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

 

 

Form 10-K

 

 

Commission File No. 1-15803

 

Avanir Pharmaceuticals

(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:

Class A Common Stock, no par value

 

 

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

None

 

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 and Exchange Act of 1934 during the preceding 12 months (or for such shorter periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  YES þ     NO o

 

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

 

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

Large Accelerated Filer o      Accelerated Filer o     Non-accelerated Filer  þ

 

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, 2007 was approximately $46.9 million, based upon the closing price on the Nasdaq Stock 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.

 

43,121,858 shares of the registrant’s Common Stock were issued and outstanding as of December 7, 2007.

 

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 2008 Annual Meeting of Shareholders, which will be held on February 21, 2008 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

 

 

PART I

 

 

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 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 under the caption “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 indicted herein, all dates referred to in this Report represent periods or dates fixed with reference to the calendar year, rather than our fiscal year ending September 30.

 

Executive Overview

 

Avanir Pharmaceuticals, a California corporation incorporated in August 1988, is a pharmaceutical company focused on developing, acquiring and commercializing novel therapeutic products for the treatment of chronic diseases. Our product candidates address therapeutic markets that include the central nervous system, inflammatory diseases and infectious diseases. Our lead product candidate, Zenvia^tm (dextromethorphan hydrobromide/quinidine sulfate), is currently in Phase III clinical development for the treatment of pseudobulbar affect (“PBA”) and diabetic peripheral neuropathic pain (“DPN pain”). Our first commercialized product, docosanol 10% cream, (sold as Abreva^® by our marketing partner GlaxoSmithKline Consumer Healthcare in North America) is the only over-the-counter treatment for cold sores that has been approved by the FDA. Our inflammatory disease program, which targets macrophage migration inhibitory factor (“MIF”), is currently partnered with Novartis and our infectious disease program, which is focused primarily on anthrax antibodies, is currently being funded by grants from the National Institute of Health/National Institute of Allergy and Infectious Disease (“NIH/NIAID”).

 

Zenvia Status

 

Zenvia is currently in Phase III clinical development for the treatment of two conditions: (1) pseudobulbar affect (“PBA”), which is an involuntary emotional expression disorder (“IEED”) and (2) diabetic peripheral neuropathic pain (“DPN pain”).

 

In October 2006, we received an “approvable” letter from the FDA for Zenvia in the treatment of patients with PBA/IEED. The approvable letter raised certain safety and efficacy concerns and the safety concerns will require additional clinical development to resolve. Based on discussions with the FDA, we were able to successfully resolve the outstanding efficacy concern of the original dose formulation. However, in order to address safety concerns, we agreed to re-formulate Zenvia and conduct one additional confirmatory Phase III clinical trial using lower dose formulations. The goal of the study is to demonstrate improved safety while maintaining significant efficacy. In October 2007, we reached agreement with the FDA under the Special Protocol Assessment (“SPA”) process, on the design of a single confirmatory Phase III clinical trial of Zenvia for the treatment of patients with PBA. We enrolled our first patient in this trial in December 2007 and expect this study to be completed (as defined as top-line safety and efficacy data becomes available) during the second half of calendar 2009.

 

In April 2007, we announced top-line data results from our first Phase III clinical trial of Zenvia for DPN pain. After receipt of these positive results, we requested a meeting with the FDA to discuss the next steps for this program. The FDA informed Avanir it would not be necessary to meet and that Avanir should develop and then submit the protocol for the next study as well as any questions related to the development program for Zenvia. We are proceeding forward under this guidance and are currently conducting 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 before interacting with the FDA. While we have received no formal direction to lower quinidine dose formulation for DPN pain, we believe it is the most prudent course of action given the current regulatory environment and the concerns raised over Zenvia for PBA.

Restructuring Activities

 

In May 2006, we acquired FazaClo^® (clozapine, USP), a product marketed for the management of treatment-resistant schizophrenia and the reduction in the risk of recurrent suicidal behavior in schizophrenia or schizoaffective disorders. We had intended to leverage the FazaClo sales force to assist with the commercial launch of Zenvia for PBA, which was planned for early 2007. However, due to the receipt of the approvable letter and the resulting delay in the planned launch of Zenvia, the strategic rationale for continued marketing of FazaClo by Avanir no longer existed. Therefore, we entered into an agreement in July 2007 to sell FazaClo to Azur Pharma, Inc. (“Azur”). The sale, which closed August 3, 2007, provided approximately $43.9 million in an up-front cash payment and may provide up to an additional $10 million in contingent payments to be paid in calendar year 2009, subject to certain regulatory conditions. In addition, the Company is eligible to receive up to $2 million in royalties, based on 3% of annualized net product revenues in excess of $17 million. Azur acquired the FazaClo sales force and support operations, representing approximately 80 employees in total. As a result, we became a substantially smaller organization following the sale of FazaClo and will be principally focused over the next two to three years on seeking regulatory approval of Zenvia for the treatment of patients with PBA and patients with DPN pain.

 

We also undertook other cost-cutting measures following receipt of the Zenvia approvable letter. We have ceased all pre-launch commercial readiness activities for Zenvia and have significantly reduced our administrative organization. We also cut back our drug discovery operations following (1) the non-renewal and termination of our Research Collaboration and License Agreement with AstraZeneca U.K. in March 2007 and (2) the completion of our two-year research collaboration with Novartis International Pharmaceutical Ltd. in March 2007. Our license agreement with Novartis currently remains in effect and Novartis is continuing clinical development of the licensed compounds. In late 2006 and early 2007, we consolidated operations to our headquarters in Orange County, California and, in July 2007, we subleased approximately 49,000 square feet of laboratory and office space, which represented all of our remaining excess facilities in San Diego, CA.

 

Based on our current capital resources and focus on obtaining approval for Zenvia, we have also structured the ongoing development of our anthrax human monoclonal antibody program so that direct development costs do not materially exceed funding levels from National Institutes of Health/National Institute of Allergy and Infectious Disease (“NIH/NIAID”) research grants or potential development partners. In May 2007, we received a one-year extension of our grant from the NIH/NIAID to fund further pre-clinical development of our anti-anthrax human monoclonal antibody and we are continuing development under this grant. We have suspended funding and development activity for our selective cytokine inhibitor program and will abandon the patents associated with this program if we are unable to find a licensing partner by the end of 2007.

 

As a result of these initiatives, we have undergone significant organizational changes in fiscal 2007. Our principal focus is currently on gaining regulatory approval for Zenvia, first for the treatment of patients with PBA and then for patients with DPN pain. We believe that the proceeds from the sale of FazaClo will be sufficient to fund our operations, including our planned confirmatory Phase III trial for Zenvia in patients with PBA, through the end of fiscal 2008. We are currently considering additional means of raising capital to fund ongoing Zenvia development and operations, including borrowing funds, selling common stock or other securities, and the monetization of remaining non-core assets. If we are unable to raise sufficient additional capital when needed in the future to fund our development programs, we may need to slow the development rate of some programs or sell additional rights to one or more drug candidates. For additional information about the risks and uncertainties that may affect our business and prospects, please see “Risk Factors.”

 

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. 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 Securities and Exchange Commission (“SEC”). No portion of our website is incorporated by reference into this Annual Report on Form 10-K. The public may read and copy the materials we file with the SEC at the SEC’s Public Reference Room, located at 100 F Street, NE, Washington, D.C. 20549. The public may obtain information regarding the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The public may also read and copy the materials we file with the SEC by visiting the SEC’s website, www.sec.gov.

Avanir Product Pipeline and Marketed Products

 

Zenvia — Pseudobulbar Affect (PBA) Indication

 

PBA is a complex neurological 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 and/or crying. PBA occurs secondary to neurological diseases such as amyotrophic lateral sclerosis (“ALS”), dementias including Alzheimer’s disease (“AD”), multiple sclerosis (“MS”), and Parkinson’s disease, as well as neurological injuries such as stroke or traumatic brain injury. While the exact number of patients is unknown, based on our review of medical literature, independent surveys and our latest market research, we believe that there are likely over one million patients in the U.S. suffering from the symptoms of PBA. In addition, we believe that the availability of an FDA-approved treatment option for these patients may lead to the correct diagnosis of additional PBA patients. If the FDA approves Zenvia, it would be the first drug approved for the treatment of PBA. Zenvia is a patented, orally administered combination of two well-characterized compounds, the active ingredient dextromethorphan (“DM”) and the enzyme inhibitor quinidine (“Q”), which serves to increase the bioavailability of dextromethorphan in the human body.

 

We received an “approvable letter” from the FDA in October 2006 for our NDA submission for Zenvia for the treatment of patients with PBA/IEED. In October 2007, we reached agreement with the FDA under the SPA process, on the design of a single confirmatory Phase III clinical trial of Zenvia for the treatment of patients with PBA. For this trial, we have developed two alternative dosage formulations of Zenvia, the first contains 30 mg of DM and 10 mg of Q (Zenvia 30/10) and the second contains 20 mg of DM and 10 mg of Q (Zenvia 20/10). The new low dose formulation of Zenvia is expected to improve the safety and tolerability profile while maintaining comparable efficacy to the Zenvia 30/30 dose tested in prior Phase III trials. We enrolled our first patient in this trial in the first quarter of fiscal 2008.

 

The NDA for Zenvia contained data from two randomized, controlled, multi-center Phase III clinical trials testing the Zenvia 30/30 dose in patients with 1) PBA secondary to ALS and in patients with 2) PBA secondary to MS. The NDA also included data from an open-label clinical study evaluating the safety of long-term exposure to Zenvia 30/30 in patients with PBA associated with a variety of neurological disorders including ALS, MS, Alzheimer’s disease, traumatic brain injury and Parkinson’s disease. Zenvia demonstrated positive results in both the primary and secondary efficacy endpoints in the prior two pivotal Phase III clinical trials in patients with PBA, as described below.

 

The Phase III clinical study of Zenvia in the treatment of patients with PBA secondary to MS, was completed in June 2004, (Ann Neurol 2006;59:780-787) and treated 150 patients at 22 clinical sites who were given either placebo or Zenvia 30/30 twice a day for 85 days. A validated scale that measures the severity of these involuntary episodes of inappropriate laughing or crying called “The Center for Neurological Study Lability Scale,” or “CNS-LS”), was used to measure the effectiveness of Zenvia in this study. Results from the Phase III trial in MS patients with PBA demonstrated statistical significance for Zenvia 30/30 versus placebo in terms of the change in CNS-LS score, the primary endpoint of the study. Zenvia 30/30 also demonstrated a significant reduction in episodes of laughing and/or crying versus the comparators. The majority of reported adverse events were mild or moderate. Of the adverse events reported in 5% or more of the study participants, only dizziness was seen significantly more for Zenvia-treated patients than in the placebo-treated patients.

