UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q


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

For the Quarterly period ended September 30, 2003.


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to .

Commission File No. 000-31101

APPLIED MOLECULAR EVOLUTION, INC.

(Exact name of registrant as specified in its charter)


Delaware		33-0374014
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

3520 Dunhill Street

San Diego, California 92121

(Address of principal executive offices and zip code)

(858) 597-4990

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES x NO o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

YES x NO o

20,968,700 shares of the Registrant’s Common Stock were outstanding as of September 30, 2003.

TABLE OF CONTENTS


		CONSOLIDATED BALANCE SHEETS
		CONSOLIDATED STATEMENTS OF OPERATIONS
		CONSOLIDATED STATEMENTS OF CASH FLOWS
		NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
	ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
	ITEM 4: CONTROLS AND PROCEDURES
PART II: OTHER INFORMATION
	ITEM 1: LEGAL PROCEEDINGS
	ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS
	ITEM 3: DEFAULTS UPON SENIOR SECURITIES
	ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
	ITEM 5: OTHER INFORMATION
	ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURES
EXHIBIT 10.35
EXHIBIT 10.36
EXHIBIT 10.37
EXHIBIT 10.38
EXHIBIT 10.39
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

APPLIED MOLECULAR EVOLUTION, INC.
FORM 10-Q INDEX


			PAGE

PART I: FINANCIAL INFORMATION
	ITEM 1: Financial Statements			3
		Consolidated Balance Sheets at September 30, 2003 (unaudited), and December 31, 2002		3
		Consolidated Statements of Operations for the three and nine months ended September 30, 2003 and 2002 (unaudited)		4
		Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and 2002 (unaudited)		5
		Notes to Consolidated Financial Statements (unaudited)		6
	ITEM 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations			8
	ITEM 3: Quantitative and Qualitative Disclosures About Market Risk			15
	ITEM 4: Controls and Procedures			15
PART II: OTHER INFORMATION
	ITEM 1: Legal Proceedings			15
	ITEM 2: Changes in Securities and Use of Proceeds			16
	ITEM 3: Defaults Upon Senior Securities			16
	ITEM 4: Submission of Matters to a Vote of Security Holders			16
	ITEM 5: Other Information			16
	ITEM 6: Exhibits and Reports on Form 8-K			16
SIGNATURES				18
EXHIBITS				19

APPLIED MOLECULAR EVOLUTION, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)


			SEPTEMBER 30,			DECEMBER 31,
			2003			2002

			(UNAUDITED)
ASSETS
Current assets:
	Cash and cash equivalents		$	7,637		$	6,336
	Short-term investments			36,021			44,783
	Prepaid expenses			318			448
	Other current assets			2,772			922

		Total current assets		46,748			52,489
Restricted cash, cash equivalents and short-term investments				—			10,500
Property and equipment, net				16,659			14,490
Patents, net				2,131			1,985
Other assets				327			507

		Total assets	$	65,865		$	79,971

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable		$	1,477		$	958
	Accrued liabilities			2,449			1,613
	Current portion of long-term debt			1,707			—
	Current portion of long-term lease obligations			125			—
	Current portion of deferred revenue			287			1,214

		Total current liabilities		6,045			3,785
Deferred revenue				1,250			158
Deferred rent				224			86
Long-term debt, net of current				4,293			10,000
Long-term lease obligation, net of current portion				490			—
Minority interest				100			—
Stockholders’ equity:
	Preferred stock, $.001 par value, 5,000,000 shares authorized, none issued			—			—
	Common stock, $.001 par value, 45,000,000 shares authorized, 24,041,811 and 23,661,477 shares issued at September 30, 2003, and December 31, 2002, respectively			24			24
	Additional paid-in capital			161,612			160,588
	Deferred compensation			(198	)		(1,213	)
	Notes receivable from employees			(994	)		(941	)
	Accumulated other comprehensive income			327			761
	Accumulated deficit			(85,622	)		(71,591	)
	Less: Treasury stock at cost, 3,073,111 shares			(21,686	)		(21,686	)

		Total stockholders’ equity		53,463			65,942

		Total liabilities and stockholders’ equity	$	65,865		$	79,971

See accompanying notes.

APPLIED MOLECULAR EVOLUTION, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)


		THREE MONTHS ENDED						NINE MONTHS ENDED
		SEPTEMBER 30,						SEPTEMBER 30,

		2003			2002			2003			2002

Revenues:
	Contract revenue from collaborations	$	626		$	1,199		$	3,332		$	3,979
	Other revenue		838			258			2,789			1,673

	Total revenue		1,464			1,457			6,121			5,652

Operating expenses:
	Research and development		5,919			3,315			15,446			10,406
	General and administrative		1,361			2,972			5,582			8,173
	Stock-based compensation		237			711			1,023			2,615

	Total operating expenses		7,517			6,998			22,051			21,194

Loss from operations			(6,053	)		(5,541	)		(15,930	)		(15,542	)
Minority interest			106			402			709			402
Interest income, net			240			638			1,190			2,281
Other financing charges			—			(604	)		—			(604	)

Net loss		$	(5,707	)	$	(5,105	)	$	(14,031	)	$	(13,463	)

Net loss per share, basic and diluted		$	(0.27	)	$	(0.24	)	$	(0.68	)	$	(0.62	)
Weighted average shares outstanding, basic and diluted			20,921			21,227			20,760			21,672

See accompanying notes.

