**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**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, 2005**

 

**Or**

 
| **o** | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|-----------------------------------------------------------------------------------------------------|

 

**For the transition periodfrom             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) |
|                                                            |       |                                    |
| **1850 Lakeside Drive  Waukegan, Illinois 60085**               |
| (Address of principal executive offices) (Zip Code)             |
|                                                            |       |                                    |
| **(847) 887-0800**                                              |
| (Registrant’s telephone number, including area code)       |

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes  **ý**   No  **o**

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act).  Yes  **ý**  No  **o**

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).  Yes  o No  ý

 

Asof October 31, 2005, the number of shares outstanding of each of the issuer’sclasses of common stock was as follows:

 
| **Title of each class**             | ** ** | **Number  of shares outstanding** | ** ** |
|-------------------------------------|------------|-----------------------------------|------------|
| Common  Stock ($.0002145 par value) |       | 23,739,889                        |       |

 

 

 

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NEOPHARM, INC.

 

FORM 10-QINDEX

 
| PART I. FINANCIAL INFORMATION |
|-------------------------------|
|                          | Item 1. | Financial Statements |
|                          |   | Condensed  Consolidated Balance Sheets as of September 30, 2005 (unaudited) and  December 31, 2004 |
|                          |   | Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2005 and 2004 (unaudited) |
|                          |   | Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2005 and 2004 (unaudited) |
|                          |   | Notes  to Condensed 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.Condensed Consolidated Balance Sheets**

 
| ** **                                                                                                                                | ** ** | **September 30 2005** | ** ** | **December 31, 2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                | ** ** | **(Unaudited)**            | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                                                |       |                       |       |                       |       |
| Current assets:                                                                                                                           |       |                       |       |                       |       |
| Cash and cash equivalents                                                                                                                 |       | $                          | 40,105,417 |                       | $          | 63,106,655 |   |
| Trade accounts receivable                                                                                                                 |       | 2,870                      |       | 10,888                     |       |
| Inventories                                                                                                                               |       | 4,368                      |       | 5,736                      |       |
| Prepaid expenses                                                                                                                          |       | 1,222,991                  |       | 1,108,282                  |       |
| Other receivables                                                                                                                         |       | 109,641                    |       | 308,087                    |       |
| Total current assets                                                                                                                      |       | 41,445,287                 |       | 64,539,648                 |       |
| Fixed assets, net of  accumulated depreciation                                                                                            |       | 2,148,131                  |       | 2,894,723                  |       |
| Total assets                                                                                                                              |       | $                          | 43,593,418 |                       | $          | 67,434,371 |   |
|                                                                                                                                      |       |                       |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                            |       |                       |       |                       |       |
| Current liabilities:                                                                                                                      |       |                       |       |                       |       |
| Accounts payable                                                                                                                          |       | $                          | 562,877    |                       | $          | 398,505 |   |
| Accrued clinical trial expense                                                                                                            |       | 6,037,731                  |       | 4,634,618                  |       |
| Accrued compensation                                                                                                                      |       | 1,790,081                  |       | 3,227,230                  |       |
| Other accrued expenses                                                                                                                    |       | 1,872,872                  |       | 940,343                    |       |
| Deferred and unearned revenue                                                                                                             |       | —                     |       | 3,400                      |       |
| Total current liabilities                                                                                                                 |       | 10,263,561                 |       | 9,204,096                  |       |
|                                                                                                                                      |       |                       |       |                       |       |
| Deferred revenue                                                                                                                          |       | 2,000,000                  |       | —                     |       |
| Deferred rent                                                                                                                             |       | 41,978                     |       | —                     |       |
|                                                                                                                                      |       |                       |       |                       |       |
| Stockholders’ equity:                                                                                                                |       |                       |       |                       |       |
| Preferred  stock, $0.01 par value; 15,000,000 shares authorized: none issued and  outstanding                                             |       | —                     |       | —                     |       |
| Common  stock, $0.0002145 par value; 50,000,000 shares authorized: 23,704,322 and  23,372,755 shares issued and outstanding, respectively |       | 5,085                      |       | 5,013                      |       |
| Additional paid-in capital                                                                                                                |       | 249,637,337                |       | 247,525,290                |       |
| Accumulated deficit                                                                                                                       |       | (218,354,543               | )          | (189,300,028               | )          |
| Total stockholders’ equity                                                                                                           |       | 31,287,879                 |       | 58,230,275                 |       |
| Total liabilities and stockholders’ equity                                                                                           |       | $                          | 43,593,418 |                       | $          | 67,434,371 |   |
|                                                                                                                                           |            |                            |            |                            |            |  |  |  |  |  |

 

The accompanying notes to condensed consolidated financial statementsare an integral part of these financial statements.

 

3

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**NEOPHARM, INC.**

 

**Condensed Consolidated Statements of OperationsThree and Nine Months Ended September 30, 2005 and 2004**(Unaudited)

 
| ** **                                 | ** ** | **Three-Month Periods Ended** | ** **  | **Nine Month Periods Ended** | ** ** |
|--------------------------------------------|------------|-------------------------------|-------------|------------------------------|------------|
| ** **                                 | ** ** | **September 30, 2005**   | ** **  | **September 30, 2004**  | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** |
| Collaboration revenue                      |       | $                             | —      |                         | $          | — |   | $ | 500,000 |   | $ | — |   |
| Product revenue                            |       | 9,480                         |        | 84,740                       |       | 35,380 |   | 116,020 |   |
| Total revenue                              |       | 9,480                         |        | 84,740                       |       | 535,380 |   | 116,020 |   |
|                                       |       |                          |        |                         |       |   |   |   |   |
| Expenses:                                  |       |                          |        |                         |       |   |   |   |   |
| Cost of product revenue                    |       | 387                           |        | 3,466                        |       | 1,736 |   | 4,008 |   |
| Research and development                   |       | 8,538,368                     |        | 10,621,195                   |       | 24,573,044 |   | 33,878,801 |   |
| Selling, general, and administrative       |       | 2,388,388                     |        | 3,712,207                    |       | 8,672,986 |   | 9,896,836 |   |
| Recovery of note receivable                |       | —                        |        | —                       |       | (2,500,000 | ) | — |   |
| Related party expenses                     |       | —                        |        | —                       |       | — |   | 69,370 |   |
| Total expenses                             |       | 10,927,143                    |        | 14,336,868                   |       | 30,747,766 |   | 43,849,015 |   |
| Loss from operations                       |       | (10,917,663                   | )           | (14,252,128                  | )          | (30,212,386 | ) | (43,732,995 | ) |
|                                       |       |                          |        |                         |       |   |   |   |   |
| Interest income                            |       | 384,720                       |        | 297,558                      |       | 1,157,871 |   | 771,754 |   |
| Net loss                                   |       | $                             | (10,532,943 | )                            | $          | (13,954,570 | ) | $ | (29,054,515 | ) | $ | (42,961,241 | ) |
| Net loss per share —                  |       |                          |        |                         |       |   |   |   |   |
| Basic and diluted                          |       | $                             | (0.45       | )                            | $          | (0.60 | ) | $ | (1.23 | ) | $ | (1.88 | ) |
| Weighted average shares outstanding — |       |                          |        |                         |       |   |   |   |   |
| Basic and diluted                          |       | 23,640,393                    |        | 23,284,925                   |       | 23,557,757 |   | 22,815,559 |   |
|                                       |       |                          |        |                         |       |   |   |   |   |
|                                            |            |                               |             |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The accompanying notes to condensed consolidated financial statementsare an integral part of these financial statements.

