ADVANCED MAGNETICS INC, 10-K405, 1998-12-23

ADVANCED MAGNETICS INC
10-K405, 1998-12-23
IN VITRO & IN VIVO DIAGNOSTIC SUBSTANCES

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

------------------------

FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934

FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1998

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

FOR THE TRANSITION PERIOD FROM _______________ TO ______________.

COMMISSION FILE NUMBER 0-14732

ADVANCED MAGNETICS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE 04-2742593
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)

61 MOONEY STREET 02138
CAMBRIDGE, MASSACHUSETTS (ZIP CODE)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (617) 497-2070

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
COMMON STOCK, PAR VALUE $.01 PER SHARE, AMERICAN STOCK EXCHANGE

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE

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 [ ]

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 the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]

As of December 7, 1998, there were 6,767,660 shares of the registrant's
Common Stock, $.01 par value per share, outstanding. The aggregate market value
of the registrant's voting stock held by nonaffiliates as of December 7, 1998
was approximately $52,971,628.

DOCUMENTS INCORPORATED BY REFERENCE

PORTIONS OF THE REGISTRANT'S PROXY STATEMENT FOR ITS 1998 ANNUAL MEETING OF
STOCKHOLDERS, SCHEDULED TO BE HELD ON FEBRUARY 2, 1999, ARE INCORPORATED BY
REFERENCE IN PART III HEREOF.

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PART I

ITEM 1. BUSINESS:

COMPANY OVERVIEW

Advanced Magnetics, Inc., a Delaware corporation ("Advanced Magnetics" or
the "Company"), develops, manufactures and markets organ-specific contrast
agents to improve the diagnostic capabilities of soft tissue magnetic resonance
imaging ("MRI") scans. Sales of the Company's liver contrast agent, Feridex
I.V.(R), have commenced in Europe, Japan, the United States, Argentina, South
Korea and Israel. The product is approved and awaiting market launch in China.
Sales of the Company's oral contrast agent GastroMARK(R), used for marking of
the bowel in MRI procedures, have commenced in Europe and the United States.
With respect to Combidex(R), the Company's contrast agent for the liver, spleen
and lymphatic system, the Company has completed Phase III trials in the United
States for imaging liver lesions and has completed patient enrollment in Phase
III trials for lymph node imaging. The Company hopes to submit a New Drug
Application ("NDA") to the U.S. Food and Drug Administration ("FDA") for both
indications in 1999. The Company's veterinary diagnostics subsidiary, Kalisto
Biologicals, Inc. ("Kalisto"), launched its lead product: the Endochek Plus(TM)
blood chemistry analyzer in July 1998. The Endochek Plus has 23 individual tests
and 9 panels available that are designed specifically for in-house veterinary
testing.

MRI is a diagnostic imaging technique that is used to identify internal
abnormalities and changes in structure. Contrast agents increase the usefulness
of MRI by allowing radiologists to differentiate structures and organs with
greater diagnostic confidence. The Company believes that MRI studies of the
liver and lymph nodes produced with contrast agents provide more diagnostic
information and permit the identification of smaller abnormalities than images
produced by MRI studies without contrast agents or images produced by contrast
enhanced computed tomography ("CECT"). As a result, MRI contrast agents
frequently allow for more accurate diagnosis and monitoring of treatment results
and may be a cost-effective way to assess medical treatments and to improve
patient outcomes. Currently, the primary use of MRI is for studies of the
central nervous system. The Company believes that the development of effective
contrast agents should increase the use of MRI as a diagnostic imaging technique
and should allow MRI to be used for a wider range of applications, in turn
generating additional demand for MRI contrast agents.

Feridex I.V. is the first organ-specific MRI contrast agent designed
specifically for the liver and is marketed in the United States, Europe, Japan,
Argentina, South Korea and Israel. The liver and the lymphatic system are among
the principal sites for metastasis of many common cancers (including colon,
prostate and breast cancer). CECT is currently the primary imaging technique
used to confirm a preliminary or suspected diagnosis of liver cancer. With
respect to the lymphatic system, there are no effective imaging techniques
currently available. An MRI contrast agent that localizes to and causes contrast
enhancement of the lymph nodes, such as the Combidex product the Company has
under development, could allow for more accurate disease diagnosis and
monitoring of treatment results. The Company believes that GastroMARK, because
it enhances the contrast between the bowel and other abdominal structures, may
increase the use of MRI as an imaging technology for the abdomen.

To facilitate the marketing and distribution of its contrast agents, the
Company has entered into strategic relationships with certain established
pharmaceutical companies. These strategic partners, both in the United States
and abroad, include: (i) Guerbet S.A. ("Guerbet"), a leading European producer
of contrast agents, in Western Europe and Brazil; (ii) Eiken Chemical Co., Ltd.,
("Eiken"), one of Japan's leading medical diagnostics manufacturers, in Japan;
(iii) Berlex Laboratories, Inc. ("Berlex"), the leading U.S. marketer of MRI
contrast agents, in the United States; and (iv) Mallinckrodt Inc.
("Mallinckrodt"), a leading manufacturer of contrast agents, in the United
States, Canada and Mexico.

The Company's expertise in organ-specific technology has provided it with
biopharmaceutical opportunities beyond its core MRI contrast agent products.
This research and development interest led the Company to enter into a research
agreement with the University of Minnesota in July 1998. Under the agreement,
Advanced Magnetics will sponsor research at the University of Minnesota over a
period of three years to develop a family of drug candidates with anti-viral or
anti-tumor characteristics.

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The Company is constantly evaluating new technology in an effort to
identify possible opportunities to supplement internal research and development
efforts. As part of these efforts, in March 1998, the Company entered into a
licensing and marketing agreement with privately-held Andaris Ltd. ("Andaris")
of Nottingham, England for the development and marketing rights to the
Quantison(TM) ultrasound contrast agent for the assessment of coronary artery
disease. Under the terms of the agreement, Advanced Magnetics will assume
responsibilities for North American development and commercialization of
Quantison subsequent to Andaris achieving certain development and performance
milestones.

The Company was incorporated in Delaware in November 1981. The Company's
principal offices are located at 61 Mooney Street, Cambridge, Massachusetts
02138, and its telephone number is (617) 497-2070.

MRI CONTRAST AGENTS

Overview

Diagnostic Imaging. Diagnostic imaging is generally a non-invasive method
to visualize internal structures, abnormalities or anatomical changes in order
to diagnose disease and injury. Today, the most widely accepted imaging
techniques include x-rays, ultrasound, nuclear medicine, Computerized Tomography
("CT") and MRI. Since the introduction of x-rays, doctors have sought
increasingly accurate and detailed non-invasive visualization of soft tissue.
For example, diagnostic imaging frequently is used to determine whether a cancer
has metastasized and to assist physicians in determining whether a treated
cancer has shrunk or recurred and the locations of such metastatic tumors. In
addition, diagnostic imaging is used in the diagnosis of disease and injury
conditions affecting the cardiovascular and central nervous systems and certain
joints, such as the knee and shoulder. The choice of diagnostic imaging
technique to be used in any particular circumstance depends upon a variety of
factors, including the particular disease or condition to be studied, image
quality, availability of imaging machines, availability of contrast agents and
cost. There is no imaging technique that is considered superior to all others
for most or all applications.

Contrast agents play a significant role in improving the quality of
diagnostic images by increasing contrast between different internal structures
or types of tissues in various disease states and medical conditions of
interest. The availability of effective contrast agents often determines the
choice of imaging technique for a particular procedure. Consequently, contrast
agents, which are administered intravenously or orally, are widely used when
available. Currently available imaging techniques can be of limited usefulness
in visualizing certain soft-tissue structures. For example, clinically useful
diagnostic imaging of small lesions in lymph nodes, a common site of metastasis
for some frequently occurring cancers such as breast cancer, is not currently
available because, the Company believes, there are no effective contrast agents
for differentiating cancerous lymph nodes from other nodes.

Magnetic Resonance Imaging. Introduced in the 1980's, MRI is the
diagnostic imaging technique of choice for the central nervous system and is
widely used for the imaging of ligaments and tendons. MRI, which represents the
first major advance in imaging since the advent of CT scanning, provides
high-quality spatial resolution and does not use radiation. In MRI procedures,
the patient is placed within the core of a large magnet where radio frequency
signals are transmitted into the patient's body. The interaction of the radio
frequency signal with the patient's body produces signals that are processed by
a computer to create cross-sectional images. The primary application of MRI
contrast agents currently marketed in the United States is for imaging the
central nervous system.

Technology

Advanced Magnetics' core imaging agent technology is based on the
characteristic properties of extremely small, polysaccharide-coated
superparamagnetic iron oxide particles. The Company's core competency is the
ability to design such particles for particular applications and manufacture the
particles in controlled sizes. The superparamagnetic particles range in size
from approximately one-thousandth to one-twentieth the size of a normal red
blood cell. When placed in a magnetic field, superparamagnetic iron oxide
particles become strongly magnetic, but do not retain their magnetism once the
field is removed. Once inside the targeted organ or area of study, the powerful
magnetic properties of the Company's iron oxide particles

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result in images that show greater soft tissue contrast to increase the
information available to the reviewing radiologist. The Company's technology and
expertise enable it to synthesize, sterilize and stabilize superparamagnetic
particles in a manner necessary for their use in pharmaceutical products such as
MRI contrast agents to aid in the diagnosis of cancer and other diseases. The
Company's rights to its contrast agent technology are derived from and protected
by license agreements, patents, patent applications and trade secrets. See
"Patents and Trade Secrets."

Products

The following table summarizes potential applications, marketing partners
and current U.S. and foreign status for each of the Company's MRI contrast agent
products.

ADVANCED MAGNETICS' PRODUCTS

<TABLE>
<CAPTION>
PRODUCT APPLICATIONS MARKETING PARTNERS UNITED STATES STATUS FOREIGN STATUS
- ------- ------------ ------------------ -------------------- --------------
<S> <C> <C> <C> <C>
Feridex I.V. Diagnosis of Berlex (United Approved and Approved and
liver lesions. States), Eiken marketed. marketed in
(Japan), Guerbet Japan, in most
(Western Europe European
and Brazil), countries,
Temis-Lostalo Argentina, Israel
(Argentina), and South Korea.
TaeJoon
Pharmaceuticals
(South Korea),
Discotrade
(Israel),
Pharmagenesis
(China and
Taiwan).

Combidex Diagnosis of Guerbet (Western U.S. Phase III European Phase
lesions of the Europe and liver/spleen trials III clinical
liver and spleen Brazil). completed. Patient trails for
and lymphatic enrollment in Phase lymphatic imaging
system imaging. III clinical trials currently
for lymph nodes underway to be
completed. NDA completed in
anticipated in 1999. 1999. CPMP filing
anticipated 1999.

GastroMARK Marking of the Guerbet (Western Approved and Approved and
bowel in Europe and marketed. marketed in many
abdominal Brazil), European
imaging. Mallinckrodt countries,
(United States, including France.
Canada and Approved in
Mexico). Canada.
</TABLE>

"Phase I clinical trials" refers to the first phase of human pharmaceutical
clinical trials in which testing for the safety and tolerance of the product is
conducted on a small group of normal subjects. "Phase II clinical trials" and
"Phase III clinical trials" refer to the second and third phases of human
clinical trials, where preliminary dosing and efficacy studies are conducted and
where additional testing for efficacy and safety is conducted on an expanded
patient group. For a further description of the substantial regulatory
requirements subsequent to the completion of preclinical testing, see
"Government Regulation and Reimbursement."

Combidex. The Company believes that Combidex will be useful in diagnostic
imaging of the liver, spleen and lymph nodes. Lymph nodes are frequently sites
for metastases of different types of cancer, particularly breast cancer and
prostate cancer, and efficient imaging of lymph nodes could play a major role in
determining appropriate courses of treatment. There are currently no available
non-invasive methods for
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distinguishing between lymph nodes enlarged by tumorous infiltration as opposed
to inflammation. Since CT and MRI without contrast agents, the only imaging
modalities currently used for imaging lymph nodes, cannot distinguish between
inflamed nodes and cancerous nodes, the current practice is to assume that
enlarged nodes are cancerous and to perform a biopsy to establish their true
status. Nodes less than one centimeter in size are assumed to be normal. The
Company believes that Combidex will enable doctors using MRI to distinguish
between cancerous and non-cancerous lymph nodes, irrespective of node size,
because its accumulation in normal lymph node tissue permits differentiation
between normal and tumor-infiltrated nodes. The Company also believes that
Combidex can be used to identify tumors in the liver and spleen because tumors
generally are hypovascular when compared to surrounding tissues.

The Company has completed Phase III studies using Combidex to image the
liver. Patient enrollment in Phase III trials using Combidex to image lymph
nodes has been completed. The Company expects to file an NDA for both
indications in 1999.

Of the approximately 655 patients and subjects who were administered
Combidex during its product development, one suffered an allergic reaction and
died in January 1996. There can be no assurance that this death or any
subsequent death that might occur during future clinical trials for this product
would not have an adverse effect on the Company's ability to continue clinical
trials or obtain regulatory approvals for Combidex or otherwise have a material
adverse effect on the Company's business, financial condition and results of
operations. See "Product Liability Insurance" and "Certain Factors That May
Affect Future Results -- Potential Product Liability; Uncertainties Related to
Insurance."

The Company has granted exclusive rights to market and sell Combidex in
Western Europe and Brazil to Guerbet. See "Licensing and Marketing
Arrangements."

Feridex I.V. The liver is a principal site for metastasis of primary
cancer originating in other parts of the body, particularly cancer of the colon,
a common cancer in the United States. Diagnosis of metastasis at an early stage
can be difficult because small tumors are frequently not accompanied by
detectable physical symptoms. Identification of metastatic tumors in the liver
has a significant impact on physicians' treatment plans for cancer. The Company
believes that Feridex I.V. allows for contrast-enhanced MRI scans of liver
tumors that may not be visible with CT scanning or ultrasound, the most widely
used techniques for liver imaging, and that increasing numbers of liver scans
will now be done using MRI instead of, or in addition to, CT scanning and
ultrasound.

Marketing of Feridex I.V. began in October 1996 by Berlex Laboratories in
the United States. Berlex Laboratories is the Company's exclusive marketing
partner for Feridex I.V. in the United States. Feridex I.V. was approved in
August 1994 by the European Union's (the "EU") Committee for Proprietary
Medicinal Products and most of the member states of the EU have since issued
local approvals to market the product. Guerbet is marketing the product in
Europe. In Japan, Eiken received approval for marketing the product in July 1997
and received pricing approval in September 1997. Feridex I.V. was launched in
Japan in September 1997 through Eiken's affiliate Tanabe Seiyaku, Ltd. See
"Licensing and Marketing Arrangements."

GastroMARK. MRI imaging of organs and tissues in the abdomen without
contrast agents is difficult because these organs and tissues cannot be easily
distinguished from the loops of the bowel. GastroMARK, the Company's oral
contrast agent for marking of the bowel, when ingested, flows through and
darkens the bowel. By more clearly identifying the intestinal loops, GastroMARK
improves visualization of adjacent abdominal tissues, including the pancreas and
pelvis.

In April 1997, the Company's marketing partner Mallinckrodt launched
GastroMARK in the United States. The Company has licensed the manufacturing and
marketing rights to GastroMARK on an exclusive basis to Guerbet in Western
Europe and Brazil. During 1993, Guerbet received initial marketing approval for
the product in several European countries, including France. See "Licensing and
Marketing Arrangements."

Licensing and Marketing Arrangements

BERLEX. In February 1995, the Company entered into a license and marketing
agreement and a supply agreement with Berlex, granting Berlex exclusive
marketing rights to Feridex I.V. in the United States.

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Under the terms of the agreements, Berlex paid a $5,000,000 license fee upon
execution of the agreements and paid an additional $5,000,000 license fee in
October 1996 upon the Company's delivery of FDA-approved product to Berlex. In
addition, the Company receives payments for manufacturing the agent and
royalties on sales of the agent. These agreements expire in 2010 but can be
terminated earlier upon the occurrence of certain specified events.

EIKEN. In 1988, the Company entered into a manufacturing and distribution
agreement with Eiken, granting Eiken the exclusive right to manufacture and
distribute Feridex I.V. in Japan. Eiken completed all the clinical trials for
Feridex I.V. and, in 1997 secured the necessary regulatory approval in Japan.
Under the terms of the agreement, Eiken paid the Company a license fee of
$1,500,000. In addition, Eiken pays royalties based upon sales. The agreement
terminates on the later of (i) the expiration of the last to expire technology
patent or (ii) ten years after the date all necessary approvals are obtained.

In 1990, the Company entered into a manufacturing and distribution
agreement with Eiken, granting Eiken the exclusive right in Japan to manufacture
and distribute GastroMARK and Combidex. In addition, for a period of 180 days
after the Company files an IND for any future Advanced Magnetics MRI contrast
agents, Eiken has the right of first refusal to manufacture and distribute such
product in Japan. Upon execution of this agreement, Eiken paid the Company a
license fee of $1,000,000. Additionally, Eiken agreed to pay the Company
royalties on sales of all products sold by Eiken under the agreement. The
agreement is perpetual but terminable upon specified events such as
nonperformance, insolvency or assignment without consent. Due to market
conditions in Japan, Eiken has decided not to market GastroMARK.

GUERBET. In 1987, the Company entered into a supply and distribution
agreement with Guerbet. Under this agreement, Guerbet has been appointed the
exclusive distributor of Feridex I.V. in Western Europe (under the tradename
Endorem(TM)) and Brazil. Guerbet is responsible for conducting clinical trials
and securing the necessary regulatory approvals in the countries in its
territory. Guerbet paid the Company license fees and is required to pay
royalties based on sales. The Company is entitled to receive an additional
percentage of Guerbet's sales in return for selling to Guerbet its requirements
for the active ingredient used in Endorem. The agreement terminates on the later
of (i) the expiration of the last to expire technology patent or (ii) ten years
after the date all necessary approvals are obtained in France.