APPLIED MOLECULAR EVOLUTION, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)


		NINE MONTHS ENDED SEPTEMBER 30,

		2003			2002

OPERATING ACTIVITIES
Net loss		$	(14,031	)	$	(13,463	)
Adjustments to reconcile net loss to net cash used in operating activities:
	Depreciation and amortization		1,051			1,082
	Amortization of stock-based compensation		1,007			2,583
	Compensation related to consultant stock options		15			33
	Deferred revenue		165			(1,526	)
	Deferred rent		138			(25	)
	Minority interest		(709	)		(402	)
	Realized gain on short-term investments		(141	)		(133	)
	Accrued interest on notes receivable from employees		(53	)		(45	)
	Other financing charges		—			604
Changes in operating assets and liabilities:
	Prepaid expenses and other assets		(1,540	)		3,239
	Accounts payable and accrued expenses		1,355			1,696

Net cash used in operating activities			(12,743	)		(6,357	)

INVESTING ACTIVITIES
Restricted cash, cash equivalents and short-term investments			10,500			(10,541	)
Purchase of property and equipment			(3,098	)		(11,802	)
Purchase of short-term investments			(21,456	)		(57,390	)
Proceeds from sale of short-term investments			29,925			60,071
Patents			(268	)		(217	)

Net cash provided by (used in) investing activities			15,603			(19,879	)

FINANCING ACTIVITIES
Proceeds from long-term obligations			6,615			10,000
Payments on long-term obligations			(10,000	)		—
Proceeds from issuance of convertible notes			—			406
Issuance of common stock, net			342			213
Purchase of treasury stock			—			(7,286	)
Investment in subsidiary by minority investors, net			1,484			482

Net cash (used in) provided by financing activities			(1,559	)		3,815

Net increase (decrease) in cash and cash equivalents			1,301			(22,421	)
Cash and cash equivalents at the beginning of the period			6,336			25,927

Cash and cash equivalents at the end of the period		$	7,637		$	3,506

Supplemental non-cash disclosure
Conversion of notes payable to equity in subsidiary		$	—		$	(406	)

See accompanying notes.

APPLIED MOLECULAR EVOLUTION, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1. Organization and Business

Applied Molecular Evolution, Inc. (the “Company” or “AME”), a Delaware corporation, was incorporated on August 14, 1989. The Company has a broad technology platform termed the AMEsystem™, which the Company’s management believes will provide AME with a valuable and efficient solution to optimizing proteins with commercial potential. The Company applies its proprietary technology to optimize proteins from all major classes of therapeutic proteins including antibodies, cytokines, hormones, enzymes and growth factors. AME’s majority-owned subsidiary, Novasite Pharmaceuticals, Inc. (“Novasite”), applies directed molecular evolution to small-molecule drug discovery and optimization.

2. Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and disclosures required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The results of operations for the interim period are not necessarily indicative of results to be expected for any other interim period or for the year as a whole. These unaudited consolidated financial statements and disclosures thereto should be read in conjunction with the audited financial statements and disclosures thereto contained in the Company’s annual report on Form 10-K for the year ended December 31, 2002.

The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and related disclosures. Changes in the estimates may affect amounts reported in future periods.

The consolidated financial statements include the accounts of the Company, its majority-owned subsidiary, Novasite, and its wholly owned subsidiary AME Torrey View, LLC (“Torrey View”). As of September 30, 2003, Novasite was 51% owned by AME. All significant intercompany accounts and transactions have been eliminated.

3. Notes Payable

During the third quarter, the Company entered into an equipment term loan for $6.0 million. This note bears interest at an annual rate of 6.5% and is payable over 36 months. This note is collateralized by specific underlying property and equipment with a book value of $3.6 million. The loan is subject to certain covenants including maintaining a minimum cash balance of $9.0 million.

The Company also entered into a leaseline whereby the Company may draw up to $4.0 million for qualifying equipment purchases. As of September 30, 2003, the Company had utilized $615,000 of the available amount and has approximately $3.4 million available for future equipment purchases. This lease bears an effective annual interest rate of 6.9% and is payable over 48 months.

4. Commitments

During the third quarter, the Company amended its current operating lease agreement for its primary operating facilities. The amended terms provide for the facilities to be leased through December 2008, with specific rent escalations. Rent expense will continue to be recorded on a straight-line basis.

On August 17, 2001, the Company entered into an Operating Agreement with Torrey View Phase II, L.P., (“TV”), to establish Torrey View. On March 4, 2002, Torrey View purchased a 10.73-acre parcel of undeveloped land in San Diego County from a third party at a cost of approximately $8.0 million. The Company may develop this property over the next few years as its corporate headquarters. The Company could also seek alternative uses for the property or sell the property if development would be inconsistent with the Company’s liquidity and cash resource needs.

In connection with the purchase, the Company borrowed approximately $10.0 million, under a $15.0 million credit facility, from Merrill Lynch Business Financial Services to fund the purchase price and certain development costs. As of June 30, 2003, the Company had repaid the outstanding loan balance under the credit facility, and all restricted cash which had collateralized the outstanding loan balance had been released.

On June 16, 2003, the Company entered into an agreement with TV to purchase TV’s interest in Torrey View for $3,169,000, of which $3,000,000 had been previously advanced to TV and accounted for as a project cost. The remaining $169,000 was expensed. This payment was in lieu of TV’s contractual right to receive a $3,750,000 payment for termination of TV’s economic interest in Torrey View. The Company is now the sole member of Torrey View.