 

4

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**NEOPHARM, INC.**

 

**Condensed Consolidated Statements of Cash FlowsNine Months Ended September 30, 2005 and 2004**(Unaudited)

 
| ** **                                                                   | ** ** | **Nine Months Ended**  | ** **  |
|------------------------------------------------------------------------------|------------|------------------------|-------------|
| ** **                                                                   | ** ** | **September 30, 2005** | ** **  | **September 30, 2004** | ** ** |
| Cash flows from operating  activities:                                       |       |                   |        |   |   |
| Net loss                                                                     |       | $                      | (29,054,515 | ) | $ | (42,961,241 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |       |                   |        |   |   |
| Depreciation and  amortization                                               |       | 983,291                |        | 1,006,620 |   |
| Stock-based compensation  expense                                            |       | 469,200                |        | 734,504 |   |
| Loss on retirement of  equipment and furniture                               |       | 4,963                  |        | — |   |
| Changes in assets and  liabilities:                                          |       |                   |        |   |   |
| Increase in current assets                                                   |       | 93,123                 |        | (768,345 | ) |
| Increase in current liabilities                                              |       | 1,247,818              |        | 2,854,624 |   |
| Increase in deferred revenue                                                 |       | 2,000,000              |        | — |   |
| Increase in deferred rent                                                    |       | 41,978                 |        | — |   |
| Net cash and cash  equivalents used in operating activities                  |       | (24,214,142            | )           | (39,133,838 | ) |
|                                                                         |       |                   |        |   |   |
| Cash flows from investing  activities:                                       |       |                   |        |   |   |
| Proceeds from maturities  of marketable securities                           |       | —                 |        | 1,046,168 |   |
| Proceeds from sales of  marketable securities                                |       | —                 |        | 3,120,183 |   |
| Purchase of equipment and  furniture                                         |       | (241,662               | )           | (437,586 | ) |
| Net cash and cash  equivalents (used in) provided by investing activities    |       | (241,662               | )           | 3,728,765 |   |
|                                                                         |       |                   |        |   |   |
| Cash flows from financing  activities:                                       |       |                   |        |   |   |
| Proceeds from issuance of  common stock                                      |       | —                 |        | 73,472,948 |   |
| Proceeds from exercise of  stock options                                     |       | 1,454,566              |        | 729,686 |   |
| Net cash and cash  equivalents provided by financing activities              |       | 1,454,566              |        | 74,202,634 |   |
|                                                                         |       |                   |        |   |   |
| Net (decrease)/increase in  cash and cash equivalents                        |       | (23,001,238            | )           | 38,797,561 |   |
| Cash and cash equivalents,  beginning of period                              |       | 63,106,655             |        | 36,958,941 |   |
| Cash and cash equivalents,  end of period                                    |       | $                      | 40,105,417  |   | $ | 75,756,502 |   |
|                                                                         |       |                   |        |   |   |
| Supplemental schedule of  non-cash financing activities:                     |       |                   |        |   |   |
| Issuance of common stock  in satisfaction of a liability                     |       | $                      | 188,353     |   | $ | — |   |
|                                                                         |       |                   |        |   |   |
| Supplemental disclosure of  cash paid for:                                   |       |                   |        |   |   |
| Interest                                                                     |       | $                      | —      |   | $ | — |   |
| Income taxes                                                                 |       | $                      | —      |   | $ | — |   |

 

The accompanying notes to condensed consolidated financial statementsare an integral part of these financial statements.

 

5

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**NEOPHARM, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(unaudited)**

 

**Note 1  Basis of Presentation**

The financial informationherein is unaudited. The balance sheet as of December 31, 2004 is derivedfrom audited financial statements.

The accompanyingunaudited condensed consolidated financial statements of NeoPharm, Inc. andsubsidiary (the “Company”) have been prepared in accordance with U.S. generallyaccepted accounting principles (“GAAP”) for interim financial information andwith the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.Accordingly, they do not contain all of the information and notes required byU.S. GAAP for complete financial statements. In the opinion of the Company, theaccompanying unaudited condensed consolidated interim financial statementscontain all adjustments (consisting of normal recurring adjustments) necessaryto present fairly the Company’s financial position as of September 30, 2005,and the results of its operations for the three and nine months ended September30, 2005 and 2004 and its cash flows for the nine months ended September 30,2005 and 2004.  The results of operationsfor the three and nine months ended September 30, 2005 are not necessarilyindicative of operating results for fiscal 2005 or future interim periods.

The unaudited condensedconsolidated financial statements include the accounts of NeoPharm, Inc. andits wholly owned subsidiary, NeoPharm EU Limited. NeoPharm EU Limited wascreated in 2004 to comply with regulatory requirements enacted for clinicaltrials conducted in the European Union. This subsidiary has nominal assets andhad not conducted any business. All significant intercompany accounts andtransactions are eliminated in consolidation.

While the Companybelieves that the disclosures presented are adequate to make the informationnot misleading, it is suggested that these financial statements be read inconjunction with the financial statements and notes included in the Company’s2004 Annual Report on Form 10-K and Amendment No. 1 filed on Form 10-K/A withthe Securities and Exchange Commission (“SEC”).

The preparation of financialstatements in conformity with U.S. GAAP requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the consolidatedfinancial statements and the reported amounts of revenue and expense during thereporting period.  Actual results coulddiffer from those estimates.

Certain prior yearamounts have been reclassified to conform to current year presentation.

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 123R, *Share-Based Payment*,a revision of SFAS No. 123, which requires the use of the fair value method ofaccounting for stock-based employee compensation effective for all awardsgranted, modified, repurchased or cancelled. This standard is now effective for the first annual reporting periodbeginning after June 15, 2005.  Thestandard provides for a prospective application of its provisions.  Under this method, the Company will beginrecognizing compensation cost for equity based compensation for all new ormodified grants after the date of adoption. In addition, the Company will recognize the unvested portion of thegrant date fair value of awards issued prior to adoption based on the fairvalues previously calculated under the disclosure provisions of SFAS No.123.  The Company is currently evaluatingthe impact that the adoption of SFAS No. 123R will have on its financialposition, results of operations, and cash flows.

In May 2005, the FASB issued SFAS No. 154, *AccountingChanges and Error Corrections*, a replacement of AccountingPrinciples Board (“APB”) Opinion No. 20, *AccountingChanges* and FASB Statement No. 3, *ReportingAccounting Changes in Interim Financial Statements*.  SFAS No. 154 applies to allvoluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement inthe unusual instance that the pronouncement does not include specifictransition provisions.SFAS No. 154 requires the retrospective application to priorperiods’ financial statements of the direct effect of a voluntary change inaccounting principle unless it is impracticable to do so.  Unless early adoption is elected,SFAS No. 154 is effective for fiscal years beginning afterDecember 15, 2005. Early adoption is permitted for fiscal years beginningafter June 1, 2005. SFAS No. 154 does not change the transitionprovisions of any existing accounting pronouncements, including those that arein a transition phase as of the effective date of this statement. The Companywill assess the impact of a retrospective application of a change in accountingprinciple in accordance with SFAS No. 154, if the need for such a changearises.

 

**Note 2 Liquidity**

As of September 30, 2005, the Company had $40,105,417 in cash and cash equivalents.  While the Company believes that its current cash and cash equivalents, will be sufficient to meet its anticipated cash needs for working capital, capital expenditures and other activities into the fourth quarter of 2006, in order for the Company to meet its liquidity needs through late 2006 and beyond, the Company will have to obtain additional capital.  While the Company has made no decision as to what course of action it will pursue to meet its liquidity needs, the options available to the Company, include, but are not limited to, one or a combination of, the following: consummate additional product licensing arrangements, delay or halt its clinical development process, further reduce its operating expenses, and/or raise additional capital through issuance of equity or debt securities.

 

Additional financing may not be available when needed or on terms acceptable to the Company.  Currently, the Company has the ability to issue approximately $46 million of equity securities, plus permitted increases, via a shelf registration, the expiration of which was recently extended until December 1, 2008, however, use of the shelf registration is conditioned on the Company’s timely filing of all required documents with the SEC.

 

6

 

**Note 3  Stock-based Compensation**

The Company applies theintrinsic-value method of accounting prescribed by APB Opinion No. 25, *Accounting for Stock Issued to Employees*, and relatedinterpretations, to account for its fixed-plan stock options.  Under this method, compensation expense ismeasured on the date of grant if the current market price of the underlyingstock exceeded the exercise price or when the number of shares and exerciseprice are known if both are not determinable at the date of grant. Compensationexpense for fixed stock options is recognized ratably over the vestingperiod.  SFAS No. 123, *Accounting for Stock-Based Compensation*, established accountingand disclosure requirements using a fair-value method of accounting forstock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to applythe intrinsic-value-based method of accounting described above, and has adoptedonly the disclosure requirements of SFAS No. 123.

