact on the Company’s financial statements.

SFAS 142 supercedes APB Opinion No. 17, “Intangible Assets,” and requires goodwill and other intangible assets that have an indefinite useful life to no longer be amortized; however, these assets must be reviewed at least annually for impairment. Application of SFAS 142 is required for the Company on October 1, 2002. We do not believe the adoption of SFAS 142 will have a significant impact on the Company’s financial statements.

SFAS 143 requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. When the liability is initially recorded, the entity capitalizes a cost by increasing the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the liability, an entity either settles the obligation for its recorded amount or incurs a gain or loss upon settlement. Application of SFAS 143 became effective for AVANIR on October 1, 2001. The adoption of this standard did not have a significant impact on the Company’s financial statements.

In August 2001 the FASB issued SFAS 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.” This statement addresses financial accounting and reporting for the impairment or disposal of long-lived Assets. This statement supercedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,” and the accounting and reporting provisions of APB Opinion No. 30, “Reporting the Results of Operations — Reporting the Effects of a Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,” for the disposal of a segment of a business (as previously defined in that Opinion). SFAS

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No. 144 becomes effective for the Company on October 1, 2002. The effect, if any, of SFAS 144 on the Company’s financial statements has not yet been determined.

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This quarterly report on Form 10-Q contains forward-looking statements concerning future events and performance of our company. You should not rely excessively on these forward-looking statements, because they are only predictions based on our current expectations and assumptions. Forward-looking statements often contain words like “estimate,” “anticipate,” “believe,” “plan” or “expect.” Many known and unknown risks and uncertainties could cause our actual results to differ materially from those indicated in these forward-looking statements. You should review carefully the risks and uncertainties identified in this report and in our most recent annual report on Form 10-K filed with the Securities and Exchange Commission. We disclaim any obligation to update or announce revisions to any forward-looking statements to reflect actual events or developments.

Overview

AVANIR Pharmaceuticals, based in San Diego and incorporated in California in 1988, is engaged in research, development, commercialization, licensing and sales of innovative drug products and antibody generation services. AVANIR’s subsidiary, Xenerex Biosciences, is engaged in research collaborations with partner companies for developing and commercializing completely human antibody products to target antigens.

AVANIR currently has a drug on the market that has been approved by the United States Food and Drug Administration (FDA). Marketed in North America by GlaxoSmithKline, Abreva™ (docosanol 10% cream) was launched in the United States in late 2000. According to AC Nielson, Abreva is the largest selling consumer healthcare product in the United States for the treatment of cold sores. The consumer research group ranked Abreva number five among the top selling new consumer healthcare products introduced in the twelve month period ended September 2001. Under the license agreement with GlaxoSmithKline, AVANIR has received $25 million in milestone payments, including the final $5 million milestone payment received in November 2001.

AVANIR has completed other license agreements or is engaged in negotiations for licensing of docosanol 10% cream to other international companies. AVANIR is also assisting those companies in their efforts to obtain regulatory approvals for manufacturing and marketing the drug. The Company currently has license agreements with companies that have a presence in Canada, South Korea, Israel, Egypt and other countries in the Middle East. The regulatory approval process is underway in each of those countries. We are also preparing for an initial filing for regulatory approval of docosonal in Europe and have made the decision to prepare for filing in Japan as well.

AVANIR’s drug development pipeline consists of clinical, pre-clinical and drug discovery programs. Current clinical development programs are centered around Neurodex™, which could potentially provide a novel approach for the treatment of several central nervous system disorders. AVANIR is currently developing two of four known potential indications for Neurodex. The leading clinical development program is for the treatment of emotional lability, a neurodegenerative condition for which no FDA-approved drug exists. A Phase II/III clinical trial for the treatment of emotional lability in patients with Lou Gehrig’s disease is underway. If the trial is successful, we plan to follow with an additional Phase III clinical trial in patients with multiple sclerosis. Positive results will be needed for both clinical trials for us to file a new drug application with the FDA in late 2003 or early 2004. We also intend to enter a Phase II dosing trial for Neurodex in the treatment of diabetic neuropathic pain later in 2002. Our preclinical research and drug discovery programs are at earlier stages of development and are directed primarily

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toward large therapeutic areas, including allergies and asthma, inflammatory diseases and cholesterol reduction.

