UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION





Washington,
DC 20549


_____________________





FORM
10-K AMENDMENT 2





x
                  ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934For
      the Fiscal Year Ended December 31,
2005





OR





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





Commission
file number


______________________


AXM
PHARMA, INC.


(Exact
name of registrant as specified in its charter)





Nevada
                (State or jurisdiction of
                incorporation or organization)
              
              20-0745214
                (I.R.S. Employer
                Identification Number)US Representative Office
                17870 Castleton Street, Suite 255,
                City of Industry, CA 91728
                (Address of principal executive offices)
              
              10591
                (Zip Code)





(909)
843-6338


(909)
843-6350


(Registrant’s
telephone number and facsimile numbers, including area code)





Securities
registered pursuant to Section 12(b) of the Act:


Common
Stock — $.001 par value




Securities
registered pursuant to Section 12(g) of the Act:


Common
Stock—$.001 par value


Preferred
Stock Purchase Rights





Weishi
      Wang


PRESIDENT
      AND CHIEF EXECUTIVE OFFICER


20955
Pathfinder Road,


Suite
100


Diamond
Bar, CA 91765


(646)
393-4365


(Name,
address and telephone number of agent for service)





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Act of 1934 during the past12
months and (2) has been subject to such filing requirement for the past
90days.   Yes  x    No  o





Aggregate
market value of the voting stock held by non-affiliates of the registrant as of
April 13, 2006: $9,529,740








TABLE
OF CONTENTS





Page No.PART
      IItem
      1.
              Explanatory
      Note
              3Item
      2.
              Business
              4Item
      3.
              Properties
              15Item
      4.
              Legal
      Proceedings
              15Item
      5.
              Submission
      of Matters to a Vote of Security Holders
              16PART
      IIItem
      6.
              Market
      for Registrant’s Common Equity, Related Stockholder Matters  and
      Issuer Purchases of Equity Securities
              17Item
      6A
              Recent
      Sales of Unregistered Securities
              17Item
      7.
              Management’s
      Discussion and Analysis of Financial Condition and Resultsof
      Operations
              23Item
      7A
              Quantitative
      and Qualitative Disclosures  About Market Risk
              28Item
      8.
              Financial
      Statements and Supplementary Data
              29Item
      9.
              Changes
      in and Disagreements with Accountants on Accounting and FinancialDisclosure
              29Item
      9A.
              Controls
      and Procedures
              29Item
      9B.
              Other
      Information
              30PART
      IIIItem
      10.
              Directors
      and Executive Officers of the Registrant
              30Item
      11.
              Executive
      Compensation
              33Item
      12.
              Security
      Ownership of Certain Beneficial Owners and Management and
      RelatedStockholder
      Matters
              36Item
      13.
              Certain
      Relationships and Related Transactions
              38Item
      14.
              Principal
      Accounting Fees and Services
              39PART
      IVItem
      15.
              Exhibits
      and Financial Statement Schedules
              39Signatures
              40Index
      to Consolidated Financial Statements
              F-1Exhibits
      Index
              E-1


2





Part
I





SPECIAL
NOTE REGARDING FORWARD-LOOKING STATEMENTS




Certain
statements made under the captions “Business” (Item 1) and “Management’s
Discussion and Analysis of Financial Condition and Results of Operations” (Item
7), the notes to our audited financial statements (Item 8) and elsewhere in this
Annual Report on Form 10-K/A, as well as statements made from time to time by
our representatives may constitute “forward-looking statements” within the
meaning of the Private Securities Litigation Reform Act of 1995. These
forward-looking statements include, without limitation, statements regarding
planned or expected manufacturing and sale of pharmaceutical products in China
or elsewhere, scale up of facility under United States Good Manufacturing
Practices (US GMP) standards,  the timing and amount of future sales
of pharmaceutical products, the potential market size, advantages or therapeutic
uses of our potential products; variation in actual savings and operating
improvements resulting from restructurings; and the sufficiency of our available
capital resources to meet our funding needs. We do not undertake any obligation
to publicly update any forward-looking statement, whether as a result of new
information, future events, or otherwise, except as required by law. Such
forward-looking statements involve known and unknown risks, uncertainties and
other factors which may cause our actual results or achievements to be
materially different from any future results or achievements expressed or
implied by such forward-looking statements. Such factors include the factors
described under “Management’s Discussion and Analysis of Financial Condition and
Results of Operations—Risk Factors” and the other factors discussed in
connection with any forward-looking statements.





Item
1. Explanatory Note





This Form
10-K/A amends and restates the Form 10-KSB for the year ended December 31, 2005
of AXM Pharma, Inc. (“the Company”) initially filed with the Securities and
Exchange Commission (the “SEC”) on April 17, 2006 (the “Original Filing”) as
amended and restated in the Form 10-KSBA for the year ended December 31, 2005 of
the Company filed with the SEC on May 1, 2006.  This Form 10-K/A is
intended to supersede such Form 10-KSBA.





This Form
10-K/A is being filed to correct errors and omissions contained in Part II, Item
6A, Item 7 and Item 7A and Part IV, Item 15, of the Original Filing. These
errors and omissions result from failure to properly record certain liabilities
and expenses related to the issuance of Secured Convertible Promissory Notes and
associated Common Stock Purchase Warrants during the quarter ended April 30,
2005 and certain liabilities and expenses related to the issuance of Series C
Preferred Stock and associated Common Stock Purchase Warrants during the quarter
ended June 30, 2004. For the convenience of the reader, this Form 10-K/A sets
forth the Original Filing in its entirety. However, this Form 10-K/A only amends
certain information contained in Part II, Item 6A, Item 7 and Item 7A and Part
IV, Item 15, “Exhibits and Financial Statement Schedules”, of the Original
Filing, solely as a result of and to reflect the correction of such errors and
omissions.





This Form
10-K/A adds this Explanatory Note as a new Part I, Item 1 for the convenience of
the reader. See also Note 2 to the Financial Statements included in Part IV,
Item 15. Forward looking statements made in the Original Filing have not been
revised to reflect events, results or developments that occurred or facts that
became known to the Company after the date of the Original Filing, and these
forward looking statements should be read in their historical
context.





In
addition, as more fully described in Part II, Item 9A of this report, following
the close of the fiscal year ended December 31, 2005 and the filing of the
Company’s Original Filing on April 17, 2006, the Company identified inadequacies
in the Company’s disclosure controls and procedures that materially affected the
Company’s internal control over financial reporting in and following the fiscal
year ended December 31, 2005. Management has and will continue to adopt remedial
measures in response to these inadequacies.





Pursuant
to the rules of the SEC, Item 15 of Part IV of the Original Filing has been
amended to include certifications re-executed as of the date of this Form 10-K/A
from the Company’s Chief Executive Officer as required by Section 302 and 906 of
the Sarbanes-Oxley Act of 2002. The certifications of the Chief Executive
Officer are attached to this Form 10-QKB/A2 as Exhibit 31.1 and
32.1.


3





Item
      2.
            Business





Overview
of AXM Pharma





Introduction





AXM Pharma, Inc., (“AXM”, “our”, “us”
or “we”) is a pharmaceutical and nutraceutical company engaged in the
production, marketing and distribution of over the counter and prescription
pharmaceutical products in The People’s Republic of China (“China”). We have
licenses to produce market and distribute drug products in various dosages and
forms as well as herbal remedies and vitamins and are currently manufacturing
four drug products for sale in China. We conduct our business in China through
our wholly owned subsidiary, AXM Pharma (Shenyang) Inc. (“AXM Shenyang”).
Further information can be found on our website:  www.axmpharma.com.
The contents of that website are not incorporated herein by reference
thereto.





History





AXM
was originally founded as Wholesale on the Net, Inc in 1999, as a Nevada
corporation.  In 2001, we changed our named to Wickliffe International
Corporation. In 2003, we acquired all of the outstanding shares of Werke
Pharmaceuticals, Inc (“Werke”), a Chinese based pharmaceutical company. Werke
owns all of the outstanding shares of AXM Shenyang, a “Wholly Foreign Owned
Enterprise (WFOE) under Chinese law. In connection with the acquisition of
Werke, we commenced operations in our current line of business and changed our
name to Axiom Pharmaceuticals and, later in 2003, to AXM Pharma,
Inc.  We conducted a series of private financings in 2003, 2004 and
2005. Prior to March 2004, our common stock was quoted under the symbol “WICK”
on the over-the-counter Bulletin Board.  In March 2004, we were listed
on the American Stock Exchange under the ticker symbol “AXJ .We continue to be
listed on AMEX under the ticker symbol “AXJ”.





Business
Strategy





Our core
business strategy is to manufacture and distribute a diverse group of over the
counter and prescription pharmaceutical and nutraceutical products, targeting
the markets of China, Hong Kong, Taiwan, Korea, The Philippines, Indonesia,
Malaysia, Singapore and Thailand. Our growth plan includes expanding our
existing product line with new products licensed from North America and Europe.
In 2004, we completed the construction of a manufacturing plant in a special
economic zone in Shenyang, China. The plant has been certified as satisfying
Chinese “Good Manufacturing Practices (GMP)”, and we intend to apply for
certification of the plant under US GMP as well. This designation would allow us
to manufacture pharmaceutical products in China for sale in the United States
market.  However, we cannot predict when if ever we will obtain
certification of the Shenyang plant under US GMP.





Manufacturing Capabilities





Our
factory in Shenyang includes over 120,000 square feet of production space
capable of producing 50,000,000 tubes for ointments, 500,000,000 tablets and
250,000,000 capsules annually. In addition, the plant contains laboratory and
administration facilities.  The factory is located in a special
economic zone, the High-Tech Industrial Development District, established in
1988 by the Chinese government to accelerate the development and
industrialization of high-tech industries in the North–Eastern portion of
China.





Current
Marketed Products





AXM Shenyang currently holds 42
licenses to produce over-the-counter and prescription pharmaceutical products in
China. To date, we have undertaken commercial sales of products under four of
these licenses under approval from the State Food and Drug Administration of
China (“SFDA”). Until the completion of our plant and its certification, our
products were produced by third-party manufacturers. In the second quarter of
2005, we began to manufacture our products in our new factory. Currently, all of
our products are sold through third-party distributors. Our current marketed
products are:


4





Asarone:
Asarone is a tablet form of medication indicated as an anti-septic,
anti-inflammatory, asthma reducing, including pediatric asthma, and coughs
prevention medicine. Additionally, Asarone has been used to treat slight and
severe infantile pneumonia, child pneumonia, adult bacterial pneumonia, and
chronic and acute bronchitis, which are symptoms of SARS. Separately, Asarone,
in the form of an injectable solution, has been identified as one of eight
experimental drugs recommended by the Chinese State Traditional Chinese Medicine
Administration for combating SARS.





Elegance:
Elegance is a menstrual relief pH balanced lotion formulated with eight herbal
extracts. The product is positioned as a therapeutic lotion to relieve vaginal
itch, vaginal irritation and vaginitis.





LiveComf:
LiveComf is a compound sulfur cream used to alleviate dermatitis, seborrheica,
scabies, acne and eczema.





LifeGate:
LifeGate is an anti-fatigue capsule categorized as a functional food that is
used for increased energy and vitality. The product is sold over-the-counter,
addressing both the chronic and acute treatment requirements.





Marketing,
Sales and Distribution





We
currently employ 90 individuals involved in marketing and sales. Also, we intend
to engage additional domestic third-party distributors to penetrate new markets.
We are developing educational programs for hospitals, doctors, clinics and
distributors with respect to our product lines.  These educational
programs are intended to improve sales and promotion of our products. We are
planning to advertise our products through medical news paper and magazine
related media.





As our
resources permit, we anticipate expanding our current domestic Chinese
distribution beyond the cities in which we currently sell through the
utilization of new distribution firms in regions currently not covered. We have
developed new distribution and marketing relationships with the following
firms:





•      China
Nat. Pharma. Group (Sinopharm)


•      Jin
Ming Shi Pharma


•      DKSH
(Taiwan) Limited


•      KerryFlex
Supply Chain Solutions Limited





Recent
Developments





Liquidity
Crisis.We are in urgent need of additional
capital.  Our cash resources have been depleted. We have not paid our
employees in China since January 2006. We are in default under the terms of
certain promissory notes as described more fully below under “Risk Factors -
We are currently in default on our obligations under our Series C Convertible
Promissory Notes.” Our lack of capital has severely constrained our
ability to grow our business.  These conditions raise substantial
doubt about our ability to continue as a going concern. The audit report
prepared by our independent registered public accounting firm relating to our
consolidated financial statements for the year ended December 31, 2005 includes
an explanatory paragraph expressing the substantial doubt about our ability to
continue as a going concern. We are currently in discussions with several
funding sources in China to obtain financing to support operations going
forward, but to date none of these discussions have resulted in additional
financing. If we are unable to raise additional capital in the immediate future,
we may be forced to cease business operations.





Default on Series C
Notes.Under the terms of certain Secured Promissory Notes
issued on April 19, 2005, we are obligated to pay interest and principal monthly
in cash or shares. However, we are obligated to make payments in cash if our
share price falls below a certain price calculated under a formula specified in
the Notes. We are currently in default in our payment obligations because we
have not been able to pay the required principal and interest to the holders of
the Notes.  We are in negotiations with the holders with a view to
restructuring the terms of the Notes.  However, no agreement has been
reached and, if we fail to reach an agreement, it will be very difficult for us
to raise any new funds from other sources (see “Risk Factors -We are currently in
default on our obligations under our Secured Promissory Notes”.)


5





Loss of Sunkist
License.In 2004, we entered into a Trademark Licensing
Agreement with Sunkist Growers Inc. (“Sunkist”) that granted us exclusive rights
to manufacture, market and sell certain vitamin and vitamin supplements under
the Sunkist brand name and trademark until December 2005 in Hong Kong, Taiwan
and Macau and until December 2008 in China. Sales under these licenses accounted
for approximately 60% of our total sales in 2005.  The agreement also
granted us a right of first refusal for any territory in the rest of Asia where
Sunkist does not currently license the product categories covered by the
agreement with us. Under the terms of the agreement, we were required to achieve
certain sales targets each year, for each category of product licensed under the
agreement.  In order to support our Sunkist license agreement, we
entered into distribution agreements with Zuellig Pharma Ltd. and Zuellig &
Woo (Hong Kong) Co., Ltd in March 2005 for distribution the Sunkist brand
products in China, Hong Kong, Macau and Taiwan. In addition, we entered into
agreements with Kerryflex Supply Chain Solutions Limited and executed a
Memorandum of Understanding with DKSH Taiwan Limited, to distribute the Sunkist
brand products in Hong Kong and Taiwan. In October 2005, we terminated the
distribution agreement with Zuellig Pharma, Inc. and Zuellig & Woo (Hong
Kong) Co., Ltd.





We failed
to achieve certain minimum sales targets during 2004 and 2005 for each category
of product and failed to pay the minimum royalties stipulated under the license
agreement. As a result, Sunkist terminated our agreement with them for sale of
products in China on February 20, 2006. The separate license agreement with
Sunkist relating to rights to sell certain products in Hong Kong, Macau and
Taiwan expired on its stated termination date in December 2005 and has not been
renewed.  Sunkist has notified us that we are in default with respect
to minimum royalties and has demanded payment of $368,000. This amount in
included in our Statement of Financial Position under the caption “Current
Liabilities.”





SEC
Investigation.The SEC is currently conducting an
investigation into the restatement of our June 30, 2005 financial
statements.  Under prior management, we recorded approximately $2.8
million of revenues related to the sale of Sunkist-branded products through our
distributor, Zuellig.  These revenues constituted substantially all of
our revenues for the quarter ended June 30, 2005.  In October 2005,
under current management, we determined that such sales were in substance
consignment arrangements since we could not determine collectabilty since
collections were not due until the distributors shipped the products;
therefore,.we should not have recognized any revenues from such
sales.  We reported this matter to the SEC which then decided to
conduct an investigation to determine if we and others may have violated the
reporting, anti-fraud, accounting and other provisions of the federal securities
laws.  The investigation is in a relatively early stage and we are not
able to predict its outcome.  We are fully cooperating with the SEC in
this investigation (see “Risk Factors -
We are currently the subject of an SEC investigation into our restatement of our
June 30, 2005 financials.”)





Certain
Considerations Related to Chinese Pharmaceutical Companies





Chinese
Legal Status of AXM Shenyang





AXM Shenyang, is classified as a Wholly
Foreign Owned Enterprise (WFOE) under Chinese Company Law. Wholly Foreign Owned
Enterprises are limited liability companies established under Chinese Company
Law, which are owned exclusively by one or more foreign investors and thus offer
controls over the company’s management, technology, and finances that the
typical foreign investor requires. Advantages of qualifying as a WFOE
include:





●
              Ability
      to carry on business in China rather than just a representative office
      function;





●
            Ability
      to issue invoices to customers in Renminbi (Chinese currency) and receive
      Renminbi revenues;





●
            Ability
      to convert Renminbi profits to US dollars for remittance to foreign parent
      company outside China;





●
            Ability
      to employ staff directly within
China;


●
            Protection
      of intellectual know-how and proprietary
  technology.








Potential disadvantages of operating as
a WFOE include unlimited liability for claims arising from operations in China,
and potentially less favorable treatment from governmental agencies in China and
other Chinese companies than we would receive if we operated through a joint
venture with a Chinese Partner.  We have not experienced any such
disadvantages in operating our business as a WFOE thus far.





6


Government
Regulation





The
modernization of regulations for the pharmaceutical industry is relatively new
in China and the manner and extent to which the pharmaceutical industry is
regulated will continue to evolve.  We are subject to the
Pharmaceutical Administrative Law, which governs the licensing, manufacture,
marketing and distribution of pharmaceutical products in China and sets penalty
provisions for violations of provisions of the Pharmaceutical Administrative
Law. In addition, as a WFOE, we are subject to the Foreign Company provisions of
the Company Law of the China, which governs the conduct of our wholly owned
subsidiary, AXM Shenyang and its officers and directors.  Changes in
these laws or new interpretations of existing laws may have a significant impact
on our methods and our costs of doing business.





Additionally,
we will be subject to varying degrees of regulation and permitting by
governmental agencies in China. For example, in 1999, the SFDA established an
administrative system for the classification of prescription and
over–the-counter drugs.  Since then, the SFDA has issued a series of
guidelines on interpretation of the new classification system in such areas as
labeling, usage instructions and packaging of over–the-counter
products.





Recently,
the SFDA implemented new Good Manufacturing Practices guidelines for licensing
pharmaceutical products. Our new factory was required to comply with these new
guidelines to begin production at the facility and failure to satisfy these new
guidelines would have a material adverse effect our business.  Our
factory received Chinese Good Manufacturing Practices approval in January
2005.





There can
be no assurance that future regulatory, judicial and legislative changes will
not have a material adverse effect on our business, that regulators or third
parties will not raise material issues with regard to our business and
operations or our compliance or non-compliance with applicable regulations or
that any changes in applicable laws or regulations will not have a material
adverse effect on our business.





Chinese
Registered Capital Requirements





Pursuant
to the Company Law of China, we are required to contribute and maintain a
certain amount of “registered capital” in our wholly owned subsidiary, AXM
Shenyang.  This capital may be in the form of tangible or intangible
assets. AXM Shenyang’s current registered capital requirement is US
$10,000,000.  We are currently in compliance with the registered
capital requirements of the Company Law.





Chinese
Environmental Laws





We are
subject to the environmental laws of China and its local
governments.  Our operations in China do not involve the use of
pollutants. Therefore, we do not incur significant expense related to compliance
with such laws nor do we expect to be affected significantly by compliance with
such laws.





Licensing
and Intellectual Property





The State
Food and Drug Administration of the government of China issues licenses and
permits for permission to market and manufacture pharmaceutical products in
China.  Generally, licenses and permits issued by the SFDA are
revocable at any time, with or without cause.  We have been granted 42
product licenses and permits, of which only four licenses currently are
commercialized. We likely will undertake a selection process to decide which of
our remaining licenses, if any, will be commercialized, and we will determine
the timeframe for such commercialization.  None of our registered
products are currently patented nor do we have any patents pending before the
government of China or any other government.




Research
and Development





We
have minimal research and development activities. Such activities are focused on
quality and laboratory testing of compounds developed by others, and
administration of the testing process for such compounds. We have developed
working relationships with Shenyang Medical University and the Liaoning Research
Institute for Traditional Chinese Medicine and Beijing Shiehe Medical University
to acquire new licenses according to market demand in the future.




7




Competition




We
compete with different companies in different therapeutic
categories.  For example, with regard to Asarone Tablets, we compete
with Liuzhou Pharmaceutical Factory, located in Liuzhou City, Guang Xi
Autonomous Region.  AXM and Liuzhou are the only two companies
approved by the SFDA to manufacture Asarone Tablets.  However because
Liuzhou distributes its Asarone tablets mainly in Southern China and AXM
distributes its products mainly in Northern China, the two companies do not
directly compete in their respective markets. We compete with two companies for
distribution of our product Lifushu herbal antiseptic skin cream, Zhejiang
Wenzhou Pharmaceutical Factory and Ying Kou Biochemical Pharmaceutical
Factory.  However, one of these competitors, Zhejiang Wenzhou, targets
its product to public bath houses, and does not compete in the pharmaceutical
distribution segments in which AXM sells Weifukang. Ying Kou Biochemical
Pharmaceutical Factory’s main business focus is its bulk bioprocessing
business.  Their herbal antiseptic product is a minor line. Our
largest competitor for Cefaxlin Capsules and Norfloxacin Capsules is Yanfeng
Pharmaceuticals, also located in Shenyang. Yanfeng Pharmaceutical Company is a
recently privatized State Owned Enterprise that employs approximately 400
persons. Their sales territory focus is in Shenyang city. We consider Yanfeng
Pharmaceutical Company to be a major competitor.





Employees





At April
13, 2006, we had no employees in our U.S.-based headquarters and 150 full-time
employees at our facilities located in China. Certain of our employees in China
have instituted legal proceedings in China related to unpaid wages ( see “Risk Factors - We have not made payments to certain
of our employees and lenders, and certain service providers have asserted claims
against us”.)





Available
Information




We file annual, quarterly and special
reports, proxy statements and other information with the Securities and Exchange
Commission.  You may read or obtain a copy of this annual report or
any other information we file with the SEC at the SEC’s Public Reference Room at
450 Fifth Street, N.W., Washington, D.C. 20549. You may obtain information
regarding the operation of the Public Reference Room by calling the SEC at
1-800-SEC-0330.  Our SEC filings are also available to the public from
the SEC web site at www.sec.gov, which contains our reports, proxy and
information statements, and other information we file electronically with the
SEC.  You can also obtain our filings at our website,
www.axmpharma.com.




The
Company also makes its periodic and current reports available, free of charge,
on its website, www.axmpharma.com, as soon as reasonably practicable after such
material is electronically filed with the SEC. Information available on our
website is not a part of, and should not be incorporated into, this annual
report on Form 10-K/A.




Our Board
of Directors has adopted a Code of Business Conduct and Ethics which is posted
on our website at www.axmpharma.com.





Risk
Factors




The
following risk factors should be read carefully in connection with evaluating
our business and the forward-looking statements that we make in this Report and
elsewhere (including oral statements) from time to time. Any of the following
risks could materially adversely affect our business, our operating results, our
financial condition and the actual outcome of matters as to which
forward-looking statements are made in this Report.


8





Risks
Related to Our Financial Condition





If
we fail to raise additional capital in the immediate future, we will be forced
to cease operations





We are in
urgent need of additional capital.  Our cash resources have been
depleted. We have not paid our employees in China since January 2006. We are in
default under the terms of certain promissory notes as described more fully
below under “Risk Factors -
We are currently in default on our obligations under our Series C Convertible
Promissory Notes.” Our lack of adequate capital has severely constrained
our ability to grow our business.  These conditions raise substantial
doubt about our ability to continue as a going concern. The audit report
prepared by our independent registered public accounting firm relating to our
consolidated financial statements for the year ended December 31, 2005 includes
an explanatory paragraph expressing the substantial doubt about our ability to
continue as a going concern. We are currently in discussions with several
funding sources in China to obtain financing to support operations going
forward; however, to date such discussions have not resulted in any additional
financing. At this time, we do not know if additional financing will be
available, nor can we predict the terms of any such financing.  If we
are unable to raise additional funds in the immediate future, we may be forced t
cease business operations.  If additional capital is raised through
the sale of equity or convertible debt securities, the issuance of such
securities would result in dilution to our existing stockholders. If additional
capital is raised through incurrence of indebtedness, our interest expense will
likely increase and restrictive covenants imposed by the lenders may impair our
ability to grow our business.





Since
our inception, we have generated significant losses from operations and we
anticipate that we will continue to generate significant losses from operations
for the foreseeable future.  As of December 31, 2005, our
accumulated deficit was approximately $28 million.  Our net loss was
$9 million and $13 million for the years ended December 31, 2005 and 2004,
respectively. Our cash outlays from operations and capital expenditures were $9
million and $10 million for 2005 and 2004, respectively. Our stockholders’
equity decreased from $5 million as of December 31, 2004 to $0.8 million as of
December 31, 2005.





We
are currently in default on our obligations under our Series C Convertible
Promissory Notes.





On April
19, 2005, we entered into a private financing with certain accredited investors
and issues secured promissory notes with an aggregate principal amount of
$3,425,000. Under the terms of the Notes, we are obligated to pay interest and
principal monthly in cash or shares. However, we are obligated to make payments
in cash if our share price falls below a certain price calculated under a
formula specified in the Notes. We are currently in default in our payment
obligations because we have not been able to pay the required repayment of
principal and interest to the holders of the Notes.  We are in
negotiations with the holders with a view to restructuring the terms of the
Notes.  However, no agreement has been reached and, if we fail to
reach an agreement, it will likely be impossible for us to raise any new funds.
Moreover, one or more holders of the Notes may bring legal claims seeking to
enforce their rights against us.





We
have not made payments to certain of our employees and lenders, and certain
service providers have asserted claims against us.





Due to our limited available cash in
the forth quarter, we were unable to allocate sufficient cash to our Chinese
subsidiary, AXM Shenyang, for it to pay its approximately 150 employees.
 As a result some of these employees have resigned. Further,  we
received notices from the Labor Arbitration Committee in China that 11 of our
current and former employees have filed a labor arbitration  claim for
unpaid salaries and un-reimbursed expenses in the aggregate amount of RMB429,958
( $53,081).





In
addition, AXM Shenyang obtained loans in the aggregate amount of 8,290,302 RMB
(US $1,002,455) between October 22, 2004 and June 26, 2005, through a series of
short term non-recourse loans from ten individual Chinese lenders.  AXM
Shenyang is in default on the principal of these loans and interest of
approximately $494,000.  Although these loans are not secured by any of our
property or assets, we could be subject to legal action if these loans are not
repaid.  Currently, no lawsuits regarding these loans have been initiated
and we are not aware that any lawsuits are being contemplated by any of the
lenders.  However, we can not assure you that the lenders will not take
legal action in the near term.





We have
also received  demand letters from Saatchi & Saatchi, alleging
that we owe them approximately RMB582,055.48 (U.S. $71,770) in connection with
advertising services allegedly provided to AXM Shenyang and from Sunkist
alleging that we owe them $368,000 for minimum royalty payments.




9





We do not
have the ability to satisfy these contingent liabilities should adverse
judgments be entered against us.  In addition, these matters make it
more difficult for us to raise new capital and divert scarce financial resources
and management time to defend against the various claims.





We
are currently in litigation with several service providers and our former chief
executive officer and an adverse determination in these proceedings could
further adversely affect our liquidity.





