**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      DC 20549**





**FORM
      10-Q**




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





**For
      the quarterly period ended December 31, 2005** .




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




for
      the
      transition period from _____ to _____.





Commission
      File Number


0-50481





**AEOLUS
      PHARMACEUTICALS, INC.**


(Exact
      Name of Registrant as Specified in Its Charter)








Delaware
            
            56-1953785(State
                or Other Jurisdiction of Incorporation or Organization)
            
            (I.R.S.
                Employer Identification No.)





23811
                Inverness PlaceLaguna
                Niguel, California
            
            92677(Address
                of Principal Executive Offices)
            
            (Zip
                Code)





(Registrant’s
      Telephone Number, Including Area Code) 949-481-9825





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 xNO o





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





Large
      accelerated filer o Accelerated
      filer o Non-accelerated filer 
x




Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).


YES o
      NO x





Indicate
      the number of shares outstanding of each of the issuer’s classes of common
      stock, as of the latest practicable date.




Class
            
            Outstanding
                as of January 31, 2006Common
                Stock, par value $.01 per share
            
            14,077,263
                shares




1


AEOLUS
      PHARMACEUTICALS, INC.


FORM
      10-Q


For
      the
      Quarter Ended December 31, 2005


Table
      of
      Contents


PAGEPART
                I. FINANCIAL
                INFORMATIONItem
                1.
            Financial
                StatementsStatement
                Regarding Financial Information.
            3Consolidated
                Balance Sheets as of December 31, 2005 (unaudited) and September
                30,
                2005.
            4Consolidated
                Statements of Operations for the Three Months ended December 31,
                2005 and
                2004 (unaudited)
            5Consolidated
                Statements of Cash Flows for the Three Months ended December 31,
                2005 and
                2004 (unaudited) .
            6Notes
                to Consolidated Financial Statements
            7Item
                2.
            Management’s
                Discussion and Analysis of Financial Condition and Results of Operations
            12Item
                3
            Quantitative
                and Qualitative Disclosures About Market Risk.
            16Item
                4
            Controls
                and Procedures
            17PART
                II. OTHER
                INFORMATIONItem
                1.
            Legal
                Proceedings
            17Item
                1A
            Risk
                Factors
            17Item
                2.
            Unregistered
                Sales of Equity Securities and Use of Proceeds
            17Item
                3.
            Defaults
                Upon Senior Securities
            17Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            17Item
                5.
            Other
                Information
            17Item
                6.
            Exhibits
            18SIGNATURES
            .
            
            19






2





**AEOLUS
      PHARMACEUTICALS, INC.**










**PART
      I - FINANCIAL INFORMATION**





ITEM
      1.  Financial
      Statements.





**Statement
      Regarding Financial Information**





The
      consolidated financial statements of Aeolus Pharmaceuticals, Inc. and its
      wholly-owned subsidiary, Aeolus Sciences, Inc. (collectively the “Company”),
      included herein have been prepared by management, without audit (except for
      the
      Consolidated Balance Sheet data as of September 30, 2005), pursuant to the
      rules
      and regulations of the Securities and Exchange Commission (“SEC”). Certain
      information normally included in the consolidated financial statements prepared
      in accordance with accounting principles generally accepted in the United States
      has been condensed or omitted pursuant to such rules and regulations. However,
      the Company believes that the disclosures are adequate to make the information
      presented not misleading. The Company recommends that you read the consolidated
      financial statements included herein in conjunction with the audited
      consolidated financial statements and notes thereto included in the Company’s
      Annual Report on Form 10-K for the fiscal year ended September 30, 2005, filed
      with the SEC on December 27, 2005.








3


**AEOLUS
        PHARMACEUTICALS, INC.**


CONSOLIDATED
          BALANCE SHEETS
 (In
        thousands, except shares and per share data)
  December
                  31,
              
              September
                  30,2005
              
              2005(Unaudited)ASSETSCurrent
                  assets:Cash
                  and cash equivalents
              
              $
              2,135
              
              $
              626Accounts
                  receivable
              
              
              14
              
              
              14Prepaids
                  and other current assets
              
              
              262
              
              
              289Total
                  current assets
              
              
              2,411
              
              
              929Other
                  assets
              
              
              8
              
              
              8Total
                  assets
              
              $
              2,419
              
              $
              937LIABILITIES
                  AND STOCKHOLDERS' EQUITYCurrent
                  liabilities:Accounts
                  payable
              
              $
              1,552
              
              $
              712Accrued
                  expenses
              
              
              177
              
              
              290current
                  maturity of long-term note payable
              
              
              889
              
              
              -Total
                  current liabilities
              
              
              2,618
              
              
              1,002Common
                  stock warrants
              
              
              1,893
              
              
              -Long-term
                  note payable
              
              
              -
              
              
              867Total
                  liabilities
              
              
              4,511
              
              
              1,869Series
                  A cumulative convertible preferred stock,  $.01 par value per share,liquidation
                  value $3.00 per share, 1,250,000 shares authorized, issued andoutstanding
                  at December 31, 2005 and no shares authorized, issued,outstanding
                  at September 30, 2005
              
