**UNITED STATES********SECURITIESAND 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  September 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 ofRegistrant as specified in its charter)

 
| **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 October 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) |       | 23,294,165                       |

 

 

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NEOPHARM, INC.

 

FORM 10-QINDEX

 
| PART I. FINANCIAL INFORMATION |    |
|-------------------------------|---------|
|                          | Item 1. | Financial Statements |   |
|                          |    | Consolidated Balance Sheets as of September 30, 2004 (Unaudited) and  December 31, 2003 |   |
|                          |    | Consolidated Statements of Operations for  the three- and nine-month periods ended September 30, 2004 and 2003  (Unaudited) |   |
|                          |    | Consolidated Statements of Cash Flows for  the nine-month periods ended September 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. | Unregistered Sales of Equity 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 |   |
| SIGNATURE PAGE                |    |

 

2

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**PART I - FINANCIAL INFORMATION**

 

**Item 1- Financial Statements**

 

**NEOPHARM,INC.Consolidated Balance Sheets**

 
| ** **                                                                                                                                | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                | ** ** | **(Unaudited)**        | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                                                |       |                   |       |                       |       |
| Current  assets:                                                                                                                          |       |                   |       |                       |       |
| Cash and  cash equivalents                                                                                                                |       | $                      | 75,756,502 |                       | $          | 36,958,941 |   |
| Investments  in marketable securities                                                                                                     |       | —                 |       | 4,166,351                  |       |
| Trade  accounts receivable                                                                                                                |       | 13,072                 |       | —                     |       |
| Inventories                                                                                                                               |       | 2,931                  |       | —                     |       |
| Prepaid  expenses                                                                                                                         |       | 1,632,184              |       | 909,833                    |       |
| Other  receivables                                                                                                                        |       | 314,741                |       | 284,750                    |       |
| Total current assets                                                                                                                      |       | 77,719,430             |       | 42,319,875                 |       |
| Fixed  assets, net of accumulated depreciation                                                                                            |       | 3,191,671              |       | 3,760,705                  |       |
| Total assets                                                                                                                              |       | $                      | 80,911,101 |                       | $          | 46,080,580 |   |
|                                                                                                                                      |       |                   |       |                       |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                            |       |                   |       |                       |       |
| Current  liabilities:                                                                                                                     |       |                   |       |                       |       |
| Accounts  payable                                                                                                                         |       | $                      | 542,023    |                       | $          | 499,682 |   |
| Accrued  clinical trial expense                                                                                                           |       | 4,624,131              |       | 1,658,293                  |       |
| Accrued  legal expenses                                                                                                                   |       | 550,894                |       | 1,076,228                  |       |
| Accrued  compensation                                                                                                                     |       | 2,569,897              |       | 2,144,163                  |       |
| Other  accrued expenses                                                                                                                   |       | 616,504                |       | 684,859                    |       |
| Unearned  revenue                                                                                                                         |       | 14,400                 |       | —                     |       |
| Total  current liabilities                                                                                                                |       | 8,917,849              |       | 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: 23,294,165 and  18,862,906 shares issued and outstanding, respectively |       | 4,998                  |       | 4,046                      |       |
| Additional  paid-in capital                                                                                                               |       | 246,640,814            |       | 171,704,628                |       |
| Accumulated  deficit                                                                                                                      |       | (174,652,560           | )          | (131,691,319               | )          |
| Total  stockholders’ equity                                                                                                          |       | 71,993,252             |       | 40,017,355                 |       |
| Total  liabilities and stockholders’ equity                                                                                          |       | $                      | 80,911,101 |                       | $          | 46,080,580 |   |

 

The accompanying notes are anintegral part of these financial statements.

 

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**NEOPHARM,INC.**

 

**ConsolidatedStatements of Operations****Three- and Nine-Month Periods Ended September 30, 2004 and 2003**(Unaudited)

 
| ** **                                  | ** ** | **Three-Month Periods Ended** | ** **  | **Nine-Month Periods Ended** | ** ** |
|---------------------------------------------|------------|-------------------------------|-------------|------------------------------|------------|
| ** **                                  | ** ** | **September 30, 2004**   | ** **  | **September 30, 2003**  | ** ** | **September 30, 2004** | ** ** | **September 30, 2003** | ** ** |
| Revenues                                    |       | $                             | 84,740      |                         | $          | — |   | $ | 116,020 |   | $ | — |   |
| Cost of  revenues                           |       | 3,466                         |        | —                       |       | 4,008 |   | — |   |
| Gross margin                                |       | 81,274                        |        | —                       |       | 112,012 |   | — |   |
|                                        |       |                          |        |                         |       |   |   |   |   |
| Expenses:                                   |       |                          |        |                         |       |   |   |   |   |
| Research and  development                   |       | 10,621,195                    |        | 9,164,262                    |       | 33,878,801 |   | 25,040,104 |   |
| Selling,  general, and administrative       |       | 3,712,207                     |        | 3,168,363                    |       | 9,896,836 |   | 15,453,434 |   |
| Related-party  expenses                     |       | —                        |        | 35,587                       |       | 69,370 |   | 110,188 |   |
| Total  expenses                             |       | 14,333,402                    |        | 12,368,212                   |       | 43,845,007 |   | 40,603,726 |   |
| Loss from  operations                       |       | (14,252,128                   | )           | (12,368,212                  | )          | (43,732,995 | ) | (40,603,726 | ) |
|                                        |       |                          |        |                         |       |   |   |   |   |
| Interest  income                            |       | 297,558                       |        | 148,615                      |       | 771,754 |   | 688,062 |   |
| Net loss                                    |       | $                             | (13,954,570 | )                            | $          | (12,219,597 | ) | $ | (42,961,241 | ) | $ | (39,915,664 | ) |
| Net loss per  share —                  |       |                          |        |                         |       |   |   |   |   |
| Basic and  diluted                          |       | $                             | (0.60       | )                            | $          | (0.65 | ) | $ | (1.88 | ) | $ | (2.12 | ) |
| Weighted  average shares outstanding — |       |                          |        |                         |       |   |   |   |   |
| Basic and  diluted                          |       | 23,284,925                    |        | 18,832,741                   |       | 22,815,559 |   | 18,822,903 |   |

 

The accompanying notes are anintegral part of these financial statements.