Important parts of our development strategy include engaging in research collaborations, acquisitions and licensing. For example, in January 2002 we entered into a research collaboration with Shanghai New Asiatic Pharmaceutical Company for the purposes of exploring other indications or uses for docosanol 10% cream, including genital herpes and herpes zoster, also known as shingles. We intend to partner with more companies that can help fund AVANIR’s research in exchange for rights to commercialize new drugs coming from this research. We also expect that Xenerex will play an important part in establishing new research collaborations and in providing a source of revenues for its services in generating human monoclonal antibodies for its partners. In January 2002, Xenerex entered into its third collaborative research agreement for generating fully human monoclonal antibodies to target antigens provided by its research partner. Xenerex now has contracts to generate antibodies to eight target antigens provided by its partners.

RESULTS OF OPERATIONS

Revenues

Revenues increased to $6.1 million for the first quarter of fiscal year 2002, representing the three months ended December 31, 2001, compared to $5.1 million in the same period a year ago. The 21% increase in revenues was due primarily to royalties earned from sales of Abreva™ by GlaxoSmithKline. Royalties on sales of Abreva continued to improve with increasing market penetration and seasonally higher demand for cold sore products. In addition to $1.1 million in royalties on product sales, revenues for the first fiscal quarter 2002 included the final $5 million milestone from GlaxoSmithKline when the company reached the one-year anniversary of introduction of Abreva. Revenues for the first fiscal quarter 2001 included earning $5 million in October 2000 when GlaxoSmithKline achieved Abreva product launch.

Having received the final $5 million milestone payment from GlaxoSmithKline during the first fiscal quarter 2002, our revenues for the next several quarters will depend substantially on the amount of royalties earned from sales of Abreva™, potential milestone payments from international licensees of docosanol 10% cream, and making further progress at Xenerex in adding to its customer base and in reaching additional milestones in providing human antibodies.

We believe GlaxoSmithKline’s launch of Abreva™ has been very successful to date, as demonstrated by achieving market leadership in the first year of introduction. We expect that sales of Abreva will generate royalties to AVANIR in the range of $3.3 million to $4.5 million during fiscal 2002, depending on GlaxoSmithKline’s level of product promotion and the timing of regulatory approval for marketing the product in Canada. We believe that future royalties on sales of Abreva will provide an important source of funds for pursuing development programs. However, we expect that royalties and milestone payments from international licensing during the next two quarters will not be enough to sustain the profitability levels that we have experienced during the past two quarters.

We continue to make progress in outlicensing docosanol 10% cream in international markets, which represent potential new sources of revenues for us in the future. However, our ability to earn license fees and milestone payments from international sources in the near term will be more unpredictable, because the timing of foreign regulatory approvals and marketing of our product will be substantially outside our control.

We expect that our subsidiary, Xenerex Biosciences, will gradually become a significant source of revenues through its antibody generation services business. Near-term revenues should help fund

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Xenerex’s growth, but the larger milestone payments that typically accompany these collaborations will depend on the progress made by our partners in evaluating, selecting and advancing our antibodies through the development pipeline. Progress by our research partners is largely unpredictable and will take years of development before an antibody reaches the market, if ever, assuming it is selected for further development.

Expenses

Operating Expenses — Total operating expenses increased to $3.6 million in the first fiscal quarter 2002, compared to $2.3 million in the same period in fiscal 2001. The 58% increase in operating expenses was primarily caused by a 79% increase in spending on research and development programs. Research and development programs accounted for 65% and 57% of total operating expenses for the fiscal quarters ended December 31, 2001 and 2000, respectively. General and administrative expenses accounted for 26% and 34% of total operating expenses for the fiscal quarters ended December 31, 2001 and 2000, respectively. Sales and marketing expenses accounted for 9% of total operating expenses for the fiscal quarters ended December 31, 2001 and 2000. These and other costs are more fully described below.

Research and Development Expenses — Research and development (R&D) expenses increased to $2.3 million in the first fiscal quarter 2002, compared to $1.3 million in the same period a year ago. The Phase II/III clinical trial for Neurodex (formerly AVP-923) in the treatment of emotional lability accounted for 29% of all R&D spending in the first fiscal quarter 2002. The Phase II/III clinical trial for Neurodex was approximately 66% completed at December 31, 2001. Toxicology and other preclinical research related to AVANIR’s lead compound for the treatment of allergies and allergic asthma accounted for 17% and development of human antibody generation technology within Xenerex Biosciences accounted for 14% of R&D spending in the first fiscal quarter 2002. The balance of R&D spending was for other programs, including preclinical research related to inflammation and cholesterol lowering compounds, and for operating and maintaining laboratory facilities.