In 1989, the Company entered into a second supply and distribution
agreement with Guerbet granting Guerbet an exclusive right in Western Europe
(under the tradename Lumirem(TM)) and Brazil to manufacture and sell GastroMARK
and any future Advanced Magnetics MRI contrast agents that Guerbet decides to
market, including Combidex. Under the terms of this second distribution
agreement, Guerbet paid the Company a license fee in 1989. In addition, Guerbet
will pay the Company both royalties and a percentage of net sales as the
purchase price for the active ingredient. The Company is required to sell to
Guerbet its requirements for the active ingredient used in the contrast agents.
The agreement is perpetual but terminable upon specified events such as
nonperformance, insolvency or assignment without consent.

MALLINCKRODT. In 1990, the Company entered into a manufacturing and
distribution agreement for GastroMARK with Mallinckrodt Medical, Inc. Under this
agreement, Mallinckrodt received the exclusive right to manufacture and
co-market GastroMARK in the United States, Canada and Mexico. The Company may
also sell the product through its own direct sales personnel. Mallinckrodt has
paid $1,350,000 under the terms of the agreement and paid $500,000 on FDA
approval of the NDA. Additionally, the Company will receive royalties based on
Mallinckrodt's GastroMARK sales and a percentage of sales for supplying the
active ingredient. The agreement is perpetual but terminable upon specified
events such as nonperformance, insolvency or assignment without consent.

SQUIBB DIAGNOSTICS. In 1991, the Company entered into agreements with
Squibb Diagnostics, a division of Bristol-Myers Squibb Co. ("Squibb
Diagnostics") covering certain technology and the manufacturing and marketing of
certain contrast agents including Combidex, which agreements have been
terminated. Under agreements returning the products and technology rights to
Advanced Magnetics, the Company is obligated to pay Squibb Diagnostics up to a
maximum of $2,750,000 in royalties in connection with future product sales of
Combidex.

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Manufacturing and Supply Arrangements

The Company's Cambridge, Massachusetts facility is registered with the FDA
and is subject to "current Good Manufacturing Practices" (cGMP) as prescribed by
the FDA. The Company currently manufactures Feridex I.V. bulk product for sale
to Guerbet, manufactures Feridex I.V. finished product for sale to Berlex and
GastroMARK bulk product for sale to Guerbet and Mallinckrodt. The Company also
manufactures Combidex for pre-clinical and clinical testing. The Company expects
to utilize contract manufacturers from time to time if appropriate.

Patents and Trade Secrets

The Company considers the protection of its technology to be material to
its business. The Company's policy is to aggressively protect its competitive
technology position by a variety of means, including applying for patents in the
United States and in appropriate foreign countries. The Company has been granted
26 United States patents and has several patent applications pending. The
Company has filed counterpart patent applications in several foreign countries.
In addition, the Company is a party to various license agreements, including
nonexclusive cross-licensing arrangements covering certain MRI imaging
technology with Nycomed Imaging A.S. of Oslo, Norway ("Nycomed") and Schering AG
("Schering"). The Company's proprietary position depends in part on these
licenses, and termination of the licenses for any reason could have a material
adverse effect on the Company by limiting or prohibiting the commercial sale of
its products. Although the Company believes that further patents will be issued
on pending applications, no assurance to this effect can be given.

The patent positions of pharmaceutical and biopharmaceutical firms,
including Advanced Magnetics, are generally uncertain and involve complex legal
and factual questions. There can be no assurance that any claims which are
included in pending or future patent applications will be issued, that any
issued patents will provide the Company with competitive advantages or will not
be challenged by others, or that the existing or future patents of third parties
will not have an adverse effect on the ability of the Company to commercialize
its products.

The Company also intends to rely on its trade secrets, know-how, continuing
technological innovations and licensing opportunities to maintain and develop
its competitive position. Although the Company seeks to protect its proprietary
information, there can be no assurance that others will not independently
develop the same or similar information, design around the patents, obtain
unauthorized access to the Company's proprietary information or misuse
information to which the Company has granted access. Litigation may be necessary
to enforce any patents issued to the Company or to determine the scope of
proprietary rights belonging to others in court or administrative proceedings.
Any litigation or administrative proceeding could result in substantial costs to
the Company and distraction of the Company's management. An adverse ruling in
any litigation or administrative proceeding could have a material adverse effect
on the Company's business, financial condition and results of operations.

Competition

The pharmaceutical and biopharmaceutical industries are subject to intense
competition and rapid technological change. The Company expects competition in
the development of new MRI contrast agents and alternative imaging modalities to
increase substantially. Certain companies, including the Company's
collaborators, which have greater human and financial resources dedicated to
product development and clinical testing than the Company, are developing MRI
contrast agents. The Company's collaborators are not restricted from developing
and marketing competing products and as a result of certain cross license
agreements among the Company and certain of its competitors (including one of
its collaborators), the Company's competitors will be able to utilize certain of
the Company's technology in the development of competing products. The Company
may not be able to compete successfully with these companies.

The Company believes that its ability to compete successfully in the MRI
contrast agent market will continue to depend on a number of factors including
the development of safe and efficacious products, timely receipt of regulatory
approvals, product manufacturing at commercially competitive costs and
compelling

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product positioning relative to its competition. In addition, the Company's MRI
contrast agents represent a relatively new approach to imaging certain organs
and anatomical regions for which market acceptance of both MRI as an appropriate
technique for such organs or anatomical regions and the Company's products as
part of such imaging is critical to the success of its contrast agent products.
Although the Company believes that its contrast agents will offer advantages
over competing MRI, CT, X-ray or nuclear medicine contrast agents, there may not
be greater acceptance of its products over other contrast agents. In addition,
to the extent that other diagnostic techniques such as CT, X-ray and nuclear
medicine may be perceived as providing greater value than MRI, any corresponding
decrease in the use of MRI could have an adverse effect on the demand for the
Company's contrast agent products. The Company's products may not present a
compelling value proposition and the Company may not be able to successfully
develop efficacious products, obtain timely regulatory approvals, manufacture
new products at commercially competitive costs, gain satisfactory market
acceptance or otherwise successfully compete in the future.

There are several MRI contrast agents for imaging lesions of the liver on
the market and in various phases of human testing in the United States and
abroad. Schering has two products in development, Resovist, a carboxydextran
superparamagnetic iron oxide formulation, and Eovist, a chelated gadolinium
compound. The Company believes that Schering has filed for European approval of
Resovist and that Eovist has completed Phase II trials in Europe. Schering has
completed Phase III studies of Resovist in the United States. The Company does
not know the status of Resovist or Eovist in Japan. Nycomed has received
marketing approval in the United States and Europe for its MnDPDP product
Teslascan for MRI of liver lesions. The Company believes that Bracco S.p.A. has
filed for marketing approval in Europe for Gadolinium BOPTA, a chelated
gadolinium compound for MR imaging of liver lesions.

In the area of oral contrast agents, Pharmacyclics, Inc. filed an NDA in
late 1995 for GADOLITE, its gadolinium-based product candidate which is not
expected to reach the market before 1999. Bracco S.p.A has received marketing
approval in the United States for Lumenhance, its liposomal encapsulated oral
manganese compound. In October 1997, the FDA approved Ferriselz(R), an oral MRI
agent from Oncomenbrane Inc. It is not known how they are planning to market
these products. These competitive products or other products developed by the
Company's competitors may be more effective than any products developed by the
Company or render the Company's technology obsolete. In addition, further
technological and product developments may make other imaging modalities more
competitive.

Many of these companies, as well as other imaging companies, have
substantially greater capital, research and development, manufacturing and
marketing resources and experience than the Company and represent significant
competition for Advanced Magnetics. Such companies may succeed in developing
technologies and products that are more effective or less costly than any that
may be developed by the Company and may also prove to be more successful than
the Company in production and marketing. Furthermore, products developed by the
Company's competitors may be more effective than any products developed by the
Company or render the Company's technology obsolete.

Government Regulation and Reimbursement

The production and marketing of the Company's products and its ongoing
research and development activities are subject to regulation for safety,
efficacy and quality by numerous governmental authorities in the United States
and other countries. Pharmaceutical products intended for diagnostic use in
humans are principally governed by FDA regulations in the United States and by
comparable government regulations in foreign countries. Various federal, state
and local statutes and regulations also govern or influence the research and
development, manufacturing, safety, labeling, storage, record-keeping,
distribution and marketing of such products. The process of completing
pre-clinical and clinical testing and obtaining the approval of the FDA and
similar health authorities in foreign countries to market a new drug product
requires a significant number of years and the expenditure of substantial
resources. Failure to obtain requisite governmental approvals or failure to
obtain approvals of the scope requested that delay or preclude the Company or
its licensees or collaborators from marketing any of the Company's products or
limit the commercial use of the products could have a material adverse effect on
the Company's business, financial condition and results of operations.

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The steps required by the FDA before a new human pharmaceutical product,
including contrasts agents, may be marketed in the United States include: (a)
pre-clinical laboratory tests, in vivo pre-clinical studies and formulation
studies; (b) the submission to the FDA of a request for authorization to conduct
clinical trials subject to an Investigational New Drug ("IND") exemption, to
which the FDA must not object, before human clinical trials may commence; (c)
adequate and well-controlled human clinical trials to establish the safety and
efficacy of the drug for its intended use; (d) submission to the FDA of an NDA;
(e) approval and validation of manufacturing facilities for production of the
pharmaceutical; and (f) review and approval of the NDA by the FDA before the
drug product may be shipped or sold commercially.

Pre-clinical tests include the laboratory evaluation of product chemistry
and formulation, as well as animal studies to assess the potential safety and
efficacy of the product. Pre-clinical test results are submitted to the FDA as a
part of the IND. Clinical trials are typically conducted in three sequential
phases, although the phases may overlap. Phase I involves the initial
administration of the drug to a small group of humans, either healthy volunteers
or patients, to test for safety, dosage tolerance, absorption, distribution,
metabolism, excretion and clinical pharmacology and, if possible, early
indications of effectiveness. Phase II involves studies in a small sample of the
actual intended patient population to assess the preliminary efficacy of the
investigational drug for a specific clinical indication, to ascertain dose
tolerance and the optimal dose range and to collect additional clinical
information relating to safety and potential adverse effects. Once an
investigational drug is found to have some efficacy and an acceptable clinical
safety profile in the targeted patient population, Phase III studies can be
initiated to further establish safety and efficacy of the investigational drug
in a broader sample of the target patient population. The results of the
clinical trials together with the results of the pre-clinical tests and complete
manufacturing information are submitted in an NDA to the FDA for approval. The
FDA may suspend clinical trials at any point in this process if it concludes
that patients are being exposed to an unacceptable health risk.

Both before and after approval is obtained, a product, its manufacturer,
and the holder of the NDA for the product are subject to comprehensive
regulatory oversight. Violations of regulatory requirements at any stage,
including the preclinical and clinical testing process, the approval process, or
thereafter (including after approval) may result in various adverse
consequences, including the FDA's delay in approving or refusal to approve a
product, withdrawal of an approved product from the market, and/or the
imposition of criminal penalties against the manufacturer and/or NDA holder. In
addition, later discovery of previously unknown problems may result in
restrictions on such product, manufacturer, or NDA holder, including withdrawal
of the product from the market. Also, new government requirements may be
established that could delay or prevent regulatory approval of the Company's
products under development.

If an NDA is submitted to the FDA, there can be no assurance that such
application will be reviewed and approved by the FDA in a timely manner, if at
all. Among the conditions for NDA approval is the requirement that a prospective
manufacturer's manufacturing procedures conform to current Good Manufacturing
Practices ("cGMP") requirements, which must be followed at all times. In
complying with those requirements, manufacturers (including a drug sponsor's
third-party contract manufacturers) must continue to expend time, money and
effort in the area of production and quality control/assurance to ensure
compliance. Even after initial FDA approval has been obtained, further studies,
including post-marketing studies, may be required to provide additional
information. Results of such post-marketing programs may limit or expand the
further marketing of the product. Even if initial marketing approval is granted,
such approval may entail limitations on the indicated uses for which a product
may be used and impose labeling requirements which may adversely impact the
Company's ability to market its products. Finally, product approvals may be
withdrawn if compliance with regulatory standards is not maintained or if
problems occur following initial marketing.

Domestic manufacturing establishments are subject to periodic inspections
by the FDA in order to assess, among other things, cGMP compliance. To supply
product for use in the United States, foreign manufacturing establishments must
comply with cGMP and are subject to periodic inspection by the FDA or by
regulatory authorities in certain of such countries under reciprocal agreements
with the FDA. Failure to maintain compliance with cGMP regulations and other
applicable manufacturing requirements of various regulatory

8
<PAGE> 10

agencies could have a material adverse effect on the Company's business,
financial condition and results of operations.

The Company is also subject to foreign regulatory requirements governing
development, manufacturing and sales of pharmaceutical products that vary widely
from country to country. Approval of a drug by applicable regulatory agencies of
foreign countries must be secured prior to the marketing of such drug in those
countries. The regulatory approval process may be more or less rigorous from
country to country and the time required for approval may be longer or shorter
than that required in the United States.

The Company is subject to regulation under local, state and federal law
regarding occupational safety, laboratory practices, handling of chemicals,
environmental protection and hazardous substances control. The Company possesses
a Byproduct Materials License from the Commonwealth of Massachusetts for
receipt, possession, manufacturing and distribution of radioactive materials.
The Company holds Registration Certificates from the United States Drug
Enforcement Administration and the Commonwealth of Massachusetts Department of
Public Health for handling controlled substances. The Company is registered with
the United States Environmental Protection Agency ("EPA") as a generator of
hazardous waste. All hazardous waste disposal must be made in accordance with
EPA and Commonwealth of Massachusetts requirements. The Company is subject to
the regulations of the Occupational Safety and Health Act and has in effect a
safety program to assure compliance with these regulations.

In both the United States and foreign markets, the Company's ability to
commercialize its products successfully also depends in part on the extent to
which reimbursement for the costs of such products and related treatments will
be available from government health administration authorities, private health
insurers and other third-party payors. Significant uncertainty exists as to the
reimbursement status of newly approved health care products and products used
for indications not approved by the FDA. If adequate reimbursement levels are
not maintained by government and other third-party payors for the Company's
products and related treatments, the Company's business, financial condition and
results of operations may be materially adversely affected.

Major Customers

One customer, Guerbet S.A., accounted for 15% of total revenues in fiscal
1998. No other customer accounted for more than 10% of total revenues in fiscal
1998.

Employees

As of December 7, 1998, the Company had approximately 62 full-time
employees, 52 of whom were engaged in research and development. In addition,
there were 13 employees at the Company's subsidiary Kalisto. The Company's
success depends in part on its ability to recruit and retain talented and
trained scientific personnel. The Company has been successful to date in
obtaining such personnel, but there can be no assurance that such success will
continue.

None of the Company's employees is represented by a labor union, and the
Company considers its relations with its employees to be excellent.

Foreign Operations

The Company has no foreign operations. Revenues in fiscal 1998, 1997 and
1996, from customers and licensees outside of the United States, principally in
Europe, amounted to 26%, 6% and 3%, respectively, of the Company's total
revenues on a consolidated basis.

Product Liability Insurance

The use of any of the Company's potential products in clinical trials and
the sale of any approved products may expose the Company to liability claims
resulting from the use of products or product candidates. These claims might be
made by customers (including corporate partners), clinical trial subjects,
patients, pharmaceutical companies or others. The Company maintains product
liability insurance coverage for claims

9
<PAGE> 11

arising from the use of its products whether in clinical trials or FDA-approved
commercial usage. However, coverage is becoming increasingly expensive and no
assurance can be given that the Company will be able to maintain insurance at a
reasonable cost. There can be no assurance that the Company's insurance will
provide sufficient amounts to protect the Company against losses due to
liability that could have a material adverse effect on the Company's business,
financial conditions and results of operations. The Company maintains product
liability insurance covering the sale of its products approved for commercial
marketing but there can be no assurance that the Company will be able to obtain
commercially reasonable product liability insurance for any product approved for
marketing in the future or that insurance coverage and the resources of the
Company would be sufficient to satisfy any liability resulting from product
liability claims. A product liability claim or series of claims brought against
the Company could have a material adverse effect on its business, financial
condition and results of operations, whether or not the plaintiffs in such
claims ultimately prevail.

Research and Development

The Company is committed to internal research and development as a method
of producing new products, improving existing products and growing revenues. The
Company spent $8,961,796, $9,304,327 and $9,671,897 in each of the last three
fiscal years respectively on research and development.

Veterinary Diagnostics Subsidiary

Kalisto Biologicals is engaged in the development, manufacture and
marketing of diagnostic products for the veterinary market. Kalisto's lead
product, the Endochek Plus(TM) chemistry analyzer, is an easy-to-use,
point-of-care system that provides veterinarians the ability to perform in-house
laboratory testing cost effectively. The Endochek Plus system was launched in
July 1998 and has a full menu of assays for veterinary use consisting of 23
tests and 9 test panels. The Endochek Plus consists of a spectrophotometer
Kalisto purchases on an OEM basis combined with proprietary software the Company
has developed in-house. The reagents consist of liquid chemistries and Enzyme
Immunoassay (ELISA) technology in a microwell format.