On July 25, 2002, a petition was filed in the Superior Court of the State of California, County of San Diego, by the Torrey Hills Community Coalition, et al., (“Coalition”), against the City of San Diego, et al. seeking to compel the City of San Diego to revoke the approval which was previously issued with respect to the development of our corporate headquarters. A petition was also filed by the Del Mar Union School District, (“School District”), on October 25, 2002, seeking a similar legal remedy. These petitions assert that the City of San Diego failed to comply with or violated various legal requirements in connection with its approval of that development, but they do not seek monetary relief from the Company. We understand that the City of San Diego believes that it has complied with all legal requirements for this project and therefore intends to vigorously oppose these petitions. The Company is named as a real party in interest, and we also intend to vigorously oppose these petitions and believe that they will not have a material adverse effect on our business.

On June 18, 2003, following a hearing on the merits of the petition of the Coalition, the Superior Court issued an order denying the petition and ruled in favor of the City of San Diego and AME. The Coalition has appealed the order denying its petition to the California Court of Appeals. The Company and the City of San Diego intend to oppose the appeal.

On August 29, 2003, the Superior Court granted a demurrer by the Company and dismissed the petition of the School District for failing to name Torrey View as a necessary real party in interest. The School District has filed an amended petition naming Torrey View as a real party in interest. The Company intends to demur to the amended petition.

5. Comprehensive Loss

Total comprehensive loss was $14,465,000 for the nine months ended September 30, 2003, and $13,321,000 for the nine months ended September 30, 2002. The difference between net loss and comprehensive loss is primarily due to the difference between the market value and the cost basis of the Company’s short-term marketable securities.

6. Computation of Net Loss Per Share

Basic and diluted net loss per share are presented in conformity with Statement of Financial Accounting Standards (“SFAS”) No. 128, Earnings per Share. In accordance with SFAS No. 128, basic and diluted net loss per share has been computed using the weighted average number of shares of common stock outstanding during the period, less shares subject to repurchase. To the extent common stock equivalents (stock options) are dilutive, they would be included in diluted per share amounts.

7. Stock-based Compensation

The Company has in effect several stock-based plans under which nonqualified and incentive stock options have been granted to employees, consultants and directors. As required by SFAS No. 123, Accounting for Stock-Based Compensation and SFAS No. 148, Accounting for Stock-Based Compensation Transition and Disclosure, the pro forma effects of stock-based compensation on net income (loss) and net earnings (loss) per common share are estimated at the date of grant using the Black-Scholes option-pricing model. For purposes of pro forma disclosures, the estimated fair value of the options is amortized as an expense over the options’ vesting period. The Company’s pro forma net loss information is as follows (in thousands, except per share amounts):


	For the Three Months Ended						For the Nine Months Ended
	September 30,						September 30,

	2003			2002			2003			2002

	(Unaudited)			(Unaudited)			(Unaudited)			(Unaudited)

Net loss attributable to common stockholders, as reported	$	(5,707	)	$	(5,105	)	$	(14,031	)	$	(13,463	)
Net loss attributable to common stockholders, pro forma	$	(6,850	)	$	(6,180	)	$	(17,351	)	$	(16,469	)
Basic and diluted net loss per share, as reported	$	(0.27	)	$	(0.24	)	$	(0.68	)	$	(0.62	)
Basic and diluted net loss per share, pro forma	$	(0.33	)	$	(0.29	)	$	(0.84	)	$	(0.76	)

8. MedImmune, Inc. (“MedImmune”)

In September 2003, the Company achieved two milestones as a result of the initiation by MedImmune of Phase II trials for Vitaxin^® in both rheumatoid arthritis and melanoma. In accordance with the terms of the license agreement, MedImmune has a certain period of time from the date of the milestone-triggering event to elect to have the milestone payment treated as cash milestones or as equity purchased at a premium. If the milestone payment is recognized as an equity purchase, 20% of the amount will be recorded as deferred royalty revenue. If the milestone payment is recognized as a cash milestone, 35% of the payment will be recognized as milestone revenue, and the remaining 65% will be recognized as deferred royalty revenue. The Company received payment of the milestones in October 2003, however, because the election of payment method described above has not been made, the entire amount of the milestones is included as deferred revenue in the accompanying balance sheet.

9. Novasite Financing

In June 2003, the Company’s subsidiary, Novasite, received $500,000 as consideration for the issuance of 500,000 shares of preferred stock to Crabtree Ventures, L.P. (“Crabtree”). John F. Richards, one of our directors, is the President of Crabtree Ventures, L.L.C., the general partner of Crabtree, a minority investor in Novasite. In addition, Novasite issued 221,000 shares of preferred stock to AME in exchange for the cancellation of $221,000 of accounts payable due to AME. In April 2003 and January 2003, Novasite received $250,000 and $750,000, respectively, as consideration for the issuance of 250,000 and 750,000 shares of preferred stock, respectively, to Crabtree.

In January 2002, Novasite received $200,000 from a private placement of 10% convertible notes with AME and Crabtree. These notes, which did not have a material beneficial conversion feature or include warrants, were converted into preferred stock of Novasite in connection with the financing which closed on September 30, 2002. In addition, in August 2002, Novasite received $350,000 from a private placement of 10% convertible notes with Crabtree. The notes plus accrued interest were converted at a discounted price into preferred stock of Novasite in connection with the financing which closed on September 30, 2002. Novasite recorded a debt discount of $477,000 related to the beneficial conversion feature of the notes, and the full amount of the debt discount was recorded as other financing charges as of September 30, 2002. In connection with the issuance of the August 2002 convertible notes, Novasite issued warrants to purchase 350,000 shares of preferred stock. The warrants are fully vested and expire in August 2006. Novasite recorded a debt discount related to the warrants of $127,000 based upon a Black-Scholes valuation, which was recorded as other financing charges as of September 30, 2002, when the notes were converted. In addition to the conversion of notes held by Crabtree and AME and related accrued interest as of September 30, 2002, which totaled $554,041, Novasite received cash proceeds of $500,000 and issued 1,430,304 shares of preferred stock. In November 2002, Novasite received an additional $250,000 as consideration for the issuance of 250,000 shares of preferred stock to Crabtree.

ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The statements in this quarterly report that are not descriptions of historical facts may be forward-looking statements that are subject to risks and uncertainties. Actual results could differ materially from those currently anticipated due to a number of factors, including those identified below and in our other publicly available documents. We are under no obligation to update any of these forward-looking statements after the filing of this quarterly report to reflect actual results or changes in our expectations.

The following information should be read in conjunction with the consolidated financial statements and the notes thereto included in Item 1 of this quarterly report. We also urge readers to review and consider our disclosures describing various factors that affect our business, including the disclosures under Management’s Discussion and Analysis of Financial Condition and Results of Operations and Risk Factors and the audited financial statements and notes thereto contained in our annual report on Form 10-K for the year ended December 31, 2002.

OVERVIEW

We are a leader in the application of directed molecular evolution to the optimization and development of human biotherapeutics. Directed molecular evolution is a process by which genes and proteins are optimized for specific commercial purposes. Our technology has been validated by, among other things, the ongoing clinical trials of Vitaxin, a humanized and optimized therapeutic monoclonal antibody candidate, that AME licensed to MedImmune, Inc. (“MedImmune”), the successful creation of Numax™ candidates by optimizing Synagis® for MedImmune and the engineering of product candidates AME-527 and AME-133, optimized versions of the FDA-approved, currently marketed monoclonal antibodies Remicade® and Rituxan®, respectively. We use our proprietary AMEsystem technology to rapidly create improvements in proteins that would be less efficient and more expensive to achieve through conventional methods. Since our inception, our principal focus has been on applying our technology to human biotherapeutics, the largest and most profitable target market for directed molecular evolution. We plan to use our directed molecular evolution technology to develop improved versions of FDA-approved, currently marketed biopharmaceuticals as well as novel human biotherapeutics. AME’s majority-owned subsidiary, Novasite, applies directed molecular evolution to small-molecule drug discovery and optimization.

Since our formation, we have expended considerable resources on the development of our AMEsystem technology and the development of Vitaxin, a product candidate engineered from an antibody we licensed from The Scripps Research Institute. Much of our research and development from 1995 to 1999 was allocated to preclinical development and initial clinical trials of Vitaxin. In 1999, we licensed Vitaxin to MedImmune, which is responsible for current and future clinical development expenses and commercialization.

To date we have generated revenue from corporate collaborations, product candidate and technology licenses, royalties and government grants. We have corporate collaborations with MedImmune, Inc., Eli Lilly and Company, Centocor, Inc., Chiron Corporation, CancerVax, Inc., Biosynexus Incorporated, Bristol-Myers Squibb Company, Seattle Genetics, Inc. and Aventis Pharmaceuticals, Inc., the final one through our majority-owned subsidiary, Novasite. We have licensed intellectual property to Biosite Incorporated in exchange for a nonrefundable, prepaid, fixed royalty which is being recognized over six years, the estimated useful lives of the related patents. Our government grants have come from the National Institutes of Health (“NIH”).

Research funding from corporate collaborators and government grants is recognized as revenue when the services are rendered.

We have incurred losses since our inception. As of September 30, 2003, we had an accumulated deficit of $85.6 million. The losses and this accumulated deficit resulted from the significant costs incurred in the development of our proprietary AMEsystem technology platform, our internal development projects and the preclinical and clinical development of Vitaxin. We expect these losses to increase as we continue to invest in our AMEsystem technology and our internal development projects, including AME-527 and AME-133.

See Note 4 of Notes to Consolidated Financial Statements and Item 1 of Part II for matters related to the Company’s wholly owned subsidiary, AME Torrey View, LLC.

On June 25, 2001, we filed a complaint against MorphoSys AG and its wholly owned subsidiary MorphoSys USA, Inc. (collectively, “MorphoSys”), in the United States District Court for the District of Massachusetts seeking injunctive relief and damages on behalf of the Company. The complaint alleges that MorphoSys is willfully infringing the Kauffman patent family under which we hold an exclusive license.

On January 6, 2003, we announced a report and recommendation from the magistrate judge in the United States District Court for the District of Massachusetts to the district judge in our legal action against MorphoSys that MorphoSys’ motion for summary judgment of non-infringement be allowed and that AME’s motion for partial summary judgment of infringement be denied and all other motions be dismissed as moot. We have filed objections to the magistrate judge’s report and recommendation. The district judge may adopt, reject or modify the magistrate judge’s recommendation or instruct the magistrate judge to reconsider the recommendation.

RESULTS OF OPERATIONS

Three Months Ended September 30, 2003, Compared to Three Months Ended September 30, 2002

Revenues. Our revenues were $1.5 million for the quarter ended September 30, 2003, and also $1.5 million for the same period in 2002.

Research and development. Research and development expenses increased to $5.9 million for the quarter ended September 30, 2003, from $3.3 million for the same period in 2002, an increase of approximately $2.6 million. The increase was primarily due to increased research and development staffing and the expansion of research and development activities in support of our internal development projects.

