**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

 
| **ý**                                                                                                                                                                                        | **QUARTERLY REPORT UNDER  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**            |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                        | ** **                                                                                             |
| **For Quarterly Period Ended June 30, 2004**                                                                                                                                                      |
|                                                                                                                                                                                              |                                                                                                   |
| **Or**                                                                                                                                                                                            |
|                                                                                                                                                                                              |                                                                                                   |
| **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 33-90516**                                                                                                                                                               |

 

 

**NEOPHARM, INC.**

(Exact name of Registrant as specified in itscharter)

 
| **Delaware**                                                    | ** ** | **51-0327886**                          |
|-----------------------------------------------------------------|------------|-----------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer Identification Number) |
|                                                            |       |                                    |
| **150 Field Drive  Suite 195  Lake Forest, Illinois 60045**     |
| (Address of principal executive offices) (Zip Code)             |
|                                                            |       |                                    |
| **(847) 295-8678**                                              |
| (Registrant’s telephone number, including area code)       |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes   ý   No  o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act). Yes   ý  No  o

 

As of July 31, 2004 the number of shares outstanding of each of theissuer’s classes of common stock was as follows:

 
| **Title of each class**            | ** ** | **Number of shares outstanding** |
|------------------------------------|------------|----------------------------------|
| Common Stock ($.0002145 par value) |       | 23,278,985                       |

 

 

----

 

NEOPHARM, INC.

 

FORM 10-QINDEX

 
| PART I. FINANCIAL INFORMATION |    |
|-------------------------------|---------|
|                          | Item 1. | Financial Statements |   |
|                          |    | Consolidated  Balance Sheets as of June 30, 2004 (Unaudited) and December 31, 2003 |   |
|                          |    | Consolidated Statements of Operations for  the three- and six-month periods ended June 30, 2004 and 2003 (Unaudited) |   |
|                          |    | Consolidated Statements of Cash Flows for  the six-month periods ended June 30, 2004 and 2003 (Unaudited) |   |
|                          |    | Notes to Consolidated Financial Statements (Unaudited) |   |
|                          | Item 2. | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |   |
|                          | Item 3. | Quantitative and Qualitative Disclosures  About Market Risk |   |
|                          | Item 4  | Controls  and Procedures |   |
| PART II. OTHER INFORMATION    |    |
|                          | Item 1. | Legal Proceedings |   |
|                          | Item 2. | Changes in Securities and Use of Proceeds |   |
|                          | Item 3. | Defaults Upon Senior Securities |   |
|                          | Item 4. | Submission of Matters to a Vote of  Security-Holders |   |
|                          | Item 5. | Other Information |   |
|                          | Item 6. | Exhibits  and Reports on Form 8-K |   |
| SIGNATURE PAGE                |    |

 

2

----

 

**PART I - FINANCIAL INFORMATION**

 

**Item 1 - Financial Statements**

 

**NEOPHARM,INC.Consolidated Balance Sheets**

 
| ** **                                                                                                                                | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|----------------------------|------------|
| ** **                                                                                                                                | ** ** | **(Unaudited)**   | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                                                |       |              |       |                       |       |
| Current assets:                                                                                                                           |       |              |       |                       |       |
| Cash and cash equivalents                                                                                                                 |       | $                 | 88,553,977 |                       | $          | 36,958,941 |   |
| Investments in marketable securities                                                                                                      |       | —            |       | 4,166,351                  |       |
| Trade accounts receivable                                                                                                                 |       | 4,072             |       | —                     |       |
| Inventories                                                                                                                               |       | 6,602             |       | —                     |       |
| Prepaid expenses                                                                                                                          |       | 439,739           |       | 909,833                    |       |
| Other receivables                                                                                                                         |       | 314,734           |       | 284,750                    |       |
| Total current assets                                                                                                                      |       | 89,319,124        |       | 42,319,875                 |       |
| Fixed assets, net of accumulated depreciation                                                                                             |       | 3,464,122         |       | 3,760,705                  |       |
| Total assets                                                                                                                              |       | $                 | 92,783,246 |                       | $          | 46,080,580 |   |
|                                                                                                                                      |       |              |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                            |       |              |       |                       |       |
| Current liabilities:                                                                                                                      |       |              |       |                       |       |
| Accounts payable                                                                                                                          |       | $                 | 404,198    |                       | $          | 499,682 |   |
| Accrued clinical trial expense                                                                                                            |       | 4,150,007         |       | 1,658,293                  |       |
| Accrued legal expenses                                                                                                                    |       | 252,230           |       | 1,076,228                  |       |
| Accrued compensation                                                                                                                      |       | 1,733,886         |       | 2,144,163                  |       |
| Other accrued expenses                                                                                                                    |       | 801,752           |       | 684,859                    |       |
| Unearned revenue                                                                                                                          |       | 17,200            |       | —                     |       |
| Total current liabilities                                                                                                                 |       | 7,359,273         |       | 6,063,225                  |       |
|                                                                                                                                      |       |              |       |                       |       |
| Stockholders’ equity:                                                                                                                |       |              |       |                       |       |
| Preferred stock, $0.01 par value; 15,000,000  shares authorized: 0 shares issued and outstanding                                          |       | —            |       | —                     |       |
| Common stock, $0.0002145 par value; 50,000,000  shares authorized: 23,278,985 and 18,862,906 shares issued and outstanding,  respectively |       | 4,995             |       | 4,046                      |       |
| Additional paid-in capital                                                                                                                |       | 246,116,966       |       | 171,704,628                |       |
| Accumulated deficit                                                                                                                       |       | (160,697,988      | )          | (131,691,319               | )          |
| Total stockholders’ equity                                                                                                           |       | 85,423,973        |       | 40,017,355                 |       |
| Total liabilities and stockholders’ equity                                                                                           |       | $                 | 92,783,246 |                       | $          | 46,080,580 |   |

 

The accompanying notes are an integral partof these financial statements.

 

3

----

 

**NEOPHARM, INC.**

 

**Consolidated Statements of Operation****sThree- and Six-Month Periods Ended June 30, 2004 and 2003**(Unaudited)

 
| ** **                                 | ** ** | **Three-Month Periods Ended** | ** **  | **Six-Month Periods Ended** | ** ** |
|--------------------------------------------|------------|-------------------------------|-------------|-----------------------------|------------|
| ** **                                 | ** ** | **June 30, 2004**        | ** **  | **June 30, 2003**      | ** ** | **June 30, 2004** | ** ** | **June 30, 2003** | ** ** |
| Revenues                                   |       | $                             | 19,080      |                        | $          | — |   | $ | 31,280 |   | $ | — |   |
| Cost of revenues                           |       | 298                           |        | —                      |       | 542 |   | — |   |
| Gross margin                               |       | 18,782                        |        | —                      |       | 30,738 |   | — |   |
|                                       |       |                          |        |                        |       |   |   |   |   |
| Expenses:                                  |       |                          |        |                        |       |   |   |   |   |
| Research and development                   |       | 12,008,378                    |        | 8,767,286                   |       | 23,257,605 |   | 15,875,842 |   |
| Selling, general, and administrative       |       | 2,984,560                     |        | 7,880,687                   |       | 6,184,629 |   | 12,285,071 |   |
| Related party expenses                     |       | 34,006                        |        | 35,409                      |       | 69,370 |   | 74,601 |   |
| Total expenses                             |       | 15,026,944                    |        | 16,683,382                  |       | 29,511,604 |   | 28,235,514 |   |
| Loss  from operations                      |       | (15,008,162                   | )           | (16,683,382                 | )          | (29,480,866 | ) | (28,235,514 | ) |
|                                       |       |                          |        |                        |       |   |   |   |   |
| Interest income                            |       | 248,683                       |        | 254,554                     |       | 474,197 |   | 539,446 |   |
| Net loss                                   |       | $                             | (14,759,479 | )                           | $          | (16,428,828 | ) | $ | (29,006,669 | ) | $ | (27,696,068 | ) |
| Net loss per share —                  |       |                          |        |                        |       |   |   |   |   |
| Basic and diluted                          |       | $                             | (0.63       | )                           | $          | (0.87 | ) | $ | (1.28 | ) | $ | (1.47 | ) |
| Weighted average shares outstanding — |       |                          |        |                        |       |   |   |   |   |
| Basic and diluted                          |       | 23,244,608                    |        | 18,826,670                  |       | 22,578,297 |   | 18,817,902 |   |

 

The accompanying notes are an integral partof these financial statements.