Veterinary Laboratory Diagnostics Market. Sales in the veterinary
laboratory diagnostics market in 1997 were estimated to be approximately $400
million with an annual growth rate of 10%. There are an estimated 27,000 animal
clinics/hospitals in the United States, with approximately 50,000 veterinarians.
In-house chemistry testing may allow veterinary practitioners to profitably
provide additional value-added services. As was the case in the human
diagnostics market, there is a growing trend towards point-of-care testing in
the animal health care market. The primary driver of this trend is the level of
care pet owners expect from their veterinarians. Veterinary care expectations
are often equivalent to the level of care pet owners expect for themselves.

Sales and Marketing. Kalisto markets its products through a combination of
distributors, independent sales representatives and its own sales force. The
Company currently has four sales people and two independent sales
representatives. In addition, the Company has established a distributor
relationship with VEDCO, the leading independent distributor group within the
U.S. veterinary market. The VEDCO group comprises twelve independent
distribution companies with approximately 200 sales representatives covering the
entire United States.

Competition. There are several companies currently providing point-of-care
systems for use in the veterinary laboratory diagnostics market. The industry is
dominated by IDEXX Laboratories, Inc. ("IDEXX"), with total sales of
approximately $263 million in 1997. IDEXX's closest direct competitor,
Synbiotics Corp., had 1997 sales of approximately $23 million. Other competitors
include Abaxis, Heska and several of the human diagnostics companies.

ITEM 2. PROPERTIES:

The Company's principal pharmaceutical manufacturing and research and
development operations are located in a modern Company-owned building of
approximately 25,000 square feet in Cambridge, Massachusetts. The Company has
leased two additional premises in Cambridge of approximately 18,000 total square
feet to be used for manufacturing, warehousing and executive office space. One
lease expires on October 31,
10
<PAGE> 12

2000 and the other lease expires on November 30, 2000. In addition, the Company
has leased premises of approximately 5,200 square feet in Princeton, New Jersey
used by the Company's clinical development group as a general business, sales
and administrative office. This lease expires on September 30, 2003. Kalisto
Biologicals, Inc. has committed to approximately 12,000 Square feet of space
through October 31, 2002. The Company believes these facilities are adequate for
its current and anticipated short-term needs and that it will be able to enter
into lease extensions or to lease comparable space, if necessary. However, the
acquisition and required regulatory approvals for additional pharmaceutical
manufacturing space can be time consuming and expensive. There is no assurance
that if the Company desired to expand its manufacturing capacity it would be
able to do so on a timely basis, if at all.

ITEM 3. LEGAL PROCEEDINGS:

The Company and certain of its officers were sued in an action entitled
David D. Stark, M.D. v. Advanced Magnetics. Inc., Jerome Goldstein, Ernest V.
Groman, and Lee Josephson, Civil Action No. 92-12157-WGY, in the United States
District Court for the District of Massachusetts on September 3, 1992. The
plaintiff, a former consultant to the Company, claims that he was incorrectly
omitted as an inventor or joint inventor on certain of the Company's patents and
on pending applications, and seeks injunctive relief and unspecified damages. In
addition, the complaint also alleges state law claims for breach of contract,
breach of good faith and fair dealing, breach of implied contract,
misappropriation of trade secrets, conversion, negligent misrepresentation,
misrepresentation, unjust enrichment and unfair trade practices. The District
Court has stayed this federal action pending resolution of an appeal in the
State Court of summary judgment in the Company's favor as well as resolution of
a jurisdictional issue. While the outcome of the action cannot be determined,
the Company believes the action is without merit and intends to defend the
action vigorously. There can be no assurance, however, that the Company will be
able to defend successfully this action and the failure by the Company to
prevail for any reason could have an adverse effect on the Company's future
business, financial condition and results of operations.

The Company and certain of its officers were sued in David D. Stark, M.D.
v. Advanced Magnetics, Inc., Jerome Goldstein, Ernest V. Groman and Lee
Josephson, Civil Action No. 93-02846-C, in the Superior Court Department of the
Massachusetts Trial Court for Middlesex County. This case involves claims of
breach of contract, breach of good faith and fair dealing, breach of implied
contract, unjust enrichment and unfair trade practices that were originally
dismissed by, but later remanded to, the Federal Court in the above-mentioned
action, as well as a new count alleging tortious interference with contractual
or advantageous relations. The Superior Court granted partial summary judgment
in the Company's favor and dismissed the unfair trade practices and tort counts.
The plaintiff's contract claims have been dismissed with prejudice and final
judgment was entered against the plaintiff. The plaintiff filed an appeal in
David D. Stark, M.D. v. Advanced Magnetics, Inc., Jerome Goldstein, Ernest V.
Groman and Lee Josephson, Appeal No. 98-P-1749 in the Massachusetts Appeals
Court, docketed on September 21, 1998. While the outcome of the action cannot be
determined, the Company believes the action is without merit and intends to
defend the action vigorously. There can be no assurance, however, that the
Company will be able to defend successfully this action and the failure by the
Company to prevail for any reason could have an adverse effect on the Company's
future business, financial condition and results of operations.

11
<PAGE> 13

requests judgment in its favor on all of Sanofi Pharmaceuticals, Inc.'s
counterclaims. The Court has scheduled a December 18, 1998 hearing date for the
Company's motion for partial summary judgment. On November 13, 1998 the Company
filed an amended complaint adding claims for unfair competition and breach of
contract against the Defendants. On November 23, 1998, Defendants answered the
Company's amended complaint, and Sanofi Pharmaceuticals, Inc. served a new set
of counterclaims seeking compensatory damages of $15,000,000 and multiple
damages as a result of the Company's alleged conduct. While the final outcome of
these claims and counterclaims cannot be determined, the Company will pursue its
claims vigorously, and believes that the Sanofi Pharmaceuticals, Inc.
counterclaims are without merit and intends to defend them vigorously.

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

No matters were submitted to a vote of the Company's security holders
during the quarter ended September 30, 1998.

EXECUTIVE OFFICERS OF THE REGISTRANT:

JEROME GOLDSTEIN, 59, is a founder of the Company and has been Chief
Executive Officer, Chairman of the Board of Directors and Treasurer since the
Company's organization in November 1981. He also serves as Chairman of the Board
of Directors of the Company's subsidiary Kalisto Biologicals. Mr. Goldstein was
a co-founder of Clinical Assays, Inc., serving from 1972 to 1980 as Vice
President and then as President. Mr. Goldstein is the brother of Leslie
Goldstein, a director of the Company, and husband of Marlene Kaplan Goldstein,
secretary.

LEONARD M. BAUM, 45, joined the Company in October 1994 as Senior Vice
President and has been President and Chief Operating Officer since May 1997.
From 1986 to September 1994, Mr. Baum was employed as Senior Director, Worldwide
Regulatory Affairs/Drug Safety by Squibb Diagnostics. Mr. Baum is also a member
of the Board of Directors of Advanced Magnetics and of the Company's subsidiary
Kalisto Biologicals.

ERNEST V. GROMAN, 53, is a co-founder of the Company and has been Senior
Vice President -- Research since June 1997. From 1994 to 1997, he was Director
of Exploratory Research and from 1981 to 1994 he was a Senior Scientist of the
Company.

PAULA M. JACOBS, 54, joined the Company in January 1986 as Vice
President -- Development. From 1981 to 1986, Dr. Jacobs was employed at Seragen,
Inc., first as Production Manager and later as General Manager of the Research
Products Division.

DENNIS LAWLER, 44, joined the Company in February 1989 as Director of
Quality Control and has been Vice President -- Quality Control since January
1997. Prior to February 1989, Mr. Lawler was employed at CIS-US, first as Senior
Quality Control Analyst, then as Production Manager and finally as Plant
Manager.

JEROME M. LEWIS, 49, joined the Company in April 1986 as a Senior Scientist
and has been Vice President -- Scientific Operations since February 1991. Prior
to April 1986, Dr. Lewis was employed as a senior scientist by Petroferm Ltd., a
biotechnology company.

MARIA A. LUCAS, 37, joined the Company in September 1994 as Director of
Operations and has been Vice President of Clinical Information since January
1998. Prior to September 1994, Ms. Lucas was employed at Squibb Diagnostics as
Senior Manager, Diagnostics Data Management.

JAMES A. MATHESON, 54, joined the Company in May 1996 as Vice
President -- Finance. Prior to May, 1996, Mr. Matheson was Controller of Diatech
Diagnostics, Inc.

MARIE R. MORRIS, 46, joined the Company in September 1994 as Director,
Clinical Affairs and has been Vice President of Clinical Affairs since January
1998. Prior to September 1994, Ms. Morris was employed at Squibb Diagnostics, as
Manager, Clinical Operations Research.

12
<PAGE> 14

MARK C. ROESSEL, 48, joined the Company in January 1982 as Director of
Regulatory Affairs and has been Vice President -- Regulatory Affairs since
January 1995. Prior to January 1982, Mr. Roessel was Compliance Manager of the
Clinical Assay Division of Baxter International, Inc.

MARLENE KAPLAN GOLDSTEIN is a founder of the Company and has been Secretary
of the Company since the Company's organization in November 1981.

PART II

ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS:

The Company's common stock is listed on the American Stock Exchange under
the symbol AVM.

The table below sets forth the high and low sales price of the Company's
common stock on the American Stock Exchange for the fiscal quarters of 1998 and
1997.

<TABLE>
<CAPTION>
FISCAL QUARTER
----------------------------------
FIRST SECOND THIRD FOURTH
----- ------ ----- ------
<S> <C> <C> <C> <C>
1998 High.......................................... 10 1/2 13 5/16 13 3/8 12
Low.............................................. 8 1/2 8 7/8 10 5/16 6 3/8
1997 High.......................................... 17 5/8 19 1/2 13 3/4 12 5/16
Low.............................................. 14 1/2 12 3/4 10 1/2 10
</TABLE>

On December 7, 1998 there were approximately 300 shareholders of record.
The Company believes that the number of beneficial holders of common stock
exceeds 2,600. The last reported sale price of the common stock on December 7,
1998 was $8.625 per share. The Company has never declared or paid a cash
dividend on its capital stock.

13
<PAGE> 15

ITEM 6. SELECTED FINANCIAL DATA:

The selected financial data set forth below has been derived from the
audited financial statements of the Company. This information should be read in
conjunction with the financial statements and notes thereto set forth elsewhere
herein.

<TABLE>
<CAPTION>
FOR THE YEARS ENDED SEPTEMBER 30,
------------------------------------------------------------------
1998 1997 1996 1995 1994
----------- ----------- ----------- ----------- ----------
<S> <C> <C> <C> <C> <C>
Statement of Operations Data:
Revenues:
License fees......................................... $ -- $ 5,500,000 $ -- $ 5,000,000 $5,505,000
Royalties............................................ 980,542 363,445 50,000 189,493 15,924
Product sales........................................ 1,399,871 1,580,357 12,762 2,120,457 280,975
Contract research and development.................... 399,897 62,920 6,810 -- --
Interest, dividends and net gains and losses on sales
of securities...................................... 3,623,836 3,495,049 1,761,450 2,287,311 1,845,005
----------- ----------- ----------- ----------- ----------
Total revenues................................. 6,404,146 11,001,771 1,831,022 9,597,261 7,646,904
Costs and Expenses:
Cost of product sales................................ 237,945 311,678 2,550 425,187 54,983
Contract research & development expenses............. 6,514 8,815 -- -- --
Company-sponsored research and development
expenses........................................... 8,961,796 9,304,327 9,671,897 8,601,791 6,621,929
Charge (credit) for purchase of in-process research
and development*................................... -- -- -- (380,000) 760,000
Selling, general & administrative expenses........... 3,701,410 1,437,599 1,871,568 1,759,348 1,963,480
----------- ----------- ----------- ----------- ----------
Total cost and expenses........................ 12,907,665 11,062,419 11,546,015 10,406,326 9,400,392
Other Income:
Other income......................................... -- 264,800 -- -- --
Gain on sale of in vitro product line**................ -- -- -- 3,404,527 2,649,580
----------- ----------- ----------- ----------- ----------
Income (loss) before provision for income taxes,
minority shareholder interest and cumulative effect
of accounting change................................. (6,503,519) 204,152 (9,714,993) 2,595,462 896,092
Minority shareholder interest in subsidiary............ (194,178) -- -- -- --
Income tax (benefit) provision......................... -- (379,022) -- 400,000 8,000
----------- ----------- ----------- ----------- ----------
Income (loss) before cumulative effect of accounting
change............................................... (6,309,341) 583,174 (9,714,993) 2,195,462 888,092
Cumulative effect of accounting change................. -- -- -- 117,540 --
----------- ----------- ----------- ----------- ----------
Net income (loss)...................................... $(6,309,341) $ 583,174 $(9,714,993) $ 2,313,002 $ 888,092
=========== =========== =========== =========== ==========
Net income (loss) per share before cumulative effect of
accounting change.................................... $ (0.93) $ 0.09 $ (1.44) $ 0.32 $ 0.13
Cumulative effect of accounting change................. -- -- -- 0.02 --
----------- ----------- ----------- ----------- ----------
Basic and diluted income (loss) per share.............. $ (0.93) $ 0.09 $ (1.44) $ 0.34 $ 0.13
=========== =========== =========== =========== ==========
Weighted average shares outstanding:
Basic................................................ 6,752,863 6,744,946 6,762,748 6,730,315 6,690,500
Diluted.............................................. 6,752,863 6,813,984 6,762,748 6,870,839 6,806,525
----------- ----------- ----------- ----------- ----------
</TABLE>

- ---------------
* In August 1994, the Company reacquired the development and marketing rights
to the MRI contrast agent Combidex previously licensed to Squibb Diagnostics,
a Division of Bristol Myers Squibb Company, Inc., and recorded a related
$760,000 charge for the purchase of in-process research and development. In
the first fiscal quarter of 1995, a credit for $380,000 was recorded to the
purchase of in-process research and development.

** On October 15, 1993, the Company sold its in vitro product line to PerSeptive
Biosystems, Inc.

<TABLE>
<CAPTION>
AT SEPTEMBER 30
-------------------------------------------------------------------
1998 1997 1996 1995 1994
----------- ----------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C>
Balance sheet data:
Working capital....................................... $27,278,502 $37,422,235 $33,605,818 $41,985,100 $38,891,406
----------- ----------- ----------- ----------- -----------
Total assets.................................. $34,114,708 $44,976,181 $41,066,373 $50,843,222 $46,672,700
----------- ----------- ----------- ----------- -----------
Stockholders' equity.................................. $32,919,398 $43,423,058 $40,132,545 $49,071,072 $45,451,475
</TABLE>

14
<PAGE> 16

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS:

OVERVIEW

Since its inception in November 1981, Advanced Magnetics, Inc., (the
"Company") has focused its efforts on developing its core superparamagnetic iron
oxide particle technology to develop magnetic resonance imaging ("MRI") contrast
agents. In October 1997, the Company acquired 80.7% of the issued and
outstanding capital stock of Kalisto Biologicals, Inc., ("Kalisto"), an
early-stage company that develops, manufactures and markets diagnostic products
for the veterinary market. The Company has funded its operations with cash from
license fees from corporate partners, royalties, sales of its products, fees
from contract research performed for third parties, the proceeds of financings
and income earned on invested cash. The Company's success in the market for
diagnostic and therapeutic products will depend, in part, on the Company's
ability to successfully develop, test, produce and market its products; obtain
necessary governmental approvals in a timely manner; attract and retain key
employees; and successfully respond to technological and other changes in the
marketplace.

The Company's operating results may continue to vary significantly from
quarter to quarter or from year to year depending on a number of factors,
including: the timing of payments from corporate partners and research grants;
the introduction of new products by the Company; the timing and size of orders
from the Company's customers; and the acceptance of the Company's products. The
Company's current planned expense levels are based in part upon expectations as
to future revenue. Consequently, profits may vary significantly from quarter to
quarter or year to year based on the timing of revenue. Revenue or profits in
any period will not necessarily be indicative of results in subsequent periods
and there can be no assurance that the Company will achieve profitability or
that revenue growth can be sustained in the future.

A substantial portion of the Company's expenses consists of research and
development expenses. The Company expects its research and development expenses
to stay about the same as it works on new products such as Quantison and the
development of any additional contrast agents or therapeutic products that
result from the Company's other research.

RESULTS OF OPERATIONS

Fiscal 1998 Compared to Fiscal 1997

Revenues

Total revenues for the fiscal year ended September 30, 1998 were $6,404,146
compared to $11,001,771 for the fiscal year ended September 30, 1997.

There were no license fee revenues for the fiscal year ended September 30,
1998 and $5,500,000 in license fee revenues for the fiscal year ended September
30, 1997. The Company received a non-refundable milestone payment of $5,000,000
in October 1996 from Berlex Laboratories, Inc. ("Berlex"), as a result of
Berlex's market launch of Feridex I.V. in the United States, under an agreement
(the "Berlex Agreement") granting Berlex a product license and exclusive
marketing rights to the Company's Feridex I.V. MRI contrast agent in the United
States. The Company received a non-refundable milestone payment of $500,000 in
December 1996 from Mallinckrodt Inc. ("Mallinckrodt") as a result of the FDA's
marketing approval of GastroMARK under an agreement (the "Mallinckrodt
Agreement") granting Mallinckrodt a product license and co-marketing rights to
the Company's GastroMARK MRI contrast agent in North America.

Royalties for the fiscal year ended September 30, 1998 were $980,542 as
compared to $363,445 in fiscal 1997. Increased royalties in fiscal 1998 reflect
initiation of product sales in Japan of the Company's Feridex I.V. liver MRI
contrast agent by Eiken Chemical Co., Ltd. ("Eiken"); increased product sales in
the United States of Feridex I.V. by Berlex, increased product sales in North
America of GastroMARK oral MRI contrast agent by Mallinckrodt as well as
increased product sales in Europe by Guerbet S.A. ("Guerbet") of Feridex
I.V.(under the trade name Endorem) and GastroMARK (under the trade name Lumirem)
as compared to fiscal 1997.