              
              354
              
              
              -Stockholders'
                  equity:Preferred
                  stock, $.01 par value per share, 3,000,000 shares
                  authorized:Series
                  B nonredeemable convertible preferred stock, 600,000 shares
                  authorized;475,087
                  shares issued and outstanding at December 31, 2005 andSeptember
                  30, 2005
              
              
              5
              
              
              5Common
                  stock, $.01 par value per share, 50,000,000 shares
                  authorized;14,059,092
                  and 14,038,259 shares issued and outstanding at December 31,
                  2005and
                  September 30, 2005, respectively
              
              
              141
              
              
              140Additional
                  paid-in capital
              
              
              146,024
              
              
              146,016Accumulated
                  deficit
              
              
              (148,616
              )
              
              (147,093
              )Total
                  stockholders' equity
              
              
              (2,446
              )
              
              (932
              )Total
                  liabilities and stockholders' equity
              
              $
              2,419
              
              $
              937The
                  accompanying notes are an integral part of these unaudited consolidated
                  financial statements.




4




**AEOLUS
                  PHARMACEUTICALS, INC.**CONSOLIDATED
                  STATEMENTS OF OPERATIONS(Unaudited)(In
                  thousands, except per share
                  data)


Three
                  Months EndedDecember
                  31,2005
              
              2004RevenueGrant
                  income
              
              $
              1
              
              $
              109Costs
                  and expenses:Research
                  and development
              
              
              1,293
              
              
              1,620General
                  and administrative
              
              
              491
              
              
              450Total
                  costs and expenses
              
              
              1,784
              
              
              2,070Loss
                  from operations
              
              
              (1,783
              )
              
              (1,961
              )Interest
                  expense, net
              
              
              (12
              )
              
              (2
              )Other
                  income
              
              
              18
              
              
              6Decrease
                  in fair value of common stock warrants
              
              
              254
              
              
              -Net
                  loss attributable to common stockholders
              
              $
              (1,523
              )
              $
              (1,957
              )Net
                  loss per weighted share attributable to common
                  stockholders:(basic
                  and diluted)
              
              $
              (0.11
              )
              $
              (0.14
              )Weighted
                  average common shares outstanding:Basic
                  and diluted
              
              
              14,038
              
              
              13,947The
                  accompanying notes are an integral part of these unaudited consolidated
                  financial statements.





5




**AEOLUS
        PHARMACEUTICALS, INC.**
  CONSOLIDATED
        STATEMENTS OF CASH FLOWS (Unaudited) (In
            thousands)
  Three
                        Months EndedDecember
                        31,2005
                    
                    2004Cash
                        flows from operating activities:Net
                        loss
                    
                    $
                    (1,523
                    )
                    $
                    (1,957
                    )Adjustments
                        to reconcile net loss to net cash used in operating
                        activities:Depreciation
                        and amortization
                    
                    
                    -
                    
                    
                    3Noncash
                        compensation
                    
                    
                    76
                    
                    
                    32Noncash
                        interest and financing costs
                    
                    
                    22
                    
                    
                    19Decrease
                        in fair value of common stock warrants
                    
                    
                    (254
                    )
                    
                    -Change
                        in assets and liabilities:Accounts
                        receivable
                    
                    
                    -
                    
                    
                    53Prepaids
                        and other assets
                    
                    
                    27
                    
                    
                    5Accounts
                        payable and accrued expenses
                    
                    
                    727
                    
                    
                    (489
                    )Net
                        cash used in operating activities
                    
                    
                    (925
                    )
                    
                    (2,334
                    )Cash
                        flows from financing activities:Proceeds
                        from issuance of Series A Preferred Stock
                    
                    
                    2,413
                    
                    
                    -Proceeds
                        from exercise of stock options
                    
                    
                    21
                    
                    
                    -Net
                        cash provided by financing activities
                    
                    
                    2,434
                    
                    
                    -Net
                        increase (decrease) in cash and cash equivalents
                    
                    
                    1,509
                    
                    
                    (2,334
                    )Cash
                        and cash equivalents at beginning of period
                    
                    
                    626
                    
                    
                    7,381Cash
                        and cash equivalents at end of period
                    
                    $
                    2,135
                    
                    $
                    5,047The
                        accompanying notes are integral part of these unaudited consolidated
                        financial statements.




6




**Aeolus
      Pharmaceuticals, Inc.**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





A.  Organization
      and Business and Basis of Presentation





Aeolus
      Pharmaceuticals, Inc. is a San Diego-based biopharmaceutical company that is
      developing a new class of catalytic antioxidant compounds for diseases and
      disorders of the central nervous system, respiratory system, autoimmune system
      and oncology. The Company has reported positive safety results from a completed
      Phase I single dose study of its lead product, AEOL 10150, in patients diagnosed
      with amyotrophic lateral sclerosis (“ALS,” also commonly referred to as “Lou
      Gehrig’s disease”) and in
      September 2005, we launched a Phase I multiple dose study of AEOL 10150 in
      patients diagnosed with ALS. We expect to complete this study by the end of
      the
      second quarter of fiscal year 2006. The
      safety data from these studies could be utilized to support subsequent efficacy
      studies of AEOL 10150 in ALS, as well as other indications for which the Company
      has developed preclinical efficacy data. In addition, the Company has launched
      the “Aeolus Pipeline Initiative” whereby the Company, in conjunction with a
      variety of academic collaborations, is focused on identifying between 1-2
      compounds evaluated from six disease categories for potential entrance into
      human clinical evaluation in 2006. The Aeolus Pipeline Initiative is an internal
      development initiative focused on advancing several of the most promising
      catalytic antioxidant compounds from our proprietary library of 200 compounds.
      The initial therapeutic focus areas for the Aeolus Pipeline Initiative are:
      radiation therapy protection and tumor therapy; Parkinson’s disease; Cystic
      Fibrosis; Chronic Obstructive Lung Disease; tumor suppression/bone marrow
      transplantation; and stroke. These therapeutic focus areas were selected based
      upon preliminary data developed using our catalytic antioxidant
      compounds.





