EXECUTIVE OVERVIEW
We are a pharmaceutical company focused on developing, acquiring and commercializing novel therapeutic products for the treatment of chronic diseases. Our product candidates address therapeutic markets in the areas of the central nervous system and inflammatory diseases. Our lead product candidate, Zenvia (dextromethorphan hydrobromide/quinidine sulfate), is currently in Phase III clinical development for the treatment of PBA and DPN pain. Our first commercialized product, docosanol 10% cream, (sold as AbrevaŽ 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. Our infectious disease program has historically been focused primarily on anthrax antibodies and, in March 2008, we sold our rights to this program to Emergent Biosolutions. Under the terms of the Emergent agreement, we were obligated to complete the remaining work under our NIH/NIAID grant. The NIH/NIAID grant ("NIH grant"), which funded the anthrax antibody program, expired on June 30, 2008. All work was completed under the grant. In connection with the anthrax antibody program, we also ceased all future research and development work related to the Xenerex program on June 30, 2008.
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 and (2) diabetic peripheral neuropathic ("DPN pain"). In October 2006, we received an "approvable" letter from the FDA for Zenvia in the treatment of patients with PBA. 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 concerns relating to the original dose formulation that was tested in our earlier trials. However, to address the remaining 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 at a lower dose. 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 as of August 2008, we are on target with our expected enrollment numbers. In May 2008, we informed the FDA of our intention to increase the planned patient enrollment numbers from 270 to approximately 300 in order to provide additional statistical power to the trial and increase the size of our safety database. We continue to expect this study to be completed (as defined as top-line safety and efficacy data becomes available) during the second half of calendar 2009, even after allowing for the increase in the size of the trial.
In April 2007, we announced positive top-line data results from our first Phase III clinical trial of Zenvia for DPN pain. Before discussing a further Phase III trial with the FDA, we made the decision to conduct 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 FDA's concerns raised over Zenvia for PBA. In May 2008, we reported a positive outcome of the formal PK study and announced that we identified alternative lower-dose quinidine formulations of Zenvia for DPN pain. The two new doses are intended to deliver similar efficacy and improved safety/tolerability versus the formulations previously tested for this indication. We intend to incorporate the PK study data into the Zenvia patent portfolio, submit a Phase III protocol to FDA under Special Protocol Assessment ("SPA") process by year end calendar 2008 and evaluate strategic options for funding further development in DPN pain. Docosanol 10% Cream
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 AbrevaŽ 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. Starting in fiscal 2007, annual Abreva sales exceeded this threshold and we began participating in the excess royalties at that time.
Inflammation Program
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. We initially provided contract research services to Novartis to support this program for two years and, in March 2007, Novartis made the decision to continue the MIF research program internally and to allow the research collaboration portion of this agreement to expire without renewal. 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.
In March 2008, we entered into an Asset Purchase and License Agreement with Emergent Biosolutions for the sale of our anthrax antibodies and license to use our proprietary Xenerex Technology platform. Under the terms of the Agreement, we are obligated to complete the remaining work under our NIH/NIAID grant ("NIH grant"). As such, revenue resulting from upfront payments totaling $250,000 that were received in the second fiscal quarter of 2008 will be deferred until the remaining work is completed under the Agreement. The NIH/NIAID grant ("NIH grant"), which funded the anthrax antibody program, expired on June 30, 2008. All work was completed under the grant. In connection with the anthrax antibody program, we also ceased all future research and development work related to the Xenerex program on June 30, 2008.
Restructuring Activities
In May 2006, we acquired FazaCloŽ (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, a launch that 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. 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 $10.0 million in contingent payments to be paid in calendar year 2009, subject to certain regulatory conditions. In addition, we are eligible to receive up to $2.0 million in royalties, based on 3% of annualized net product revenues in excess of $17.0 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, as well as the divestiture of our drug discovery operations in San Diego, 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 have suspended all funding activities for our selective cytokine inhibitor program and have also ended all further prosecution and maintenance of associated patents.

As a result of these initiatives, we have undergone significant organizational changes since fiscal 2007. Our principal focus is currently on gaining regulatory approval for Zenvia TM, 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 and the proceeds from the April 2008 common stock offering will be sufficient to fund our operations, including our ongoing confirmatory Phase III trial for Zenvia in patients with PBA, through the date by which we expect that FDA will render an approval decision with respect to Zenvia for PBA. 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 SEC. No portion of our website is incorporated by reference into this Quarterly Report on Form 10-Q. 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.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES To understand our financial statements, it is important to understand our critical accounting policies and estimates. The preparation of our financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates and assumptions are required in the determination of revenue recognition and sales deductions for estimated chargebacks, rebates, sales incentives and allowances, certain royalties and returns and losses. Significant estimates and assumptions are also required in the appropriateness of capitalization and amortization periods for identifiable intangible assets, inventories, the potential impairment of goodwill and other intangible assets, income taxes, contingencies, estimate on net working capital adjustment and stock-based compensation. Some of these judgments can be subjective and complex, and, consequently, actual results may differ from these estimates. For any given individual estimate or assumption made by us, there may also be other estimates or assumptions that are reasonable. Although we believe that our estimates and assumptions are reasonable, they are based upon information available at the time the estimates and assumptions are made. Actual results may differ significantly from our estimates.
A summary of significant accounting policies and a description of accounting policies that are considered critical may be found in Part II, Item 7 of our Annual Report on Form 10-K for the year ended September 30, 2007 in the "Critical Accounting Policies and Estimates" section and in Note 2 of the Notes to our condensed consolidated financial statements included herein.