 

4

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**NEOPHARM,INC.**

 

**ConsolidatedStatements of Cash Flows****Nine-Month Periods Ended September 30, 2004 and 2003**(Unaudited)

 
| ** **                                                                   | ** ** | **Nine-Month Periods Ended** | ** **  |
|------------------------------------------------------------------------------|------------|------------------------------|-------------|
| ** **                                                                   | ** ** | **September 30, 2004**  | ** **  | **September 30, 2003** | ** ** |
| Cash flows  from operating activities:                                       |       |                         |        |   |   |
| Net loss                                                                     |       | $                            | (42,961,241 | ) | $ | (39,915,664 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                         |        |   |   |
| Depreciation                                                                 |       | 1,006,620                    |        | 804,084 |   |
| Stock-based  compensation expense                                            |       | 734,504                      |        | 434,215 |   |
| Changes in  assets and liabilities:                                          |       |                         |        |   |   |
| Increase in  current assets                                                  |       | (768,345                     | )           | (789,558 | ) |
| Increase in  current liabilities                                             |       | 2,854,624                    |        | 2,407,048 |   |
| Net cash and  cash equivalents used in operating activities                  |       | (39,133,838                  | )           | (37,059,875 | ) |
|                                                                         |       |                         |        |   |   |
| Cash flows  from investing activities:                                       |       |                         |        |   |   |
| Proceeds  from maturities of marketable securities                           |       | 1,046,168                    |        | 3,508,362 |   |
| Proceeds  from sales of marketable securities                                |       | 3,120,183                    |        | — |   |
| Purchase of  marketable securities                                           |       | —                       |        | (2,497,213 | ) |
| Purchase of  equipment and furniture                                         |       | (437,586                     | )           | (674,616 | ) |
| Net cash and  cash equivalents provided by investing activities              |       | 3,728,765                    |        | 336,533 |   |
|                                                                         |       |                         |        |   |   |
| Cash flows  from financing activities:                                       |       |                         |        |   |   |
| Net proceeds  from issuance of common stock                                  |       | 74,202,634                   |        | 195,562 |   |
| Cash paid in  lieu of fractional shares for stock dividend                   |       | —                       |        | (9,060 | ) |
| Net cash and  cash equivalents provided by financing activities              |       | 74,202,634                   |        | 186,502 |   |
|                                                                         |       |                         |        |   |   |
| Net  increase/(decrease) in cash and cash equivalents                        |       | 38,797,561                   |        | (36,536,840 | ) |
| Cash and  cash equivalents, beginning of period                              |       | 36,958,941                   |        | 87,591,975 |   |
| Cash and  cash equivalents, end of period                                    |       | $                            | 75,756,502  |   | $ | 51,055,135 |   |
|                                                                         |       |                         |        |   |   |
| Supplemental  disclosure of cash paid for:                                   |       |                         |        |   |   |
| Interest                                                                     |       | $                            | —      |   | $ | — |   |
| Income taxes                                                                 |       | $                            | —      |   | $ | — |   |

 

The accompanying notes are anintegral part of these financial statements.

 

5

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**NEOPHARM,INC.**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 1  Basis of Presentation**

Thefinancial information herein is unaudited. The balance sheet as of December 31,2003 is derived from audited financial statements.

 

Theaccompanying unaudited consolidated financial statements of NeoPharm, Inc. (the“Company”) have been prepared in accordance with generally accepted accountingprinciples for interim financial information and with the instructions to Form10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not contain all ofthe information and notes required by U.S. generally accepted accountingprinciples for complete financial statements. In the opinion of the Company,the accompanying unaudited interim consolidated financial statements containall adjustments (consisting of normal recurring adjustments) necessary topresent fairly the Company’s financial position as of September 30, 2004, andthe results of their operations for the three- and nine-month periods endedSeptember 30, 2004 and 2003, and their cash flows for the nine-month periodsended September 30, 2004 and 2003.

 

Theconsolidated financial statements include the accounts of NeoPharm, Inc. andits wholly-owned subsidiary, NeoPharm EU Limited.  NeoPharm EU Limited was created to complywith regulatory requirements enacted for clinical trials conducted in theEuropean Union.  As of September 30,2004, this subsidiary has nominal assets and had not conducted anybusiness.  All significant intercompanyaccounts and transactions are eliminated in consolidation.

 

Whilethe Company believes that the disclosures presented are adequate to make theinformation not misleading, it is suggested that these financial statements beread in conjunction with the financial statements and notes included in theCompany’s 2003 Annual Report on Form 10-K filed with the Securities andExchange Commission.

 

**Note 2  Stock-based Compensation**

 

TheCompany applies the intrinsic value method of accounting prescribed byAccounting Principles Board (APB) Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related interpretations, toaccount for its fixed-plan stock options. Under this method, compensation expense is recorded only if the currentfair value of the underlying stock exceeded the exercise price.   Statement of Financial Accounting Standards(SFAS) No. 123, *Accounting for Stock-Based Compensation*,established accounting and disclosure requirements using a fair value method ofaccounting for stock-based employee compensation plans.  As allowed by SFAS No. 123, the Company haselected to continue to apply the intrinsic value method of accounting describedabove, and has adopted only the disclosure requirements of SFAS No. 123, andrelated amendments.

 

TheCompany accounts for option grants under the plan by applying the provisions ofAPB Opinion No. 25, under which no compensation cost is recognized for thestock option awards to employees, in instances where the exercise price of theoptions granted is equal to fair value on the date of grant.  The following table illustrates the effect onnet loss if the fair value method had been applied in each period.

 
| ** **                                                                                                 | ** ** | **For the three-month periods  ended:** | ** **  | **For the nine-month periods  ended:** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|-------------|----------------------------------------|------------|
| ** **                                                                                                 | ** ** | **September 30, 2004**                  | ** **  | **September 30, 2003**                 | ** ** | **September 30, 2004** | ** ** | **September 30, 2003** | ** ** |
|                                                                                                       |       |                                    |        |                                   |       |   |   |   |   |
| Net loss, as  reported                                                                                     |       | $                                       | (13,954,570 | )                                      | $          | (12,219,597 | ) | $ | (42,961,241 | ) | $ | (39,915,664 | ) |
| Add  stock-based employee compensation expense included in reported net loss(1)                            |       | 103,187                                 |        | 94,867                                 |       | 303,070 |   | 192,825 |   |
| Deduct total  stock-based employee compensation expense determined under fair value method  for all awards |       | (2,237,636                              | )           | (1,990,321                             | )          | (6,278,036 | ) | (5,825,541 | ) |
| Pro forma  net loss                                                                                        |       | $                                       | (16,089,019 | )                                      | $          | (14,115,051 | ) | $ | (48,936,207 | ) | $ | (45,548,380 | ) |
|                                                                                                       |       |                                    |        |                                   |       |   |   |   |   |
| Basic and  diluted loss per share of common stock                                                          |       |                                    |        |                                   |       |   |   |   |   |
| As reported                                                                                                |       | $                                       | (0.60       | )                                      | $          | (0.65 | ) | $ | (1.88 | ) | $ | (2.12 | ) |
| Pro forma                                                                                                  |       | $                                       | (0.69       | )                                      | $          | (0.75 | ) | $ | (2.14 | ) | $ | (2.42 | ) |

 

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(1)           Value of restricted stock granted tonon-employee directors and compensation expense relating to options granted toan executive at 85% of fair value.