The following tableillustrates the effect on net loss if the fair-value method had been applied ineach period:

 
| ** **                                                                                                      | ** ** | **Three months ended** | ** **  | **Nine months ended**  | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|------------------------|-------------|------------------------|------------|
| ** **                                                                                                      | ** ** | **September 30, 2005** | ** **  | **September 30, 2004** | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** |
|                                                                                                            |       |                   |        |                   |       |   |   |   |   |
| Net loss, as reported                                                                                           |       | $                      | (10,532,943 | )                      | $          | (13,954,570 | ) | $ | (29,054,515 | ) | $ | (42,961,241 | ) |
| Add stock-based employee compensation expense included in reported  net loss(1)                                 |       | 80,652                 |        | 103,187                |       | 233,077 |   | 303,070 |   |
| Deduct total stock-based employee compensation expense determined  under fair-value-based method for all awards |       | (315,358               | )           | (2,237,636             | )          | (712,859 | ) | (6,278,036 | ) |
| Pro forma net loss                                                                                              |       | $                      | (10,767,649 | )                      | $          | (16,089,019 | ) | $ | (29,534,297 | ) | $ | (48,936,207 | ) |
|                                                                                                            |       |                   |        |                   |       |   |   |   |   |
| Basic and diluted loss per share of common stock                                                                |       |                   |        |                   |       |   |   |   |   |
| As reported                                                                                                     |       | $                      | (0.45       | )                      | $          | (0.60 | ) | $ | (1.23 | ) | $ | (1.88 | ) |
| Pro forma                                                                                                       |       | $                      | (0.46       | )                      | $          | (0.69 | ) | $ | (1.25 | ) | $ | (2.14 | ) |

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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.

 

**Note4  Cash Equivalents and Investments**

The Company considers allhighly liquid investments purchased with an original maturity of three monthsor less to be cash equivalents. Included with cash are cash equivalents of$39,545,839 and $62,919,437 as of September 30, 2005 and December 31 2004,respectively. The carrying value of these investments approximates their fairmarket value due to their short maturity and liquidity.

**Note 5Inventory**

Inventory is comprisedsolely of finished goods associated with NeoPhectin and is stated at the lowerof cost or market, as determined by the first in, first out method (“FIFO”).  Inventory cost consists of direct materialand direct labor costs.  Since productsare currently produced in the Company’s research and development facilities,the Company has not allocated any overhead costs as a product cost.  Application of overhead as a product cost isnot material.

 Inventory at September 30, 2005 and December31, 2004 consisted of the following:
| ** **                   | ** ** | **September 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|------------------------------|------------|------------------------|------------|-----------------------|------------|
|                         |       |                   |       |                  |       |
| Finished goods on hand       |       | $                      | 4,368      |                  | $          | 5,413 |   |
| Inventory subject to  return |       | —                 |       | 323                   |       |
|                         |       | $                      | 4,368      |                  | $          | 5,736 |   |

 

Inventory subject to returnrepresents NeoPhectin products shipped to wholesale customers that have notbeen recognized as revenue.

 

7

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**Note6  Fixed Assets**

Fixed assets are recordedat cost and are depreciated using the straight line method over their estimateduseful lives. Maintenance and repairs that do not extend the life of assets arecharged to expense when incurred. When properties are disposed of, the relatedcosts and accumulated depreciation are removed from the accounts and any gainor loss is reported in the period the disposition takes place. Totaldepreciation and amortization expense for the three months ended September 30,2005 and 2004, was $303,195 and $327,721, respectively.  Total depreciation and amortization expense forthe nine months ended September 30, 2005 and 2004 was $983,291 and $1,006,620,respectively.

Long-lived assets arereviewed for impairment whenever events or changes in circumstances indicatethe carrying amount of an asset may not be recoverable. Recoverability ofassets to be held and used is measured by a comparison of the carrying amountof an asset to estimated undiscounted cash flows expected to be generated bythe asset. If the carrying amount of an asset exceeds its estimated future cashflows, an impairment charge is recognized by the amount by which the carryingamount of the asset exceeds the fair value of the asset.

**Note7  Stockholders’ Equity**

 

The Company maintains aStockholder Rights Plan whereby rights to purchase shares of Series A ParticipatingPreferred Stock become exercisable by the Company’s stockholders after anynon-excluded party acquires, or announces an intention to acquire, 15% or moreof the Company’s outstanding common stock.

 

On January 27, 2004, theCompany received proceeds of $73,980,938 (net of underwriting discounts andcommissions of $4,722,188, but before expenses of $507,990) by issuing4,312,500 shares of common stock in a public offering.

 

**Note 8Revenue Recognition**

 

The Company recognizesrevenue when persuasive evidence of an arrangement exists, delivery hasoccurred or services have been rendered, the price is fixed or determinable,and collectibility is reasonably assured.

For product sales notsubject to rights of return, the Company recognizes revenue upon shipment astitle and risk of loss has passed to the customer. For product sales subject torights of return, the Company recognizes revenue upon shipment when it canreasonably estimate the level of returns at the time of shipment. Given thelimited sales history of its products, the Company is currently unable toreasonably estimate the level of returns at the time of shipment. Accordingly,revenue related to shipments to distributors that have been granted a right ofreturn is currently being recognized when the right of return has expired,which occurs upon the earlier of shipment of the product by the distributor toan end user or expiration of the right of return, which is 60-180 daysdepending upon the distributor. The Company warrants its products in a mannerconsistent with industry standards and has not incurred any warranty costsrelated to the sale of NeoPhectin.

The Company enters intocollaboration and technology licensing arrangements, which contain multipledeliverables. Under the provisions of Emerging Issues Task Force (“EITF”) IssueNo. 00-21, *Accounting for RevenueArrangements with Multiple Deliverables*, the Company evaluateswhether these deliverables constitute separate units of accounting to whichtotal arrangement consideration is allocated. A deliverable qualifies as aseparate unit of accounting when the item delivered to the customer hasstandalone value, there is objective and reliable evidence of fair value ofitems that have not been delivered to the customer, and, if there is a generalright of return for the items delivered to the customer, delivery orperformance of the undelivered items is considered probable and substantiallyin the control of the Company. Arrangement consideration is allocated to unitsof accounting on a relative fair basis or the residual method if the Company isunable to determine the fair value of all deliverables in the arrangement.Consideration allocated to a unit of accounting is limited to the amount thatis not contingent upon future performance by the Company. Upon determination ofseparate units of accounting and allocated consideration, the general criteriafor revenue recognition are applied to each unit of accounting. In instanceswhere an arrangement provides for up-front non-refundable payments that are nototherwise allocated to a unit of accounting, the Company recognizes thesepayments ratably over the term of the contract or expected period ofperformance, whichever is longer.

TheCompany has entered into collaboration and license agreements with thirdparties.  The terms of one of itscollaboration agreements provided for an upfront nonrefundable payment to theCompany of $150,000 as well as an additional $350,000 upon delivery of acustomized formulation of NeoPhectin to the customer.  The Company delivered the customizedformulation in June 2005, and the Company has recognized the full contractamount as revenue.  The Company has alsoentered into an agreement with Nippon Kayaku Co., Ltd. (“Nippon”) in which thedevelopment and commercialization rights in Japan for cintredekin besudotox (“IL13-PE38QQR”)were licensed.  The Company received a $2million upfront nonrefundable fee in January 2005 and is entitled to receivefuture additional fees, milestone payments and royalties.  Nippon is responsible for all developmentcosts in Japan.  The Company has agreedto provide or arrange for contract manufacture of a commercial supply ofcintredekin besudotox upon receipt of marketing approval by Nippon.  The upfront nonrefundable fee received by theCompany will be recognized ratably as revenue once the general criteria forrevenue recognition have been met for the unit of accounting to which the feehas been allocated.