15
<PAGE> 17

Product sales for the fiscal year ended September 30, 1998 were $1,399,871
compared to $1,580,357 for the fiscal year ended September 30, 1997. These
results reflect substantial shipments in fiscal 1997 to Berlex to support the
Feridex I.V. launch offset in part by an increase in shipments to Guerbet during
fiscal 1998 as compared to fiscal 1997. Product sales in fiscal 1998 included
$220,853 in product sales from the Endochek Plus blood chemistry analyzer for
veterinary use launched by the Company's subsidiary Kalisto Biologicals.

Contract research and development revenues were $399,897 during the fiscal
year ended September 30, 1998 compared with $62,920 in the fiscal year ended
September 30, 1997. The increase in fiscal year 1998 reflects the reimbursement
of certain development costs of approximately $370,000 under the Berlex
Agreement.

Interest, dividends and gains and losses on sales of securities resulted in
revenues of $3,623,836 for the fiscal year ended September 30, 1998 compared to
$3,495,049, for the fiscal year ended September 30, 1997. The increase was
primarily due to a net gain on sales of securities of $2,473,826 for the fiscal
year ended September 30, 1998 compared to a net gain of $1,867,350 for the
fiscal year ended September 30, 1997. Interest income for the fiscal year ended
September 30, 1998 was $978,546 compared to $1,385,670 for the fiscal year ended
September 30, 1997. Dividend income of $171,464 for the year ended September 30,
1998 was $ 70,565 less than the $242,029 for the fiscal year ended September 30,
1997.

Costs and Expenses

The cost of product sales for the fiscal year ended September 30, 1998 was
$237,945 compared to $311,678 for the fiscal year ended September 30, 1997. The
cost of product sales for the fiscal year ended September 30, 1998 related to
the launch of the Endochek Plus system, a veterinary blood chemistry analyzer,
by Kalisto and the cost of contrast agent sales. The cost of product sales for
fiscal 1998 was 17% of product sales and for fiscal 1997 was 20% of product
sales. This change is attributable to changes in product mix and the
introduction of the Endochek Plus system.

Research and development expenses for the fiscal year ended September 30,
1998 were $8,961,796, a decrease of 4% compared to $9,304,327 for the fiscal
year ended September 30, 1997. The decrease was primarily attributable to a
reduction in direct, company-sponsored research and development programs and an
increase in collaborative research partnerships. The decreases were partially
offset by $555,408 in R&D expenditures at Kalisto. The Company expects that
expenditures for research and development for fiscal 1999 will continue at
present levels.

Selling, general and administrative expenses for the fiscal year ended
September 30, 1998 were $3,701,410, an increase of $2,263,811 from $1,437,599
for the fiscal year ended September 30, 1997. The increase is attributable to
the addition of Kalisto and increases in legal expenses.

Income Taxes

There was no income tax provision for the fiscal year ended September 30,
1998 due to a net operating loss. There was an income tax benefit for the fiscal
year ended September 30, 1997 resulting from payments from the Internal Revenue
Service for contingent refunds.

Earnings

In the fiscal year ended September 30, 1998, the Company recorded a net
loss of ($6,309,341), or ($0.93) per share. In the fiscal year ended September
30, 1997, the Company recorded a net profit of $583,174, or $0.09 per share.

16
<PAGE> 18

RESULTS OF OPERATIONS

Fiscal 1997 Compared to Fiscal 1996

Revenues

Total revenues for the fiscal year ended September 30, 1997 were
$11,001,771 compared to $1,831,022 for the fiscal year ended September 30, 1996.

There were license fee revenues for the fiscal year ended September 30,
1997 of $5,500,000 and none for the fiscal year ended September 30, 1996. The
Company received a non-refundable milestone payment of $5,000,000 in October
1996 from Berlex as a result of Berlex's market launch of Feridex I.V. in the
United States, under the Berlex Agreement granting Berlex a product license and
exclusive marketing rights to the Company's Feridex I.V. MRI contrast agent in
the United States. The Company received a non-refundable milestone payment of
$500,000 in December 1996 from Mallinckrodt as a result of the FDA's marketing
approval of GastroMARK under the Mallinckrodt Agreement granting Mallinckrodt a
product license and co-marketing rights to the Company's GastroMARK MRI contrast
agent in North America.

Royalties for the fiscal year ended September 30, 1997 were $363,445 as
compared to $50,000 in fiscal 1996. Royalties in fiscal 1997 reflect product
sales in the United States of the Company's Feridex I.V. liver MRI contrast
agent by Berlex and product sales in North America of GastroMARK oral MRI
contrast agent by Mallinckrodt as well as increased product sales in Europe by
Guerbet of Feridex I.V. (under the trade name Endorem) and GastroMARK (under the
trade name Lumirem) as compared to fiscal 1996.

Product sales for the fiscal year ended September 30, 1997 were $1,580,357
compared to $12,762 for the fiscal year ended September 30, 1996 which resulted
primarily from the initial product launch by Berlex in the United States of
Feridex I.V. and by Mallinckrodt in North America of GastroMARK in the 1997
fiscal year.

Interest, dividends and gains and losses on sales of securities resulted in
revenues of $3,495,049 for the fiscal year ended September 30, 1997 compared to
$1,761,450 for the fiscal year ended September 30, 1996.

Interest income for the fiscal year ended September 30, 1997 was $1,385,670
compared to $1,400,597 for the fiscal year ended September 30, 1996. Dividend
income of $242,029 for the year ended September 30, 1997 was $112,471 less than
the $354,500 for the fiscal year ended September 30, 1996. There was a net gain
on sales of securities of $1,867,350 for the fiscal year ended September 30,
1997 compared to a net gain of $6,353 for the fiscal year ended September 30,
1996. The increase was primarily attributable to gains realized on the sale of a
certain security.

Costs and Expenses

The cost of product sales for the fiscal year ended September 30, 1997 was
$311,678 compared to $2,550 for the fiscal year ended September 30, 1996. The
cost of product sales for the fiscal year ended September 30, 1997 related
primarily to the introduction in the United States of Feridex I.V. and
GastroMARK. The cost of product sales for both fiscal years was 20% of product
sales.

Research and development expenses for the fiscal year ended September 30,
1997 were $9,304,327, a decrease of 4% compared to $9,671,897 for the fiscal
year ended September 30, 1996. The decrease was primarily attributable to
reduced staffing. The Company made payments during fiscal 1997 of $800,000 in
accordance with its agreements to license technology from a third party based on
the achievement of certain milestones.

Selling, general and administrative expenses for the fiscal year ended
September 30, 1997 were $1,437,599, a decrease of 23% from $1,871,568 for the
fiscal year ended September 30, 1996. The decrease was primarily attributable to
the write-off of expenses in fiscal 1996 associated with a proposed, but later
terminated, public offering of the Company's common stock.

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Other

Other income of $264,800 was recognized during the fiscal year ended
September 30, 1997 as the result of an insurance settlement for flood damages in
the research and development laboratory in October 1996.

Income Taxes

The income tax benefit resulted from payments from the Internal Revenue
Service for contingent refunds. There was no income tax provision for the fiscal
year ended September 30, 1997 due to the applicable net operating loss
carry-forwards. There was no income tax provision for the fiscal year ended
September 30, 1996 due to a net operating loss.

Earnings

In the fiscal year ended September 30, 1997, the Company recorded a net
profit of $583,174, or $0.09 per share. In the fiscal year ended September 30,
1996, the Company recorded a net loss of ($9,714,993), or ($1.44) per share.

Liquidity and Capital Resources

At September 30, 1998, the Company's cash and cash equivalents totaled
$7,704,245, compared with $10,724,740 at September 30, 1997. In addition, the
Company had marketable securities of $19,096,942 at September 30, 1998 as
compared to $27,365,765 on September 30, 1997. Net cash used in operating
activities was $8,981,704 in the fiscal year ended September 30, 1998 compared
to net cash used in operating activities of $202,281 in the fiscal year ended
September 30, 1997, an increase of $8,779,423. The increase in cash used in
operating activities was due primarily to a net loss of $6,309,341 for the year
ended September 30, 1998, compared with a net profit of $583,174 in the fiscal
year ended September 30, 1997. Cash provided by investing activities was
$5,927,801 for the fiscal year ended September 30, 1998 compared to $803,333
provided by investing activities in the fiscal year ended September 30, 1997.
Cash provided by investing activities in the fiscal year ended September 30,
1998 included the investment of $7,426,189 in marketable securities, offset by
$5,000,000 from maturing United States Treasury notes and $8,993,685 from the
sale of marketable securities. Cash used in investing activities in the fiscal
year ended September 30, 1997 included the purchase of marketable securities of
$20,380,048. Proceeds from United States Treasury notes maturing was $12,500,000
and proceeds from the sale of marketable securities was $9,270,016 in the fiscal
year ended September 30, 1997. Cash provided by financing activities was $33,408
for the fiscal year ended September 30, 1998 and included proceeds of $189,757
from the issuances of common stock offset by the purchase of 16,800 shares of
the Company's common stock on the open market for $156,349. In the fiscal year
ended September 30, 1997 cash used in financing activities was $682,154 mainly
due to the purchase of treasury stock in the open market for $861,599. In May
1996, the Board of Directors authorized the purchase of up to 250,000 shares of
the Company's common stock on the open market at prevailing market prices. This
authorization was extended in November 1997.

Capital expenditures in the fiscal year ended September 30, 1998 were
$584,360 compared to $533,590 in the fiscal year ended September 30, 1997. The
capital expenditures in both years continued the Company's efforts to upgrade
laboratory and production equipment. The Company has no current commitment for
any significant expenditures on property, plant and equipment, including
purchases related to the Year 2000 compliance issue. The Company expects that
expenditures for research and development for fiscal 1999 will continue at
present levels.

Management believes that funds for future needs can be generated from
existing cash balances, cash generated from investing activities and cash
generated from operations. In addition, the Company will consider from time to
time various financing alternatives and may seek to raise additional capital
through equity or debt financing or to enter into corporate partnering
arrangements. There can be no assurance, however, that funding will be available
on terms acceptable to the Company, if at all.

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Impact of Recently Issued Accounting Pronouncements

The FASB recently issued Statement No 130 ("SFAS 130"), "Reporting
Comprehensive Income". This statement requires changes in comprehensive income
to be shown in a financial statement that is displayed with the same prominence
as other financial statements. While not mandating a specific financial
statement format, the Statement requires that an amount representing total
comprehensive income be reported. The Statement is effective for fiscal years
beginning after December 15, 1997. Reclassification of financial statements for
earlier periods is required for comparative purposes. The Company believes the
implementation of SFAS 130 may have a material impact on comprehensive income.

The FASB also issued Statement No. 131 ("SFAS 131"), "Disclosures about
Segments of an Enterprise and Related Information". This Statement, which
supersedes Statement No. 14, "Financial Reporting for Segments of a Business
Enterprise," changes the way public companies report information about segments.
The Statement, which is based on the management approach to segment reporting,
includes requirements to report segment information quarterly and entity-wide
disclosures about products and services, major customers, and the material
countries in which the entity holds assets and reports revenues. The Statement
is effective for periods beginning after December 15, 1997. Restatement for
earlier years is required for comparative purposes unless impracticable. In
addition, SFAS 131 need not be applied to interim periods in the initial year,
however, in subsequent years, interim period information must be presented on a
comparative basis. The Company is currently evaluating this Statement and its
effect on financial statement disclosures.

In June 1998, the FASB issued Statement No. 133 ("SFAS 133"), "Accounting
for Derivative Instruments and Hedging Activities" which is effective for fiscal
years beginning after June 15, 1999. The statement establishes accounting and
reporting standards requiring that every derivative instrument be recorded in
the balance sheet as either an asset or liability, measured at its fair value.
SFAS No. 133 also requires that changes in the derivative's fair value be
recognized currently in earnings unless specific hedge accounting criteria are
met. Adoption of this standard is not expected to have a material impact on the
financial position or results of operations of the Company.

Certain Factors That May Affect Future Results

The Company does not provide forecasts of its future financial performance.
However, from time to time, information provided by the Company or statements
made by its employees may contain "forward looking" information that involves
risks and uncertainties. In particular, statements contained in this Form 10-K
that are not historical facts (including, but not limited to statements
contained in this Item 7 relating to liquidity and capital resources and the
Year 2000 issue) constitute forward looking statements and are made under the
safe harbor provisions of the Private Securities Litigation Reform Act of 1995.
The Company's actual results of operations and financial condition have varied
and may in the future vary significantly from those stated in any forward
looking statements. Factors that may cause such differences include, without
limitation, the risks, uncertainties and other information discussed below and
within this Form 10-K, as well as the accuracy of the Company's internal
estimates of revenue and operating expense levels. The following discussion of
the Company's risk factors should be read in conjunction with the financial
statements and related notes thereto. Such factors, among others, may have a
material adverse effect upon the Company's business, results of operations and
financial condition.

Early Stage of Product Commercialization; Uncertainty of Product
Development. The Company has not generated significant revenues from the sale
of its products. Feridex I.V. and GastroMARK are still relatively new to the
market and represent a new technology platform for physicians to adopt. In
addition, Kalisto has only recently introduced its Endochek Plus product. While
the Company has completed human clinical testing of Combidex, this product and
the Company's other product candidates may require significant additional
research and development efforts, including extensive human clinical testing,
prior to submission of any regulatory application for commercial sale of such
products. Such products are not expected to be commercially available for
several years, if at all. The development of new pharmaceutical products is
highly uncertain and the Company's development programs may not be completed
successfully, required regulatory

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<PAGE> 21

approvals may not be obtained on a timely basis, if at all, and products,
including Combidex, Feridex I.V. or GastroMARK, may not be commercially
successful.

The Company's long term viability and growth will depend on the successful
commercialization of Feridex I.V., GastroMARK and other products resulting from
its research activities. If any of the Company's development programs are not
completed successfully, required regulatory approvals are not obtained or
products for which approvals are obtained are not commercially successful, the
Company's business, financial condition and results of operations could be
materially adversely affected.

Need for Future Funding; Uncertainty of Access to Capital. The Company has
expended and will continue to expend substantial funds to complete the research,
development, clinical trials, regulatory approvals and other activities through
final commercialization of its products. It is possible that the Company may
need additional financing to satisfy its capital and operating requirements
relating to the development, manufacturing and marketing of its products. The
Company may seek such financing through arrangements with collaborative partners
and through public or private sales of the Company's securities, including
equity securities. The Company may not be able to obtain financing on acceptable
terms, if at all. Any additional equity financings could be dilutive to the
Company's stockholders. If adequate additional funds are not available, the
Company may be required to curtail significantly one or more of its research and
development programs or obtain funds through arrangements with collaborative
partners or others that may require the Company to relinquish rights to certain
of its products and product candidates on terms that it might otherwise find
unacceptable.

Government Regulation; Regulatory Approval. Prior to marketing, every
product candidate must undergo an extensive regulatory approval process in the
United States and in every country in which the Company intends to test and
market its product candidates and products. This regulatory process includes
testing and clinical trials of each product candidate to demonstrate safety and
efficacy and can require many years and the expenditure of substantial resources
in the United States and in foreign countries in which approval is sought. Data
obtained from preclinical testing and clinical trials are subject to varying
interpretations, which can delay, limit or prevent FDA approval or foreign
regulatory approval. In addition, changes in FDA approval policies or
requirements may occur or new regulations may be promulgated which may result in
delay or failure to receive FDA approval. Similar delays or failures may be
encountered in foreign countries. Delays and related costs in obtaining
regulatory approvals could have a material adverse effect on the Company's
business, financial condition and results of operations. Although the Company
has received approval in the United States and in certain foreign countries to
market Feridex I.V. and GastroMARK, the Company may not be able to obtain
further regulatory approvals for any products developed by the Company. Failure
to obtain requisite governmental approvals or failure to obtain approvals of the
scope requested could delay and may preclude the Company or its licensees or
other collaborators from marketing the Company's products or limit the
commercial use of the products and could have a material adverse effect on the
Company's business, financial condition and results of operations.

Regulatory approvals may entail limitations on the indicated uses of such
products and impose labeling requirements which may adversely impact the
Company's ability to market its products. Even if regulatory approval is
obtained, a marketed product and its manufacturer are subject to continuing
regulatory review. Noncompliance with regulatory requirements of the approval
process at any stage may result in various adverse consequences, including the
FDA's or a foreign regulatory agency's delay in approving, or its refusal to
approve, a product, withdrawal of an approved product from the market or, under
certain circumstances, the imposition of criminal penalties. Any such adverse
consequences could have a material adverse effect on the Company's business,
financial condition and results of operations.

Uncertainties Relating to Clinical Trials; Technological
Uncertainty. Before obtaining regulatory approvals for the commercial sale of
any of its contrast agents or other product candidates, the Company must
demonstrate through extensive preclinical testing and human clinical trials that
the product is safe and efficacious. The results from preclinical testing and
early clinical trials of products under development by the Company may not be
predictive of results obtained in subsequent clinical trials. Clinical trials
are often conducted with patients in the most advanced stages of disease. During
the course of treatment, these patients

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can die or suffer adverse medical effects for reasons that may not be related to
the product being tested, but which can nevertheless adversely affect clinical
trial results or approvals by the FDA or foreign regulatory agencies. Clinical
testing of a pharmaceutical product is itself subject to approvals by various
governmental regulatory authorities. Advanced Magnetics may not be permitted by
regulatory authorities to commence or continue clinical trials. Any delays in,
or termination of, the Company's clinical trial efforts could have a material
adverse effect on the Company's business, financial condition and results of
operations.