 

6

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**Note 3 Investments**

TheCompany considers all highly liquid investments purchased with an originalmaturity of three months or less to be cash equivalents.  Included with cash are cash equivalents of$74,581,330 and $36,484,817 as of September 30, 2004 and December 31, 2003,respectively.  The carrying value ofthese investments approximates their fair market value due to their shortmaturity and liquidity.

 

Investmentsin marketable securities include liquid investments purchased with an originalmaturity of between three months and one year. As provided by SFASNo. 115, *Accounting for Certain Investments in Debtand Equity Securities,*the Company has elected to treat all of itsinvestments in marketable securities as “available-for-sale,” which requiresthese investments to be recorded at fair market value. Unrealized gains andlosses, net of related tax effect, on available-for-sale securities deemed tobe temporary are excluded from earnings and are reported as a separatecomponent of other comprehensive income until realized. Realized gains andlosses 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.  The Company has not experienced any declinesin fair market value of its investments that were other than temporary.  As of September 30, 2004, the Company had noinvestments in marketable securities. Dividend and interest income arerecognized when earned. Realized gains on investments sold during the three-and nine-month periods ended September 30, 2004 was $0 and $192, respectively.  No investments were sold during the three-and nine-month periods ended September 30, 2003.

 

**Note 4 Inventory**

Inventoryis comprised solely of NeoPhectinTM and NeoPhectin-ATTM (together “NeoPhectin”)  finished goods and is stated at the lower ofcost or market, as determined by the first in, first out method (FIFO).  Inventory cost consists of direct materialand direct labor costs.  As products arecurrently produced in the Company’s research and development facilities, theCompany has not allocated any overhead costs as a product cost.  Application of overhead as a product cost isnot material.  Inventory as of September30, 2004 and December 31, 2003 consist of the following:

 
| ** **                   | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|------------------------------|------------|------------------------|------------|-----------------------|------------|
|                         |       |                   |       |                  |       |
| Finished  goods on hand      |       | $                      | 2,833      |                  | $          | — |   |
| Inventory  subject to return |       | 98                     |       | —                |       |
|                         |       |                   |       |                  |       |
|                         |       | $                      | 2,931      |                  | $          | — |   |

 

Inventory subject to return represents NeoPhectin products shipped to awholesale customer that have not been recognized as revenue (see note 7).

 

**Note 5  FixedAssets**

 

Fixedassets are recorded at cost and are depreciated using the straight line methodover their estimated useful lives. During 2003, the Company revised itsestimate of the useful life of computer equipment from five years to threeyears. Maintenance and repairs that do not extend the life of assets arecharged to expense when incurred.

 

Long-livedassets are reviewed for impairment whenever events or changes in circumstancesindicate the carrying amount of an asset may not be recoverable. Recoverabilityof assets to be held and used is measured by a comparison of the carryingamount of an asset to estimated undiscounted cash flows expected to begenerated by the asset. If the carrying amount of an asset exceeds itsestimated future cash flows, an impairment charge is recognized by the amountby which the carrying amount of the asset exceeds 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.

 

The Company maintains a Stockholder Rights Plan (the “Plan”) wherebyrights to purchase shares of Series A Participating Preferred Stock becomeexercisable by the Company’s stockholders after any partyacquires, or announces intentions to acquire, 15% or more of the Company'soutstanding common stock.  On September20, 2004, the Company’s Board of Directors approved and adopted an amendment tothe Plan, reducing from 30% to 22% the percentage of outstanding shares ofcommon stock of the Company which John N. Kapoor, together with his affiliates,can own before being deemed to be an Acquiring Person under the Plan.

 

**Note 7  RevenueRecognition**

 

TheCompany commenced sales of products in 2004. All revenue represents sales of NeoPhectin transfection reagent productssold to either distributors or to end-user customers.

 

7

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Revenueis recognized when persuasive evidence of an arrangement with the customer at afixed or determinable price exists, products are shipped, title and risk ofloss passes to the customer, and collection of amounts owed is reasonablyassured.  Shipments of product todistributors are subject to unconditional rights of return for a period of 180days from the date of shipment.  Giventhe limited sales history of NeoPhectin, the Company is currently unable toreasonably estimate the level of returns at the time of product shipment.  Accordingly, revenue is currently beingrecognized when the right of return has expired, which occurs upon the earlierof shipment of product by the distributor to an end-user or 180 days.

 

**Note 8  Loss Per Share**

 

Thefollowing table sets forth the computation of the basic and diluted net lossper share:

 
| ** **                           | ** ** | **For the three-month periods  ended:** | ** **  | **For the nine-month periods  ended:** | ** ** |
|--------------------------------------|------------|-----------------------------------------|-------------|----------------------------------------|------------|
| ** **                           | ** ** | **September 30, 2004**                  | ** **  | **September 30, 2003**                 | ** ** | **September 30, 2004** | ** ** | **September 30, 2003** | ** ** |
| Numerator:                           |       |                                    |        |                                   |       |   |   |   |   |
| Net loss                             |       | $                                       | (13,954,570 | )                                      | $          | (12,219,597 | ) | $ | (42,961,241 | ) | $ | (39,915,664 | ) |
|                                 |       |                                    |        |                                   |       |   |   |   |   |
| Denominator:                         |       |                                    |        |                                   |       |   |   |   |   |
| Weighted  average shares outstanding |       | 23,284,925                              |        | 18,832,741                             |       | 22,815,559 |   | 18,822,903 |   |
|                                 |       |                                    |        |                                   |       |   |   |   |   |
| Loss per  share - basic and diluted  |       | $                                       | (0.60       | )                                      | $          | (0.65 | ) | $ | (1.88 | ) | $ | (2.12 | ) |
|                                 |       |                                    |        |                                   |       |   |   |   |   |
| Potential  common share equivalents: |       |                                    |        |                                   |       |   |   |   |   |
| Stock  options                       |       | 3,715,020                               |        | 3,305,916                              |       | 3,606,729 |   | 3,307,663 |   |

 

Asthe Company has incurred a net loss for all periods presented, basic anddiluted per share amounts are equivalent as the effect of all potential commonshare equivalents is anti-dilutive.