 

The Phase III clinical study of Zenvia in the treatment of 140 patients with PBA secondary to ALS was completed in June 2002 (Neurology, 2004; 63:1364-1370). This clinical trial had three treatment arms and compared Zenvia 30/30 to each of its two individual components; dextromethorphan 30 mg and quinidine 30 mg. Results from the Phase III trial in ALS patients with PBA demonstrated statistical significance for Zenvia 30/30 versus the comparators in terms of the change in CNS-LS score, the primary endpoint of the study. Zenvia 30/30 also demonstrated a significant reduction in episodes of laughing and/or crying versus the comparators. Nausea, dizziness and somnolence at a significantly higher incidence in the Zenvia 30/30 group compared with the DM and Q groups.

Zenvia — Diabetic Peripheral Neuropathic Pain (“DPN pain”) Indication

 

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. One of the most debilitating forms of DPN pain is caused by nerve damage that can result from diabetes. 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 diabetic peripheral neuropathic 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. The neuropathic pain market is continuing to grow rapidly. In 2006, neuropathic pain therapies accounted for over $2.6 billion in sales among the seven largest markets (i.e. the United States., Japan, France, Germany, Italy, Spain and the United Kingdom.)

 

In April 2007, we announced positive top-line data from our first Phase III clinical trial of Zenvia 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 Zenvia, 45/30 mg DMQ dosed twice daily (“DMQ 45”) and 30/30 mg DMQ dosed twice daily (“DMQ 30”), were compared to placebo based on daily patient diary entries for the Pain Rating Scale. Both Zenvia treatment groups had lower pain ratings than placebo patients (p <0.0001 in both cases). In the DMQ 45 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 DMQ 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).

 

Zenvia 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 DMQ 45 patient group (p=0.0002) and for the DMQ 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 Peripheral Neuropathy Quality of Life Scale Composite score and thus not achieving statistical significance, the DMQ 45 patients showed a greater improvement than placebo patients (p=0.05) and the DMQ 30 patients showed a 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 DMQ 45 and DMQ 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 DMQ 45, DMQ 30 and placebo groups, respectively, and no deaths occurred during the study.

 

After receipt of these positive results, we requested a meeting with the FDA to discuss the next steps for this program. The FDA informed Avanir it would not be necessary to meet and that Avanir should submit the protocol for the next study as well as any questions related to the development program for Zenvia. Before interacting further with the FDA we are proceeding forward under this guidance and are currently conducting 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. While we have received no formal direction from the FDA to lower quinidine dose formulation for DPN pain, we believe it is the most prudent course of action given the current regulatory environment and the concerns raised in the approvable letter for Zenvia for PBA.

 

Docosanol 10% Cream — Cold Sores

 

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 Canada, Denmark, Finland, Israel, Korea, Norway, Portugal, Spain, Poland, Greece and Sweden and is sold by our marketing partners in these territories. In 2000, we granted a subsidiary of GlaxoSmithKline, SB Pharmco Puerto Rico, Inc. (“GlaxoSmithKline”) the exclusive rights to market docosanol 10% cream in North America. GlaxoSmithKline markets the product under the name Abreva^® in the United States

and Canada. In fiscal 2003, we sold an undivided interest in our GlaxoSmithKline license agreement for docosanol 10% cream to Drug Royalty USA, Inc. (“Drug Royalty USA”) for $24.1 million. We retained the right to receive 50% of all royalties under the GlaxoSmithKline license agreement for annual net sales of Abreva in North America in excess of $62 million. We also retained the rights to develop and license docosanol 10% cream outside North America for the treatment of cold sores and other potential indications. We have six other collaborations for docosanol around the world. Two of these collaborations currently generate revenue and the other four may generate future revenue for the Company depending on clinical and regulatory success outside of the United States.

 

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 sell the material to our licensees for commercialization. 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.

 

Macrophage Migration Inhibitory Factor (“MIF”) — Inflammation

 

In April 2005, we entered into an exclusive Research Collaboration and License Agreement with Novartis regarding the license of certain compounds that regulate macrophage migration inhibitory factor (“MIF”) in the treatment of various inflammatory diseases. In March 2007, Novartis made the decision to continue the MIF research program internally. As a result, the research collaboration portion of this agreement was not renewed. Under the terms of the license agreement, we are eligible to receive over $200 million in combined upfront and milestone payments upon achievement of development, regulatory, and sales objectives. We are also eligible to receive escalating royalties on any worldwide product sales generated from this program.

 

Xenerex Human Antibody Technology — Anthrax/Other Infectious Diseases

 

Our patented Xenerex antibody technology can be used to develop human monoclonal antibodies for use as prophylactic and therapeutic drugs, which may be used to prevent or treat anthrax and other infectious diseases. This proprietary technology provides a platform for accessing human monoclonal antibodies against disease antigens. The Xenerex technology is capable of generating fully human antibodies to target antigens and draws on the natural diversity of the human donor population. Using Xenerex technology, we have discovered a human monoclonal antibody, AVP-21D9, that provides immediate post-exposure neutralization and immediate immunity to animals exposed to a lethal dose of recombinant anthrax toxins.

 

Our anthrax antibody is in preclinical development and is currently being funded by grants from the NIH/NIAID. In May 2007, we were notified that we had been awarded a one-year extension of our $2.0 million research grant from the NIH/NIAID for ongoing research and development related to our anthrax antibody. Under the terms of the grant, the NIH/NIAID will reimburse us for up to $2.0 million in certain expenses related to the establishment of a current Good Manufacturing Practices (“cGMP”) manufacturing process and the preclinical testing of the anthrax antibody. Subject to certain conditions, we, as the awardee organization, retain the principal worldwide patent rights to any invention developed with the U.S. government support. Our progress on this program will substantially depend on future grants, as well as our business priorities. Currently, we expect that we will continue with the development of this program only to the extent that its development is funded by research grants. Because all of our monoclonal antibody research is at an early preclinical stage of development and is unpredictable in terms of the outcome, we are unable to predict the cost and timing for development of this antibody.

 

Discontinued Programs

 

Reverse Cholesterol Transport (“RCT”) Technology — Atherosclerosis

 

In July 2005, we entered into an exclusive Research Collaboration and License agreement with AstraZeneca regarding the license of certain compounds we discovered for the potential treatment of cardiovascular disease. In March 2007, the Research Collaboration and License agreement was mutually terminated. According to the terms of the agreement, AstraZeneca returned the lead molecule and will return or make available all related rights to

Avanir. Following the mutual decision to terminate, we have elected to no longer prosecute any patents associated with this program and we do not expect to continue with any further development efforts for this program.

 

AVP-13358 — Selective Cytokine Inhibitor

 

In November 2006, in an effort to reduce operating expenses we decided to suspend clinical activities associated with the selective cytokine inhibitor program and seek potential partners for the program. AVP-13358 is an internally discovered novel, orally active drug molecule that has anti-inflammatory and other pharmacological properties that could be useful against certain disease targets. Given our limited resources and the lack of partnership interest, we have made the decision to no longer prosecute any patents associated with this program and we do not expect to continue with any further development efforts for this program.

 

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 scientific personnel.

 

Zenvia for Pseudobulbar Affect.  Although we anticipate that Zenvia, if approved, could be 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, Zenvia may face competition from the following products:

 

 

Zenvia for painful diabetic neuropathy.  We anticipate that Zenvia for the treatment of painful diabetic neuropathy, 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 these identified below. Additionally, many other companies are developing drug candidates for this indication and we expect competition for Zenvia, if approved to treat DPN pain, to be intense. Current approved competitors include:

 

 

Antibody generation technology.  Several companies, including Emergent BioSolutions, Medarex Inc., Elusys Therapeutics, PharmAthene, VaxGen and MedImmune have research programs focused on developing anthrax antibodies. These companies are generally large and have greater resources to dedicate to development work.

 

Docosanol 10% cream.  Abreva faces intense competition in North America 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 Zenvia from one of several available commercial suppliers. Further, we licensed to various pharmaceutical companies the exclusive rights to manufacture and distribute docosanol 10% cream.

 

We, and the manufacturers of our products and product candidates, rely on suppliers of raw materials used in the commercial manufacturing of our products. Some of these materials, including the active ingredients in docosanol 10% cream and Zenvia, are custom and available from only a limited number of sources. We currently attempt to mitigate the risk associated with such sole source raw materials and production by actively managing our inventories and supply and production arrangements. We attempt to remain apprised of the financial condition of our suppliers and their ability to continue to supply our raw materials and finished products in an uninterrupted and timely manner. We have not experienced any significant shortages in supplies of such raw materials or finished products. Unavailability of certain materials or the loss of current sources of production could cause an interruption in production and a reduced supply of finished product pending establishment of new sources, or in some cases, implementation of alternative processes. See Item 1A, “Risk Factors,” for additional discussion of the risks associated with our outsourcing of manufacturing functions.

 

Patents and Proprietary Rights

 

As of September 30, 2007, we owned or had the rights to 183 issued patents (42 U.S. and 141 foreign) and 271 pending applications (35 U.S. and 236 foreign). Patents and patent applications owned by the Company include Zenvia; docosanol-related products and technologies; Xenerex antibody technologies; selective cytokine inhibitor; MIF inhibitor technology and reverse cholesterol transport enhancer.

 

 

 

 

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

 

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

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

 

Government Regulations

 

The FDA and comparable regulatory agencies in foreign countries regulate extensively 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 New Drug Application (“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 new drug application 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. In addition, the handling, care and use of laboratory mice, including the hu-PBL-SCID mice and rats, used for Xenerex technology are subject to the Guidelines for the Humane Use and Care of Laboratory Animals published by the National Institutes of Health.

 

Regulatory obligations continue post-approval, and include the reporting of adverse events when a drug is utilized in the broader commercial population. Promotion and marketing of drugs is also strictly regulated, with penalties imposed for violations of FDA regulations, the 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.

 

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.

 

Human Resources

 

As of December 14, 2007, we employed 25 persons, including 9 engaged in research and development activities, including drug discovery, clinical development, and regulatory affairs, and 16 in general and administrative functions such as human resources, finance, accounting, business development and investor relations. Our staff includes 6 employees with Ph.D. or M.D. degrees. None of our employees are unionized and we believe that our relationship with our employees is good.

 

Financial Information about Segments

 

Refer to Note 19, “Segment Information” in the Notes to the Condensed Consolidated Financial Statements.

 

Research and Development

 

Our research and development expenses were $13.1 million in 2007, $27.0 million in 2006, and $26.1 million in 2005.

 

General Information

 

You are advised to read this Form 10-K in conjunction with other reports and documents that we file from time to time with the 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 directly from us or from the SEC and 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. We make available free of charge on or through our Internet website located at www.avanir.com our SEC filings on Forms 10-K, 10-Q and 8-K and any amendments to those filings as soon as reasonably practicable after electronic filing with the SEC.

 

Item 1A.  Risk Factors

 

Risks Relating to Our Business

 

We must conduct additional clinical trials for Zenvia and there can be no assurance that the FDA will approve Zenvia or that an approval, if granted, will be on terms we may seek.