RESULTS OF OPERATIONS
COMPARISON OF THREE MONTHS ENDED JUNE 30, 2008 AND 2007
Revenues and Cost of Revenues

                                                    Three Months ended
                                                         June 30,
                                                 2008               2007              $ Change           % Change
PRODUCT SALES
Net revenues                                  $     3,550        $         -        $      3,550               100 %
Cost of revenues                                        -                  -                   -                 0 %

Gross margin                                  $     3,550        $         -        $      3,550               100 %

LICENSES, RESEARCH SERVICES AND GRANTS
Revenues:
Research services                             $         -        $   181,692        $   (181,692 )            -100 %
Government research grant                         527,517            122,398             405,119               331 %
License agreements                              1,534,552          1,443,543              91,009                 6 %
Royalty and sale of royalty rights                584,314            453,091             131,223                29 %

Revenues from licenses, research
services and grants                             2,646,383          2,200,724             445,659                20 %

Costs:
Research services                                 155,450          1,202,476          (1,047,026 )             -87 %
Government research grant                         358,028            201,178             156,850                78 %

Costs from research services and grants           513,478          1,403,654            (890,176 )             -63 %

Research services and other gross margin        2,132,905            797,070           1,335,835               168 %

Total gross margin                            $ 2,136,455        $   797,070        $  1,339,385               168 %

Revenues
Net product revenues for the three months ended June 30, 2008 include sales of docosanol 10% cream of $4,000. Revenues from licenses, royalties, research services and grants increased by $446,000 to $2.6 million for the third quarter of fiscal 2008 compared to $2.2 million in the third quarter of fiscal 2007. The increase in revenues is attributed to an increase of $405,000 in government grant revenue related to our anthrax antibody program, which ended June 30, 2008. This increase is offset by a decrease in research revenue of $182,000 primarily related to our research services agreements with AstraZeneca and Novartis, neither of which are still active.
Potential revenue-generating contracts that remained active as of June 30, 2008 include several docosanol 10% cream license agreements and our license agreement with Novartis for our MIF technology. We may continue to seek partnerships with pharmaceutical companies that can help fund our operations in exchange for sharing in the success of any licensed compounds or technologies. Cost of Revenues
Cost of licenses, research services and grants declined to $513,000 or 19% of revenues for the third quarter of fiscal 2008 compared with $1.4 million or 64% of revenues for the third quarter of fiscal 2007. The decline in cost of revenues is primarily attributed to a 87% decline in the cost of research services due to the termination of the AstraZeneca agreement and non-renewal of the Novartis agreement. The cost of licenses, research services and grants includes primarily direct and indirect payroll costs and the costs of outside vendors.

Operating Expenses

                                                    Three Months ended
                                                         June 30,
                                                 2008                2007              $ Change          % Change
OPERATING EXPENSES
Research and development                      $ 3,139,685        $  2,604,294        $    535,391               21 %
Selling, general and administrative             2,350,071           7,469,784          (5,119,713 )            -69 %

Total Operating Expenses                      $ 5,489,756        $ 10,074,078        $ (4,584,322 )            -46 %

Research and Development Expenses
Research and development expenses increased by $535,000 from $2.6 million in the third quarter of fiscal 2007 to $3.1 million for the third quarter of fiscal 2008. The increase is primarily due to increased costs incurred for Zenvia due to the confirmatory Phase III trial for the PBA indication of Zenvia. 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 by $5.1 million from $7.5 million for the third quarter of fiscal 2007 compared to $2.4 million for the third quarter of fiscal 2008. The decrease is primarily attributed to a decrease in our overall selling, general and administrative expenses as a result of the restructuring and the significant organizational changes that we made to our infrastructure in the last half of fiscal 2007. Specifically, the decrease is primarily attributed to expense reductions in personnel, legal and consulting expenses.
Share-Based Compensation
During the second quarter of fiscal 2007, we updated our projected forfeiture rates as it applies to stock-based compensation considering recent actual data. Forfeiture rates for the nine month periods ended June 30, 2008 and 2007 were estimated to be approximately 30% based on our historical experience. Future estimates may differ substantially from our current estimates. Total compensation expense for our share-based payments in the three month period ended June 30, 2008 and the same period in 2007 was $351,000 and $538,000, respectively. Selling, general and administrative expense in the three month periods ended June 30, 2008 and 2007 include share-based compensation expense of $279,000 and $247,000, respectively. Research and development expense in the three month periods ended June 30, 2008 and 2007 include share-based compensation expense of $72,000 and $119,000, respectively. As of June 30, 2008, $4.0 million of total unrecognized compensation costs related to nonvested options and awards is expected to be recognized over a weighted average period of 2.0 years. See Note 12, "Employee Equity Incentive Plans" in the Notes to Condensed Consolidated Financial Statements (Unaudited) for further discussion. Other Income (Expenses)
For the three month period ended June 30, 2008, interest expense decreased to $114,000, compared to $233,000 for the same period in the prior year. The decrease in interest expense in 2008 is primarily due to a 3% decrease in the interest rate applied to Senior Notes as compared to the prior year. In addition, the balance on the Notes decreased as compared to the prior year, mostly attributed to the $11 million payment made in August 2007. The Seller Notes were issued in connection with the purchase of Alamo.
For the three month period ended June 30, 2008, interest income increased to $316,000, compared to $89,000 for the same period in the prior year. The increase is due to approximately a 500% increase in the average balance of cash, cash equivalents and investments in securities for the quarter ended June 30, 2008, compared to the same period in the prior year.