 

8

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**Note 9Loss Per Share**

 

The following table setsforth the computation of basic and diluted net loss per share:

 
| ** **                          | ** ** | **Three months ended** | ** **  | **Nine months ended**  | ** ** |
|-------------------------------------|------------|------------------------|-------------|------------------------|------------|
| ** **                          | ** ** | **September 30, 2005** | ** **  | **September 30, 2004** | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** |
| Numerator:                          |       |                   |        |                   |       |   |   |   |   |
| Net loss                            |       | $                      | (10,532,943 | )                      | $          | (13,954,570 | ) | $ | (29,054,515 | ) | $ | (42,961,241 | ) |
|                                |       |                   |        |                   |       |   |   |   |   |
| Denominator:                        |       |                   |        |                   |       |   |   |   |   |
| Weighted average shares outstanding |       | 23,640,393             |        | 23,284,925             |       | 23,557,757 |   | 22,815,559 |   |
|                                |       |                   |        |                   |       |   |   |   |   |
| Loss per share - basic and diluted  |       | $                      | (0.45       | )                      | $          | (0.60 | ) | $ | (1.23 | ) | $ | (1.88 | ) |
|                                |       |                   |        |                   |       |   |   |   |   |
| Potential common share equivalents: |       |                   |        |                   |       |   |   |   |   |
| Stock options                       |       | 3,499,387              |        | 3,715,020              |       | 3,393,307 |   | 3,606,729 |   |
|                                     |            |                        |             |                        |            |  |  |  |  |  |  |  |  |  |  |

As the Company has incurred a net loss for all periods presented, basicand diluted per share amounts are the same, since the effect of all potentialcommon share equivalents is anti-dilutive.

 

**Note 10  Transactions with Related Parties**

The following tableprovides further information about related party expenses reflected in thecondensed consolidated statements of operations.
| ** **                   | ** ** | ** **       | ** ** | **Three months ended** | ** ** | **Nine months ended**  | ** ** |
|------------------------------|------------|------------------|------------|------------------------|------------|------------------------|------------|
| **Related Party**            | ** ** | **Expense Type** | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** |
| Akorn, Inc.                  |       | Consulting       |       | $                      | —     |                   | $          | — |   | $ | — |   | $ | 6,250 |   |
| E.J. Financial Enterprises   |       | Consulting       |       | —                 |       | —                 |       | — |   | 62,500 |   |
| E.J. Financial Enterprises   |       | Direct Expenses  |       | —                 |       | —                 |       | — |   | 620 |   |
| Total related party expenses |       |             |       | $                      | —     |                   | $          | — |   | $ | — |   | $ | 69,370 |   |

 

Prior to June 30, 2004,the Company received management consulting services from EJ Financial Enterprises, Inc.(“EJ Financial”), a healthcare consulting and investment firm in which John N.Kapoor, Ph.D., (“Dr. Kapoor”) a member of the Company’s Board of Directors andthe Company’s former Chairman of the Board of Directors, and a significantstockholder of the Company, is the sole stockholder. The consulting agreementwith EJ Financial expired on June 30, 2004 and was not renewed.

The Company had enteredinto a consulting agreement with an individual who is also an employee ofAkorn, Inc., a Louisiana corporation (“Akorn”).  Dr. Kapoor is also the Chairman of the AkornBoard of Directors, and a substantial stockholder in both Companies. Theconsulting agreement was terminated in 2004.

In December 2001, NeoPharm entered into a transaction wherebyNeoPharm loaned to Akorn, $3,250,000 to assist Akorn in the completion of itslyophilized products manufacturing facility in Decatur, Illinois. In connectionwith the loan transaction, NeoPharm entered into the following agreements:Promissory Note, dated December 20, 2001, in the original principal amountof $3,250,000 by Akorn to NeoPharm; Processing Agreement, datedDecember 20, 2001, by and between Akorn and NeoPharm; Subordination andIntercreditor Agreement, dated December 20, 2001, by and between John N. Kapoor,as Trustee 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 granted 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 

 

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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 equal that to becharged by the new senior lender, which was 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 until October 2004 to provide the required manufacturingrights and to subordinate Akorn’s indebtedness to NeoPharm to Akorn’sindebtedness to its new senior lender. Akorn’s refinancing was completed onOctober 7, 2003. On October 6, 2004, NeoPharm presented Akorn, with aformal “Notice of Default” on the Amended and Restated Promissory Noteresulting from Akorn’s failure to meet its obligations under the ProcessingAgreement. Because the carrying value of the Promissory Note was zero, therewas no financial impact as a result of any event of default under, ornon-payment of, the Promissory Note.  OnMay 16, 2005, the Company and Akorn entered into a Note Repayment Agreement (“RepaymentAgreement”) whereby the Company agreed to accept $2,500,000 as payment in fullfor all outstanding principal and interest due and owing under the PromissoryNote, which has been paid.  In addition,the parties mutually agreed to terminate the Processing Agreement.  As a result of the Repayment Agreement, theCompany recorded a $2,500,000 benefit which was recorded as “Recovery of NoteReceivable” on the Company’s unaudited Condensed Consolidated Statement ofOperations for the nine months ended September 30, 2005.

**Note 11Employee Termination Benefits**

In an effort to decreaseexpenses, the Company reduced its workforce by a total of 30 employees(approximately 23%) in November 2004, consisting of 26 employees from itsresearch and development groups and 4 employees from the administrative group.Terminated employees were eligible to receive salary continuation through December 31,2004, severance, 2004 earned bonus, Company paid insurance benefits andoutplacement services. All $1,149,277 of employee termination costs wereexpensed in 2004 and no additional amounts were expensed in 2005.  The $760,759 accrued as of December 31, 2004was paid during the first quarter of 2005.

**Note 12 Commitments**

On April 25, 2005,the Company and Mr. Ronald G. Eidell, a director of the Company, finalizedan employment agreement (“Employment Agreement”) under which Mr. Eidell isemployed, on an interim basis, as the Company’s President and Chief ExecutiveOfficer (“CEO”).  Mr. Eidell had been serving as President and CEOsince March 8, 2005 under a principal terms employment agreement (PTA)executed between the Company and Mr. Eidell on March 10, 2005, whichhas now been superceded by the terms of the Employment Agreement.  Under the Employment Agreement,Mr. Eidell will receive a base salary of $260,000.  Under the PTA,Mr. Eidell had agreed to a base salary of $325,000, subject, however, tothe Company entering into a separate agreement with Tatum CFO Partners LLP (“Tatum”),of which Mr. Eidell continues to be a partner, providing for up to 20% ofMr. Eidell’s base salary and bonus, if any, to be remitted to Tatum. Under the terms of an agreement entered into with Tatum, an annualized amountof $65,000, prorated for the period of Mr. Eidell’s employment by theCompany, is to be paid to Tatum.  The amount of the Tatum payment has beendeducted from the PTA base salary figure of $325,000, resulting in the new basesalary of $260,000 for Mr. Eidell under the Employment Agreement. Additionally, Mr. Eidell is entitled to an annual performance-based milestonebonus payment, of which 20% would be payable to Tatum, as per the Tatumagreement, and a monthly transportation allowance of $1,500.  On March 10, 2005, Mr. Eidell received astock option grant of 80,000 shares at an exercise price equal to the closingprice of the Company’s stock on that date. The stock options shall vest at the earlier of the termination of theEmployment Agreement as a result of Mr. Eidell’s resignation to allow a newpermanent CEO to take office or one year from the date of grant.

On June 17, 2004,NeoPharm entered into an Employment Agreement with Gregory P. Young to serve asthe Company’s President, Chief Executive Officer and a director. Mr. Youngresigned as the Company’s President and CEO, and as a director, onMarch 8, 2005, and the Company entered into a Separation Agreement andFull Release of All Claims (the “Separation Agreement”) with Mr. Young. Underthe terms of the Separation Agreement, Mr. Young is eligible to receive asalary continuance for 12 months based upon his annual base salary at the timeof his resignation ($325,000) and Company paid insurance premiums under theCompany’s medical insurance plan. The salary continuance and medical insurancepremium payments, but not the other provisions of the Separation Agreement,including but not limited to, the restrictive covenants contained therein,cease at such time as Mr. Young accepts full-time employment or the firstdate that Mr. Young provides consulting or other services to certain othercompeting pharmaceutical or biotechnology organizations, other than acharitable entity. The Company was notified in August 2005 that Mr. Youngaccepted a full-time position.  As aresult, the Company reversed $197,609 of salary continuance and medicalinsurance premium expense previously recorded, as outlined under the terms ofthe Separation Agreement.  Additionally,Mr. Young continues to serve as a consultant to the Company until March11, 2006 or upon the termination of the Separation Agreement, whichever isearlier.  During the consulting period,options previously granted to Mr. Young continue to vest and remainexercisable until 90 days after termination of his consulting duties. While62,500 options have vested during the consulting period to date, no additionaloptions are scheduled to vest prior to the termination of Mr. Young’sconsulting duties and all unvested options previously granted to Mr. Youngare expected to be

 

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forfeited.  For the three and nine months ended September30, 2005, the Company recorded compensation expense of $26,772 and $236,125,respectively, relating to the options granted to Mr. Young that have vestedduring the period of his serving as a consultant to the Company.