 

4

----

 

**NEOPHARM, INC.**

 

**Consolidated Statements of Cash****FlowsSix-Month Periods Ended June 30, 2004 and 2003**(Unaudited)

 
| ** **                                                                   | ** ** | **Six-Month Periods Ended** | ** **  |
|------------------------------------------------------------------------------|------------|-----------------------------|-------------|
| ** **                                                                   | ** ** | **June 30, 2004**      | ** **  | **June 30, 2003** | ** ** |
| Cash flows from operating activities:                                        |       |                        |        |   |   |
| Net loss                                                                     |       | $                           | (29,006,669 | ) | $ | (27,696,068 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities: |       |                        |        |   |   |
| Depreciation                                                                 |       | 678,898                     |        | 522,331 |   |
| Stock-based compensation expense                                             |       | 257,154                     |        | 165,958 |   |
| Changes in assets and liabilities:                                           |       |                        |        |   |   |
| (Increase)/decrease in current assets                                        |       | 429,436                     |        | (983,476 | ) |
| Increase in current liabilities                                              |       | 1,296,048                   |        | 3,639,364 |   |
| Net cash and cash equivalents used in operating  activities                  |       | (26,345,133                 | )           | (24,351,891 | ) |
|                                                                         |       |                        |        |   |   |
| Cash flows from investing activities:                                        |       |                        |        |   |   |
| Proceeds from maturities of marketable securities                            |       | 1,046,168                   |        | 3,005,123 |   |
| Proceeds from sales of marketable securities                                 |       | 3,120,183                   |        | — |   |
| Purchase of marketable securities                                            |       | —                      |        | (378,263 | ) |
| Purchase of equipment and furniture                                          |       | (382,315                    | )           | (455,259 | ) |
| Net cash and cash equivalents provided by  investing activities              |       | 3,784,036                   |        | 2,171,601 |   |
|                                                                         |       |                        |        |   |   |
| Cash flows from financing activities:                                        |       |                        |        |   |   |
| Net proceeds from issuance of common stock                                   |       | 74,156,133                  |        | — |   |
| Cash paid in lieu of fractional shares for stock  dividend                   |       | —                      |        | (9,060 | ) |
| Net cash and cash equivalents provided by/(used  in) financing activities    |       | 74,156,133                  |        | (9,060 | ) |
|                                                                         |       |                        |        |   |   |
| Net increase/(decrease) in cash and cash  equivalents                        |       | 51,595,036                  |        | (22,189,350 | ) |
| Cash and cash equivalents, beginning of period                               |       | 36,958,941                  |        | 87,591,975 |   |
| Cash and cash equivalents, end of period                                     |       | $                           | 88,553,977  |   | $ | 65,402,625 |   |
|                                                                         |       |                        |        |   |   |
| Supplemental disclosure of cash paid for:                                    |       |                        |        |   |   |
| Interest                                                                     |       | $                           | —      |   | $ | — |   |
| Income taxes                                                                 |       | $                           | —      |   | $ | — |   |

 

The accompanying notes are an integral partof these financial statements.

 

5

----

 

**NEOPHARM, INC.**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEME****NTS**

 

**Note 1  Basis of Presentation**

The financial information herein isunaudited. The balance sheet as of December 31, 2003 is derived fromaudited financial statements.

 

The accompanying unaudited consolidatedfinancial statements of NeoPharm, Inc. (the “Company”) have been prepared inaccordance with generally accepted accounting principles for interim financialinformation and with the instructions to Form 10-Q and Rule 10-01 of RegulationS-X. Accordingly, they do not contain all of the information and notes requiredby accounting principles generally accepted in the United States of America forcomplete financial statements. In the opinion of the Company, the accompanyingunaudited interim consolidated financial statements contain all adjustments(consisting of normal recurring adjustments) necessary to present fairly theCompany’s financial position as of June 30, 2004, and the results of theiroperations for the three- and six-month periods ended June 30, 2004 and 2003,and their cash flows for the six-month periods ended June 30, 2004 and 2003.

 

The consolidated financial statements includethe accounts of NeoPharm, Inc. and its wholly-owned subsidiary, NeoPharm EULimited.  All significant intercompanyaccounts and transactions are eliminated in consolidation.

 

While the Company believes that thedisclosures presented are adequate to make the information not misleading, itis suggested that these financial statements be read in conjunction with thefinancial statements and notes included in the Company’s 2003 Annual Report onForm 10-K filed with the Securities and Exchange Commission.

** **

**Note 2  Stock-based Compensation**

 

The Company applies the intrinsic-value-basedmethod of accounting prescribed by Accounting Principles Board (APB) OpinionNo. 25, *Accounting for Stock Issued to Employees*,and related interpretations, to account for its fixed-plan stock options.  Under this method, compensation expense isrecorded only if the current fair value of the underlying stock exceeded theexercise price.   Statement of FinancialAccounting Standards (SFAS) No. 123, *Accounting for Stock-BasedCompensation*, established accounting and disclosure requirementsusing a fair-value-based method of accounting for stock-based employeecompensation plans.  As allowed by SFASNo. 123, the Company has elected to continue to apply the intrinsic-value-basedmethod of accounting described above, and has adopted only the disclosurerequirements of SFAS No. 123, and related amendments.

 

The Company accounts for option grants underthe plan by applying the provisions of APB Opinion No. 25, under which nocompensation cost has been recognized for the stock option awards to employees,since the exercise price of the options granted is equal to fair value on thedate of grant.  The following tableillustrates the effect on net loss if the fair-value-based method had been appliedin each period.
| ** **                                                                                                      | **For the three-month periods ended:** | ** **  | **For the six-month periods ended:** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|----------------------------------------|-------------|--------------------------------------|------------|
| ** **                                                                                                      | **June 30, 2004**                      | ** **  | **June 30, 2003**                    | ** ** | **June 30, 2004** | ** ** | **June 30, 2003** | ** ** |
|                                                                                                            |                                   |        |                                 |       |   |   |   |   |
| Net loss, as reported                                                                                           | $                                      | (14,759,479 | )                                    | $          | (16,428,828 | ) | $ | (29,006,669 | ) | $ | (27,696,068 | ) |
| Add stock-based employee compensation expense  included in reported net loss(1)                                 | 52,069                                 |        | 97,958                               |       | 199,883 |   | 97,958 |   |
| Deduct total stock-based employee compensation  expense determined under fair-value-based method for all awards | (2,098,145                             | )           | (1,929,433                           | )          | (4,040,400 | ) | (3,835,220 | ) |
| Pro forma net loss                                                                                              | $                                      | (16,805,555 | )                                    | $          | (18,260,303 | ) | $ | (32,847,186 | ) | $ | (31,433,330 | ) |
|                                                                                                            |                                   |        |                                 |       |   |   |   |   |
| Basic and diluted loss per share of common stock                                                                |                                   |        |                                 |       |   |   |   |   |
| As reported                                                                                                     | $                                      | (0.63       | )                                    | $          | (0.87 | ) | $ | (1.28 | ) | $ | (1.47 | ) |
| Pro forma                                                                                                       | $                                      | (0.72       | )                                    | $          | (0.97 | ) | $ | (1.45 | ) | $ | (1.67 | ) |

 

----

(1)           Valueof restricted stock granted to non-employee directors.

** **

**Note 3  Investments**

The Company considers all highly liquidinvestments purchased with an original maturity of three months or less to becash equivalents.  Included with cash arecash equivalents of $85,180,128 and $36,484,817 as of June 30, 2004 andDecember 31, 2003, respectively.  Thecarrying value of these investments approximates their fair market value due totheir short maturity and liquidity.