General and administrative. General and administrative expenses decreased to $1.4 million for the quarter ended September 30, 2003, from $3.0 million for the same period in 2002, a decrease of approximately $1.6 million. The decrease was primarily due to the decrease in legal expenses incurred in our litigation against MorphoSys.

Stock-based compensation. Deferred compensation for options granted to employees is the difference between the exercise price and the estimated fair value of our common stock on the date the options were granted. Deferred compensation is included as a component of stockholders’ equity and is being amortized on an accelerated basis in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 28 over the vesting periods of the related options, which is generally four years.

Deferred compensation for options granted to consultants has been determined in accordance with SFAS No. 123, Accounting for Stock-Based Compensation, as the fair value of the equity instruments issued, and is periodically remeasured as the underlying options vest in accordance with the Emerging Issues Task Force’s No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.

For the three months ended September 30, 2003, we recorded non-cash, stock-based compensation of $237,000 ($82,000 and $155,000 related to research and development and general and administrative, respectively), compared to $711,000 ($229,000 and $482,000 related to research and development and general and administrative, respectively) for the same period in 2002.

Interest income, net. Net interest income decreased to $240,000 for the quarter ended September 30, 2003 from $638,000 for the same period in 2002, a decrease of approximately $398,000. The decrease was primarily due to lower interest rates and lower cash, cash equivalent and short-term investment balances in 2003.

Other financing charges. We incurred no other financing charges for the three-month period ended September 30, 2003, compared to $604,000 for the three-month period ended September 30, 2002. The decrease is due to a non-cash finance charge related to the issuance and conversion of convertible debt at below market price and the issuance of warrants by our majority-owned subsidiary, Novasite, to one of its minority investors (See Note 9).

Nine Months Ended September 30, 2003, Compared to Nine Months Ended September 30, 2002

Revenues. Our revenues increased to $6.1 million for the nine months ended September 30, 2003, from $5.7 million for the same period in 2002, an increase of approximately $400,000. The increase was primarily due to revenue recognized under our grants from the NIH.

Research and development. Research and development expenses increased to $15.4 million for the nine months ended September 30, 2003, from $10.4 million for the same period in 2002, an increase of approximately $5.0 million. The increase was primarily related to additional research and development staffing and expansion of facilities to support our internal development projects.

General and administrative. General and administrative expenses decreased to $5.6 million for the nine months ended September 30, 2003, from $8.2 million for the same period in 2002, a decrease of approximately $2.6 million. The decrease was primarily due to the decrease in legal expenses incurred in our litigation against MorphoSys.

For the nine months ended September 30, 2003, we recorded non-cash, stock-based compensation of $1.0 million ($337,000 and $686,000 related to research and development and general and administrative, respectively), compared to $2.6 million ($845,000 and $1.8 million related to research and development and general and administrative, respectively) for the same period in 2002.

Interest income, net. Net interest income decreased to $1.2 million for the nine months ended September 30, 2003, from $2.3 million for the same period in 2002, a decrease of approximately $1.1 million. The decrease was primarily due to lower interest rates and lower cash, cash equivalent and short-term investment balances in 2003.

Other financing charges. We incurred no other financing charges for the nine-month period ended September 30, 2003, compared to

$604,000 for the nine-month period ended September 30, 2002. The decrease is due to a non-cash finance charge related to the issuance and conversion of convertible debt at below market price and the issuance of warrants by our majority-owned subsidiary, Novasite, to one of its minority investors (See Note 9).

LIQUIDITY AND CAPITAL RESOURCES

In July 2000, we sold 5.3 million shares of common stock in an initial public offering resulting in net proceeds to the Company of approximately $94.5 million (excluding offering expenses). Prior to the initial public offering, we had financed our operations primarily through private placements of equity securities, with aggregate net proceeds of approximately $39.9 million. In addition, we have generated $26.8 million of cash from corporate collaborations through September 30, 2003.

As of September 30, 2003, we had approximately $43.7 million in unrestricted cash, cash equivalents and short-term investments, compared to $51.1 million of unrestricted cash, cash equivalents and short-term investments as of December 31, 2002. As of September 30, 2003, we had no restricted cash, reflecting full repayment of the Merrill Lynch Business Financial Services Credit facility which had a $10.5 million restricted cash balance as of December 31, 2002.

For the nine months ended September 30, 2003, we used cash of approximately $12.7 million in operating activities, net of non-cash charges for depreciation and patent amortization totaling $1.1 million, non-cash, stock based compensation totaling $1.0 million, an increase in deferred revenue of $165,000 and changes in operating assets and liabilities of $185,000.

For the nine months ended September 30, 2003, we generated cash of approximately $15.6 million from investing activities. Our investing activities consisted primarily of sales and maturities of short-term investments offset by purchases of short-term investments and property and equipment. We expect to continue to make investments in our infrastructure, including purchasing property and equipment to support our operations.

For the nine months ended September 30, 2003, we used cash of approximately $1.6 million for financing activities. Our financing activities consisted primarily of the repayment of our Merrill Lynch Business Financial Services credit facility of $10.0 million. This was offset by cash proceeds of $6.6 million received from our collateralized equipment financing facilities, a $1.5 million investment by a minority investor in our majority-owned subsidiary, Novasite, and $342,000 received from the sale of common stock under our Employee Stock Purchase Plan and from the exercise of stock options.