The
      “Company” or “Aeolus” refers collectively to Aeolus Pharmaceuticals, Inc., a
      Delaware corporation (“Aeolus”), and its wholly owned subsidiary, Aeolus
      Sciences, Inc., a Delaware corporation. As of December 31, 2005, Aeolus also
      owned a 35.0% interest in CPEC LLC, a Delaware limited liability company
      (“CPEC”). The Company’s primary operations are located in San Diego, California.




All
      significant intercompany activity has been eliminated in the preparation of
      the
      consolidated financial statements. The unaudited consolidated financial
      statements have been prepared in accordance with the requirements of Form 10-Q
      and Rule 10-01 of Regulation S-X. Some information and footnote disclosures
      normally included in financial statements prepared in accordance with generally
      accepted accounting principles have been condensed or omitted pursuant to those
      rules and regulations. In the opinion of management, the accompanying unaudited
      consolidated financial statements include all adjustments (consisting only
      of
      normal recurring adjustments) necessary to present fairly the consolidated
      financial position, results of operations and cash flows of the Company. The
      consolidated balance sheet at September 30, 2005 was derived from the Company’s
      audited financial statements included in the Company’s Annual Report on Form
      10-K for the fiscal year ended September 30, 2005. The unaudited consolidated
      financial statements included herein should be read in conjunction with the
      audited consolidated financial statements and the notes thereto included in
      that
      Annual Report on Form 10-K and in the Company’s other SEC filings. Results for
      the interim period are not necessarily indicative of the results for any other
      period.





7


**Aeolus
      Pharmaceuticals, Inc.**




B.  Liquidity





The
      Company has incurred significant losses from operations of $1,523,000 and
      $6,937,000, and cash outflows from operations of $925,000 and $6,842,000, for
      the three months ended December 31, 2005 and for the fiscal year ended September
      30, 2005, respectively. The Company expects to incur additional losses and
      negative cash flow from operations during the remainder of fiscal year 2006
      and
      for several more years.





M anagement
      believes the Company has adequate financial resources to conduct operations
      through the second quarter of fiscal year 2006. This raises substantial doubt
      about our ability to continue as a going concern, which will be dependent on
      our
      ability to generate sufficient cash flows to meet our obligations on a timely
      basis, to obtain additional financing and, ultimately, to achieve operating
      profit.





The
      Company intends to explore strategic and financial alternatives, including
      a
      merger or acquisition with or by another company, the sale of shares of stock,
      the establishment of new collaborations for current research programs that
      include initial cash payments and on-going research support and the
      out-licensing of our compounds for development by a third party. The Company
      believes that without additional investment capital it will not have sufficient
      cash to fund its activities in the near future, and will not be able to continue
      operating. As such, the Company’s continuation as a going concern is dependent
      upon its ability to raise additional financing. The Company is actively pursuing
      additional equity financing to provide the necessary funds for working capital
      and other planned activities.





If
      the
      Company is unable to obtain additional financing to fund operations beyond
      the
      second quarter of fiscal year 2006, it will need to eliminate some or all of
      its
      activities, merge with another company, sell some or all of its assets to
      another company, or cease operations entirely. There can be no assurance that
      the Company will be able to obtain additional financing on favorable terms
      or at
      all, or that the Company will be able to merge with another Company or sell
      any
      or all of its assets.




C.  Net
      Loss Per Common Share





The
      Company computes basic net loss per weighted average share attributable to
      common stockholders using the weighted average number of shares of common stock
      outstanding during the period. The Company computes diluted net loss per
      weighted average share attributable to common stockholders using the weighted
      average number of shares of common and dilutive potential common shares
      outstanding during the period. Diluted weighted average common shares excluded
      incremental shares of approximately 10,123,000 as of December 31, 2005 issuable
      upon the exercise or conversion of stock options to purchase common stock,
      convertible preferred stock, convertible debt and warrants to purchase common
      stock. These shares were excluded due to their antidilutive effect as a result
      of the Company’s net losses.