 

Investments in marketable securities includeliquid investments purchased with an original maturity of between three monthsand one year. As provided by SFAS No. 115, *Accountingfor Certain Investments in Debt and Equity Securities,*the Companyhas elected to treat all of its investments in marketable securities as“available-for-sale,” which requires these investments to be recorded at fairmarket value. Unrealized gains and losses, net of related tax effect, onavailable-for-sale securities deemed to be temporary are excluded from earningsand are reported as a separate component of other comprehensive income untilrealized. Realized gains and losses from the sale of available-for-salesecurities are determined on a specific identification basis. A decline inmarket value of available-for-sale securities that is deemed to be other thantemporary, results in the reduction of the carrying amount to fair value. Theimpairment is charged to earnings and a new cost basis for the security isestablished.  The Company has notexperienced any declines in fair market value of its investments that wereother than temporary.  As of June 30,2004, the Company had no investments in marketable securities. Dividend andinterest income are recognized when earned. Realized gains on investments soldduring the three- and six-month periods ended June 30, 2004 was $20 and $192,respectively.  No investments were soldduring the three- and six-month periods ended June 30, 2003.

 

6

----

 

**Note 4  Inventory**

Inventory is comprised solely of NeoPhectinfinished goods and is stated at the lower of cost or market, as determined bythe first in, first out method (FIFO). Inventory cost consists of direct material and direct labor costs.  As products are currently produced in theCompany’s research and development facilities, the Company has not allocatedany overhead costs as a product cost. Application of overhead as a product cost is not material.  Inventory as of June 30, 2004 and December31, 2003 consisted of the following:

 
| ** **                  | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|-----------------------------|------------|-------------------|------------|-----------------------|------------|
|                        |       |              |       |                  |       |
| Finished goods on hand      |       | $                 | 6,455      |                  | $          | — |   |
| Inventory subject to return |       | 147               |       | —                |       |
|                        |       |              |       |                  |       |
|                        |       | $                 | 6,602      |                  | $          | — |   |

 

Inventory subject to returnrepresents NeoPhectin products shipped to a wholesale customer that have notbeen recognized as revenue (see note 7).

 

**Note 5  Fixed Assets**

 

Fixed assets are recorded at cost and aredepreciated using the straight line method over their estimated useful lives.During 2003, the Company revised its estimate of the useful life of computerequipment from five years to three years. Maintenance and repairs that do notextend the life of assets are charged to expense when incurred.

 

Long-lived assets are reviewed for impairmentwhenever events or changes in circumstances indicate the carrying amount of anasset may not be recoverable. Recoverability of assets to be held and used ismeasured by a comparison of the carrying amount of an asset to estimatedundiscounted cash flows expected to be generated by the asset. If the carryingamount of an asset exceeds its estimated future cash flows, an impairmentcharge is recognized by the amount by which the carrying amount of the assetexceeds the fair value of the asset.

 

**Note 6  Stockholders'Equity**

 

On January 27, 2004, the Company received proceeds of $73,980,938 (netof the underwriting discounts and commissions, but before expenses) by issuing4,312,500 shares of common stock in a public offering.

 

**Note 7  Revenue Recognition**

 

The Company commenced sales of products in2004.  All revenue represents sales ofNeoPhectinTM and NeoPhectin-ATTM (together “NeoPhectin”) transfection reagentproducts sold to Avanti Polar Lipids, Inc. (Avanti), through a non-exclusivedistribution agreement, or to end-user customers.

 

Revenue is recognized when persuasiveevidence of an arrangement with the customer at a fixed or determinable priceexists, products are shipped, title and risk of loss passes to the customer,and collection of amounts owed is reasonably assured.

Shipments of product to Avanti are subject tounconditional rights of return for a period of 180 days from the date ofshipment.  Given the limited saleshistory of NeoPhectinTM, the Company is currently unable to reasonably estimatethe level of returns at the time of product shipment.  Accordingly, revenue is currently being recognizedwhen the right of return has expired, which occurs upon the earlier of shipmentof product by the distributor to an end-user or 180 days.

** **

7

----

 

**Note 8  Loss Per Share**

 

The following table sets forth thecomputation of the basic and diluted net loss per share:

 

| ** **                          | ** ** | **For the three-month periods ended:** | ** **  | **For the six-month periods ended:** | ** ** |
|-------------------------------------|------------|----------------------------------------|-------------|--------------------------------------|------------|
| ** **                          | ** ** | **June 30, 2004**                      | ** **  | **June 30, 2003**                    | ** ** | **June 30, 2004** | ** ** | **June 30, 2003** | ** ** |
| Numerator:                          |       |                                   |        |                                 |       |   |   |   |   |
| Net loss                            |       | $                                      | (14,759,479 | )                                    | $          | (16,428,828 | ) | $ | (29,006,669 | ) | $ | (27,696,068 | ) |
|                                |       |                                   |        |                                 |       |   |   |   |   |
| Denominator:                        |       |                                   |        |                                 |       |   |   |   |   |
| Weighted average shares outstanding |       | 23,244,608                             |        | 18,826,670                           |       | 22,578,297 |   | 18,817,902 |   |
|                                |       |                                   |        |                                 |       |   |   |   |   |
| Loss per share - basic and diluted  |       | $                                      | (0.63       | )                                    | $          | (0.87 | ) | $ | (1.28 | ) | $ | (1.47 | ) |
|                                |       |                                   |        |                                 |       |   |   |   |   |
| Potential common share equivalents: |       |                                   |        |                                 |       |   |   |   |   |
| Stock options                       |       | 3,621,647                              |        | 3,294,901                            |       | 3,529,263 |   | 3,284,447 |   |

 

As the Company has incurred a net loss forall periods presented, basic and diluted per share amounts are equivalent asthe effect of all potential common share equivalents is anti-dilutive.

** **

**Note 9  Transactions with Related Parties**

 

The following table provides further detailof the related party expenses reflected in the statements of operations.

 

| ** **                   | ** ** | ** **       | ** ** | **For the three-month periods ended:** | ** ** | **For the six-month periods ended:** | ** ** |
|------------------------------|------------|------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| **Related Party**            | ** ** | **Expense Type** | ** ** | **June 30, 2004**                      | ** ** | **June 30, 2003**                    | ** ** | **June 30, 2004** | ** ** | **June 30, 2003** | ** ** |
| Akorn, Inc.                  |       | Consulting       |       | $                                      | 2,500      |                                 | $          | 3,750 |   | $ | 6,250 |   | $ | 11,419 |   |
| E.J. Financial  Enterprises  |       | Consulting       |       | 31,250                                 |       | 31,250                               |       | 62,500 |   | 62,500 |   |
| E.J. Financial Enterprises   |       | Direct  Expenses |       | 256                                    |       | 409                                  |       | 620 |   | 682 |   |
| Total related party expenses |       |             |       | $                                      | 34,006     |                                 | $          | 35,409 |   | $ | 69,370 |   | $ | 74,601 |   |

 

During 2004 and 2003, the Company receivedmanagement consulting services from EJ Financial Enterprises, Inc.("EJ Financial"), a healthcare consulting and investment firm inwhich Dr. John N. Kapoor, a member of the Company’s Board ofDirectors and the Company's immediate past Chairman of the Board of Directors,is the sole stockholder.  The consultingagreement with EJ Financial expired on June 30, 2004 and was not renewed.