Many of the Company's products are subject to technological uncertainty.
Only two of the Company's products, Feridex I.V. and GastroMARK, have been
approved for sale in the United States. The Company's MRI contrast agents may
cause adverse reactions, including death, in certain persons under certain
conditions. These factors may adversely affect the development or
commercialization of the Company's products.

Dependence on Collaborative Relationships. The Company's strategy for the
development and commercialization of its contrast agent product candidates has
been, to date, to enter into strategic alliances with various corporate
partners, licensees, and other collaborators. In some cases, the Company may be
dependent upon these collaborators to conduct preclinical and clinical testing,
to obtain regulatory approvals and to manufacture and market products. The
Company may not derive any revenues or profits from these activities and the
Company may not be able to enter into future collaborative relationships even if
it desires to do so. If any of the Company's collaborators breaches its
agreement with the Company or otherwise fails to perform, such event could have
a material adverse effect on the Company's business, financial condition and
results of operations.

Competition and Risk of Technological Obsolescence. The pharmaceutical and
biopharmaceutical industries are subject to intense competition and rapid
technological change. The Company has many competitors, many of which have
substantially greater capital and other resources than the Company and represent
significant competition for Advanced Magnetics. Such companies may succeed in
developing technologies and products that are more effective or less costly than
any that may be developed by the Company, and such companies may be more
successful than the Company in developing, manufacturing and marketing products.
In addition, the Company's MRI contrast agents represent a relatively new
approach to imaging certain organs, and market acceptance of both MRI as an
appropriate imaging technique for such organs and the Company's products as
contrast agents is critical to the Company's ability to compete successfully.
The Company may not be able to compete successfully in the future. Developments
by others may render the Company's products or product candidates or
technologies obsolete or noncompetitive. The Company's collaborators or
customers may choose to use competing technologies or products.

Uncertainty Regarding Patents and Proprietary Rights. The patent positions
of pharmaceutical and biopharmaceutical firms, including Advanced Magnetics, are
generally uncertain and involve complex legal and factual questions. Because of
the substantial length of time and expense associated with bringing new products
through development and regulatory approval to the marketplace, the
pharmaceutical and biopharmaceutical industries place considerable importance on
obtaining patent and trade secret protection for new technologies, products and
processes. The Company may not be successful or timely in obtaining any such
patents. The breadth of the claims obtained may not provide significant
protection of the Company's technology and the degree of protection afforded by
patents for licensed technologies or for future discoveries may not be adequate
to protect the Company's proprietary technology. Moreover, patents issued to
Advanced Magnetics may be contested, invalidated or circumvented. Future patent
interferences involving patents of either the Company or its licensors may have
a material adverse effect on the Company's business, financial condition or
results of operations. Moreover, claims of infringement or violation of the
proprietary rights of others may be asserted against the Company. If Advanced
Magnetics is required to defend against such claims or to protect its own
proprietary rights against others, the Company may incur substantial costs which
could have a material adverse effect on the Company's business, financial
condition and results of operations.

In the future, Advanced Magnetics may be required to obtain additional
licenses to patents or other proprietary rights of others. Such licenses may not
be available on acceptable terms, if at all. The failure to obtain such licenses
could result in delays in marketing the Company's products or the inability to
proceed with the development, manufacturing or sale of product candidates
requiring such licenses. In addition, the

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termination of any of the Company's existing licensing arrangements could have a
material adverse effect on the Company's business, financial condition and
results of operations.

The Company also relies upon unpatented trade secrets and improvements,
unpatented know-how and continuing technological innovation to develop and
maintain its competitive position, which it seeks to protect, in part, by
confidentiality agreements with its corporate partners, collaborators, employees
and consultants. These agreements may be breached and the Company may not have
adequate remedies for any such breach. The Company's trade secrets may become
known or independently discovered by its competitors. In addition, the Company
cannot be certain that others will not independently develop substantially
equivalent or superceding proprietary technology, or that an equivalent product
will not be marketed in competition with the Company's products, thereby
substantially reducing the value of the Company's proprietary rights.

Uncertainty of Third-Party Reimbursement. In both the United States and
foreign markets, the Company's ability to commercialize its products may depend
in part on the extent to which reimbursement for the costs of such products and
related treatments will be available from government health administration
authorities, private health insurers and other third-party payors. In the United
States, there have been, and the Company expects that there will continue to be,
a number of federal and state proposals to reform the health care system.
Significant uncertainty exists as to the reimbursement status of both
newly-approved health care products and products used for indications not
approved by the FDA. Currently, in the United States there is no established
reimbursement policy for the Company's approved products. If adequate
reimbursement levels are not established and maintained by government and/or
other third-party payors for the Company's products and related treatments, the
Company's business, financial condition and results of operations may be
materially adversely affected.

Limited Manufacturing Experience and Capacity. Advanced Magnetics has
limited experience in manufacturing contrast agents in commercial quantities.
Currently, the Company manufactures bulk Feridex I.V. product for sale by
Guerbet, Feridex I.V. finished product and GastroMARK bulk product in its
Massachusetts facilities. These facilities are subject to current Good
Manufacturing Practices ("cGMP") regulations prescribed by the FDA. The Company
is subject to the risk that it may not be able to continue to operate at
commercial scale in compliance with the cGMP regulations. Failure to operate in
compliance with such cGMP regulations and other applicable manufacturing
requirements of various regulatory agencies could have a material adverse effect
on the Company's business, financial condition and results of operations. In
addition, the Company is dependent on contract manufacturers for the production
of certain of its product candidates. In the event that the Company is unable to
obtain or retain manufacturing for its product candidates, it will not be able
to develop and commercialize its products as planned. The Company may not be
able to enter into agreements for the manufacture of future products with
manufacturers whose facilities and procedures comply with cGMP and other
regulatory requirements or that such manufacturer will be able to deliver
required quantities of product that conform to specifications in a timely
manner.

Lack of Marketing and Sales History. Advanced Magnetics has limited
experience in marketing and selling its current products and product candidates
and currently relies on its corporate partners to market and sell Feridex I.V.
and GastroMARK. In order to achieve commercial success for any product approved
by the FDA for which the Company does not have a marketing partner, Advanced
Magnetics may have to develop a marketing and sales force or enter into
arrangements with others to market and sell its products. Advanced Magnetics may
not be successful in attracting and retaining qualified marketing and sales
personnel and may not be able to enter into marketing and sales agreements with
others on acceptable terms, if at all. Furthermore, Advanced Magnetics or its
corporate partners may not be successful in marketing and selling the Company's
products.

Potential Product Liability; Uncertainties Related to Insurance. The use
of any of the Company's product candidates in clinical trials and the sale of
any approved products may expose the Company to liability claims resulting from
the use of products or product candidates. The Company maintains product
liability insurance coverage for claims arising from the use of its products in
clinical trials and commercial use. However, coverage is becoming increasingly
expensive and the Company may not be able to maintain insurance at a reasonable
cost. Furthermore, the Company's insurance may not provide sufficient coverage

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<PAGE> 24

amounts to protect the Company against losses due to liability that could have a
material adverse effect on the Company's business, financial condition and
results of operations. The Company presently maintains product liability
insurance covering the sale of Feridex I.V. and GastroMARK, but the Company may
not be able to obtain commercially reasonable product liability insurance for
any product presently being marketed or for any product approved for marketing
in the future. Insurance coverage and the resources of the Company may not be
sufficient to satisfy any liability resulting from product liability claims. A
product liability claim or series of claims brought against the Company could
have a material adverse effect on its business, financial condition and results
of operations, whether or not the plaintiffs in such claims ultimately prevail.

Attraction and Retention of Key Employees. Because of the specialized
nature of its business, Advanced Magnetics is highly dependent on its ability to
attract and retain qualified scientific and technical personnel for the research
and development activities conducted or sponsored by the Company. In addition,
the Company is substantially dependent upon Jerome Goldstein, its Chairman of
the Board and Chief Executive Officer, and upon Leonard Baum, its President and
Chief Operating Officer. The loss of Mr. Goldstein, Mr. Baum or certain other
key executive officers could be detrimental to the Company. Furthermore, the
Company's anticipated growth and expansion into areas and activities requiring
additional expertise, such as clinical testing, regulatory compliance,
manufacturing, marketing and sales, and veterinary diagnostics, may require the
addition of new management personnel and the development of additional expertise
by existing management personnel. There is intense competition for qualified
personnel in the areas of the Company's activities, and the Company may not be
able to continue to attract and retain the qualified personnel necessary for the
development of its business. The failure to attract and retain such personnel or
to develop such expertise could adversely affect the Company's business,
financial condition and results of operations.

Volatility of Common Stock Price. The market prices for securities of
biopharmaceutical and pharmaceutical companies, including the Company, have
historically been highly volatile. Fluctuations in operating results may cause
the market price of the Company's Common Stock to be volatile. In addition, the
market prices for securities of biopharmaceutical and pharmaceutical companies
have from time to time experienced significant price and volume fluctuations
that are unrelated to the operating performance of such companies. Various
factors and events, including announcements by the Company or its competitors
concerning technological innovations, new products, clinical trial results,
agreements with collaborators, governmental regulations, developments in patent
or other proprietary rights, public concern regarding the safety of drugs
developed by the Company or others, may have a significant impact on the market
price of the Company's Common Stock.

Year 2000 Readiness Disclosure Statement

The widely publicized Year 2000 issue arose because many existing computer
programs use only the last two digits to define the applicable year. As a
result, such computer programs may misinterpret "00" as the year 1900 rather
than the year 2000. The consequences of such a misinterpretation could range
from a simple miscalculation to a system failure that might cause a disruption
of operations, including, among other things, a temporary inability to process
transactions, send invoices, or engage in similar normal business activities.
Since computer and microprocessor use is so widespread, the issue has become a
societal concern, the potential impact of which is not yet known.

Under the auspices of the Audit Committee, the Company is assessing its
exposure to potential disruptions caused by the Year 2000 issue. In the first
phase of its readiness investigation, the Company identified its Clinical Data
Network (which tracks and analyzes the results of product trials in support of
FDA approvals) and its accounting system as mission-critical components that
required protection from Year 2000-related disruption. The Company, in order to
address Year 2000 concerns and as part of a general systems upgrade, has
determined to replace both of these systems. The Company has obtained written
confirmation that the new software applications are Year 2000 compliant. The
Company expects that each of these third party applications will be installed
and operational by the end of June 1999. The Company's computer hardware
platforms, on which these systems run, have been confirmed as Year 2000
compliant by their manufacturers and the Company expects to have completed
testing of them by the end of August 1999.

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In addition to evaluating its computer systems, the Company recognizes that
the Year 2000 issue may impact machines or equipment that rely on embedded
microchips. The Company has evaluated and tested such equipment used in its
manufacturing facilities and believes that it does not have a material risk of
disruptions in manufacturing due to a Year 2000-related failure. The Company is
in the process of evaluating its non-manufacturing equipment.

In addition to the Company's critical systems, the Company recognized that
it relies on third party service providers and suppliers in the conduct of its
business and that there was potential exposure to Year 2000-related business
disruptions as a result. For example, third party service providers handle the
payroll function for the Company, and the Company also relies on the services of
telecommunication companies, banks, and utility companies, among others.

The Company has contacted all of its significant service providers and
obtained assurances that they are addressing Year 2000 issues in a prudent
fashion. However, the Company, like all others, is subject to exposure to
disruptions in the generic systems that all businesses and consumers rely on
generally.

The Company is currently obtaining assurances from its significant raw
material suppliers that there will be no interruption of service as a result of
the Year 2000 issue, and to the extent such assurances are not given, the
Company intends to devise contingency plans to ameliorate the potential negative
effects in the event of the unavailability of materials. The Company also
intends to increase inventory levels moderately prior to December 1999 as a
contingency against possible disruptions anywhere in its supply chain.

A failure of any contingency plan developed by the Company may not prevent
a business interruption caused by one or more of the Company's third party
service providers or suppliers, and such a failure may have a material adverse
effect on the Company. In addition, the failure on the part of the accounting
systems of the Company's customers due to the Year 2000 issue could result in a
delay in the payment of invoices issued by the Company. A failure of the
accounting systems of a significant number of the Company's customers would have
a material adverse effect on the Company.

All expenses related to determining and addressing Year 2000 readiness have
been expensed as incurred and have amounted to roughly $40,000 to date. The
Company has provided $200,000 for the enhancement of its systems in its
operating and capital budgets for the current fiscal year. However, if
compliance efforts of which the Company is not currently aware are required and
are not completed on time, or if the cost of any required updating, modification
or replacement of the Company's IT systems exceeds the Company's estimates, the
Year 2000 issue could have a material adverse impact on the Company.

Various statements in this discussion of Year 2000 issues are
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995. These statements include statements of the
Company's expectation, statements with regard to schedules and expected
completion dates and statements regarding expected Year 2000 compliance. These
forward-looking statements are subject to various risk factors which may
materially affect the Company's efforts to achieve Year 2000 compliance. These
risk factors include the inability of the Company to complete the plans and
modifications that it has identified, the wide variety of information systems
and components, both hardware and software, that must be evaluated, the variety,
number and complexity of equipment used in the Company's operations and the
large number of vendors and customers with which the Company interacts. The
Company's assessments of the effect of Year 2000 on the Company are based, in
part, upon information received from third parties and the Company's reasonable
reliance on that information. Therefore, the risk that inaccurate information is
supplied by third parties upon which the Company reasonably relied must be
considered as a risk factor that might affect the Company's Year 2000 efforts.
The Company is attempting to reduce the risks by utilizing an organized
approach, extensive testing, and allowance of ample contingency time to address
issues identified by tests.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK:

The Company owns financial instruments that are sensitive to market risks
as part of its investment portfolio. The investment portfolio is used to
preserve the Company's capital until it is required to fund operations,
including the Company's research and development activities. None of these
market-risk sensitive

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<PAGE> 26

instruments are held for trading purposes. The Company does not own derivative
financial instruments in its investment portfolio. The investment portfolio
contains instruments that are subject to both the risk of a decline in interest
rates and a decline in equity markets.

Interest Rate Risk -- The Company's investment portfolio includes debt
instruments that are primarily United States government bonds of less than one
year in duration. These bonds are subject to interest rate risk, and could
decline in value if interest rates fluctuate. Due to the short duration and
conservative nature of these instruments, the Company does not believe that it
has a material exposure to interest rate risk.

Equity Market Risk -- The Company's investment portfolio includes
publicly-traded stocks of domestic issuers. Assuming a decline of 10% in the
market for domestic stocks generally, the Company's equity investments may be
expected to decline a corresponding 10%, resulting in a hypothetical reduction
of the value of the net assets of the Company (as of September 30, 1998) of
approximately 3%. The use of a 10% estimate in the decline of equity securities
is strictly for estimation and evaluation purposes only. The value of the
Company's assets may rise or fall by a greater amount depending on actual
general market performances and the value of individual securities owned by the
Company.

ITEM 8. FINANCIAL STATEMENTS:

The Company's Financial Statements and related Report of Independent
Accountants are presented in the following pages. The financial statements filed
in this Item 8 are as follows:

Report of Independent Accountants

Financial Statements:

Consolidated Balance Sheets -- September 30, 1998 and 1997

Consolidated Statements of Operations -- for the years ended September
30, 1998, 1997 and 1996

Consolidated Statements of Stockholders' Equity -- for the years ended
September 30, 1998, 1997 and 1996

Consolidated Statements of Cash Flows -- for the years ended September
30, 1998, 1997 and 1996

Reconciliation of Net Income (Loss) to Net Cash Used in Operating
Activities -- for the years ended September 30, 1998, 1997 and 1996

Notes to Consolidated Financial Statements

25
<PAGE> 27

INDEX TO FINANCIAL STATEMENTS

<TABLE>
<S> <C>
Report of Independent Accountants........................... 27

Consolidated Balance Sheets -- September 30, 1998 and
1997...................................................... 28

Consolidated Statements of Operations -- for the years ended
September 30, 1998, 1997 and 1996......................... 29

Consolidated Statements of Stockholders' Equity -- for the
years ended September 30, 1998, 1997 and 1996............. 30

Consolidated Statements of Cash Flows -- for the years ended
September 30, 1998, 1997 and 1996......................... 31

Reconciliation of Net Income(Loss) to Net Cash Used in
Operating Activities -- for the years ended September 30,
1998, 1997 and 1996....................................... 32

Notes to Consolidated Financial Statements.................. 33
</TABLE>

26
<PAGE> 28

REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders of Advanced Magnetics, Inc.:

In our opinion, the consolidated financial statements listed in the
accompanying index present fairly, in all material respects, the financial
position of Advanced Magnetics, Inc. and its subsidiary at September 30, 1998
and 1997, and the results of their operations and their cash flows for each of
the three years in the period ended September 30, 1998, in conformity with
generally accepted accounting principles. 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 of these statements in accordance with generally accepted auditing
standards which 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, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.

PricewaterhouseCoopers LLP

Boston, Massachusetts
November 4, 1998

27
<PAGE> 29

ADVANCED MAGNETICS, INC.

CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
SEPTEMBER 30,
--------------------------
1998 1997
----------- -----------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents................................... $ 7,704,245 $10,724,740
Marketable securities....................................... 19,096,942 27,365,765
Accounts receivables........................................ 995,010 546,807
Inventories................................................. 448,630 113,178
Prepaid expenses............................................ 228,985 224,868
----------- -----------
Total current assets.............................. 28,473,812 38,975,358
Property, plant and equipment:
Land........................................................ 360,000 360,000
Buildings................................................... 4,497,005 4,356,295
Laboratory equipment........................................ 8,065,834 7,722,445
Furniture and fixtures...................................... 745,560 645,299
----------- -----------
13,668,399 13,084,039
Less -- accumulated depreciation and amortization........... (8,331,740) (7,332,118)
----------- -----------
Net property, plant and equipment........................... 5,336,659 5,751,921
Other assets................................................ 304,237 248,902
----------- -----------
Total assets...................................... $34,114,708 $44,976,181
=========== ===========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable............................................ $ 422,993 $ 443,925
Accrued expenses............................................ 720,266 1,059,070
Income taxes payable........................................ 52,051 50,128
----------- -----------
Total current liabilities......................... 1,195,310 1,553,123
Commitments and contingencies
Stockholders' equity:
Preferred stock, par value $.01 per share, authorized
2,000,000 shares; none issued............................. -- --
Common stock, par value $.01 per share, authorized
15,000,000 shares; issued and outstanding 6,767,358 shares
as of September 30, 1998 and 6,740,626 shares as of
September 30, 1997........................................ 67,674 67,406
Additional paid-in capital.................................. 44,277,698 44,244,558
Retained earnings (deficit)................................. (12,404,643) (6,095,302)
Net unrealized gains on marketable securities............... 978,669 5,206,396
----------- -----------
Total stockholders' equity........................ 32,919,398 43,423,058
----------- -----------
Total liabilities and stockholders' equity........ $34,114,708 $44,976,181
=========== ===========
</TABLE>

The accompanying notes are an integral part of the consolidated financial
statements.

28
<PAGE> 30

ADVANCED MAGNETICS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
FOR THE YEARS ENDED SEPTEMBER 30,
-----------------------------------------
1998 1997 1996
----------- ----------- -----------
<S> <C> <C> <C>
Revenues:
License fees........................................ $ -- $ 5,500,000 $ --
Royalties........................................... 980,542 363,445 50,000
Product sales....................................... 1,399,871 1,580,357 12,762
Contract research and development................... 399,897 62,920 6,810
Interest, dividends and net gains and losses on
sales of securities............................... 3,623,836 3,495,049 1,761,450
----------- ----------- -----------
Total revenues............................ 6,404,146 11,001,771 1,831,022
Costs and expenses:
Cost of product sales............................... 237,945 311,678 2,550
Contract research and development expenses.......... 6,514 8,815 --
Company-sponsored research and development
expenses.......................................... 8,961,796 9,304,327 9,671,897
Selling, general and administrative expenses........ 3,701,410 1,437,599 1,871,568
----------- ----------- -----------
Total cost and expenses................... 12,907,665 11,062,419 11,546,015
Other income:
Other income...................................... -- 264,800 --
----------- ----------- -----------
Income (loss) before provision for income taxes and
minority interest in subsidiary................... (6,503,519) 204,152 (9,714,993)
Minority interest in subsidiary..................... (194,178)
Income tax (benefit) provision.................... -- (379,022) --
----------- ----------- -----------
Net income (loss)................................... $(6,309,341) $ 583,174 $(9,714,993)
=========== =========== ===========
Basic and diluted net income (loss) per share....... $ (0.93) $ 0.09 $ (1.44)
=========== =========== ===========
Weighted average shares outstanding:
Basic............................................. 6,752,863 6,744,946 6,762,748
----------- ----------- -----------
Diluted........................................... 6,752,863 6,813,984 6,762,748
----------- ----------- -----------
</TABLE>

The accompanying notes are an integral part of the consolidated financial
statements.

29
<PAGE> 31

ADVANCED MAGNETICS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
FOR THE YEARS ENDED SEPTEMBER 30, 1996, 1997, 1998
-----------------------------------------------------------------------------
NET
UNREALIZED
COMMON STOCK ADDITIONAL RETAINED GAINS ON TOTAL
------------------- PAID-IN EARNINGS MARKETABLE STOCKHOLDERS'
SHARES AMOUNT CAPITAL (DEFICIT) SECURITIES EQUITY
--------- ------- ----------- ------------ ---------- -------------
<S> <C> <C> <C> <C> <C> <C>
Balance at September 30, 1995...... 6,753,413 $67,534 $45,093,972 $ 3,036,517 $ 873,049 $49,071,072
Shares issued in connection with
the exercise of stock options.... 26,445 264 185,697 -- -- 185,961
Shares surrendered in connection
with the exercise of stock
options.......................... (921) (9) (18,463) -- -- (18,472)
Shares issued in connection with
employee stock purchase plan..... 8,875 89 141,379 -- -- 141,468
Common shares repurchased.......... (26,200) (262) (476,083) -- -- (476,345)
Net change in unrealized gains on
marketable securities............ -- -- -- -- 943,854 943,854
Net loss........................... -- -- -- (9,714,993) -- (9,714,993)
--------- ------- ----------- ------------ ---------- -----------
Balance at September 30, 1996...... 6,761,612 $67,616 $44,926,502 $ (6,678,476) $1,816,903 $40,132,545
========= ======= =========== ============ ========== ===========
Shares issued in connection with
the exercise of stock options.... 42,450 425 271,148 -- -- 271,573
Shares surrendered in connection
with the exercise of stock
options.......................... (13,757) (138) (209,289) -- -- (209,427)
Shares issued in connection with
employee stock purchase plan..... 11,621 116 117,183 -- -- 117,299
Common shares repurchased.......... (61,300) (613) (860,986) -- -- (861,599)
Net change in unrealized gains on
marketable securities............ -- -- -- -- 3,389,493 3,389,493
Net income......................... -- -- -- 583,174 -- 583,174
--------- ------- ----------- ------------ ---------- -----------
Balance at September 30, 1997...... 6,740,626 $67,406 $44,244,558 $ (6,095,302) $5,206,396 $43,423,058
========= ======= =========== ============ ========== ===========
Shares issued in connection with
the exercise of stock options.... 39,846 399 163,456 -- -- 163,855
Shares surrendered in connection
with the exercise of stock
options.......................... (2,190) (22) (28,722) -- -- (28,744)
Shares issued in connection with
employee stock purchase plan..... 5,876 59 54,587 -- -- 54,646
Common shares repurchased.......... (16,800) (168) (156,181) -- -- (156,349)
Net change in unrealized gains on
marketable securities............ -- -- -- -- (4,227,727) (4,227,727)
Net loss........................... -- -- -- (6,309,341) -- (6,309,341)
--------- ------- ----------- ------------ ---------- -----------
Balance at September 30, 1998...... 6,767,358 $67,674 $44,277,698 $(12,404,643) $ 978,669 $32,919,398
========= ======= =========== ============ ========== ===========
</TABLE>

The accompanying notes are an integral part of the consolidated financial
statements.

30
<PAGE> 32

ADVANCED MAGNETICS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
FOR THE YEARS ENDED SEPTEMBER 30,
--------------------------------------------
1998 1997 1996
------------ ------------ ------------
<S> <C> <C> <C>
Cash flows from operating activities:
Cash received from customers..................... $ 1,637,449 $ 7,043,429 $ 1,330,567
Cash paid to suppliers and employees............. (12,686,577) (9,330,973) (10,850,727)
Dividends and interest received.................. 1,139,685 1,441,441 2,099,445
Royalties received............................... 925,817 -- --
Net proceeds from insurance settlement........... -- 264,800 --
Income taxes paid................................ (2,500) -- (20,000)
Income tax refund................................ 4,422 379,022 10,245
------------ ------------ ------------
Net cash used in operating activities............ (8,981,704) (202,281) (7,430,470)

Cash flows from investing activities:
Proceeds from sales of marketable securities..... 8,993,685 9,270,016 10,733,541
Proceeds from notes and bonds maturing........... 5,000,000 12,500,000 9,499,911
Purchase of marketable securities................ (7,426,189) (20,380,048) (2,378,934)
Capital expenditures............................. (584,360) (533,590) (466,452)
(Increase) decrease in other assets.............. (55,335) (53,045) (50,785)
------------ ------------ ------------
Net cash provided by investing activities........ 5,927,801 803,333 17,337,281

Cash flows from financing activities:
Proceeds from issuances of common stock, net..... 189,757 179,445 308,957
Purchase of treasury stock....................... (156,349) (861,599) (476,345)
------------ ------------ ------------
Net cash (used in) provided by financing
activities..................................... 33,408 (682,154) (167,388)
------------ ------------ ------------
Net (decrease) increase in cash and cash
equivalents.................................... (3,020,495) (81,102) 9,739,423
Cash and cash equivalents at beginning of year... 10,724,740 10,805,842 1,066,419
------------ ------------ ------------
Cash and cash equivalents at end of year......... $ 7,704,245 $ 10,724,740 $ 10,805,842
============ ============ ============
</TABLE>

The accompanying notes are an integral part of the consolidated financial
statements.

31
<PAGE> 33

ADVANCED MAGNETICS, INC.

RECONCILIATION OF NET INCOME (LOSS)
TO NET CASH USED IN OPERATING ACTIVITIES

<TABLE>
<CAPTION>
FOR THE YEARS ENDED SEPTEMBER 30,
-----------------------------------------
1998 1997 1996
----------- ----------- -----------
<S> <C> <C> <C>
Net income (loss)................................... $(6,309,341) $ 583,174 $(9,714,993)
----------- ----------- -----------
Adjustments to reconcile net income (loss) to net
cash used in operating activities:
Non-cash reduction in value of investment in
subsidiary........................................ 194,178 -- --
Minority interest in subsidiary..................... (194,178) -- --
Depreciation........................................ 999,622 1,112,539 1,076,482
Accretion of U. S. Treasury Notes discount.......... (52,574) (227,721) (32,217)
(Increase) decrease in accounts receivable.......... (448,203) (397,572) 1,637,558
(Increase) decrease in inventories.................. (335,452) 68,988 (126,599)
(Increase) decrease in prepaid expenses............. (4,117) (93,634) (31,892)
(Increase) decrease in recoverable income taxes..... -- -- 90,117
Increase (decrease) in accounts payable and accrued
expenses.......................................... (359,736) 619,295 (222,701)
Increase (decrease) in income taxes payable......... 1,923 -- (99,872)
Net realized (gains) on sales of marketable
securities........................................ (2,473,826) (1,867,350) (6,353)
----------- ----------- -----------
Total adjustments......................... (2,672,363) (785,455) 2,284,523
----------- ----------- -----------
Net cash used in operating activities............... $(8,981,704) $ (202,281) $(7,430,470)
=========== =========== ===========
</TABLE>

The accompanying notes are an integral part of the consolidated financial
statements.

32
<PAGE> 34

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

A. SUMMARY OF ACCOUNTING POLICIES:

Business

Founded in November 1981, Advanced Magnetics, Inc., a Delaware Corporation
(the "Company"), is a biopharmaceutical company engaged in the development and
manufacture of compounds utilizing the Company's core proprietary colloidal
superparamagnetic particle technology and core polysaccharide technology for
magnetic resonance imaging ("MRI"). The initial products developed by the
Company are diagnostic imaging agents for use in conjunction with MRI to aid in
the diagnosis of cancer and other diseases.

The Company is subject to risks common to companies in the industry
including, but not limited to, development by the Company or its competitors of
new technological innovations, uncertainty of product development and
commercialization, lack of marketing and sales history, dependence on key
personnel, market acceptance of products, product liability, dependence on
information technology, protection of proprietary technology, and compliance
with FDA government regulations.

Consolidation Policy

In October 1997, the Company acquired 80.7% of the issued and outstanding
capital stock of Kalisto Biologicals, Inc., ("Kalisto"), an early-stage company
that develops, manufactures and markets diagnostic products for the veterinary
market. The Company wrote off $194,178 of its investment in Kalisto relating to
in-process research and development as a result of this acquisition. Since the
date of acquisition, the financial statements of the Company have included the
accounts of Kalisto and have been adjusted by the minority shareholders'
interest. The financial statements have been prepared in accordance with
generally accepted accounting principles and all significant intercompany
balances and transactions have been eliminated.

Use of Estimates

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make certain 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 revenue and expenses during the reported
period. Actual results could differ from those estimates.

Cash and Cash Equivalents

Cash and cash equivalents consist of cash on hand, money market funds and
marketable securities having a maturity of less than three months at the date
acquired. Substantially all of the cash and cash equivalents at September 30,
1998 and 1997 were held in a money market account.

Marketable Securities

The Company's current portfolio consists of securities classified as
available-for-sale which are recorded at fair market value. The fair values of
marketable securities are based on quoted market prices. Net unrealized gains
and losses on marketable securities are recorded as a separate component of
stockholders' equity. Interest income is accrued as earned. Dividend income is
accrued on the ex-dividend date, and net realized gains and losses are computed
on the basis of average cost and are recognized when realized.

Inventories

Inventories are stated at the lower of cost (determined on a first-in,
first-out basis) or market.

33
<PAGE> 35
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Property, Plant and Equipment

Property, plant and equipment are stated at cost. The cost of additions and
improvements is recorded in the property accounts while maintenance and repairs
are expensed as incurred. Upon sale or other disposition of property and
equipment, the cost and related depreciation are removed from the accounts and
any resulting gain or loss is reflected in income.

Depreciation

Depreciation is recorded by the straight line method based on rates
sufficient to provide for retirement over estimated useful lives as follows:
buildings -- 40 years; laboratory equipment and furniture and fixtures -- 5
years; and leasehold improvements -- over the life of the lease.

Revenue Recognition

Revenue is recognized when products are shipped, when contract objectives
are achieved or when research activities are performed. License and royalty
revenues are accrued as earned.

Other Income

Other Income of $264,800 was recognized during the fiscal year ended
September 30, 1997 as the result of an insurance settlement for flood damages in
the research and development laboratory in October 1996.

Income Taxes

The provision (benefit) for income taxes includes federal and state income
taxes currently payable and deferred income taxes arising from the recognition
of certain income and expenses in different periods for financial and tax
reporting purposes.

Income (Loss) per Share

Effective December 31, 1997, the Company adopted Statement of Financial
Accounting Standards No. 128 (SFAS 128) "Earnings per Share" which requires
disclosure of basic earnings per common share and diluted earnings per common
share for all periods presented. The financial statement data has been restated
to reflect adoption of this statement. The weighted average common and common
equivalent shares used in the computation of basic and diluted earnings per
share is presented below. Aggregate options of 408,649 (weighted average
exercise price of $11.30) and 407,645 options (weighted average exercise price
of $13.86) for 1998 and 1996, respectively, have not been included in the
calculation of weighted average shares since their effect would be
anti-dilutive, given the net loss in both years. In 1997, aggregate options of
5,050 (weighted average exercise price of $16.98) have not been included in the
calculation of weighted average shares since they were "out of the money" and
their effect would be anti-dilutive.

<TABLE>
<CAPTION>
FOR THE YEARS ENDED SEPTEMBER 30,
----------------------------------------
1998 1997 1996
----------- ---------- -----------
<S> <C> <C> <C>
Numerator:
Net income (loss)............................ $(6,309,341) $ 583,174 $(9,714,993)
=========== ========== ===========
Denominator:
Weighted average number of common shares
issued and outstanding..................... 6,752,863 6,744,946 6,762,748
Assumed exercise of options reduced by the
number of shares which could have been
purchased with the proceeds of those
options.................................... -- 69,038 --
----------- ---------- -----------
Weighted average common and common equivalent
shares..................................... 6,752,863 6,813,984 6,762,748
Basic and diluted net income (loss) per
share...................................... $ (0.93) $ 0.09 $ (1.44)
</TABLE>

34
<PAGE> 36
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Reclassifications

Certain amounts from the prior year have been reclassified to conform to
the current year's presentation.

B. MARKETABLE SECURITIES:

The cost and fair value of the marketable securities portfolio at September
30 are as follows:

<TABLE>
<CAPTION>
1998 1997
1998 COST FAIR VALUE 1997 COST FAIR VALUE
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
U.S. government securities
Due in one year or less............. $ 7,484,642 $ 7,513,215 $ 5,000,000 $ 4,998,900
Due after one through five years.... -- -- 7,438,569 7,429,650
Corporate bonds....................... 482,403 582,500 -- --
Preferred stock....................... 543,003 570,000 1,557,409 1,801,260
Common stock.......................... 9,608,225 10,431,227 8,163,391 13,135,955
----------- ----------- ----------- -----------
Totals...................... $18,118,273 $19,096,942 $22,159,369 $27,365,765
=========== =========== =========== ===========
</TABLE>

At September 30, 1998, gross unrealized holding gains were $978,669. At
September 30, 1997, gross unrealized holding gains and gross unrealized holding
losses were $5,344,117 and $137,721 respectively, resulting in a net unrealized
holding gain of $5,206,396. For the fiscal years ended September 30, 1998 and
1997, the net unrealized holding gains have been recorded as a separate
component of stockholders' equity.

During the year ended September 30, 1998, gross realized gains on the sale
of marketable securities were $2,473,826. During the year ended September 30,
1997, gross realized gains and gross realized losses on the sale of marketable
securities were $1,932,504 and $65,154, respectively, resulting in a net
realized gain of $1,867,350. During the year ended September 30, 1996, gross
realized gains and gross realized losses on the sale of marketable securities
were $660,126 and $653,773, respectively, resulting in a net realized gain of
$6,353. Proceeds from U.S. treasury notes maturing were $5,000,000, $12,500,000
and $9,499,911 in 1998, 1997 and 1996 respectively.

Interest, dividends and net gains (losses) on sales of securities consist
of the following:

<TABLE>
<CAPTION>
FOR THE YEARS ENDED SEPTEMBER 30,
--------------------------------------
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
Interest income................................ $ 978,546 $1,385,670 $1,400,597
Dividend income................................ 171,464 242,029 354,500
Net gains on sales of securities............... 2,473,826 1,867,350 6,353
---------- ---------- ----------
Totals............................... $3,623,836 $3,495,049 $1,761,450
========== ========== ==========
</TABLE>

C. INVENTORIES:

The Company's inventories consisted entirely of raw materials of $448,630
on September 30, 1998 and $113,178 on September 30, 1997.