We plan to continue increasing our spending on established R&D programs in the development pipeline. For example, through the next several quarters we intend to expand our clinical development programs for Neurodex by initiating a Phase II clinical trial for the treatment of diabetic neuropathic pain. We also intend to continue toxicology work and other advanced preclinical research on our lead compound for treating allergy and allergic asthma.

In the first fiscal quarter 2001, R&D expenses primarily related to initiating the Phase II/III clinical trial for Neurodex in treating emotional lability and development of the antibody generation technology. The Neurodex Phase II/III clinical trial began in November 2000.

General and Administrative Expenses — General and administrative expenses amounted to $954,000 in the first fiscal quarter 2002, representing a 23% increase over expenses of $773,000 in the same period in the prior year. Higher expenses were attributable to increased staff size to support growing R&D and commercial development programs. General and administrative expenses grew at a slower rate than R&D and sales and marketing expenses as the Company concentrated its efforts on R&D programs and outlicensing of docosanol 10% cream.

Sales and Marketing Expenses — During the first fiscal quarter 2002, sales and marketing expenses were $320,000, compared with $214,000 in the same period a year ago. Higher expenses in the first fiscal quarter 2002 were related to expanding efforts to out-license docosanol 10% cream in Europe and the Middle East, establishing a research collaboration in the People's Republic of China, and increasing commercial development activity at Xenerex Biosciences. Sales and marketing activity for the same period in fiscal year 2001 was relatively low while we directed most of our efforts toward GlaxoSmithKline’s launch of Abreva.

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Income from Operations

For the first fiscal quarter 2002, income from operations was $2.5 million, compared to $2.8 million for the same period a year ago. Higher fiscal 2002 operating expenses were only partially offset by the $1 million increase in revenues attributable to Abreva royalties. Higher operating expenses were related to the greater number and extent of R&D programs, increased staff size in the general and administrative areas, and increases in sales and marketing activities, including licensing activities for docosanol 10% cream.

Other Income and Expenses

Interest Income — In the first fiscal quarter 2002, interest income amounted to $188,000, compared to $335,000 for the same period a year ago. The decrease in interest income during the first fiscal quarter 2002 was primarily due to lower interest rates on investments compared with the same period a year ago.

Other Income — Other income for the first fiscal quarter 2002 primarily consists of one-time fees charged by the Company to potential licensees for exclusive rights to negotiate license agreements for docosanol 10% cream and rental income for use of the Company’s conference center and emergency standby power generating equipment.

Interest Expense — In the first fiscal quarter 2002, interest expense amounted to $15,000, compared to $3,000 for the same period a year ago. Higher levels of interest expense will continue for the foreseeable future. Higher interest expense for the first fiscal quarter 2002 was primarily related to $495,000 in new capital equipment lease financing transactions for an emergency power generator and various new pieces of laboratory equipment.

Net Income

For the first fiscal quarter 2002, net income attributable to common shareholders was $2.8 million, compared to $3.1 million for the same period a year ago. Basic net income per share was $0.05 and diluted net income per share was $0.04, compared to basic and diluted net income per share of $0.05 for the same period a year ago. Given the uncertainty in the amounts and timing of revenues other than Abreva™ royalties, and planned increases in spending associated with an expanded drug development pipeline, we expect to incur losses at least through the next two quarters. Thereafter, for a period of at least two years, we expect to have some quarterly periods of profitability and some quarterly periods of losses, depending on the amounts and timing of license fees and milestone payments.

LIQUIDITY AND CAPITAL RESOURCES

At December 31, 2001, we had cash and cash equivalents of $12.5 million, short and long-term investments of $11.7 million and a net working capital balance of $12.6 million. At September 30, 2001, we had cash and cash equivalents of $16.5 million, short and long-term investments of $5.3 million and a net working capital balance of $16.4 million. We use finance leases to fund portions of our equipment purchases, but we do not maintain a line of credit with any financial institution. Explanations of the changes in net cash provided by operating and financing activities and net cash used for investing activities are provided below.

Operating Activities. Net cash provided by operating activities amounted to $2.8 million in the first fiscal quarter 2002, compared to $2.7 million during the same period a year ago. Net income of $2.8 million and $3.1 million for the fiscal quarters ended 2002 and 2001, respectively, accounted for most of the net cash provided by operating activities. Net cash provided by operating activities increased in the first fiscal quarter 2002 over the same period a year ago because we obtained better payment terms from a number of vendors, which enabled us to reduce the amount of prepayments on our purchases of equipment and services.