 

In October 2006, we received an “approvable letter” from the FDA for our new drug application (“NDA”) submission for Zenvia in the treatment of patients with the PBA/IEED indication. The approvable letter raised certain safety and efficacy concerns and the safety concerns will require additional clinical development to resolve. Based on discussions with the FDA, we were able to successfully resolve the outstanding efficacy concern of the original dose formulation. However, in order to address the safety concerns, we agreed to re-formulate Zenvia and conduct one additional confirmatory Phase III clinical trial using lower dose formulations. The goal of the study is to demonstrate improved safety while maintaining significant efficacy. The study is expected to be completed (as

defined as top-line safety and efficacy data becomes available) during the second half of calendar 2009. It is possible that the efficacy will be so reduced that we will not be able to satisfy the FDA’s efficacy requirements and there can be no assurance that the FDA will approve Zenvia for commercialization.

 

Even if the confirmatory trial is successful, the additional development work will be costly and time consuming. Because our patents covering Zenvia expire at various times from 2011 through 2019 (without accounting for potential extensions that might be available or new patents that may be issued), any substantial delays in regulatory approval would negatively affect the commercial potential for Zenvia for this indication. Additionally, it is possible that Zenvia may not be approved with the labeling claims or for the patient population that we consider most desirable for the promotion of the product. Less desirable labeling claims could adversely affect the commercial potential for the product and could also affect our long-term prospects.

 

Additionally, although we have a Special Protocol Assessment (“SPA”) from the FDA for our recently completed Phase III trial for DPN pain and for our planned confirmatory Phase III trial for Zenvia for PBA, there can be no assurance that the terms of the SPA will ultimately be binding on the FDA. An SPA is intended to serve as a binding agreement from the FDA on the adequacy of the design of a planned clinical trial. However, even where an SPA has been granted, additional data may subsequently become available that causes the FDA to reconsider the previously agreed upon scope of review and the FDA may have subsequent safety or efficacy concerns that override the SPA. As a result, even with an SPA, we cannot be certain that the trial results will be found to be adequate to support an efficacy claim and product approval.

 

The FDA’s safety concerns regarding Zenvia for the treatment of PBA may extend to other clinical indications that we are pursuing, including DPN pain. Due to these concerns, we expect to develop Zenvia for other indications using alternative doses, which may negatively affect efficacy.

 

We are currently developing Zenvia for the treatment of DPN pain, for which we have completed a Phase III trial. Although the FDA has not expressly stated that the safety concerns and questions raised in the PBA approvable letter would apply to other indications such as DPN pain, we believe that it is possible that the FDA will raise similar concerns for this indication. Accordingly, we are investigating the potential use of alternative formulations with lower doses of quinidine and various DM levels in the next Phase III trial for Zenvia for this indication. Although we achieved positive results in our initial Phase III trial, an alternative lower dose may not yield the same levels of efficacy as seen in the earlier trials and any drop in efficacy may be so great that the drug does not demonstrate a statistically significant improvement over placebo. Additionally, any alternative dose 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 Zenvia for other indications or may need to undertake significant additional clinical trials, which would be costly and cause potentially substantial delays. There is also a risk that due to the change in dosage levels, the FDA may require two additional Phase III trials for regulatory approval, which would be costly and delay the potential commercial launch of this drug.

 

We have limited capital resources and will 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, accumulating operating losses totaling $238 million as of September 30, 2007, and we expect to continue to incur substantial operating losses for the foreseeable future. As of September 30, 2007, we had approximately $33.6 million in cash, cash equivalents, investments in marketable securities and restricted cash. Additionally, because we sold FazaClo in August 2007, we currently do not have any meaningful sources of recurring revenue or cash flow.

 

In light of our current capital resources, lack of near-term revenue opportunities and substantial long-term capital needs, we will need to raise significant amounts of additional capital in the future to complete the development of Zenvia and to finance our long-term operations. Based on our current loss rate and existing capital resources as of the date of this filing, we estimate that we have sufficient funds to sustain our operations at their current levels through the next twelve months. Although we expect to be able to raise additional capital and/or curtail current levels of operations to be able to continue to fund our operations beyond that time, there can be no assurance that we will be able to do so. If we are unable to raise additional capital to fund future operations, then we

may be unable to fully execute our development plans for Zenvia and DPN pain. This may result in significant delays in our planned clinical trial of Zenvia for PBA and may force us to further curtail our operations.

 

Any transactions that we may engage in to raise capital could dilute our shareholders and diminish certain commercial prospects.

 

We will seek to raise additional capital and may do so at any time through various financing alternatives, including licensing or sales of our technologies, drugs and/or drug candidates, selling shares of common or preferred stock, 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 and any such financing will dilute our existing shareholders. If we instead seek to raise capital through licensing transactions or sales of one or more of our technologies, drugs or drug candidates, as we have stated we are actively considering with certain investigational compounds, 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.

 

Our 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. Such patents and patent applications cover Zenvia, docosanol 10% cream and other potential drug candidates that could come from our technologies such as anti-inflammatory compounds and antibodies. Because of the competitive nature of the biopharmaceutical industry, we cannot assure you that:

 

 

Even if we successfully preserve our intellectual property rights, third parties, including other biotechnology or pharmaceutical companies, may allege that our technology infringes on their rights. 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.

 

We currently have only a limited term of patent coverage for Zenvia, which could result in the introduction of generic competition within in a few years of product launch.

 

Our PBA related patents for Zenvia expire at various times from 2011 through 2012 and our DPN pain patents for Zenvia expire in 2016. These expirations do not account for any potential patent term restoration nor does this account for the issuance of any patents pending. If Zenvia is approved, we can apply for a five year extension to one patent covering Zenvia; however, as Zenvia is not a new chemical entity, it is unknown whether or not Zenvia will qualify for patent term restoration under the U.S. Patent and Trademark Office (“USPTO”) guidelines. Once the patents covering Zenvia expire or the three-year Hatch Waxman exclusivity period has passed, generic drug

companies would be able to introduce competing versions of the drug. Although we have filed additional new patents for Zenvia, there can be no assurance that these patents will issue or that any patents will have claims that are broad enough to prevent generic competition. If we are unsuccessful in strengthening our patent portfolio, our long-term revenues from Zenvia sales may be less than expected.

 

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 process 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. 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 have recently experienced significant turnover in senior management.

 

Over the past 12 months, we have experienced significant turnover in our senior management team, including the departures of our President and Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer, Vice President of Human Resources, Vice President of Drug Discovery, Vice President of Business Development, and Vice President of Clinical Affairs. As a result of these changes, we essentially have a new management team. It is not yet possible to assess how effective this management team will be and whether they will be able to work together to accomplish the Company’s business objectives. Additionally, changes in management are disruptive to the organization and any further changes may slow the Company’s progress toward its goals. Further, the Board of Directors may seek to reduce its size to streamline operations and to reflect the fact that the Company is significantly smaller than it was previously. Changes in Board composition may also be disruptive and the loss of the experience and capabilities of any of our Board members may reduce the effectiveness of the Board.

 

We face challenges 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 clinical and regulatory affairs, sales and marketing and accounting and finance. Because we have a relatively small organization, the loss of any executive officers 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 clinical and regulatory affairs team, the pace of clinical development for Zenvia could be slowed significantly. We have experienced extensive employee turnover recently, as discussed above, and the loss of any additional key employees could adversely affect our business and cause significant disruption in our operations.

 

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, such as the planned Phase III confirmatory trial for Zenvia for PBA, 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 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 recent Phase III trial of Zenvia 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 expect to be able to fully address these concerns, we may not be able to resolve these 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.

 

Clinical trials can be delayed for a variety of reasons. If we experience any such delays, we would be unable to commercialize our product candidates on a timely basis, which would materially harm our business.

 

Clinical trials may not begin on time or may need to be restructured after they have begun. Additionally, clinical trials can experience delays for a variety of other reasons, including delays related to:

 

 

 

If we experience significant delays in or termination of clinical trials, our financial results and the commercial prospects for our product candidates or any other products that we may develop will be adversely impacted. In addition, our product development costs would increase and our ability to generate revenue could be impaired.

 

The pharmaceutical industry is highly competitive and most of our competitors are larger 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 similar areas as our research. For example, we expect that Zenvia will compete against antidepressants, atypical anti-psychotic agents and other agents.

 

Our competitors may have specific expertise and development technologies that are better than ours and many of these companies, either alone or together with their research partners, have substantially greater financial resources, larger research and development staffs and substantially greater experience than we do. 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. Even if we receive regulatory approval for one of our product candidates, the approval may be subject to limitations on the indicated uses for which the product may be marketed or to the conditions of approval or contain requirements for costly post-marketing testing and surveillance to monitor the safety or efficacy of the product.

 

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, 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.

 

Developing and marketing 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. Although we maintain product liability insurance coverage, product liability claims can be high in the pharmaceutical industry and our insurance may not sufficiently cover our actual liabilities. If product 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 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 and the imposition of higher insurance requirements could impose additional costs on us.

 

Risks Related to Reliance on Third Parties

 

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. 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 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 Zenvia and the API for docosanol 10% cream and supplies for 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 Zenvia, and a sole manufacturer for the finished form of Zenvia. 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 Zenvia supplier. Any delays or difficulties in obtaining APIs or in manufacturing, packaging or distributing our products and product candidates could delay Zenvia clinical trials for PBA and/or DPN pain. Additionally, the third parties we rely on for manufacturing and packaging are subject to regulatory review, and any regulatory compliance problems with these third parties could significantly delay or disrupt our commercialization activities.

 

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 license arrangement for our MIF compound, we have no direct control over the development of this drug candidate and have only limited, if any, input on the direction of development efforts. These development efforts are ongoing 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, as was the case in early 2007 when AstraZeneca terminated our license and collaboration agreement for our reverse cholesterol transport (“RCT”) mechanism technology. 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.

 

We expect to rely entirely on third parties for international 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 Zenvia, 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 Zenvia in international markets, or if our collaborators’ efforts are unsuccessful, our ability to generate revenue 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 Class A 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:

 

 

Additionally, our stock price has been volatile as a result of announcements of regulatory actions and decisions relating to our product candidates, including Zenvia, and periodic variations in our operating results. We expect that our operating results will continue to vary from quarter-to-quarter. Our operating results and prospects may also vary depending on our partnering arrangements for our MIF technology, which has been licensed to a third party that controls the continued progress and pace of development, meaning that the achievement of development milestones is outside of our control.

 

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, such as the one we experienced following the announcement of the Zenvia approvable letter, could give rise to shareholder 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.

 

 

None.

 

 

As of September 30, 2007, we lease and occupy an aggregate of 13,099 square feet of space used for research and development and administrative operations in three buildings in California. Our headquarters and commercial and administrative offices are located in Aliso Viejo, California, where we currently occupy 11,319 square feet. The Aliso Viejo office lease expires in June 2011. We also currently occupy 1,780 square feet of laboratory and office facilities in one building located in San Diego, California, and we sublease approximately 57,945 square feet in three buildings in San Diego. The terms of the leases for the San Diego facilities vary from August 2008 (representing 27,575 square feet) to January 2013 (representing 30,370 square feet).

 

 

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 or our policy limits may be inadequate to fully satisfy any damage awards or settlements. If this were to happen, the payment of any such awards could have a material adverse

effect on our operations, 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 and lawsuits will not likely have a material effect on our operations or financial position. We have no significant legal proceedings ongoing at this time.