 

**Note 9  Transactions with RelatedParties**

 

Thefollowing table provides further information about related party expensesreflected in the consolidated statements of operations.

 
| ** **                   | ** ** | ** **       | ** ** | **For the three-month periods  ended:** | ** ** | **For the nine-month periods  ended:** | ** ** |
|------------------------------|------------|------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| **Related Party**            | ** ** | **Expense Type** | ** ** | **September 30, 2004**                  | ** ** | **September 30, 2003**                 | ** ** | **September 30, 2004** | ** ** | **September 30, 2003** | ** ** |
| Akorn, Inc.                  |       | Consulting       |       | $                                       | —     |                                   | $          | 3,750 |   | $ | 6,250 |   | $ | 15,169 |   |
| E.J. Financial Enterprises   |       | Consulting       |       | —                                  |       | 31,250                                 |       | 62,500 |   | 93,750 |   |
| E.J.  Financial Enterprises  |       | Direct Expenses  |       | —                                  |       | 587                                    |       | 620 |   | 1,269 |   |
| Total related party expenses |       |             |       | $                                       | —     |                                   | $          | 35,587 |   | $ | 69,370 |   | $ | 110,188 |   |

 

During2004 and 2003, the Company received management consulting services from EJFinancial Enterprises, Inc. (“EJ Financial”), a healthcare consulting andinvestment firm in which Mr. John N. Kapoor, Ph.D., a member of theCompany’s Board of Directors and the Company’s former Chairman of the Board ofDirectors, is the sole stockholder.  Theconsulting agreement with EJ Financial expired on June 30, 2004 and was notrenewed.

 

InDecember 2001, NeoPharm entered into a transaction whereby NeoPharm loanedto Akorn, Inc., a Louisiana corporation, $3,250,000 to assist Akorn in thecompletion of its lyophilized products manufacturing facility in Decatur,Illinois. Mr. Kapoor, a member of the Company’s Board of Directors and theCompany’s former Chairman of the Board of Directors, is the Chairman of theAkorn Board of Directors and holds a substantial stock position in bothcompanies. In connection with the loan transaction, NeoPharm entered into thefollowing agreements: Promissory Note, dated December 20, 2001, in theoriginal principal amount of $3,250,000 by Akorn to NeoPharm; Processing Agreement,dated December 20, 2001, by and between Akorn and NeoPharm; Subordinationand Intercreditor Agreement, dated December 20, 2001, by and between JohnN. Kapoor, as Trustee under The John N. Kapoor Trust, dated September 20,1989 and NeoPharm; and a Subordination, Standby and Intercreditor Agreement,dated December 20, 2001, by and among Akorn, Akorn (NewJersey), Inc., The Northern Trust Company and NeoPharm. The PromissoryNote issued by Akorn was due in December 2006, and accrued interest at arate equal to that received on the Company’s investments in marketablesecurities, which is lower than the interest rate paid by Akorn on its otheroutstanding debt. The Processing Agreement grants NeoPharm access to at least15% of the annual lyophilization manufacturing capacity at Akorn at mostfavored customer pricing, upon completion of the facility. The ProcessingAgreement also provided that Akorn was to begin providing lyophilizationservices on or before June 30, 2003. At the time these transactions wereentered into, Akorn represented that the manufacturing facility would beoperational in 2003, approximately the time when NeoPharm originallyanticipated it would need to manufacture its lyophilized drug

 

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productcandidates for Phase II/III clinical trials. In 2001, NeoPharm recorded thePromissory Note net of a valuation allowance of $1,266,619 reflecting thedifference between the actual loan amount and the present value of the loanusing an estimated market interest rate of 10%. As of December 31, 2002,the Company determined the Promissory Note was impaired and recorded a chargeto fully reserve for the Promissory Note and related accrued interest. OnAugust 18, 2003, NeoPharm presented Akorn with a formal “Notice of Default”on the Promissory Note. Because the carrying value of the Promissory Note waszero, there was no financial statement impact as a result of any event ofdefault under, or non-payment of, the Promissory Note. In September 2003,Akorn advised NeoPharm that it wished to refinance its senior debt with a newsenior lender, which lender would require NeoPharm to subordinate its debt. Inorder to preserve the possibility of collecting Akorn’s debt to NeoPharm,NeoPharm and Akorn entered into an Amended and Restated Promissory Note inconsideration of a higher rate of interest (which would now equal that to becharged by the new senior lender, which is the prime rate plus 175 basispoints) and the possibility of accelerated mandatory repayments once Akorn’ssenior debt was repaid in full.  NeoPharm also agreed to waive Akorn’s default, to allow Akorn untilOctober 2004 to provide the manufacturing rights and to subordinate Akorn’sindebtedness to NeoPharm to Akorn’s indebtedness to its new senior lender.Akorn’s refinancing was completed on October 7, 2003.  On October 6, 2004, NeoPharm presented Akornwith a formal “Notice of Default” on the Amended and Restated Promissory Note.Because the carrying value of the Promissory Note was zero, there was nofinancial statement impact as a result of any event of default under, ornon-payment of, the Promissory Note.

 

**Note 10 Commitments**

 

On June 17, 2004, James M. Hussey resigned as the Company’s President,Chief Executive Officer and a member of the Board of Directors.  In accepting Mr. Hussey’s resignation, theBoard of Directors authorized the Company to enter into a Separation Agreementand Full Release of all Claims (the “Separation Agreement”) with Mr.Hussey.  Under the terms of theSeparation Agreement, Mr. Hussey will receive a salary continuance for 12months based upon his annual base salary at the time of his resignation($339,768), Company paid insurance premiums under the Company’s medicalinsurance plan, plus a payment equal to 50% of Mr. Hussey’s target milestonebonus when 2004 bonuses are paid to the Company’s employees, provided theSeparation Agreement has not been terminated prior to that time.  The salary continuance and medical insurancepremium payments will cease at such time as Mr. Hussey accepts full-timeemployment or the first date that Mr. Hussey provides consulting or otherservices to any other pharmaceutical or biotechnology organization.  Additionally, Mr. Hussey agreed to serveas a consultant to the Company for a period of up to 24 months or thetermination of the Separation Agreement, whichever is earlier, during whichtime all options previously granted to Mr. Hussey continue to vest and remainexercisable until 90 days after termination as a consultant.  For the nine-month period ended September 30,2004, the Company recorded compensation expense of $374, 454 relating tooptions previously granted to Mr. Hussey that continue to vest during the termof the consulting agreement.