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Investing Activities. Net cash used for investing activities during the first fiscal quarter 2002, amounted to $6.8 million, including investments in securities totaling $7.7 million, capital expenditures of $189,000 and patent costs of $128,000, partially offset by sales and maturities of investments totaling $1.2 million. As short-term interest rates came down through most of 2001, we sought to achieve higher yields on our available cash by investing in securities that had maturities longer than one year. Our investment strategy of seeking higher yields through longer maturities of government securities and bank CDs primarily resulted in a $4 million reduction in cash and cash equivalents and a $6.4 million net increase in short and long-term investments. Net cash used for investing activities in the first fiscal quarter 2001 amounted to $423,000, including capital expenditures of $290,000 and patent costs of $228,000.

Financing Activities. During the first fiscal quarter 2002, net cash used for financing activities amounted to $12,000. During the same period a year ago, net cash provided by financing activities amounted to $868,000, primarily from issuances of Class A common stock on exercises of stock options and stock purchase warrants. Other financing activities in the fiscal quarters ended 2002 and 2001, related primarily to short-term financing of insurance premiums and payments of dividends on preferred stock.

We believe that cash and short and long-term investments totaling $24.3 million at December 31, 2001, provide us with sufficient liquidity to fund at least two years of operating costs. However, given the uncertainty of the timing and amounts of revenues from sources other than royalties and our plans for expanding our drug development pipeline, it is more likely than not that we will raise capital in the next twelve months to enhance our capital base and liquidity.

RECENT ACCOUNTING PRONOUNCEMENTS

     See Note 11, “Recent Accounting Pronouncements” for a discussion of recent accounting pronouncements and their effect, if any, on the Company.

RISK FACTORS THAT MIGHT AFFECT FUTURE OPERATIONS

We expect our quarterly revenues and operating results to fluctuate for a number of reasons.

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

• Seasonality. Our sequential royalty revenues from sales of Abreva by GlaxoSmithKline in the United States are expected to fluctuate downward in the summer months based on historical industry sales data for cold sore treatments, which indicates some seasonality.

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

• Concentration of significant customers, suppliers and industries. Milestone payments and royalties earned from a single licensee (GlaxoSmithKline) accounted for approximately 91% and 93% of our fiscal 2001 and 2000 net revenues, respectively. All of the milestone payments from GlaxoSmithKline have now been received. Future revenues from GlaxoSmithKline will come exclusively from Abreva royalties. Our business could be adversely affected if GlaxoSmithKline

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terminated its business relationship with us or significantly reduced the amount of marketing and promotion of Abreva. Additionally, we purchase our raw materials from a sole foreign supplier that has been approved for manufacture by the FDA. Any disturbances or delays in the manufacture of the raw materials could seriously and adversely affect our business.

If we experience any delays in obtaining regulatory approval for Abreva™ in Canada or if GlaxoSmithKline experiences problems in manufacturing or reduces promotion of the product, then our royalties from sales of Abreva will be materially and adversely affected.

We have signed an exclusive license agreement with GlaxoSmithKline for manufacturing and sales of Abreva in North America. Abreva is approved for sale only in the United States at this time. We have completed the application for regulatory approval for marketing in Canada and we are currently awaiting a decision. We could experience problems or delays in obtaining regulatory approval in Canada, which has a market size that is about 10% of the size of the U.S. market. Further, our royalty revenues from sales of Abreva next year will be substantially influenced by the level of GlaxoSmithKline’s marketing and promotion of the product. Any problem or delay in manufacturing, or any material reduction in product promotion could affect materially and adversely our business operations and financial condition.

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

AVANIR and its licensees could face the following risks in our efforts to obtain regulatory approval as an OTC product and to market and sell docosanol 10% cream in foreign countries:

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

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

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

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

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

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

Abreva competes with several other products for oral-facial herpes currently on the market in the U.S., as well as other products or potential products that are or may be under development or undergoing FDA review. Most of our competitors, including Blistex, Inc., Bayer Corp. and Schering Plough, have substantial financial resources, research and development facilities and manufacturing and marketing experience. Even with Abreva being marketed by one of the world’s largest consumer healthcare companies, GlaxoSmithKline, not all competitive responses and the impacts of those responses can be foreseen.

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We may issue additional shares of our Class A common stock. These issuances may dilute the value of our Class A common stock to current shareholders and may adversely affect the market price of our Class A common stock.