 

 

There were no matters submitted to a vote of our security holders during the fourth quarter of fiscal 2007.

 

PART II

 

 

On April 11, 2006, our Class A common stock began trading on the NASDAQ Global Market under the stock symbol “AVNR” simultaneously with the discontinuation of trading of our stock on the American Stock Exchange. For approximately five years prior to April 11, 2006, our Class A common stock traded under the symbol “AVN” on The American Stock Exchange (the “AMEX”). The following table sets forth the high and low closing sales prices for our Class A common stock in each of the quarters over the past two fiscal years, as quoted on the NASDAQ and AMEX. This historical stock price information has been adjusted to reflect our one-for-four reverse stock split, which was effected on January 16, 2006.

 

 

On December 7, 2007, the closing sales price of Class A Common Stock was $1.61 per share.

 

As of December 7, 2007, we had approximately 26,065 shareholders, including 927 holders of record and an estimated 25,138 beneficial owners. We have not paid any dividends on our Class A 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 total return provided shareholders on AVANIR Pharmaceuticals’ common stock relative to the cumulative total returns of the Russell 2000 index and the NASDAQ Pharmaceutical 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 9/30/2002 and its relative performance is tracked through 9/30/2007.

 

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.

Stock Performance Graph

 

 

*$100 Invested on 9/30/02 In stock or Index-Including reinvestment of dividends. Fiscal year ending September 30.

 

 

The stock price performance included in this graph is not necessarily indicative of future stock price performance.

 

 

The selected consolidated financial data set forth below at September 30, 2007 and 2006, and for the fiscal years ended September 30, 2007, 2006 and 2005, 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, 2005, 2004 and 2003, and for the years ended September 30, 2004 and 2003, 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 financial statements included in our Quarterly Reports on Form 10-Q and have been modified to reflect the restatement of our quarterly results for the three months ended March 31, 2007. 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. See Note 3 in the Notes to our Consolidated Financial Statements contained in Item 8 of this Annual Report on Form 10-K for information on 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 under the caption, “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.

 

In August 2007, we sold our FazaClo business and related support operations to Azur Pharma, Inc. We have reflected the financial results of this business as discontinued operations in the consolidated statements of operations for the years ended September 30, 2007 and 2006. The assets and liabilities of this business are reflected as assets and liabilities of discontinued operations in the consolidated balance sheet as of September 30, 2006. Unless otherwise noted, this Management’s Discussion and Analysis of Financial Condition and Results of Operations relates only to financial results from continuing operations.

Executive Overview

 

Avanir Pharmaceuticals is a pharmaceutical company focused on developing, acquiring and commercializing novel therapeutic products for the treatment of chronic diseases. Our product candidates address therapeutic markets that include the central nervous system, inflammatory diseases and infectious diseases. Our lead product candidate, Zenvia^tm (dextromethorphan hydrobromide/quinidine sulfate), is currently in Phase III clinical development for the treatment of pseudobulbar affect (“PBA”) and diabetic peripheral neuropathic pain (“DPN pain”). Our first commercialized product, docosanol 10% cream, (sold as Abreva^® by our marketing partner GlaxoSmithKline Consumer Healthcare in North America) is the only over-the-counter treatment for cold sores that has been approved by the FDA. Our inflammatory disease program, which targets macrophage migration inhibitory factor (“MIF”), is currently partnered with Novartis and our infectious disease program, which is focused primarily on anthrax antibodies, is currently being funded by grants from the National Institute of Health/National Institute of Allergy and Infectious Disease (“NIH/NIAID”).

 

The following is a summary of significant developments in fiscal 2007 and subsequent to the end of fiscal 2007 through the date of this filing that have materially affected our operations, financial condition and prospects:

 

 

We have historically sought to maintain flexibility in our cost structure by actively managing several outsourced functions, such as clinical trials, legal counsel, documentation and testing of internal controls, pre-clinical development work, and manufacturing, warehousing and distribution services, rather than maintaining all of these functions in house. We believe the benefits of outsourcing, including being flexible and being able to

rapidly respond to program delays or successes far outweigh the higher costs often associated with outsourcing at this stage of our development.

 

We intend to continue to seek partnerships with pharmaceutical companies to help fund research and development programs in exchange for sharing in the rights to commercialize new drugs. Trends in revenues and various types of expenses are discussed further in the “Results of Operations.”

 

Our principal focus is currently on gaining regulatory approval for Zenvia for PBA and then for DPN pain. We expect that the proceeds from our sale of FazaClo will be sufficient to fund our operations, including our planned confirmatory Phase III trial for Zenvia for PBA, through the next twelve months. We are currently considering additional means of raising capital, including borrowing funds, selling common stock or other securities, and the monetization of additional assets. If we are unable to raise capital as needed to fund our operations, then we may need to slow the rate of development of some of our programs or sell additional rights to one or more of our drug candidates. For additional information about the risks and uncertainties that may affect our business and prospects, please see “Risk Factors.”

 

Critical Accounting Policies and Estimates for Continuing Operations

 

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. The preparation of these 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. 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. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from our estimates if past experience or other assumptions do not turn out to be substantially accurate.

 

We believe that the application of our accounting policies for purchase price allocations in business combinations, share-based compensation expense, revenue recognition, expenses in outsourced contracts, research and development expenses and valuation of long-lived and intangible assets, all of which are important to our financial position and results of operations, require significant judgments and estimates on the part of management.

 

Purchase Price Allocation in Business Combinations

 

The allocation of purchase price for business combinations requires extensive use of accounting estimates and judgments to allocate the purchase price to the identifiable tangible and intangible assets acquired, including in-process research and development, and liabilities assumed based on their respective fair values. In fiscal 2006, we completed the acquisition of Alamo Pharmaceuticals LLC. See Note 3 “Acquisition of Alamo Pharmaceuticals, Inc. / Sale of FazaClo” in the Notes to Consolidated Financial Statements for a detailed discussion.

 

Share-based compensation expense

 

We grant options 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 subject to the provisions of revised Statement of Financial Accounting Standards No. 123, “Share-Based Payment” (“FAS 123R”). Effective October 1, 2005, we adopted FAS 123R, including the provisions of the SEC’s Staff Accounting Bulletin No. 107 (“SAB 107”), and use the fair value method to account for share-based payments with a modified prospective application that provides for certain changes to the method for valuing share-based compensation. The valuation provisions of FAS 123R apply to new awards and to awards that are outstanding on the effective date and subsequently modified or cancelled. Under the modified prospective application, prior periods are not revised for comparative purposes.

 

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%. FAS 123R 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 pre-vesting forfeitures based on our historical experience.

 

If factors change and we employ different assumptions in the application of FAS 123R in future periods, the compensation expense that we record under FAS 123R 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 under FAS 123R. 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. 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 in accordance with FAS 123R and SAB 107 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 guidance in FAS 123R and SAB 107 is relatively new, and best practices are not well established. The application of these principles 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. Additionally, the application of FAS 123R is very complex. In November 2007, we announced a restatement of our financial results for the three and six months ended March 31, 2007 and the three and nine months ended June 30, 2007 primarily due to computation errors in our software used to calculate FAS 123R expense.

 

Previous versions of the software system we use to calculate share-based compensation expense applied a weighted average forfeiture rate in the calculation of share-based compensation. The old version consistently applied the forfeiture rate throughout the vesting period and allowed for a true-up of share-based compensation expense once the award had vested in full. The true-up was necessary because the old method did not properly attribute the cost over the vesting period. Because of the use of this method, the old version failed to properly account for the full expense of vested awards.

 

Under the new version of the software, forfeiture rates are applied in the calculation of share-based compensation expense up to the point each individual tranche is fully vested. As each tranche vests, the new version properly recognizes 100% of share-based compensation expense over the attribution period related to these vested tranches.

In addition, our evaluation of share-based compensation expense uncovered a data input error when the forfeiture rate was adjusted to 30% in the second fiscal quarter of 2007. This data input error, combined with the software version issue discussed above, resulted in a material understatement of share-based compensation expense as of March 31, 2007.

 

Revenue Recognition

 

General.  We recognize revenue in accordance with the SEC’s Staff Accounting Bulletin Topic 13 (“Topic 13”), “Revenue Recognition.” Revenue is recognized 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) the seller’s price to the buyer is fixed and determinable; and (4) collectibility is reasonably assured.

 

Certain product sales are subject to rights of return. For these products, our revenue recognition policy is consistent with the requirements of Statement of Financial Accounting Standards No. 48, “Revenue Recognition When Right of Return Exists” (“FAS 48”). FAS 48 states that revenue from sales transactions where the buyer has the right to return the product shall be recognized at the time of sale only if several criteria are met, including that the seller be able to reasonably estimate future returns.

 

Certain revenue transactions include multiple deliverables. We allocate revenue to separate elements in multiple element arrangements based on the guidance in Emerging Issues Task Force No. 00-21 (“EITF 00-21”), “Accounting for Revenue Arrangements with Multiple Deliverables.” Revenue is allocated to a delivered product or service when all of the following criteria are met: (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. We use the relative fair values of the separate deliverables to allocate revenue.

 

Revenue Arrangements with Multiple Deliverables.  We have 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. In accordance with EITF 00-21, 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.

 

When a delivered product or service (or group of delivered products or services) meets the criteria for separation in EITF 00-21, 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.

 

Research and Development Services.  Revenue from research and development services is recognized during the period in which the services are performed and is based upon the number of full-time-equivalent personnel working on the specific project at the agreed-upon rate. Reimbursements from collaborative partners for agreed upon direct costs including direct materials and outsourced, or subcontracted, pre-clinical studies are classified as revenue in accordance with EITF Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent,” and recognized in the period the reimbursable expenses are incurred. Payments received in advance are recorded as deferred revenue until the research and development services are performed or costs are incurred.

 

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 costs of unsaleable returns, managed care chargebacks, cash discounts, freight and warehousing, and miscellaneous write-offs.

 

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 GlaxoSmithKline will pay Drug Royalty USA over the term of the agreement by (2) the unamortized deferred revenue amount.

 

Government Research Grant Revenue.  We recognize revenues from federal research grants during the period in which the related expenditures are incurred.

 

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 in SAB Topic 13 are met. We sell the API Docosanol to various licensees upon receipt of a written order for the materials. Shipments generally occur fewer than five 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, and to provide research and development services. Also, classified within cost of product sales is the amortization of the acquired FazaClo product rights.

 

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 subsequent to September 30, 2007. A 3% variance in our estimate of the work completed in our largest contract could increase or decrease our quarterly operating expenses by approximately $213,000.

 

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 in-process research and development.  In accordance with Statement of Financial Accounting Standards No. 141, “Business Combinations” (“FAS 141”), we immediately charge the costs associated with acquired in-process research and development (“IPR&D”) to research and development expense upon acquisition. These amounts represent an estimate of the fair value of acquired IPR&D for projects that, as of the acquisition date, had not yet reached technological feasibility, had no alternative future use, and had uncertainty in receiving future economic benefits from the acquired IPR&D. We determine the future economic benefits from the acquired IPR&D to be uncertain until such technology is approved by the FDA or when other significant risk factors are abated. We incurred significant IPR&D expense related to the Alamo acquisition. See also Note 3, “Acquisition of Alamo Pharmaceuticals, Inc. / Sale of FazaClo — In-Process Research and Development” in the Notes to Consolidated Financial Statements.