 

In December 2001, NeoPharm entered intoa transaction whereby NeoPharm loaned to Akorn, Inc., a Louisianacorporation, $3,250,000 to assist Akorn in the completion of its lyophilizedproducts manufacturing facility in Decatur, Illinois. Dr. Kapoor, a memberof the Company’s Board of Directors and the Company's immediate past Chairmanof the Board of Directors, is the Chairman of the Akorn Board of Directors andholds a substantial stock position in both companies. In connection with theloan transaction, NeoPharm entered into the following agreements: PromissoryNote, dated December 20, 2001, in the original principal amount of$3,250,000 by Akorn to NeoPharm; Processing Agreement, dated December 20,2001, by and between Akorn and NeoPharm; Subordination and IntercreditorAgreement, dated December 20, 2001, by and between John N. Kapoor, asTrustee under The John N. Kapoor Trust, dated September 20, 1989 andNeoPharm; and a Subordination, Standby and Intercreditor Agreement, datedDecember 20, 2001, by and among Akorn, Akorn (New Jersey), Inc., TheNorthern Trust Company and NeoPharm. The Promissory Note issued by Akorn wasdue in December 2006, and accrued interest at a rate equal to thatreceived on the Company’s investments in marketable securities, which is lowerthan the interest rate paid by Akorn on its other outstanding debt. TheProcessing Agreement grants NeoPharm access to at least 15% of the annuallyophilization manufacturing capacity at Akorn at most favored customerpricing, upon completion of the facility. The Processing Agreement alsoprovided that Akorn was to begin providing lyophilization services on or beforeJune 30, 2003. At the time these transactions were entered into, Akornrepresented that the manufacturing facility would be operational in 2003,approximately the time when NeoPharm originally anticipated it would need tomanufacture its lyophilized drug product candidates for Phase II/III clinicaltrials. In 2001, NeoPharm recorded the Promissory Note net of a valuationallowance of $1,266,619 reflecting the difference between the actual loanamount and the present value of the loan using an estimated market interestrate of 10%. As of December 31, 2002, the Company determined thePromissory Note was impaired and recorded a charge to fully reserve for thePromissory Note and related accrued interest. On August 18, 2003, NeoPharmpresented Akorn with a formal “Notice of Default” on the Promissory Note.Because the carrying value of the Promissory Note was zero, there was no 

 

8

----

 

financial statement impact as a result of anyevent of default under, or non-payment of, the Promissory Note. InSeptember 2003, Akorn advised NeoPharm that it wished to refinance itssenior debt with a new senior lender, which lender would require NeoPharm tosubordinate its debt. In order to preserve the possibility of collectingAkorn’s debt to NeoPharm and in consideration of a higher rate of interest(which would now equal that to be charged by the new senior lender, which isthe prime rate plus 175 basis points) and the possibility of acceleratedmandatory repayments once Akorn’s senior debt was repaid in full, NeoPharmagreed to waive Akorn’s default, to allow Akorn until October 2004 toprovide the manufacturing rights and to subordinate Akorn’s indebtedness toNeoPharm to Akorn’s indebtedness to its new senior lender. Akorn’s refinancingwas completed on October 7, 2003.

 

**Note 10 Commitments**

 

On June 17, 2004, James M.Hussey resigned as the Company’s President, Chief Executive Officer and amember of the Board of Directors.  Inaccepting Mr. Hussey’s resignation, the Board of Directors authorized the Companyto enter into a Separation Agreement and Full Release of all claims (the“Separation Agreement”) with Mr. Hussey. Under the terms of the Separation Agreement, Mr. Hussey will receive asalary continuance for 12 months based upon his annual base salary at the timeof his resignation ($339,768), Company paid insurance premiums under theCompany’s medical insurance plan, plus a payment equal to 50% of Mr. Hussey’starget milestone bonus when 2004 bonuses are paid to the Company’s employees,provided the Separation Agreement has not been terminated prior to thattime.  The salary continuance and medicalinsurance premium payments will cease at such time as Mr. Hussey acceptsfull-time employment or the first date that Mr. Hussey provides consulting or otherservices to any other pharmaceutical or biotechnology organization.  Additionally, Mr. Hussey becomes aconsultant to the Company for a period of up to 24 months or the termination ofthe Separation Agreement, whichever is earlier, during which time all optionspreviously granted to Mr. Hussey continue to vest and remain exercisable until90 days after termination as a consultant.

 

On June 17, 2004, NeoPharm also entered into an Employment Agreementwith Mr. Gregory P. Young to serve as the Company’s President, Chief ExecutiveOfficer and a Director in place of Mr. Hussey. Under the terms of the Employment Agreement, effective July 12, 2004,Mr. Young will receive an annual base salary of $325,000 and a sign-on bonus of$97,500.  The sign-on bonus is payable intwo installments, with the first $25,000 installment paid upon commencement ofemployment on July 12, 2004, and the second installment of $72,500 due onFebruary 15, 2005.  Mr. Young is also entitledto an annual performance-based milestone bonus payment, a monthly car allowanceof $600, and an annual reimbursement of up to $3,000 for the cost of financialand estate planning.  Additionally, uponcommencing his employment on July 12, 2004, Mr. Young will receive a stockoption grant of 250,000 options with a grant price of 85% of the Company’sclosing stock price on July 12, 2004. These options vest in four equal annual installments on the anniversaryof the option grant date.  The EmploymentAgreement also allows for additional specified option grants of up to 350,000options in the future if the Company’s common stock reaches certainpre-determined closing price levels.

 

9

----

 

**Note11  Contingencies**

 

On April 19, 2002, the Company filed aDemand for Arbitration with the American Arbitration Association in accordancewith the terms of its license agreement dated February 19, 1999 (the“License Agreement”) with Pharmacia Corporation, Pharmacia andUpjohn, Inc. and Pharmacia and Upjohn Company (collectively, “Pharmacia”),for the purpose of resolving a dispute with Pharmacia concerning delays in thedevelopment programs for LEP (Liposome Encapsulated Paclitaxel) and LED(Liposome Encapsulated Doxorubicin) which were being conducted by Pharmacia.The Company contended that Pharmacia failed in its duty under the LicenseAgreement to use reasonable efforts to develop LEP and LED and that suchfailure constituted a breach of the License Agreement. The Company furthercontended that Pharmacia breached its duty to consult with NeoPharm on theprogress of the drug development program and thereby impaired NeoPharm’sability to monitor the development of these compounds. The Company sought alldamages to which it was entitled, including but not limited to, loss of co-promotionand royalty revenues that would have been received if LEP and LED had not beendelayed, and milestone payments that would have been received if the programshad been properly conducted by Pharmacia. On May 16, 2002, Pharmaciaresponded by denying the Company’s allegations, asserting various counterclaimsand seeking restitution of monies paid, reimbursement of out-of-pocket expensesand substantial punitive damages.  OnApril 30, 2004, the Company was advised that its claims against Pharmacia (now Pfizer) and Pharmacia’s claims against the Company were denied byarbitrators of the American Arbitration Association. The Company is currentlyworking with Pfizer to resolve remaining issues as to the ownership of LEP-ETU,LEP and LED, and has commenced discussions with Pfizer regarding the return ofdevelopment rights for these drug product candidates.  The Company believes that the return of thedevelopment rights for these drug product candidates will not create a materialobligation for the Company.  No predictioncan be made as to the successful outcome of these discussions. 

 

TheCompany has also been named in several putative class action lawsuits (the“Class Action Suits”) each of which alleges various violations of the federalsecurities laws in connection with the Company’s public statements during theperiod from September 25, 2000 through April 19, 2002 as they relateto the Company’s LEP drug product candidate. The original lawsuits also namedas individual defendants John N. Kapoor, the former Chairman of the Company,and James M. Hussey, the Company’s former President and CEO, andDr. Aquilur Rahman, a former director and executive officer of theCompany. The first of these Class Action Suits was filed on April 26, 2002and all of the Class Action Suits have been filed in the United States DistrictCourt for the Northern District of Illinois, Eastern Division. OnSeptember 16, 2002, a consolidated amended complaint was filed againstNeoPharm in this matter. The amended complaint shortened the class period toOctober 31, 2001 through April 19, 2002, removed Dr. Rahman as adefendant, and added Dr. Imran Ahmad, the Company’s current ChiefScientific Officer and Executive Vice President of Research and Development, asa defendant. The Company intends to vigorously defend each and every claim inthe class action suits and, on November 4, 2002, moved to have thecomplaint dismissed. The Company’s motion to dismiss was granted in part anddenied in part in February 2003. Dr. Kapoor was dismissed from the lawsuitat that time. No trial date has been set. Management is unable to estimate arange of possible loss, if any. In addition, the Company maintains insurancecoverage to mitigate the financial impact of any potential loss.