8




**Aeolus
      Pharmaceuticals, Inc.**




D.  Series
      A Convertible Preferred Stock





On
      November 21, 2005, the Company completed a private placement whereby the Company
      issued to certain accredited investors an aggregate of 1,250,000 shares of
      Series A Convertible Preferred Stock (the “Series A Preferred Stock”) at a
      stated price of $2.00 per share and warrants to purchase up to an aggregate
      of
      2,500,000 shares of common stock at an exercise price of $1.00 per share and
      a
      five year term resulting in net proceeds of $2,413,000. The Series A Preferred
      Stock accrues dividends at the rate of 6% of the stated price annually, which
      may be paid in either cash or in our common stock at the Company’s discretion
      and will be accreted to earnings available to common shareholders on a quarterly
      basis. Each convertible preferred share is convertible into two shares of our
      common stock and has a liquidation preference of $3.00 per share. Subject to
      certain limitations, in the event we issue securities at a price per share
      lower
      than the current conversion price per share, then the conversion price of the
      Series A Preferred Stock shall be reduced to such issue price. The warrants
      contain a “cashless exercise” feature that allows the holders, under certain
      circumstances, to exercise the warrants without making a cash payment to the
      Company.





The
      fair
      value of the warrants on November 21, 2005 was estimated to be $2,146,000 using
      the Black-Scholes option pricing model with the following assumptions: dividend
      yield of 0%; expected volatility of 112% risk free interest rate of 4.4%; and
      an
      expected life of five years. The proceeds from the private placement were first
      allocated to the fair value of the warrants and the remaining proceeds were
      attributed to the value of the preferred stock.  This
      results in a carrying value of Series A Preferred Stock of $354,000 as of
      December 31, 2005. The carrying value of the Series A Preferred Stock has not
      been accreted to its redemption value as the occurrence of the redemption event
      is not considered probable.





Offering
      costs of the private placement were $88,000 which were charged to additional
      paid in capital.





Pursuant
      to the terms of the registration rights agreement entered into in connection
      with the transaction, the Company is required to file a registration statement
      by February 17, 2006. The registration rights agreement further provides that
      if
      a registration statement is not filed, or declared effective within specified
      time periods, the Company would be required to pay each holder an amount in
      cash, as liquidated damages, equal to 1.5% per month of the aggregate purchase
      price paid by such holder in the private placement for the common stock and
      warrants then held. In accordance with EITF 00-19, “Accounting for Derivative
      Financial Instruments Indexed To, and Potentially Settled In a Company’s Own
      Stock,” and the terms of the warrants and the transaction documents, at the
      closing date, November 21, 2005 the fair value of the warrants issued in the
      private placement were accounted for as a liability. The warrant liability
      will
      be reclassified to equity when, and if, the Securities and Exchange Commission
      declares the registration statement effective. Until such date in which a
      registration statement registering the shares underlying the warrants is
      declared effective, the warrant liability will be revalued at each balance
      sheet
      date and any changes in fair value will be charged to the statement of
      operations. Between November 21, 2005 and December 31, 2005, the fair
      value of the warrant decreased by $254,000 which was credited to the
      statement of operations. The warrant liability and revaluations have not and
      will not have any impact on the Company’s working capital, liquidity, or
      business operations.





Certain
      provisions of the Certificate of Designations, Preferences and Rights of Series
      A Convertible Preferred Stock (the “Certificate of Designations”) provide that
      the Company shall not perform certain activities without the consent of a
      majority of the holders of the outstanding shares of Series A Preferred Stock,
      including, but not limited to:






9




**Aeolus
      Pharmaceuticals, Inc.**




·
            amend
                any of the provisions of the Certificate of Incorporation or Bylaws
                of the
                Company or the Certificate of
                Designations;


·
            authorize,
                create, designate, issue or sell any class or series of capital stock
                which is senior to or*pari
                passu*with the Series A Preferred Stock;


·
            increase
                the number of authorized shares of Series A Preferred Stock or authorize
                the issuance of or issue any shares of Series A Preferred
                Stock;


·
            increase
                or decrease the number of authorized shares of any class of capital
                stock
                of the Company;


·
            declare
                or pay any dividend, except with respect to the Series A Preferred
                Stock
                as set forth above;


·
            materially
                change the nature or scope of the business of the
                Company;


·
            consummate
                or agree to make any sale, transfer, assignment, pledge, lease, license
                or
                similar transaction by which the Company grants on an exclusive basis
                any
                rights to any of the Company’s intellectual property;


·
            approve
                the annual budget of the Company or any changes
                thereto;


·
            incur
                any indebtedness for borrowed money in excess of $50,000.00;


·
            create,
                incur, assume or suffer to exist, any material lien, charge or other
                encumbrance on any of the Company’s properties or assets; or


·
            increase
                the compensation or benefits payable or to become payable to the
                Company’s
                directors or executives, subject to certain
                exceptions.





The
      Certificate of Designations also provides that so long as the lead investors
      in
      the private placement shall own any shares of Series A Preferred Stock, each
      of
      these investors shall have the right to elect a majority of the Company’s Board
      of Directors.  This
      right to control the Company’s Board of Directors results in Series A preferred
      stockholders having the ability to require the Company to redeem all, or a
      portion, of the outstanding shares of Series A Preferred Stock for cash of
      $3.00
      per share, plus all accrued and unpaid dividends, should the Company execute
      a
      definitive agreement with respect to an acquisition, as defined in the related
      transaction documents. As a result, and in accordance with the guidance provided
      in EITF D-98, the Company has presented the Series A Preferred Stock outside
      of
      permanent equity.