 

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 receives 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 alsoentitled to an annual performance-based milestone bonus payment, a monthly carallowance of $600, and an annual reimbursement of up to $3,000 for the cost offinancial and estate planning.  Additionally,upon commencing his employment on July 12, 2004, Mr. Young received 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.

 

**Note 11 Contingencies**

 

OnApril 30, 2004, the Company’s arbitration case with Pfizer was completed whenthe arbitral panel dismissed each party’s claims against the other.  On September 15, 2004, the Company enteredinto a license termination agreement with Pfizer which returned the developmentrights for drug product candidates LEP and LED to the Company.

 

TheCompany has been named in several putative class action lawsuits (the “ClassAction 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 Mr. Kapoor, the former Chairman of the Company, andJames M. Hussey, the Company’s former President and CEO, and Dr. AquilurRahman, a former director and executive officer of the Company. The first ofthese Class Action Suits was filed on April 26, 2002 and all of the ClassAction Suits have been filed in the United States District Court for theNorthern District of Illinois, Eastern Division. On September 16, 2002, aconsolidated amended complaint was filed against NeoPharm in this matter. Theamended complaint shortened the class period to October 31, 2001 throughApril 19, 2002, removed Dr. Rahman as a defendant, and addedDr. Imran Ahmad, the Company’s current Chief Scientific Officer andExecutive Vice President of Research and Development, as a defendant. TheCompany intends to vigorously defend each and every claim in the class actionsuits and, on November 4, 2002, moved to have the complaint dismissed. TheCompany’s motion to dismiss was granted in part and denied in part inFebruary 2003. Mr. Kapoor was dismissed from the lawsuit at thattime. No trial date has been set. Management is unable to estimate a range ofpossible loss, if any. In addition, the Company maintains insurance coverage tomitigate the financial impact of any potential loss.

 

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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 arbitration with Pharmacia (now Pfizer) regardingthe development of its LEP and LED drug product candidates and the class actionlawsuits which have been filed against the Company relating to its publicstatements regarding the development of LEP. The Company cannot predict with certainty the direction theinvestigation will take or its ultimate outcome, and therefore is unable todetermine whether the results of the investigation will have a material adverseimpact on the Company’s results of operations and financial position.

 

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.

 

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**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 the Company’sAnnual Report on Form 10-K.  The resultsdiscussed below are not necessarily indicative of the results to be expected inany future periods.  The followingdiscussion contains forward-looking statements that are subject to risks anduncertainties which could cause actual results to differ from statements made.See “Forward Looking Statements” below.

 

**Overview**

 

We are a biopharmaceutical company engaged in theresearch, development, and commercialization of drugs for the treatment ofvarious cancers. Our corporate strategy is to become a leader in the research,development, and commercialization of new and innovative anti-cancertreatments. We currently operate at two locations, and had 134 full timeemployees as of September 30, 2004.  Ourcorporate headquarters and clinical development team are located in LakeForest, Illinois, and our research and development facility is in Waukegan,Illinois.

 

Since we began doing business in June 1990, wehave devoted our resources primarily to funding research and productdevelopment programs. To date, we have not received FDA approval of any of ourdrug product candidates.  We expect tocontinue to incur losses for the foreseeable future as we continue our researchand development activities, which include the sponsorship of human clinical trialsfor our drug product candidates.  Untilwe are able to consistently generate revenue through the sale of drug ornon-drug products, we anticipate that we will be required to fund thedevelopment of our pre-clinical compounds and drug product candidates primarilyby other means, including, but not limited to, licensing the development rightsto some of our drug product candidates to third parties or selling stock in theCompany.

 

In the third quarter ended September 30, 2004,management’s efforts were devoted primarily to enrolling additional patientsand opening additional study sites in the Phase III PRECISE clinical trial forour lead drug product candidate, IL13-PE38QQR, advancing our lead NeoLipid drugproduct candidates (LEP-ETU and LE-SN38) through Phase I clinical development,engaging third parties in discussions for the possible licensing of developmentrights to some of our drug product candidates, responding to a consentsolicitation initiated by our former Chairman of the Board of Directors to,among other things, remove our independent directors, and increasing sales forour new cationic cardiolipin based transfection reagents, NeoPhectin andNeoPhectin-AT. Significant events occurring during the third quarter included,the appointment of Gregory P. Young as our new President and Chief ExecutiveOfficer on July 12, 2004 and the return to us of the development rights forliposomal paclitaxel (LEP) and liposomal doxorubicin (LED) pursuant to atermination agreement entered into with Pfizer in September.  As a result of the Termination Agreementreached with Pfizer for the return of LEP and LED, we are now free to furtherdevelop and/or license these compounds at our discretion.

 

The PRECISE trial, our Phase III clinical trial forIL13-PE38QQR for the treatment of glioblastoma multiforme (GBM), began inMarch 2004 with the enrollment of our first patient, and patientenrollment continues to accelerate as additional clinical study sites areactivated. As of October 31, 2004, 70 patients have been enrolled inPRECISE.  Our current plans continue toanticipate the completion of enrollment for PRECISE in 2005 and the submissionof a Biologics License Application (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.

 

During the third quarter of 2004, we continued toadvance our Phase I NeoLipid drug product candidates towards Phase II/IIIclinical trials. The drug product candidates currently in Phase I clinicaldevelopment include: LEP-ETU, our improved NeoLipidTM formulation of liposomalpaclitaxel; LE-SN38 (liposomal SN38) for the treatment of colorectal and othercancers; and, LErafAON (liposomal craf antisense oligonucleotide) for thetreatment of radiation and/or chemotherapy resistant tumors. We currentlyanticipate that both LEP-ETU and LE-SN38 will complete enrollment in Phase Iclinical trials in 2004.