 

On March 26, 2004, the Company received a letter from the Securitiesand Exchange Commission (SEC) stating that the SEC is conducting a formalinvestigation of the Company.  The SECstated in its letter that it has made no determination of any violation of lawby the Company or any individual at this time. Previously, this matter had been the subject of an informal SECinquiry.  The Company continues to fullycooperate with the SEC and intends to continue to do so in order to bring thisongoing inquiry to a conclusion as promptly as possible.  The Company believes the investigation is anoutgrowth of the Company’s recently concluded arbitration with Pharmacia (nowPfizer) regarding the development of its LEP and LED drug product candidatesand the class action lawsuits which have been filed against the Companyrelating to its public statements regarding the development of LEP.  The Company cannot predict with certainty thedirection the investigation will take or its ultimate outcome.

 

Thepharmaceutical industry has traditionally experienced difficulty in maintainingproduct liability insurance coverage at desired levels. To date, no significantproduct liability suit has ever been filed against the Company. However, if asuit was filed and a judgment entered against the Company, it could have amaterial adverse effect upon the Company’s operations and financial condition.While the Company maintains insurance to cover the use of its drug productcandidates in clinical trials, the Company does not maintain insurance coveringthe sale of its drug product candidates nor is there any assurance that it willbe able to obtain or maintain such insurance on acceptable terms or withadequate coverage against potential liabilities.

 

10

----

 

**Item 2****- Management’s Discussion and Analysis of Financial Condition andResults of Operations**

 

Thefollowing should be read in conjunction with the financial statements andrelated notes and Management’s Discussion and Analysis of Financial Conditionand Results of Operations and the Risk Factors section included in theCompany’s Annual Report on Form 10-K. The results discussed below are not necessarily indicative of theresults to be expected in any future periods. The following discussion contains forward-looking statements that aresubject to risks and uncertainties which could cause actual results to differfrom statements made. See “Forward Looking Statements” below.

 

**Overview**

 

Weare a biopharmaceutical company engaged in the research, development andcommercialization of drugs for the treatment of various cancers. Our corporatestrategy is to become a leader in the research, development andcommercialization of new and innovative anti-cancer treatments. We currentlyoperate at two locations, and had 129 full time employees as of June 30,2004.  Our corporate headquarters andclinical development team are located in Lake Forest, Illinois, and ourresearch and development facility is in Waukegan, Illinois.

 

Sincewe began doing business in June 1990, we have devoted our resourcesprimarily to funding research and product development programs. To date, wehave not received FDA approval of any of our drug product candidates.  We expect to continue to incur losses for theforeseeable future as we continue our research and development activities,which include the sponsorship of human clinical trials for our drug productcandidates.  Until we are able toconsistently generate revenue through the sale of drug or non-drug products, weanticipate that we will be required to fund the development of our pre-clinicalcompounds and drug product candidates primarily by other means, including, butnot limited to, licensing the development rights to some of our drug productcandidates to third parties or selling stock in the Company.

 

Inthe second quarter ended June 30, 2004, management’s efforts were devotedprimarily to enrolling patients and opening study sites in the Phase IIIPRECISE clinical trial for our lead drug product candidate, IL13-PE38QQR,advancing our lead NeoLipid drug product candidates (LEP-ETU and LE-SN38)through Phase I clinical development toward possible initiation of Phase II in2004, working with Pfizer for the return to us of the development rights forliposomal paclitaxel and liposomal doxorubicin, engaging third parties forpotentially licensing development rights to some of our drug productcandidates, and increasing sales for our new cationic cardiolipin basedtransfection reagents, NeoPhectin and NeoPhectin-AT. Significant eventsoccurring during the second quarter included the rendering of a final decisionin our arbitration case against Pharmacia (now Pfizer) on April 30, 2004 (seePart II Item 1. Legal Proceedings) and the resignation of ourPresident and Chief Executive Officer, and the hiring of a new President andChief Executive Officer, on June 17, 2004.

 

Inits decision, a panel of arbitrators of the American Arbitration Associationadvised us that our claims against Pharmacia and Pharmacia’s claimsagainst us were denied. We are currently working with Pfizer to resolveremaining issues as to the ownership of LEP-ETU, LEP and LED, and havecommenced discussions with Pfizer regarding the return to us of developmentrights for these drug product candidates. No prediction can be made as to the successfuloutcome of these discussions. During the second quarter of 2004, we incurredless than $1,000 in arbitration related expenses, including legal expenses.This brings the total expenses incurred for the arbitration since February 2002through June 30, 2004 to approximately $14.4 million. At this time, we donot expect to incur any material additional arbitration related expenses in2004.

 

OnJune 17, 2004, we announced the resignation of James M. Hussey as President,CEO and a director of the Company, and the appointment of Gregory P. Young asMr. Hussey’s successor, effective July 12, 2004.  Additionally, on June 17, 2004, the Board ofDirectors elected Erick E. Hanson, an independent director, as Chairman of theBoard, replacing John N. Kapoor, Ph.D. Dr. Kapoor continues as a member of the Company’s Board of Directors.

 

ThePRECISE trial, our Phase III clinical trial for IL13-PE38QQR for the treatmentof glioblastoma multiforme (GBM), began in March 2004 with the enrollmentof our first patient, and patient enrollment continues to accelerate asadditional clinical study sites are activated. As of July 31, 2004, 29 patientshave been enrolled in PRECISE.  Ourcurrent plans continue to anticipate the completion of enrollment for PRECISEin 2005 and the submission of a BLA with the FDA in 2006 seeking marketingapproval of the drug. However, there can be no assurance the trial will meetits endpoint or that the FDA will approve the BLA. Assuming that we receivedauthorization to begin selling IL13-PE38QQR, we currently anticipate the firstsales of the product in 2007.

 

11

----

 

Duringthe second quarter of 2004, we continued to advance our Phase I NeoLipid drugproduct candidates towards Phase II/III clinical trials. The drug productcandidates currently in Phase I clinical development include: LEP-ETU, our newNeoLipidTM formulation of liposomal paclitaxel; LE-SN38 (liposomal SN38) for thetreatment of colorectal and other cancers; and, LErafAON (liposomal craf antisenseoligonucleotide) for the treatment of radiation and/or chemotherapy resistanttumors. We currently anticipate that both LEP-ETU and LE-SN38 will completeenrollment in Phase I clinical trials in 2004.

 

 It is difficult to predict with any certaintythe timing, estimated costs to complete development, and anticipated completiondates of drug product candidates in Phase I clinical development. A number offactors contribute to this uncertainty, including: side effects encountered inearly stage clinical trials, ability to scale up manufacturing for commercialsupply, and the size and scope of pivotal Phase III clinical trials are unknownuntil sufficient data is available to present a Phase III plan to the FDA forapproval. In addition, our drug product candidates are required to be approvedby the FDA after completing Phase III clinical trials before we can sell thedrugs to generate revenue and, potentially, realize net cash inflows. Becauseour lead drug product candidate, IL13-PE38QQR, has recently entered a Phase IIIclinical trial, we are able to make some estimates regarding anticipatedexpenses to be incurred to complete the Phase III PRECISE study. Our currentestimates anticipate further direct expenses of approximately $27 millionto complete the Phase III clinical trial for IL13-PE38QQR. Additional Phase Iand Phase II expenses are also expected to be incurred for IL13-PE38QQR as weare conducting other clinical trials to investigate the potential to useIL13-PE38QQR in other forms of glioblastoma multiforme in addition to recurrentglioblastoma multiforme.

 

Thetable below includes a summary of identified direct project costs incurred todate for our major research and development projects. Generally, identifiedproject costs include expenses incurred specifically for clinical trials andpre-clinical studies we conduct, and exclude expenses incurred for salariespaid to our professional staff, overhead expenses for our Lake Forest andWaukegan facilities and general laboratory supplies used in our research, whichare identified as non-project specific.