On June 17, 2004,James M. Hussey resigned as the Company’s President, Chief Executive Officerand a member of the Board of Directors. In accepting Mr. Hussey’sresignation, the Board of Directors authorized the Company to enter into aSeparation Agreement and Full Release of all Claims (the “Hussey Agreement”)with Mr. Hussey. Under the terms of the Hussey Agreement, Mr. Husseywas scheduled to receive a salary continuance for 12 months based upon hisannual base salary at the time of his resignation ($339,768), Company paidinsurance premiums under the Company’s medical insurance plan, plus a paymentof 50% of Mr. Hussey’s target milestone bonus when 2004 bonuses are paidto the Company’s employees. 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 competing pharmaceutical or biotechnology organizations.Additionally, Mr. Hussey agreed to serve as a consultant to the Companyfor a period of up to 24 months or upon the termination of the HusseyAgreement, whichever is earlier, during which time all options previouslygranted to Mr. Hussey continue to vest and remain exercisable until 90days after termination as a consultant. All compensation expense associatedwith these options was recorded in 2004 due to the acceleration of vesting thatoccurred upon the execution of the Hussey Agreement. On March 11, 2005, theCompany entered into an amendment to the Hussey Agreement in which Mr. Husseyagreed to accept the Company’s common stock as consideration in lieu of allremaining cash payments due to him under the Hussey Agreement. As of March 10,2005, the effective date of the amendment, Mr. Hussey was owed $188,353, whichrepresented, at the closing price of the Company’s common stock on March 10,2005, 23,692 shares of the Company’s common stock, which shares were issued toMr. Hussey. Mr. Hussey will continue to provide consulting services to theCompany until June 17, 2006.

**Note13  Contingencies**

The Company has beennamed in several putative class action lawsuits (the “Class Action Suits”) eachof which alleges various violations of the federal securities laws inconnection with the Company’s public statements during the period fromSeptember 25, 2000 through April 19, 2002 as they relate to theCompany’s LEP drug product candidate. The original lawsuits also named asindividual defendants John N. Kapoor, former Chairman of the Company, and JamesM. Hussey, the Company’s former President and CEO, and Dr. Aquilur Rahman,a former director and executive officer of the Company. The first of theseClass Action Suits was filed on April 26, 2002 and all of the Class ActionSuits have been filed in the United States District Court for the NorthernDistrict of Illinois, Eastern District. 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. Dr. Kapoor was dismissed from the lawsuit at thattime. In November 2004, the plaintiffs filed a motion to amend and a motion forsummary adjudication. The motion to amend seeks to again make Dr. Kapoor adefendant, and realleges that certain pre-class period statements areactionable. The Company has opposed both motions.  No trial date has been set and discovery isongoing. Management is unable to estimate the potential outcome or a range ofpossible losses, if any.  In addition,the Company maintains insurance coverage to mitigate the financial impact ofany potential loss.

 

OnMarch 26, 2004, the Company received a letter from the Securities and ExchangeCommission (“SEC”) stating that the SEC is conducting a formal investigation ofthe Company.  The SEC stated in itsletter that it has made no determination of any violation of law by the Companyor any individual at this time.  Previously,this matter had been the subject of an informal SEC inquiry.  The Company continues to fully cooperate withthe SEC and intends to continue to do so in order to bring the inquiry to aconclusion as promptly as possible.  TheCompany believes the investigation is an outgrowth of the arbitration claimfiled by the Company against Pharmacia (now Pfizer) regarding the developmentof its LEP and LED drug product candidates and the Class Action Suits whichhave been filed against the Company relating to its public statements regardingthe development of LEP.  The Companycannot predict with certainty the direction the investigation will take or itsultimate outcome, and therefore is unable to determine whether the results ofthe investigation will have a material adverse impact on the Company’s resultsof operations or financial position.

 

The pharmaceuticalindustry has traditionally experienced difficulty in maintaining productliability insurance coverage at desired levels. To date, no significant productliability suit has ever been filed against the Company. However, if a suit werefiled and a judgment entered against the Company, it could have a materialadverse effect upon the Company’s operations and financial position. While theCompany maintains insurance to cover the use of its drug product candidates inclinical trials, the Company does not maintain insurance covering the sale ofits drug product candidates nor is there any assurance that it will be able toobtain or maintain such insurance on acceptable terms or with adequate coverageagainst potential liabilities.

 

**Note 14Subsequent Events**

 

On October 28, 2005,NeoPharm entered into an Employment Agreement with Guillermo A. Herrera toserve as the Company’s

 

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President, ChiefExecutive Officer and a member of the Board of Directors.  Under the terms of his Employment Agreement,Mr. Herrera will receive an annual base salary of $425,000 and a grant ofshares of the Company’s common stock, at the time of hire, equal to a totalfair market value of $200,000 based upon the closing share price as of October28, 2005.  Mr. Herrera is also eligiblefor an annual performance-based bonus payment and receives a monthly carallowance of $1,000.  Additionally, Mr.Herrera will receive a common stock option grant of 500,000 options with a grantprice equal to the fair market value on the date of grant.  The options vest in four equal annualinstallments on the anniversary of the option grant date.

 

On October 28, 2005, Mr.Ronald Eidell resigned as interim President and CEO to allow Mr. Herrera totake office as President and CEO.  Inaccordance with the terms of Mr. Eidell’s Employment Agreement, a $96,000performance based bonus will be paid to him. In addition, under the terms of an agreement between the Company andTatum, of which Mr. Eidell is a partner, the Company will pay $24,000 to Tatumupon making the bonus payment to Mr. Eidell. Additionally, 80,000 options, previously granted to Mr. Eidell, will nowbe exercisable pursuant to the original terms of the option grant.  Mr. Eidell will remain a member of the Boardof Directors and will serve on the Audit Committee, as a non-independent memberof the Audit Committee.

** **

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**Item 2****- Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

Anystatements made by NeoPharm, Inc. (“we”, “us”, “our”, or the “Company”) in thisquarterly report that are forward looking are made pursuant to the safe harborprovisions of the Private 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, recruitment of patients,production and marketing of the Company’s drug candidates, including, but notlimited to cintredekin besudotox (“IL13-PE38QQR”), including the PRECISE trial,the marketing 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, unexpected adverse sideeffects or inadequate therapeutic efficacy of the Company’s drug candidatesthat could slow or prevent products coming to market, the uncertainty of patentprotection for the Company’s intellectual property or trade secrets, theability of the Company to raise additional funds on terms acceptable to theCompany and other factors referenced under “Risk Factors” in the Company’sAnnual Report on Form 10-K and Amendment No. 1 filed on Form 10-K/A for the fiscal year ended December 31, 2004.

 

The following should beread in conjunction with the financial statements and related notes andManagement’s Discussion and Analysis of Financial Condition and Results ofOperations and the Risk Factors section included in the Company’s 2004 AnnualReport on Form 10-K and Amendment No. 1 filed on Form 10-K/A.  The results discussed below are notnecessarily indicative of the results to be expected in any futureperiods.  The following discussion containsforward-looking statements that are subject to risks and uncertainties, whichcould cause actual results to differ from statements made.

 

**Overview**

 

We are abiopharmaceutical 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 94 full time employees as ofSeptember 30, 2005.  Our corporateheadquarters and research and development facility are located in Waukegan,Illinois and our clinical development personnel are located in Lake Forest,Illinois.