 

 It isdifficult to predict with any certainty the timing of and total estimated coststo complete development of drug product candidates in Phase I clinicaldevelopment, as well as the estimated date such drug product candidates wouldbe available for sale, if approved by the FDA. A number of factors contributeto this uncertainty, including: side effects encountered in early stageclinical trials, ability to scale up manufacturing for commercial supply, andthe fact that the size and scope of pivotal Phase III clinical trials areunknown until sufficient data is available to present a Phase III plan to theFDA for approval. In addition, our drug product candidates are required to beapproved by the FDA after completing Phase III clinical trials before we cansell the drugs to generate revenue and, potentially, realize net cash inflows.Because our lead drug product candidate, IL13-PE38QQR, has recently entered aPhase III clinical trial, we are able to make some estimates regardinganticipated expenses to be incurred to complete the Phase III PRECISE study.Our current estimates anticipate further direct expenses of approximately$23 million to complete the Phase III clinical trial for IL13-PE38QQR. AdditionalPhase I and Phase II expenses are also expected to

 

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beincurred for IL13-PE38QQR as we are conducting other clinical trials toinvestigate the potential to use IL13-PE38QQR in other forms of glioblastomamultiforme in addition to recurrent glioblastoma multiforme.

 

The table below includes a summary of identifieddirect project costs incurred to date for our major research and developmentprojects. Generally, identified project costs include expenses incurredspecifically for clinical trials and pre-clinical studies we conduct, andexclude expenses incurred for salaries paid to our professional staff, overheadexpenses for our Lake Forest and Waukegan facilities and general laboratorysupplies used in our research, which are 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                                |       | $                                      | 4,358,903  |                             | $          | 14,039,100                                            |       | $ | 33,097,386 |   |
| LE-SN38                                  |       | 521,900                                |       | 1,696,712                        |       | 4,298,119                                             |       |
| LEP-ETU                                  |       | 887,612                                |       | 2,339,421                        |       | 3,277,778                                             |       |
| LErafAON                                 |       | 346,773                                |       | 1,085,329                        |       | 7,321,405                                             |       |
| Non-project  specific                    |       | 4,506,007                              |       | 14,718,239                       |       | N/A                                                   |       |
| Total  research and development expenses |       | 10,621,195                             |       | 33,878,801                       |       | N/A                                                   |       |
|                                          |            |                                        |            |                                  |            |                                                       |            |  |  |  |

 

Sales of our novel cationic cardiolipin basedtransfection reagents, NeoPhectinTM and NeoPhectin-ATTM, increased during thethird quarter by approximately 444% from second quarter 2004 sales.  NeoPhectinTM is our *in vitro*transfection reagent, and NeoPhectin-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 September 2, 2004, Mr. Kapoor, a director and21.7% stockholder of the Company, filed a preliminary consent solicitationstatement with the SEC, pursuant to which Mr. Kapoor, among other requestedactions, seeks to remove, without cause, the Company’s other non-employeedirectors and replace them with nominees selected by Mr. Kapoor.  On September 18, 2004, in accordance with theCompany’s by-laws and Delaware law, the Board set September 28, 2004 as therecord date for the determination of stockholders who are entitled to execute,withhold, or revoke consents relating to Mr. Kapoor’s proposals.  Executed, withheld or revoked consents mustbe received by the Company on or before November 27, 2004.

 

                On October29, 2004, we announced an estimated net loss for the fiscal year endingDecember 31, 2005 of approximately $42 to $46 million.  This estimate includes 2005 cost savings ofapproximately $4 million from a planned restructuring of approximately 25% ofthe Company's workforce, plus reductions in planned spending for some of ourdrug product candidates and operations.

 

**Results of Operations – Three-Month Period Ended September 30, 2004 vs.Three-Month Period Ended September 30, 2003.**

 

The Company recorded revenue of $85 thousand for thethree-month period ended September 30, 2004. The sole source of revenue was from sales of NeoPhectin andNeoPhectin-AT.  No revenue was recordedfor the three-month period ended September 30, 2003.

 

Research and development expense for the three-monthperiod ended September 30, 2004 increased by approximately $1.5 million ascompared to the same period in 2003. The increase in research and developmentexpenses was related to increased spending on our clinical research anddevelopment programs of approximately $867 thousand primarily related to ourPhase III PRECISE clinical trial for IL13-PE38QQR, and increased payrollrelated expenses of approximately $589 thousand for the three-month periodended September 30, 2004.

 

Selling, general, and administrative expensesincreased by approximately $508 thousand during the three-month period endedSeptember 30, 2004 as compared to the three-month period ended September 30,2003.  The increase in selling, general,and administrative expenses during the third quarter of 2004 was primarilyrelated to compensation expense of approximately $374 thousand recognized inthe third quarter of 2004 related to stock options granted to our former CEOwhile he was an employee that remain exercisable while he provides services asa consultant to the Company and $366 thousand in expenses incurred to respondto the consent solicitation initiated by Mr. Kapoor seeking, among otherthings, to remove, without cause, the Company’s other non-employeedirectors.  Other selling, general, andadministrative expenses were approximately $232 thousand less for thethree-month period ended September 30, 2004 as compared with the same period in2003.

 

The Company generated interest income on cash andinvestments of approximately $298 thousand and $149 thousand for thethree-month periods ended September 30, 2004 and September 30, 2003,respectively.  The increase in interestincome for the three-month period ended September 30, 2004 was a direct resultof increased cash balances available for investing in 2004.

 

As a result of the above items, net loss and basicand diluted loss per share for the three-month periods ended September 30, 2004and September 30, 2003 were approximately $14.0 million and $12.2 million,respectively, and $0.60 and $0.65, respectively.

 

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**Results of Operations – Nine-Month Period Ended September 30, 2004 vs.Nine-Month Period Ended September 30, 2003.**

 

The Company recorded revenue of $116 thousand forthe nine-month period ended September 30, 2004. The sole source of revenue was from sales of NeoPhectin andNeoPhectin-AT.  No revenue was recordedfor the nine-month period ended September 30, 2003.

 

Research and development expense for the nine-monthperiod ended September 30, 2004 increased by approximately $8.8 million ascompared to the same period in 2003. The increase in research and developmentexpenses was related to increased spending for our clinical drug productcandidate development programs of approximately $7.2 million primarily as aresult of our ongoing Phase III PRECISE trial for IL13-PE38QQR, and increasedpayroll related expenses of approximately $1.6 million.