E.  Stock-Based
      Compensation





Below
      is
      a summary of Aeolus stock option activity during the three-month period ended
      December 31, 2005:


**Shares**
              
              **Weighted
                  Average Exercise Price**Outstanding
                  at September 30, 2005
              
              
              2,394,091
              
              $
              4.05Granted
              
              
              46,350
              
              $
              1.04Exercised
              
              
              (20,833
              )
              $
              1.00Forfeited
              
              
              -
              
              
              -Outstanding
                  at December 31, 2005
              
              
              2,419,608
              
              $
              4.02Exercisable
                  at December 31, 2005
              
              
              2,337,107
              
              $
              4.13


For
      the
      three months ended December 31, 2005 and 2004, all stock options were issued
      with an exercise price at or above the fair market value of the Company’s common
      stock on the date of grant.





Beginning
      October 1, 2005, the Company adopted Statement of Financial Accounting Standards
      (“SFAS”) No. 123(R), “Share-Based Payments” (“SFAS No. 123(R)”) on a modified
      prospective transition method to account for its employee stock options. Under
      the modified prospective transition method, fair value of new and previously
      granted but unvested equity awards are recognized as compensation expense in
      the
      income statement, and prior period results are not restated. As a result of
      the
      adoption, the Company’s income from continuing operations decreased by
      $28,000.





10




**Aeolus
      Pharmaceuticals, Inc.**




For
      the
      three months ended December 31, 2005, stock-based compensation expense
      recognized in the income statement is as follows (in thousands):


Research
                  and development expenses
              
              $
              12General
                  and administrative expenses
              
              $
              64Total
                  stock-based compensation expense
              
              $
              76




The
      total
      deferred compensation expense for outstanding stock options was $68,000 as
      of
      December 31, 2005, which will be recognized over the next year. The fair value
      of the options associated with the above compensation expense for the three
      months ended December 31, 2005, was determined at the date of the grant using
      the Black-Scholes option pricing model with the following weighted average
      assumptions:





Dividend
                yield
            
            
            0
            %Expected
                volatility
            
            
            189
            %Risk-free
                interest rate
            
            
            4.3%
                - 4.6
            %Expected
                option life after shares are vested
            
            
            10
                years





If
      the
      Company had accounted for stock-based compensation plans using the fair value
      based accounting method described by SFAS No. 123 for the periods prior to
      October 1, 2005, the Company’s net income per common share-basic and diluted for
      the three months ended December 31, 2004, would have approximated the following
      (in thousands, except per share data):


Net
                  loss attributable to common stockholders as reported
              
              $
              (1,957
              )Pro
                  forma adjustment for stock-based compensation
              
              
              (202
              )Pro
                  forma net loss attributable to common stockholders
              
              $
              (2,159
              )Basic
                  and diluted net loss per weighted share attributable to common
                  stockholders:As
                  reported
              
              $
              (0.14
              )Pro
                  forma - adjusted for stock-based compensation.......
              
              $
              (0.15
              )




The
      fair
      value of each option grant for employees and consultants was estimated on the
      date of the grant using the Black-Scholes option valuation model with the
      following weighted-average assumptions used for grants for the three months
      ended December 31, 2004:





Dividend
                yield
            
            
            0
            %Expected
                volatility
            
            
            195
            %Risk-free
                interest rate
            
            
            2.9%
                - 4.3
            %Expected
                option life (in years from vesting)
            
            
            3






11




**Aeolus
      Pharmaceuticals, Inc.**




F.  Commitments
      and Contingencies




At
      December 31, 2005, the Company had future contractual operating lease
      commitments of $159,000 primarily for its former office and laboratory
      facilities in North Carolina, for which the Company has accrued the entire
      amount as a reserve related to future rent costs for its office and laboratory
      facilities that are no longer in use.





In
      December 1999, the Company sold its anti-infectives division (“IRL”) to a
      private pharmaceutical company. The Company remains contingently liable through
      May 2007 for a lease obligation of approximately $1,387,000 assumed by the
      purchaser on the former IRL facility in Cranbury, New Jersey. No amounts are
      recorded in the accompanying financial statements for this contingent
      liability.




Item
      2.  Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations .





Introduction





Unless
      otherwise noted, the terms “we,” “our” or “us” refer collectively to
      Aeolus Pharmaceuticals, Inc. and our
      wholly owned subsidiary, Aeolus Sciences, Inc.