 

| **Research  Project**                   | ** ** | **Costs Incurred in  Current Quarter** | ** ** | **Costs Incurred Year to Date** | ** ** | **Total Costs  Incurred Since  Beginning of Project** | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|---------------------------------|------------|-------------------------------------------------------|------------|
| IL13-PE38                               |       | $                                      | 4,701,539  |                            | $          | 9,680,197                                             |       | $ | 28,738,483 |   |
| LE-SN38                                 |       | 713,351                                |       | 1,174,812                       |       | 3,776,219                                             |       |
| LEP-ETU                                 |       | 825,486                                |       | 1,451,809                       |       | 2,390,166                                             |       |
| LErafAON                                |       | 460,709                                |       | 738,556                         |       | 6,974,632                                             |       |
| Non-project specific                    |       | 5,307,293                              |       | 10,212,231                      |       | N/A                                                   |       |
| Total research and development expenses |       | 12,008,378                             |       | 23,257,605                      |       | N/A                                                   |       |
|                                         |            |                                        |            |                                 |            |                                                       |            |  |  |  |

 

Salesof our novel cationic cardiolipin based transfection reagents, NeoPhectinTM andNeoPhectin-ATTM, increased during the second quarter by approximately 56% fromfirst quarter sales.  We currentlyanticipate that sales of NeoPhectinTM products will generate approximately $100,000in revenues during 2004.  NeoPhectinTM isour *in vitro* transfection reagent, andNeoPhectin-ATTM is our *in vivo*transfection reagent for use in animals. Our current laboratory facilitiesprovide us with the ability to produce commercial quantities of the materialwithout reducing the level of our research and development activities.  Accordingly, we do not expect to incursignificant incremental costs to produce NeoPhectinTM products.

 

On April 7,2004, we created a wholly owned subsidiary based in the United Kingdom,NeoPharm EU Limited, for the purpose of conducting clinical trials in theEuropean Union.  Because our Phase IIIPRECISE trial is enrolling patients in Europe, in addition to North America andIsrael, the subsidiary was created specifically to comply with regulatoryrequirements enacted for clinical trials conducted in the European Union.  As of June 30, 2004, this subsidiary hasnominal assets and had not conducted any business.

 

**Resultsof Operations – Three-Month Period Ended June 30, 2004 vs. Three-Month PeriodEnded June 30, 2003.**

 

TheCompany recorded revenue of $19,080 for the three-month period ended June 30,2004.  The sole source of revenue wasfrom sales of NeoPhectin and NeoPhectin-AT. No revenue was recorded for the three-month period ended June 30, 2003.

 

Researchand development expense for the three-month period ended June 30, 2004increased by approximately $3.2 million as compared to the same period in 2003.The increase in research and development expenses was primarily related toapproximately $3.6 million in expenses incurred for the Phase III PRECISE trialinitiated in March 2004.

 

Selling,general, and administrative expenses decreased by approximately $4.9 millionfor the three-month period ended June 30, 2004 versus the three-month periodended June 30, 2003 due to a reduction of approximately $6.1 million inarbitration related expenses during the second quarter of 2004.  The reduction in arbitration related expenseswas offset by increases in other selling, general and administrative expensesof approximately $1.2 million, due to increased payroll and consulting relatedexpenses of approximately $508 thousand primarily associated with increases instaffing and recruiting expenses, increased information technology relatedexpenses of approximately $174 thousand related to upgrading our systems tocomply with new regulatory requirements, increased franchise (non-income) taxesof approximately $167 thousand related to additions in capital stock from theCompany’s sale of stock to the public in 

 

12

----

 

January2004, increased professional fees of approximately $159 thousand for legal andaccounting services, increased insurance expense of approximately $93 thousandresulting from increases in premiums combined with increased limits for ourproperty and casualty coverage, and increased other general and administrativeexpenses of approximately $99 thousand related to general corporate activities.

 

TheCompany generated interest income on cash and investments of approximately $249thousand and $255 thousand for the three-month periods ended June 30, 2004 andJune 30, 2003, respectively.  

 

Asa result of the above items, net loss and basic and diluted loss per share forthe three-month periods ended June 30, 2004 and June 30, 2003 wereapproximately $14.8 million and $16.4 million, respectively, and $0.63 and $0.87, respectively.

 

**Resultsof Operations – Six-Month Periods Ended June 30, 2004 vs. Six-Month PeriodsEnded June 30, 2003.**

 

TheCompany recorded revenue of $31,280 for the six-month period ended June 30,2004.  The sole source of revenue wasfrom sales of NeoPhectin and NeoPhectin-AT. No revenue was recorded for the six-month period ended June 30, 2003.

 

Researchand development expense for the six-month period ended June 30, 2004 increasedby approximately $7.4 million as compared to the same period in 2003. Theincrease in research and development expenses was primarily related toapproximately $7.8 million in expenses incurred for the Phase III PRECISE trialinitiated in March 2004.

 

Selling,general, and administrative expenses decreased by approximately $6.1 millionfor the six-month period ended June 30, 2004 versus the six-month period endedJune 30, 2003 due to a reduction of approximately $8.0 million in arbitrationrelated expenses during 2004.  Thereduction in arbitration related expenses was offset by increases in otherselling, general and administrative expenses of approximately $1.9 million, dueto increased payroll and consulting related expenses of approximately $910thousand primarily associated with increases in staffing and recruitingexpenses, increased insurance expense of approximately $242 thousand resultingfrom increases in premiums combined with increased limits for our property andcasualty coverage, increased information technology related expenses ofapproximately $201 thousand related to upgrading our systems to comply with newregulatory requirements, increased franchise (non-income) taxes of approximately$174 thousand related to additions in capital stock from the Company’s sale ofstock to the public in January 2004, increased professional fees ofapproximately $271 thousand for legal and accounting services, and increasedother general and administrative expenses of approximately $102 thousandrelated to general corporate activities.

 

TheCompany generated interest income on cash and investments of approximately $474thousand and $539 thousand for the six-month period ended June 30, 2004 and June30, 2003, respectively.  The reduction ininterest income in 2004 was a direct result of a decrease in interest ratesearned on investments.

 

Asa result of the above items, net loss and basic and diluted loss per share forthe six month periods ended June 30, 2004 and June 30, 2003 were approximately$29.0 million and $27.7 million,respectively, and $1.28 and $1.47, respectively.

 

**Liquidityand Capital Resources**

 

Asof June 30, 2004, we had approximately $88.6 million in cash and cashequivalents, and no debt. All excess cash is currently invested in marketablesecurities with less than three months to maturity. We currently believe thatour cash on hand at June 30, 2004, should be adequate to fund our operationsfor at least the next 18 months.

 

Weno longer expect to incur material expenses related to our arbitration case. Asa result, the primary use of funds over the next 12 - 24 monthswill be to fund our clinical and pre-clinical research and development efforts.The most significant expenses will be incurred in relation to the PRECISE PhaseIII clinical trial for our brain tumor drug product candidate, IL13-PE38QQR. Atthe present time, we expect to spend approximately $27 million over thenext 24 months to complete the PRECISE trial. Additional expenses are alsoexpected to be incurred as we continue to move our Phase I drug productcandidates towards, and potentially into, Phase II clinical trials.

 

Wemay seek to satisfy our future funding requirements through public or privateofferings of securities, with collaborative or other arrangements withcorporate partners or from other sources including, but not limited to, salesof NeoPhectinTM. Additional financing may not be available when needed or onterms acceptable to us. If adequate financing is not available, we may berequired to delay, scale back or eliminate certain of our research anddevelopment programs, relinquish rights to certain of our technologies, cancerdrugs or products, or license third parties to commercialize products ortechnologies that we would otherwise seek to develop ourselves.

 

NeoPharmhas no debt, no capital leases, no exposure to off-balance sheet arrangements,no special purpose entities, nor 

 

13

----

 

activitiesthat include non-exchange-traded contracts accounted for at fair value. Thefollowing table summarizes our estimated contractual obligations as of June 30,2004:

 
| ** **                                             | ** ** | **Payments Due by Period** | ** ** |
|--------------------------------------------------------|------------|----------------------------|------------|
| **Contractual  Obligations**                           | ** ** | **Total**                  | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than  5 years** | ** ** |
| Operating lease                                        |       | $                          | 1,457,007  |   | $ | 585,875 |   | $ | 660,284 |   | $ | 210,848 |   | $ | 0 |   |
| License agreements—milestone based payments(1)(2) |       | 2,525,000                  |       | 225,000 |   | 850,000 |   | 350,000 |   | 1,100,000 |   |
| Total                                                  |       | $                          | 3,982,007  |   | $ | 810,875 |   | $ | 1,510,284 |   | $ | 560,848 |   | $ | 1,100,000 |   |

 

----

(1)                                These amounts do not include potentialsales-based royalty payments that may be required under the various licenseagreements.