 

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.

 

Capitalization and Valuation of Long-Lived and Intangible Assets

 

In accordance with FAS 141 and Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“FAS 142”), goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead are tested for impairment on an annual basis or more frequently if certain indicators arise. Goodwill represents the excess of purchase price of an acquired business over the fair value of the underlying net tangible and intangible assets. The Company operates in one segment and goodwill is evaluated at the company level as there is only one reporting unit. Goodwill is evaluated in the fourth fiscal quarter of each year. There was no impairment to goodwill for the fiscal years ended September 30, 2007 and 2006.

 

Intangible assets with finite useful lives are amortized over their respective useful lives and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“FAS 144”.) The method of amortization shall reflect the pattern in which the economic benefits of the intangible asset are consumed or otherwise used up. If that pattern cannot be

reliably determined, a straight- line amortization method will be used. Intangible assets with finite useful lives include trade name and license agreements, which are being amortized over their estimated useful lives ranging from one to 15.5 years.

 

In accordance with FAS 144, intangible assets and other long-lived assets, except for goodwill, are evaluated for impairment whenever events or changes in circumstances indicate that their carrying value may not be recoverable. If the review indicates that intangible assets or long-lived assets are not recoverable (i.e. the carrying amount is less than the future projected undiscounted cash flows), their carrying amount would be reduced to fair value. Factors we consider important that could trigger an impairment review include the following:

 

 

Prior to October 1, 2005, intangible assets with finite useful lives also include capitalized external legal costs incurred in connection with patents and patent applications pending. We amortized costs of approved patents and patent applications pending over their estimated useful lives. For patents pending, we amortized the costs over the shorter of a period of twenty years from the date of filing the application or, if licensed, the term of the license agreement. For patent and patent applications pending and trademarks that we abandon, we charge the remaining unamortized accumulated costs to expense.

 

Change in Method of Accounting for Patent-related Costs

 

In the fourth quarter of fiscal 2006, we changed our method of accounting, effective October 1, 2005 for legal costs, all of which were external, associated with the application for patents. Prior to the change, we expensed as incurred all internal costs associated with the application for patents and capitalized external legal costs associated with the application for patents. Costs of approved patents were amortized over their estimated useful lives or if licensed, the terms of the license agreement, whichever was shorter, while costs for patents pending were amortized over the shorter period of twenty years from the date of the filing application or if licensed, the term of the license agreement. Amortization expense for these capitalized costs was classified as research and development expenses in our consolidated statements of operations. Under the new method, external legal costs are expensed as incurred and classified as research and development expenses in our consolidated statements of operations. We believe that this change is preferable because it will result in a consistent treatment for all costs, that is, under our new method both internal and external costs associated with the application for patents are expensed as incurred. In addition, the change will provide a better comparison with our industry peers. The $3.6 million cumulative effect of the change on prior years as of October 1, 2005 is included as a charge to net loss in fiscal 2006, retrospectively applied to the first quarter. The effect of the change for the fiscal year ended September 30, 2006 was to increase the net loss by $3.7 million, $3.6 million of which represents the cumulative effect of the change on prior years, or $0.12 per basic and diluted share.

 

Pro forma amounts assuming the new method for patent-related costs was applied retroactively are as follows:

 

 

Restructuring Expense

 

We record costs and liabilities associated with exit and disposal activities, as defined in Statements of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“FAS 146”), at fair value in the period the liability is incurred. In periods subsequent to initial measurement, changes to a liability are measured using the credit-adjusted risk-free rate applied in the initial period. In fiscal years 2007 and 2006, we recorded costs and liabilities for exit and disposal activities related to a relocation plan, including a decision to discontinue occupying certain leased office and laboratory facilities, in accordance with FAS 146. The liability is

evaluated and adjusted as appropriate on at least a quarterly basis for changes in circumstances. Please refer to Note 4, “Relocation of Commercial and General and Administrative Operations” in the Notes to Consolidated Financial Statements for further information.

 

Critical Accounting Policies and Estimates for Discontinued Operations

 

Revenue Recognition

 

Product Sales — FazaClo.  As discussed previously in this filing and also in Note 3, “Acquisition of Alamo Pharmaceuticals, Inc. / Sale of FazaClo” in the Notes to Consolidated Financial Statements, we acquired Alamo Pharmaceuticals LLC (“Alamo”) on May 24, 2006, with one marketed product, FazaClo (clozapine, USP), that began shipping to wholesale customers in July 2004 in 48-pill units. At that time, FazaClo had a two-year shelf life. In June 2005, Alamo received FDA approval to extend the product expiration date to three years. In October 2005, Alamo began shipping 96-pill units and accepted returns of unsold or undispensed 48-pill units. In August 2007, we sold our product rights to FazaClo to Azur Pharma, Inc. As a result of our sale of FazaClo near the end of fiscal 2007, we have reflected all FazaClo-related revenue and expenses as discontinued operations for all periods presented.

 

During fiscal 2007, we sold FazaClo to pharmaceutical wholesalers, the three largest of which accounted for approximately 84% of our net wholesale shipments for the fiscal year ended 2007. They resold our product to outlets such as pharmacies, hospitals and other dispensing organizations. We had agreements with our wholesale customers, various states, hospitals, certain other medical institutions and third-party payers throughout the U.S. These agreements frequently contain commercial incentives, which may have included pricing allowances and discounts payable at the time the product was sold to the dispensing outlet or upon dispensing the product to patients. Consistent with pharmaceutical industry practice, wholesale customers can return purchased product during an 18-month period that begins six months prior to the product’s expiration date and ends 12 months after the expiration date. Additionally, several of our dispensing outlets have the right to return expired product at any time. Once products have been dispensed to patients, the right of return expires.

 

Beginning in the first quarter of fiscal 2007, we obtained third-party information regarding certain wholesaler inventory levels, a sample of outlet inventory levels and third-party market research data regarding FazaClo sales. The third-party data includes, (i) IMS Health Audit — National Sales Perspective reports (“NSP”), which is a projection of near-census data of wholesaler shipments of product to all outlet types, including retail and non-retail and; (ii) IMS Health National Prescription Audit (“NPA”) Syndicated data, which captures end-user consumption from retail-dispensed prescriptions based upon projected data from pharmacies estimated to represent approximately 60% to 70% of the U.S. prescription universe. Further, we analyzed historical rebates and chargebacks earned by State Medicaid, Medicare Part D and managed care customers. Based upon this additional information and analysis obtained, we estimated the amount of product that was shipped that was no longer in the wholesale or outlet channels, and hence no longer subject to a right of return. Therefore, we began recognizing revenues, net of returns, chargebacks, rebates, and discounts, in the first quarter of fiscal 2007, for product that we estimated had been sold to patients and that was no longer subject to a right of return.

 

FazaClo product revenues were recorded net of provisions for estimated product pricing allowances including: State Medicaid base and supplemental rebates, Medicare Part D discounts, managed care contract discounts and prompt payment discounts were at an aggregate rate of approximately 25.8% of gross revenues for the fiscal year ended September 30, 2007. Provisions for these allowances are estimated based upon contractual terms and require management to make estimates regarding customer mix to reach. We considered our current contractual rates with States related to Medicaid base and supplemental rebates, with private organizations for Medicare Part D discounts and contracts with managed care organizations. We review these rates at least quarterly and make adjustments, if necessary.

 

Nature of Operating Expenses

 

In fiscal 2007, our operating expenses were influenced substantially by the amount of spending devoted to sales and marketing of FazaClo, program research funded by our partners and Zenvia clinical development expenses. During the past three years, we substantially expanded our drug development pipeline, which required that we allocate significant amounts of our resources to such programs, including increased spending on clinical

trials as those programs advance in their development. We believe that future operating expenses over the next two years will be comprised mainly of our Phase III clinical trial expenses and general and administrative expenses such as finance, human resources and facilities.

 

Our business is exposed to significant risks, as discussed in the section entitled “Risk Factors,” which may result in additional expenses, delays and lost opportunities that could have a material adverse effect on our results of operations and financial condition.

 

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 discovery, development 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 geographic area based on selling location. All our operations are currently located in the United States; therefore, total revenues for fiscal 2007, 2006 and 2005 are attributed to the United States. All long-lived assets for fiscal 2007 and 2006 are located in the United States.

 

Comparison of Fiscal 2007 and 2006

 

Revenues

 

Net product revenues were $72,000 and $18,000 for the fiscal years ended September 30, 2007 and 2006 respectively. See section “Loss from Discontinued Operations” for a detailed discussion of net revenues related to FazaClo.

 

Revenues from licenses, research services and grants declined to $9.2 million for the fiscal year ended September 30, 2007 compared to $15.2 million for the fiscal year ended September 30, 2006. This decline was principally due to a decrease in research revenues of $5.4 million due to a $5.0 million milestone earned under the AstraZeneca license agreement in the first quarter of fiscal year 2006 that was not repeated in the first quarter of fiscal year 2007. In addition, revenue from license arrangements declined $3.5 million. As a result of the termination of the contract research services that we were providing to AstraZeneca and Novartis, our revenues were lower than in 2006. These decreases were partially offset by an increase in revenue from royalties of $2.3 million primarily from the receipt of $1.5 million from HBI for their achievement of a regulatory milestone. However, we expect our related research and development expenses to be reduced by a corresponding amount in future periods. See Note 16 “License and Research Collaboration Agreements” and Note 19 “Segment Information” in Notes to Consolidated Financial Statements.

 

Cost of Revenues

 

Cost of product revenues was $328,000 and $3,000 for the fiscal years ended September 30, 2007 and 2006, respectively. The cost of product revenues in fiscal year ended September 30, 2007 is attributable to a $260,000 write off of obsolete inventory in the second quarter of 2007. See section “Loss from Discontinued Operations” for a detailed discussion of cost of product revenues related to FazaClo.

 

Cost of licenses, research services and grants declined to $4.3 million or 47% of revenues compared with $7.5 million or 49% of revenues for the fiscal year ended September 30, 2006. The cost of licenses, research services and grants includes primarily direct and indirect payroll costs and the costs of outside vendors.

 

 

Research and Development Expenses

 

Research and development expenses decreased $13.9 million or 51% for the fiscal year ended September 30, 2007 compared to the fiscal year ended September 30, 2006. The decrease is primarily due to decreased costs of $13.9 million incurred for Zenvia product research and development (PBA/IEED and DPN), which was spent in fiscal year ended September 30, 2006 in preparation for the planned product launch. In addition, decreased costs of $652,000 were incurred for the AVP-13358 Allergy study.