There
is currently pending in Los Angeles superior court, a lawsuit filed by Praxis
Advertising and Design, Inc. claiming payment of an unpaid package design fee of
$119,800.  In addition, in November 2005, Don Bates, Inc., our former
U.S. Good Manufacturing Practices consultant, instituted legal action against us
in U.S. District Court, District of Nevada, claiming unpaid consultancy fees.
 Don Bates, Inc. has alleged that $362,652.00, plus accrued interest, is
due to them.   In November 2005, we became aware of a lawsuit filed in
the District Court of Clark County, Nevada by our former CEO Peter Cunningham,
whom we fired for cause on July 20, 2005. Mr. Cunningham’s counsel claims to
have properly served us with a summons and complaint and took a default against
us on November 9, 2005.  Mr. Cunningham’s complaint alleges unpaid base
salary, unpaid commissions, un-reimbursed expenses and unpaid severance totaling
approximately $180,000. We intend to contest these claims and will consider
appropriate cross-claims.  An adverse determination in one or more of
these proceedings would further impair our liquidity.





We
are currently the subject of an SEC investigation into our restatement of our
June 30, 2005 financials.





The SEC
is currently conducting an investigation into the restatement of our June 30,
2005 financial statements.  Under prior management, the Company
recorded approximately $2.8 of revenues related to the sale of Sunkist-branded
products through our distributor, Zuellig.  These revenues constituted
substantially all of our revenues for the quarter ended June 30,
2005.  In October 2005, under current management, we determined that
such sales were in substance consignment arrangements since we could not
determine collectabilty since collections were not due until the distributors
shipped the products; therefore. We should not have recognized any revenues from
such sales.  We reported this matter to the SEC which then decided to
conduct an investigation to determine if we and others may have violated the
reporting, anti-fraud, accounting and other provisions of the federal securities
laws.  The investigation is in a relatively early stage and we are not
able to predict its outcome.  We are fully cooperating with the SEC in
this investigation.





The
pendency of the SEC investigation has had a material adverse affect upon our
ability to raise new capital.  A number of prospective investors have
indicated they are not willing to proceed with an investment in the Company
until the SEC investigation is resolved.  Moreover, if the SEC
determines to seek sanctions against the Company following completion of its
investigation, such sanctions could create further difficulties for our ability
to raise capital and continue in business.





If
we fail to continue to meet all applicable American Stock Exchange requirements,
our common stock could be delisted, which would adversely affect the market
liquidity and price of our common stock .





Our common stock is listed on the
American Stock Exchange (AMEX).  In order to maintain that listing, we
must satisfy minimum financial and other requirements.  The AMEX has
notified us that we may not be in compliance with their continued listing
standards because our substantial operating losses cast doubt upon our ability
to continue as a going concern and three of our independent directors resigned
in February, including the Chair of our Audit Committee.  We have
responded to the AMEX with a plan to improve our financial condition and we have
notified the AMEX that we have elected two new independent directors, one of
whom qualifies as a financial expert.  The AMEX is currently
considering our responses.  If they deem the responses inadequate, or
if we are unable to execute our plan to improve our financial condition, then
the AMEX may commence delisting proceedings against us.  In this
regard, it should be noted that our plan depends upon obtaining funds from third
parties and, to date, we have not closed any arrangements with such third
parties to provide the necessary funding.  The AMEX has stated that we
must execute upon our plan to improve our financial condition by May 2,
2006.


10





If we fail to continue to meet all
applicable AMEX requirements in the future and AMEX determines to delist our
common stock, the delisting could adversely affect the market liquidity of our
common stock and the market price of our common stock could decrease.  Such
delisting could also adversely affect our ability to obtain financing for the
continuation of our operations and could result in the loss of confidence by
investors, suppliers and employees.





Our
disclosure controls and procedures are not effective, which may result in our
filing unreliable reports with the SEC.





As a
result of the restatement discussed above, we concluded that our disclosure
controls and procedures have not been effective to ensure that information
required to be disclosed in reports that we file or submit under the Securities
Exchange Act of 1934 is processed, summarized and reported within the time
periods specified by the SEC.  As a result, our SEC reports may not be
reliable.  This may impair our ability to raise new
capital.  It may also expose us to new liabilities if we file false or
misleading reports.  .





We
have outstanding warrants that may adversely affect us in the future and cause
dilution to existing Shareholders.





In
connection with the issuance of the Secured Promissory Notes, we issued warrants
to holders of the Notes to purchase our common stock at certain prices as
adjusted pursuant to the terms of the warrants. The warrants were issued in
tranches with exercise periods expiring on June 24, 2007, August 21, 2008,
September 12, 2008, and December 31, 2008.  There are currently
3,683,689 warrants outstanding, which are exercisable at a price of $3.00 per
share, with the exception of those warrants which expire on June 24, 2007, which
are exercisable at a price of $5.50 per share, subject to adjustment in certain
circumstances.  Exercise of the warrants may cause dilution in the
interests of other shareholders as a result of the additional common stock that
would be issued upon exercise.  In addition, sales of the shares of
our common stock issuable upon exercise of the warrants could have a depressive
effect on the price of our stock, particularly if there is not a coinciding
increase in demand by purchasers of our common stock. Further, the terms on
which we may obtain additional financing during the period any of the warrants
remain outstanding may be adversely affected by the existence of these warrants
as well.





Risks
Related to Our Business Operations in China





We
may not be able to obtain regulatory approvals for our products or reimbursement
from the sale of our products.





The
manufacture and sale of pharmaceutical products in China is highly regulated by
a number of state, regional and local authorities.  These regulations
significantly increase the difficulty and costs involved in obtaining and
maintaining regulatory approval and reimbursement listings for marketing new and
existing products.  In addition, our future growth and profitability
are, to a significant extent, dependent upon our ability to obtain timely
regulatory approvals and reimbursement from the relevant
authorities.





Changes
in the laws and regulations in China may adversely affect our ability to conduct
our business.





The
pharmaceutical industry is relatively new in the emerging markets of China that
we are targeting, and the manner and extent to which it is regulated in these
geographical areas is evolving.   As a Chinese corporation, AXM
Pharma is subject to the Company Law of The Peoples Republic of China and more
specifically to the Foreign Company provisions of the Company Law and the Law on
Foreign Capital Enterprises of the People's Republic of
China.  Additionally, as a pharmaceutical company, we are subject to
the Pharmaceutical Administrative Law.  Changes in existing laws or
new interpretations of such laws may have a significant impact on our methods
and costs of doing business. For example, new legislative proposals for
pharmaceutical product pricing, reimbursement levels, approval criteria and
manufacturing requirements may be proposed and adopted.  Such new
legislation or regulatory requirements may have a material adverse effect on our
financial condition, results of operations or cash flows.  In
addition, we will be subject to varying degrees of regulation and licensing by
governmental agencies in China. There can be no assurance that the future
regulatory, judicial and legislative changes will not have a material adverse
effect on AXM Pharma, that regulators or third parties will not raise material
issues with regard to AXM Pharma or our compliance or non-compliance with
applicable laws or regulations or that any changes in applicable laws or
regulations will not have a material adverse effect on AXM Pharma or our
operations.


11








We
may experience barriers to conducting business due to governmental
policy.





The SFDA
set up a classification administrative system in 1999 for prescription and
over–the-counter drugs.  Since then, the SFDA has issued a series of
guidelines for interpretation of the new classification system for labeling,
usage instructions and packaging of over–the-counter products. The SFDA
currently requires that pharmaceutical manufacturers clearly label drugs for
over–the-counter sales and distinguish them from those to be sold in hospitals
as ethical drugs. We have instituted this policy as required by the
SFDA.  To date, we have never experienced any problems with compliance
with the regulations of the SFDA.   We have never been
investigated for noncompliance by this agency nor have we violated any
regulations of the SFDA.





Our
business may be adversely affected by government plans to consolidate state
owned pharmaceutical companies in China.





The
Ministry of Commerce announced plans to consolidate nearly 5,000 state owned
pharmaceutical companies into approximately 12 to 15 companies.  The
Ministry of Commerce has stated that it targets the size of these remaining
firms to be at least U.S. $ 10.0 billion revenue per annum in the future (U.S.$
5.0 billion by the year 2010).  Their primary business will be to make
generic pharmaceutical products for sale to state owned hospitals. The planned
consolidation has already commenced and is anticipated to continue until the
goals of the Ministry of Commerce have been realized. We are not aware, however,
at this time of how many companies have been consolidated or when the planned
consolidation will be completed.  A recent example of the
consolidation amongst state owned pharmaceutical companies is the acquisition by
the conglomerate Huayuan Group of a 40% stake in Shanghai Pharmaceutical
Group.  This new company will be involved in manufacture, distribution
and research and development.  An objective of the consolidation is to
establish a manufacturing standard consistent with U.S. Good Manufacturing
Practices.  It is planned that all products manufactured in The
Peoples Republic of China will meet U.S. Good Manufacturing Practices standard
in the future.





Capital
outflow policies in China may hamper our ability to remit income to the United
States.





China has
adopted currency and capital transfer regulations. These regulations require
that we comply with complex regulations for the movement of capital. In order to
comply with these regulations we may have to revise or change the banking
structure of our company or its subsidiaries   Although we
believe that we are currently in compliance with these regulations, should these
regulations or the interpretation of them by courts or regulatory agencies
change we may not be able to remit all income earned and proceeds received in
connection with our operations to the U.S.





Fluctuation
of the Renminbi could materially affect our financial condition and results of
operations.





The value
of the Renminbi fluctuates and is subject to changes in China’s political and
economic conditions.  Since 1994, the conversion of Renminbi into
foreign currencies, including US dollars, has been based on rates set by the
People’s Bank of China, which are set daily based upon the previous day’s
interbank foreign exchange market rates and current exchange rates on the world
financial markets. Since 1994, the official exchange rate for the conversion of
Renminbi to US dollars has generally been stable.





On July
21, 2005, the PRC allowed the RMB to fluctuate within a narrow range, ending its
decade-old fixed valuation peg to the US dollar.  The new RMB rate
reflects an approximately 2% increase in value against the US
dollar.  Historically, the Chinese government has benchmarked the RMB
exchange ratio against the US dollar, thereby mitigating the associated foreign
currency exchange rate fluctuation risk.


12





We
may face obstacles from the political system in China.





Foreign
companies conducting operations in China face significant political, economic
and legal risks. The government of the Peoples Republic of China has a history
of intervening in business affairs in order to achieve its political
objectives.  While current policies favor foreign investment, these
policies may change without warning.  Moreover, corruption and a legal
system which is not fully developed pose significant risks for companies doing
business in China.





We
may have difficulty establishing adequate management, legal and financial
controls in China.





China
historically has been deficient in Western style management and financial
reporting concepts and practices, as well as in modern banking, computer and
other control systems.  We may have difficulty in hiring and retaining
a sufficient number of qualified employees to work in China. As a result of
these factors, we may experience difficulty in establishing management, legal
and financial controls, collecting financial data and preparing financial
statements, books of account and corporate records and instituting business
practices that meet Western standards.





Trade
barriers and taxes may have an adverse effect on our business and
operations.





We may
experience barriers to conducting business and trade in our targeted emerging
markets in the form of delayed customs clearances, customs duties and tariffs.
In addition, we may be subject to repatriation taxes levied upon the exchange of
income from local currency into foreign currency, substantial taxes of profits,
revenues, assets and payroll, as well as value-added tax. The markets in which
we plan to operate may impose onerous and unpredictable duties, tariffs and
taxes on our business and products, and there can be no assurance that this will
not have an adverse effect on our finances and operations.





It
will be extremely difficult to acquire jurisdiction and enforce liabilities
against our officers, directors and assets based in China.





Because
several of our directors, including Wei Shi Wang, the chairman of our Board of
Directors, are Chinese citizens it may be difficult, if not impossible, to
acquire jurisdiction over these persons in the event a lawsuit is initiated
against AXM Pharma and/or its officers and directors by a shareholder or group
of shareholders in the U.S.  Also, although our executive officers are
U.S. citizens, because they may be residing in China at the time such a suit is
initiated, achieving service of process against such persons would be extremely
difficult.  Furthermore, because the majority of our assets are
located in China, it would also be extremely difficult to access those assets to
satisfy an award entered against us in U.S. court.





There
can be no guarantee that China will comply with the membership requirements of
the World Trade Organization.





Due in
part to the relaxation of trade barriers following World Trade Organization
accession in January 2002, we believe the Chinese market presents a significant
opportunity for both domestic and foreign drug manufacturers. With the Chinese
accession to the World Trade Organization, the Chinese pharmaceutical industry
is gearing up to face the new patent regime that is required by World Trade
Organization regulation.  The Chinese government has begun to reduce
its average tariff on pharmaceuticals.  China has also agreed that
foreign companies will be allowed to import most products, including
pharmaceuticals, into any part of China.  Current trading rights and
distribution restrictions are to be phased out over a three-year
period.  In the sensitive area of intellectual property rights, China
has agreed to implement the trade-related intellectual property agreement of the
Uruguay Round. There can be no assurances that China will implement any or all
of the requirements of its membership in the World Trade Organization in a
timely manner, if at all.


13





General
Business Risks





We
may not be able to adequately protect and maintain our intellectual
property.





Our
success will depend in part on our ability to protect and maintain intellectual
property rights and licensing arrangements for our products.  None of
our products are patented.  As a result, competitors may be able to
sell products that are substantially the same as our products.  We
depend upon licenses from third parties for the rights to sell our
products.  No assurance can be given that licenses or rights used by
us will not be challenged, invalidated, infringed or circumvented, or that the
rights granted thereunder will provide competitive advantages to
us.  There can be no assurance that we will be able to obtain a
license to any third-party technology that we may require to conduct our
business or that such technology can be licensed at a reasonable
cost.  There is no certainty that we will not be challenged by our
partners for non-compliance with our licensing
arrangements.  Furthermore, there can be no assurance that we will be
able to remain in compliance with our existing or future licensing arrangements.
Consequently, there may be a risk that licensing arrangements are withdrawn with
no penalties to the licensor or compensation to us.





We
may have difficulty competing with larger and better financed companies in our
sector.





The
prescription and over–the-counter drug markets in China are very competitive and
competition may increase.  Products compete on the basis of efficacy,
safety, side effect profiles, price and brand differentiation.  Some
of our competitors may have greater technical and financial resources than we do
and may use these resources to pursue a competitive position that threatens our
products.  Our products could be rendered obsolete or uneconomical by
the development of new pharmaceuticals to treat conditions addressed by our
products, as a result of technological advances affecting the cost of
production, or as a result of marketing or pricing action by one or more of our
competitors.





We are dependant on
certain key existing and future personnel.





Our
success will depend, to a large degree, upon the efforts and abilities of our
officers and key management employees such as Zhenyu Kong, our President of
China Operations and Chief Operating Officer of AXM Shenyang; and, Wang Wei Shi,
Chief Executive Officer of AXM Shenyang and Chairman of AXM Pharma. The loss of
the services of one or more of our key employees could have a material adverse
effect on our operations.   We do not currently maintain key man
life insurance on any of our key employees.  In addition, as our
business plan is implemented, we will need to recruit and retain additional
management and key employees in virtually all phases of our
operations.  Key employees will require not only a strong background
in the pharmaceutical industry, but a familiarity with language and culture in
the markets in which we compete. We cannot assure that we will be able to
successfully attract and retain key personnel.





We
may be subject to product liability claims in the future.





We face
an inherent business risk of exposure to product liability claims in the event
that the use of our technologies or products is alleged to have resulted in
adverse side effects.  Side effects or marketing or manufacturing
problems pertaining to any of our products could result in product liability
claims or adverse publicity.  These risks will exist for those
products in clinical development and with respect to those products that receive
regulatory approval for commercial sale.  Furthermorewe do not
currently maintain product liability insurance, although we have not
historically experienced any problems associated with claims by users of our
products,




There
may not be sufficient liquidity in the market for our securities in order for
investors to sell their securities.


There is
currently only a limited public market for our common stock, which is listed on
the American Stock Exchange, and there can be no assurance that a trading market
will develop further or be maintained in the future.   During the
month of March 2006, our common stock traded an average of approximately 134,957
shares per day.  As of April 13, 2006, the closing bid price of our
common stock on the American Stock Exchange was  $.43 per
share.  As of April 13, 2006, we had approximately 134 shareholders of
record not including shares held in street name.  In addition, during
the past two years our common stock has had a trading range with a low price of
$.30 per share and a high price of $7 per share.




14





The fact that our directors and
officers own approximately27.57% of our capital stock may decrease
your influence on shareholder decisions.





Our
executive officers and directors, in the aggregate, beneficially own
approximately 27.57% of our capital stock.  As a result, our officers
and directors will have the ability to influence our management and affairs and
the outcome of matters submitted to shareholders for approval, including the
election and removal of directors, amendments to our bylaws and any merger,
consolidation or sale of all or substantially all of our assets.





Item
      3.
            Properties





Our
corporate and United States offices are located at 17870 Castleton Street, Suite
255, City of Industry, California 91748.  The current rent for these
premises is $1,842 per month.  Our lease expires on January 24,
2009.  In January 2006, we closed our office located at 7251 West Lake
Mead Blvd, Suite 300, Las Vegas, Nevada, 89128. The rent for the office in Las
Vegas was $5,378 per month.





Our
principal administrative, sales and marketing facilities are located at No.
F.3004 Sankei Torch Bldg, 262A Shifu Road, Shenyang City, Liaoning Province, The
People’s Republic of China.  The current rent for these facilities is
US$2,917 per month and our lease expires in October 2007.





Our
factory is located at No. 2 Feiyun Road, Nunnan New District, Shenyang,
China.  It is a 120,000 square foot facility comprised of a solid dose
facility, an ointment facility, and an administrative building.





Item
      4.
            Legal
      Proceedings





In
February 2006, we became aware of a lawsuit filed in Los Angeles superior court
from the Praxi Advertising and Design, Inc. claiming payment of an unpaid
package design fee of $119,800.





In
November 2005, Don Bates, Inc., our former U.S. Good Manufacturing Practices
consultant, instituted legal action against us in U.S. District Court, District
of Nevada, claiming unpaid consultancy fees.  Don Bates, Inc. has alleged
that $362,652.00, plus accrued interest, is due to them.   We believe
that this suit is without merit as, among other things, the fees billed by the
plaintiff for services rendered to us were excessive.  We intend to
contest this claim and will consider appropriate cross-claims.  There has
been no discovery in this matter and we cannot predict its outcome.





In
November 2005, we became aware of a lawsuit filed in the District Court of Clark
County, Nevada by our former CEO Peter Cunningham, whom we fired for cause on
July 20, 2005. Mr. Cunningham’s counsel claims to have properly served us with a
summons and complaint and took a default against us on November 9, 2005.
 We are disputing the validity of the service, and have retained counsel.
We anticipate that the default will be set aside.  Mr. Cunningham’s
complaint alleges unpaid base salary, unpaid commissions, un-reimbursed expenses
and unpaid severance totaling approximately $180,000.  The complaint also
requests declaratory relief to amend an allegedly incorrect Form 8-K filing
which stated that Mr. Cunningham was fired for cause.   We intend to
vigorously defend this case and believe hawse have meritorious claims against
Mr. Cunningham which may be asserted in a cross-complaint.   There has
been no discovery in this matter and we cannot predict its outcome.





AXM
Shenyang obtained loans in the aggregate amount of 8,290,302 RMB (US $1,002,455)
between October 22, 2004 and June 26, 2005, through a series of short term
non-recourse loans from ten individual Chinese lenders. AXM Shenyang is in
default on the principal of these loans and interest of approximately
$494,000.  Although these loans are not secured by any of our property
or assets, we could be subject to legal action if these loans are not repaid.
 Currently, no lawsuits regarding these loans have been initiated and we
are not aware that any lawsuits are being contemplated by any of the lenders.


15





In July
2005, we received a demand letter from Saatchi & Saatchi, an advertising
firm, that alleged that we owed them approximately RMB 582,055.48 (U.S. $71,770)
in connection with advertising services provided to AXM Shenyang.  We
currently are reviewing their claim and intend to negotiate a settlement of such
claim.  We do not anticipate that this matter will have a material impact
on our business or operations.





The SEC
is currently conducting an investigation to determine if we and others may have
violated the reporting, anti-fraud, accounting and other provisions of the
federal securities laws.  This investigation resulted from our
restatement of our financial statements for the period ended June 30,
2005.  The investigation is currently at an early stage and we are not
able to assess the likelihood that the SEC will commence enforcement proceedings
against us or the nature and potential impact of any remedies the SEC might
seek.  We are cooperating fully with the SEC in this
investigation.





Item
      5.
            Submission
      of Registrant’s Common Equity, Related Stockholder
  Matters





The
Company did not submit any matters to a vote of the security holders during the
fourth quarter of fiscal 2005.


16


PART
II





Item
      6.
            Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases ofEquity
      Securities





The
common stock is currently listed on the American Stock Exchange under the symbol
“AXJ.” Prior to March 14, 2003, the date on which the reverse acquisition with
Werke Pharmaceuticals, Inc. occurred, the common stock was quoted under the
symbol “WICK” on the over-the-counter Bulletin Board.





The
following table sets forth the quarterly high and low bid prices for the common
stock since the quarter ended March 31, 2004.  The prices set forth
below represent inter-dealer quotations, without retail markup, markdown or
commission and may not be reflective of actual transactions.





(a)Fiscal
      2004 and 2005
                                  
                                  High
                                  
                                  LowQuarter
      Ended March 31, 2004
                                  
                                  
                                  7.30
                                  
                                  
                                  3.80Quarter
      Ended June 30, 2004
                                  
                                  
                                  5.49
                                  
                                  
                                  3.70Quarter
      Ended September 30, 2004
                                  
                                  
                                  4.35
                                  
                                  
                                  2.05Quarter
      Ended December 31, 2004
                                  
                                  
                                  3.63
                                  
                                  
                                  1.80Quarter
      Ended March 31, 2005
                                  
                                  
                                  3.15
                                  
                                  
                                  2.21Quarter
      Ended June 30, 2005
                                  
                                  
                                  2.75
                                  
                                  
                                  1.72Quarter
      Ended September 30, 2005
                                  
                                  
                                  2.35
                                  
                                  
                                  1.23Quarter
      Ended December 31, 2005
                                  
                                  
                                  1.61
                                  
                                  
                                  0.30








Starting
on March 3, 2004, our common stock listed on the American Stock Exchange, also
called the AMEX, under the trading symbol “AXJ.”





At April
13, 2006, the closing bid price of our common stock was $.43 per share and there
were approximately 134 record holders of our common stock.  This
number excludes any estimate by AXM Pharma of the number of beneficial owners of
shares held in street name, the accuracy of which cannot be
guaranteed.





We have
not paid cash dividends on any class of common equity since formation and we do
not anticipate paying any dividends on our outstanding common stock in the
foreseeable future.





Item
      6A
            Recent
      Sales of Unregistered Securities





In March
2003, we issued an aggregate of 11,420,000 shares of common stock in exchange
for all of the issued and outstanding capital stock of Werke Pharmaceuticals,
Inc.  The shares issued to the former shareholders of Werke
Pharmaceuticals, Inc. were issued to 25 accredited investors pursuant to an
exemption from registration under Section 4(2) of the Securities Act and to 33
non-U.S. persons pursuant to an exemption from registration under Regulation S
promulgated under the Securities Act.





In April
2003, we issued 30,000 shares of restricted common stock to Rabelaisian
Resources, Plc. pursuant to a consulting agreement for business and product
development services.  The shares were issued pursuant to the
exemption from registration provided by Section 4(2) of the Securities Act for
issuances not involving a public offering.  The shares were valued at
$1.80 per share, the market price for shares of our common stock at the time of
issuance.  The total aggregate value of the consideration paid to
Rabelasian Resources was $54,000.





On April
30, 2003, we issued 150,000 shares of restricted common stock to Madden
Consulting, Inc. pursuant to a consulting agreement for investor and public
relations services. On September 18, 2003, we issued an additional 400,000
shares to Madden Consulting, in connection with renewal of its consulting
agreement.  The shares were issued pursuant to the exemption from
registration provided by Section 4(2) of the Securities Act for issuances not
involving a public offering.  The shares issued on April 30, 2003,
were valued at $1.80 per share and the shares issued on September 18, 2003, were
valued at $5.00 per share, the market price for shares of our common stock at
the respective times of issuance.  The total aggregate value of the
consideration paid to Madden Consulting was $270,000 on April 30, 2003, and
$2,000,000 on September 18, 2003.


17





In May,
2003, we issued 25,000 shares of restricted common stock to Robert Alexander
pursuant to a consulting agreement for services related to the identification
and evaluation of pharmaceutical companies, products and licenses in
Canada.  The shares were issued pursuant to the exemption from
registration provided by Section 4(2) of the Securities Act for issuances not
involving a public offering.  The shares were valued at $1.50 per
share, the market price for shares of our common stock at the time of
issuance.  The total aggregate value of the consideration paid to
Robert Alexander was $37,500.





On May
21, 2003, we issued 40,000 shares of restricted common stock to Amaroq Capital,
LLC pursuant to a consulting agreement for services related to business
development and financial consulting.  The shares were issued pursuant
to the exemption from registration provided by Section 4(2) of the Securities
Act for issuances not involving a public offering.  The shares were
valued at $1.75 per share, the market price for shares of our common stock at
the time of issuance.  The total aggregate value of the consideration
paid to Amaroq Capital was $70,000.





In May
2003, we issued 15,000 shares of restricted common stock to McCartney
Multimedia, Inc. in consideration for the creation of our website and corporate
logo.  The shares were issued pursuant to the exemption from
registration provided by Section 4(2) of the Securities Act for issuances not
involving a public offering.  The shares were valued at $1.75 per
share, the market price for shares of our common stock at the time of
issuance.  The total aggregate value of the consideration paid to
McCartney Multimedia was $26,250.





In June
2003, we issued 80,000 shares of restricted common stock to Woodbridge
Management, Ltd. pursuant to a consulting agreement for services related to
business development, corporate strategy, and assistance with joint ventures,
mergers and acquisitions.  The shares were issued pursuant to the
exemption from registration provided by Section 4(2) of the Securities Act for
issuances not involving a public offering.  The shares were valued at
$4.45 per share, the market price for shares of our common stock at the time of
issuance.  The total aggregate value of the consideration paid to
Woodbridge Management was $356,000.





On August 21, 2003, and September 12,
2003, we issued 2,750,000 shares of our preferred stock at a price per share of
$2.00 and 2,750,000 warrants, each of which entitles the holder to purchase one
share of our common stock for a period of five years from the date of issuance
at a price of $3.00 per share, to two accredited investors pursuant to a private
equity financing.  Each share of preferred stock is convertible, at
the option of the holder, into one share of common stock, subject to adjustment
for certain occurrences.   We also issued a five-year warrant to
purchase up to 275,000 units, with each Unit consisting of one share of
preferred stock and one warrant at an exercise price of $2.00 per Unit, to TN
Capital Equities, Ltd., our placement agent in connection with the private
equity financing.  The private equity financing described above was
made pursuant to the exemption from the registration provisions of the
Securities Act provided by Section 4(2) of the Act and Rule 506 of Regulation D
promulgated thereunder.





On August
31, 2003, we issued 41,667 shares to Peter Cunningham, our President and Chief
Executive Officer, pursuant to the terms of his employment agreement with
us.  The shares were issued pursuant to the exemption from
registration provided by Section 4(2) of the Securities Act for issuances not
involving a public offering.  The shares were valued at $5.00 per
share, the market price for shares of our common stock at the time of
issuance.  The total aggregate value of the consideration paid to
Peter W. Cunningham was $208,335.





On
September 18, 2003, we issued 100,000 shares to Lan Hao, our Chief Financial
Officer, pursuant to the terms of his employment agreement with
us.  The shares were issued pursuant to the exemption from
registration provided by Section 4(2) of the Securities Act for issuances not
involving a public offering.  The shares were valued at $5.00 per
share, the market price for shares of our common stock at the time of
issuance.  The total aggregate value of the consideration paid to Lan
S. Hao was $500,000.