In the third fiscal quarter of 2008, a gain on extinguishment of debt was recorded in the amount of $968,000 resulting from the Company's accelerated re-payment of the outstanding principal under the Senior Notes. The Company paid $10.9 million in full satisfaction of the Notes. The accelerated repayment of the Notes represented an estimated savings of approximately $1.2 million in principal and interest payments through the original Maturity Date, net of estimated lost earnings on cash balances that would have been held through the Maturity Date.
In September 2007, a court awarded us 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. In April 2008, we received the settlement in the amount of $1.25 million. The settlement was recorded in Other Income in the third quarter of fiscal 2008.
Loss from Discontinued Operations
Loss from discontinued operations was $484,000 in the three month period ended June 30, 2008, compared to loss from discontinued operations of $1.1 million for the three month period ended June 30, 2007. The loss recognized in the three month period ended June 30, 2008 is attributed to the accrual for the Net Working Capital Adjustment of $484,000.
Net Loss
Net loss was $1.4 million, or $0.02 per share, in the three month period ended June 30, 2008, compared to a net loss of $9.2 million, or $0.23 per share for the three month period ended June 30, 2007.
COMPARISON OF NINE MONTHS ENDED JUNE 30, 2008 AND 2007

Revenues and Cost of Revenues

                                                    Nine Months ended
                                                         June 30,
                                                 2008               2007              $ Change           % Change
PRODUCT SALES
Net revenues                                  $   129,820        $         -        $    129,820               100 %
Cost of revenues                                   21,714                  -              21,714               100 %

Gross margin                                  $   108,106        $         -        $    108,106               100 %

LICENSES, RESEARCH SERVICES AND GRANTS
Revenues:
Research services                             $         -        $ 2,372,384        $ (2,372,384 )            -100 %
Government research grant                       1,006,922            475,474             531,448               112 %
License agreements                              1,648,459          1,556,827              91,632                 6 %
Royalty and sale of royalty rights              2,993,992          1,955,804           1,038,188                53 %

Revenues from licenses, research
services and grants                             5,649,373          6,360,489            (711,116 )             -11 %

Costs:
Research services                                 232,257          2,973,715          (2,741,458 )             -92 %
Government research grant                         915,563            666,166             249,397                37 %

Costs from research services and grants         1,147,820          3,639,881          (2,492,061 )             -68 %

Research services and other gross margin        4,501,553          2,720,608           1,780,945                65 %

Total gross margin                            $ 4,609,659        $ 2,720,608        $  1,889,051                69 %

Revenues
Net product revenues for the nine months ended June 30, 2008 include sales of docosanol 10% cream of $130,000. Revenues from licenses, royalties, research services and grants declined by $700,000 to $5.6 million for the first nine months of fiscal 2008 compared to $6.4 million in the first nine months of fiscal 2007. The decrease in revenues is attributed to a decline in revenue of $2.4 million from research services from our agreements with AstraZeneca and Novartis. In the second fiscal quarter of 2008, neither of the collaboration services agreements with

AstraZeneca or Novartis were still active, although our license agreement with Novartis remained in effect at that time.
The revenue decrease was partially offset by an increase in revenue from royalties of $1 million. The increase in royalty revenue is related to royalty revenue from GSK of $934,000 recorded in the first quarter of 2008 an increase of $720,000 from the prior year, pursuant to the royalty sale arrangement relating to our GSK license agreement in which we are entitled to receive 4% of all annual net sales of Abreva in North America in excess of $62 million. Potential revenue-generating contracts that remained active as of June 30, 2008 include several docosanol 10% cream license agreements and our license agreement with Novartis for our MIF technology. Partnering, licensing and research collaborations have been, and may continue to be, an important part of our business development strategy. We may continue to seek partnerships with . . .