 

Over the next two years, we expect that our research and development costs will consist mainly of expenses related to the confirmatory Phase III trial for Zenvia for PBA.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses decreased $11.5 million, or 36% for the fiscal year ended September 30, 2007, compared to the fiscal year ended September 30, 2006. The decrease is primarily attributed to fiscal year 2006 expenditures that were not repeated in fiscal 2007 relating to external marketing costs in the amount of $7.7 million associated with the anticipated Zenvia product launch, for which commercialization was delayed in October 2006 following receipt of the approvable letter. In addition, $1.7 million for continuing medical education grants related to PBA/IEED in the prior fiscal year were not repeated in fiscal 2007 and fiscal 2007 compensation expense decreased by $1.4 million as compared to the prior year due to related decreases in overall headcount and compensation levels in general and administrative areas.

 

Additionally, in September 2007, a court awarded reimbursement of attorneys fees spent over a four-year period in connection with the enforcement of a settlement agreement entered into with a former employee. The total fees awarded were approximately $1.3 million. We cannot currently estimate the timing for collection or the probability of collecting the full amount, and therefore, no amounts have been recognized in income as of September 30, 2007.

 

Share-Based Compensation

 

Total compensation expense for our share-based payments in the fiscal year ended September 30, 2007 and 2006 was $2.2 million (excluding $508,000 included in discontinued operations) and $2.8 million (excluding $283,000 included in discontinued operations), respectively. Selling, general and administrative expense in the fiscal years ended September 30, 2007 and 2006 includes share-based compensation expense of $1.9 million and $2.4 million, respectively. Research and development expense in the fiscal year ended September 30, 2007 and 2006 includes share-based compensation expense of $365,000 and $465,000, respectively. As of September 30, 2007, $1.7 million of total unrecognized compensation costs related to unvested awards is expected to be recognized over a weighted average period of 2.1 years. See Note 2, “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements for further discussion.

 

Interest Expense and Interest Income

 

For the fiscal year ended September 30, 2007, interest expense increased to $1.2 million, compared to $406,000 for the prior fiscal year. The increase is primarily due to the Seller Notes with an original balance of $25.1 million issued in May 2006 in connection with the purchase of Alamo.

 

For the fiscal year ended September 30, 2007, interest income decreased to $623,000, compared to $1.8 million for the prior fiscal year. The decrease is due to approximately a 58% decrease in the average balance of cash, cash

equivalents and investments in securities for fiscal year ended September 30, 2007, compared to the prior fiscal year.

 

Net Loss

 

Net loss was $20.9 million, or $0.53 per share, for the fiscal year ended September 30, 2007, compared to a net loss of $62.6 million, or $2.04 per share for the fiscal year ended September 30, 2006. The decrease in net loss is primarily attributed to decreased operating expenses totaling $24.9 million which is mainly due to decreased spending in the Zenvia product research and development area of $13.9 million, as well as, the decreased spending in marketing costs from the Zenvia product launch of $7.7 million, the gain on the sale of the FazaClo product line of $12.2 million, the decrease in the discontinued operations loss of $3.9 million and the $3.6 million cumulative effect of the change in accounting principle which occurred in 2006 only.

 

Income/(Loss) from Discontinued Operations

 

For the fiscal year ended September 30, 2007, income from discontinued operations was $7.5 million, compared to a loss of $8.7 million for the fiscal year ended September 30, 2006. This decrease in loss was mainly due to the recognition of net product revenues of FazaClo of $17.0 million in fiscal 2007, including revenue that was deferred as of September 30, 2006. No product revenues were recognized for FazaClo in the fiscal year ended September 30, 2006. Product margin on these net sales were $12.4 million for the year ended September 30, 2007. The product margin was offset with operating expenses incurred of $16.7 million in fiscal year ended September 30, 2007 compared to $7.9 million in fiscal year ended September 30, 2006. A majority of the operating expenses incurred in fiscal year 2007 pertain to the FazaClo product launch as well as the increase in headcount as a result of the Alamo acquisition. Also contributing to the decrease in net loss is the gain recorded in fiscal 2007 on the sale of FazaClo in the amount of $12.2 million.

 

Comparison of Fiscal 2006 and 2005

 

Revenues

 

Revenues decreased by $1.5 million, or 9%, to $15.2 million in fiscal 2006 from $16.7 million in fiscal 2005. The decrease is mainly due to a $7.6 million decrease in license revenues; partially offset by a $6.2 million increase in research and development service revenues. License revenues in fiscal 2006 consist mainly of our receipt of a $5.0 million payment relating to the achievement of a milestone under the AstraZeneca license agreement. License revenues in fiscal 2005 included $12.8 million of license fees from the AstraZeneca and Novartis license agreements. Research and development service revenues increased in fiscal 2006 as compared to the prior period due to the full year effect of research revenues generated from the AstraZeneca and Novartis license agreements in the current year, as opposed to our receipt of revenue for only a partial year in fiscal 2005.

 

Potential revenue-generating contracts that remained active as of September 30, 2006 included license agreements with AstraZeneca and Novartis, nine docosanol 10% cream license agreements and one Zenvia sublicense. AstraZeneca and Novartis were engaged in preclinical and/or clinical development efforts of our licensed RCT and MIF programs. See Note 16 “License and Research Collaboration Agreements” and Note 19 “Segment Information” in Notes to Consolidated Financial Statements.

 

Cost of Revenues

 

Cost of licenses, research services and grants increased to $7.5 million or 49% of revenues for the fiscal year ended September 30, 2006 compared with $2.8 million or 17% of revenues for the fiscal year ended September 30, 2005. The increase was due to a $4.9 million increase in cost of research services funded by partners.

 

 

Research and Development Expenses

 

R&D expenses increased $854,000 or 3% for the fiscal year ended September 30, 2006 compared to the fiscal year ended September 30, 2005. R&D expenses increased to $27.0 million in fiscal 2006 from $26.1 million in fiscal 2005. R&D expenses in fiscal 2006 were related to continuation of the open label safety study of Zenvia in the treatment for IEED/PBA, a Phase III clinical trial of Zenvia for the treatment of diabetic neuropathic pain, and a Phase I clinical trial of our leading compound for the selective cytokine inhibitor program. R&D expenses also included pre-clinical research related to antibody development programs and compounds that regulate MIF and RCT Research. The MIF and RCT research programs were funded by our partners. The increase in R&D expenses was due to a $1.8 million increase in spending for the open label safety study of Zenvia for the treatment of IEED/PBA, a $7.6 million increase in spending for the Phase III clinical trial of Zenvia for the treatment of diabetic neuropathic pain and a $2.4 million increase in medical affairs. The increase was offset in part by a $3.7 million decrease in spending on the MIF and RCT research programs as they were fully funded by partners in fiscal 2006. In fiscal 2005, we incurred a one-time $7.2 million charge in connection with the acquisition of additional contractual rights to Zenvia.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses increased $13.6 million, or 72% for the fiscal year ended September 30, 2006, compared to the fiscal year ended September 30, 2005. Our selling, general and administrative expenses increased to $32.4 million in fiscal 2006, compared to $18.8 million in fiscal 2005. These increased expenses primarily related to a $6.2 million increase in expenses related to the expansion of our pre-launch activities and market research for Zenvia for the treatment of IEED/PBA, as well as the hiring of additional sales and marketing personnel; $2.5 million in share-based compensation expense; $1.7 million in expenses from continuing medical educational grants; a $1.4 million increase in expenses related to increases in headcount and compensation levels in general and administrative areas; and a $622,000 increase in legal fees.

 

Share-Based Compensation

 

Through fiscal year 2005, we accounted for our stock plans using the intrinsic value method. Effective at the beginning of fiscal year 2006, we adopted FAS 123R and elected to adopt the modified prospective application method. FAS 123R requires us to use a fair-valued based method to account for share-based compensation. Accordingly, share-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as expense over the employees’ requisite service period. Total compensation cost for our share-based payments in fiscal 2006 was $2.8 million (excluding $283,000 included in discontinued operations), including $302,500 related to stock options granted in fiscal 1999 as discussed below. Selling, general and administrative expense and research and development expense in fiscal 2006 include: share-based compensation of $2.4 million and $465,000, respectively. As of September 30, 2006, $7.2 million of total unrecognized compensation costs related to unvested awards is expected to be recognized over a weighted average period of 2.7 years. See Note 2, “Significant Accounting Policies — Change in Accounting Method for Share-Based Compensation” in the Notes to Consolidated Financial Statements for further discussion.

 

On July 28, 2006, the Public Company Accounting Oversight Board (PCAOB) issued Staff Audit Practice Alert No. 1 entitled, “Matters Relating to Timing and Accounting for Options Grants.” Prompted by the PCAOB release, the Company and the independent audit committee of the Board of Directors authorized a review of the

Company’s historical stock option practices. The review was conducted with the assistance of an outside law firm and an outside consulting firm.

 

As a result of this review, one exception was found in which the measurement date for 50,000 fully vested common stock options should have been November 30, 1999 instead of October 30, 1999. Based on this, the Company should have recorded a non-cash charge of $302,500 and a corresponding increase in common stock in the first quarter of fiscal year 2000. The Company has concluded that this adjustment is not material to the Company’s consolidated financial statements in any interim or annual period presented in this or any previously filed Form 10-K. Therefore, the charge was recognized in the quarter ended September 30, 2006.

 

Based upon this review, management and the independent audit committee of the Board of Directors were satisfied that no evidence was found that indicated that the Company otherwise intentionally manipulated stock option grant dates or was remiss in communicating grants to optionees in a timely manner. Further, the Company’s documentation and practices followed the intent of the Board of Directors in granting such options and that the methods of approval and the Company’s practices did not provide for management discretion in selecting or manipulating the option grant dates.

 

Interest Expense and Interest Income

 

For the fiscal year ended September 30, 2006, interest expense increased to $406,000, compared to $93,000 for the prior fiscal year. The increase was primarily due to the Seller Notes with an original balance of $25.1 million issued in May 2006 in connection with the purchase of Alamo.

 

For the fiscal year ended September 30, 2006, interest income increased to $1.8 million, compared to $620,000 for the prior fiscal year. The increase was primarily due to a 73% increase in average balance of cash, cash equivalents and investments in securities in fiscal 2006, compared to the prior year.

 

Cumulative Effect of Change in Accounting Principle

 

In the fourth quarter of fiscal 2006, we changed our method of accounting, effective October 1, 2006 for legal costs, all of which were external, associated with the application for patents. The $3.6 million cumulative effect of the change on prior years as of October 1, 2005 is included as a charge to net loss in fiscal 2006, retrospectively applied to the first quarter. The effect of the change for fiscal 2006 was to increase the net loss by $3.7 million, $3.6 million of which represents the cumulative effect of the change on prior years, or $0.12 per basic and diluted share.

 

Net Loss

 

Net loss was $62.6 million, or $2.04 per share, in fiscal 2006, compared to a net loss of $30.6 million, or $1.19 per share, in fiscal 2005. The increase in net loss was primarily attributed to the $3.6 million cumulative effect of the change of accounting method for legal costs, the $13.6 million increase in selling, general and administrative costs (that was mainly due to increased spending related to the expansion of the pre-launch activities and market research for Zenvia for the treatment of IEED/PBA), the increase in the discontinued operations loss of $8.7 million, and $4.7 million increase in cost of licenses, research services and grants mainly due to increased spending for research services funded by partners.