18


On December 31, 2003, we issued 860,000
shares of our preferred stock, at a price per share of $2.25 and 1,000,000
warrants.  Each share of preferred stock is convertible, at the option
of the holder, into one share of common stock, subject to adjustment for certain
occurrences.  Each warrant entitles the holder to purchase one share
of our common stock for a period of five years from the date of issuance at a
price of $3.00 per share.  Holders of our warrants may also exercise
the warrants through a cashless exercise under certain
circumstances.   In addition, we issued to TN Capital Equities,
our placement agent, a five-year warrant to purchase up to 86,000 shares of our
preferred stock for $2.25 per share and up to 100,000 warrants to purchase
shares of our common stock upon exercise at $3.00 per share, on a pro-rata basis
to the number of shares of preferred stock purchased.   The
private equity financing described above was made pursuant to the exemption from
the registration provisions of the Securities Act provided by Section 4(2) of
the Act and Rule 506 of Regulation D promulgated thereunder.





On
January 26, 2004, the Board authorized the issuance of 100,000 shares of
restricted common shares and 50,000 warrants to Great Eastern Securities, Inc.
pursuant to an investment banking agreement. The shares are to be
released quarterly based upon a vesting schedule of 25,000 shares
per quarter during the term of the agreement.   Pursuant to
an agreement that was executed on December 18, 2003, Great Eastern will provide
investor relations related services and assist us with broker relations for our
stock.  The warrants are for a term of five years and have an exercise
price equal to $4.74 per share.  The shares were issued pursuant to
the exemption from registration provided by Section 4(2) of the Securities Act
for issuances not involving a public offering.  The shares were valued
at $5.65 per share, the market price for shares of our common stock at the time
of issuance.  The total aggregate value of the consideration paid to
Great Eastern Securities, Inc. was $639,828, including a $104,828 charge for the
value of the warrants issued.





On
February 2, 2004 and April 20, 2004, we issued 200,000 shares of restricted
common and 100,000 shares of restricted common, respectively to the Aston
Organization pursuant to a consulting agreement and amendment
thereto.  20,000 shares were released when the April 20, 2004
amendment was signed.    The remaining 180,000 shares are to
be released monthly based upon a vesting schedule of 15,000 shares per month
during the term of the agreement.   The services to be provided
under the agreement are investor relations.  The shares were issued
pursuant to the exemption from registration provided by Section 4(2) of the
Securities Act for issuances not involving a public offering.  The
shares were valued at $5.65 per share and $4.27 per share, respectively, the
market price for shares of our common stock at the time of
issuance.  Therefore, the total aggregate value of the consideration
paid to the Aston Organization was $1,557,000.





On May 7,
2004, we issued 120,000 shares of restricted common stock, and 200,000
warrants at $6.00 per warrant, to XCL Partners, Inc.  20,000 shares
were released when the agreement was signed on June 24, 2004.  The
remaining 100,000 shares are to be released monthly based upon a vesting
schedule of 10,000 shares per month for  ten months ,
beginning 30 days after effective date of the agreement   The
services to be provided under the agreement are investor
relations.   20,000 warrants shall vest
immediately.  The remaining 180,000 warrants shall be released monthly
based on a vesting schedule of 15,000 warrants per month for eleven months. The
shares were issued pursuant to the exemption from registration provided by
Section 4(2) of the Securities Act for issuances not involving a public
offering.  The shares were valued at $4.09 per share, the market price
for shares of our common stock at the time of issuance.  Therefore,
the total aggregate value of the consideration paid to the XCL Partners will be
$ 490,800.





On May
10, 2004, we issued 300,000 shares to Madden Consulting, Inc. pursuant to a
consulting agreement for investor and public relations services. The shares were
issued pursuant to the exemption from registration provided by Section 4(2) of
the Securities Act for issuances not involving a public offering.  The
shares were valued at $3.92 per share, the market price for shares of our common
stock at the time of issuance.  The total aggregate value of the
consideration paid to Madden Consulting was $1,176,000.





On June
24, 2004, we issued 30.425 shares of our preferred stock, at a price per share
of $100,000 and 357,936 common stock purchase warrants, each of which entitles
the holder to purchase one share of our common stock, $.001 par value, for a
period of three years from the date of issuance at a price equal to $5.50 per
share to accredited investors pursuant to a private equity
financing.  Each share of the preferred stock is convertible into a
number of fully paid and non-assessable shares of our common stock obtained by
dividing the face value of $100,000 per share by the fixed conversion price of
$4.25 per share.  In addition, we issued to HC Wainwright, our
placement agent, a three-year warrant to purchase up to 3 shares of our Series C
Preferred Stock at a price of $100,000per share and up to 53,691 warrants on a
pro-rata basis to the number of shares of Preferred Stock purchased upon
exercise.  We also issued 53,691 warrants to The Shemano Group, our
co-placement agent.  The private equity financing described above was
made pursuant to the exemption from the registration provisions of the
Securities Act for issuances not involving a public offering provided by Section
4(2) of the Act and Rule 506 of Regulation D promulgated thereunder. The
securities issued have not been registered under the Act and may not be offered
or sold in the United States absent registration or an applicable exemption from
registration requirements.


19





On June
24, 2004, we issued 100,000 warrants to each of SF Capital Partners Ltd.,
Gryphon Master Fund, L.P., Banyon Asia Limited and Banyon Mac 24, Ltd. in
consideration for services provided related to our recent private equity
financing.  The private equity financing described above was made
pursuant to the exemption from the registration provisions of the Securities Act
for issuances not involving a public offering provided by Section 4(2) of the
Act and Rule 506 of Regulation D promulgated thereunder. The securities issued
have not been registered under the Act and may not be offered or sold in the
United States absent registration or an applicable exemption from registration
requirements.





On July
21, 2004, we issued 100,000 shares of restricted common stock to Chet Howard,
our former Chief Financial Officer and Chief Accounting Officer.  The
shares were issued pursuant to the exemption from registration provided by
Section 4(2) of the Securities Act for issuances not involving a public
offering. The shares were valued using the closing stock price on the date of
issue, pursuant to which the stock was valued at $3.83 at the time of
issuance.  The total aggregate value of the consideration paid to Mr.
Howard was valued at $383,000.





On July
21, 2004, we issued 100,000 shares of restricted common stock to Harry Zhang,
our Chief Accounting Officer of our wholly owned subsidiary. The shares were
issued pursuant to the exemption from registration provided by Section 4(2) of
the Securities Act for issuances not involving a public offering.  The
shares were valued using the closing stock price on the date of issue, pursuant
to which the shares were valued at $3.83 at the time of issuance.  The
total aggregate value of the consideration paid to Mr. Zhang was valued at
$383,000.





On August
27, 2004, we issued 35,000 stock options to each to Montgomery Simus and Mark
Bluer, both of whom are members of our Board of Directors. The options were
valued using the Black Scholes value method, pursuant to which the options were
valued at a total of $ 190,400 at the time of issuance.





On
September 1, 2004, we issued stock options, for an aggregate of 100,000 shares
to Dreamvest, LLC pursuant to a consulting agreement.  The options
were issued pursuant to the exemption from registration provided by Section 4(2)
of the Securities Act for issuances not involving a public offering. The options
were valued using the intrinsic value method, pursuant to which the options were
valued at $2.69 at the time of issuance.





On
September 8, 2004, we issued stock options, for an aggregate of 57,500 stock
options to RCG Capital Markets Group, Inc., pursuant to a consulting
agreement.  A Termination Agreement, dated January 14, 2005 terminated
the consulting agreement with RCG.  The options were issued pursuant
to the exemption from registration provided by Section 4(2) of the Securities
Act for issuances not involving a public offering.  The options were
valued using the intrinsic value method, pursuant to which the options were
valued at $3.90 at the time of issuance.





On
September 10, 2004, we issued 83,334 shares of restricted common shares to Peter
Cunningham, our Chief Executive Officer pursuant to his employment agreement.
The shares were issued pursuant to the exemption from registration provided by
Section 4(2) of the Securities Act for issuances not involving a public
offering.  The shares were valued at $3.83 per share, the market price
for shares of our common stock at the time of issuance.  Therefore,
the total aggregate value of the consideration paid to Mr. Cunningham was valued
at $319,169.





In
October 2004, we engaged Byrle Lerner, a beneficial owner of more than five
percent of our common stock (6.44%), to provide consulting services to AXM
Pharma.  Mr. Lerner will receive 60,000 restricted common shares and
100,000 options to purchase our common stock at $2.15 per share for his
services.  The current agreement with Mr. Lerner is for one year and
is terminable by either Mr. Lerner or us upon thirty days written
notice.


20





In October 2004, we engaged Aurelius
Consulting to provide marketing and investor relations services. The initial
term of the agreement is one year.  Aurelius is entitled to receive
12,500 shares of our restricted common stock per quarter during the term of its
agreement, in consideration for their services. The initial 12,500 shares were
paid on behalf of AXM Pharma by Byrle Lerner in a private
transfer.  The shares were valued at $2.29 per share, the market price
for shares of our common stock at the time of transfer.  Therefore,
the total aggregate value of the transaction recognized by AXM Pharma was
$28,625.





In October 2004, we agreed to issue
Mirador Consulting 30,000 restricted common shares pursuant to a consulting
agreement with a 3 month term that may be renewed upon the written consent of
both Mirador and us. The agreement is for corporate consulting and investor
relations services.  The 30,000 shares were paid on behalf of AXM
Pharma by Byrle Lerner in a private transfer.  The shares were valued
at $2.15 per share, the market price for shares of our common stock at the time
of transfer.  Therefore, the total aggregate value of the transaction
recognized by AXM Pharma was $64,500.





On
January 19 and June 29, 2005, we issued 50,017 and 28,583 shares of common stock
as dividends to Series C Preferred shareholders as payment of interest totaling
$141,048 and $40,016, respectively.





On
March 31, 2005 we issued 350,000 shares of restricted common stock to Madden
Consulting as compensation for investor relations consulting services.  The
stock was valued at $2.74 per share, the closing stock price on the date of
issuance, the Company recognized $959,000.





In
March 2005, we issued 94,117 shares of common stock to Iroquis Capital for the
conversion of 4 shares of Series C Preferred Stock.





In
March 2005, we issued 725,000 shares of common stock to SF Capital for the
conversion of 725,000 shares of Series A Preferred.





In
March 2005, we issued 30,000 shares of restrict stock to each of XCL Partner
Inc. and Ashton Organization pursuant to consulting services.  The
total value the consideration was $80,400 and $79,500,
respectively.





On
April 1, 2005, we issued 40,000 shares of restricted common stock to Newbridge
Securities as compensation for investor relations consulting services.  The
stock was valued at $2.75 per share, the closing stock price on the date of
issuance; the Company recognized $110,000 in expenses for the issuance of this
stock.  On April 1, 2005 we issued 45,000 shares of stock to Zhu Ming and
10,000 shares of stock to Li Shuzhen, both at $2.75 per share and totaling
$151,250 for certain license rights.





On
April 19, 2005, AXM Pharma, Inc. accepted subscriptions in the amount of
$3,125,000, with 8 accredited investors pursuant to a private equity financing.
 The placement was co-managed by H.C. Wainwright & Co, Inc. and Chardan
Capital Markets.  Net proceeds from the offering after estimated costs and
expenses, including fees of the placement agent, were approximately $2,767,500.
 We issued 6.25 Units, each consisting of one (1) $500,000 Secured
Promissory Note and three hundred thousand (300,000) Common Stock Purchase
Warrants (Series A Warrants) and three hundred thousand (300,000) special Common
Stock Purchase Warrants (Series B Warrants).  For each $500,000 of Notes
purchased pursuant to that certain Note and Warrant Purchase Agreement entered
into on April 19, 2005 between the Company and those Purchasers listed on
Exhibit A to the Agreement, such Purchaser shall receive a Series A Warrant to
purchase up to 300,000 shares of Common Stock at an exercise price of $2.90 per
share and a Series B Warrant to purchase up to 300,000 shares of Common Stock at
an exercise price per share of $3.50.  Each Purchaser shall also be
entitled to receive a Series C Warrant to purchase a number of shares of Common
Stock equal to one hundred percent (100%) of the number of Conversion Shares
issuable upon conversion of such Purchaser’s Note at an exercise price per share
equal to the Conversion Price.  The Series A Warrants and the Series B
Warrants shall expire five (5) years following the Closing Date and the Series C
Warrants shall expire one (1) year following the effective date of the
registration statement providing for the resale of the Conversion Shares and the
Warrant Shares.


21





Each Note
is due on April 19, 2007 and is convertible at the option of the holder anytime
in whole or in part at $2.10.  The notes bear interest at the rate of nine
percent (9%) per annum, convertible into shares of AXM’s common stock, par value
$0.001 per share.  The interest is payable monthly commencing on the fifth
(5th) month
following the issuance date, in cash or in shares of AXM’s common stock.
 Commencing on the fifth (5th) month
following the issuance date and continuing thereafter on the first (1st)
business day of each month until the maturity date, AXM shall pay the principal
installment amount equal to one-twentieth (1/20th) of the
original principal amount of the note plus any accrued but unpaid interest to
the holder; provided, however, if on any principal payment date, the outstanding
principal amount of the note plus any accrued but unpaid interest is less than
the principal installment amount, then AXM shall pay such lesser amount.
 AXM may pay the Principal Installment Amount in cash or registered shares
of common stock. If AXM elects to pay the principal installment amount in
registered shares of common stock, the number of registered shares of common
stock to be issued to the holder shall be an amount equal to the Principal
Installment Amount divided by eighty-five percent (85%) of the average of the
VWAP for the five (5) trading days immediately preceding the principal payment
date; provided,
that, in no
event shall the number of registered shares of common stock to be issued to the
holder be greater than an amount equal to the principal installment amount
divided by eighty percent (80%) of the VWAP on the date AXM provides the holder
with notice as to how AXM will pay the upcoming Principal Installment Amount,
which notice must be given ten (10) business days prior to such
payment.





The
parties to the Note and Purchase Agreement, along with AXM’s wholly owned
subsidiary AXM Pharma (Shenyang) Inc., also entered into a Security Agreement
dated April 19, 2005.  Pursuant to the Security Agreement, Investors are
granted a security interest in the real property at which AXM Pharma (Shenyang)
Inc.’s factory is located and all equipment and inventory of every kind and
nature located on the real property, as well as all proceeds and products of
such real property, except for any accounts receivables.  This security is
senior to all other creditors except for the existing line of credit with
Shanghai Pudong Development Bank.  Additionally, AXM also granted a
security interest in 100% of the shares of its wholly owned subsidiary, Werke
Pharmaceuticals, Inc., which owns AXM Shenyang.





In
addition to its fees and expenses, the placement agent and co-placement agent,
or its assigns, will receive commissions and warrants as follows, but each agent
shall only receive such commissions and warrants for the investors participating
in the offering through each agent’s own efforts.  A selling commissions in
an amount equal to 10% of the gross subscription proceeds shall be awarded, as
well as one (1) 5-year Warrant to purchase shares of the Company’s Common Stock
at $2.90 per share for each 10 shares underlying the Notes and Warrants issued
by the Company in connection with the offering.





We are
obligated to file a registration statement within 30 days of the closing
covering the shares of common stock underlying the Notes and Warrants and an
additional number of shares to account for monthly redemptions.





On
April 22 and April 26, 2005, we issued totaling 78,329 shares of common stock to
SRG Capital for the conversion of fractional shares of Series C
Preferred.





On
June 14, 2005, we issued 11,700 shares of common stock to Gryphon Master Fund
for the conversion of 11,700 shares of Series A Preferred Stock.





On
July 1 and August 10, 2005, we issued totaling 111,800 shares of Common Stock to
National Financial Service in connection with the conversion of 111,800 shares
of its Series A Preferred Stock.





On
August 8, 2005, we completed a sale of shares of Common Stock by the exercise of
the Company’s warrant for gross proceeds of $2,127,436.  This financing was
made pursuant to a Special Warrant Offer extended to the purchasers listed in
the Note and Warrant Purchase Agreement dated as of April 19, 2005.





On
August 31, 2005, we issued 150,000 shares to Madden Consulting, Inc. pursuant to
a consulting agreement.  The services to be provided under the
consulting agreement were investor and public relations, which was valued at
$252,000.


22




On
September 9, 2005, we issued 50,000 shares to Ashok Patel pursuant to a
consulting agreement. The services to be provided under the consulting agreement
were advisory of strategic licensing and marketing, which was valued as
$77,000.




On
September 19, 2005, we issued 245,645 shares of Common Stock (valued at
$334,077) to convertible debenture holders in payment of principal and interest
due under the debentures.  Of this amount, $171,250 represented principal
payments and the balance interest expense.





Equity
Compensation Plan Information





Plan Category
                
                (a)
                  Number of securities to be
                  issued upon exercise of
                  outstanding options,
                  warrants and rights
                
                
                (b)
                  Weighted average exercise
                  price of outstandingoptions,
                  warrants and
                  rights
                
                
                (c)
                  Number of securities
                  remaining available for
                  future issuance under
                  equitycompensation plans
                  (excluding securities
                  reflected in column (a)Equity
      Compensation plans approved by security holders
                
                
                2,477,500
                
                
                $
                4.58
                
                
                
                522,500Equity
      compensation plans not approved by security holders
                
                
                1,493,334
                
                
                $
                4.05
                
                
                
                0Total
                
                
                2,477,500
                
                
                $
                4.58
                
                
                
                522,500





We did
not issue any options in 2005 under our 2005 equity incentive plan, approved by
our shareholders in March 2005.





Item
      7:
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations





General





AXM Pharma, Inc. is a pharmaceutical
and nutraceutical company engaged in the production, marketing and distribution
of over the counter and prescription pharmaceutical products in China. We have
licenses to produce, market and distribute drug products in various dosages and
forms, as well as herbal remedies and vitamins. Currently, subject to having
sufficient resources, we plan to develop sales of Chinese products such as
Asarone, Lifegate, LiveComf and Elegance though our operations in
Shenyang.  Products sold through AXM Shenyang will be sold primarily
to the mainland Chinese market, which includes hospital and retail
sales.  We plan to continue to deemphasize hospital sales in favor of
retail sales through pharmacies, which generally provide better margins than
hospital sales.





Liquidity
and Capital Resources





We are in
urgent need of additional capital.  Our cash resources have been
depleted. We have not paid our employees in China since January 2006. We are in
default under the terms of certain promissory notes as described more fully
below under “Risk Factors -
We are currently in default on our obligations under our Convertible Promissory
Notes.” These conditions raise substantial doubt about our ability to
continue as a going concern. The audit report prepared by our independent
registered public accounting firm relating to our consolidated financial
statements for the year ended December 31, 2005 includes an explanatory
paragraph expressing the substantial doubt about our ability to continue as a
going concern. We are currently in discussions with several funding sourcess in
China to obtain financing to support operations going forward; however, to date
these discussions have not resulted in our obtaining any additional financing.
At this time, we do not know if additional financing will be available, nor can
we predict the terms of any additional financing.  If we do not raise
additional capital in the immediate future, we may be forced to cease
operations.  If additional capital is raised through the sale of
equity or convertible debt securities, the issuance of such securities would
result in dilution to our existing stockholders. If additional capital is raised
through incurrence of indebtedness, our interest expense will likely increase
and restrictive covenants imposed by the lenders may impair our ability to grow
our business.


23





Since
our inception, we have generated significant losses from operations and we
anticipate that we will continue to generate significant losses from operations
for the foreseeable future.  As of December 31, 2005, our
accumulated deficit was approximately $28 million.  Our net loss was
$9 million and $13 million for the years ended December 31, 2005 and 2004,
respectively. Our cash outlays from operations and capital expenditures were $9
million and $10 million for 2005 and 2004, respectively. Our stockholders’
equity decreased from $5 million as of December 31, 2004 to $0.8 million as of
December 31, 2005.





Under the
terms of certain Secured Promissory Notes issued on April 19, 2005, we are
obligated to pay interest and principal monthly in cash or shares. However, we
are obligated to make payments in cash if our share price falls below a certain
price calculated under a formula specified in the Notes. We are currently in
default in our payment obligations because we have not been able to pay the
required repayment of principal and interest to the holders of the
Notes.  We are in negotiations with the holders with a view to
restructuring the terms of the Notes.  However, no agreement has been
reached and, if we fail to reach an agreement, it will likely be impossible for
us to raise any new funds (see “Risk Factors -We are currently in
default on our obligations under our Secured Promissory Notes”.)





Cash
Sources and Uses





Total
assets increased from $12,516,807 at December 31, 2004 to $13,833,946 at
December 31, 2005.  The increase is primarily attributable to the
receipt of $4,941,192 and $2,654,467 in net proceeds from the placement of
securities and short-term bank loans offset by losses incurred in normal
operations.





Our total
outstanding current liabilities increased to $12,969,219 at December 31, 2005,
as compared to approximately $7,553,587 at December 31, 2004.  The
increase in current liabilities was the result of an increase in short-term
loans and accrued interest and principle on the secured promissory
notes.





From
December 31, 2004, to December 31, 2005, our cash and cash equivalents decreased
by approximately $1,163,061. We received net proceeds from the sale of the
secured promissory notes of $3,034,000.  We also received $1,907,193
form the exercise of warrants to acquire common stock.  These amounts
were offset by general, administrative and selling expenses of approximately
$7,621,405. The sales, general and administrative expenditures were incurred
primarily in connection with offerings of securities, marketing expenses and
legal, accounting and consulting fees.  We incurred approximately $2
million and $5.6 million of non-cash general, administrative and selling
expenses in 2005 and 2004, respectively.  The non-cash expense is
incurred for services (e.g. financial consulting and investor relations
services) for which we pay our vendor in shares of our common
stock.


Capital
used to date in activities associated with the building and certification of the
new facilities in Shenyang is approximately US$7.4 million. To fulfill our
planned sales expansion, implement the required systems and fund our working
capital needs, we will need to raise approximately $6 million in additional
funds during 2006.  We are currently seeking to raise this additional
capital through either sales of our equity securities or debt financing, secured
by our factory and equipment in Shenyang, but there cannot be any guarantees
that we will be able to raise this additional capital on acceptable terms or at
all.  We are not currently in a position to generate cash inflows by
calling for the exercise of any of our outstanding warrants because the trading
price of our stock is below $2.1 per share. If we are not able to raise
additional capital, we will be forced to cease operations.





Financing
Activities





On August
8, 2005, we completed the sale of 1,488,100 shares of Common Stock for gross
proceeds of $2,127,436 (net proceeds of $1,907,193).  This financing was
made pursuant to a Special Warrant Offer extended to the purchasers listed in
the Note and Warrant Purchase Agreement dated as of April 19, 2005.  Eight
out of the nine original purchasers participated in the Special Warrant
Offer.


24





On April
19, 2005 we completed a private financing with 9 accredited investors.  We
executed notes totaling $3,125,000.  Net proceeds from the issuance of the
notes after offering costs were approximately $2,767,500. The notes were issued as a
portion of 6.25 Units, each consisting of one (1) $500,000 Secured Promissory
Note; three hundred thousand (300,000) Common Stock Purchase Warrants (Series A
Warrants); and three hundred thousand (300,000) special Common Stock Purchase
Warrants (Series B Warrants).  The Notes bear interest at 9% and are
repayable in equal installments during the period September 2005-April 2007 (see
description above under Recent
Sales of Unregistered Securities.)





Results
of Operations





Year
Ended December 31, 2005 Compared to Year Ended December 31, 2004.





Revenue - During the fiscal
year ended December 31, 2005, we generated $2,021,728 from product sales
compared to revenues from product sales for the fiscal year ended December 31,
2004, of $2,115,751. Approximately 60% or our 2005 revenues were derived from
the sale of Sunkist labeled products.  Due to the termination of our
license arrangements with Sunkist, we will have only minimal sales in 2006
derived from the Sunkist-labeled products.   The balance of our
2005 sales and all of our 2004 sales were derived from products produced by our
Shenyang operations.  The decline in sales of Shenyang produced
products from 2005 to 2004 is principally a result of lack of adequate capital
has severely constrained our ability to market and promote our
products.





During
the second quarter of 2005, we entered into three international markets for our
Sunkist-labeled products:  Hong Kong; Taiwan and the PRC.  Although we
received purchase orders for certain products from distributors in these
territories, we concluded that, under our distribution agreements, several of
the elements necessary to the recognition of the revenue related to these
purchase orders were not in place as of September 30, 2005. Therefore, we
restated our financial statements for the quarter ended June 30,
2005.  In addition, we concluded that the business arrangements with
our distributors for the Sunkist-labeled products were not
satisfactory.  We therefore entered new distribution agreements with
Kerryflex Supply Chain Solutions Limited and a Memorandum of Understanding with
DKSH Taiwan Limited in Hong Kong and Taiwan in the forth quarter of 2005. We
recognized revenue of Sunkist labeled products of $1.2 million in 2005 taking
into account the restatement.





Our
license agreements with Sunkist in Hong Kong, Macau and Taiwan expired at
December 31, 2005, and our license for China was terminated in February 20,
2006. As a result, we no longer have any right to sell Sunkist-labeled
products.





Future revenues will be derived from
the sale of products produced at our Shenyang facility.  To date, our
ability to conduct manufacturing operations at Shenyang and sales activity in
China has been severely constrained by our lack of funds.  If we are
unable to raise substantial additional funds, we may not have the ability to
generate significant sales from our Shenyang operation.  In such
event, we may consider licensing arrangements or other
strategies.  However, we have no such arrangements in place and no
assurance can be given that satisfactory arrangements can be
obtained.





Gross Profit -Gross profit
on product sales for the fiscal year ended December 31, 2005, was $772,368
compared to $1,065,468 for the fiscal year ended December 31, 2004. The decrease
was the result of lower margins on the Sunkist labeled products.





Sales, General and Administrative
Expenses - We incurred Sales, General and Administrative expenses of $
9,629,424, for fiscal year ended December 31, 2005, compared to $15,055,322 for
the fiscal year ended December 31, 2004, a decrease of
$5,425,898.  The decrease in expenses is primarily due to the decrease
in consulting fees and personnel costs.  We incurred approximately $2
million in 2005 in non-cash SG&A expenses in recognition of stock, warrants
and options issued to cover administrative services provided by consultants and
approximately $7.6 million of cash expenditures, a decrease of $1.8 million from
the same period last year.





25


Inventory written-off - We
delivered Sunkist brand products of Chewchew Bear multi-vitamins to
distributors, of which, $313,000 of such product was labeled to be sold in
China.  However, we had not obtained the necessary import license for
this product from the Chinese government as of December 31, 2005. The
inventories remain in the distributor’s warehouse in Hong Kong.  We
can not predict when we will obtain the necessary license to remove this product
from the distributor’s warehouse. Accordingly, we have written off the value of
this product from our inventory. During 2005, we outsourced and manufactured
Sunkist brand products of Leafs vitamin supplement strips in China. The raw
material had quality problems, resulting in a write-off of
$219,000.  As a result of the above, we took an inventory write-off of
approximately $532,000 during 2005





Non-Cash Consulting Expenses -During the year ended December 31, 2005, our Board of Directors
authorized the issuance of shares of our restricted common stock, warrants and
stock options to various consultants in lieu of cash payments. Based upon the
common stock trading price at the times of issuance, and FASB rules, we were
required to incur non-cash consulting expenses of approximately $2 million for
the issuance of these shares during the year ended December 31,
2005.





Net Loss –As a result of the
above, we recorded a net loss from operations for the fiscal year ended December
31, 2005, of $9,247,932 compared to a net loss of $13,250,883 for the fiscal
year ended December 31, 2004.  The decrease is the result of the
aforementioned decrease in Selling, General and Administrative expenses. The net
loss per share for the year ended December 31, 2005 was $0.45 per share
calculated on weighted average shares outstanding of 20,433,762, compared to a
net loss per share for the year ended December 31, 2004 of $0.82 calculated on
weighted average shares outstanding of 16,066,789.