If we raise additional capital by issuing additional shares of Class A common stock at a price or a value per share less than the then-current price per share of Class A common stock, then the value of the shares of Class A common stock outstanding will be diluted or reduced. Further, even if we were to sell shares of common stock at prices higher than today’s price, sales of such shares may depress our market price and dilute earnings per share.

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

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

• difficulties in obtaining regulatory approval of docosanol 10% cream in Canada, Israel, Korea and other foreign countries;

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

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

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

• shipping delays;

• difficulties in managing operations across disparate geographic areas;

• fluctuations in foreign currency exchange rates;

• prices of competitive products;

• difficulties associated with enforcing agreements through foreign legal systems; and

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

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

Governmental authorities in the U.S., including the FDA, and other countries regulate significantly the development, production, testing, manufacturing and marketing of pharmaceutical products. The clinical testing and regulatory approval process can take a number of years and require the expenditure of substantial resources. Failure to obtain, or delays in obtaining, these approvals will adversely affect our business operations, including our ability to commence marketing of any proposed products. We may find it necessary to use a significant portion of our financial resources for research and development and the clinical trials necessary to obtain these approvals for our proposed products. We will continue to incur costs of development without any assurance that we will ever obtain regulatory approvals for any of

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our products under development. In addition, we cannot predict the extent to which adverse governmental regulation might arise from future U.S. or foreign legislative or administrative action. Moreover, we cannot predict with accuracy the effect of unspecified, but possible, future changes in the regulatory approval process and in the domestic health care system for which we develop our products. Future changes could affect adversely the time frame required for regulatory review, our financial resources, and the sale prices of our proposed products, if approved for sale.

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

We face substantial risks of failing to complete the development of our research programs for the treatment of central nervous system disorders, allergy and asthma, and other areas. Our Phase II/III clinical trials of Neurodex for the treatment of emotional lability in ALS and MS patients may experience setbacks or failures for reasons we have not anticipated. Our Phase II clinical trial of Neurodex for the treatment of neuropathic pain may not show proof of concept. Our observations during preclinical research of our lead compound for treating allergy and asthma, while showing effectiveness in several in-vitro and ex-vivo assays and in-vivo allergy models, may not be relevant to the development of, indicate the efficacy of, or have the safety profile necessary for a proposed product for human use. Unsuccessful clinical trial results for our proposed products could affect materially and adversely our future business operations and financial condition. The development process for medical products is lengthy and capital intensive. Our drug development programs are exposed to all of the risks inherent in product development based on innovative technologies, including unanticipated development problems and the possible lack of funding or collaborative partners, which could result in the abandonment or substantial change in the development of a specific product.

Business interruptions could adversely affect our business.

Our operations are vulnerable to interruption by fire, earthquake, power loss, telecommunications failure, terrorist attacks and other events beyond our control. For example, during 2001, California experienced shortages in adequate supply of electricity, resulting in “rolling blackouts,” where certain areas are not provided with any electricity for periods of up to two hours. The immediate impact was a significant increase in power rates for most users, including us. Additionally, the loss of electrical power or “blackouts” for any significant periods of time could harm either our vendors or our ability to conduct our experiments or to provide antibody research services for others. Further, we could lose valuable progress made to date in experiments currently underway. We have attempted to mitigate the severity of power losses by installing emergency power equipment, which we intend to use for those electrical needs that we consider to be the most critical to operating our business. However, the emergency power unit does not cover all of our electrical needs.

Our acquisition and alliance activities could disrupt our ongoing business.

We intend to continue to make investments in products and technologies, acquire or inlicense technologies, and, in the future, could acquire entire companies to expand our product development pipeline and sales revenues. Acquisitions and strategic alliances often involve risks, including: difficulty in assimilating the acquired technologies, operations and employees, difficulty in managing research collaborations, difficulty in retaining key employees of an acquired operation, disruption of our ongoing business, inability to successfully integrate the acquired technology and operations into our business and lack of experience in developing the acquired technology.

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Difficulties in acquiring inlicensed technologies that we believe are necessary to fill our product development pipeline may restrict our growth.

Our business strategy for growth is not only through internal development, but also through inlicensing of products, potential products and/or technologies at various stages in the drug development pipeline. We will face intense competition in attempting to inlicense other products and technologies. In addition, we may not be able to locate suitable products and technologies to fit our strengths, be able to obtain them on acceptable terms, or have the financial resources to develop products from the inlicensed technology. If we are unable to add to our product development pipeline, our growth may be limited and it may affect our business and stock price negatively. Also, we must have the financial resources to acquire and/or inlicense new products and technologies and develop and market the products, if approved. We can provide no assurance that we will be successful in our inlicensing strategy or that it will have the desired effect on our future growth or stock price.