 

(2)                                Milestone based payment obligations arecontingent upon successfully reaching objectively determinable stages in thedevelopment of drug product candidates. The Company has estimated the periodthe payment may be due, if at all, based upon its expectations of the timelinefor continued successful development of the drug product candidates.

 

**Critical Accounting Policies**

 

Inpreparing the Company’s financial statements in conformity with accountingprinciples generally accepted in the United States of America, management mustmake a variety of decisions which impact the reported amounts and relateddisclosures. Such decisions include the selection of the appropriate accountingprinciples to be applied, the assumptions on which to base accountingestimates, and the consistent application of those accounting principles. Dueto the type of industry in which the Company operates and the nature of itsbusiness, the following accounting policies are those that management believesare most important to the portrayal of the Company’s financial condition andresults and that require management’s most difficult, subjective or complexjudgments, often as a result of the need to make estimates about the effect ofmatters that are inherently uncertain.

 

*Investments in Marketable Securities*

 

Asprovided by SFAS No. 115, *Accountingfor Certain Investments in Debt and Equity Securities*, the Companyhas elected to treat all of its investments in marketable securities as“available-for-sale,” which requires these investments to be recorded at fairmarket value. Unrealized gains and losses, net of related tax effect, onavailable-for-sale securities are excluded from earnings and are reported as aseparate component of other comprehensive income until realized. Realized gainsand losses from the sale of available-for-sale securities are determined on aspecific identification basis. A decline in market value of available-for-salesecurities that is deemed to be other than temporary, results in the reductionof the carrying amount to fair value. The impairment is charged to earnings anda new cost basis for the security is established. Significant judgment isrequired to determine instances in which an other than temporary decline in thefair value of marketable securities has occurred. Management considersavailable positive and negative information in making this judgment, including:the nature of the investments; the causes of impairments; the number ofinvestment positions that are in an unrealized-loss position; the severity andduration of the impairment; and management’s ability and intent to hold themarketable security as well as forecasted recovery of fair value.

 

*Income Taxes*

 

Inassessing the realizability of deferred tax assets, management considerswhether it is more likely than not that some portion or all of the deferred taxassets will not be realized. The ultimate realization of deferred tax assets isdependent upon the generation of future taxable income during the periods inwhich those temporary differences become deductible. Management considers thescheduled reversal of deferred tax liabilities, projected future taxableincome, and tax planning strategies in making this assessment. Significantjudgments are required to estimate the generation of future taxable income andthe timing of the reversal of deferred tax liabilities.

 

*Revenue Recognition*

 

TheCompany provides for general rights of return of products sold to itsdistributor.  Appropriately determiningrevenue recognition when the general right of return exists requires the use ofjudgment in estimating the level of returns. In certain circumstances, management may not be able to develop areasonable estimate of the level of returns. Making such a determination also requires the use of significantjudgment.  Management has determined thatgiven the limited sales history of NeoPhectin, the Company is currently unableto develop a reasonable estimate of the level of returns.  Accordingly, the Company is currentlyrecognizing revenue for products shipped to its distributor upon the expirationof the right of return which occurs upon the earlier of 

 

14

----

 

shipmentof product by the distributor to an end-user or 180 days.

 

*Stock-Based Compensation*

 

TheCompany applies the intrinsic-value-based method of accounting prescribed byAccounting Principles Board (APB) Opinion No. 25, *Accounting for Stock Issued to Employees*,and related interpretations including FASB Interpretation No. 44, *Accounting for Certain Transactions Involving StockCompensation, an Interpretation of APB Opinion No. 25*, issuedin March 2000, to account for its fixed-plan stock options. Under thismethod, compensation cost is recorded on the date of grant only if the currentmarket price of the underlying stock exceeded the exercise price. SFASNo. 123, *Accounting for Stock-BasedCompensation*, established accounting and disclosure requirementsusing a fair-value-based method of accounting for stock-based employeecompensation plans. As allowed by SFAS No. 123, the Company has elected tocontinue to apply the intrinsic-value-based method of accounting describedabove, and has adopted only the disclosure requirements of SFAS No. 123.Significant judgments are required in determining an appropriate method fordetermining the fair value of stock-based compensation. The Company has electedto utilize the Black-Scholes option-pricing model to make the fair valuedetermination. Inputs into the option-pricing model are subject to estimationthat may affect the determination of fair value.

 

**ForwardLooking Statements**

 

Any statements made by NeoPharm, Inc. (“we”, “us”,“our”, or the “Company”) in this quarterly report that are forward looking aremade pursuant to the safe harbor provisions of the Private SecuritiesLitigation Reform Act of 1995.  TheCompany cautions readers that important factors may affect the Company’s actualresults and could cause such results to differ materially from forward-lookingstatements made by or on behalf of the Company. Such factors include, but are not limited to, those risks anduncertainties relating to difficulties or delays in development, testing,regulatory approval, production and marketing of the Company’s drug candidates,including, but not limited to IL13-PE38QQR, including the PRECISE trial, themarketing of non-drug products such as NeoPhectinTM and NeoPhectin-ATTM,uncertainty regarding the outcome of class action litigation against theCompany, resolution of the ongoing SEC investigation, resolution of ownershipissues for LEP, LED and LEP-ETU with Pfizer, unexpected adverse side effects orinadequate therapeutic efficacy of the Company’s drug candidates that couldslow or prevent products coming to market, the uncertainty of patent protectionfor the Company’s intellectual property or trade secrets, and other factorsreferenced under “Risk Factors” in the Company’s Annual Report on Form 10-K forthe fiscal year ended December 31, 2003.

 

**Item 3****– Quantitative and Qualitative Disclosures about Market Risk**

 

Asof June 30, 2004, we did not own any derivative instruments, but we wereexposed to market risks, primarily changes in U.S. interest rates. As of June30, 2004, we held total cash and cash equivalents (maturity less than90 days) of $88,553,977. Declines in interest rates over time will reduceour interest income from our investments. Based upon our balance of cash and cashequivalents, as of June 30, 2004, a decrease in interest rates of 1.0% wouldcause a corresponding decrease in our annual interest income of approximately$885,000.

 

**Item 4****– Controls and Procedures**

 

Asof June 30, 2004, we carried out an evaluation, under the supervision and withthe participation of our management, including our Chief Executive Officer andChief Financial Officer, of the effectiveness of the design and operation ofour disclosure controls and procedures. Based on that evaluation, our management,including the Chief Executive Officer and Chief Financial Officer, concludedthat our disclosure controls and procedures are operating effectively asdesigned.

 

We are committed to a continuing process of identifying, evaluating andimplementing improvements to the effectiveness of our disclosure and internalcontrols and procedures. Our management, including our Chief Executive Officerand Chief Financial Officer, does not expect that our controls and procedureswill prevent all errors. A control system, no matter how well conceived andoperated, can provide only reasonable, not absolute, assurance that theobjectives of the control system are met. Because of the inherent limitationsin all control systems, no evaluation of controls can provide absoluteassurance that all control issues within the Company have been detected. Theseinherent limitations include the realities that judgments in decision-makingcan be faulty, and that breakdowns can occur because of a simple error ormistake. Additionally, controls can be circumvented by the individual acts ofsome persons, by collusion of two or more people, or by management override ofthe control. The design of any system of controls is also based in part uponcertain assumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions. Over time, controls may become inadequate becauseof changes in conditions, or the degree of compliance with the policies orprocedures may deteriorate. Because of the inherent limitations in any controlsystem, misstatements due to error or violations of law may occur and not bedetected.

 

Therehave been no significant changes in our internal controls over financial reportingthat occurred during the period covered by this report that have materiallyaffected, or are reasonably likely to affect, our internal control overfinancial reporting.