Critical
Accounting Policies




We
believe the following critical accounting policies, among others, affect our
more significant judgments and estimates used in the preparation of our
financial statements:





Revenue Recognition-Product
sales revenue is recognized when the goods are shipped, title and risk of loss
passes and collectability is reasonably assured.  In situations where
a distributor’s sales reporting to us is inadequate or untimely, we have to
judge whether all of the elements required for revenue recognition have been
met, including assurance of collectability.  In such instances, we may
conclude that revenue recognition of such sales should be delayed until payments
are received from the distributor.  Any provision for discounts and
estimated returns are accounted for in the period the related sales are
recorded.





Allowance for Doubtful Accounts- We maintain allowances for doubtful accounts for estimated losses
resulting from the inability of our customers to make required
payments.  The allowance for doubtful accounts is based on specific
identification of customer accounts and our best estimate of the likelihood of
potential loss, taking into account such factors as the financial condition and
payment history of major customers.  We evaluate the collectability of
our receivables at least quarterly.  If the financial condition of our
customers were to deteriorate, resulting in an impairment of their ability to
make payments, additional allowances may be required.  The differences
could be material and could significantly impact cash flows from operating
activities.





Sales Allowances -A portion
of our business is to sell products to distributors who resell the products to
the end customers.  In certain instances, these distributors obtain
discounts based on the contractual terms of these arrangements.  Sales
discounts are usually based upon the volume of purchases or by reference to a
specific price in the related distribution agreement.  We recognize
the amount of these discounts at the time the sale is
recognized.  Additionally, sales returns allowances are estimated
based on historical return data, and recorded at the time of sale.  If
the quality or efficacy of our products deteriorates or market conditions
otherwise change, actual discounts and returns could be significantly higher
than estimated, resulting in potentially material differences in cash flows from
operating activities.





Inventory - We write down our
inventory for estimated obsolescence or unmarketable inventory equal to the
difference between the cost of inventory and the estimated market value based
upon assumptions about future demand, future pricing and market
conditions.  If actual future demands, future pricing or market
conditions are less favorable than those projected by management, additional
inventory write-downs may be required and the differences could be
material.  Such differences might significantly impact cash flows from
operating activities.


26


Accounting for Stock-Based
Compensation - We account for stock-based compensation for employees and
non-employee members of our board of directors in accordance with Accounting
Principles Board, or APB, Opinion No. 25, “Accounting for Stock Issued to
Employees.” Under APB Opinion No. 25, compensation expense is based on the
intrinsic value on the measurement date, calculated as the difference between
the fair value of our common stock and the relevant exercise price. We account
for stock-based compensation for non-employees, who are not members of our board
of directors, at fair value using a Black-Scholes option-pricing model in
accordance with the provisions of SFAS No. 123, “Accounting for Stock-Based
Compensation” and other applicable accounting principles.  There were
2,140,000 stock options granted to employees and directors in
2004.  There were not any options granted to employees in
2005.





Had
compensation expense been determined based on the estimated fair value at the
measurement dates of awards under those plans consistent with the method
prescribed by SFAS No. 123, our December 31, 2005 and 2004 net loss would have
been changed to the pro forma amounts indicated below.  No options
were granted in 2005.





In
December 2002, the Financial Accounting Standards Board issued its Statement No.
148, “Accounting for Stock-Based Compensation — Transition and Disclosure—an
amendment of Financial Accounting Standards Board Statement No. 123.” This
Statement amends Statement of Financial Accounting Standards No. 123, to provide
alternative methods of transition for an entity that voluntarily changes to the
fair value based method of accounting for stock-based employee
compensation.  It also amends the disclosure provisions of Statement
of Financial Accounting Standards No. 123 to require prominent disclosure about
the effects on reported net income of an entity’s accounting policy decisions
with respect to stock-based employee compensation. The transition and annual
disclosure provisions of Statement of Financial Accounting Standards No. 148 are
effective for fiscal years ending after December 15, 2002, and the interim
disclosure provisions were effective for the first interim period beginning
after December 15, 2002. We did not voluntarily change to the fair value based
method of accounting for stock-based employee compensation, therefore, the
adoption of Statement of Financial Accounting Standards No. 148 did not have a
material impact on our operations and/or financial position.





Convertible Preferred
Stock-Convertible Preferred Sock issued by AXM Pharma is initially offset by a
discount representing the relative fair values of the embedded conversion option
in the Preferred Stock and the warrants issued with the Preferred
Stock.  The fair value of the warrants and embedded conversion option
are calculated based on available market data using appropriate valuation
models.  The excess of the sum of the values of the embedded
conversion option plus the warrants over the cash proceeds received from the
issuance of the Preferred Stock is charged to interest expense.





Secured Promissory Notes-Convertible Secured
Promissory Notes that we issued are initially offset by a discount representing
the relative fair values of the conversion option embedded in the Notes and
warrants issued with the Notes.  The fair value of the warrants and
embedded conversion option are calculated based on available market data using
appropriate valuation models.  The excess of the sum of the values of
the embedded conversion option plus the warrants over the cash proceeds received
from the issuance of the Notes is charged to interest expense. The carrying
value of the Notes is accreted to the face amount over the term of the Notes
using an effective interest method.





Warrants-Warrants issued in
connection with our Secured Promissory Notes and Convertible Preferred Stock
have been classified as liabilities due to certain provisions that may require
cash settlement in certain circumstances. At each balance sheet date, we adjust
the warrants to reflect their current fair value. We estimate the fair value of
these instruments using the Black-Scholes option pricing model which takes into
account a variety of factors, including historical stock price volatility,
risk-free interest rates, remaining term and the closing price of our common
stock. Changes in the assumptions used to estimate the fair value of these
derivative instruments could result in a material change in the fair value of
the instruments. We believe the assumptions used to estimate the fair values of
the warrants are reasonable.  See Item 6A. Quantitative and Qualitative
Disclosures about Market Risk for additional information on the
volatility in market value of derivative instruments.





Deferred Financing Costs.-
Deferred financing costs attributable to the issuance of Secured Promissory
Notes and Convertible Preferred Stock have been amortized to interest expense
over the term of those instruments.


27


Fair Value of Financial Instruments-Financial
instruments that are subject to fair disclosure requirements are carried in the
financial statements at amounts that approximate fair value and include cash and
cash equivalents, accounts receivable and accounts payable.  Fair
values are based on assumptions concerning the amount and timing of estimated
future cash flows and assumed discount rates reflecting varying degrees of
perceived risk.





Valuation of Intangibles -From time to time, we acquire intangible assets that are beneficial to
our product development processes. We periodically evaluate the carrying value
of intangibles, including the related amortization periods.  In
evaluating acquired intangible assets, we determine whether there has been
impairment by comparing the anticipated undiscounted cash flows from the
operation and eventual disposition of the product line with its carrying
value.  If the undiscounted cash flows are less than the carrying
value, the amount of the impairment, if any, will be determined by comparing the
carrying value of each intangible asset with its fair value.  Fair
value is generally based on either a discounted cash flows analysis or market
analysis.  Future operating income is based on various assumptions,
including regulatory approvals, patents being granted, and the type and nature
of competing products. If regulatory approvals or patents are not obtained or
are substantially delayed, or other competing technologies are developed and
obtain general market acceptance or market conditions otherwise change, our
intangibles may have a substantially reduced value, which could be material.





Deferred Taxes -We record a
valuation allowance to reduce the deferred tax assets to the amount that is more
likely than not to be realized.  We have considered estimated future
taxable income and ongoing tax planning strategies in assessing the amount
needed for the valuation allowance.  Based on these estimates, all of
our deferred tax assets have been reserved.  If actual results differ
favorably from those estimates used, we may be able to realize all or part of
our net deferred tax assets.  Such realization could positively impact
our operating results and cash flows from operating activities.





Value Added Tax -Value added
tax payable is reported as a significant liability.  The accounting
policies adopted by management include full disclosure of the value added tax
liability calculated at 17% of the difference between ex-factory price and the
cost of raw materials, less the cost of the fees paid to the third-party
original equipment manufacturing company.





Litigation -We account for
litigation losses in accordance with Statement of Financial Accounting Standards
(SFAS) No. 5, “Accounting for Contingencies.”  Under SFAS No. 5, loss
contingency provisions are recorded for probable losses at management’s best
estimate of a loss, or when a best estimate cannot be made, a minimum loss
contingency amount is recorded.  These estimates are often initially
developed substantially earlier than the ultimate loss is known, and the
estimates are refined each accounting period, as additional information is
known.  Accordingly, we are often initially unable to develop a best
estimate of loss; therefore, the minimum amount, which could be zero, is
recorded.  As information becomes known, either the minimum loss
amount is increased or a best estimate can be made, resulting in additional loss
provisions.  Occasionally, a best estimate amount is changed to a
lower amount when events result in an expectation of a more favorable outcome
than previously expected.  Due to the nature of current litigation
matters, the factors that could lead to changes in loss reserves might change
quickly and the range of actual losses could be significant, which could
materially impact our results of operations and cash flows from operating
activities.





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





Fair Value of Warrants and
Derivative Liabilities. As of December 31, 2005, the value of our warrant
liability was $2.9 million. We estimate the fair value of these instruments
using the Black-Scholes option pricing models, which takes into account a
variety of factors, including historical stock price volatility, risk-free
interest rates, remaining maturity and the closing price of our common stock. We
believe that the change in value from period to period is most significantly
impacted by the closing price of our common stock at each reporting period. The
following table illustrates the potential effect on the fair value of derivative
securities of changes in certain assumptions made:


28





Increase\decrease(in
      thousands)10%
      increase in stock price
                  
                  $
                  40420%
      increase in stock price
                  
                  $
                  8185%
      increase in assumed volatility
                  
                  $
                  20010%
      decrease in stock price
                  
                  $
                  (431
                  )20%
      decrease in stock price
                  
                  $
                  (808
                  )5%
      decrease in assumed volatility
                  
                  $
                  (236
                  )





Item
      8.
              Financial
      Statements and Supplementary
Data





The
financial statements and financial statement schedules begin on page F-1 of this
report.





Item
      9.
            Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure





None.





Item
9A. Controls and Procedures





Evaluation
and Disclosure Controls and Procedures





We have
evaluated the effectiveness of the design and operation of our “disclosure
controls and procedures,” as such term is defined in Rules 13a-15e promulgated
under the Exchange Act as of this report. Based upon the evaluation, the Chief
Executive Officer and Chief Financial Officer have concluded that our disclosure
controls and procedures were not effective as of the end of the period covered
by this report to provide reasonable assurance that information required to be
disclosed by the Company in reports that it files or submits under the Exchange
Act is recorded, processed, summarized and report within the time periods
specified in SEC rules and forms.





In this
regard, our current management noted in particular our restatement necessitated
by an improper recognition of revenues in the second quarter of
2005.  In order to address this matter, we have undertaken a number of
steps to improve our disclosure process.  We have changed our Chief
Financial Officer and the composition of our Audit Committee.  We have
appointed an experienced and independent individual who qualifies as a financial
expert to serve as Chair of the Audit Committee.  We have implemented
a more rigorous disclosure process.  Nonetheless, in light of our
limited financial resources and the concomitant limitations on our financial
reporting infrastructure, we believe it is premature to conclude that our
disclosure controls and procedures are effective.




Changes
in Internal Controls




The
Company maintains a system of disclosure controls and procedures. The term
“disclosure controls and procedures,” as defined by regulations of the SEC,
means controls and other procedures that are designed to ensure that information
required to be disclosed in the reports that the Company files or submits to the
SEC under the Securities Exchange Act of 1934, as amended (the “Act”), is
recorded, processed, summarized and reported, within the time periods specified
in the SEC’s rules and forms. Disclosure controls and procedures include,
without limitation, controls and procedures designed to ensure that information
required to be disclosed by the Company in the reports that it files or submits
to the SEC under the Act is accumulated and communicated to the Company’s
management, including its Chief Executive Officer and its Principal Financial
Officer, as appropriate to allow timely decisions to be made regarding required
disclosure.


29


The
Company’s Chief Executive Officer and the Audit Committee of the Board of
Directors completed an evaluation of the effectiveness of the design and
operation of the Company’s disclosure controls and procedures (as such term is
defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of
1934, as amended) for the year ended December 31, 2005 and concluded that the
Company’s disclosure controls and procedures were not effective as of the end of
that period.  Specifically, management and the Audit Committee of the
Board of Directors believe that the Company’s disclosure controls and procedures
have not been adequate in the following respects:





·
            The
      Company did not maintain effective controls, including policies and
      procedures, over accounting for financing agreements and related party
      transactions.





·
            The
      Company did not maintain effective controls to provide reasonable
      assurance that management oversight and review procedures were properly
      performed over the accounts and disclosures in its consolidated financial
      statements, and that accounts were complete and accurate and consistent
      with detailed supporting documentation. In addition, the Company did not
      maintain effective controls over communications among its management to
      provide reasonable assurance that the preparation of its consolidated
      financial statements and disclosures were complete and
      accurate.





These
inadequacies prompted management to adopt remedial measures. Certain of these
measures have been implemented as of the date of filing of this Form 10-K/A;
others are currently in process of being implemented.





Remediation
Measures:





As of
March 1, 2008, the Company has taken the following steps to remediate the
inadequacies in the Company’s disclosure controls and procedure for related
party transactions:





Any out
of the ordinary course of business payment made to any current or former
investor and/or their families and associates will be subject to approval by the
Chair of the Company’s Audit Committee.





As of
March 1, 2008, the Company has taken the following steps to remediate the
inadequacies in the Company’s disclosure controls and procedure for financing
agreements:





·
            The
      finance department has adopted a schedule for preparation of financial
      reports that provides the CEO and Accounting Manager sufficient lead time
      to review and comment on the financial reports. Included on the schedule
      are monthly “close” meetings with the CEO and the Chairman of the Audit
      Committee to review the closing financial
  statements.





·
            The
      Company has created a committee responsible for disclosure matters that
      will report to senior management. The committee will meet on a monthly
      basis to determine whether any material events have occurred, or are
      likely to occur, that may require disclosure in a current or periodic
      report





·
            The
      finance department will review with the Chairman of the Audit Committee on
      a timely basis, and in no event, later than the monthly finance meeting,
      any events that signal a significant deficiency or material
      weakness





Item
      9B.
            Other
      Information





None.





PART
III.





Item
      10.
            Directors
      and Executive Officers of the
Registrant





The
following table and text set forth the names and ages of all directors and
executive officers of AXM Pharma as of April 28, 2006. On September 25, 2005, we
elected Baozhong  Zhang to serve on the Board of Directors.  On
October 13, 2005, Chet Howard resigned as Chief Executive Officer and Chief
Financial Officer of the Company.  On that same day, Wang Wei Shi was
elected by the Board of Directors to serve as the Company’s Chief Executive
Officer and elected Harry Zhang to serve as the Company’s Chief Financial
Officer.  On March 8, 2006, we elected Elliot M. Maza and Wenzhou
Zhang to serve as directors on the Board of Directors.  Elliot M. Maza
also serves as the Chairman of the Audit Committee.


30


The Board
of Directors is comprised of only one class. All of the directors will serve
until the next annual meeting of shareholders, which is anticipated to be held
in May of 2006, and until their successors are elected and qualified, or until
their earlier death, retirement, resignation or removal.  There are no
family relationships among directors and executive officers. Also provided
herein are brief descriptions of the business experience of each director and
executive officer during the past five years and an indication of directorships
held by each director in other companies subject to the reporting requirements
under the Federal securities laws.





Name
            
            Age
            
            PositionWang
      Wei Shi
            
            48
            
            ChairmanHarry
      Zhang
            
            42
            
            Acting
      Chief Financial OfficerElliot
      M. Maza
            
            50
            
            DirectorBaozhong  Zhang
            
            61
            
            DirectorWenzhou
      Zhang
            
            63
            
            DirectorZhenyu
      Kong
            
            61
            
            President
      of China Operations & Chief Operating Officer of AXM
      Sheyang





Ms. Wang Wei Shi,
Chairman.
 Ms. Wang became Chairman of AXM Pharma when we acquired Werke
Pharmaceuticals, Inc. in March 2003 and has been Chairman of AXM Shenyang and
Vice-Chairman of Werke Pharmaceuticals, Inc. since December 2000.  From
1999 until December 2000, Ms. Wang was Chairman and General Manager of Shenyang
Tianwei Pharmaceutical Factory, Ltd., a predecessor to AXM Shenyang.  Since
May 1996, she has also been Chairman of Liaoning Shenda Import and Export
Company, a Chinese import/export company.  From 1984 through 1988, Ms. Wang
was the Manager of the Finance Department of the Shenyang Five Mineral Import
and Export Company, a Chinese import/export company.  Ms. Wang attended
Beijing University and Shenyang University and studied financial management,
accounting and economics.





Harry Zhang, Chief Financial
Officer.  Mr. Zhang became Chief Financial Officer on October
13, 2005.  Mr. Zhang has been the Chief Accounting Officer for the our
subsidiary, AXM Pharma Shenyang, Inc. since 2004. For the 4 years prior thereto
he was employed by the international accounting firm of Deloitte and Touche LLP,
initially as a senior auditor in its New York office for 2 years and then as
audit manager for its Beijing office for an additional two years.




Elliot M. Maza,
Director.   Mr. Maza became a director on March 8,
2006.  Mr. Maza also currently is the Chief Financial Officer of
Emisphere Technologies, Inc. (NASDAQ: EMIS), a biopharmaceutical
company.  During his career, Mr. Maza has held distinguished positions
in the areas of finance and law. While at Emisphere, he has successfully
restructured the company’s indebtedness, helped the company raise capital and
implemented Section 404 under the Sarbases-Oxley Act. Since December 2004, he
has also served as a member of the Board of Directors and chairman of the audit
committee of Tapestry Pharmaceuticals Inc. (NASDAQ:
TPPH).  Previously, he was a Partner at Ernst and Young LLP and a Vice
President at Goldman Sachs, JP. Morgan Securities and BT Securities Corporation.
Mr. Maza previously practiced law at Sullivan and Cromwell LLP.  He
received his J.D. degree from the University of Pennsylvania Law School in 1985
and his C.P.A. from the State of New Jersey in 1981.




Baozhong Zhang,
Director.Mr. Zhang was elected to serve on the Board of
Directors on September 25, 2005.  Mr. Zhang has extensive
international pharma experience, having spent 36 years in the pharma sector,
including 15 years as a vice general manager and general manager of Northeastern
Pharmaceutical Group, and 21 years as technician, engineer, vice general manager
and general manager with the Sixth Pharmaceutical Factory in Northeast
China.




31




Wenzhou Zhang,
Director.Mr. Zhang became a director on March 8,
2006.  Mr. Zhang has 38 years of pharmaceutical industry experience
and management experience in China.  For the past 10 years, he has
served as a Vice Official to the State Food and Drug Administration and the
State Drug Administration in China.  Previous to that time, Mr. Zhang
served as the Secretary of Chongqing Municipality, the Chairman of the Chongqing
Economic Reform Committee, an official of Chongqing Drug Administration, and as
a General Manager of Chongqing Pharmaceutical Factory.




Zhenyu Kong, President of China
Operations and Chief Operating Officer of AXM
Shenyang.Mr. Kong spent nearly 25 years at China
National Pharmaceutical Group, China’s leading pharmaceutical company, where he
was Chairman of China National Pharmaceutical Group United Engineering.
 China National Pharmaceutical Group Corp., also known as, SINOPHARM, is
actively engaged in the research and development, capital investment,
manufacture and trade of pharmaceuticals and medical instruments.
 SINOPHARM has achieved an annual sales volume of 10 billion RMB (over 1.2
billion U.S. Dollars) and a total import and export volume of 200 million U.S.
Dollars.  Prior to becoming Chairman of SINOPHARM, Mr. Kong was the
Director of the Planning and Development Department of China National
Pharmaceutical Group Corporation.  From 1998 to 1999, Mr. Kong was the
director of the International Department of China National.  Mr. Kong has
tremendous expertise in planning and developing extensive product portfolios and
commendable strength in research, production, sales and distribution, as well
as, international trade.  Mr. Kong has held various leadership roles in
many industry associations, which solidified his significant place in China’s
pharmaceutical industry.  He pioneered the organization of national drug
and pharmaceutical ingredients exhibitions, national medical equipment
exhibitions and other exhibitions in China and abroad. Mr. Kong has played a key
role in the shaping of industry structure, improving market regulation,
maintaining disaster reserves, overseeing pharmaceutical supplies, encouraging
international economic and technological cooperation, as well as, foreign
investment and technological exchanges.  Mr. Kong attended Beijing Chemical
Engineering University from 1963 to 1968.





Audit Committee Financial Expert and
Identify Audit Committee:





The Audit
Committee focuses its efforts on assisting our Board of Directors to fulfill its
oversight responsibilities with respect to AXM Pharma’s:





·
            Quarterly
      and annual consolidated financial statements and financial information
      filed with the Securities and Exchange
  Commission;





·
            System
      of internal controls;





·
            Financial
      accounting principles and policies;





·
            Internal
      and external audit processes; and





·
            Regulatory
      compliance programs.





The
current Audit Committee members are Mr. Maza (Chair), Baozhong Zhang and Wenzhou
Zhang.  The committee meets periodically with management to consider the
adequacy of AXM Pharma’s internal controls and financial reporting process.
 It also discusses these matters with AXM Pharma’s independent auditors and
with appropriate financial personnel employed by AXM Pharma.  The committee
reviews our financial statements and discusses them with management and our
independent auditors before those financial statements are filed with the
Securities and Exchange Commission.  The committee met 6 times in 2005 and
2006.





The
committee has the sole authority to retain and dismiss our independent auditors
and periodically reviews their performance and independence from management.
 The independent auditors have unrestricted access and report directly to
the committee.




32




Audit Committee Financial
Expert.





The Board
has determined that the Chairman of the committee, Mr. Maza is an “audit
committee financial expert” as that term is defined in Item 401(e) of Regulation
S-B and “independent” for purposes of currently adopted American Stock Exchange
listing standards and Section 10A(m)(3) of the Securities Exchange Act of 1934.
 Mr Maza is also currently on the Board of Directors and serves as chairman
of the audit committee of Tapestry Pharmaceuticals Inc. Our Board of
Directors has determined that such simultaneous service does not impair the
ability of Mr. Maza to effectively serve as the Chairman of AXM Pharma’s Audit
Committee.





Compliance
with Section 16(a) of the Exchange Act





Section
16(a) of the Exchange Act requires our officers, directors and persons who own
more than 10% of any class of our securities registered under Section 12(g) of
the Exchange Act to file reports of ownership and changes in ownership with the
SEC. Officers, directors and greater than 10% stockholders are required by SEC
regulation to furnish us with copies of all Section 16(a) forms they
file.





We
believe that there was compliance with all other filing requirements of Section
16(a) applicable to our officers, directors and 10% stockholders during fiscal
2005.





Code
of Ethics





The
Company has always encouraged its employees, including officers and directors to
conduct business in an honest and ethical manner.  Additionally, it has
always been our policy to comply with all applicable laws and provide accurate
and timely disclosure.  In February 2005, our Board adopted a formal
written code of ethics for all of our employees.





Our codes
of ethics are designed to deter wrongdoing and promote honest and ethical
conduct and compliance with applicable laws and regulations.  These codes
also incorporate our expectations of our executives that enable us to provide
accurate and timely disclosure in our filings with the Securities and Exchange
Commission and other public communications.  Our codes of ethics are posted
on our website, http://www.axmpharma.com.  Any future changes or amendments
to our code of ethics, and any waiver of our codes of ethics will also be posted
on our website when applicable.




You may
obtain a copy of any of our codes of ethics at no cost, by written request to:
 AXM Pharma, Inc., 17870 Castleton Street, Suite 255, City of Industry,
California; or, oral request at: (626) 964-2848.




Item
      11.
            Executive
      Compensation




SUMMARY
COMPENSATION TABLE





Annual
      Compensation
                                                    
                                                    
                                                    Long
      Term CompensationAwards
                                                    
                                                    
                                                    PayoutsName
                                                      And
                                                      Principal
                                                      Position
                                                      
                                                      (a)
                                                    
                                                    Year
                                                      (b)
                                                    
                                                    Salary($)
                                                      (c)
                                                    
                                                    
                                                    Bonus($)
                                                      (d)
                                                    
                                                    
                                                    Other
                                                      Annual
                                                      Compen-
                                                      sation
                                                      ($)
                                                      (e)
                                                    
                                                    
                                                    Restricted
                                                      Stock
                                                      Award(s)
                                                      $
                                                      (f)
                                                    
                                                    
                                                    Securities
                                                      Underlying
                                                      Options/
                                                      SARs
                                                      (#)
                                                      (g)
                                                    
                                                    
                                                    LTIP
                                                      Payouts
                                                      $
                                                      (h)
                                                    
                                                    
                                                    All
                                                      Other
                                                      Compen-
                                                      sation
                                                      $
                                                      (i)Wang
      Wei Shi
                                                      President,
      CEO
                                                    
                                                    2005
                                                    
                                                    $
                                                    240,000
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0Chairman
      of
                                                    
                                                    2004
                                                    
                                                    
                                                    240,000
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    300,000
                                                    (1)
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0the
      Board
                                                    
                                                    2003
                                                    
                                                    
                                                    240,000
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0Harry
      Zhang
                                                      CFO,
                                                    
                                                    2005
                                                    
                                                    
                                                    120,000
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0Chief
                                                    
                                                    2004
                                                    
                                                    
                                                    80,000
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    383,000
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0Accounting
      Officer
                                                    
                                                    2003
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0Peter
      W.
                                                    
                                                    2005
                                                    
                                                    
                                                    70,000
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0Cunningham
                                                    
                                                    2004
                                                    
                                                    
                                                    240,000
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    208,335
                                                    
                                                    
                                                    
                                                    40,000
                                                    (2)
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0Former
      President and CEO
                                                    
                                                    2003
                                                    
                                                    
                                                    50,000
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    208,335
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0Chet
      Howard
                                                    
                                                    2005
                                                    
                                                    
                                                    100,000
                                                    
                                                    
                                                    
                                                    60,000
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0Former
      CFO
                                                    
                                                    2004
                                                    
                                                    
                                                    120,000
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    383,000
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    02003
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0
                                                    
                                                    
                                                    
                                                    0




33




(1) The
purchase price of the shares of the Common Stock covered by the Option is
 $4.14 per share.


(2)  The
purchase price of the shares of the Common Stock covered by the Option is
 $4.14 per share.





OPTION/SAR
IN LAST FISCAL YEAR





Option/SAR
Grants





None of our executive officers were
granted options or SARs during the last fiscal year.





Aggregated
Option/Sar Exercised And Fiscal Year-End Option/Sar Value Table





None
of our executive officers exercised options or SARs during the last fiscal year.





Long
Term Incentive Plans





None of
our executive officers were granted Long Term Incentive awards in the last
fiscal year.





Board
of Directors





Our
directors who are employees do not receive any compensation from AXM Pharma for
services rendered as directors. The Board has created three classes of fees for
outside directors: (1) outside directors who are “independent,” as defined in
the Exchange Act will be paid $4,500.00 per month; (2) outside directors who are
not “independent” will receive $3,000.00 per month; and, (3) the Vice Chairman
will receive a flat fee of $18,000.00 per month, inclusive of committee fees and
the Chairwoman will receive a flat fee of $20,000.00 per month.  All board
members of U.S. citizenship are entitled to participate in AXM Pharma’s health
insurance plan.  Since August 24, 2004, our Board of Directors issued
2,030,000 stock options exercisable at $4.14 per share to members of our Board
of Directors and employees and an additional 40,000 and 70,000 stock options
exercisable at $5.70 and 2.72 per share, respectively.  The foregoing
options were granted under the Company’s 2004 Incentive and NonStatutory Stock
Option Plan.