 

Since we began doingbusiness in June 1990, we have devoted our resources primarily to fundingresearch and product development programs. To date, we have not received Foodand Drug Administration (“FDA”) approval of any of our drug productcandidates.  We expect to continue toincur losses for the foreseeable future as we continue our research anddevelopment 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, collaborating withthird parties to develop formulations of their compounds using our technology,or selling Company issued securities.

 

In the quarter endedSeptember 30, 2005, management’s efforts were primarily devoted to overseeingthe Phase III PRECISE clinical trial for our lead drug product candidate,cintredekin besudotox (IL13-PE38QQR), advancing our NeoLipid drug productcandidates (LEP-ETU, LE-SN38, and LErafAON) through the clinical developmentprocess, engaging potential partners in discussions pertaining to potentiallicensing of our drug product candidates, and exploring potential opportunitiesto reduce expenses in an effort to reduce the amount of cash used in operations.

 

Ourlead drug product candidate, cintredekin besudotox, is currently in a Phase IIIclinical trial (the “PRECISE trial”) for the treatment of glioblastomamultiforme (“GBM”) at first recurrence.  Cintredekin besudotox is a fusion protein comprised of Interleukin-13(“IL13”) as the targeting mechanism and Pseudomonas Exotoxin A (“PEA”) as thecytotoxin. This treatment is highly selective for malignant glioma cells sincethese tumors express a high number of receptors for IL13 while normal braintissue elements have minimal to no detectable IL13 binding.  To date, cintredekin besudotox has receivedorphan drug status (which provides extended marketing exclusivity) in both theU.S. and Europe, fast track designation (which facilitate development andexpedite review of new drug compounds) in the U.S., and was included by the FDAas the oncologic biologic therapeutic in the Continuous Marketing Application(“CMA”) Pilot 2 Program, where the FDA and fast track drug applicants enterinto an agreement to engage in frequent scientific feedback and interactions.

 

Webegan enrolling patients in the PRECISE trial in March 2004 and, as ofOctober 31, 2005, 277 patients have been enrolled. In June 2005, theindependent Data Monitoring Committee responsible for overseeing our PRECISEtrial met, analyzed, and reviewed the data for the trial’s first futilityanalysis and recommended that the PRECISE trial continue as planned.  If current enrollment rates continue, weanticipate the completion of enrollment (up to 300 patients total) for PRECISEin 2005 and, assuming a favorable trial result, the submission of a Biologics LicenseApplication (“BLA”) with the FDA in 2006 seeking marketing approval of thedrug. However, there can be no assurance the trial will meet its endpoint inthe time anticipated, that the FDA will approve the BLA or that the FDA willnot require additional data or testing. Assuming that we receive authorizationto begin selling cintredekin besudotox, we currently anticipate the first salesof the product in 2007.  Enrollment alsocontinues in our Phase I clinical trial of cintredekin besudotox for malignantglioma patients at initial diagnosis.

 

   During the quarter ended September 30, 2005,we completed our bioequivalence study of LEP-ETU and bioequivalence topaclitaxel (Taxol®) was demonstrated. The clinical program of LEP-ETU will be accelerated to support a505(b)(2) New Drug application (“NDA”) submission to the FDA.  Preparations are being finalized for a100-patient comparator study in metastatic breast cancer for which we expect tocommence enrollment in the first quarter of 2006.  Additionally, we continued our efforts incollaboration with Cancer and Leukemia Group B (“CALGB”), a national oncologyclinical research group sponsored by the U.S. National Cancer Institute (“NCI”)

 

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to begin a Phase IIclinical trial for LE-SN38 for patients suffering from recurrent metastaticcolorectal cancer, which is expected by CALGB to obtain final NCI and FDAapprovals, later in 2005. We also continued enrollment in our Phase I clinicaltrial of our LErafAON drug product candidate, with completion of enrollmentdependent on the number of dose levels studied.

 

It is difficult topredict with any certainty the timing of and total estimated costs to completedevelopment of drug product candidates in early stage, or Phase I/II, 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, but not limited to: side effects encountered inearly stage clinical trials, ability to scale up manufacturing for commercialsupply, and the fact that the size and scope of pivotal Phase III clinicaltrials are unknown until sufficient data is available to present a Phase IIIplan to the FDA for approval. In addition, our drug product candidates arerequired to be approved by the FDA after completing Phase III clinical trialsbefore we can sell the drugs to generate revenue and, potentially, realize netcash inflows. Because our lead drug product candidate, cintredekin besudotox,has entered a Phase III clinical trial, we are able to estimate that we willincur further direct expenses of approximately $8 million to complete thePhase III PRECISE study. Additional Phase I and Phase II expenses will also beincurred for cintredekin besudotox as we are conducting other clinical trialsto investigate the potential of cintredekin besudotox in other stages ofglioblastoma multiforme, such as initial diagnosis, in addition to recurrentglioblastoma multiforme.  Furthermore,additional expense will need to be incurred to file a BLA to complete ourefforts to commercialize cintredekin besudotox.

 

The table below includesa summary of identified direct project costs incurred to date for our majorresearch and development projects. Generally, identified project costs includeexpenses incurred specifically for clinical trials and pre-clinical studies weconduct, and exclude expenses incurred for salaries paid to our professionalstaff, overhead expenses for our Lake Forest and Waukegan facilities and generallaboratory supplies used in our research, which are included as non-projectspecific.

 
| **Research Project**                    | ** ** | **Costs Incurred in  Current Quarter** | ** ** | **Costs Incurred Year to Date** | ** ** | **Total Costs  Incurred Since  Beginning of Project** | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|---------------------------------|------------|-------------------------------------------------------|------------|
| Cintredekin besudotox                   |       | $                                      | 4,621,694  |                            | $          | 12,245,662                                            |       | $ | 51,216,269 |   |
| LEP-ETU                                 |       | 747,974                                |       | 2,232,937                       |       | 6,256,312                                             |       |
| LE-SN38                                 |       | 146,933                                |       | 476,776                         |       | 4,944,366                                             |       |
| LErafAON                                |       | 43,791                                 |       | 268,634                         |       | 7,701,239                                             |       |
| Non-project specific                    |       | 2,977,976                              |       | 9,349,035                       |       | N/A                                                   |       |
| Total research and development expenses |       | $                                      | 8,538,368  |                            | $          | 24,573,044                                            |       | N/A |   |
|                                         |            |                                        |            |                                 |            |                                                       |            |  |  |  |

 

In order to decreaseexpenses, we reduced our workforce by a total of 30 employees (approximately23%) in November 2004, consisting of 26 employees from our research anddevelopment groups and 4 employees from our selling, general, andadministrative group. Terminated employees were eligible to receive continuedsalary and insurance benefits through December 31, 2004 (the terminationdate), 2004 earned bonus payable in February 2005 (contingent on Board ofDirectors’ approval of the 2004 bonus pool, which was subsequently given), twomonths severance pay in 2005, two months of Company paid medical insurancepremiums paid in 2005, and outplacement services.

We successfully completednegotiations on two collaborations in December 2004. The firstcollaboration resulted in 2005 revenue of $500,000 as we provided a customizedNeoPhectin formulation to our customer, a privately held biotechnology company,of their proprietary compound. The collaboration allows us to negotiate alicense agreement for any customized formulation using our NeoPhectintechnology that may be developed commercially. Additionally, we entered into anexclusive license agreement with Nippon Kayaku Co., Ltd. (“Nippon”) for theJapanese development rights for cintredekin besudotox. In addition to the $2million up-front licensing fee we received in January 2005, we have alsocontracted to receive future additional license fees, milestone payments androyalties. Nippon is responsible for all development costs in Japan.

On October 31,2005, we announced the appointment of Guillermo A. Herrera as our new Presidentand CEO and the resignation of Ronald G. Eidell as interim President and CEO toallow Mr. Herrera to take office.  Mr. Eidellwill remain as a member of the Board of Directors and will serve on the AuditCommittee, as a non-independent member of the Audit Committee.

In addition to ourongoing efforts to enter into additional collaborations, we continue to monitorand analyze our expenses in an effort to further reduce our net loss. Wecurrently estimate that the fiscal year 2005 net loss will be between $37 and$38 million, or $1.57 to $1.61 per share, and we now expect that cash used inoperations will be less than $34 million for 2005. This compares to our fiscalyear 2004 net loss of approximately $57.6 million, or $2.51 per share, and cashused in operations of approximately $52.2 million.

