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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2006

Commission File Number 001-31932

HYTHIAM, INC.

(Exact name of registrant as specified in its charter)


Delaware		88-0464853
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

11150 Santa Monica Boulevard, Suite 1500, Los Angeles, California 90025
(Address of principal executive offices, including zip code)

(310) 444-4300
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ No o

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

Large accelerated filer o Accelerated filer þ Non-accelerated filer o

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

Yes o No þ

As of November 7, 2006, there were 40,333,725 shares of registrant’s common stock, $0.0001 par value, outstanding.

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

HYTHIAM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited)


(In thousands, except share data)
	September 30,			December 31,
	2006			2005
ASSETS

Current assets
Cash and cash equivalents	$	3,654		$	3,417
Marketable securities		21,589			43,583
Restricted cash		92			44
Receivables, net		718			249
Prepaids and other current assets		692			427

Total current assets		26,745			47,720
Long-term assets
Property and equipment, less accumulated depreciation of $1,954 and $1,172, respectively		3,688			3,498
Intellectual property, less accumulated amortization of $532 and $374, respectively		3,446			2,733
Deposits and other assets		486			511

	$	34,365		$	54,462

LIABILITIES AND STOCKHOLDERS’ EQUITY

Current liabilities
Accounts payable	$	4,913		$	2,652
Accrued compensation and benefits		1,559			1,285
Other accrued liabilities		437			364

Total current liabilities		6,909			4,301
Long-term liabilities
Deferred rent liability		517			422

		7,426			4,723


Stockholders’ equity
Preferred stock, $.0001 par value; 50,000,000 shares authorized; no shares issued and outstanding		—			—
Common stock, $.0001 par value; 200,000,000 shares authorized; 40,229,000 and 39,504,000 shares issued and 39,869,000 and 39,144,000 shares outstanding at September 30, 2006 and December 31, 2005, respectively		4			4
Additional paid-in-capital		93,895			89,176
Accumulated deficit		(66,960	)		(39,441	)

		26,939			49,739

	$	34,365		$	54,462

See accompanying notes to financial statements.

HYTHIAM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)


(In thousands, except per share amounts)	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
Revenues	$	1,071		$	361		$	2,896		$	794
Operating Expenses
Salaries and benefits		3,800			2,452			11,501			6,361
Research and development		773			796			2,077			1,168
Other operating expenses		6,399			3,648			17,188			8,742
Depreciation and amortization		311			221			940			625

Total operating expenses		11,283			7,117			31,706			16,896

Loss from operations		(10,212	)		(6,756	)		(28,810	)		(16,102	)
Interest income		384			152			1,293			487

Loss before provision for income taxes		(9,828	)		(6,604	)		(27,517	)		(15,615	)
Provision for income taxes		1			—			2			—

Net loss	$	(9,829	)	$	(6,604	)	$	(27,519	)	$	(15,615	)


Basic and diluted net loss per share	$	(0.25	)	$	(0.22	)	$	(0.70	)	$	(0.52	)


Basic and diluted weighted average number of shares outstanding		39,744			29,867			39,468			29,806

See accompanying notes to financial statements.

HYTHIAM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)


(In thousands)	Nine Months Ended
	September 30,
	2006			2005
Operating activities
Net loss	$	(27,519	)	$	(15,615	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		940			625
Provision for bad debt		148			10
Loss on disposition of fixed assets		—			20
Deferred rent liability		84			32
Lease incentives granted		—			30
Share-based expense		2,506			1,648
Changes in current assets and liabilities:
Receivables		(617	)		(69	)
Prepaids and other current assets		(93	)		(279	)
Accounts payable		2,261			1,393
Accrued compensation and benefits		274			(39	)
Other accrued liabilities		84			(147	)

Net cash used in operating activities		(21,932	)		(12,391	)


Investing activities
Purchases of marketable securities		(19,454	)		(8,091	)
Proceeds from sales and maturities of marketable securities		41,448			21,414
Restricted cash		(48	)		(65	)
Purchases of property and equipment		(972	)		(699	)
Deposits and other assets		25			(143	)
Proceeds from maturity of deposit as collateral for letter of credit		—			355
Cash deposited as collateral		—			(802	)
Cost of intellectual property		(133	)		(137	)

Net cash provided by investing activities		20,866			11,832


Financing activities
Costs incurred on equity financing activities		—			(194	)
Exercises of stock options and warrants		1,303			203

Net cash provided by financing activities		1,303			9


Net increase (decrease) in cash and cash equivalents		237			(550	)
Cash and cash equivalents at beginning of period		3,417			4,000

Cash and cash equivalents at end of period	$	3,654		$	3,450


Supplemental disclosure of cash paid
Income taxes	$	3		$	—

Supplemental disclosure of non-cash activity
Common stock, options and warrants issued for outside services	$	378		$	230
Common stock issued for intellectual property		738

See accompanying notes to financial statements.