 

Selling, general, and administrative expensesdecreased by approximately $5.6 million for the nine-month period endedSeptember 30, 2004 versus the nine-month period ended September 30, 2003 due toa reduction of approximately $9.1 million in arbitration related expensesduring 2004.  The reduction inarbitration related expenses was offset by increases in other selling, generaland administrative expenses of approximately $3.5 million, due to increasedpayroll and consulting related expenses of approximately $2.1 million primarilyassociated with increases in staffing and recruiting expenses, increasedprofessional fees of approximately $840 thousand for legal and accountingservices, increased information technology related expenses of approximately$230 thousand primarily related to upgrading our systems to comply with newregulatory requirements, increased commercial insurance expense ofapproximately $210 thousand resulting from increases in premiums combined withincreased limits for our property and casualty coverage, and increased othergeneral and administrative expenses of approximately $120 thousand related togeneral corporate activities.

 

The Company generated interest income on cash andinvestments of approximately $772 thousand and $688 thousand for the nine-monthperiods ended September 30, 2004 and September 30, 2003, respectively.

 

As a result of the above items, net loss and basicand diluted loss per share for the nine-month periods ended September 30, 2004and September 30, 2003 were approximately $43.0 million and $39.9 million,respectively, and $1.88 and $2.12, respectively.

 

**Liquidity and Capital Resources**

 

As of September 30, 2004, we had approximately $75.8million in cash and cash equivalents, and no debt. All excess cash is currentlyinvested in marketable securities with less than three months to maturity. Wecurrently believe that our cash on hand at September 30, 2004, should beadequate to fund our operations for at least the next 21 months.

 

The primary use of funds over the next12 - 24 months will be to fund our clinical and pre-clinicalresearch and development efforts. The most significant expenses will beincurred in relation to the PRECISE Phase III clinical trial for our braintumor drug product candidate, IL13-PE38QQR. At the present time, we expect tospend approximately $23 million over the next 24 months to completethe PRECISE trial. Additional expenses are also expected to be incurred as wecontinue to move our Phase I drug product candidates towards, and potentiallyinto, Phase II clinical trials.

 

We may seek to satisfy our future fundingrequirements through public or private offerings of securities, withcollaborative or other arrangements with corporate partners or from othersources including, but not limited to, sales of NeoPhectinTM. Additionalfinancing may not be available when needed or on terms acceptable to us. Ifadequate financing is not available, we may be required to delay, scale back,or eliminate certain of our research and development programs, relinquishrights to certain of our technologies, cancer drugs or products, or licensethird parties to commercialize products or technologies that we would otherwiseseek to develop ourselves.

 

NeoPharm has no debt, no capital leases, no exposureto off-balance sheet arrangements, no special purpose entities, nor activitiesthat include non-exchange-traded contracts accounted for at fair value. Thefollowing table summarizes our estimated contractual obligations as ofSeptember 30, 2004:

 

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| ** **                                              | ** ** | **Payments Due by Period** | ** ** |
|---------------------------------------------------------|------------|----------------------------|------------|
| **Contractual Obligations**                             | ** ** | **Total**                  | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than  5 years** | ** ** |
| Operating  lease                                        |       | $                          | 1,313,320  |   | $ | 577,580 |   | $ | 592,895 |   | $ | 142,845 |   | $ | 0 |   |
| License  agreements—milestone based payments(1)(2) |       | 2,525,000                  |       | 225,000 |   | 850,000 |   | 350,000 |   | 1,100,000 |   |
| Total                                                   |       | $                          | 3,838,320  |   | $ | 802,580 |   | $ | 1,442,895 |   | $ | 492,845 |   | $ | 1,100,000 |   |

 

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(1)           These amounts do not include potential sales-basedroyalty payments that may be required under the various license agreements.

 

(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**

 

In preparing the Company’s financial statements inconformity with accounting principles generally accepted in the United Statesof America, management must make a variety of decisions which impact thereported amounts and related disclosures. Such decisions include the selectionof the appropriate accounting principles to be applied, the assumptions onwhich to base accounting estimates, and the consistent application of thoseaccounting principles. Due to the type of industry in which the Companyoperates and the nature of its business, the following accounting policies arethose that management believes are most important to the portrayal of theCompany’s financial condition and results and that require management’s mostdifficult, subjective or complex judgments, often as a result of the need tomake estimates about the effect of matters that are inherently uncertain.

 

*Investments in Marketable Securities*

 

As provided by SFAS No. 115, *Accounting for Certain Investments in Debt and EquitySecurities*, the Company has elected to treat all of its investmentsin marketable securities as “available-for-sale,” which requires theseinvestments to be recorded at fair market value. Unrealized gains and losses,net of related tax effect, on available-for-sale securities are excluded fromearnings and are reported as a separate component of other comprehensive incomeuntil realized. 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. Significant judgment is required to determine instances in whichan other than temporary decline in the fair value of marketable securities hasoccurred. Management considers available positive and negative information inmaking this judgment, including: the nature of the investments; the causes ofimpairments; the number of investment positions that are in an unrealized-lossposition; the severity and duration of the impairment; and management’s abilityand intent to hold the marketable security as well as forecasted recovery offair value.

 

*Income Taxes*

 

In assessing the realizability of deferred taxassets, management considers whether it is more likely than not that someportion or all of the deferred tax assets will not be realized. The ultimaterealization of deferred tax assets is dependent upon the generation of futuretaxable income during the periods in which those temporary differences becomedeductible. Management considers the scheduled reversal of deferred taxliabilities, projected future taxable income, and tax planning strategies inmaking this assessment. Significant judgments are required to estimate thegeneration of future taxable income and the timing of the reversal of deferredtax liabilities.

 

*Revenue Recognition*

 

The Company provides for general rights of return ofproducts sold to its distributor. Appropriately determining revenue recognition when the general right ofreturn exists requires the use of judgment in estimating the level ofreturns.  In certain circumstances,management may not be able to develop a reasonable estimate of the level ofreturns.  Making such a determinationalso requires the use of significant judgment. Management has determined that given the limited sales history ofNeoPhectin, the Company is currently unable to develop a reasonable estimate ofthe level of returns.  Accordingly, theCompany is currently recognizing revenue for products shipped to itsdistributor upon the expiration of the right of return which occurs upon theearlier of shipment of product by the distributor to an end-user or 180 days.