This
      report contains, in addition to historical information, statements by us with
      respect to expectations about our business and future results which are
“forward-looking” statements under the Private Securities Litigation Reform Act
      of 1995. These statements and other statements made elsewhere by us or by our
      representatives, which are identified or qualified by words such as “likely,”
“will,” “suggests,” “expects,” “might,” “believe,” “could,” “should,” “may,”
“estimates,” “potential,” “predict,” “continue,” “would,” “anticipates,”
“plans,” or similar expressions, are based on a number of assumptions that are
      subject to risks and uncertainties. Such statements include, but are not limited
      to, those relating to Aeolus’ product candidates, as well as its proprietary
      technologies and uncertainties and other factors that may cause Aeolus’ actual
      results to be materially different from historical results or from any results
      expressed or implied by such forward-looking statements. Important factors
      that
      could cause results to differ include risks associated with uncertainties of
      progress and timing of clinical trials, scientific testing, obtaining regulatory
      approval, the need to obtain funding for pre-clinical and clinical trails and
      operations, the scope and validity of intellectual property protection for
      Aeolus’ product candidates, proprietary technologies and their uses, new
      accounting and SEC requirements and competition from other biopharmaceutical
      companies. Certain of these factors and others are more fully described in
      Aeolus’ filings with the SEC, including, but not limited to, Aeolus’ Annual
      Report on Form 10-K for the fiscal year ended September 30, 2005. All
      forward-looking statements are based on information available as of the date
      hereof, and we do not assume any obligation to update such forward-looking
      statements. Readers are cautioned not to place undue reliance on these
      forward-looking statements, which speak only as of the date hereof.





12




**Aeolus
      Pharmaceuticals, Inc.**




Operations
      Summary





We
      are
      developing a series of catalytic antioxidant molecules to protect against the
      damaging effects of reactive oxygen derived molecules, commonly referred to
      as
      free radicals. Free radicals cause damage in a broad group of diseases and
      conditions. Our initial target applications will be the use of our catalytic
      antioxidants for amyotrophic lateral sclerosis, also known as “ALS” or “Lou
      Gehrig’s disease,” stroke, Parkinson’s disease and cancer radiation therapy. We
      have
      reported positive safety results from a completed Phase I single dose study
      of
      AEOL 10150 in patients diagnosed with ALS. In addition, in September 2005,
      we
      launched a Phase I multiple dose study of AEOL 10150 in patients diagnosed
      with
      ALS. We expect to complete this study by the end of the second quarter of fiscal
      year 2006. The
      safety data from these studies could be utilized to support subsequent efficacy
      studies of AEOL 10150 in ALS, as well as other indications for which the Company
      has developed preclinical efficacy data.





We
      do not
      have any revenue, other than grant income, and therefore we must rely on public
      or
      private equity offerings, debt financings, collaboration arrangements or grants
      to
      finance our operations.





Need
      for Additional Funds





We
      believe we have adequate financial resources to fund our operations through
      the
      second quarter of fiscal year 2006, but in order to fund on-going operating
      cash
      requirements beyond the second quarter of fiscal year 2006, or to accelerate
      or
      expand our programs, we will need to raise significant additional funds. Our
      need for additional financing is discussed under “Liquidity and Capital
      Resources.”





Results
      of Operations





We
      had
      net losses attributable to common stockholders of $1,523,000 for the three
      months ended December 31, 2005, versus net losses attributable to common
      stockholders of $1,957,000 for the three months ended December 31, 2004.





In
      August
      2003, we were awarded a $100,000 Small Business Innovation and Research (“SBIR”)
      Phase I grant from the National Cancer Institute, a division of the National
      Institutes of Health. In March 2004, we were awarded up to $375,000 for the
      first year of a SBIR Phase II grant and received approval for a second year
      of
      the Phase II grant program in January 2005. Pursuant to the grants, we are
      studying the antitumor and radiation-protective effects of our catalytic
      antioxidants. The study is a collaboration between us and the Department of
      Radiation Oncology at Duke University Medical Center. We recognized $1,000
      and
      $109,000 of grant income during the three months ended December 31, 2005 and
      2004, respectively.





Research
      and development (“R&D”) expenses decreased $327,000, or 20%, to $1,293,000
      for the three months ended December 31, 2005 from $1,620,000 for the three
      months ended December 31, 2004. Our primary operational focus and R&D
      spending during the three months ended December 31, 2005 was on conducting
      our
      Phase I multiple dose clinical trial for the treatment of ALS and the
      advancement of the Aeolus Pipeline Initiative, while our primary operational
      focus and R&D spending during the three months ended December 31, 2004 was
      on preclinical pharmacology and toxicology tests on our lead compound, AEOL
      10150, and the launch of our Phase I single dose clinical trial for the
      treatment of ALS. Clinical trial expenses for the three months ended December
      31, 2005 was $865,000 compared to $468,000 during the three months ended
      December 31, 2004. Preclinical expenses primarily related to the Aeolus Pipeline
      Initiative for the three months ended December 31, 2005 were $106,000, whereas
      preclinical expenses related to pharmacology and toxicology testing of AEOL
      10150 during the three months ended December 31, 2004 were $750,000.




13




**Aeolus
      Pharmaceuticals, Inc.**




R&D
      expenses for our antioxidant program have totaled $29,966,000 from inception
      through December 31, 2005. Because of the uncertainty of our research and
      development and clinical studies, we are unable to predict the level of spending
      and the anticipated program completion date, if any. However, we expect that
      R&D expenses during the remainder of fiscal year 2006 will be higher than
      those incurred in the quarter ended December 31, 2005 as we complete the
      multi-dose Phase I study in ALS, continue the clinical development of AEOL
      10150
      and expand our pre-clinical testing activities to further the development of
      other compounds in our pipeline.