 

15

----

 

**PART II- OTHER INFORMATION**

 

Item 1.                                                           Legal Proceedings

 

OnApril 19, 2002, the Company filed a Demand for Arbitration with theAmerican Arbitration Association in accordance with the terms of its licenseagreement dated February 19, 1999 (the “License Agreement”) with PharmaciaCorporation, Pharmacia and Upjohn, Inc. and Pharmacia and Upjohn Company(collectively, “Pharmacia”), for the purpose of resolving a dispute withPharmacia concerning delays in the development programs for LEP (LiposomeEncapsulated Paclitaxel) and LED (Liposome Encapsulated Doxorubicin) which werebeing conducted by Pharmacia. The Company contended that Pharmacia failed inits duty under the License Agreement to use reasonable efforts to develop LEPand LED and that such failure constituted a breach of the License Agreement.The Company further contended that Pharmacia breached its duty to consult withNeoPharm on the progress of the drug development program and thereby impairedNeoPharm’s ability to monitor the development of these compounds. The Company soughtall damages to which it was entitled, including but not limited to, loss ofco-promotion and royalty revenues that would have been received if LEP and LEDhad not been delayed, and milestone payments that would have been received ifthe programs had been properly conducted by Pharmacia. On May 16, 2002,Pharmacia responded by denying the Company’s allegations, asserting variouscounterclaims and seeking restitution of monies paid, reimbursement ofout-of-pocket expenses and substantial punitive damages.  On April 30, 2004, the Company wasadvised that its claims against Pharmacia (now Pfizer) and Pharmacia’sclaims against the Company were denied by arbitrators of the AmericanArbitration Association. The Company is currently working with Pfizer to resolveremaining issues as to the ownership of LEP-ETU, LEP and LED, and has commenceddiscussions with Pfizer regarding the return of development rights for thesedrug product candidates. No prediction can be made as to the successful outcomeof these discussions.

 

TheCompany has also been named in several putative class action lawsuits (the“Class Action Suits”) each of which alleges various violations of the federalsecurities laws in connection with the Company’s public statements during theperiod from September 25, 2000 through April 19, 2002 as they relateto the Company’s LEP drug product candidate. The original lawsuits also namedas individual defendants John N. Kapoor, the former Chairman of the Company,and James M. Hussey, the Company’s former President and CEO, andDr. Aquilur Rahman, a former director and executive officer of theCompany. The first of these Class Action Suits was filed on April 26, 2002and all of the Class Action Suits have been filed in the United States DistrictCourt for the Northern District of Illinois, Eastern Division. OnSeptember 16, 2002, a consolidated amended complaint was filed againstNeoPharm in this matter. The amended complaint shortened the class period toOctober 31, 2001 through April 19, 2002, removed Dr. Rahman as adefendant, and added Dr. Imran Ahmad, the Company’s current ChiefScientific Officer and Executive Vice President of Research and Development, asa defendant. The Company intends to vigorously defend each and every claim inthe class action suits and, on November 4, 2002, moved to have thecomplaint dismissed. The Company’s motion to dismiss was granted in part anddenied in part in February 2003. Dr. Kapoor was dismissed from thelawsuit at that time. No trial date has been set. Management is unable toestimate a range of possible loss, if any. In addition, the Company maintainsinsurance coverage to mitigate the financial impact of any potential loss.

 

On March 26, 2004, the Company received a letter from the Securitiesand Exchange Commission (SEC) stating that the SEC is conducting a formalinvestigation of the Company.  The SECstated in its letter that it has made no determination of any violation of lawby the Company or any individual at this time. Previously, this matter had been the subject of an informal SECinquiry.  The Company continues to fullycooperate with the SEC and intends to continue to do so in order to bring thisongoing inquiry to a conclusion as promptly as possible.  The Company believes the investigation is anoutgrowth of the Company’s recently concluded arbitration with Pharmacia (nowPfizer) regarding the development of its LEP and LED drug product candidatesand the class action lawsuits which have been filed against the Companyrelating to its public statements regarding the development of LEP.  The Company cannot predict with certainty thedirection the investigation will take or its ultimate outcome.

 

Item 2.                                                           Changes in Securities and Use of Proceeds

None

 

Item 3.                                                           DefaultsUpon Senior Securities

None

 

16

----

 

Item 4.                                                           Submissionof Matters to a Vote ofSecurity-Holders

 

On June 17, 2004 the Companyheld its Annual Meeting of Stockholders to vote on the matters listedbelow.  All of the matters voted on at the Annual Meeting were approved bythe Company’s stockholders at the Annual Meeting.

 

1.           To elect sixdirectors to serve until the 2005 Annual Meeting of Stockholders.

 

Withrespect to the election for directors, the votes were as follows:

 
|             | **VOTES  FOR** |   | **VOTES   AGAINST** |   | **VOTES   WITHHELD** |
|------------------|----------------|--------|---------------------|--------|----------------------|
|             |           |   |                |   |                 |
| John N. Kapoor   | 21,788,717     |   | 0                   |   | 577,849              |
| Gregory P. Young | 22,028,104     |   | 0                   |   | 338,462              |
| Matthew P. Rogan | 16,298,433     |   | 0                   |   | 6,068,133            |
| Kaveh T. Safavi  | 17,006,203     |   | 0                   |   | 5,360,363            |
| Sander A. Flaum  | 12,745,858     |   | 0                   |   | 9,260,708            |
| Erick E. Hanson  | 17,006,266     |   | 0                   |   | 5,360,300            |

 

2.           To ratify theappointment of KPMG LLP as the Company’s independent public accountants.

 
| **VOTES  FOR** |   | **VOTES  AGAINST** |   | **ABSTENTIONS** |   | **NOT-VOTED** |
|----------------|--------|--------------------|--------|-----------------|--------|---------------|
|           |   |               |   |            |   |          |
| 22,300,737     |   | 62,363             |   | 3,466           |   | 0             |

 

Item 5.                                                           Other Information

None

 

Item 6.                                                             Exhibits and Reports on Form 8-K

 

(a)        Exhibits

 
| Exhibit  10.1 |   | Separation Agreement and Full Release of All Claims entered into with  James M. Hussey |
|---------------|--------|----------------------------------------------------------------------------------------|
|          |   |                                                                                   |
| Exhibit  10.2 |   | Employment  Agreement with Gregory P. Young                                            |
|          |   |                                                                                   |
| Exhibit  31.1 |   | Certification  of the Chief Executive Officer                                          |
|          |   |                                                                                   |
| Exhibit  31.2 |   | Certification  of the Chief Financial Officer                                          |
|          |   |                                                                                   |
| Exhibit  32.1 |   | Certification  pursuant to section 906 of the Sarbanes-Oxley Act                  |
|          |   |                                                                                   |
| Exhibit  32.2 |   | Certification  pursuant to section 906 of the Sarbanes-Oxley Act                  |

 

(b)         Reportson Form 8-K

 

OnMay 3, 2004, the Company furnished a report on Form 8-K incorporating a pressrelease announcing the decision of the Arbitration Panel in connection with thearbitration proceeding which the Company had initiated against Pharmacia, Inc.(now Pfizer, Inc.), including the Panel’s decision to dismiss all claims byeach of the parties.

 

On May 10, 2004, the Company furnished a report on Form 8-K incorporating a pressrelease reporting the Company’s financial results for the first quarter endedMarch 31, 2004.

 

OnJune 18, 2004, the Company furnished a report on Form 8-K incorporating a pressrelease announcing the 

 

17

----

 

appointmentof a new President and CEO and the election of a new Chairman, and theresignation of its former President and Chief Executive Officer.

 

18

----

 

**SIGNATUREPAGE**

 

**Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.**

 
|                   | NEOPHARM,  INC. |
|------------------------|-----------------|
| Date:  August 11, 2004 | By:             | /s/  Lawrence A. Kenyon |
|                   |            | Lawrence  A. Kenyon, |
|                   |            | *Chief  Financial Officer  (Principal Accounting Officer and  Principal Financial Officer)* |

 

19

----