34


Employment
Agreements




Mr.
Cunningham was originally hired to serve as our Chief Operating Officer, but in
September 2003, Mr. Cunningham was promoted to the positions of President and
Chief Executive Officer.  When Mr. Cunningham was promoted, other than
the change in his responsibilities, the terms of his employment agreement
remained the same.  On January 31, 2005, Chet Howard replaced Mr.
Cunningham as Chief Executive Officer.  Mr. Cunningham became
President of International Sales.  Although other terms of his
employment agreement had not yet been finalized, the Board approved certain
aspects of Mr. Cunningham’s compensation, including Mr. Cunningham’s
compensation of $10,000 per month for a one-year contract with AXM for this
position.  The Board also approved a three-month severance package for
Mr. Cunningham in the event that he was terminated other than for
cause.  Additionally, Mr. Cunningham was to receive 3% of net sales
based upon a projected budget that had been prepared and approved by the
Board.  Mr. Cunningham also had the opportunity to receive 5% of net
sales if he retained any sales over the stated budget.   Mr.
Cunningham’s employment agreement was to be amended to reflect his position
change, but a new employment agreement was never reached because Mr. Cunningham
was terminated for cause on July 20, 2005.




On
January 31, 2005, Chet Howard was appointed by the Board of Directors to replace
Peter Cunningham as Chief Executive Officer. Mr. Howard became our Chief
Executive Officer on February 1, 2005, and continued to act as our Chief
Financial Officer until October 13, 2005 when he voluntarily resigned from the
position.  Pursuant to the terms of his agreement with AXM Pharma, Mr.
Howard was paid a Base Salary of $240,000 per year, distributed in equal monthly
installments.  Mr. Howard also received a $60,000 signing bonus.  In
addition, Mr. Howard was entitled to receive 250,000 incentive employee stock
options per year, vesting quarterly.  During the term of his employment
under the Agreement, at the Board’s discretion, Mr. Howard was also eligible to
participate in all bonus and incentive plans.  Mr. Howard was eligible to
participate in all employee benefit plans to the extent maintained by the
Company, including (without limitation) any life, disability, health, accident
and other insurance programs, paid vacations, and similar plans or programs,
subject in each case to the generally applicable terms and conditions of the
plan or program in question and to the determinations of any committee
administering such plan or program.  Mr. Howard’s salary, bonus and
incentives were reviewed by our Board of Directors and compensation committee
with the goal of bringing his salary in line with industry standards.  Mr.
Howard’s employment agreement was for a two-year term.   Mr. Howard
voluntarily terminated his employment agreement.  Upon his voluntary
termination we accrued salary, vested deferred compensation (other than pension
plan or profit sharing plan benefits, which were to be paid in accordance with
the applicable plan), and accrued vacation pay, all to the date of termination,
but no severance compensation. Mr. Howard’s agreement requires that he keep
confidential any proprietary information acquired while employed and upon
termination of his employment.  He was also prohibited from soliciting any
employees of AXM Pharma for a period of six months following his termination for
any reason.





The
Company entered into an employment agreement with Mr. Kong on March 31, 2005;
Mr. Kong began his employment on May 1, 2005.  The term of the Agreement is
for one (1) year beginning on the Effective Date, but may be extended by the
mutual agreement of the parties and, unless terminated in writing at least
thirty (30) days prior to the expiration of the initial term, shall
automatically renew for an additional one-year term on the first anniversary of
the Effective Date and on each successive anniversary of the Effective Date
unless terminated in writing similarly to the procedure stated above.
   Mr. Kong’s Base Salary will be US $20,000.00 per month.
 The Company will contribute $17,500 per month and AXM Shenyang shall
contribute the remaining $2,500 per month less any deductions for taxes.
 Mr. Kong will also receive 200,000 incentive employee stock options per
year, vesting quarterly.  Mr. Kong is eligible to participate in all
employee benefit plans to the extent maintained by the Company for its
China-based employees.  Mr. Kong may be terminated for cause, upon which he
will receive all accrued salary, incentive compensation to the extent earned,
vested deferred compensation, and accrued vacation pay, all to the date of
termination.  Additionally, his incentive compensation and bonuses, to the
extent earned, shall be paid within thirty (30) days of the date of the
termination.  If Mr. Kong’s employment is terminated for any reason, he
will retain all of his rights to benefits that have vested, but his rights to
participate in those plans will cease upon his employment termination unless the
termination is a Termination Other Than for Cause, in which case his rights of
participation will continue for a period of three (3) months following the
termination of his employment.  If Mr. Kong’s employment is terminated in a
Termination Other Than for Cause or by Company due to Mr. Kong’s disability, he
will be paid as severance pay his Base Salary for the period commencing on the
date that his employment is terminated and ending on the date which is one (1)
month thereafter.  Due to Mr. Kong’s employment with the Company, he will
have access to the Company’s Confidential Information.  In consideration
for that access, Mr. Kong agrees that for a period of twelve (12) months after
termination of his employment, he will not use such Confidential Information to
compete with the business of the Company.  In addition, for a period of
twelve (12) months after termination of his employment, he will not induce or
attempt to induce any employee of the Company to discontinue his or her
employment with the Company for the purpose of becoming employed by any
competitor of Company, nor will he initiate discussions, negotiations or
contacts with persons known by him to be a customer or supplier of the Company
at the time his employment with the Company is terminated, for the purpose of
competing with the Company.  Notwithstanding anything to the contrary
contained in the Agreement, the previously stated Non-Compete provisions will
not be applicable in the event of any Termination Other Than for Cause with
respect to Mr. Kong’s employment.


35


The
Company currently has no employment agreements in effect with Ms. Wang Wei-Shi
or Mr. Harry Zhang.





Stock
Option Plans





On
February 1, 2005 our Board of Directors approved the 2005 Equity Incentive Plan,
which will replace the 2004 Plan.  Our shareholders approved the 2005 Plan
at our Special Meeting on March 10, 2005.  The 2005 Plan is intended
to further our growth and financial success by providing additional incentives
to our directors, executives and selected employees and consultants so that such
participants may acquire or increase their proprietary interest in the Company.
 Stock options available under the 2005 Plan include "Incentive Stock
Options", as defined in Code section 422 and any regulations promulgated under
that Section, and "Nonstatutory Options" at the discretion of the Board of
Directors.  Additionally, Stock Appreciation Rights, Restricted Stock,
Restricted Stock Unit, Performance Awards, Dividend Equivalents, or Other
Stock-Based Awards may be granted under the Equity Plan.  Shares available
under the 2005 Plan include 5,000,000 shares of our common stock, plus all
Shares remaining available for issuance under the 2004 Plan on the effective
date of the Equity Plan.  As of April 13, 2006, no stock options have
been granted pursuant to the 2005 Plan.





Item
      12.
            Security
      Ownership of Certain Beneficial Owners and Management and Related
      StockholderMatters




As used
in this section, the term beneficial ownership with respect to a security is
defined by Rule 13d-3 under the Securities Exchange Act of 1934, as amended, as
consisting of sole or shared voting power (including the power to vote or direct
the vote) and/or sole or shared investment power (including the power to dispose
of or direct the disposition of) with respect to the security through any
contract, arrangement, understanding, relationship or otherwise, subject to
community property laws where applicable.





As of
April 13, 2006, we had a total of 22,162,185 shares of common stock and 826,500
(presently convertible into approximately 1,922,093 shares of common stock)
shares of preferred stock issued and outstanding, which are the only issued and
outstanding voting equity securities of AXM Pharma.  Shares of Preferred
Stock vote on as converted basis with the common stock.  At the date of
this Prospectus, each share of Preferred Stock is convertible into one share of
common stock.





The
following table sets forth, as of April 13, 2006: (a) the names and addresses of
each beneficial owner of more than five percent (5%) of our common stock and
Preferred Stock (taken together as one class) known to us, the number of shares
of common stock and Preferred Stock beneficially owned by each such person, and
the percent of our common stock and Preferred Stock so owned; and (b) the names
and addresses of each director and executive officer, the number of shares our
common stock and Preferred Stock beneficially owned, and the percentage of our
common stock and Preferred Stock so owned, by each such person, and by all of
our directors and executive officers as a group. Each person has sole voting and
investment power with respect to the shares of our common stock and Preferred
Stock, except as otherwise indicated. Beneficial ownership consists of a direct
interest in the shares of common stock and Preferred Stock, except as otherwise
indicated.


36





NAME AND ADDRESS
              
              AMOUNT AND NATURE OF
                BENEFICIAL OWNERSHIP
              
              
              PERCENTAGE
                OF VOTING OF
                SECURITIES(1)Ms.
      Wang Wei Shi
                46
      Wen An Road
                Building
      4, 5th
      Floor
                Shenyang,
      Liaoning,
                The
      Peoples Republic Of China 110003
              
              
              6,047,000
              (2)
              
              
              27.29
              %Harry
      Zhang
                STE
      2109  Beijing Exchange BLDG NO
                128  Jianguo
      RD, Beijing, 100022 P. R China
              
              
              100,000
              
              
              
              0.45
              %Elliot
      M. Maza
                114
      Chestnut Street
                Englewood,
      NJ 07631
              
              
              0
              
              
              
              0
              %Chaoying(Charles)
      Li
                14/F,
      Buiding A, Huixium Plaza, No
                Beishuan
      Zhong Road, Chaoyang District
                Beijing
      100101, P.R. China
              
              
              210,000
              
              
              
              0.95
              %Baozhong  Zhang
                100-7
      East Binke Road
                Shenke
      District
                Shenyang
      Liaoning, F4 110015
              
              
              0
              
              
              
              0
              %Wenzhou
      Zhang
                No.2
      Feiyun Road Hunnan New District
                Shenyang,
      Liaoning. P.R. China
              
              
              0
              
              
              
              0
              %Zhenyu
      Kong
                Room
      2109
                The
      Exchange Beijing, No.118 Jianguo
                Road,
                Chaoyang
      District
                Beijing
      100022, China
              
              
              50,000
              (3)
              
              
              0.23
              %Peter
      W. Cunningham
                755
      Promontory Point Drive West
                Newport
      Beach, California 92660
              
              
              555,001
              (4)
              
              
              2.5
              %Mr.
      Chet Howard
                11792
      Lily Rubin Ave.
                Las
      Vegas, NV 89138
              
              
              200,000
              (5)
              
              
              0.9
              %Gryphon
      Master Fund, L.P.
                500
      Crescent Court
                Suite
      270
                Dallas,
      Texas  75201
              
              
              1,838,200
              
              
              
              8.29
              %Byrle
      Lerner
                2904
      Via Campesina
                Palo
      Verdes Estates, CA 90274
              
              
              1,165,300
              (6)
              
              
              5.26
              %All
      directors and officers as a group (10 persons)
              
              
              7,162,001
              
              
              
              32.32
              %


37


(1)  All
Percentages have been rounded up to the nearest one hundredth of one
percent.





(2)
Includes 3,137,000 shares owned by Ms. Wang directly, including 300,000 stock
options and 2,910,000 shares owned by members of her immediate
family.




(3)
Includes 50,000 incentive stock options Mr. Kong is entitled to receive through
his employment agreement with AXM Pharma.  Mr. Kong is entitled to receive
an additional 150,000 incentive stock options during the year pursuant to his
employment agreement, which provides that he is entitled to receive 200,000
 incentive stock options per year, vesting quarterly beginning in May 2005.




(4)
Includes 125,001 shares owned by Mr. Cunningham directly and 30,000 shares owned
by Rabelaisian Resources, Plc., a company owned by Mr. Cunningham. Also includes
41,667 shares Mr. Cunningham was entitled to receive through his employment
agreement with AXM Pharma as Chief Executive Officer.  Mr. Cunningham
ceased being our Chief Executive Officer on January 31, 2005 and his employment
agreement was amended accordingly.  Also includes 400,000 stock
options granted to Mr. Cunningham on April 29, 2004, under the 2004 Qualified
and Nonstatutory Stock Option Plan




(5)
Includes 100,000 stock options, at an exercise price of $3.83 per share, granted
to Mr. Howard on April 29, 2004, under the 2004 Qualified and Nonstatutory Stock
Option Plan.





(6)
Includes 60,000 shares of restricted stock Mr. Lerner is entitled to receive
under his consulting agreement, dated October 25, 2004.





Changes
in Control





As of the
date of this filing, there are no arrangements, which may result in a change in
control of AXM Pharma, Inc.





Item
13.    Certain Relationships and Related
Transactions




We are
party to a consulting agreement with TriPoint Capital Advisors, LLC, a company
in which Mark Elenowitz, a director and significant shareholder of AXM Pharma,
indirectly owns a 40% interest.  Pursuant to the terms of the consulting
agreement, we are required to pay TriPoint a monthly fee of $17,500.  The
current agreement between Tripoint Capital Advisors and AXM Pharma has a
one-year term and is terminable by either party, with or without cause, upon 30
days written notice.  Additionally, on  May 1, 2002, pursuant to the
terms of a previous consulting agreement with TriPoint, Werke Pharmaceuticals,
Inc., our wholly owned subsidiary issued TriPoint 500,000 shares of its common
stock, which shares were exchanged pursuant to the terms of our share exchange
agreement with the shareholders of Werke Pharmaceuticals, Inc. into shares of
AXM Pharma common stock.  On April 29, 2004, the Board authorized Peter
Cunningham to sign a new agreement with Tripoint Capital Advisors for their
consulting services.  In addition, we are party to a consulting agreement
with Investor Communications Company, LLC , a company in which Mark Elenowitz
directly benefits from 20% of the stock compensation received from the Company.
 Pursuant to the terms of the consulting agreement, Werke Pharmaceuticals,
Inc. is required to pay Investor Communications Company, LLC a monthly fee of
$14,000 and  issued to Investor Communications Company, LLC 120,000 shares
of its common stock which were subsequently converted into shares of AXM Pharma
common stock as a result of the Share Exchange.


38





In
October 2004, we engaged Byrle Lerner, a beneficial owner of more than five
percent of our common stock (5.55%), to provide consulting services to AXM
Pharma.  Mr. Lerner received 60,000 shares of our restricted stock and
100,000 options to purchase our common stock at $2.15 per share for his
services.  The agreement with Mr. Lerner was for one year and was
terminable by either Mr. Lerner or us upon thirty days written notice.





In
November 2004, Byrle Lerner paid 12,500 shares of restricted common stock to
Aurelius Consulting and 30,000 shares to Mirador Consulting on behalf of AXM
Pharma pursuant to consulting agreements with those entities.





On
December 31, 2005, AXM Pharma, Inc. received advances of approximately $237,000
from Wei Shi Wang, Chief Executive Officer and Chairman of the Board. The
amounts are unsecured and due upon demand.





Item
14.    Principal Accounting Fees and
Services


Section
4.03


Information
required by this item is incorporated by reference to the Proxy Statement to be
distributed in connection with our next annual meeting of
stockholders.





PART
IV





Item
15.    Exhibits and Financial Statement
Schedules




(a)
              (1)
      Financial Statements




A list of
the financial statements filed as a part of this report appears on page
F-1.




(2)
Financial Statement Schedules




Schedules
have been omitted because the information required is not applicable or is shown
in the Financial Statements or the corresponding Notes to the Consolidated
Financial Statements.




(3)
Exhibits




A list of
the exhibits filed as a part of this report appears on pages E-1 and E-2, which
follow immediately after the financial statements.




(b)
            See
      Exhibits listed under the heading “Exhibit Index” set forth on page
      E-1.




(c)
            Schedules
      have been omitted because the information required is not applicable or is
      shown in the Financial Statements or the corresponding Notes to the
      Consolidated Financial
Statements


39


SIGNATURES





Pursuant
to the requirements of the Securities Exchange Act of 1934, the Registrant has
duly caused this Annual Report on Form 10-K/A to be signed on its behalf by the
undersigned, hereunto duly authorized.





AXM PHARMA,
      INC.By:
      /s/ Weishi WangWeishi
      WangChief
      Executive Officer





Pursuant
to the requirements of the Securities Exchange Act of 1934, the Registrant has
duly caused this Annual Report on Form 10-K/A to be signed on its behalf by the
undersigned hereunto duly authorized.








Name and Signature
                      
                      Title
                      
                      Date/s/
      Wang Wei Shi
                      
                      Chief
      Executive Officer
                      
                      January
      16, 2009Wang
      Wei Shi/s/
      Zhang Baozhong
                      
                      Director
                      
                      January
      16, 2009Zhang
      Baozhong/s/
      Elliot Maza
                      
                      Director
                      
                      January
      16, 2009Elliot
      Maza/s/
      Tracey O’Neill
                      
                      Director
                      
                      January
      16, 2009Tracey
      O’Neill


40




AXM
Pharma, Inc.





CONSOLIDATED
FINANCIAL STATEMENTS





Index





AXM
      Pharma, Inc.
              PageReport
      of Independent Registered Public Accounting Firm
              F-2Consolidated
      Balance Sheet as of December 31, 2005
              F-3Consolidated
      Statements of Operations for the years ended December 31, 2005 and
      2004
              F-4Consolidated
      Statements of Cash Flows for the years ended December 31, 2005 and
      2004
              F-6Consolidated
      Statement of Stockholders’ Equity for the years ended December 31, 2005
      and 2004
              F-5Notes
      to the Consolidated Financial Statements
              F-7


F-1


REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the
Board of Directors


AXM
Pharma, Inc.


City
of Industry, California





We have
audited the accompanying consolidated balance sheet of AXM Pharma, Inc. as of
December 31, 2005 and the related statements of operations, stockholders’
equity, and cash flows for each of the two years then ended.  These
financial statements are the responsibility of AXM Pharma’s
management.  Our responsibility is to express an opinion on these
financial statements based on our audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements.  An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation.  We believe that our audits provide a reasonable basis
for our opinion.





In our
opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of AXM Pharma, Inc. as of December 31,
2005 and the results of its operations and its cash flows for each of the two
years then ended, in conformity with accounting principles generally accepted in
the United States of America.





The
accompanying consolidated financial statements have been prepared assuming that
AXM Pharma, Inc. will continue as a going concern.  As discussed in
Note 1 to the consolidated financial statements, AXM Pharma has incurred losses
of $9,247,932 and $13,250,883 for the years ended December 31, 2005 and 2004,
respectively.  AXM Pharma will require additional working capital to
develop its business until AXM Pharma either (1) achieves a level of revenues
adequate to generate sufficient cash flows from operations; or (2) obtains
additional financing necessary to support its working capital
requirements.  These conditions raise substantial doubt about AXM
Pharma’s ability to continue as a going concern.  Management's plans
in regard to this matter are also described in Note 1.  The
accompanying financial statements do not include any adjustments that might
result from the outcome of these uncertainties.









LBB &
Associates Ltd., LLP (formerly Lopez, Blevins, Bork & Associates Ltd.,
LLP)


Houston,
Texas





April 7,
2006, except for Note 2, which is as of July 10, 2008.


F-2


AXM
Pharma, Inc.
 Consolidated
Balance Sheet
 December
31, 2005
 RESTATED
 
 ASSETSCurrent
      AssetsCash
                                
                                $
                                92,620Accouns
      Receivable
                                
                                
                                1,071,008Inventories
                                
                                
                                2,287,487Prepaid
      expenses and other
                                
                                
                                609,207Total
      current assets
                                
                                
                                4,060,322Property
      and equipment, net
                                
                                
                                7,558,010Licenses
                                
                                
                                1,601,138Deferred
      financing costs
                                
                                
                                614,476TOTAL
      ASSETS
                                
                                $
                                13,833,946LIABILITIES AND STOCKHOLDERS'
      EQUITYCurrent
      LiabilitesConvertible
      secured debentures
                                
                                $
                                973,279Acounts
      payable and accured expenses
                                
                                
                                5,102,821Short-term
      loans
                                
                                
                                3,960,249Preferred
      Stock Derivative Liability
                                
                                
                                99,725Conversion
      Derivative Liability
                                
                                
                                888,922Warrant
      Liability
                                
                                
                                1,944,223Total
      current liabilities
                                
                                
                                12,969,219Commitments
      and ContingenciesSTOCKHOLDERS'
      EQUITY:Series
      A, Preferred stock, $.001 par value, 10,000,000  shares
      authorized, 826,500 shares issed and outstanding
                                
                                
                                826Series
      B, Preferred stock, $.001 par value, 2,000,000  shares
      authorized, no shares issed and outstanding
                                
                                
                                -Series
      C, Preferred stock, $.001 par value, 100 shares  authorized, 17
      shares issed and outstanding
                                
                                
                                -Common
      stock, $.001 par value, 50,000,000 shares  authorized,
      21,609,630 shares issed and outstanding
                                
                                
                                21,610Additional
      paid-in capital
                                
                                
                                28,619,190Accumulated
      deficit
                                
                                
                                (27,776,899
                                )864,727TOTAL
      LIABILILITIES AND STOCKHOLDERS' EQUITY
                                
                                $
                                13,833,946





See
accompanying summary of accounting policies and notes to the financial
statements


F-3


AXM
Pharma, Inc.
 CONSOLIDATED
STATEMENTS OF OPERATION
 YEARS
ENDED DECEMBER 31, 2005 AND 2004
 RESTATED
 
 2005
                    
                    
                    2004Revenues
                    
                    $
                    2,021,728
                    
                    
                    $
                    2,115,751Cost
      of revenues
                    
                    
                    1,249,360
                    
                    
                    
                    1,050,283Gross
      Profit
                    
                    
                    772,368
                    
                    
                    
                    1,065,468Selling,
      general and adimistrative
                    
                    
                    9,629,424
                    
                    
                    
                    15,526,639Operating
      Loss
                    
                    
                    (8,857,056
                    )
                    
                    
                    (14,461,171
                    )Interest
      expense
                    
                    
                    (7,102,563
                    )
                    
                    
                    (673,115
                    )Other
      income
                    
                    
                    6,711,687
                    
                    
                    
                    1,883,403Net
      Loss
                    
                    $
                    (9,247,932
                    )
                    
                    $
                    (13,250,883
                    )Net
      loss applicable to common shareholders:Net
      loss
                    
                    $
                    (9,247,932
                    )
                    
                    $
                    (13,250,883
                    )Net
      loss per share;Base
      and diluted
                    
                    $
                    (0.45
                    )
                    
                    $
                    (0.82
                    )Weighted
      average shares outstanding:Base
      and diluted
                    
                    
                    20,433,762
                    
                    
                    
                    16,066,789





See
accompanying summary of accounting policies and notes to the financial
statements


F-4


AXM
Pharma, Inc.
 CONSOLIDATED
STATEMENTS OF STOCKHOLDER'S EQUITY
 YEARS
ENDED DECEMBER 31, 2005 AND 2004
 RESTATED
 
 Shares
                    
                    
                    Amount
                    
                    
                    Shares
                    
                    
                    Amount
                    
                    
                    Additional
                      paid
      in
                      capital
                    
                    
                    Accumulated
                      Deficit
                    
                    
                    TotalBalance,
      December 31, 2003
                    
                    
                    13,728,347
                    
                    
                    
                    13,728
                    
                    
                    
                    2,750,000
                    
                    
                    
                    2,750
                    
                    
                    
                    12,844,354
                    
                    
                    
                    (5,278,084
                    )
                    
                    
                    7,582,748Issuance
      of preferred stock  and warrants, net of expense
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    860,030
                    
                    
                    
                    860
                    
                    
                    
                    1,737,773
                    
                    
                    
                    -
                    
                    
                    
                    1,738,633Issuance
      of common stock for  warrants, net of expense
                    
                    
                    1,070,016
                    
                    
                    
                    1,070
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    3,271,155
                    
                    
                    
                    -
                    
                    
                    
                    3,272,225Issuance
      of commons stock  and warrants for services
                    
                    
                    1,161,001
                    
                    
                    
                    1,161
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    5,619,337
                    
                    
                    
                    -
                    
                    
                    
                    5,620,498Conversions
      of preferred stock
                    
                    
                    2,076,175
                    
                    
                    
                    2,077
                    
                    
                    
                    (1,935,006
                    )
                    
                    
                    (1,935
                    )
                    
                    
                    (142
                    )
                    
                    
                    -
                    
                    
                    
                    -Net
      Loss
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (13,250,883
                    )
                    
                    
                    (13,250,883
                    )Balance,
      December 31, 2004
                    
                    
                    18,035,539
                    
                    
                    
                    18,036
                    
                    
                    
                    1,675,024
                    
                    
                    
                    1,675
                    
                    
                    
                    23,472,477
                    
                    
                    
                    (18,528,967
                    )
                    
                    
                    4,963,221Issuance
      of common stock for  dividend
                    
                    
                    78,600
                    
                    
                    
                    79
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    180,985
                    
                    
                    
                    -
                    
                    
                    
                    181,064Issuance
      of common stock and  warrants for assets
                    
                    
                    55,000
                    
                    
                    
                    55
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    933,434
                    
                    
                    
                    -
                    
                    
                    
                    933,489Issuance
      of common stock and  warrants for services
                    
                    
                    685,800
                    
                    
                    
                    685
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    1,789,952
                    
                    
                    
                    -
                    
                    
                    
                    1,790,637Issuance
      of common stock in  connection with exercise
      of  warrants
                    
                    
                    1,488,100
                    
                    
                    
                    1,488
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    1,908,681
                    
                    
                    
                    -
                    
                    
                    
                    1,910,169Issuance
      of common stock for  repayment of principal
      and  interest
                    
                    
                    245,645
                    
                    
                    
                    246
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    333,833
                    
                    
                    
                    -
                    
                    
                    
                    334,079Issuance
      of common stock for  conversion of preferred
    stock
                    
                    
                    1,020,946
                    
                    
                    
                    1,021
                    
                    
                    
                    (848,507
                    )
                    
                    
                    (849
                    )
                    
                    
                    (172
                    )
                    
                    
                    -
                    
                    
                    
                    -Net
      Loss
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (9,247,932
                    )
                    
                    
                    (9,247,932
                    )Balance,
      December 31, 2005
                    
                    
                    21,609,630
                    
                    
                    
                    21,610
                    
                    
                    
                    826,517
                    
                    
                    
                    826
                    
                    
                    
                    28,619,190
                    
                    
                    
                    (27,776,899
                    )
                    
                    
                    864,727




See
accompanying summary of accounting policies and notes to the financial
statements


F-5


AXM
PHARMA, Inc.
 CONSOLIDATED
STATEMENTS OF CASHFLOW
 YEARS
ENDED DECEMBER 31, 2005 AND 2004
 RESTATED
 
 2005
                          
                          
                          2004Cash
      flows from operating activities:Net
      Loss
                          
                          $
                          (9,247,932
                          )
                          
                          $
                          (13,250,883
                          )Adjustments
      to reconcile net loos to cash used in operating
activities:Common
      stock issued for services and dividends
                          
                          
                          1,971,701
                          
                          
                          
                          5,620,498Non-cash
      interest expense
                          
                          
                          6,022,544
                          
                          
                          
                          673,115Bad
      Debt
                          
                          
                          
                          
                          
                          
                          810,793Inventory
      write-off
                          
                          
                          532,105
                          
                          
                          
                          1,714,200Depreciation
      and amortization
                          
                          
                          56,309
                          
                          
                          
                          32,167Change
      in derivative instruments
                          
                          
                          (6,711,687
                          )
                          
                          
                          (1,883,402
                          )Changes
      in assets and liabilitiesAccounts
      Receivable
                          
                          
                          (1,040,258
                          )
                          
                          
                          1,773,436Prepaid
      expenses
                          
                          
                          -
                          
                          
                          
                          471,317Advances
                          
                          
                          (164,105
                          )
                          
                          
                          1,023,578Inventories
                          
                          
                          (817,462
                          )
                          
                          
                          (1,472,576
                          )Accounts
      payable and accrued expenses
                          
                          
                          786,916
                          
                          
                          
                          903,038Cash
      flows from operating activities:
                          
                          
                          (8,611,869
                          )
                          
                          
                          (3,584,719
                          )Cash
      flows from investing activities:Capital
      Expenditures
                          
                          
                          (453,943
                          )
                          
                          
                          (6,892,907
                          )Cash
      flows from financing activities:Proceeds
      from short-term loans
                          
                          
                          2,958,581
                          
                          
                          
                          1,001,668Proceeds
      from sale of preferred stock
                          
                          
                          -
                          
                          
                          
                          4,508,633Proceeds
      from exercise of warrants
                          
                          
                          1,910,169
                          
                          
                          
                          3,272,225Proceeds
      from notes payable
                          
                          
                          3,034,000Cash
      flows from financing activities:
                          
                          
                          7,902,750
                          
                          
                          
                          8,782,526Net
      decrease in cash
                          
                          
                          (1,163,062
                          )
                          
                          
                          (1,695,100
                          )Cash,
      beginning of period
                          
                          
                          1,255,682
                          
                          
                          
                          2,950,782Cash,
      end of period
                          
                          $
                          92,620
                          
                          
                          $
                          1,255,682Supplemental
      cash flow information:Interest
      paid
                          
                          $
                          111,629
                          
                          
                          $
                          -Supplemental
      non-cash transactions:Common
      stock and warrants for assets
                          
                          $
                          933,489
                          
                          
                          $
                          -Common
      stock for principal and interest
                          
                          $
                          334,079
                          
                          
                          $
                          -
  See
accompanying summary of accounting policies and notes to the financial
statements


F-6


AXM
PHARMA, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





1.  Nature
of Our Business and Liquidity





Nature of our Business.AXM Pharma, Inc.,
(“AXM”, “our”, “us” or “we”) is a pharmaceutical and nutraceutical company
engaged in the production, marketing and distribution of over the counter and
prescription pharmaceutical products in The People’s Republic of China
(“China”). We have licenses to produce market and distribute drug products in
various dosages and forms as well as herbal remedies and vitamins and are
currently manufacturing four drug products for sale in China. We conduct our
business in China through our wholly owned subsidiary, AXM Pharma (Shenyang)
Inc. (“AXM Shenyang”).