We expect our cash requirements to increase in 2003 as we continue our research and development efforts, hire additional personnel and accommodate our future facility needs. These facility needs include leased space at our current facilities, and may include the development of the property purchased by Torrey View, the Company’s wholly owned subsidiary. The Company may develop this property as its corporate headquarters over the next few years, which could involve a substantial commitment. The Company could also seek alternative uses for the property or sell the property if development would be inconsistent with the Company’s liquidity and cash resource needs. We believe that our current cash, cash equivalents and short-term investments and interest earned thereon, together with funding received from collaborators and government grants, will be sufficient to satisfy our anticipated cash needs for working capital and capital expenditures for at least the next two years. However, it is possible that we will seek additional financing within this timeframe. We may raise additional funds through public or private financing, collaborative relationships or other arrangements. We cannot guarantee that additional funding, if sought, will be available on terms favorable to us. Furthermore, any additional equity financing may be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants. Our failure to raise capital when needed may harm our business and operating results.

RISK FACTORS

We have not achieved profitability and may never become profitable.

We are at an early stage of development. We incurred a net loss of $14.0 million for the nine months ended September 30, 2003, and our revenue for the same period was $6.1 million. Additionally, we have had net losses each year since inception and as of September 30, 2003, had an accumulated deficit of $85.6 million. We expect to report a net loss for fiscal year 2003, and we expect to report increasing net losses for the foreseeable future. We may never achieve profitability. The size of our net losses will depend, in part, on the rate of growth, if any, in our contract revenue and on the level of our expenses. To date, we have derived most of our revenue from corporate collaborations and expect to continue to do so for the foreseeable future. Revenue from corporate collaborations is uncertain because our ability to secure future agreements will depend upon our ability to address the needs of our potential collaborators. We expect to spend significant amounts to fund research and development and enhance our AMEsystem technology. We expect that our operating expenses will increase significantly in the near term, and consequently, we will need to generate significant additional revenue to achieve profitability. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis.

We may need additional capital in the future. If additional capital is not available, we may have to curtail or cease operations.

We may need to raise more capital to continue our operations. We may seek additional funds from public and private stock offerings, corporate collaborations, borrowings under lease lines of credit or other sources. If we cannot raise more capital, we may have to reduce our capital expenditures, scale back our development of new products, reduce our workforce or license to others product candidates or products that we otherwise would seek to commercialize ourselves. We expect that our current resources, together with future operating revenues, will be sufficient to fund operations for at least the next two years. The amount of capital we will need will depend on many factors, including:

•		the success of our research and development efforts

•		our ability to establish collaborative agreements

•		our costs of prosecuting and maintaining patents

•		the market and competing technological developments

Additional capital may not be available on terms acceptable to us, or at all. Any additional equity financing may be dilutive to stockholders, and debt financing, if available, may include restrictive covenants.

The commercial utility of our AMEsystem technology is unproven and may never be realized.

While we have met with initial success in applying our AMEsystem technology, to prove its commercial value, we or our collaborators will need to commercialize biotherapeutic candidates that we have optimized. Successful commercialization of biotherapeutic candidates requires: preclinical testing, clinical trials, regulatory approval and commercial manufacturing. It will take us or our collaborators many years to complete these steps for any biotherapeutic candidate. If we or our collaborators do not undertake and successfully complete these activities, then our AMEsystem technology will be of little commercial value, and our ability to generate revenue will be limited. Currently, there is one product candidate, Vitaxin, in clinical trials that has been optimized using our technology.

We have announced the optimization of only two types of proteins and may not be able to optimize certain proteins, thereby limiting our market potential.

To date we have announced the optimization of only proteins from the classes of antibodies and enzymes for corporate collaborators and internal development projects. If, through the application of our AMEsystem technology we are unable to optimize certain proteins, the scope of our potential business will be significantly limited.

If our collaborators are not successful or if we are unable to find collaborators in the future, we may not be able to commercialize product candidates.

Our strategy for developing and commercializing product candidates may call for us to enter into contractual arrangements with collaborators. We may be unsuccessful in attracting collaborators to develop and commercialize our product candidates. Some

collaborators may not perform their obligations as we expect, or we may not derive any revenue from these arrangements. We do not know whether these collaborators will successfully develop and market any product candidates under their respective agreements. Moreover, some of our collaborators may acquire or develop competing technologies and product candidates targeted by our collaborative programs. Our success depends in part upon the performance by these collaborators of their responsibilities under these arrangements. We have no control over the resources that any collaborator may devote to the development and commercialization of product candidates under these collaborations. Our collaborators may terminate their agreements with us or otherwise fail to conduct their collaborative activities successfully and in a timely manner. Our collaborators may elect not to develop product candidates arising out of our collaborative arrangements or not to devote sufficient resources to develop, manufacture, market or sell these product candidates.

If product candidates we optimize do not receive regulatory approval, neither we nor our collaborators will be able to commercialize these product candidates.

The FDA must approve any therapeutic product candidate before it can be marketed in the United States. The regulatory process is expensive and time-consuming. Before we or a collaborator can file a new drug or biologic application with the FDA, the product candidate must undergo extensive testing, including animal studies and human clinical trials that can take many years and may require substantial expenditures. Data obtained from such testing may be susceptible to varying interpretations which could delay, limit or prevent regulatory approval. Changes in regulatory policy for product approval may cause delays or rejections. Because our product candidates will be developed in a novel way, government regulatory authorities may subject these product candidates to greater scrutiny than those developed using more conventional methods. Our collaborators are in early stages of the FDA regulatory process for product candidates we have optimized.