 

Loss from Discontinued Operations

 

For the fiscal year ended September 30, 2006, loss from discontinued operations was $8.7 million, compared to no loss for the fiscal year ended September 30, 2005. The loss from discontinued operations is a result of the operations of FazaClo, which was acquired in May of 2006 as part of the Alamo acquisition.

 

Liquidity and Capital Resources

 

We assess our liquidity by 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 accounts receivable, inventories, accounts payable and capital expenditures; the timing and extent of cash received

from milestone payments under license agreements; funds required for acquisitions; funds required to repay notes payable and capital lease obligations as they become due; 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 and working capital requirements and investing activities.

 

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

 

 

 

Operating activities.  Net cash used for operating activities amounted to $46.6 million in the fiscal year 2007 compared to $40.8 million in the fiscal year 2006. The increase in cash used is primarily related to funding the operating loss for the period, recognition of deferred revenues, and reductions in accounts payable. Accounts payable and accrued expenses decreased by $13.9 million and was primarily due to payments of invoices in clinical, marketing and general and administrative activities.

 

Investing activities.  Net cash provided by investing activities was $59.6 million in the fiscal year 2007, compared to net cash of $7.4 million used in the fiscal year 2006. This increase is mainly due to proceeds from investments in securities of $16.9 million compared to investments in securities of $65.8 million offset by proceeds from investments of $64.9 million in 2006. Net cash provided by investing activities of discontinued operations was $42.1 million compared to net cash used by investing activities of discontinued operations of $4.8 million in 2006. We invested $59,000 in property and equipment in fiscal 2007, compared to $1.7 million in fiscal 2006. In fiscal 2007, we generated $774,000 from disposals of property and equipment.

 

Financing activities.  Net cash provided by financing activities was $12.7 million in fiscal year 2007, consisting of $30.9 million in net proceeds from sales of our common stock offset by $6.8 million to reduce long-term debt and $11.4 million net cash used in financing activities of discontinued operations in 2007. Net cash provided by financing activities amounted to $44.5 million in fiscal 2006, consisting of $44.8 million received from the sale of our common stock through private placements and from exercises of warrants and stock options.

 

In June 2005, we filed a shelf registration statement on Form S-3 with the SEC to sell an aggregate of up to $100 million in Class A common stock and preferred stock, depositary shares, debt securities and warrants. This shelf registration statement was declared effective on August 3, 2005 and through September 30, 2007, we had sold a total of 14,406,755 shares of Class A common stock under this registration statement, raising gross offering proceeds of approximately $71.5 million and net offering proceeds of approximately $69.5 million. We have also issued under this registration statement common stock warrants to purchase a total of 1,053,000 shares of our

Class A common stock at an exercise price of $3.30 per share. The warrants became exercisable in May 2007 and all unexercised warrants expired in November 2007. The warrants may be exercised on a net basis in certain circumstances but in no event would the company be required to settle the warrants in cash.

 

In December 2006 we entered into a financing facility with Brinson Patrick Securities Corporation. Under this facility, we have offered and sold an aggregate of 6,126,000 shares of Class A common stock, which resulted in net proceeds of $16.1 million. As of December 14, 2007, 5.6 million shares remained available for sale under this facility. Sales are made under our effective shelf registration statement.

 

As of September 30, 2007, we have contractual obligations for long-term debt, capital (finance) lease obligations and operating lease obligations, as summarized in the table that follows. We have no off-balance sheet arrangements.

 

 

 

 

As part of the purchase consideration of the Alamo acquisition, we initially issued three promissory notes in the principal amounts of $14,400,000, $6,675,000 and $4,000,000 (the “First Note,” “Second Note” and “Third Note”, respectively) (collectively, the “Notes”). The Notes bear interest at an average rate equal to the London Inter-Bank Offered Rate, or “LIBOR,” plus 1.33%. Interest accruing on the Notes is payable monthly and the principal amount of the Notes matures on May 24, 2009, provided that (i) the Selling Holders may demand early repayment of the First Note if the closing price of our common stock, as reported on the NASDAQ Global Market, equals or exceeds $15.00 per share for a total of 20 trading days in any 30 consecutive trading-day period (the “Stock Contingency”), and (ii) we must apply 20% of any future net offering proceeds from equity offerings and other financing transactions to repay the Notes (starting with the First Note), and must repay the Notes in full if we have raised in an offering more than $100,000,000 in future aggregate net proceeds. In connection with the equity offering we completed in the first nine months of fiscal year 2007, and in accordance with the terms of the Notes, we used approximately $6.1 million or 20% of the net proceeds received to pay down the First Note. In connection with our sale of FazaClo in August 2007, we agreed to prepay $11 million of outstanding principal due under the Notes, and the Note holder agreed to suspend the Company’s obligation to use a portion of future equity offering proceeds to repay the Notes, up to $55 million in net offering proceeds. Twenty percent of any offering proceeds above this amount will need to be paid to the Note holders, as per the original agreement.

 

We have the right to prepay, in cash or in common stock, the amounts due under the Notes at any time, provided that we may only pay the Notes in common stock if the Stock Contingency has occurred prior to the maturity date and if we have registered the shares on an effective registration statement filed with the SEC. If we elect to prepay the Notes with common stock, the shares will be valued at 95% of the average closing price of the common stock, as reported on the NASDAQ Global Market, for the five trading days prior to repayment, subject to a price floor.

 

Alamo Earn-Out Payments.  In connection with the Alamo acquisition, 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”). Based on the results of the quarters ended March 31, 2007 and June 30, 2007, we issued the first and second of these revenue-based payments through the issuance of additional promissory notes in the principal amount of $2,000,000 per note. As previously discussed in this filing, we sold the FazaClo product line

to Azur Pharma. 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 Pharma.

 

Eurand Milestone and Royalty Payments.  In August 2006, we entered into a development and license agreement (“Eurand Agreement”) with Eurand, Inc. (“Eurand”), under which Eurand will provide R&D services using Eurand’s certain proprietary technology to develop a once-a-day controlled release capsule, a new formulation of Zenvia for the treatment of IEED/PBA (“Controlled-Release Zenvia”). Under the terms of the Eurand Agreement, we will pay Eurand for development services on a time and material basis. We will be required to make payments up to $7.6 million contingent upon achievement of certain development milestones and up to $14.0 million contingent upon achievement of certain sales targets. In addition, we will be required to make royalty payments based on sales of Controlled-Release Zenvia, if it is approved for commercialization. Development milestone events include program initiation, delivery of prototypes, delivery of clinical trial material for phase 1, achieving target PK Profile in the pilot clinical study, delivery of clinical trial material for phase 3, and filing of the first NDA for the Product with the FDA, completion of manufacturing validation and approval of the NDA with the FDA. Sales target milestones are $2.0 million upon achieving $100 million of U.S. net revenues, $4.0 million upon achieving $200 million of U.S. net revenues and $8.0 million upon achieving $400 million of U.S. net revenues. The agreement remains in effect on a country by country basis for the longer of 10 years after first commercial sale or the life of any Eurand patent, unless earlier terminated in accordance with the agreement. In November 2006, we notified Eurand to suspend activity on this project until further notice. The Company may terminate the agreement upon 30 days’ notice. Upon expiration of the agreement the Company shall own a fully-paid irrevocable license. Effective December 2006, we suspended further work under this agreement until resolution of further development plans for Zenvia resulting from our meeting with the FDA in late February 2007. All material remaining obligations would only be due in the event we reinstate the agreement in future.

 

Zenvia License Milestone Payments.  We hold the exclusive worldwide marketing rights to Zenvia for certain indications pursuant to an exclusive 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 both indications, 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. In fiscal 2005, we paid $75,000 to CNS under the CNS license agreement, and will need to pay a $75,000 milestone if the FDA approves our NDA for Zenvia for the treatment of PBA/IEED. In addition, we are obligated to pay CNS a royalty on commercial sales of Zenvia with respect to each indication, if and when 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 Zenvia to a third party.

 

Under our agreement with CNS, we are required to make payments on achievements of up to a maximum of ten milestones, based upon five specific medical indications. Maximum payments for these milestone payments could total approximately $2.1 million if we pursued the development of Zenvia for all of the licensed indications. Of the clinical indications that we currently plan to pursue, expected milestone payments could total $800,000. In general, individual milestones range from $150,000 to $250,000 for each accepted 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 revenues.

 

Management Outlook

 

The minimum amount of securities available for sale under our existing shelf registration was approximately $28.5 million as of September 30, 2007. We believe that cash equivalents and unrestricted investments in securities of approximately $33.6 million at September 30, 2007, which includes the net proceeds from the sale of FazaClo, will be sufficient to sustain our planned level of operations for the next twelve months. However, the Company 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. If we are unable to generate sufficient cash flows from licensed technologies or are unable to raise sufficient capital, management believes that expenditures could be curtailed in order to continue operations for the next 12 months.

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

 

Recent Accounting Pronouncements

 

See Note 2, “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements for a discussion of recent accounting pronouncements and their effect, if any, on the Company.

 

 

As described below, we are exposed to market 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 as we expand international distribution of docosanol 10% cream and purchase additional services from outside the U.S. Until such time as we are faced with material amounts of foreign currency exchange rate risks, we do not plan to use derivative financial instruments, which can be used to hedge such risks. We will evaluate the use of derivative financial instruments to hedge our exposure as the needs and risks should arise.

 

Interest Rate Sensitivity

 

Our investment portfolio consists primarily of fixed income instruments with an average duration of approximately 14 months as of September 30, 2007 (11 months as of September 30, 2006). The primary objective of our investments in debt securities is to preserve principal while achieving attractive yields, without significantly increasing risk. We classify our investments in securities as of September 30, 2007 as available-for-sale and our restricted investments in securities as held-to-maturity. These available-for-sale securities are subject to interest rate risk. In general, we would expect that the volatility of this portfolio would decrease as its duration decreases. Based on the average duration of our investments as of September 30, 2007 and 2006, an increase of one percentage point in the interest rates would have resulted in increases in comprehensive losses of approximately $280,000 and $171,000, respectively.

 

At September 30, 2007, we had approximately $11.7 million of variable rate debt that was issued as part of the purchase price for the acquisition of Alamo. Based on the amount of outstanding variable rate debt at September 30, 2007, if the interest of our variable rate debt were to increase or decrease by 1%, interest expense would increase or decrease on an annual basis by approximately $117,000.

 

 

Our 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 Interim Chief Financial Officer, 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.

 

As previously reported, in connection with that evaluation, our CEO and Interim CFO concluded that our disclosure controls and procedures were not effective as of March 31, 2007 due to a material weakness in internal controls over financial reporting. Subsequently, we determined that it was necessary to restate our condensed consolidated financial statements for the fiscal quarters ended March 31, 2007 and June 30, 2007 and that these financial statements should no longer be relied upon.