 

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**Results of Operations — Three Months EndedSeptember 30, 2005 vs. Three Months Ended September 30, 2004.**

 

The Company recorded product revenue of $9,480 for thethree months ended September 30, 2005 as compared to $84,740 for the threemonths ended September 30, 2004.  Thesole source of product revenue in both periods was from sales of NeoPhectin andNeoPhectin-AT.  No collaboration revenuewas recognized in the three months ended September 30, 2005 and 2004.

 

Research and developmentexpense for the three months ended September 30, 2005 decreased byapproximately $2.1 million as compared to the same period in 2004. The decreasein research and development expenses was primarily related to a reduction inthe number of clinical trials being conducted by the Company in 2005, resultingin a reduction in expenses of approximately $0.6 million, reduced research anddevelopment payroll related expenses of approximately $1.3 million primarilyresulting from the 2004 workforce reduction, and a reduction of approximately$0.2 million in expenses related to non-project specific research.

Selling, general, andadministrative expenses were approximately $2.4 million for the three monthsended September 30, 2005 and $3.7 million for the three months ended September30, 2004.  The decrease was primarily dueto $0.3 reduced compensation and severance related costs for former CEOs JamesHussey and Gregory Young, lower legal expenses of $0.6 million, principally dueto a consent solicitation initiated by Dr. Kapoor, former Chairman and acurrent board member initiated in 2004, and $0.4 million reduction of stockcompensation expense in 2005 for former CEO, James Hussey, for options thatremained exercisable while he provided consulting services to NeoPharm.

 

The Company generatedinterest income on cash and investments of approximately $0.4 million and $0.3million for the three months ended September 30, 2005 and 2004,respectively.  The increase in interestincome during the period was primarily due to increases in short-term interestrates offset by the decline in average cash and cash equivalents.

 

**Results of Operations — NineMonths Ended September 30, 2005 vs. Nine Months Ended September 30, 2004.**

The Company recordedproduct revenue of $35,380 for the nine months ended September 30, 2005 ascompared to $116,020 for the nine months ended September 30, 2004.  The sole source of product revenue in bothperiods was from sales of NeoPhectin and NeoPhectin-AT.  During the nine months ended September 30,2005, we also recognized a total of $500,000 of revenue related tocollaboration fees earned in 2005 for a customized NeoPhectin formulation.  No collaboration revenue was recognized in2004.

Research and developmentexpense for the nine months ended September 30, 2005 decreased by approximately$9.3 million as compared to the same period in 2004. The decrease in researchand development expenses was primarily related to a reduction in the number ofclinical trials being conducted by the Company in 2005, resulting in areduction in expenses of approximately $4.0 million, reduced research anddevelopment payroll related expenses of approximately $3.0 million primarilyresulting from the 2004 workforce reduction, and a reduction of approximately$2.3 million in expenses related to non-project specific research.

Selling, general, andadministrative expenses were approximately $8.7 million for the nine monthsended September 30, 2005 and $9.9 million for the nine months ended September30, 2004.  The reduction in selling,general and administrative expenses during the period was due to a $1.6 millionreduction in legal and accounting expenses principally due to the conclusion ofour arbitration case against Pharmacia (now Pfizer) in 2004 and legal feesassociated with the consent solicitation filed by Dr. Kapoor, former Chairmanof the Board of Directors and a current director initiated in 2004 and to alesser extent decreased accounting costs associated with regulatory compliance,offset by a $0.4 million increase for product licensing milestone payments.

 

On May 16, 2005, NeoPharmaccepted $2.5 million as payment in full for all outstanding principal andinterest due and owing on a promissory note that had previously been determinedto be impaired.  As a result of thepayment, a $2.5 million benefit was recorded as Recovery of Note Receivable.

 

The Company generatedinterest income on cash and investments of approximately $1.2 million and $0.8million for the nine months ended September 30, 2005 and 2004,respectively.  The increase in interestincome in 2005 was primarily due to increases in short-term interest ratesoffset by the decline in average cash and cash equivalents.

 

**Liquidity and Capital Resources**

 

As of September 30, 2005, the Company had$40,105,417 in cash and cash equivalents. While the Company believes that its current cash and cash equivalents,will be sufficient to meet its anticipated cash needs for working capital,capital expenditures and other activities into the fourth quarter of 2006, inorder for the Company to meet its liquidity needs through late 2006 and beyond,the Company will have to obtain additional capital.  While the Company has made no decision as towhat course of action it will pursue to meet its liquidity needs, the optionsavailable to the Company, include, but are not limited to, one or a combinationof, the following: consummate additional product licensing arrangements, delayor halt its clinical development process, further reduce its operatingexpenses, and/or raise additional capital through issuance of equity or debtsecurities.

 

Additional financing may not be available when neededor on terms acceptable to the Company. Currently, the Company has the ability to issue approximately $46million of equity securities, plus permitted increases, via a shelfregistration, the expiration of which was recently extended untilDecember 1, 2008, however, use of the shelf registration is conditioned onthe Company’s timely filing of all required documents with the SEC.

 

In January 2004, we received approximately$73.5 million, after underwriting fees and expenses, through the sale ofcommon stock via a shelf registration.

 

The primary use of cash over the next 15 months willbe to fund our clinical and pre-clinical research and development efforts andcommercialization of cintredekin besudotox. The most significant expenses willbe incurred in relation to the PRECISE trial for our brain tumor drug productcandidate, cintredekin besudotox. At the present time, we expect to spendapproximately $8 million over the next 15 months to complete the PRECISE trial.Additional expenses are also expected to be incurred as we continue to move ourPhase I and Phase II drug product candidates towards, and potentially into,Phase II and Phase III clinical trials.

 

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NeoPharm has no debt, nocapital leases, no exposure to off-balance sheet arrangements, no specialpurpose entities, nor activities that include non-exchange-traded contractsaccounted for at fair value.

 

The following tablesummarizes our estimated contractual obligations as of September 30, 2005:

 
| ** **                                           | ** ** | **Payments Due by Period** | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|
| **Contractual Obligations**                          | ** ** | **Total**                  | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than  5 years** | ** ** |
| Operating lease                                      |       | $                          | 1,111,015  |   | $ | 448,699 |   | $ | 662,316 |   | $ | — |   | $ | — |   |
| Clinical trial monitoring (CRO) agreements (1)       |       | 1,426,274                  |       | 1,426,274 |   | — |   | — |   | — |   |
| License agreements—milestone based payments (2) |       | 2,350,000                  |       | 50,000 |   | 1,200,000 |   | — |   | 1,100,000 |   |
| Total                                                |       | $                          | 4,887,289  |   | $ | 1,924,973 |   | $ | 1,862,316 |   | $ | — |   | $ | 1,100,000 |   |
|                                                      |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)                                These amounts include only contractual obligationsfor direct expenses for the PRECISE trial, exclusive of clinical trial sitecosts for treating patients.

 

(2)                                These amounts do not include potentialsales-based royalty payments that may be required under the various licenseagreements.  Milestone based payment obligations are contingentupon successfully reaching objectively determinable stages in the developmentof drug product candidates. The Company has estimated the period the paymentmay be due, if at all, based upon its expectations of the timeline forcontinued successful development of the drug product candidates.

 

**CriticalAccounting Policies**

 

In preparing the Company’sfinancial statements in conformity with U.S. generally accepted accountingprinciples (“GAAP”), management must make a variety of decisions that impactthe reported amounts and related disclosures. Such decisions include theselection of the appropriate accounting principles to be applied, theassumptions on which to base accounting estimates, and the consistent applicationof those accounting principles. Due to the type of industry in which theCompany operates and the nature of its business, the following accountingpolicies are those that management believes are most important to the portrayalof the Company’s financial condition and results and that require management’smost difficult, subjective or complex judgments, often as a result of the needto make estimates about the effect of matters that are inherently uncertain.

 

*IncomeTaxes*

 

In assessing therealizability of deferred tax assets, management considers whether it is morelikely than not that some portion or all of the deferred tax assets will not berealized. The ultimate realization of deferred tax assets is dependent upon thegeneration of future taxable income during the periods in which those temporarydifferences become deductible. Management considers the scheduled reversal ofdeferred tax liabilities, projected future taxable income, and tax planningstrategies in making this assessment. Significant judgments are required toestimate the generation of future taxable income and the timing of the reversalof deferred tax liabilities.