Our core
business strategy is to manufacture and distribute a diverse group of over the
counter and prescription pharmaceutical products, targeting the markets of
China, Hong Kong, Taiwan, Korea, The Philippines, Indonesia, Malaysia, Singapore
and Thailand. Our growth plan includes expanding our existing product line with
new products licensed from North America and Europe. In 2004, we completed the
construction of a manufacturing plant in a special economic zone in Shenyang,
China. The plant has been certified as satisfying Chinese “Good Manufacturing
Practices (GMP)”, and we intend to apply for certification of the plant under US
GMP as well. This designation would allow us to manufacture pharmaceutical
products in China for sale in the United States market.





Our
factory in Shenyang includes over 120,000 square feet of production space
capable of producing 50,000,000 tubes for ointments, 500,000,000 tablets and
250,000,000 capsules annually. In addition, the plant contains laboratory and
administration facilities.  The factory is located in a special
economic zone, the High-Tech Industrial Development District, established in
1988 by the Chinese government to accelerate the development and
industrialization of high-tech industries in the North–Eastern portion of
China.   The factory satisfies Chinese GMP and we intend to apply
for certification of the plant under US GMP as well. AXM Shenyang employs 150
people.





We
currently employ 90 individuals involved in marketing and sales. Also, we intend
to engage additional domestic third-party distributors to penetrate new markets.
We are developing educational programs for hospitals, doctors, clinics and
distributors with respect to our product lines.  These educational
programs are intended to improve sales and promotion of our
products.





As our
resources permit, we anticipate expanding our current domestic Chinese
distribution beyond the cities in which we currently sell through the
utilization of new distribution firms in regions currently not covered. We have
developed new distribution and marketing relationships with the following
firms:





•      China
Nat. Pharma. Group (Sinopharm)


•      Jin
Ming Shi Pharma


•      DKSH
(Taiwan) Limited


•      KerryFlex
Suplly Chain Solutions Limited





Liquidity.We are in urgent need
of additional capital.  Our cash resources have been depleted. We have
not paid our employees in China since January 2006. We are in default under the
terms of certain promissory notes as described more fully below under “Risk Factors -
We are currently in default on our obligations under our Series C convertible
promissory note.” These conditions raise substantial doubt about our
ability to continue as a going concern. The audit report prepared by our
independent registered public accounting firm relating to our consolidated
financial statements for the year ended December 31, 2005 includes an
explanatory paragraph expressing the substantial doubt about our ability to
continue as a going concern. We are currently in discussions with several banks
in China to obtain financing to support operations going forward, but we can
offer no assurance that we will obtain additional financing. If additional
capital is raised through the sale of equity or convertible debt securities, the
issuance of such securities would result in dilution to our existing
stockholders. We cannot assure you that financing will be available on favorable
terms or at all.


F-7


Since
our inception, we have generated significant losses from operations and we
anticipate that we will continue to generate significant losses from operations
for the foreseeable future.  As of December 31, 2005, our
accumulated deficit was approximately $28 million.  Our net loss was
$9 million and $13 million for the years ended December 31, 2005 and 2004,
respectively. Our cash outlays from operations and capital expenditures were $9
million and $10 million for 2005 and 2004, respectively. Our stockholders’
equity decreased from $5 million as of December 31, 2004 to $0.8 million as of
December 31, 2005.





Under the
terms of certain Secured Promissory Notes issued on April 19, 2005, we are
obligated to pay interest and principal monthly in cash or shares. However, we
are obligated to make payments in cash if our share price falls below a certain
price calculated under a formula specified in the Notes. We are currently in
default in our payment obligations because we have not been able to pay the
required repayment of principal and interest to the holders of the
Notes.  We are in negotiations with the holders with a view to
restructuring the terms of the Notes.  However, no agreement has been
reached and, if we fail to reach an agreement, it will likely be impossible for
us to raise any new funds (see “Risk Factors -We are currently in
default on our obligations under our Secured Promissory Notes”.)





2.  SUMMARY
OF SIGNIFICANT ACCOUNTING POLICIES





Restatement







We have
restated our financial statements as of and for the year ended December 31,
2005 to properly record liabilities and expenses related to the issuance of
certain Secured Promissory Notes and associated Common Stock Purchase Warrants
during the quarter ended April 30, 2005 and certain Series C Preferred Stock and
associated Common Stock Purchase Warrants during the quarter ended June 30,
2004. See, Note 7, “Series C
Convertible Preferred Stock” and Note 8, “Secured Promissory
Notes”.




The
accompanying consolidated financial statements for the year ended December 31,
2005 have been restated to reflect these changes.


F-8





Consolidated
Balance Sheet
 December
31, 2005
 
 December
      31,2005
      as previously
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              December
      31,reported
                                              
                                              
                                              Note
      A
                                              
                                              
                                              Note
      B
                                              
                                              
                                              Note
      C
                                              
                                              
                                              Note
      D
                                              
                                              
                                              Note
      E
                                              
                                              
                                              Note
      F
                                              
                                              
                                              Note
      G
                                              
                                              
                                              Note
      H
                                              
                                              
                                              2005
      restatedASSETSCurrent
      AssetsCash
                                              
                                              $
                                              92,620
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              92,620Accouns
      Receivable
                                              
                                              
                                              1,071,008
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              1,071,008Inventories
                                              
                                              
                                              2,287,487
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              2,287,487Prepaid
      expenses and other
                                              
                                              
                                              609,207
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              609,207Total
      current assets
                                              
                                              
                                              4,060,322
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              4,060,322Property
      and equipment, net
                                              
                                              
                                              7,558,010
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              7,558,010Licenses
                                              
                                              
                                              1,601,138
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              1,601,138Deferred
      financing costs
                                              
                                              
                                              685,403
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              (70,927
                                              )
                                              
                                              
                                              614,476TOTAL
      ASSETS
                                              
                                              $
                                              13,904,873
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              13,833,946LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      LiabilitesConvertible
      secured debentures
                                              
                                              $
                                              1,057,184
                                              
                                              
                                              
                                              (1,057,184
                                              )
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              
                                              
                                              
                                              973,279
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              973,279Acounts
      payable and accured expenses
                                              
                                              
                                              4,718,517
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              199,219
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              185,085
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              5,102,821Short-term
      loans
                                              
                                              
                                              3,960,249
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              3,960,249Preferred
      Stock Liability
                                              
                                              
                                              1,308,408
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              (1,208,683
                                              )
                                              
                                              
                                              
                                              
                                              
                                              
                                              99,725Conversion
      Liability
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              2,062,762
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              (1,173,840
                                              )
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              888,922Warrant
      Liability
                                              
                                              
                                              802,137
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              5,471,250
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (3,578,916
                                              )
                                              
                                              
                                              
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (750,248
                                              )
                                              
                                              
                                              -
                                              
                                              
                                              
                                              1,944,223Total
      current liabilities
                                              
                                              
                                              11,846,495
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              12,969,219Commitments
      and ContingenciesSTOCKHOLDERS'
      EQUITY:Series
      A, Preferred stock, $.001 par value, 10,000,000shares authorized,
      826,500 shares issed and outstanding
                                              
                                              
                                              826
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              826Series B, Preferred stock, $.001 par value, 2,000,000
      sharesauthorized, no shares issed and
      outstanding
                                              
                                              
                                              -
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              -Series
      C, Preferred stock, $.001 par value, 100 sharesauthorized, 17
      shares issed and outstanding
                                              
                                              
                                              -
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              -Common
      stock, $.001 par value, 50,000,000 sharesauthorized, 21,609,630
      shares issed and outstanding
                                              
                                              
                                              21,610
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              21,610Additional
      paid-in capital
                                              
                                              
                                              28,958,231
                                              
                                              
                                              
                                              (339,041
                                              )
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              28,619,190Accumulated
      deficit
                                              
                                              
                                              (26,922,289
                                              )
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              (27,776,899
                                              )2,058,378
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              864,727TOTAL
      LIABILILITIES AND STOCKHOLDERS' EQUITY
                                              
                                              $
                                              13,904,873
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              13,833,946
 
 Notes:
 A) To
reverse the deemed dividend and note payable originally booked to record it
properly
 B) To
re-book the issuance of the converible notes by valuing the conversion of the
notes and warrants separately.
 C) To
accrue the interest on the convertible notes.
 D) To
revalue the warrant liability and convertible note conversion feature liability
at December 31, 2005.
 E) To
accrete the vaue of the note to its original value.
 F) To
accrue interest on the preferred stock issued in 2004.
 G) To
revalue the warrant liability and preferred stock liability asssociated with the
preferred stock issuance at December 31, 2005.
 H) To
amortize placement fee costs paid to the agency for the preferred stock
issuance.




F-9





CONSOLIDATED
STATEMENTS OF OPERATION


YEAR
ENDED DECEMBER 31, 2005





December 31,2005 as previously
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  December 31,reported
                                  
                                  
                                  Note A
                                  
                                  
                                  Note B
                                  
                                  
                                  Note C
                                  
                                  
                                  Note D
                                  
                                  
                                  Note E
                                  
                                  
                                  Note F
                                  
                                  
                                  Note G
                                  
                                  
                                  Note H
                                  
                                  
                                  2005 - RestatedRevenues
                                  
                                  $
                                  2,021,728
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  2,021,728Cost
      of revenues
                                  
                                  
                                  1,249,360
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  1,249,360Gross
      Profit
                                  
                                  
                                  772,368
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  772,368Selling,
      general and adimistrative
                                  
                                  
                                  9,629,424
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  9,629,424Operating
      Loss
                                  
                                  
                                  (8,857,056
                                  )
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  (8,857,056
                                  )Interest
      expense
                                  
                                  
                                  2,231,225
                                  
                                  
                                  
                                  (1,323,684
                                  )
                                  
                                  
                                  4,766,512
                                  
                                  
                                  
                                  199,219
                                  
                                  
                                  
                                  
                                  
                                  
                                  973,279
                                  
                                  
                                  
                                  185,085
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  70,927
                                  
                                  
                                  
                                  (7,102,563
                                  )Other
      Income
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  4,752,756
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  1,958,931
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  6,711,687Net
      Loss
                                  
                                  $
                                  (11,088,281
                                  )
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  $
                                  (9,247,932
                                  )Net
      loss applicable to common shareholders:Net
      loss
                                  
                                  $
                                  (11,088,281
                                  )
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  (9,247,932
                                  )Benefical
      conversion of preferred stock
                                  
                                  
                                  -
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  -Deemed
      dividend from beneficial converision feature of warrants
                                  
                                  
                                  (428,058
                                  )
                                  
                                  
                                  -
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  -Net
      loss applicable to common shareholders:
                                  
                                  $
                                  (11,516,339
                                  )
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  $
                                  (9,247,932
                                  )Net
      loss per share;Base
      and diluted
                                  
                                  $
                                  (0.56
                                  )
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  $
                                  (0.45
                                  )Weighted
      average shares outstanding:Base
      and diluted
                                  
                                  
                                  20,433,762
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  20,433,762





Notes:


A) To
reverse the deemed dividend and note payable originally booked to record it
properly


B) To
re-book the issuance of the converible notes by valuing the conversion of the
notes and warrants separately.


C) To
accrue the interest on the convertible notes.


D) To
revalue the warrant liability and convertible note conversion feature liability
at December 31, 2005.


E) To
accrete the vaue of the note to its original value.


F) To
accrue interest on the preferred stock issued in 2004.


G) To
revalue the warrant liability and preferred stock liability asssociated with the
preferred stock issuance at December 31, 2005.


H) To
amortize placement fee costs paid to the agency for the preferred stock
issuance.





F-10




CONSOLIDATED
STATEMENTS OF OPERATION
 YEAR
ENDED DECEMBER 31, 2004
 
 December 31,2004 as previously
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            December 31,reported
                            
                            
                            Note A
                            
                            
                            Note B
                            
                            
                            Note C
                            
                            
                            Note D
                            
                            
                            Note E
                            
                            
                            2004 restatedRevenues
                            
                            $
                            2,115,751
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            2,115,751Cost
      of revenues
                            
                            
                            1,050,283
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            1,050,283Gross
      Profit
                            
                            
                            1,065,468
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            1,065,468Selling,
      general and adimistrative
                            
                            
                            15,055,322
                            
                            
                            
                            
                            
                            
                            471,317
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            15,526,639Operating
      Loss
                            
                            
                            (13,989,854
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (14,461,171
                            )Interest
      expense
                            
                            
                            -
                            
                            
                            
                            539,848
                            
                            
                            
                            
                            
                            
                            
                            96,346
                            
                            
                            
                            
                            
                            
                            36,921
                            
                            
                            
                            (673,115
                            )Other
      Income
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            1,883,403
                            
                            
                            
                            
                            
                            
                            
                            1,883,403Net
      Loss
                            
                            $
                            (13,989,854
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            $
                            (13,250,883
                            )Net
      loss applicable to common shareholders:Net
      loss
                            
                            $
                            (13,989,854
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (13,250,883
                            )Benefical
      conversion of preferred stock
                            
                            
                            (1,413,374
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            -Deemed
      dividend from beneficial converision feature of
    warrants
                            
                            
                            (1,009,085
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            -Net
      loss applicable to common shareholders:
                            
                            $
                            (16,412,313
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            $
                            (13,250,883
                            )Net
      loss per share;Base
      and diluted
                            
                            $
                            (1.02
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            $
                            (0.82
                            )Weighted
      average shares outstanding:Base
      and diluted
                            
                            
                            16,066,789
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            16,066,789
 
 Notes:
 A) To
properly book the preferred stock that was issued in 2004 along with the
warrants issued with it.
 B) To
book the warrants given to placement agency and to properly record the placement
agency fee
 C) To
record the interest that accrues in association with the preferred stock. It was
not booked prior.
 D) To
revalue the warrant liability and preferred stock liability asssociated with the
preferred stock issuance
 at
December 31, 2004.
 E) To
amortize the financing costs associated with the preferred
stock.




Use of Estimates.The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities at the date of the balance sheet.  Actual results could
differ from those estimates.





Principles of Consolidation.
The consolidated financial statements include the accounts of one subsidiary.
All inter-company transactions have been eliminated in
consolidation.





Cash and Cash Equivalents.Cash equivalents include highly liquid, temporary cash investments having
original maturity dates of three months or less.  For reporting
purposes, cash equivalents are stated at cost plus accrued interest, which
approximates fair value.





Inventories.Inventories
are valued at the lower of cost or market.  Cost is determined by
using the average cost method.  Inventories consist primarily of raw
materials and packaging for our pharmaceutical products.


F-11





Equipment and Long-Lived
Assets.Property and equipment are stated at cost less
accumulated depreciation.  Major renewals and improvements are
capitalized; minor replacements, maintenance and repairs are charged to current
operations.  Depreciation is computed by applying the straight-line
method over the estimated useful lives of machinery and equipment (three to
seven years). The majority of our long-lived assets are located in The People’s
Republic of China. We perform reviews for the impairment of long-lived assets
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable.





Licenses.Licenses
consist of permits to produce pharmaceutical products which were acquired in a
business combination.  The licenses were valued at their historical
cost.  The cost of the licenses is not amortized because they have an
indefinite life.  The licenses are reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable.  The permits are in the Peoples Republic of
China. During 2005 and 2004, management of the Company determined that no
impairment adjustment related to these intangibles was necessary.





We
believe our licenses have market value independent from our ability to exploit
them because they can be transferred to third parties. In the event that we fail
to exploit them ourselves due to a lack of financial resources, we plan to
recover the costs of these licenses by a sale to third parties.





Derivative
Instruments. We have issued and outstanding certain instruments with
embedded derivative features which we analyze in accordance with the
pronouncements relating to accounting for derivative instruments and hedging
activities to determine if these instruments are derivatives or have embedded
derivatives that must be bifurcated. Under the applicable accounting literature,
the estimated value of the embedded derivative, if any, is bifurcated from its
host instrument on the date of sale or issuance of the securities or debt based
on a valuation utilizing the appropriate valuation model. The embedded
derivative liability is classified as such and is marked-to-market and adjusted
to fair value at each reporting date and the change in fair value is recorded to
other (income) expense, net. In addition, freestanding warrants are accounted
for as equity securities or liabilities in accordance with the provisions of the
applicable accounting literature. As the conversion rate or exercise price of
all outstanding instruments vary with the fair value of our common stock, they
are recorded as an obligation at fair value, marked-to-market at each reporting
date, and carried on a separate line of the accompanying balance sheet. If there
is more than one embedded derivative, their value is considered in the
aggregate.





Convertible Preferred Stock -Convertible Preferred Sock issued by AXM Pharma is initially offset by a
discount representing the relative fair values of the embedded conversion option
and the warrants issued with the Preferred Stock.  The fair value of
the warrants and embedded conversion option are calculated based on available
market data using appropriate valuation models.  The excess of the sum
of the values of the embedded conversion option plus the warrants over the cash
proceeds received from the issuance of the Preferred Stock is charged to
interest expense.





Secured Promissory Notes -Convertible Secured Promissory Notes that we issued are initially offset
by a discount representing the relative fair values of the conversion option
embedded in the Notes and warrants issued with the Notes.  The fair
value of the warrants and embedded conversion option are calculated based on
available market data using appropriate valuation models.  The excess
of the sum of the values of the embedded conversion option plus the warrants
over the cash proceeds received from the issuance of the Notes is charged to
interest expense. The carrying value of the Notes is accreted to the face amount
over the term of the Notes using an effective interest method.





Warrants -Warrants issued in
connection with our Secured Promissory Notes and Convertible Preferred Stock
have been classified as liabilities due to certain provisions that may require
cash settlement in certain circumstances. At each balance sheet date, we adjust
the warrants to reflect their current fair value. We estimate the fair value of
these instruments using the Black-Scholes option pricing model which takes into
account a variety of factors, including historical stock price volatility,
risk-free interest rates, remaining term and the closing price of our common
stock. Changes in the assumptions used to estimate the fair value of these
derivative instruments could result in a material change in the fair value of
the instruments. We believe the assumptions used to estimate the fair values of
the warrants are reasonable.  See Item 6A. Quantitative and Qualitative
Disclosures about Market Risk for additional information on the
volatility in market value of derivative instruments.


F-12




Deferred Financing Costs.Deferred financing costs attributable to the issuance of Secured
Promissory Notes and Convertible Preferred Stock have been amortized to interest
expense over the term of the notes.





Value Added Tax
Payable.We are subject to a value added tax rate of 17% on
product sales by The Peoples Republic of China.  Value added tax
payable is computed net of value added tax paid on purchases for all sales in
The Peoples Republic of China.





Revenue
Recognition.We recognize product sales revenue when the goods
are shipped, title and risk of loss passes and collectability is reasonably
assured.  In situations where a distributor’s sales reporting to us is
inadequate or untimely, we have to judge whether all of the elements required
for revenue recognition have been met, including assurance of
collectability.  In such instances, we may conclude that revenue
recognition of such sales should be delayed until payments are received from the
distributor.  Any provision for discounts and estimated returns are
accounted for in the period the related sales are recorded.





Income Taxes.Income taxes are
computed using the asset and liability method.  Under the asset and
liability method, deferred income tax assets and liabilities are determined
based on the differences between the financial reporting and tax bases of assets
and liabilities and are measured using the currently enacted tax rates and
laws.  A valuation allowance is provided for the amount of deferred
tax assets that, based on available evidence, are not expected to be
realized.





Foreign Currency Translation.Transactions and balances originally denominated in U.S. dollars are
presented at their original amounts.  Transactions and balances in
other currencies are converted into U.S. dollars in accordance with Statement of
Financial Accounting Standards (SFAS) No. 52, "Foreign Currency Translation,”
and are included in determining net income or loss.




For
foreign operations with the local currency as the functional currency, assets
and liabilities are translated from the local currencies into U.S. dollars at
the exchange rate prevailing at the balance sheet date. Revenues and expenses
are translated at weighted average exchange rates for the period to approximate
translation at the exchange rates prevailing at the dates those elements are
recognized in the financial statements. Translation adjustments resulting from
the process of translating the local currency  financial statements
into U.S. dollars are included in determining comprehensive
loss.




The
reporting currency is the U.S. dollar.  The functional currency of our
subsidiary, AXM Shenyang, is the Renminbi (“RMB”) which is the local currency in
China.  The financial statements of our subsidiary are translated into
U.S. dollars using period-end exchange rates for assets and liabilities, and
average rates of exchange for the period for revenues, costs, and
expenses.  Net gains and losses resulting from foreign exchange
transactions are included in the consolidated statements of
operations.





Stock-Based Compensation.We
account for stock-based compensation for employees and non-employee members of
our board of directors in accordance with Accounting Principles Board, or APB,
Opinion No. 25, “Accounting for Stock Issued to Employees.” Under APB Opinion
No. 25, compensation expense is based on the intrinsic value on the measurement
date, calculated as the difference between the fair value of our common stock
and the relevant exercise price. We account for stock-based compensation for
non-employees, who are not members of our board of directors, at fair value
using a Black-Scholes option-pricing model in accordance with the provisions of
SFAS No. 123, “Accounting for Stock-Based Compensation” and other applicable
accounting principles.  We recorded stock-based compensation expense
of approximately $5,600,000 during 2004.  There were 2,140,000 stock
options granted to employees and directors in 2004.  There were not
any options granted to employees in 2005.


Had
compensation expense been determined based on the estimated fair value at the
measurement dates of awards under those plans consistent with the method
prescribed by SFAS No. 123, our December 31, 2005 and 2004 net loss would have
been changed to the pro forma amounts indicated below.  No options
were granted in 2005.


F-13





December 31, 2005
                      
                      
                      December 31, 2004Net
      loss applicable to common shareholders:As
      reported
                      
                      $
                      (9,247,932
                      )
                      
                      $
                      (13,250,883
                      )Stock
      based compensation under fair value method
                      
                      
                      -
                      
                      
                      
                      -Pro
      forma
                      
                      $
                      (9,247,932
                      )
                      
                      $
                      (13,250,883
                      )Net
      loss applicable to common shareholders per sharebasic
      and diluted:As
      reported
                      
                      $
                      (0.45
                      )
                      
                      $
                      (0.82
                      )Stock
      based compensation under fair value method
                      
                      
                      -
                      
                      
                      
                      -Pro
      forma
                      
                      
                      (0.45
                      )
                      
                      $
                      (0.82
                      )





The fair
value of each option grant was estimated on the date of grant using the
Black-Scholes option pricing model with the following assumptions: risk free
rate of 2.0%; volatility of 79% for 2004 with no assumed dividend yield; and
expected lives of two to five years.  No stock options were issued to
employees in 2005.





Fair Value of Financial
Instruments.Financial instruments that are subject to fair
disclosure requirements are carried in the financial statements at amounts that
approximate fair value and include cash and cash equivalents, accounts
receivable and accounts payable.  Fair values are based on assumptions
concerning the amount and timing of estimated future cash flows and assumed
discount rates reflecting varying degrees of perceived risk.





Basic and Diluted Net Loss per Share.Basic net loss per share is computed using the weighted average number of
common shares outstanding during the period.  Diluted net loss per
share is computed using the weighted average number of common and, if dilutive,
potential common shares outstanding during the period. Potential common shares
consist of the incremental common shares issuable upon the exercise of stock
options and warrants (using the treasury stock method).  For 2005 and
2004, there were no potential common shares outstanding that were related to
shares issuable upon the exercise of stock options or warrants.





Impact
of Recent Accounting Pronouncements





In
November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of
ARB No. 43. This statement clarifies the accounting for idle capacity expense,
freight, handling costs, and wasted material and is effective for the third
quarter of 2005. We believe the adoption of this statement will not have a
material effect on our results of operations, cash flows or financial
position.





In
December 2004, the FASB issued SFAS No. 123(R), Share Based Payment. This
statement establishes standards for the accounting for transactions in which an
entity exchanges its equity instruments for goods and services. It focuses
primarily on accounting for transactions in which an entity obtains employee
services in share-based payment transactions (employee stock options). The
statement requires the measurement of the cost of employee services received in
exchange for an award of equity instruments (such as employee stock options) at
fair value on the grant date. That cost will be recognized over the period
during which an employee is required to provide services in exchange for the
award (the requisite service period). The effective date of this statement is
the first quarter of 2006. We are still considering transition methods under
this standard.





In
December 2004, the FASB issued SFAS No. 153, Exchanges of Non-monetary Assets,
an amendment of APB 29. This statement clarifies that all non-monetary
transactions that have commercial substance should be recorded at fair value and
is effective for the first quarter of 2005. The adoption of this statement did
not have a material effect on its results of operations, cash flows or financial
position.





3.  INVENTORY
WRITE-OFF





We
delivered Sunkist brand products of Chewchew Bear multi-vitamins to
distributors, of which, $313,000 of such product was labeled to be sold in
China.  However, we had not obtained the necessary import license for
this product from the Chinese government as of December 31, 2005. The
inventories remain in the distributor’s warehouse in Hong Kong.  We
can not predict when we will obtain the necessary license to remove this product
from the distributor’s warehouse. Accordingly, we have written off the value of
this product from our inventory.


F-14





During
2005, we outsourced and manufactured Sunkist brand products of Leafs vitamin
supplement strips in China. The raw material had quality problems, resulting in
a write-off of $219,000.





As a
result of the above, we took an inventory write-off of approximately $532,000
during 2005.





4.  ACCOUNTS
RECEIVABLE





Our trade
accounts receivable are shown net of allowance for doubtful accounts of
$0.





AXM
Pharma maintains allowances for doubtful accounts for estimated losses resulting
from the inability of its customer to make required payments.  If the
financial condition of AXM Pharma's customer were to deteriorate, resulting in
an impairment of their ability to make payments, additional allowances may be
required.





5.
PROPERTY AND EQUIPMENT





Components
of property, plant, and equipment, at December 31, 2005 are as
follows:





Land
                  
                  $
                  932,286Vehicles
                  
                  
                  70,630Equipment
                  
                  
                  622,858Construction
      in progress
                  
                  
                  6,011,3177,637,091Less:
      accumulated depreciation
                  
                  
                  (79,081
                  )$
                  7,558,010





Depreciation
expense totaled $56,309 and $32,167 in 2005 and 2004, respectively, and was
included in selling general and administrative expenses.





AXM
Pharma expects to reclassify construction in progress in the first half of
2006.