D. COMMITMENTS:

The Company leases laboratory, office and warehouse space under various
agreements. Rental expense for the years ended September 30, 1998, 1997 and 1996
amounted to $572,729, $339,311, and $340,848, respectively. Future minimum lease
payments for fiscal 1999, 2000, 2001, 2002 and 2003 amount to $543,921,
$561,110, $337,493, $301,823 and $164,010, respectively.

35
<PAGE> 37
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

E. ACCRUED EXPENSES:

Accrued expenses consist of the following at September 30:

<TABLE>
<CAPTION>
1998 1997
-------- ----------
<S> <C> <C>
Salaries and other compensation...................... $249,234 $ 183,000
License and royalty fees............................. 29,540 497,307
Clinical trials...................................... 177,722 188,288
Professional fees.................................... 169,000 56,500
Other................................................ 94,770 133,975
-------- ----------
Totals..................................... $720,266 $1,059,070
======== ==========
</TABLE>

F. INCOME TAXES:

Deferred tax assets and deferred tax liabilities are recognized based on
temporary differences between the financial reporting and tax basis of assets
and liabilities using statutory rates. A valuation allowance is recorded against
deferred tax assets if it is more likely than not that some or all of the
deferred tax assets will not be realized.

The income tax (benefit) provision consisted of the following:

<TABLE>
<CAPTION>
FOR THE YEARS ENDED SEPTEMBER 30,
---------------------------------
1998 1997 1996
-------- --------- --------
<S> <C> <C> <C>
Currently payable:
Federal......................................... $ -- $(379,022) $ --
State........................................... -- -- --
-------- --------- --------
-- (379,022) --
-------- --------- --------
Deferred:
Federal......................................... -- -- --
State........................................... -- -- --
-------- --------- --------
-- -- --
-------- --------- --------
$ -- $(379,022) $ --
======== ========= ========
</TABLE>

The provisions for income taxes were at different rates than the U.S.
statutory rates for the following reasons:

<TABLE>
<CAPTION>
FOR THE YEARS ENDED SEPTEMBER 30,
----------------------------------
1998 1997 1996
------- -------- -------
<S> <C> <C> <C>
U.S. federal statutory tax (benefit) rate.............. (34.0)% 34.0% (34.0)%
Dividends received deductions.......................... (0.6) (31.0) (0.9)
Prior years income tax refunds......................... -- (186.1) --
Other, including a prior year tax adjustment........... (0.1) (2.6) 0.1
Losses without tax benefit............................. 34.7 -- 38.2
Tax benefit of temporary differences................... -- (--) (3.4)
----- ------ -----
--% (185.7)% --%
===== ====== =====
</TABLE>

The $379,022 tax benefit recorded in fiscal 1997 is due to refunds of
alternative minimum taxes paid in prior years.

36
<PAGE> 38
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The components of the deferred tax assets and liabilities at September 30,
were as follows:

<TABLE>
<CAPTION>
1998 1997
------------ -----------
<S> <C> <C>
ASSETS
Net operating loss carryforwards....................... $ 7,645,130 $ 5,133,259
Research and experimentation tax credit carryforward... 2,511,022 2,146,627
Deductible intangibles................................. 111,370 121,571
Other.................................................. 248,310 226,013

LIABILITIES
Property, plant and equipment depreciation............. (246,347) (329,162)
Other.................................................. (77,245) (55,206)
------------ -----------
Subtotal............................................... 10,192,240 7,243,102
Valuation allowance.................................... (10,192,240) (7,243,102)
------------ -----------
Net deferred taxes....................................... $ -- $ --
============ ===========
</TABLE>

Due to the uncertainty surrounding the realization of the favorable tax
attributes in future tax returns, the Company has placed a valuation allowance
against its otherwise recognizable net deferred tax assets. Realization of
favorable tax attributes is, therefore, reflected as a tax benefit in the
provision for income taxes.

At September 30, 1998, the Company had unused net operating loss (NOL)
carryforwards for federal income tax purposes of approximately $18,950,000 which
expire in fiscal 2018. The Company also has federal research and experimentation
credits of approximately $2,190,000 which expire in fiscal 2013.

G. STOCK PLANS:

The Company's 1993 Stock Plan (the "1993 Stock Plan") provides for the
grant of options to the Company's directors, officers, employees and consultants
to purchase up to an aggregate of 500,000 shares of common stock at a price
equal to the fair market value of the stock at the date of the grant. The
maximum term of the options under the 1993 Stock Plan is ten years. The number
of shares available for future grants at September 30, 1998 was 125,875.

The Company's 1983 Stock Option Plan (the "1983 Plan") does not allow for
option grants after June 1993. The 1983 Plan provided for the grant of options
to purchase up to 900,000 shares of common stock at a price equal to the fair
market value of the stock at the date of grant to the Company's employees and
mandatory grants to outside directors upon initial election to the Board of
Directors. The maximum terms of incentive stock options and non-statutory
options under the 1983 Plan are ten years and ten years plus thirty days,
respectively.

The Company has also granted to certain scientific advisors non-statutory
options to purchase a total of 32,625 shares of common stock at a price equal to
fair market value at the date of grant. As of September 30, 1998, 29,625 options
have been exercised.

On November 5, 1991, the Company's Board of Directors adopted the 1992
Non-Employee Director Stock Option Plan (the "1992 Plan") which the shareholders
approved. This plan provides for the grant to each non-employee director on
November 5, 1991, and each fifth anniversary thereafter, of an option to
purchase 5,000 shares of common stock up to an aggregate of 100,000 shares at a
price equal to the fair market value of the stock at the date of the grant,
vesting over a five year period. Under this plan, options to purchase 30,000
shares of common stock at a price of $21.00 per share and an additional 30,000
shares of common stock at a price of $15.25 per share were granted on November
5, 1991 and 1996, respectively. The 1992 Plan also provided for the grant of
options for 5,000 shares to new members of the Board of Directors. A total of
10,000 stock options were granted to new directors during fiscal year 1997 under
the 1992 Plan. No grants may be made under this plan after November 4, 2001.

37
<PAGE> 39
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

On November 10, 1992, the Company's Board of Directors adopted the 1993
Non-Employee Director Stock Option Plan (the "1993 Plan") which the shareholders
approved. This plan provides for the grant to each non-employee director on
November 10, 1992, and each sixth anniversary thereafter an option to purchase
5,000 shares of common stock up to an aggregate of 100,000 shares at a price
equal to the fair market value of the stock at the date of the grant, vesting
over a five year period. Under this plan, options to purchase 30,000 shares of
common stock at a price of $14.50 per share were granted on November 10, 1992.
The 1993 Plan also provided for the grant of options for 5,000 shares to new
members of the Board of Directors. A total of 10,000 stock options were granted
to new directors during fiscal year 1997 under the 1993 Plan. No grants may be
made under this plan after November 10, 2002.

During the fiscal year ended September 30, 1997, the Company's Board of
Directors approved the exchange of stock options by the Company's employees and
directors at the fair market value of the stock at the effective date of the
exchange. This provided for the cancellation of any unexercised stock options
and the reissuance of an equal number of stock options at the new price, with
50% of any previously vested options vesting immediately. The stock options
cancelled were originally issued under the 1983 and 1993 Stock Option Plans and
the 1992 and 1993 Non-Employee Director Stock Option Plans and were reissued
under the 1993 Stock Option Plan. 236,825 options under the 1983 and 1993 Stock
Plans were exchanged effective on July 3, 1997 at an exercise price of $11.50.
110,000 options under the 1992 and 1993 Non-Employee Director Stock Option Plans
were exchanged effective on August 5, 1997 at an exercise price of $11.125.

The Company adopted the disclosure provision of SFAS 123, "Accounting for
Stock-Based Compensation" ("FAS123") in 1997 and has applied APB opinion 25 and
related interpretations in accounting for its Plans.

Stock option activity for the years ended September 30, 1998, 1997 and 1996
is as follows:

<TABLE>
<CAPTION>
1998 1997 1996
------------------ ------------------- ------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
------- -------- -------- -------- ------- --------
<S> <C> <C> <C> <C> <C> <C>
Outstanding at beginning of year........ 460,195 $10.73 407,645 $13.86 426,315 $13.29
Granted................................. 13,500 $11.88 475,825 $12.17 14,500 $21.37
Exercised............................... (39,846) $ 4.11 (42,450) $ 6.40 (26,445) $ 7.03
Cancelled............................... (25,200) $12.58 (380,825) $16.45 (6,725) $20.56
------- ------ -------- ------ ------- ------
Outstanding at end of year.............. 408,649 $11.30 460,195 $ 0.66 407,645 $13.86
------- ------ -------- ------ ------- ------
Options exercisable at year-end......... 135,392 $11.04 98,070 $ 8.01 252,626 $11.82
======= ====== ======== ====== ======= ======
Weighted average fair value of options
granted during the year............... $6.16 $5.63 $9.84
======= ======== =======
</TABLE>

The fair value of each option granted during 1998, 1997 and 1996 was
estimated on the date of grant using the Black-Scholes option-pricing model with
the following weighted average assumptions: (1) expected life of 7.1 years in
1998 and 6.0 years in 1997 and 1996 (2) expected volatility of 37.5% in 1998 and
36% in 1997 and 1996 (3) risk-free interest rate of 6.34% in 1998 and 6.2% in
1997 and 1996 and (4) no dividend yield.

38
<PAGE> 40
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following table summarizes information about stock options outstanding
and exercisable at September 30, 1998:

<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------------ ----------------------
WEIGHTED WEIGHTED
WEIGHTED AVERAGE AVERAGE
RANGE OF NUMBER AVERAGE REMAINING EXERCISE NUMBER EXERCISE
EXERCISE PRICES OUTSTANDING CONTRACTUAL LIFE PRICE EXERCISABLE PRICE
- --------------- ----------- ----------------- -------- ----------- --------
<S> <C> <C> <C> <C> <C>
$ 6.50 - $10.49 15,337 1.3 $ 7.48 15,337 $ 7.48
$10.50 - $12.24 393,312 8.3 $11.45 120,055 $11.50
- --------------- ------- --- ------ ------- ------
$ 6.50 - $12.24 408,649 8.0 $11.30 135,392 $11.04
======= === ====== ======= ======
</TABLE>

Employee Stock Purchase Plan:

The Company's 1997 Employee Stock Purchase Plan (the "Purchase Plan")
provides for the issuance of up to 150,000 shares of common stock to employees
of the Company. Under the terms of the Purchase Plan, eligible employees may
purchase shares in five annual offerings ending in 2002, through payroll
deductions of up to a maximum of 10% of the employee's earnings, at a price
equal to the lower of 85% of the fair market value of the stock on the
applicable annual offering commencement date of June 1 or termination date of
May 31. The first offering under the Purchase Plan ended on May 31, 1998 and
5,876 shares of common stock were purchased by eligible employees at a price of
approximately $9.30 per share. As of September 30, 1998, 5,876 shares have been
issued under this plan.

Had the Company adopted SFAS 123, the weighted average for each purchase
right granted during fiscal 1998, 1997 and 1996 would have been $3.45, $3.68 and
$5.72, respectively.

Pro Forma Disclosures:

Had compensation cost for the Company's 1998, 1997 and 1996 grants for
stock-based compensation plans been determined consistent with SFAS 123, the
Company's net income (loss) and net income (loss) per share for 1998, 1997 and
1996 would approximate the pro forma amounts below:

<TABLE>
<CAPTION>
1998 1997 1996
----------- -------- -----------
<S> <C> <C> <C> <C>
Net income (loss)............................. As reported $(6,309,341) $583,174 $(9,714,993)
Pro forma $(6,933,323) $276,163 $(9,748,848)
Basic and diluted net income (loss) per
share....................................... As reported $ (0.93) $ 0.09 $ (1.44)
Pro forma $ (1.03) $ 0.04 $ (1.44)
</TABLE>

The effects of applying SFAS 123 in this pro-forma disclosure are not
indicative of future amounts. SFAS 123 does not apply to awards prior to fiscal
1996 and additional awards in future years are anticipated.

H. EMPLOYEE'S SAVING PLAN:

The Company provides a 401(k) Plan to employees of the Company by which
they may defer compensation for income tax purposes under Section 401(k) of the
Internal Revenue Code. Each employee may elect to defer a percentage of his or
her salary on a pre-tax basis up to a specified maximum percentage. The Company
matches every dollar each employee contributes to the 401(k) Plan up to six
percent of each employee's salary to a maximum of $2,000 annually per employee.
Salary deferred by employees and contributions by the Company to the 401(k) Plan
are not taxable to employees until withdrawn from the 401(k) Plan and
contributions are deductible by the Company when made. The amount of the
Company's matching contribution for the 401(k) Plan was $99,710, $104,943, and
$110,542 for 1998, 1997, and 1996, respectively.

39
<PAGE> 41
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

I. COMMON STOCK TRANSACTIONS:

In November 1997, the Board of Directors extended the authorization granted
in May 1996 to purchase 250,000 shares of the Company's common stock in the
aggregate on the open market. Through September 30, 1998, the Company purchased
104,300 shares for $1,494,293 and the shares have been retired.

J. PREFERRED STOCK:

The preferred stock may be issued from time to time in one or more series.
The rights, preferences, restrictions, qualifications and limitations of such
stock shall be determined by the Board of Directors.

K. BUSINESS SEGMENTS AND CUSTOMERS:

The Company's operations are located solely within the United States. The
Company is focused principally on developing and manufacturing contrast agents.
Accordingly, its revenues are attributable to one principal business segment.
The Company performs ongoing credit evaluations of its customers and generally
does not require collateral. Two customers accounted for 56% and 19%
respectively, of the Company's product revenues in fiscal 1998, one customer
accounted for 54% of the Company's revenues in fiscal 1997, and no customer
accounted for more than 10% of the Company's revenues in fiscal 1996.

Revenues in fiscal 1998 from customers and licensees outside of the United
States, principally in Europe, amounted to 26% of the Company's total revenues.
Revenues from customers and licensees outside the United States were not
significant in fiscal 1997 and 1996.

L. LEGAL PROCEEDINGS:

The Company and certain of its officers were sued in an action entitled
David D. Stark, M.D. v. Advanced Magnetics. Inc., Jerome Goldstein, Ernest V.
Groman, and Lee Josephson, Civil Action No. 92-12157-WGY, in the United States
District Court for the District of Massachusetts on September 3, 1992. The
plaintiff, a former consultant to the Company, claims that he was incorrectly
omitted as an inventor or joint inventor on certain of the Company's patents and
on pending applications, and seeks injunctive relief and unspecified damages. In
addition, the complaint also alleges state law claims for breach of contract,
breach of good faith and fair dealing, breach of implied contract,
misappropriation of trade secrets, conversion, negligent misrepresentation,
misrepresentation, unjust enrichment and unfair trade practices. The District
Court has stayed the federal action pending resolution of an appeal in the State
Court of summary judgment in the Company's favor as well as resolution of a
jurisdictional issue. While the outcome of the action cannot be determined, the
Company believes the action is without merit and intends to defend the action
vigorously. There can be no assurance, however, that the Company will be able to
defend successfully this action and the failure by the Company to prevail for
any reason could have an adverse effect on the Company's future business,
financial condition and results of operations.

40
<PAGE> 42
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

failure by the Company to prevail for any reason could have an adverse effect on
the Company's future business, financial condition and results of operations.

The Company filed suit on October 7, 1997 against Sanofi Pharmaceuticals,
Inc. (formerly known as Sanofi Winthrop, Inc.) and Sanofi SA (collectively,
"Defendants") in the Superior Court of the Commonwealth of Massachusetts. The
action is entitled Advanced Magnetics, Inc. v. Sanofi Pharmaceuticals, Inc. and
Sanofi SA, Civil Action No. 97-5222B. The Company claims that the Defendants
tortiously interfered with a license, supply and marketing agreement (the
"Agreement"), and seeks unspecified monetary damages. In addition, the Company
seeks a declaration that the Defendants do not have any rights under the
Agreement and that the Company has not breached the Agreement. Sanofi
Pharmaceuticals, Inc., filed counterclaims against the Company on February 4,
1998 seeking compensatory damages of $11,500,000 and multiple damages as a
result of the Company's alleged breach of the Agreement. Sanofi Pharmaceuticals,
Inc. also filed a motion to dismiss the Company's tortious interference claim,
which the Court denied on July 3, 1998. On October 26, 1998, the Company served
a motion for partial summary judgment which, among other things, requests
judgment in its favor on all of Sanofi Pharmaceuticals, Inc.'s counterclaims.
The Court has scheduled a December 18, 1998 hearing date for the Company's
motion for partial summary judgment. On November 13, 1998 the Company filed an
amended complaint adding claims for unfair competition and breach of contract
against the Defendants. On November 23, 1998, Defendants answered the Company's
amended complaint, and Sanofi Pharmaceuticals, Inc. served a new set of
counterclaims seeking compensatory damages of $15,000,000 and multiple damages
as a result of the Company's alleged conduct. While the final outcome of these
claims and counterclaims cannot be determined, the Company will pursue its
claims vigorously, and believes that the Sanofi Pharmaceuticals, Inc.
counterclaims are without merit and intends to defend them vigorously.