General
      and administrative (“G&A”) expenses increased $41,000, or 9%, to $491,000
      for the three months ended December 31, 2005 from $450,000 for the three months
      ended December 31, 2004. G&A expenses were higher during the three months
      ended December 31, 2005 versus the three months ended December 31, 2004 due
      to a
      higher level of consulting fees and legal fees offset by a decline in employment
      costs and rent expenses. During the three months ended December 31, 2005, the
      Company’s administration and accounting activities were outsourced while during
      the same period in 2004, employees performed these functions resulting in a
      higher level of consulting fees ($60,000) and a lower level of employment costs
      ($66,000) during the quarter ended
      December 31, 2005 .
      Legal
      fees increased $31,000 during the quarter ended December 31, 2005 as a result
      of
      the Company’s increased regulatory compliance responsibilities. Rental expenses
      decreased by $19,000 during the quarter ended December 31, 2005 when compared
      to
      the same quarter last year as the Company closed its administrative offices
      in
      August 2005 and outsourced all of its administration functions, as a result
      of
      which we did not incur any rental expense during the quarter.





Effective
      October 1, 2005, we adopted SFAS No. 123(R). SFAS No. 123(R) required that
      we
      recognize the fair value of equity awards granted to our employees as
      compensation expense in the income statement over the requisite service period.
      For the three months ended December 31, 2005, we recognized $28,000 in
      stock-based compensation expense as a result of the adoption of SFAS No. 123(R),
      which is included in G&A expenses. Additionally, we recognized $48,000 of
      stock-based compensation charges associated with stock option grants to
      consultants.





In
      accordance with EITF 00-19, “Accounting for Derivative Financial Instruments
      Indexed To, and Potentially Settled In a Company’s Own Stock,” and the terms of
      the warrants and the transaction documents, at the closing date, November 21,
      2005, the fair value of the warrants issued in the private placement were
      accounted for as a liability. Until such date in which a registration statement
      registering the shares underlying the warrants is declared effective, the
      warrant liability will be revalued at each balance sheet date and any changes
      in
      fair value will be charged to the statement of operations. Between November
      21,
      2005 and December 31, 2005, the fair value of the warrant decreased by
      $254,000 which was credited to the statement of operations. The warrant
      liability and revaluations have not and will not have any impact on the
      Company’s working capital, liquidity, or business operations.




14


**Aeolus
      Pharmaceuticals, Inc.**




Liquidity
      and Capital Resources





We
      do not
      have any revenue, other than grant income, and therefore we rely on investors,
      grants, collaborations and licensing of our compounds to finance our operations.
      At December 31, 2005, we had $2,135,000 of cash, an increase of $1,509,000
      from
      September 30, 2005. The increase in cash was primarily due to the net proceeds
      of $2,413,000 from the sale of the Series A Convertible Preferred Stock, offset
      by an increase of $727,000 in accounts payable and accrued expenses due to
      a
      higher level of payables as of December 31, 2005 when compared to September
      30,
      2005, and a $1,523,000 net loss for the three months ended December 31, 2005. We
      believe we have adequate financial resources to conduct operations through
      the
      second quarter of fiscal year 2006, but in order to fund on-going operating
      cash
      requirements beyond that point, or to further accelerate or expand our programs,
      we need to raise significant additional funds.





We
      incurred significant losses from operations of $1,783,000 and $6,937,000, and
      cash outflows from operations of $925,000 and $6,842,000, for the three months
      ended December 31, 2005 and for the fiscal year ended September 30, 2005,
      respectively. Our ongoing future cash requirements will depend on numerous
      factors, particularly the progress of our catalytic antioxidant program and
      clinical trials and our ability to negotiate and complete collaborative
      agreements or out-licensing arrangements. In order to help fund our on-going
      operating cash requirements, we intend to seek new collaborations for our
      antioxidant research program that include initial cash payments and on-going
      research support. In addition, we might sell additional shares of our stock
      and
      explore other strategic and financial alternatives, including a merger with
      another company, the sale of stock, the establishment of new collaborations
      for
      current research programs, that include initial cash payments and ongoing
      research support and the out-licensing of our compounds for development by
      a
      third party.





There
      are
      significant uncertainties as to our ability to access potential sources of
      capital. We may not be able to enter into any collaboration on terms acceptable
      to us, or at all, due to conditions in the pharmaceutical industry or in the
      economy in general or based on the prospects of our catalytic antioxidant
      program. Even if we are successful in obtaining a collaboration for our
      antioxidant program, we may have to relinquish rights to technologies, product
      candidates or markets that we might otherwise develop ourselves. These same
      risks apply to any attempt to out-license our compounds.





Similarly,
      due to market conditions, the illiquid nature of our stock and other possible
      limitations on equity offerings, we may not be able to sell additional
      securities or raise other funds on terms acceptable to us, if at all. Any
      additional equity financing, if available, would likely result in substantial
      dilution to existing stockholders.





Our
      forecast of the period of time through which our financial resources will be
      adequate to support our operations is forward-looking information, and actual
      results could vary.





15




**Aeolus
      Pharmaceuticals, Inc.**




Off-Balance
      Sheet Arrangements





We
      do not
      have any off-balance sheet arrangements that have or are reasonably likely
      to
      have a current or future effect on our financial condition, changes in financial
      condition, revenues or expenses, results of operations, liquidity, capital
      expenditures or capital resources. We do have operating leases, which are
      generally for office and laboratory space. In accordance with accounting
      principles generally accepted in the United States, operating leases are not
      reflected in the accompanying consolidated balance sheets. We do not have any
      capital leases.