If we are unable to adequately protect our proprietary technology, our competitive position could be hurt.

The patent positions of pharmaceutical and biotechnology companies, including our patent position, are generally uncertain and involve complex legal and factual questions. We may be able to protect our proprietary rights from infringement by third parties only to the extent that our proprietary technologies are covered by valid and enforceable patents or are effectively maintained as trade secrets. Furthermore, others may independently develop similar or alternative technologies or design around our patented technologies. Litigation or other proceedings to defend or enforce our intellectual property rights could require us to spend significant time and money and could disrupt and harm our business.

We also rely upon trade secrets, technical know-how, and continuing inventions to develop and maintain our competitive position. Others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets or disclose our technology, and we may not be able to meaningfully protect our trade secrets or be capable of protecting our rights to our trade secrets.

If we infringe third-party patents or breach our license agreements, litigation may deplete our resources and undermine our ability to use our AMEsystem technology.

Our commercial success depends in part on neither infringing valid, enforceable patents or proprietary rights of third parties, nor breaching any licenses that may relate to our technology and product candidates. Our commercial success might also become dependent on us not infringing valid, enforceable patents or proprietary rights which might be developed by third parties in the future. We are aware of third-party patents that may relate to our technology. It is possible that we may unintentionally infringe these patents or other patents or proprietary rights of third parties. Any legal action taken against us or our collaborators claiming damages and seeking to enjoin commercial activities relating to our product candidates and processes affected by third-party rights may require us or our collaborators to obtain licenses in order to continue to manufacture or market the affected product candidates and processes. In addition, these actions may subject us to potential liability for damages. We or our collaborators may not prevail in an action, and any license required under a patent may not be made available on commercially acceptable terms, or at all. Litigation could result in substantial costs and the diversion of management’s efforts, regardless of the result of the litigation.

If we lose our key personnel or are unable to attract and retain additional personnel, we may be unable to successfully develop our technology.

We are highly dependent on the principal members of our management and scientific staff, particularly our President, Chief Executive Officer and Chairman of the Board, William D. Huse, M.D., Ph.D. If we lose their services we may not achieve our objectives. In addition, recruiting and retaining qualified scientific personnel to perform future research and development work will be critical to our

success. We do not have sufficient personnel to fully execute our business plan, and there is currently a shortage of skilled executives and scientists, which is likely to continue. As a result, competition for experienced executives and scientists from numerous companies and academic and other research institutions may limit our ability to hire or retain personnel on acceptable terms. If we fail to attract and retain sufficient personnel, we may not be able to develop or implement our technology.

Public perception of ethical and social issues may limit the use of our technology, which could reduce our revenue.

Our success will depend upon our ability to develop product candidates through the application of our directed molecular evolution technology. Governmental authorities could, for social or other purposes, limit the use of genetic modification or prohibit the practice of our technology. Ethical and other concerns about the use of products derived from modified genes could adversely affect their market acceptance. If our technology or the product candidates we develop cannot be marketed as a result, we would lose our core business.

We use hazardous chemicals and radioactive and biological materials in our business. Any claims relating to improper handling, storage or disposal of these materials could be time-consuming and costly.

We use hazardous materials, including chemicals, and radioactive and biological materials. These materials include o-phenylenediamine dihydrochloride, ethidium bromide and acrylamide. Our operations also produce hazardous waste products. We cannot eliminate the risk of accidental contamination or discharge and any resultant injury from these materials. We could be subject to civil damages in the event of an improper or unauthorized release of, or exposure of individuals to, hazardous materials. In addition, claimants may sue us for injury or contamination that results from the use of these materials. Federal, state and local laws and regulations govern the use, manufacture, storage, handling and disposal of these materials. Compliance with environmental laws and regulations may be expensive, and current or future environmental regulations may impair our research, development or production efforts.

If people are harmed by protein therapeutics developed using our AMEsystem technology, we may be sued for product liability.

We may be sued for product liability and other claims if our technology or products developed from our technology are alleged to have caused harm. We may not be able to avoid significant liability exposure. We maintain product liability insurance, but we may not have sufficient coverage. If we are sued for any injury caused by our product candidates and found liable, our financial condition, reputation and ability to find collaborators may be harmed.

Substantial sales of our common stock by our existing stockholders could cause our stock price to fall.

Future sales of our common stock by our stockholders under Rule 144 of the Securities Act of 1933 (“Securities Act”), or through the exercise of outstanding registration rights or otherwise could have an adverse effect on the price of our common stock. Shares of our common stock which are not held by our affiliates are eligible for sale in the public market in reliance on Rule 144(k) or Rule 701 under the Securities Act without any volume restrictions. Additionally, we registered a total of 7,622,625 shares of common stock reserved for issuance under our stock plans. Some of our existing stockholders have rights to require us to register their shares for future sale.

Our financial condition could be affected by offerings of our subsidiary’s stock.

We could engage in future offerings or other sales of the common or preferred stock of our majority-owned subsidiary, Novasite, if our board determines that it is in the best interests of the stockholders to pursue that course of action. This could adversely affect our business, financial condition and results of operations. For example, any offering or other sale of a portion of our subsidiary’s stock could reduce the subsidiary’s contribution to our gross revenues.

We are subject to influence from our executive officers and directors who may vote in ways with which you disagree because they have interests both as managers and stockholders.