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

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

Our future success also depends on our continuing ability to identify, hire, train and retain highly qualified, technical, sales, marketing and customer service personnel. We presently employ approximately 45 people in AVANIR and our subsidiary, Xenerex Biosciences, and we expect to hire additional people throughout the year. While we have employment and employee retention agreements with certain key executives, they are limited in scope and provide no real assurance that any of these people will continue their employment with us. We do not have “key person” life insurance policies. The industry in which we compete has a high level of employee mobility and aggressive recruiting of skilled personnel, which creates intense competition for qualified personnel, particularly in product research, development, sales and marketing.

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

We rely substantially on the protection of our intellectual property for docosanol, with 22 U.S. and foreign docosanol patents and 39 additional docosanol-related patent applications pending. We also have patent and patent applications pending on other products and technologies, and have inlicensed the rights to market a potential product that treats multiple central nervous system disorders that has six issued patents. Because of the competitive nature of the bio-pharmaceutical industry, we cannot assure you that:

• the claims in the pending patent applications will be allowed or that we will even be issued additional patents;

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

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

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

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

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

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

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

We rely substantially on confidentiality agreements to protect our innovations. We cannot assure you that secrecy obligations will be honored, or that others will not develop independently similar or superior technology. In addition, if our consultants, key employees or other third parties apply technological information independently developed by them or by others to our projects, then disputes may arise as to the proprietary rights to this information in which we may not receive a favorable resolution.

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

The testing, marketing, and sale of pharmaceutical products involves the risk of product liability claims by consumers and other third parties. We maintain product liability insurance coverage for our clinical trials in the amount of $2 million per incident and $2 million in the aggregate. However, product liability claims can be high in the pharmaceutical industry and our insurance may not cover sufficiently all of the possible liabilities. If a suit against our business or proposed products is successful, then the lack or insufficiency of insurance coverage could affect materially and adversely our business and financial condition. Furthermore, various distributors of pharmaceutical products require minimum product liability insurance coverage before their purchase or acceptance of products for distribution. Failure to satisfy these insurance requirements could impede our ability to achieve broad distribution of our proposed products.

The conversion or exercise of currently outstanding stock purchase warrants and stock options, or conversion of redeemable convertible preferred stock currently outstanding will have a dilutive effect on our Class A common stock.

As of February 1, 2002, the Company had outstanding stock options to purchase an aggregate of 5,144,994 shares of Class A common stock at exercise prices ranging from $0.30 to $6.44 per share and warrants to acquire up to 1,184,550 shares of Class A common stock at exercise prices ranging from $0.9144 to $2.715 per share. The Company has other securities that may have a dilutive effect, including 50 shares of Series D redeemable convertible preferred stock, which at recent market prices may be converted into approximately 186,900 shares of Class A common stock at a fixed conversion price of $2.715 per share.

Sales in the public market of shares of Class A common stock acquired upon exercise of stock options and warrants may affect adversely the prevailing market prices for Class A common stock. Negative

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price movements in the shares of Class A common stock likely would affect adversely our ability to obtain additional equity capital on favorable terms, if at all.

We do not intend to declare or pay cash dividends in the foreseeable future.

We do not intend to declare or pay cash dividends on our Class A or Class B common stock in the foreseeable future. We expect to retain any earnings, if and when achieved, to finance our business.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

Interest rate sensitivity

Our investment portfolio consists primarily of fixed income instruments with an average duration of 3.1 years as of December 31, 2001 (2.8 years as of September 30, 2001). The primary objective of our investments in debt securities is to preserve principal while achieving attractive yields, without significantly increasing risk. We carry some investments that we intend to hold to maturity and others that we classify as available-for-sale. These available-for-sale securities are subject to interest rate risk. In general, we would expect that the volatility of this portfolio would increase as its duration increases.

PART II OTHER INFORMATION

Item 1-5. NOT APPLICABLE

Item 6. EXHIBITS AND REPORTS ON FORM 8-K

     None.

SIGNATURES

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

Signature	Title	Date
/s/Gerald J. Yakatan, Ph.D. Gerald J. Yakatan, Ph.D.	President and Chief Executive Officer (Principal Executive Officer)	February 14, 2002
/s/Gregory P. Hanson Gregory P. Hanson	Vice President, Finance and Chief Financial Officer (Principal Financial and Accounting Officer)	February 14, 2002

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