ITEM
      3.  Quantitative
      and Qualitative Disclosures About Market Risk.





Our
      exposure to market risk is presently limited to the interest rate sensitivity
      of
      our cash and cash equivalents, which is affected by changes in the general
      level
      of U.S. interest rates. However, we believe that we are not subject to any
      material market risk exposure and do not expect that changes in interest rates
      would have a material effect upon our financial position. A hypothetical 10%
      change in interest rates would not have a material effect on our Statement
      of
      Operations or Cash Flows for the three months ended December 31, 2005. We do
      not
      have any foreign currency or other derivative financial
      instruments.





16




**Aeolus
      Pharmaceuticals, Inc.**




ITEM
      4.  Controls
      and Procedures .





As
      of the
      end of the period covered by this report, we carried out an evaluation, under
      the supervision and with the participation of our management, including our
      Chief Executive Officer and Chief Accounting Officer, of the effectiveness
      of
      our disclosure controls and procedures (as defined in Rule 13a-15(e)) pursuant
      to Rule 13a-15 of the Securities and Exchange Act of 1934 as amended. Based
      upon
      their evaluation, our Chief Executive Officer and Chief Accounting Officer
      have
      concluded that our disclosure controls and procedures are
      effective.





No
      change
      in our internal control over financial reporting occurred during our last fiscal
      quarter that has materially affected, or is reasonably likely to materially
      affect, our internal control over financial reporting.





Management
      is aware that there is a lack of segregation of duties due to the small number
      of employees and consultants addressing the Company’s general administrative and
      financial matters. However, management has determined that, considering the
      employees involved and the control procedures in place, risks associated with
      such lack of segregation are not significant and any potential benefits of
      adding employees or consultants to clearly segregate duties do not justify
      the
      expenses associated with such increases at this time.





**PART
      II. - OTHER INFORMATION**





ITEM
            1.
            Legal
                Proceedings.





None.





ITEM
            1A.
            Risk
                Factors.





None.





ITEM
            2.
            Unregistered
                Sales of Equity Securities and Use of
                Proceeds.





None.





ITEM
            3.
            Defaults
                Upon Senior Securities.





None.




ITEM
            4.
            Submission
                of Matters to a Vote of Security
                Holders.





None.





ITEM
            5.
            Other
                Information.





None.





17




**Aeolus
      Pharmaceuticals, Inc.**




ITEM
            6.
            Exhibits





**Exhibit
                #**
            
            **Description**3.1
            
            Certificate
                of Incorporation, as amended (incorporated by reference to Exhibit
                3.1 of
                the Company’s Form 10-Q dated June 30, 2004).3.2
            
            Certificate
                of Designations, Preferences and Rights of Series A Convertible Preferred
                Stock of the Company dated November 18, 2005 (incorporated by reference
                to
                Exhibit 3.1 to the Company's Current Report on Form 8-K filed November
                23,
                2005).3.3
            
            Amended
                and Restated Bylaws (incorporated by reference to Exhibit 3.1 to
                the
                Company’s Current Report on Form 8-K filed October 27,
                2005).4.1
            
            Form
                of Common Stock Certificate (incorporated by reference to Exhibit
                4.1 to
                the Company’s Quarterly Report on Form 10-Q filed August 11,
                2004).4.2
            
            Form
                of Warrant to Purchase Common Stock of Aeolus Pharmaceuticals, Inc.
                dated
                November 21, 2005 issued to investors (incorporated by reference
                to
                Exhibit 10.2 to the Company's Current Report on Form 8-K filed November
                23, 2005).4.3
            
            Registration
                Rights Agreement dated November 21, 2005 by and among the Company
                and each
                of the Purchasers whose names appear on the Schedule attached thereto
                (incorporated by reference to Exhibit 4.1 to the Company's Form 8-K
                filed
                November 23, 2005).10.1
            
            Purchase
                Agreement dated November 21, 2005 by and among the Company and the
                investors whose names appear on the signature pages thereof (incorporated
                by reference to Exhibit 10.1 to the Company's Form 8-K filed November
                23,
                2005).31.1
            
            Certification
                of the Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a)
                and 15d-14(a).31.2
            
            Certification
                of theChief
                Accounting Officerpursuant to Exchange Act Rules 13a-14(a) and 15d-14(a).32.1
            
            Certification
                by the Chief Executive Officer and Chief Accounting Officer pursuant
                to 18
                U.S.C. §1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
                of 2002.







18




**Aeolus
      Pharmaceuticals, Inc.**




**SIGNATURES**





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













AEOLUS
                PHARMACEUTICALS, INC.Date:February
                16, 2006
            By:
            /s/
                Richard P. Burgoon, Jr.Richard
                P. Burgoon, Jr.
              Chief
                Executive Officer
              (Principal
                Executive Officer)Date:February
                16, 2006
            By:
            /s/
                Michael P. McManusMichael
                P. McManus
              Chief
                Accounting Officer and Treasurer
              (Principal
                Financial and Accounting Officer)





19