 

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*Stock-Based Compensation*

 

The Company applies the intrinsic value method ofaccounting prescribed by Accounting 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 method of accounting for stock-based employee compensationplans. As allowed by SFAS No. 123, the Company has elected to continue toapply the intrinsic value method of accounting described above, and has adoptedonly the disclosure requirements of SFAS No. 123. Significant judgmentsare required in determining an appropriate method for determining the fairvalue of stock-based compensation. The Company has elected to utilize theBlack-Scholes option-pricing model to make the fair value determination. Inputsinto the option-pricing model are subject to estimation that may affect thedetermination of fair value.

 

**Forward Looking Statements**

 

Any statements made byNeoPharm, Inc. (“we”, “us”, “our”, or the “Company”) in this quarterly reportthat are forward looking are made pursuant to the safe harbor provisions of thePrivate Securities Litigation Reform Act of 1995.  The Company cautions readers that importantfactors may affect the Company’s actual results and could cause such results todiffer materially from forward-looking statements made by or on behalf of theCompany.  Such factors include, but arenot limited to, those risks and uncertainties relating to difficulties ordelays in development, testing, regulatory approval, production and marketingof the Company’s drug candidates, including, but not limited to IL13-PE38QQR,including the PRECISE trial, the marketing of non-drug products such asNeoPhectinTM and NeoPhectin-ATTM, uncertainty regarding the outcome of classaction litigation against the Company, resolution of the ongoing SECinvestigation, unexpected adverse side effects or inadequate therapeuticefficacy of the Company’s drug product candidates that could slow or preventproducts coming to market, the uncertainty of patent protection for the Company’sintellectual property or trade secrets, and other factors referenced under “RiskFactors” in the Company’s Annual Report on Form 10-K for the fiscal year endedDecember 31, 2003.

 

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

 

As of September 30, 2004, we did not own anyderivative instruments, but we were exposed to market risks, primarily changesin U.S. interest rates. As of September 30, 2004, we held total cash and cashequivalents (maturity less than 90 days) of $75,756,502. Declines ininterest rates over time will reduce our interest income from our investments.Based upon our balance of cash and cash equivalents, as of September 30, 2004,a decrease in interest rates of 1.0% would cause a corresponding decrease inour annual interest income of approximately $758,000.

 

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

 

As of September 30, 2004, we carried out anevaluation, under the supervision and with the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures. Based on that evaluation, our management, including the ChiefExecutive Officer and Chief Financial Officer, concluded that our disclosurecontrols and procedures are operating effectively as designed.

 

We are committed to a continuing process ofidentifying, evaluating and implementing improvements to the effectiveness ofour disclosure and internal controls and procedures. Our management, includingour Chief Executive Officer and Chief Financial Officer, does not expect thatour controls and procedures will prevent all errors. A control system, nomatter how well conceived and operated, can provide only reasonable, notabsolute, assurance that the objectives of the control system are met. Becauseof the inherent limitations in all control systems, no evaluation of controlscan provide absolute assurance that all control issues within the Company havebeen detected. These inherent limitations include the realities that judgmentsin decision-making can be faulty, and that breakdowns can occur because of asimple error or mistake. Additionally, controls can be circumvented by theindividual acts of some persons, by collusion of two or more people, or bymanagement override of the control. The design of any system of controls isalso based in part upon certain assumptions about the likelihood of futureevents, and there can be no assurance that any design will succeed in achievingits stated goals under all potential future conditions. Over time, controls maybecome inadequate because of changes in conditions, or the degree of compliancewith the policies or procedures may deteriorate. Because of the inherentlimitations in any control system, misstatements due to error or violations oflaw may occur and not be detected.

 

There have been no significant changes in ourinternal controls over financial reporting that occurred during the periodcovered by this report that have materially affected, or are reasonably likelyto affect, our internal control over financial reporting.

 

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**PART II - OTHER INFORMATION**

 

Item 1.                    Legal Proceedings

 

The Company has been named in several putative classaction lawsuits (the “Class Action Suits”) each of which alleges variousviolations of the federal securities laws in connection with the Company’spublic statements during the period from September 25, 2000 throughApril 19, 2002 as they relate to the Company’s LEP drug product candidate.The original lawsuits also named as individual defendants John N. Kapoor, theformer Chairman of the Company, and James M. Hussey, the Company’s formerPresident and CEO, and Dr. Aquilur Rahman, a former director and executiveofficer of the Company. The first of these Class Action Suits was filed onApril 26, 2002 and all of the Class Action Suits have been filed in theUnited States District Court for the Northern District of Illinois, EasternDivision. On September 16, 2002, a consolidated amended complaint wasfiled against NeoPharm in this matter. The amended complaint shortened theclass period to October 31, 2001 through April 19, 2002, removedDr. Rahman as a defendant, and added Dr. Imran Ahmad, the Company’scurrent Chief Scientific Officer and Executive Vice President of Research andDevelopment, as a defendant. The Company intends to vigorously defend each andevery claim in the class action suits and, on November 4, 2002, moved tohave the complaint dismissed. The Company’s motion to dismiss was granted inpart and denied in part in February 2003. Dr. Kapoor was dismissedfrom the lawsuit at that time. No trial date has been set. Management is unableto estimate a range of possible loss, if any. In addition, the Companymaintains insurance coverage to mitigate the financial impact of any potentialloss.

 

On March 26, 2004, the Company received aletter from the Securities and Exchange Commission (SEC) stating that the SECis conducting a formal investigation of the Company.  The SEC stated in its letter that it has madeno determination of any violation of law by the Company or any individual atthis time.  Previously, this matter hadbeen the subject of an informal SEC inquiry. The Company continues to fully cooperate with the SEC and intends to continueto do so in order to bring this ongoing inquiry to a conclusion as promptly aspossible.  The Company believes theinvestigation is an outgrowth of the Company’s 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, and therefore isunable to determine whether the results of the investigation will have amaterial adverse impact on the Company’s results of operations and financialposition.

 

Item 2.                    UnregisteredSales of Equity Securities and Use of Proceeds

None

 

Item 3.                    DefaultsUpon Senior Securities

None

 

Item 4.                    Submissionof Matters to a Vote of Security Holders

None

 

Item 5.                    Other Information

None

 

Item 6.                    Exhibits

 

 
| 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 |

 

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**SIGNATURE PAGE**

 

**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 theundersigned, thereunto duly authorized.**

 
|                   | NEOPHARM, INC. |
|------------------------|----------------|
| Date: November 8, 2004 | By:            | /s/ Lawrence A. Kenyon |
|                   |           | Lawrence A. Kenyon, |
| * *               | * *       | *Chief Financial Officer  (Principal Accounting Officer and  Principal Financial Officer)* |

 

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