 

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*Contingencies*

To properly account forand provide disclosure of loss contingencies, management must apply judgment indetermining whether a loss contingency is: probable, reasonably possible, orremote. In instances where management has determined that a loss contingency isprobable, it must make use of estimates to determine the amount of probableloss. Management must apply judgment in determining whether or not it can makea reasonable estimate. Management must also apply judgment in determiningwhether or not disclosure of loss contingencies that have been accrued shouldbe made for the consolidated financial statements not to be misleading.

*Stock-BasedCompensation*

 

The Company applies theintrinsic-value-based method of accounting prescribed by Accounting PrinciplesBoard (“APB”) Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related interpretations includingFASB Interpretation No. 44, *Accountingfor Certain Transactions Involving Stock Compensation, an Interpretation of APBOpinion No. 25*, issued in March 2000, to account for itsfixed-plan stock options. Under this method, compensation expense is measuredon the date of grant only if the current market price of the underlying stockexceeded the exercise price or when the number of shares and exercise price areknown if both are not determinable at the date of grant. Compensation expensefor fixed stock options is recognized ratably over the vesting period.  Statement of Financial Accounting Standards (“SFAS”)   No. 123, *Accounting for Stock-Based Compensation*, establishedaccounting and disclosure requirements using a fair value method of accountingfor stock-based employee compensation plans. As allowed by SFAS No. 123,the Company has elected to continue to apply the intrinsic value method ofaccounting described above, and has adopted only the disclosure requirements ofSFAS No. 123. Significant judgments are required in determining anappropriate method for determining the fair value of stock-based compensation.The Company has elected to utilize the Black-Scholes option-pricing model tomake the fair value determination. Inputs into the option-pricing model aresubject to estimation that may affect the determination of fair value.

*RevenueRecognition*

 

The Company follows theprovisions as set forth by current accounting rules, which primarily includeStaff Accounting Bulletin (“SAB”) 104, *RevenueRecognition,*and Emerging Issues Task Force (“EITF”) IssueNo. 00-21, *Accounting for RevenueArrangements with Multiple Deliverables.*Generally, revenue isrecognized when evidence of an arrangement exists, delivery has occurred orservices have been rendered, the price is fixed and determinable, andcollectibility is reasonably assured.

 

The Company provides forgeneral rights of return of products sold to its distributors.  Appropriately determining revenue recognitionwhen the general right of return exists requires the use of judgment inestimating the level of returns.  Incertain circumstances, management may not be able to develop a reasonableestimate of the level of returns.  Makingsuch a determination also requires the use of significant judgment.  Management has determined that given thelimited sales history of NeoPhectin, the Company is currently unable to developa reasonable estimate of the level of returns. Accordingly, the Company is currently recognizing revenue for productsshipped to its distributor upon the expiration of the right of return whichoccurs upon the earlier of shipment of product by the distributor to anend-user or, depending on the distributor, 60 to 180 days.

 

The Company has recentlyentered in collaboration and license agreements with third parties that containmultiple deliverables. Under the provisions of EITF Issue No. 00-21, adetermination must be made on each contract as to whether a deliverableconstitutes a separate unit of accounting. The amount of revenue to berecognized is based on the fair value for each unit of accounting within thearrangement. Management’s judgment is required to determine, based upon thefacts and circumstances of each arrangement, whether or not each deliverablehas standalone value and whether or not there exists a sufficient level ofobjective and reliable evidence of fair value of the undelivered items.  Additionally, units of accounting may bedelivered over an indeterminate period of time. Management judgment is requiredto estimate the period over which recognition of allocated revenue occurs.

 

**Item 3****— Quantitative and QualitativeDisclosures about Market Risk**

 

As of September 30,2005, we did not own any derivative instruments, but we were exposed to marketrisks, primarily changes in U.S. interest rates. As of September 30, 2005,we held total cash and cash equivalents of $40,105,417. All cash equivalentshave a maturity less than 90 days. Declines in interest rates over timewill reduce our interest income from our investments. Based upon our balance ofcash and cash equivalents as of September 30, 2005, a decrease in interestrates of 1.0% would cause a corresponding decrease in our annual interestincome of approximately $401,054.

 

 

**Item 4****— Controls and Procedures**

 

Asof September 30, 2005, we carried out an evaluation, under the supervisionand with the participation of our management,

 

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including our ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures. Based on thatevaluation, our management, including the Chief Executive Officer and ChiefFinancial Officer, concluded that our disclosure controls and procedures areoperating effectively as designed.

 

Therehave been no significant changes in our internal control over financialreporting that occurred during the period covered by this report that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**PART II -OTHER INFORMATION**

 

**Item 1 -Legal Proceedings**

 

The Company has beennamed in several putative class action lawsuits (the “Class Action Suits”) eachof which alleges various violations of the federal securities laws inconnection with the Company’s public statements during the period fromSeptember 25, 2000 through April 19, 2002 as they relate to theCompany’s LEP drug product candidate. The original lawsuits also named asindividual defendants John N. Kapoor, Chairman of the Company, and James M.Hussey, the Company’s former President and CEO, and Dr. Aquilur Rahman, aformer director and executive officer of the Company. The first of these ClassAction Suits was filed on April 26, 2002 and all of the Class Action Suitshave been filed in the United States District Court for the Northern Districtof Illinois, Eastern District. On September 16, 2002, a consolidated amendedcomplaint was filed against NeoPharm in this matter. The amended complaintshortened the class period to October 31, 2001 through April 19,2002, removed Dr. Rahman as a defendant, and added Dr. Imran Ahmad,the Company’s current Chief Scientific Officer and Executive Vice President ofResearch and Development, as a defendant. The Company intends to vigorouslydefend each and every claim in the class action suits and, on November 4,2002, moved to have the complaint dismissed. The Company’s motion to dismisswas granted in part and denied in part in February 2003. Dr. Kapoorwas dismissed from the lawsuit at that time. In November 2004, the plaintiffsfiled a motion to amend and a motion for summary adjudication. The motion toamend seeks to again make Dr. Kapoor a defendant, and realleges that certainpre-class period statements are actionable. The Company has opposed bothmotions.  No trial date has been set anddiscovery is ongoing. Management is unable to estimate the potential outcome ora range of possible losses, if any.  Inaddition, the Company maintains insurance coverage to mitigate the financialimpact of any potential loss.

 

OnMarch 26, 2004, the Company received a letter from the Securities and ExchangeCommission (“SEC”) stating that the SEC is conducting a formal investigation ofthe Company.  The SEC stated in itsletter that it has made no determination of any violation of law by the Companyor any individual at this time.  Previously,this matter had been the subject of an informal SEC inquiry.  The Company continues to fully cooperate withthe SEC and intends to continue to do so in order to bring the inquiry to aconclusion as promptly as possible.  TheCompany believes the investigation is an outgrowth of the Company’s previouslyconcluded arbitration with Pharmacia (now Pfizer) regarding the development ofits LEP and LED drug product candidates and the class action lawsuits whichhave been filed against the Company relating to its public statements regardingthe development of LEP.  The Company cannotpredict with certainty the direction the investigation will take or itsultimate outcome, and therefore is unable to determine whether the results ofthe investigation will have a material adverse impact on the Company’s resultsof operations and financial position.

 

**Item 2.****                                                        ****Unregistered Sales of EquitySecurities and Use of Proceeds**

 

None

 

**Item 3.****                                                        ****Defaults Upon Senior Securities**

 

None

 

**Item 4.****                                                        ****Submission of Matters to a Voteof 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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**SIGNATUREPAGE**

 

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

 
|                   |     | NEOPHARM, INC.                                                                             |
|------------------------|----------|--------------------------------------------------------------------------------------------|
| Date: November 8, 2005 | By:      | /s/ Lawrence A. Kenyon                                                                     |
|                   |     | Lawrence A. Kenyon,                                                                        |
| * *               | * * | *Chief Financial Officer  (Principal Accounting Officer and  Principal Financial Officer)* |

 

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