6.
SHORT-TERM LOANS





We have
loans outstanding with an aggregate principal amount of $3,960,249 at December
31, 2005. Our wholly owned subsidiary secured these loans from the Shenyang
Branch of Shanghai Pudong Development Bank in the amount of 20 million RMB
(US$2,416,422)  with a one-year term and 5 million (US$609,756) with a
term of six months on January 14 and August 18, 2005, respectively.   The
loans have an annual interest rate of 6.417%, interest is due quarterly and
principal is due upon maturity.  The loans are secured by our properties
through a Mortgage Agreement between AXM (Shenyang) and the Development Bank,
and the land-use right of the state-owned land.  Both notes mature
after December 31, 2005 and are currently in default.





Between October 22, 2004 and July 5,
2005, we secured additional loans through a series of short term, non-recourse
loans from individual Chinese lenders. Most of the loans have an interest rate
of 24% annually and a maturity of 180 days from inception. We used the proceeds
of the loans to finance certain costs associated with construction of our
factory in Shenyang, China and operations in China. At December 31, 2005, we had
outstanding non-recourse loans due of $934,071 all of which are in default and
accruing interest at 40%.




7:
SERIES C CONVERTIBLE PREFERRED STOCK




On June
24, 2004, we issued to accredited investors pursuant to a private equity
financing, 30.425 shares of our Series C Preferred Stock (the “Series C Prefs”),
at a price per share of $100,000 and 357,936 Common Stock Purchase Warrants,
each of which entitles the holder to purchase one share of our common stock,
$.001 par value, for a period of three years from the date of issuance at a
price equal to $5.50 per share. In addition, we issued to HC Wainwright, our
placement agent, a three-year warrant to purchase up to 3 shares of Series C
Prefs at a price of $100,000 per share, which is convertible into 70,588 common
shares, and upon exercise, entitles HC Wainwright up to 35,793 warrants on a
pro-rata basis to the number of shares of Series C Prefs purchased upon
exercise. We also issued 53,691 warrants to purchase our common stock at $5.50
per share to The Shemano Group, our co-placement agent. Total proceeds were
approximately $2,770,000, net of expenses.




F-15




The
Series C Prefs carry the rights and preferences set forth in a Certificate of
Designation which is incorporated herein by reference (the “Certificate of
Designation”). Each share of Series C Pref is initially:




·
            convertible
      into shares of our Common Stock as determined by dividing the Liquidation
      Preference Amount per share ($100,000) by the applicable conversion price
      per share ($4.25) (subject to adjustment in the event of any subdivision,
      combination of shares, stock dividend, stock split, recapitalization,
      reclassification, reorganization, merger or other combination). If we
      issue any shares of our capital stock, other than (i) the issuance or sale
      of options to purchase shares of Common Stock pursuant to a stock option
      or equity incentive plan approved by the Board of Directors of the
      Company, or the issuance or sale of any shares of Common Stock upon the
      exercise of any such options, (ii) shares of Common Stock issued upon
      conversion of shares of any of the Series C Preferred Stock, (iii)
      securities issued in connection with any underwritten primary public
      offering of the Company’s securities pursuant to a registration statement
      declared effective by the Securities and Exchange Commission, (iv) the
      issuance of securities as consideration for a bona fide business
      acquisition of or by the Company whether by merger, consolidation, sale of
      assets, sale or exchange of stock or otherwise, which involves a third
      party which is not affiliated with the Company or its current stockholders
      or in a strategic alliance or as equity kickers in lease and financing
      transactions, the primary purpose of which is not to raise equity capital;
      (v) in the case of (i), (ii) and (iii), any additional shares of Common
      Stock as may be issued by virtue of anti-dilution provisions, if any,
      applicable to such options or securities; or (vi) any additional shares of
      Common Stock as may be issued by virtue of the adjustment provisions
      applicable to the Series C Preferred, the conversion price of the Series C
      Preferred Stock  Preferred shall be adjusted to that price
      determined by multiplying the Conversion Price by a fraction, the
      numerator of which is equal to the sum of (A) the number of shares of
      Common Stock outstanding immediately prior to the new issuance plus (B)
      the number of shares of Common Stock which the aggregate consideration for
      the new common shares to be issued would purchase at a price per share
      equal to the Conversion price; and the denominator of which is the number
      of shares of Common Stock outstanding immediately after the new
      issuance.  lowered to a price equal to the securities
      issued;




·
            entitled
      to vote on all matters submitted to a vote of the holders of our Common
      Stock, together with the holders of the Common Stock, on an as-converted
      basis. Without the written consent or affirmative vote of the Holders of
      at least 75% of the then outstanding shares of Series C Preferred, we may
      not authorize or issue any shares of capital stock, or affect certain
      other changes to the Company’s capital
  structure;




·
            entitled
      to dividends at a rate per annum of 6% of the stated Liquidation
      Preference Amount per share; and




·
            entitled
      to a liquidation preference equal to the aggregate stated Liquidation
      Preference Amount of all Series C Preferred shares held by such Holder
      upon the occurrence of any liquidation, dissolution or winding up of the
      Company, whether voluntary or involuntary, or in the event of the
      Company’s insolvency. If any sale or transfer of all or substantially all
      of the assets of the Company in a transaction or series of transactions
      (“Asset Sale”) is proposed to occur, we are obligated to given written
      notice to Holders of Series C Preferred, who shall be entitled to elect
      that the Asset Sale be deemed a liquidation, dissolution and winding up of
      the Company and to demand payment of the liquidation preference with
      respect to such Holder’s shares upon the consummation of the Asset
      Sale.




F-16




Upon the
occurrence of (i) the institution against the Company of any proceedings under
the United States Bankruptcy Code or any other federal or state bankruptcy,
reorganization, receivership, insolvency or other similar law affecting the
rights of creditors generally, which proceeding is not dismissed within thirty
(30) days of filing or (ii) the institution by the Company of any proceedings
under the United States Bankruptcy Code or any other federal or state
bankruptcy, reorganization, receivership, insolvency or other similar law
affecting the rights of creditors generally or the making by the Company of a
composition or an assignment or trust mortgage for the benefit of auditors, the
Holders may elect to have all or any portion of the then-outstanding Series C
Preferred redeemed by the Company. Upon the redemption election, we will pay the
Holders a redemption payment equal to the aggregate stated Liquidation
Preference Amount of the Series C  Preferred shares which are to be
redeemed.





APB
Opinion 14 (as amended), states that a portion of the proceeds of debt
securities issued with detachable stock purchase warrants is allocable to the
warrants and should be accounted for as paid-in capital. The allocation should
be based on the relative fair values of the two securities at time of issuance.
APB 14 by its terms does not apply to preferred stock. However, the Emerging
Issues Task Force noted in EITF Issues No. 98-5, that a similar methodology
would be used in circumstances in which convertible securities are issued along
with another security, and that proceeds from the issuance of convertible
preferred stock with detachable warrants should be allocated between the
preferred stock and the other securities based on the relative fair values of
the components. EITF 00-19 provides that proceeds from the issuance of warrants
or other derivative instruments that give the counterparty the choice of cash
settlement or settlement in shares, should be reported as a liability, which is
measured at fair value, with changes in fair value reported in earnings. EITF
00-19 further provides that a contract that contains an indeterminate number of
shares to be delivered in a share settlement is essentially a contract that
gives the counterparty a choice of cash settlement or settlement in shares and
should be recorded as a liability.





Both
the Series C Prefs and the Warrants issued with those Prefs contain such
provisions as a result of the anti-dilution features contained in the Statement
of Designation of the Series C Convertible Preferred Stock, the Warrants and
other relevant contracts. Accordingly we have accounted for the Series C Prefs
and the associated Warrants as derivative liabilities at the time of issuance
using the Black Scholes Option pricing model. On June 24, 2004, the date of the
transaction, the value of the warrants issued with the Series C Preferred stock
was determined to be $1,135,605, based on a closing stock price of $5.10 on that
date. See Note 9: Derivative
Instrument Liabilities, for further discussion of the liability related
to the warrants.





The
Series C Prefs essentially contain a call option on our common stock. APB 14
generally provides that debt securities which are convertible into common stock
of the issuer or an affiliated company at a specified price at the option of the
holder and which are sold at a price or have a value at issuance not
significantly in excess of the face amount are not bifurcated into separate
obligations. The terms of such securities generally include (1) an interest rate
which is lower than the issuer could establish for nonconvertible debt, (2) an
initial conversion price which is greater than the market value of the common
stock at time of issuance, and (3) a conversion price which does not decrease
except pursuant to anti-dilution provisions. The Series C Prefs do not satisfy
these conditions because the initial conversion price of $2.10 per common share
was lower than the market value of the common stock at time of issuance, which
was $2.50 per share. Accordingly the determination of whether the conversion
feature should be accounted for separately should be governed by FASB Statement
133, “Accounting for Derivative Instruments and Hedging
Activities”.





We have
determined that based on the provisions of FASB Statement 133, the embedded
conversion option present in the Series C Prefs should be valued separately at
the commitment date. Under FASB 133, a contract that contains an “embedded”
derivative instrument; i.e., implicit or explicit terms that affect some or all
of the cash flows or the value of other exchanges required by the contract in a
manner similar to a derivative instrument, under certain circumstances, must be
bifurcated into a host contract and the embedded derivative, with each component
accounted for separately. The issuer's accounting depends on whether a separate
instrument with the same terms as the embedded written option would be a
derivative instrument pursuant to paragraphs 6-11 of this Statement. Although
the option embedded in the Series C Prefs is indexed to our own stock, a
separate instrument with the same terms as the embedded option would not be
classified in stockholders' equity in the statement of financial position, but
rather would be classified as a liability due to the contractual provisions of
the Series C Prefs that essentially require cash settlement. Therefore, the
written option is considered to be a derivative instrument under and should be
separated from the host contract. On June 24, 2004, the date of the transaction,
the value of the conversion option embedded in the Series C Prefs was determined
to be $2,446,743, based on a closing stock price of $5.10 on that date. The
excess of the sum of the initial value of the conversion option plus the initial
value of the warrants has been charged to interest expense. The liability
related to the embedded option in the Series C Prefs and the Warrants will be
marked to market for all future periods they remain outstanding with an
offsetting charge to earnings.  At December 31, 2005, the derivative
liability associated the conversion option embedded in the Series C Prefs was
$99,724, with the change in fair value recorded in other
expenses.


F-17





EITF
Issues No. 98-5, “Accounting for Convertible Securities with Beneficial
Conversion Features or Contingently Adjustable Conversion Ratios,” and 00-27,
“Application of Issue No. 98-5 to Certain Convertible Instruments,” which under
certain circumstances require the bifurcation of an embedded conversion feature
from the host instrument, provide that when the fair value of the common stock
into which the preferred stock can be converted exceeds the proceeds (a
beneficial conversion feature), the issuer should allocate a portion of the
proceeds equal to that excess to paid-in capital or to a liability if the issuer
has a cash payment obligation.  Under the guidance of EITF issues 98-5
and 00-27, we determined that any embedded beneficial conversion feature in the
Series C Prefs is inherent in the liability recorded for the embedded conversion
option in the Series C Prefs and is not accounted for separately.





We
incurred placement fees of $272,500 and issued 485,714 warrants to two placement
agents in connection with the Series C Preferred stock issuance for the year
ended December 31, 2004.  The warrants were valued on the closing
date, June 24, 2004, using the Black Scholes option pricing model, at a value of
$411,599.  This amount was recorded as a warrant liability. The
warrant liability will be marked to market at each future reporting date. The
warrant liability had a value of $15,662 at December 31, 2005.  Total
costs associated with the issuance of the Series C Pref were $684,099, of which,
$471,317 was charged to expense immediately as the holder of the Series C Prefs
can convert immediately. The total remaining cost of $212,782 has been allocated
to the Warrants, and is being amortized over the 3 year term of the
Warrants.





The
Series C Prefs carry a cumulative dividend of 6% per annum. Under the
Certificate of Designation, dividends accrue from the date specified for payment
in the Certificate of Designation of the Series C Prefs. The dividend is payable
semi-annually in arrears. As of December 31, 2005, we have accrued dividends
payable of $281,431, with a corresponding offset to interest
expense.





8.
SECURED CONVERTIBLE PROMISSORY NOTES





On April
20, 2005 we completed a private financing with 8 accredited investors.  We
issued Secured Convertible Promissory Notes (the “Notes”) with an aggregate face
amount of $3,125,000. Each Note is due on April 19, 2007 and is convertible at
the option of the holder anytime in whole or in part at $2.10 per common share.
Net proceeds from the issuance of the Notes after offering costs were
approximately $2,767,500.





The Notes
were issued as a portion of 6.25 Units, each consisting of one (1) $500,000
Secured Promissory Note; three hundred thousand (300,000) Common Stock Purchase
Warrants (Series A Warrants); and three hundred thousand (300,000) special
Common Stock Purchase Warrants (Series B Warrants).  The Notes bear
interest at 9% and are repayable in equal installments during the period
September 2005 through April 2007.  The Series A Warrants were issued with
an exercise price of $2.90 per share and the Series B Warrants were issued with
an exercise price per share of $3.50.  Each Purchaser also received a
Series C Warrant to purchase a number of shares of Common Stock equal to one
hundred percent (100%) of the number of Conversion Shares issuable upon
conversion of such Purchaser’s Notes at an exercise price per share equal to the
Conversion Price.  The Series A Warrants and the Series B Warrants expire
five (5) years following the Closing Date and the Series C Warrants expire one
(1) year following the effective date of the registration statement providing
for the resale of the Conversion Shares and the Warrant Shares.




APB
Opinion 14 (as amended), states that a portion of the proceeds of debt
securities issued with detachable stock purchase warrants is allocable to the
warrants and should be accounted for as paid-in capital. The allocation should
be based on the relative fair values of the two securities at time of issuance.
EITF 00-19 provides that proceeds from the issuance of warrants or other
derivative instruments that give the counterparty the choice of cash settlement
or settlement in shares, should be reported as a liability, which is measured at
fair value, with changes in fair value reported in earnings. EITF 00-19 further
provides that a contract that contains an indeterminate number of shares to be
delivered in a share settlement is essentially a contract that gives the
counterparty a choice of cash settlement or settlement in shares and should be
recorded as a liability.


F-18




Both
the Notes and the Warrants issued with the Notes contain such provisions as a
result of the anti-dilution features contained in the Notes, the Warrants and
other relevant contracts. Accordingly we have accounted for the Notes and the
associated Warrants as derivative liabilities at the time of issuance using the
Black Scholes Option pricing model. On April 20, 2005, the date of the
transaction, the value of the warrants issued with the Notes was determined to
be $5,471,250, based on a closing stock price of $2.07 on that date. See Note 9: Derivative Instrument
Liabilities, for further discussion of the liability related to the
warrants.





The Notes
essentially contain a call option on our common stock. APB 14 generally provides
that debt securities which are convertible into common stock of the issuer or an
affiliated company at a specified price at the option of the holder and which
are sold at a price or have a value at issuance not significantly in excess of
the face amount are not bifurcated into separate obligations. The terms of such
securities generally include (1) an interest rate which is lower than the issuer
could establish for nonconvertible debt, (2) an initial conversion price which
is greater than the market value of the common stock at time of issuance, and
(3) a conversion price which does not decrease except pursuant to anti-dilution
provisions. The Notes do not satisfy these conditions because the initial
conversion price of $2.10 per common share was lower than the market value of
the common stock at time of issuance, which we $2.50 per share. Accordingly the
determination of whether the conversion feature should be accounted for
separately should be governed by FASB Statement 133, “Accounting for Derivative
Instruments and Hedging Activities”.




We have
determined that based on the provisions of FASB Statement 133, the embedded
conversion feature present in the Notes should be valued separately at the
commitment date. Under FASB 133, a contract that contains an “embedded”
derivative instrument; i.e., implicit or explicit terms that affect some or all
of the cash flows or the value of other exchanges required by the contract in a
manner similar to a derivative instrument, under certain circumstances, must be
bifurcated into a host contract and the embedded derivative, with each component
accounted for separately. The issuer's accounting depends on whether a separate
instrument with the same terms as the embedded written option would be a
derivative instrument pursuant to paragraphs 6-11 of this Statement. Although
the option embedded in the Notes is indexed to our own stock, a separate
instrument with the same terms as the embedded option would not be classified in
stockholders' equity in the statement of financial position, but rather would be
classified as a liability due to the contractual provisions of the Notes that
essentially require cash settlement. Therefore, the written option is considered
to be a derivative instrument under and should be separated from the host
contract. On April 20, 2005, the date of the transaction, the value of the
conversion option embedded in the Notes was determined to be $2,062,762, based
on a closing stock price of $2.07 on that date. This value has been recorded as
a liability with a corresponding decrease in the carrying value of the Notes.
The excess of the sum of the initial value of the conversion option plus the
initial value of the Series A and Series B warrants issued with the Notes has
been charged to interest expense. The liability related to the embedded option
in the Notes and the Series A and Series B Warrants will be marked to market for
all future periods they remain outstanding with an offsetting charge to
earnings.  At December 31, 2005, the derivative liability associated
with the conversion option embedded in the Notes was $ 888,922, with the change
in fair value recorded in other expenses. See Note 9: Derivative Instrument
Liabilities.




The
carrying value of the Notes has initially been recorded at zero because the sum
of the initial value of the warrants plus the conversion option embedded in the
Notes exceeds the proceeds. The liability for the Notes will accrete to their
face amount over the term of the Notes calculated based on an effective interest
method with an offsetting charge to interest expense. As of December 31, 2005,
the carrying value of the Notes was $973,279.




We
determined the initial fair value of the Series A and Series B warrants issued
with the Notes to be $5,471,250 based on the Black-Scholes option pricing model.
This value has been recorded as a liability with a corresponding decrease in the
carrying value of the Notes. This difference will be amortized over the term of
the Notes as interest expense calculated using an effective interest method. See
Note 9: Derivative Instrument
Liability, for a further discussion of the liability related to the
issuance of the Series A and Series B Warrants.


F-19




EITF
Issues No. 98-5, “Accounting for Convertible Securities with Beneficial
Conversion Features or Contingently Adjustable Conversion Ratios,” and 00-27,
“Application of Issue No. 98-5 to Certain Convertible Instruments,” provide that
when the fair value of the common stock into which the note can be converted
exceeds the proceeds (a beneficial conversion feature), the issuer should
allocate a portion of the proceeds equal to that excess to paid-in capital or to
a liability if the issuer has a cash payment obligation. The beneficial
conversion feature recognized is limited to the proceeds received from the
issuance of the notes after allocating the value of any warrants issued together
with the Notes. Under the guidance of EITF issues 98-5 and 00-27, we determined
that the Notes do not contain an embedded beneficial conversion feature because
the proceeds from the issuance of the Notes was less than the value of the
Warrants issued with the Notes and therefore, the limitation described above is
applicable.  In addition, under the guidance of EITF issues 98-5 and
00-27, we determined that any embedded beneficial conversion feature in the
Notes is inherent in the liability recorded for the embedded conversion option
in the Notes and is not accounted for separately.




Under the
terms of the Series C Warrants issued with the Notes, each Purchaser is entitled
to purchase a number of shares of Common Stock equal to one hundred percent
(100%) of the number of Conversion Shares issuable upon conversion of such
Purchaser’s Notes, at an exercise price per share equal to the Conversion Price.
We recorded the liability for the Notes at an amount equal to the full
consideration received upon issuance, less the value of the Series A and Series
B Warrants, but without considering the value of the Series C Warrants because
the determination of the number of Common Shares underlying the Series C
Warrants and the exercise price of the Series C Warrants is dependent on the
Conversion Price of the Notes at the time of conversion, which was indeterminate
on the issue date of the Notes and Warrants.




We
incurred placement fees and legal expenses of approximately $357,500 in
connection with the issuance of the Notes. We recorded these costs as deferred
financing costs, which are to be amortized over the term of the Notes, without
any allocation to the Warrants.





9.
DERIVATIVE INSTRUMENT LIABILITIES





Derivative
instruments consist of the following:





December 31, 2005Warrants
      issued with Series C Convertible Preferred Stock
                  
                  $
                  36,226Warrants
      issued to the placement agents
                  
                  
                  15,663Warrants
      issued with Secured Promissory Notes
                  
                  
                  1,892,334Preferred
      stock conversion liability
                  
                  
                  99,725Convertible
      note conversion liability
                  
                  
                  888,922$
                  2,932,870





Warrants issued with Series C
Convertible Preferred Stock. As described above in Note 7, in connection
with the issuance of the Series C Prefs, we issued Warrants to purchase up to an
aggregate of 357,936 shares of our common stock.  We also issued to
our placement agent, HC Wainwright, a three-year warrant to purchase up to 3
shares of Series C Prefs at a price of $100,000 per share, which is convertible
into 70,588 common shares and 53,691 warrants to purchase our common stock at
$5.50 per share to The Shemano Group, our co-placement agent.





As of
December 31, 2005 the total number of Warrants issued and outstanding with
respect to the Series C Prefs is 357,936.  At December 31, 2005 the
Series C Pref warrant liability was $36,226 and the Series C placement agency
warrant liability was $15,663.





Warrants issued with Secured
Promissory Notes. As described above in Note 8, in connection with the
issuance of Secured Promissory Notes, we issued Series A and Series B Warrants
to purchase up to an aggregate of 3,750,000 shares of our common
stock.


F-20


The
Warrants issued with the Notes provide the holder with registration rights,
which obligate the Company to register the common shares underlying the Warrants
within 30 days of the closing. The terms of the Warrants specify a liquidated
damages penalty of 1% of the Holder’s initial investment in the Notes for each
calendar month that the Company is delinquent in obtaining or maintaining a
valid registration statement covering the Common Shares underlying the
Notes.  Accordingly we have accounted for the Warrants as liabilities.
The liability for the Series A and Series B Warrants, measured at fair value,
has been offset by a reduction in the carrying value of the Notes. The liability
for the Series A and Series B Warrants will be marked to market for each future
period they remain outstanding. The value of the Series C Warrants will be
offset by a charge to earnings rather than as a discount from the carrying value
of the Notes when the value of these Warrants becomes determinable, which will
occur upon conversion of the Notes.





As of
December 31, 2005 the total number of Series A and Series B Warrants issued and
outstanding with respect to the Notes is 3,750,000 and the liability associated
with these warrants was $1,892,334.





Conversion Option Embedded in Series
C Convertible Preferred Stock. As described above in Note 7, we have
determined that based on the provisions of FASB Statement 133, the embedded
conversion option present in the Series C Prefs should be valued separately at
the commitment date. The option permits the holder to acquire our common stock
at a price of $4.25 per share.





The
Series C Prefs provide the holder with certain anti dilution rights that render
the number of common shares issuable upon a conversion to be indeterminate. In
addition, the Series C Prefs provide the holder with certain registration
rights, which obligate the Company to register the common shares underlying the
Series C Prefs within 30 days of the closing. Accordingly we have accounted for
the conversion option embedded in the Series C Prefs as derivative liabilities
at the time of issuance using the Black Scholes Option pricing model. The
liability for the conversion option, measured at fair value, has been offset by
a reduction in the carrying value of the Series C Prefs. The liability for the
conversion option will be marked to market for each future period the Series C
Prefs remain outstanding. At December 31, 2005, the Series C Pref conversion
option liability was $99,725.





Conversion Option Embedded in Secured
Promissory Notes. As described above in Note 8, we have determined that
based on the provisions of FASB Statement 133, the embedded conversion option
present in the Notes should be valued separately at the commitment date. The
option permits the holder to acquire our common stock at a price of $2.10 per
share.





The Notes
provide the holder with certain anti dilution rights that render the number of
common shares issuable upon a conversion to be indeterminate. In addition, the
Notes provide the holder with certain registration rights, which obligate the
Company to register the common shares underlying the Notes within 30 days of the
closing. Accordingly we have accounted for the conversion option embedded in the
Notes as derivative liabilities at the time of issuance using the Black Scholes
Option pricing model. The liability for the conversion option, measured at fair
value, has been offset by a reduction in the carrying value of the Notes. The
liability for the conversion option will be marked to market for each future
period the Notes remain outstanding. At December 31, 2005, the Note conversion
option liability was $888,922.





10.
STOCKHOLDERS’ EQUITY





Common Stock.We periodically issue common stock for services
rendered.  Common stock issued is valued at fair market value, which
is the quoted market price.  During the years ended December 31, 2005
and 2004, we issued 685,800 and 1,161,001 shares of common stock and warrants
for services valued at $1,790,637 and $5,620,498, respectively.





On
January 19 and June 29, 2005, we issued 50,017 and 28,583 shares of common stock
as dividends to Series C Preferred shareholders as payment of interest totaling
$141,048 and $40,016, respectively.





On March
31, 2005 we issued 350,000 shares of restricted common stock to Madden
Consulting as compensation for investor relations consulting services.  The
stock was valued at $2.74 per share, the closing stock price on the date of
issuance. We recognized $959,000 in expenses for the issuance of this
stock.





In March
2005, we issued 94,117 shares of common stock to Iroquis Capital for the
conversion of 4 shares of Series C Preferred Stock.


F-21





In March
2005, we issued 725,000 shares of common stock to SF Capital for the conversion
of 725,000 shares of Series A Preferred.




In March,
2005, we issued 30,000 shares of restricted common stock to each of XCL Partner
Inc. and Ashton Organization pursuant to consulting services.  The
total value the consideration was $80,400 and $79,500,
respectively.





In March 2005, we issued 10,000 shares
of restricted common stock for consulting services.  The stock was
valued at $26,800.





On April
1, 2005, we issued 40,000 shares of restricted common stock to Newbridge
Securities as compensation for investor relations consulting services.  The
stock was valued at $2.75 per share, the closing stock price on the date of
issuance; the Company recognized $110,000 in expenses for the issuance of this
stock.





On April
20, 2005 we completed a private financing with 8 accredited
investors.  We issued Secured Convertible Promissory Notes (the
“Notes”) with an aggregate face amount of $3,125,000. Each Note is due on April
19, 2007 and is convertible at the option of the holder anytime in whole or in
part at $2.10.





The Notes
were issued as a portion of 6.25 Units, each consisting of one (1) $500,000
Secured Promissory Note; three hundred thousand (300,000) Common Stock Purchase
Warrants (Series A Warrants); and three hundred thousand (300,000) special
Common Stock Purchase Warrants (Series B Warrants).  The Notes bear
interest at 9% and are repayable in equal installments during the period
September 2005 through April 2007.  The Series A Warrants were issued
with an exercise price of $2.90 per share and the Series B Warrants were issued
with an exercise price per share of $3.50.  Each Purchaser also
received a Series C Warrant to purchase a number of shares of Common Stock equal
to one hundred percent (100%) of the number of Conversion Shares issuable upon
conversion of such Purchaser’s Notes at an exercise price per share equal to the
Conversion Price.  The Series A Warrants and the Series B Warrants
expire five (5) years following the Closing Date and the Series C Warrants
expire one (1) year following the effective date of the registration statement
providing for the resale of the Conversion Shares and the Warrant
Shares.





On April
22 and April 26, 2005, we issued totaling 78,329 shares of common stock to SRG
Capital for the conversion of fractional shares of Series C
Preferred.





On June
14, 2005, we issued 11,700 shares of common stock to Gryphon Master Fund for the
conversion of 11,700 shares of Series A Preferred Stock.  On April 22 and
April 26, 2005, we also issued totaling 78,329 shares of common stock to SRG
Capital for the conversion of fractional shares of Series C
Preferred.





On
July 1 and August 10, 2005, we issued totaling 111,800 shares of Common Stock to
National Financial Service in connection with the conversion of 111,800 shares
of its Series A Preferred Stock.





On August
8, 2005, we completed a sale of 1,488,100 shares of Common Stock for the
exercise of the Company’s warrant for gross proceeds of $2,127,436.  This
financing was made pursuant to a Special Warrant Offer extended to the
purchasers listed in the Note and Warrant Purchase Agreement dated as of April
19, 2005.