These restatements had no impact on the Company’s previously reported revenues, cash flows from operations or total cash and cash equivalents shown in the Company’s condensed consolidated financial statements for the three and six months ended March 31, 2007 and the three and nine months ended June 30, 2007.

 

The Company did not have effective internal controls over financial reporting for the calculation of share-based compensation expense. Previous versions of a widely utilized software program used to calculate share-based compensation expense incorrectly applied a weighted average forfeiture rate in the calculation of share-based compensation. Previous versions consistently applied the forfeiture rate throughout the vesting period and allowed for a true-up of share-based compensation expense once the award had vested in full. The true-up was necessary because the old versions did not properly attribute the expense over the vesting period. Because of the use of this method, the old version failed to properly account for the full expense of vested awards during the interim periods prior to the award reaching its final vest date.

 

Under the new version of the software, forfeiture rates are applied in the calculation of share-based compensation expense up to the point each individual tranche is fully vested. As each tranche vests, the new version properly recognizes 100% of share-based compensation expense over the attribution period related to these vested tranches.

 

In addition, the Company’s evaluation of share-based compensation expense uncovered a data input error when the forfeiture rate was adjusted to 30%. This data input error, combined with the software version issue discussed above, resulted in a material understatement of share-based compensation expense as of March 31, 2007.

 

The error had no impact on the Company’s previously reported revenues, cash flows from operations or total cash and cash equivalents shown in the Company’s condensed consolidated financial statements for the fiscal quarter ended March 31, 2007.

 

The Company’s corporate monitoring controls failed to operate at a sufficient level of precision to detect the understatement of share-based compensation expense and the material misstatement of operating expenses and net loss.

 

The Company intends to review share-based compensation expense on a quarterly basis, supplemented by external consultants and independent computational reviews, to ensure that total share-based compensation expense is recognized for vested shares. The Company is in the process of evaluating remediation efforts to address the issues affecting the calculation of share-based compensation expense. The Company will perform these measures during the preparation of the 2008 first quarter financial reports. Additional measures may be forthcoming as the Company evaluates the effectiveness of these efforts.

 

Changes in Internal Control over Financial Reporting

 

There has been no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. However, we have initiated or intend to initiate remediation measures to address the material weakness identified above. The remediation measures include or are expected to include the following:

 

 

We may adopt additional remediation measures related to the identified control deficiencies as necessary as well as to continue to evaluate our internal controls on an ongoing basis and to upgrade and enhance them as needed.

Our Audit Committee has taken an active role in reviewing and discussing the identified material weakness with our auditors and financial management. Our management and the Audit Committee will actively monitor the implementation and effectiveness of the remediation measures taken by the Company’s financial management.

 

Item 9B.  Other Information

 

In November 2007, we entered into a task order (the “Task Order”) under the Company’s Clinical Development Master Service Agreement (the “Agreement”) with Kendle International Inc. (“Kendle”). Pursuant to the Task Order, Kendle will provide clinical trial management and related clinical services to the Company relating to the Company’s planned Phase III trial for Zenvia for the treatment of pseudobulbar affect (PBA) (An extension of services for Protocol No. 07-AVP-123, entitled: “A Double-Blind, Randomized, Placebo Controlled, Multicenter Study to Assess the Safety and Efficacy and to Determine the Pharmacokinetics of Two Doses of AVP-923 (Dextromethorphan/Quinidine) in the treatment of Pseudobulbar Affect (PBA) in Patients with Amyotrophic Lateral Sclerosis and Multiple Sclerosis.”)

 

This Task Order is effective as of November 1, 2007 and will terminate on September 9, 2009. Either party may terminate the Agreement or the Task Order upon material breach or insolvency or on 60 days’ prior written notice. In addition to the Double-Blind study, we also have a contract with Kendle to perform our Open Label study. .

 

PART III

 

 

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 2008 Annual Meeting of Shareholders.

 

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 key employees and their ages as of December 14, 2007 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.

 

 

Keith Katkin.  Mr. Katkin joined Avanir in July of 2005 as Senior Vice President of Sales and Marketing. In March 2007 he was promoted to President and Chief Executive Officer and as a director. Prior to joining Avanir, Mr. Katkin previously served as Vice President of Commercial Development for Peninsula Pharmaceuticals from May 2004 to July 2005, playing a key role in the sale of Peninsula to Johnson & Johnson. Prior to his tenure at Peninsula, Mr. Katkin was Vice President of Pulmonary and Infectious Disease Marketing at InterMune, Inc., a biopharmaceutical company, from May 2002 to April 2004. From 1996 to April 2002, Mr. Katkin held Sales and Marketing positions with Amgen Inc., a global biotechnology company. Earlier in his career, Mr. Katkin spent several years at Abbott Laboratories. Mr. Katkin received a Bachelor of Science 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 is also a Certified Public Accountant.

Randall E. Kaye, M.D.  Dr. Kaye joined Avanir in January 2006 as Vice President of Medical Affairs and assumed the role of 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.

 

Martin J. Sturgeon.  Mr. Sturgeon joined Avanir in February 2007 as Vice President and Chief Accounting Officer. In July 2007 Mr. Sturgeon assumed the role of Interim Chief Financial Officer. Previously, Mr. Sturgeon was a consultant with DLC, Inc., a consulting firm, serving in senior finance roles including Chief Accounting Officer and Chief Financial Officer for several publicly traded client companies. Mr. Sturgeon has over 25 years of experience in senior financial positions including eight years with Toshiba America Information Systems, Inc. as the Vice President, Group Controller. His career also includes experience in executive financial roles with companies such as Western Digital, Corinthian Colleges, and Novacare. Mr. Sturgeon holds a Bachelor’s of Business Administration degree in Accounting from the University of San Diego and an M.B.A. in Finance from IESE, a European M.B.A. program sponsored by Harvard University.

 

Eric S. Benevich.  Mr. Benevich joined Avanir in July 2005 as Senior Director of Marketing. In October 2006 he became the Executive Director of Marketing and in August 2007 he was promoted to Vice President of Communications. Previously, Mr. Benevich was the Senior Director of Marketing at Peninsula Pharmaceuticals leading all pre-launch activities to support the launch of two antibiotics into the hospital market. Mr. Benevich also has experience in other commercial areas such as sales, market research, and brand marketing at companies such as Astra Merck and Amgen Inc. Mr. Benevich completed his undergraduate studies in International Business at Washington State University and has completed several MBA courses at Villanova University.

 

Gregory J. Flesher.  Mr. Flesher joined Avanir in 2006 as Senior Director of Commercial Strategy and was responsible for lifecycle and new product planning. While in this role, he also led the commercial integration of Alamo Pharmaceuticals following their acquisition. In November 2006 he became the Executive Director of Business Development and Portfolio Strategy and in August of 2007 he was promoted to Vice President of Business Development. Mr. Flesher has over 14 years of biotechnology and pharmaceutical industry experience and has held positions of increasing responsibility across R&D, Sales, Marketing, and Business Development. Prior to joining Avanir, he was a Sales Director at Intermune Pharmaceuticals with responsibility for trade relations, managed care, and patient support programs. Mr. Flesher also has brand management and commercial analytics experience from Amgen Inc. and Eli Lilly and Company. He began his career within the R&D organization of Eli Lilly and Company. Mr. Flesher completed his undergraduate studies in Biology at Purdue University and his doctorate studies in Biochemistry and Molecular Biology at Indiana University School of Medicine.

 

Code of Ethics

 

We have adopted a code of ethics for directors, officers (including our principal executive officer, principal financial officer, and principal accounting officer and controller), and employees. This code of ethics 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.

 

 

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.

 

PART IV

 

 

(a) Financial Statements and Schedules

 

Financial statements for the three years ended September 30, 2007, 2006 and 2005 are attached. The index to these financial statements appears on page F-1.

 

(b) Exhibits

 

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

 

 

 

 

SIGNATURES

 

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

 

Keith A. Katkin

President and Chief Executive Officer

 

Date: December 20, 2007

 

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

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

 

To the Board of Directors and Shareholders of
Avanir Pharmaceuticals

 

We have audited the accompanying consolidated balance sheet of AVANIR Pharmaceuticals and subsidiaries (the “Company”) as of September 30, 2007, and the related consolidated statements of operations, shareholders’ equity (deficit) and comprehensive loss, and cash flows for the year then ended. 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 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 the consolidated financial statements are free of material misstatement. The Company has determined that it is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes 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 audit provides a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of AVANIR Pharmaceuticals and subsidiaries as of September 30, 2007 and the results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.

 

We have also audited the retrospective adjustments to the Company’s consolidated financial statements as of and for the year ended September 30, 2006 for the operations discontinued by the Company during 2007 discussed in Note 3 to the consolidated financial statements. Our audit procedures included auditing the reclassification of the discontinued operations in the 2006 consolidated financial statements and related disclosures. In our opinion, such retrospective adjustments to the consolidated financial statements and related disclosures for 2006 in Note 3 are appropriate and have been appropriately applied. However, we were not engaged to audit, review, or apply any procedures to the 2006 consolidated financial statements of the Company other than with respect to the retrospective adjustments and, accordingly, we do not express an opinion or any other form of assurance on the 2006 consolidated financial statements taken as a whole.

 

/s/ KMJ Corbin & Company LLP

 

Irvine, California

December 19, 2007

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

 

To the Board of Directors and Shareholders of
Avanir Pharmaceuticals

 

We have audited, before the effects of the retrospective adjustments for the discontinued operations discussed in Note 3 to the consolidated financial statements, the accompanying consolidated balance sheet of Avanir Pharmaceuticals and subsidiaries (the “Company”) as of September 30, 2006, and the related consolidated statements of operations, shareholders’ (deficit) equity and comprehensive loss, and cash flows for each of the two years in the period ended September 30, 2006 (the 2006 and 2005 consolidated financial statements before the effects of the adjustments discussed in Note 3 to the consolidated financial statements are not presented herein). These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with 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 the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, such 2006 and 2005 consolidated financial statements, before the effects of the retrospective adjustments for the discontinued operations discussed in Note 3 to the consolidated financial statements, present fairly, in all material respects, the financial position of Avanir Pharmaceuticals and subsidiaries as of September 30, 2006, and the results of their operations and their cash flows for each of the two years in the period ended September 30, 2006, in conformity with accounting principles generally accepted in the United States of America.

 

As discussed in Note 2 to the financial statements, the Company (1) adopted Statement of Financial Accounting Standards No. 123(R), Share-based Payment, and (2) changed its method of accounting for certain patent related costs, effective October 1, 2005.

 

We were not engaged to audit, review, or apply any procedures to the retrospective adjustments for the discontinued operations discussed in Note 3 to the consolidated financial statements and, accordingly, we do not express an opinion or any other form of assurance about whether such retrospective adjustments are appropriate and have been properly applied. Those retrospective adjustments were audited by other auditors.

 

/s/ Deloitte & Touche LLP

 

Costa Mesa, California

December 15, 2006

Avanir Pharmaceuticals

 

CONSOLIDATED BALANCE SHEETS

 

 

See notes to consolidated financial statements.

Avanir Pharmaceuticals

 

CONSOLIDATED STATEMENTS OF OPERATIONS