M. AGREEMENTS:

To facilitate the marketing and distribution of its contrast agents, the
Company has entered into strategic relationships with certain established
pharmaceutical companies. These companies, both in the United States and abroad,
include: (i) Guerbet S.A. ("Guerbet"), a leading European producer of contrast
agents, in Western Europe and Brazil; (ii) Eiken Chemical Co., Ltd. ("Eiken"),
one of Japan's leading medical diagnostics manufacturers; (iii) Berlex
Laboratories, Inc. ("Berlex"), the leading marketer of MRI contrast agents, in
the United States; and (iv) Mallinckrodt Inc. ("Mallinckrodt") a leading
manufacturer of contrast agents, in the United States, Canada and Mexico.

On February 1, 1995, the Company entered into an agreement with Berlex
granting Berlex a product license and exclusive marketing rights to Feridex
I.V.(R) in the United States and Canada. Under the terms of the agreement,
Berlex paid a $5,000,000 non-refundable license fee in fiscal 1995. An
additional $5,000,000 license fee was received in October 1996 as a result of
the FDA's marketing approval and Berlex's market launch of Feridex I.V. in the
United States. In addition, the company receives payments for manufacturing the
product and royalties on sales. The Company also receives revenue related to
reimbursement for certain clinical development costs.

In 1990, the Company entered into a manufacturing and distribution
agreement with Mallinckrodt granting Mallinckrodt a product license and
co-marketing rights to GastroMARK(R) in the United States, Canada and Mexico.
Under the terms of the agreement, Mallinckrodt paid a $500,000 non-refundable
license fee in fiscal 1997 as a result of the FDA's marketing approval of
Feridex I.V. in the United States. In addition, the company receives payments
for manufacturing the product and royalties on sales.

In 1988, the Company entered into a manufacturing and distribution
agreement with Eiken, granting Eiken the exclusive right to manufacture and
distribute Feridex I.V. in Japan. Eiken pays royalties based upon sales. The
agreement terminates on the later of (i) the expiration of the last to expire
technology patent or (ii) ten years after the date all necessary approvals are
obtained.

41
<PAGE> 43
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

In 1990, the Company entered into a manufacturing and distribution
agreement with Eiken, granting Eiken the exclusive right in Japan to manufacture
and distribute Combidex. In addition, for a period of 180 days after the Company
files an IND for any future Advanced Magnetics MRI contrast agents, Eiken has
the right of first refusal to manufacture and distribute such product in Japan.
Additionally, Eiken agreed to pay the Company royalties on sales of all products
sold by Eiken under the agreement. The agreement is perpetual but terminable
upon specified events such as nonperformance, insolvency or assignment without
consent.

In 1987, the Company entered into a supply and distribution agreement with
Guerbet. Under this agreement, Guerbet has been appointed the exclusive
distributor of Feridex I.V. in Western Europe (under the tradename Endorem(TM))
and Brazil. Guerbet is responsible for conducting clinical trials and securing
the necessary regulatory approvals in the countries in its territory. Guerbet
paid the Company license fees and is required to pay royalties based on sales.
The agreement terminates on the later of (i) the expiration of the last to
expire technology patent or (ii) ten years after the date all necessary
approvals are obtained in France.

In 1989, the Company entered into a second supply and distribution
agreement with Guerbet granting Guerbet an exclusive right in Western Europe
(under the tradename Lumirem(TM)) and Brazil to manufacture and sell GastroMARK
and any future Advanced Magnetics MRI contrast agents that Guerbet decides to
market, including Combidex. In addition, Guerbet will pay the Company both
royalties and a percentage of net sales as the purchase price for the active
ingredient. The Company is required to sell to Guerbet its requirements for the
active ingredient used in the contrast agents. The agreement is perpetual but
terminable upon specified events such as nonperformance, insolvency or
assignment without consent.

In 1991, the Company entered into agreements with Squibb Diagnostics, a
division of Bristol-Myers Squibb Co. ("Squibb Diagnostics") covering certain
technology and the manufacturing and marketing of certain contrast agents
including Combidex, which agreements have been terminated. Under agreements
returning the products and technology rights to Advanced Magnetics, the Company
is obligated to pay Squibb Diagnostics up to a maximum of $2,750,000 in
royalties in connection with product sales of Combidex.

In March 1998, the Company entered into a licensing and marketing agreement
with privately-held Andaris Ltd. ("Andaris") of Nottingham, England for the
development and marketing rights to the Quantison ultrasound contrast agent for
the assessment of coronary artery disease. Under the terms of the agreement,
Advanced Magnetics will assume responsibilities for North American development
and commercialization of Quantison subsequent to Andaris achieving certain
development and performance milestones.

The Company is the licensee of certain technologies under agreements with
third parties which require the Company to make payments in accordance with
these license agreements and upon the attainment of particular milestones. The
Company is also required to pay royalties on a percentage of certain product
sales, if any. During fiscal year 1997 and 1996, the Company made milestone
payments of $800,000 and $725,000, respectively, in relation to these
agreements. There were no milestone payments in 1998. Future milestone payments
are not to exceed $818,000.

N. RELATED PARTY TRANSACTIONS:

During the fiscal years ended September 30, 1998, 1997 and 1996, the
Company paid approximately $58,410, $58,910 and $26,573, respectively, to
Fahnestock & Co. Inc. as commissions on transactions involving its investments
in securities. Mr. Leslie Goldstein, a shareholder and member of the Company's
Board of Directors and the brother of Jerome Goldstein, Chairman of the Board
and CEO of the Company, is employed by SRG Associates, a division of Fahnestock
& Co. Inc., as an investment analyst and advisor.

42
<PAGE> 44
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

O. CONSOLIDATED QUARTERLY FINANCIAL DATA -- UNAUDITED:

The following table provides quarterly data for the fiscal years ended
September 30, 1998, and 1997.

<TABLE>
<CAPTION>
FISCAL 1998 QUARTERS ENDED
-----------------------------------------------------------
SEPTEMBER 30 JUNE 30 MARCH 31 DEC. 31, 1997
------------ ----------- ----------- -------------
<S> <C> <C> <C> <C>
License fees.......................... $ -- $ -- $ -- $ --
Royalties............................. 180,542 60,000 370,000 370,000
Product sales......................... 605,689 170,158 619,464 4,560
Contract research and development..... 399,897 -- -- --
Interest, dividends and net gains and
losses on sales of securities....... 371,511 1,263,335 996,977 992,013
----------- ----------- ----------- -----------
Total revenues.............. 1,557,639 1,493,493 1,986,441 1,366,573
Cost of product sales................. 99,679 28,947 103,514 5,805
Operating expenses.................... 3,478,718 2,967,515 3,108,987 3,114,500
Minority interest in subsidiary....... -- (40,637) (80,243) (73,298)
----------- ----------- ----------- -----------
Net income (loss)..................... $(2,020,758) $(1,462,332) $(1,145,817) $(1,680,434)
=========== =========== =========== ===========
Basic and diluted net income (loss)
per share........................... $ (0.30) $ (0.22) $ (0.17) $ (0.25)
</TABLE>

<TABLE>
<CAPTION>
FISCAL 1997 QUARTERS ENDED
-----------------------------------------------------------
SEPTEMBER 30 JUNE 30 MARCH 31 DEC. 31, 1996
------------ ----------- ----------- -------------
<S> <C> <C> <C> <C>
License fees.......................... $ -- $ -- $ -- $ 5,500,000
Royalties............................. 57,541 85,000 95,904 125,000
Product sales......................... 372,366 394,656 209,793 603,542
Contract research and development..... -- -- -- 62,920
Interest, dividends and net gains and
losses on sales of securities....... 984,385 705,323 1,058,895 746,446
----------- ----------- ----------- -----------
Total revenues.............. 1,414,292 1,184,979 1,364,592 7,037,908
Cost of product sales................. 60,722 83,436 33,139 143,196
Operating expenses.................... 3,386,242 2,312,148 2,425,778 2,617,758
Other (income)........................ -- (264,749) (51) --
Provisional credit-income taxes....... -- (379,022) -- --
----------- ----------- ----------- -----------
Net income (loss)..................... $(2,032,672) $ (566,834) $(1,094,274) $ 4,276,954
=========== =========== =========== ===========
Basic and diluted net income (loss)
per share........................... $ (0.30) $ (0.08) $ (0.16) $ 0.63
</TABLE>

P. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS:

The FASB recently issued Statement No. 130 ("SFAS 130"), "Reporting
Comprehensive Income". This statement requires changes in comprehensive income
to be shown in a financial statement that is displayed with the same prominence
as other financial statements. While not mandating a specific financial
statement format, the Statement requires that an amount representing total
comprehensive income be reported. The Statement is effective for fiscal years
beginning after December 15, 1997. Reclassification of financial statements for
earlier periods is required for comparative purposes. The Company believes the
implementation of SFAS 130 may have a material impact on comprehensive income.

43
<PAGE> 45
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The Statement, which is based on the management approach to segment reporting,
includes requirements to report segment information quarterly and entity-wide
disclosures about products and services, major customers, and the material
countries in which the entity holds assets and reports revenues. The Statement
is effective for periods beginning after December 15, 1997. Restatement for
earlier years is required for comparative purposes unless impracticable. In
addition, SFAS 131 need not be applied to interim periods in the initial year,
however, in subsequent years, interim period information must be presented on a
comparative basis. The Company is currently evaluating this Statement and its
effect on financial statement disclosures.

44
<PAGE> 46

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE:

Not applicable.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT:

The information required by this item, with respect to the directors of the
registrant, is incorporated by reference from the Company's definitive proxy
statement in connection with its Annual Meeting of Stockholders to be held on
February 2, 1999, filed with the Commission on or about December 28, 1998, under
the caption "Election of Directors".

The information required by this item, with respect to executive officers
of the registrant, can be found in Part I hereof.

ITEM 11. EXECUTIVE COMPENSATION:

The information required by this item is incorporated by reference from the
Company's definitive proxy statement in connection with its Annual Meeting of
Stockholders to be held on February 2, 1999, filed with the Commission on or
about December 28, 1998, under the captions "Compensation of Directors" and
"Compensation and Other Information Concerning Directors and Officers."

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT:

The information required by this item is incorporated by reference from the
Company's definitive proxy statement in connection with its Annual Meeting of
Stockholders to be held on February 2, 1999, filed with the Commission on or
about December 28, 1998, in the table under the caption "Principal
Stockholders".

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS:

Not applicable.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K:

(a) The following documents are filed as part of this Annual Report on Form
10-K:

1. Consolidated Financial Statement Schedules. Consolidated
financial statement schedules have been omitted because the required
information is not present or not present in amounts sufficient to require
submission of the schedule, or because the information required is included
in the consolidated financial statements or the notes thereto.

2. The exhibits listed in the Exhibit Index immediately preceding the
Exhibits are filed as a part of this Annual Report on Form 10-K.

(b) Reports on Form 8-K:

No reports on Form 8-K were filed by the Company during the fiscal quarter
ended September 30, 1998.

45
<PAGE> 47

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.

ADVANCED MAGNETICS, INC.

By: /s/ JEROME GOLDSTEIN
----------------------------------
Jerome Goldstein, Chairman of the
Board of Directors and Treasurer

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 dates indicated.

<TABLE>
<CAPTION>
SIGNATURE TITLE DATED
--------- ----- -----
<S> <C> <C>

/s/ JEROME GOLDSTEIN Chairman of the Board of December 23, 1998
- --------------------------------------------------- Directors and Treasurer
Jerome Goldstein (principal executive and
financial officer)

/s/ JAMES MATHESON Vice President -- Finance December 23, 1998
- --------------------------------------------------- (principal accounting
James Matheson officer)

/s/ LEONARD M. BAUM Director December 23, 1998
- ---------------------------------------------------
Leonard M. Baum

/s/ LESLIE GOLDSTEIN Director December 23, 1998
- ---------------------------------------------------
Leslie Goldstein

/s/ JOSEPH B. LASSITER, III Director December 23, 1998
- ---------------------------------------------------
Joseph B. Lassiter, III

/s/ MICHAEL D. LOBERG Director December 23, 1998
- ---------------------------------------------------
Michael D. Loberg

/s/ EDWARD B. ROBERTS Director December 23, 1998
- ---------------------------------------------------
Edward B. Roberts

/s/ GEORGE M. WHITESIDES Director December 23, 1998
- ---------------------------------------------------
George M. Whitesides
</TABLE>

46
<PAGE> 48

EXHIBIT INDEX

<TABLE>
<CAPTION>
SEQUENTIALLY
EXHIBIT NUMBERED
NUMBER DESCRIPTION PAGE
- ------- ----------- ------------
<C> <S> <C>
3.1(1) Certificate of Incorporation of the Company, as amended.

3.2(2) By-Laws of the Company, as amended.

10.1(6) 1983 Stock Option Plan of the Company, as amended on
November 13, 1990.

10.2(7) 1987 Employee Stock Purchase Plan.

10.3(7) 1992 Employee Stock Purchase Plan.

10.4(7) 1992 Non-Employee Director Stock Option Plan.

10.5(9) 1993 Stock Plan.

10.6(9) 1993 Non-Employee Director Stock Option Plan.

10.7(13) 1997 Employee Stock Purchase Plan.

10.8(2) Clinical Testing, Supply and Marketing Agreement between the
Company and Guerbet S.A. dated May 22, 1987 (confidential
treatment previously granted).

10.9(4) Clinical Testing, Supply and Marketing Agreement between the
Company and Eiken Chemical Co., Ltd., dated August 30, 1988
(confidential treatment previously granted).

10.10(5) Contrast Agent Agreement dated between the Company and
Guerbet S.A. dated September 29, 1989 (confidential
treatment previously granted).

10.11(6) Contrast Agent Agreement between the Company and Eiken
Chemical Co., Ltd. dated March 27, 1990 (confidential
treatment previously granted).

10.12(6) Amendment to Clinical Testing, Supply and Marketing
Agreement between the Company and Eiken Chemical Co., Ltd.,
dated September 29, 1990 (confidential treatment previously
granted).

10.13(6) License, Supply and Marketing Agreement between the Company
and Mallinckrodt Medical, Inc., dated June 28, 1990
(confidential treatment previously granted).

10.14(7) Technology License Agreement between the Company and Squibb
Diagnostics, dated February 5, 1991 (confidential treatment
previously granted).

10.15(7) Agreement of Amendment to Clinical Testing, Supply and
Marketing Agreement between the Company and Guerbet S.A.,
dated August 13, 1990.

10.16(11) Termination Agreement dated August 30, 1994 between the
Company and Bristol-Myers Squibb Co.

10.17(12) License and marketing agreement between the Company and
Berlex Laboratories, Inc. dated as of February 1, 1995.

10.18(12) Supply Agreement between the Company and Berlex
Laboratories, Inc. dated as of February 1, 1995.

10.19(14) Lease and Lease Agreement between the Company and Carnegie
Center Associates dated September 6, 1994.

10.20(14) Lease between Silver Lake Realty Trust and Kalisto
Biologicals, Inc. dated October 24, 1997.

10.21(15) Promissory Note dated February 10, 1998 issued to the
Company by Leonard Baum.

23.1 Consent of PricewaterhouseCoopers LLP, independent
accountants.

27 Financial Data Schedule
</TABLE>

- ---------------
(1) Incorporated herein by reference to the exhibits to the Company's
Registration Statement on Form S-8 (File No. 33-13953).

(2) Incorporated herein by reference to the exhibits to the Company's Annual
Report on Form 10-K for the fiscal year ended September 30, 1987.

(3) Incorporated herein by reference to the exhibits to the Company's
Registration Statement on Form S-1 (File No. 33-5312).

47
<PAGE> 49

(4) Incorporated herein by reference to the exhibits to the Company's Annual
Report on Form 10-K for the fiscal year ended September 30, 1988.

(5) Incorporated herein by reference to the exhibits to the Company's Annual
Report on Form 10-K for the fiscal year ended September 30, 1989.

(6) Incorporated herein by reference to the exhibits to the Company's Annual
Report on Form 10-K for the fiscal year ended September 30, 1990.

(7) Incorporated herein by reference to the exhibits to the Company's Annual
Report on Form 10-K for the fiscal year ended September 30, 1991.

(8) Incorporated herein by reference to the exhibits to the Company's Current
Report on Form 8-K dated October 15, 1993.

(9) Incorporated herein by reference to the exhibits to the Company's
definitive proxy statement for the fiscal year ended September 30, 1992.

(10) Incorporated herein by reference to the exhibits to the Company's Annual
Report on Form 10-K, as amended, for the fiscal year ended September 30,
1993.

(11) Incorporated herein by reference to the exhibits to the Company's Annual
Report on Form 10-K, for the fiscal year ended September 30, 1994.

(12) Incorporated herein by reference to the exhibits to the Company's Quarterly
Report on Form 10-Q, for the fiscal quarter ended December 31, 1994.

(13) Incorporated herein by reference to the exhibits to the Company's
definitive proxy statement for the fiscal year ended September 30, 1996.

(14) Incorporated herein by reference to the exhibits to the Company's Annual
Report on Form 10-K, for the fiscal year ended September 30, 1997.

(15) Incorporated herein by reference to the exhibits to the Company's Quarterly
Report on Form 10-Q, for the fiscal quarter ended March 31, 1998.

<PAGE> 1

EXHIBIT 23.1

CONSENT OF INDEPENDENT ACCOUNTANTS

We consent to the incorporation by reference in the Registration Statements
of Advanced Magnetics, Inc. on Form S-8 (File Nos. 33-8697, 33-13953, 33-40744,
33-46963, and 333-28417) of our report, dated November 4, 1998, on our audits of
the consolidated financial statements of Advanced Magnetics, Inc. as of
September 30, 1998 and 1997, and for the years ended September 30, 1998, 1997,
and 1996, which report is included in this Annual Report on Form 10-K.

PricewaterhouseCoopers LLP

Boston, Massachusetts
December 23, 1998

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