On August
31, 2005, we issued 150,000 shares of restricted common stock to Madden
Consulting, Inc. pursuant to a consulting agreement.  The services to
be provided under the consulting agreement were investor and public relations,
which was valued at $252,000.




On
September 9, 2005, we issued 50,000 shares of restricted common stock to Ashok
Patel pursuant to a consulting agreement. The services to be provided under the
consulting agreement were advisory of strategic licensing and marketing, which
was valued as $77,000.




On
September 19, 2005, we issued 245,645 shares of of restricted common stock
(valued at $334,077) to convertible debenture holders in payment of principal
and interest due under the debentures.  Of this amount, $171,250
represented principal payments and the balance interest
expense.


F-22





On
September 8, 2005, we issued 60,000 shares of of restricted common stock (valued
at $88,200) for services rendered.





On
January 26, 2004, the Board authorized the issuance of 100,000 shares of
restricted common shares and 50,000 warrants to Great Eastern Securities, Inc.
pursuant to an investment banking agreement. The shares are to be
released quarterly based upon a vesting schedule of 25,000 shares
per quarter during the term of the agreement.   Pursuant to
an agreement that was executed on December 18, 2003, Great Eastern will provide
investor relations related services and assist AXM Pharma with broker relations
for our stock.  The warrants are for a term of five years and have an
exercise price equal to $4.74 per share.  The shares were valued at
$5.35 per share, the market price for shares of our common stock at the time of
issuance.  Therefore, the total aggregate value of the consideration
paid to Great Eastern Securities, Inc. was $639,828 including a $104,828 charge
computed using the black-scholes option pricing model.





On
February 2, 2004 and April 20, 2004, we issued 200,000 shares of restricted
common and 100,000 shares of restricted common, respectively to the Aston
Organization pursuant to a consulting agreement and amendment
thereto.  20,000 shares were released when the April 20, 2004
amendment was signed.    The remaining 180,000 shares are to
be released monthly based upon a vesting schedule of 15,000 shares per month
during the term of the agreement.   The shares were valued at
$5.65 per share and $4.27 per share, respectively, the market price for shares
of our common stock at the time of issuance.  Therefore, the total
aggregate value of the consideration paid to the Aston Organization was
$1,557,000.  At December 31, 2004, 270,000 common shares had been
issued for consideration of $1,387,500.  The remaining 30,000 common
shares were issued in January and February 2005.





On May 7,
2004, we issued 120,000 shares of restricted common stock, and 200,000
warrants at $6.00 per warrant, to XCL Partners, Inc.  20,000 shares
were released when the agreement was signed on June 24, 2004.  The
remaining 100,000 shares are to be released monthly based upon a vesting
schedule of 10,000 shares per month for ten months ,
beginning 30 days after effective date of the agreement   The
services to be provided under the agreement are investor
relations.   20,000 warrants shall vest
immediately.  The remaining 180,000 warrants shall be released
monthly based on a vesting schedule of 15,000 warrants per month for eleven (11)
months.  The shares were valued at $4.09 per share, the market price
for shares of our common stock at the time of issuance.  Therefore,
the total aggregate value of the consideration paid to XCL Partners was $957,815
including a $467,015 charge computed using the black-scholes option pricing
model.  At December 31, 2004, 80,000 common shares had been issued for
consideration of $640,100, including $312,900 for the value of the
warrants.  The remaining 40,000 common shares and 66,000 warrants were
issued in January, February, March and April 2005.





On May
10, 2004, we issued 300,000 shares of restricted common stock to Madden
Consulting, Inc. pursuant to a consulting agreement.  The services to
be provided under the consulting agreement were investor and public
relations.  The shares were valued at $3.92 per share, the market
price for shares of our common stock at the time of
issuance.  Therefore, the total aggregate value of the consideration
paid to Madden Consulting was $1,176,000.




On June
24, 2004, we issued 100,000 warrants to each of SF Capital Partners Ltd.,
Gryphon Master Fund, L.P., Banyon Asia Limited and Banyon Mac 24, Ltd. in
consideration for services provided related to our recent private equity
financing.





On July
21, 2004, we issued 100,000 shares of restricted common stock to Chet Howard,
our Chief Financial Officer and Chief Accounting Officer.  The shares
were valued using the closing stock price on the date of issue, pursuant to
which the stock was valued at $3.83 at the time of
issuance.  Therefore, the total aggregate value of the consideration
paid to Mr. Howard was valued at $383,000.





On July
21, 2004, we issued 100,000 shares of restricted common stock to Harry Zhang,
our Chief Accounting Officer of our wholly owned subsidiary.  The
shares were valued using the closing stock price on the date of issue, pursuant
to which the shares were valued at $3.83 at the time of
issuance.  Therefore, the total aggregate value of the consideration
paid to Mr. Zhang was valued at $383,000.


F-23





On
September 1, 2004, we issued stock options, for an aggregate of 100,000 options
to Dreamvest, LLC pursuant to a consulting agreement.  The options
have an exercise price of $2.69 and were valued using black-scholes option
pricing model for a charge of approximately $173,000.





On
September 10, 2004, we issued 83,334 shares of restricted common shares to Peter
Cunningham, our Chief Executive Officer pursuant to his employment
agreement.  The shares were valued at $3.83 per share, the market
price for shares of our common stock at the time of
issuance.  Therefore, the total aggregate value of the consideration
paid to Mr. Cunningham was valued at $319,169.





In
October 2004, we engaged Byrle Lerner, a beneficial owner of more than five
percent of our common stock (6.44%), to provide consulting services to AXM
Pharma.  Mr. Lerner will receive 60,000 restricted common shares and
100,000 options to purchase our common stock at $2.15 per share for his
services.  The current agreement with Mr. Lerner is for one year and
is terminable by either Mr. Lerner or us upon thirty days written
notice.





In
October 2004, we engaged Aurelius Consulting to provide marketing and investor
relations services. The initial term of the agreement is one
year.  Aurelius is entitled to receive 12,500 shares of our restricted
common stock per quarter during the term of its agreement, in consideration for
their services. The initial 12,500 shares were paid on behalf of AXM Pharma by
Byrle Lerner in a private transfer.  The shares were valued at $2.29
per share, the market price for shares of our common stock at the time of
transfer.  Therefore, the total aggregate value of the transaction
recognized by AXM Pharma was $28,625.





In
October 2004, we agreed to issue Mirador Consulting 30,000 restricted common
shares pursuant to a consulting agreement with a 3 month term that may be
renewed upon the written consent of both Mirador and us. The agreement is for
corporate consulting and investor relations services.  The 30,000
shares were paid on behalf of AXM Pharma by Byrle Lerner in a private
transfer.  The shares were valued at $2.15 per share, the market price
for shares of our common stock at the time of transfer.  Therefore,
the total aggregate value of the transaction recognized by AXM Pharma was
$64,500.





Convertible
Preferred Stock.AXM Pharma is authorized to issue up to 12,000,100 shares in aggregate of
preferred stock, and has to date designated 3 series, which are summarized
below:




Total Series
                              Authorized
                            
                            
                            Stated Value
                            
                            Voting
                            
                            Annual
                              Dividends per
                              Share
                            
                            Conversion
                              RateSeries
      A
                            
                            
                            10,000,000
                            
                            
                            $
                            2.00
                            
                            Yes
                            
                            
                            n/a
                            
                            1
      for 1Series
      B
                            
                            
                            2,000,000
                            
                            
                            
                            2.25
                            
                            Yes
                            
                            
                            n/a
                            
                            1
      for 1Series
      C
                            
                            
                            100
                            
                            
                            
                            425,000
                            
                            Yes
                            
                            
                            6
                            %
                            705,882
      for
1




Dividends
are payable semi-annually in January and June for Series C.  Accrued
but unpaid dividends do not pay interest.




The
holder of each share of the Series A, B and C Preferred Stock shall be entitled
to the number of votes equal to the number of shares of Common Stock into which
such share of Series A Preferred Stock could be converted for purposes of
determining the shares entitled to vote at any regular, annual or special
meeting of shareholders of AXM Pharma, and shall have voting rights and powers
equal to the voting rights and powers of the Common Stock.




On June
24, 2004, we issued 30.425 shares of our Series C preferred stock, at a price
per share of $100,000 and 357,936 common stock purchase warrants, each of which
entitles the holder to purchase one share of our common stock, $.001 par value,
for a period of three years from the date of issuance at a price equal to $5.50
per share to accredited investors pursuant to a private equity
financing.  Each share of the preferred stock is convertible into a
number of fully paid and non-assessable shares of our common stock obtained by
dividing the face value of $100,000
per share by the fixed conversion price of $4.25 per share.  In
addition, we issued to HC Wainwright, our placement agent, a three-year warrant
to purchase up to 3 shares of our Series C Preferred Stock at a price of
$100,000 per share and up to 35,793 (53,691) warrants on a pro-rata basis to the
number of shares of Preferred Stock purchased upon exercise.  We also
issued 53,691 warrants to The Shemano Group, our co-placement
agent.  Total proceeds were approximately $2,770,000, net of
expenses.





F-24




11.
STOCK OPTION PLANS





In April of 2004, our Shareholders
approved the “2004 Qualified and Non-statutory Stock Option Plan.” The Board of
Directors reserved 3,000,000 shares of our common stock to be issued in the form
of incentive and/or non-qualified stock options for employees, directors and
consultants to AXM. On April 29, 2004, our shareholders approved and ratified
the issuance of 2,140,000 options to employees, directors and consultants.
 On February 1, 2005, our Board of Directors approved the 2005 Equity
Incentive Plan, which will replace the 2004 Plan.  Our shareholders
approved the 2005 Plan at our Special Meeting on March 10, 2005.
  Shares available under the 2005 Plan include 5,000,000 shares of our
common stock, plus all shares remaining available for issuance under the 2004
Plan.





Stock option activity during the
periods indicated is as follows:





Number of
                    Shares
                  
                  
                  Weighted
                    Average
                    Exercise PriceOutstanding,
      December 31, 2003
                  
                  
                  —
                  
                  
                  $
                  —Granted
                  
                  
                  2,140,000
                  
                  
                  
                  4.08Exercised
                  
                  
                  —
                  
                  
                  
                  —Forfeited
                  
                  
                  —
                  
                  
                  
                  —Expired
                  
                  
                  —
                  
                  
                  
                  —Outstanding,
      December 31, 2004
                  
                  
                  —
                  
                  
                  
                  —Granted
                  
                  
                  —
                  
                  
                  
                  —Exercised
                  
                  
                  —
                  
                  
                  
                  —Forfeited
                  
                  
                  —
                  
                  
                  
                  —Expired
                  
                  
                  —
                  
                  
                  
                  —Outstanding,
      December 31, 2005
                  
                  
                  2,140,000
                  
                  
                  $
                  4.08Exercisable,
      December 31, 2005
                  
                  
                  2,140,000
                  
                  
                  $
                  4.08





At December 31, 2005, the range of
exercise prices and weighted average remaining contractual life of outstanding
options was $2.72 to $4.14, respectively.  The weighted average grant
date fair value of the options issued in 2004 amounted to $2.66. No stock
options were issued in 2005 to employees.





12.  INCOME
TAXES





Our
subsidiary, AXM (Shenyang) is incorporated in The People’s Republic of China
(PRC), which is governed by the Income Tax Law of the PRC concerning Foreign
Investment Enterprises and Foreign Enterprises and various local income tax laws
(the "Income Tax Laws''). Under the Income Tax Laws, foreign investment
enterprises ("FIE'') generally are subject to an income tax at an effective rate
of 33% (30% state income taxes plus 3% local income taxes) on income as reported
in their statutory financial statements after appropriate tax adjustments unless
the enterprise is located in specially designated regions or cities for which
more favorable effective rates apply. Upon approval by the PRC tax authorities,
FIEs scheduled to operate for a period of 10 years or more and engaged in
manufacturing and production may be exempt from income taxes for two years,
commencing with their first profitable year of operations, and thereafter with a
50% exemption for the next three years.  As of December 31, 2005, we
had not attained profitable operations for tax purposes.


F-25





For the years ended December 31, 2005
and 2004, we incurred net losses and, therefore, had no tax
liability.  The net deferred tax asset generated by the loss
carry-forward has been fully reserved.  The cumulative net operating
loss carry-forward is approximately $18,000,000 at December 31, 2005, and will
expire in the years 2007 through 2025.





Deferred income taxes consist of the
following at December 31, 2005:





Long-term:Net
      operating loss
                  
                  $
                  6,000,000Valuation
      allowance
                  
                  
                  (6,000,000
                  )$
                  -





13.
VALUE ADDED TAX PAYABLE





We are
subject to Chinese value added tax at a rate of 17% on product sales. Value
added tax payable on sales is computed net of value added tax paid on purchases
for all domestic sales.





14.
DISTRIBUTION OF PROFITS





As
stipulated by the relevant laws and regulations applicable to China’s foreign
investment enterprises, we are required to make appropriations from net income
as determined under accounting principles generally accepted in the PRC (“PRC
GAAP”) to non-distributable reserves which include a general reserve, an
enterprises expansion reserve and employee welfare and bonus
reserves.





The
general reserve is used to offset future extraordinary losses as defined under
PRC GAAP. We may, upon a resolution passed by the owners, convert the general
reserve into capital. The employee welfare and bonus reserve is used for the
collective welfare of our employees. The enterprise expansion reserve is used
for the expansion of AXM Pharma and can be converted to capital subject to
approval by the relevant authorities. We did not record any reserves in 2005 and
2004.  We incurred losses under accounting principles generally
accepted under the PRC.  Therefore, we were not required to record
such reserves.  No such adjustments are required under accounting
principles generally accepted in the United States of America in 2005 and
2004.





15.
EMPLOYEE RETIREMENT BENEFITS AND POST RETIREMENT BENEFITS





Our
employees in the PRC are entitled to retirement benefits calculated with
reference to their basic salaries on retirement and their length of service in
accordance with a government managed benefits plan. The PRC government is
responsible for the benefit liability to these retired employees.  We
are required to make contributions to the state retirement plan based on 19% of
the employees’ monthly basic salaries.  We do not have any other post
retirement benefit plans and does not provide any post-employment
benefits.





16.
COMMITMENTS AND CONTINGENCIES





Commitments:Operating Leases.
Our corporate and United States offices are located at 17870 Castleton Street,
Suite 255, City of Industry, California 91748.  The current rent for
these premises is $1,842 per month with a 5% increase each year. Our lease
expires on January 24, 2009.  In January 2006, we closed our office
located at 7251 West Lake Mead Blvd, Suite 300, Las Vegas, Nevada, 89128. The
rent for the office in Las Vegas was $5,378 per month.


F-26





Our
principal administrative, sales and marketing facilities are located at No.
F.3004 Sankei Torch Bldg, 262A Shifu Road, Shenyang City, Liaoning Province, The
Peoples Republic of China.  The current rent for these facilities is
US$2,917 per month and our lease expires in October 2007.





Future
minimum lease payments under non-cancelable leases with terms in excess of one
year are as follows:





Twelve Months Ending December
      31,2006
                    
                    $
                    59,8662007
                    
                    
                    52,2862008
                    
                    
                    24,2752009
                    
                    
                    2,0342010
      and thereafter
                    
                    
                    -Total
                    
                    $
                    138,461




Contingencies.In February 2006, we became
aware of a lawsuit filed in Los Angeles superior court from the Praxi
Advertising and Design, Inc. claiming payment of an unpaid package design fee
of  $119,800.





In
November 2005, Don Bates, Inc., our former U.S. Good Manufacturing Practices
consultant, instituted legal action against us in U.S. District Court, District
of Nevada, claiming unpaid consultancy fees.  Don Bates, Inc. has alleged
that $362,652.00, plus accrued interest, is due to them.   We believe
that this suit is without merit as, among other things, the fees billed by the
plaintiff for services rendered to us were excessive.  We intend to
contest this claim and will consider appropriate cross-claims.  There has
been no discovery in this matter and we cannot predict its outcome.





In
November 2005, we became aware of a lawsuit filed in the District Court of Clark
County, Nevada by our former CEO Peter Cunningham, whom we fired for cause on
July 20, 2005. Mr. Cunningham’s counsel claims to have properly served us with a
summons and complaint and took a default against us on November 9, 2005.
 We are disputing the validity of the service, and have retained counsel.
We anticipate that the default will be set aside.  Mr. Cunningham’s
complaint alleges unpaid base salary, unpaid commissions, un-reimbursed expenses
and unpaid severance totaling approximately $180,000.  The complaint also
requests declaratory relief to amend an allegedly incorrect Form 8-K filing
which stated that Mr. Cunningham was fired for cause.   We intend to
vigorously defend this case and believe hawse have meritorious claims against
Mr. Cunningham which may be asserted in a cross-complaint.   There has
been no discovery in this matter and we cannot predict its outcome.





AXM
Shenyang obtained loans in the aggregate amount of 8,290,302 RMB (US $1,002,455)
between October 22, 2004 and June 26, 2005, through a series of short term
non-recourse loans from ten individual Chinese lenders. AXM Shenyang is in
default on the principal of these loans and interest of approximately
$494,000.  Although these loans are not secured by any of our property
or assets, we could be subject to legal action if these loans are not repaid.
 Currently, no lawsuits regarding these loans have been initiated and we
are not aware that any lawsuits are being contemplated by any of the lenders.





In July
2005, we received a demand letter from Saatchi & Saatchi, an advertising
firm, that alleged that we owed them approximately RMB582,055 (U.S. $71,770) in
connection with advertising services provided to AXM Shenyang.  We
currently are reviewing their claim and intend to negotiate a settlement of such
claim.  We do not anticipate that this matter will have a material impact
on our business or operations.





The SEC
is currently conducting an investigation to determine if we and others may have
violated the reporting, anti-fraud, accounting and other provisions of the
federal securities laws.  This investigation resulted from our
restatement of our financial statements for the period ended June 30,
2005.  The investigation is currently at an early stage and we are not
able to assess the likelihood that the SEC will commence enforcement proceedings
against us or the nature and potential impact of any remedies the SEC might
seek.  We are cooperating fully with the SEC in this
investigation.


F-27





AXM
Pharma received notices from the Labor Arbitration Committee in China that 11 of
our current and former employees have filed a labor arbitration  claim
for unpaid salaries and un-reimbursed expenses in the aggregate amount of
RMB429,958 ( $53,081).





AXM
Pharma, Inc. is involved in lawsuits, claims and proceedings, including those
identified above, which arise in the ordinary course of business.  In
accordance with SFAS No. 5, “Accounting for Contingencies,” AXM makes a
provision for a liability when it is both probable that a liability has been
incurred and the amount of the loss can be reasonably estimated.  AXM
Pharma believes it has adequate provisions for any such matters.  AXM
Pharma reviews these provisions at least quarterly and adjusts these provisions
to reflect the impacts of negotiations, settlements, rulings, advice of legal
counsel, and other information and events pertaining to a particular case.
 Litigation is inherently unpredictable.  However, AXM Pharma believes
that it has valid defenses with respect to legal matters pending against it.
 Nevertheless, it is possible that cash flows or results of operations
could be materially affected in any particular period by the unfavorable
resolution of one or more of these contingencies.





We intend
to vigorously defend these and other lawsuits and claims against us.
 However, we cannot predict the outcome of these lawsuits, as well as other
legal proceedings and claims with certainty.  An adverse resolution of
pending litigation could have a material adverse effect on our business,
financial condition and results of operations.  AXM Pharma is subject to
legal proceedings and claims that arise in the ordinary course of business.
 AXM Pharma’s management does not expect that the results in any of these
legal proceedings will have adverse affect on the Company’s financial condition
or results of operations.





17.
RELATED PARTY TRANSACTIONS





At December 31, 2005, AXM Pharma, Inc.
received advances of approximately $237,000 from Wei Shi Wang, Chief Executive
Officer and Chairman of the Board.  The amounts are included in
accrued expense and are unsecured and due upon demand


F-28


EXHIBITS
INDEX





Exhibit Number
                        
                        Description4.13^
                        
                        Securities
      Purchase Agreement dated as of June 24, 20044.14^
                        
                        Registration
      Rights Agreement dated as of June 24, 20044.15^
                        
                        Form
      of Common Stock Purchase Warrant issued June 24, 20044.16^
                        
                        Designation
      of Rights and Preferences of Series C Preferred Stock dated as of June 24,
      20044.16#
                        
                        Loan
      Agreement between AXM Pharma(Shenyang), Inc. and Shenyang Branch of
      Shanghai Pudong Development Bank4.17#
                        
                        Mortgage
      Agreement between AXM Pharma (Shenyang) Inc.and Shenyang Branch of
      Shanghai Pudong Development Bank4.18##
                        
                        Form
      of Note and Warrant Purchase Agreement, dated April 19, 2005, by and
      between the Company and each of the Purchasers thereto4.19##
                        
                        Form
      of Registration Rights Agreement, dated April 19, 2005, by and between the
      Company and each of the Purchasers thereto.4.20##
                        
                        Form
      of Convertible Promissory Note dated April 19, 20054.21##
                        
                        Form
      of Series A Warrant4.22##
                        
                        Form
      of Series B Warrant4.22##
                        
                        Form
      of Series C Warrant4.23##
                        
                        Form
      of Security Agreement, dated April 19, 2005, by and between the Company
      and each of the Secured parties thereto4.23##
                        
                        Form
      of Mortgage Agreement, dated April 19, 2005, by and between the Company
      and each of the Mortgagees thereto4.24###
                        
                        Form
      of Series D
Warrant
  4.25####
              
              2005
      Equity Incentive Plan10.4****
              
              Agreement
      on Agency for Sale (Distribution) between Shenyang Taiwei Pharmaceutical
      Factory and Liaoning Weikang Medicine Co., Ltd.10.5****
              
              Consulting
      Agreement with Tripoint Capital Advisors, LLC10.6****
              
              Consulting
      Agreement with Amaroq Capital,
LLC


E-1





10.7****
                
                Consulting
      Services Agreement with Woodbridge Management, Ltd.10.8****
                
                Consulting
      Agreement with Madden Consulting, Inc.10.9****
                
                Investment
      Banking Agreement with Great Eastern Securities, Inc.10.10****
                
                Investor
      Relations Agreement with the Aston Organization10.11+++
      2
                
                Incentive
      and Nonstatutory Stock Option Plan10.12++++
                
                Consulting
      Agreement with Byrle Lerner10.13++++
                
                Consulting
      Agreement with Aurelius Consulting10.14++++
                
                Consulting
      Agreement with Mirador Consulting, Inc10.15++++
                
                Consulting
      Agreement with Dreamvest, llc10.16++++
                
                Consulting
      Agreement with RCG10.17++++
                
                Termination
      Agreement with RCG10.18(2)(3)
                
                Chet
      Howard’s Employment Agreement10.19(2)(4)
                
                Peter
      Cunningham’s Employment Agreement10.20(2)(3)
                
                Zhenyu
      Kong’s Employment Agreement10.21(5)
                
                Transition
      Agreement14.1++
                
                Code
      of Ethics for Board of Directors14.2++
                
                Code
      of Ethics for Executive Officers16.1^^
                
                Letter
      from Malone & Bailey, PLLC regarding change in certifying accountant,
      dated September 2, 2004.21.1++
                
                Subsidiaries
      of the Company31.1+
                
                Certification
      of Chief Executive Officer and Principal Accounting Officer pursuant to
      Rule 13a-14(a)32.1+
                
                Certification
      of Chief Executive Officer and Principal Accounting Officer pursuant to 18
      U.S.C. 135099.1****
                
                Form
      of lock-up agreement by officers, directors and 5% or greater
      shareholders




E-2




****
Incorporated herein by reference to Exhibits 10.1 to 10.10 of the Company’s
Registration Statement on Form SB-2 Dated March 4, 2004.





+++Incorporated
herein by reference to Exhibit 10.11 of the Company’s Annual Report on Form
10-KSB/A dated April 6, 2004.





++++Incorporated
herein by reference to Exhibit 10.12 to 10.17 of the Company’s Annual Report on
Form 10-KSB/A dated April 15, 2005.





+ Filed
herewith





++
Incorporated herein by reference to Exhibit 14.1, 14.2 and 21.1 of the Company’s
Annual Report on Form 10-KSB dated March 29, 2004





(2)
Exhibit represents a management contract or compensatory plan or
arrangement.





(3)
Incorporate herein by reference to Exhibit 10.1, 10.2, 10.3, and 10.4 of the
Company’s Current Report on Form 8-K/A dated April 4, 2005.





(4)
Incorporated herein by reference to Exhibit 10.1 of the Post-Effective Amendment
No. 6 to the Company’s Registration Statement on Form SB-2 Dated May 17,
2004





(5)
Incorporated herein by reference to Exhibits 10.1 of the Company’s Current
Report on Form 8-K Dated September 25, 2005





^
Incorporated herein by reference to Exhibits 10.1 to 10.4 of the Company’s
Current Report on Form 8-K Dated June 24, 2004





^^
Incorporated by reference to Exhibit 16.1 to the Company’s amendment to Current
Report on Form 8-K/A filed on September 2, 2004





#
Incorporated herein by reference to Exhibits 10.1 to 10.2 of the Company’s
Current Report on Form 8-K Dated January 24, 2005





##
Incorporated herein by reference to Exhibits 10.1 to 10.8 of the Company’s
Current Report on Form 8-K Dated April 20, 2005





###
Incorporated herein by reference to Exhibits 10.1 of the Company’s Current
Report on Form 8-K Dated August 9, 2005





####Incorporated
herein by reference to Exhibit 99.1 of the Company’s Current Report on Form 8-K
dated March 10, 2005.





(c)
Reports on Form 8-K.





1.
            On
      January 21, 2005, we filed a report on Form 8-K regarding
      received collateral a short -term
loan.


2.
            On
      February 1, 2005, we filed a report on Form 8-K regarding promoted Chet
      Howard to Chief Executive Officer..


3.
            On
      March 10, 2005, we file a report on Form 8-K regarding Board of Directors
      approved the 2005 Equity Incentive
Plan.


E-3





4.
            On
      April 20, 2005, we filed a report on Form 8-K regarding results of
      operations and financial condition.


5.
            On  January  24,
      2005, we filed a report on Form 8-K/A regarding creation of a direct
      financial obligation


6.
            On
      April 20, 2005, we filed a report on Form 8-K disclosing an additional
      private financing we completed.


7.
            On
      April 20, 2005, we filed a report on Form 8-K regarding accepted
      subscription with 8 accredited investors pursuant to a private equity
      financing.


8.
            On
      May 16, 2005, we filed a report on Form 8-K our financial results for the
      first quarter of fiscal 2005.


9.
            On
      June 15, 2005, we filed a Form 8-K disclosing a private financing with 9
      accredited investors.


10.
            On
      July 21, 2005, we filed a Form 8-K disclosing a termination of employee
      agreement with Peter Cunningham.


11.
            On
      August 9, 2005, we filed a Form 8-K regarding completed a financing
      through a Special Warrant Offer.


12.
            On
      August 10, 2005, we filed a Form 8-K regarding received additional
      commitments pursuant to the private
financing.


13.
            On
      August 15, 2005, we filed a Form 8-K regarding held a conference call
      discussing our fiscal 2005, second quarter results and current
      events.


14.
            On
       September  25, 2005, we filed a Form 8-K regarding its
      principal shareholder entered into a Transition Agreement with its former
      financial consultants, investor relations firm and  legal counsel,
       as well as 2 former directors and certain other related
      parties.


15.
            On
      October 13, 2005, we filed a Form 8-K disclosing Mr. Chet Howard resigned
      as Chief Executive Officer and Chief Financial Officer of the
      Company.


16.
            On
      October 28, 2005, we filed a Form 8-K disclosing the restatement of the
      second quarter revenue of 2005.


17.
            On
      November 22, 2005, we filed a Form 8-K disclosing estimated revenues and
      net loss for its third quarter of fiscal
2005.


18.
            On
      October 31, 2005, we filed a Form 8-K regarding default of the principal
      and interest payments due to the 9 holders of its April, 2005 Convertible
      Debentures.


E-4