As of September 30, 2003, our officers and directors and their affiliates, in the aggregate, owned beneficially approximately 29% of our outstanding shares of common stock. As a result, these stockholders, acting together, would be able to effectively control most matters requiring approval by our stockholders, including the election of a majority of the directors. If your interests as a stockholder are different from their interests as both managers and stockholders, you may not agree with their decisions.

ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we invest in may have market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate, and the prevailing interest rate later rises, the market value of our investment will probably decline. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds and government and non-government debt securities. The average duration of all of our investments as of September 30, 2003, was less than two years. Due to the short-term nature of these investments, we believe that we have no material exposure to interest rates arising from our investments. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest sensitive financial instruments. Declines in interest rates over time will, however, reduce our investment income, while increases in interest rates over time will increase our interest expense.

ITEM 4: CONTROLS AND PROCEDURES

(a) Evaluation of disclosure controls and procedures. We maintain “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating potential disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

Based on their evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our Chief Executive Officer and Chief Financial Officer have concluded that, subject to the limitations noted above, our disclosure controls and procedures were effective to ensure that material information relating to us, including our consolidated subsidiaries, was made known to them by others within those entities, particularly during the period in which this Quarterly Report on Form 10-Q was being prepared.

(b) Changes in internal control over financial reporting. There were no significant changes in our internal control over financial reporting or, to our knowledge, in other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

PART II: OTHER INFORMATION

ITEM 1: LEGAL PROCEEDINGS

On June 25, 2001, we filed a complaint against MorphoSys in the United States District Court for the District of Massachusetts seeking injunctive relief and damages on behalf of the Company. The complaint alleges that MorphoSys is willfully infringing the Kauffman patent family under which we hold an exclusive license.

On July 25, 2002, a petition was filed in the Superior Court of the State of California, County of San Diego, by the Coalition against the City of San Diego, et al. seeking to compel the City of San Diego to revoke the approval which was previously issued with respect to the development of our corporate headquarters. A petition was also filed by the School District on October 25, 2002, seeking a similar legal remedy. These petitions assert that the City of San Diego failed to comply with or violated various legal requirements in

connection with its approval of that development, but they do not seek monetary relief from the Company. We understand that the City of San Diego believes that it has complied with all legal requirements for this project and therefore intends to vigorously oppose these petitions. The Company is named as a real party in interest, and we also intend to vigorously oppose these petitions and believe that they will not have a material adverse effect on our business.

ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS

(a) Not applicable.

(b) Not applicable.

(d) The effective date of our first registration statement, filed on Form S-1 under the Securities Act of 1933 (No. 333-36830) relating to our initial public offering of common stock, was July 26, 2000. A total of 5,347,500 shares of our common stock were sold at a price of $19.00 per share to an underwriting syndicate led by CIBC World Markets, UBS PaineWebber Incorporated, formerly known as PaineWebber Incorporated, and SG Cowen. Of these 5,347,500 shares, 697,500 shares were issued upon exercise of the underwriters’ over-allotment option. The offering commenced on July 27, 2000, and closed on August 2, 2000. The initial public offering resulted in gross proceeds of $101.6 million, $7.1 million of which was applied toward the underwriting discount. Expenses related to the offering totaled approximately $1.6 million. No direct or indirect payments were made to any directors, officers, owners of ten percent or more of any class of our equity securities or other affiliates of the Company other than for reimbursement of expenses. Net proceeds to us, after deducting these expenses, were approximately $92.9 million. We have used approximately $10.9 million of the net offering proceeds for a portion of the repurchase of approximately 3.1 million shares of our stock for $21.7 million, $10.0 million for purchases of property and equipment and approximately $33.3 million to fund our net losses. The balance of the proceeds was applied towards the purchase of temporary investments consisting of U.S. government agencies’ obligations, corporate bonds, asset-backed securities and cash and cash equivalents.

ITEM 3: DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

ITEM 5: OTHER INFORMATION

None.

ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

10.35 Third Amendment to Lease Agreement for 11095 Flintkote Avenue, San Diego, California dated as of March 14, 2003.

10.36 Fourth Amendment to Lease Agreement for 11095 Flintkote Avenue, San Diego, California dated as of August 4, 2003.

10.37 Fifth Amendment to Lease Agreement for 3520 Dunhill Street, San Diego, California dated as of August 20, 2003.

10.38 Master Lease Agreement with General Electric Capital Corporation dated September 24, 2003.

10.39 Loan and Security Agreement with Silicon Valley Bank dated September 29, 2003.

31.1 Certification of the Chief Executive Officer of Applied Molecular Evolution, Inc., Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934.

31.2 Certification of the Chief Financial Officer of Applied Molecular Evolution, Inc., Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934.

32.1 Certification furnished Pursuant to Section 1350 of Chapter 63 of 18 U.S.C. as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2 Certification furnished Pursuant to Section 1350 of Chapter 63 of 18 U.S.C. as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(b) Reports on Form 8-K during the second quarter

On August 5, 2003, pursuant to Item 12 we filed a current report on Form 8-K, with an exhibit attached thereto, furnishing information relating to the Company’s results of operations for the three and six months ended June 30, 2003.

SIGNATURES

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


Date: November 4, 2003	By:	/s/ William D. Huse, M.D., Ph.D.

		William D. Huse, M.D., Ph.D.
		President, Chief Executive Officer
		and Chairman of the Board

Date: November 4, 2003	By:	/s/ Lawrence E. Bloch, M.D., J.D.

		Lawrence E. Bloch, M.D., J.D.
		Chief Financial Officer and Secretary

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APPLIED MOLECULAR EVOLUTION INC 10-Q