Hythiam, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited)

Note 1. Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements for Hythiam, Inc. and our subsidiaries have been prepared in accordance with the Securities and Exchange Commission (“SEC”) rules for interim financial information and do not include all information and notes required for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Interim results are not necessarily indicative of the results that may be expected for the entire fiscal year. The accompanying financial information should be read in conjunction with the financial statements and the notes thereto in our most recent Annual Report on Form 10-K, from which the December 31, 2005 balance sheet has been derived.

The condensed consolidated financial statements include the accounts of our wholly-owned subsidiaries and The PROMETA Center, Inc. (the “PROMETA Center”), a California professional corporation, which is owned by our senior vice president and medical director. Under the terms of a management services agreement, we provide and perform all nonmedical management and administrative services for the medical group. We also agreed to provide a working capital loan to the medical group up to a maximum of $1,500,000 to allow it to pay its obligations, including our management fees. Payment of our management fee is subordinate to payments of other obligations of the medical group, and repayment of the working capital loan is not guaranteed by the shareholder or any other third party. We have determined that the PROMETA Center is a variable interest entity, and that we are the primary beneficiary as defined in Financial Accounting Standards Board (“FASB”) Interpretation No. 46 (Revised 2003), “Consolidation of Variable Interest Entities — an Interpretation of ARB No. 51.” Accordingly, we are required to consolidate the accounts of the PROMETA Center.

All intercompany transactions and balances have been eliminated in consolidation. Certain reclassifications have been made in the prior period to be consistent with current period presentation.

Note 2. Cash Equivalents and Marketable Securities

We invest available cash in short-term commercial paper, certificates of deposit and high grade variable rate securities. Liquid investments with an original maturity of three months or less when purchased are considered to be cash equivalents.

Investments, including auction rate securities and certificates of deposit, with maturity dates greater than three months when purchased, which have readily determined fair values, are classified as available-for-sale investments and reflected in current assets as marketable securities at fair market value. Auction rate securities are recorded at par value, which equals fair market value, as the rate on such securities resets generally every 7, 28 or 35 days.

Restricted cash represents deposits secured as collateral for a bank credit card program.

Note 3. Basic and Diluted Loss per Share

In accordance with Statement of Financial Accounting Standards (“SFAS”) 128, “Computation of Earnings Per Share,” basic loss per share is computed by dividing the net loss to common stockholders for the period by the weighted average number of common shares outstanding during the period. Diluted loss per share is computed by dividing the net loss for the period by the weighted average number of common and dilutive common equivalent shares outstanding during the period.

Common equivalent shares, consisting of 7,292,000 and 6,906,000 of incremental common shares as of September 30, 2006 and 2005, respectively, issuable upon the exercise of stock options and warrants have been excluded from the diluted earnings per share calculation because their effect is anti-dilutive.

Note 4. Share-Based Expense

Stock Options – Employees and Directors

On January 1, 2006, we adopted SFAS 123 (Revised 2004) (“SFAS 123R”), “Share-Based Payment,” which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. SFAS 123R requires companies to estimate the fair value of share-based payment awards to employees and directors on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the consolidated statements of operations. Prior to the adoption of SFAS 123R, we accounted for shared-based awards to employees and directors using the intrinsic value method, in accordance with Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees” as allowed under SFAS 123, “Accounting for Stock-Based Compensation.” Under the intrinsic value method, no share-based compensation expense had been recognized in our consolidated statements of operations for awards to employees and directors because the exercise price of our stock options equaled the fair market value of the underlying stock at the date of grant.

We adopted SFAS 123R using the modified prospective method, which requires the application of the new accounting standard as of January 1, 2006, the first day of our 2006 fiscal year. In accordance with the modified prospective method, our consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123R. As a result of adopting SFAS 123R on January 1, 2006, share-based compensation expense recognized under SFAS 123R for employees and directors for the three and nine months ended September 30, 2006 was $577,000 and $1.5 million, respectively, which impacted our basic and diluted loss per share by $0.01 and $0.04, respectively. There was no share-based compensation expense related to employee or director stock options recognized during 2005.

Share-based compensation expense recognized in our consolidated statements of operations for the three and nine months ended September 30, 2006 includes compensation expense for share-based payment awards granted prior to, but not yet vested, as of January 1, 2006 based on the grant date fair value estimated in accordance with the pro-forma provisions of SFAS 123, and for the share-based payment awards granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. For share-based awards issued to employees and directors, share-based compensation is attributed to expense using the straight-line single option method, which is consistent with our presentation of pro-forma share-based expense required under SFAS 123 for prior periods. Share-based compensation expense recognized in our consolidated statements of operations for the nine months ended September 30, 2006 is based on awards ultimately expected to vest, reduced for estimated forfeitures. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In our pro-forma information required under SFAS 123 for the periods prior to 2006, we accounted for forfeitures as they occurred.

The following table illustrates the effect on net loss and loss per share if we had applied the fair value recognition provisions of SFAS 123 to share-based awards granted under our stock option plan for the three and nine months ended September 30, 2005. For purposes of this pro-forma disclosure, the fair value of the options is estimated using the Black-Scholes pricing model and amortized to expense over the options’ contractual term.


	Three Months Ended			Nine Months Ended
	September 30, 2005			September 30, 2005
Net loss, as reported	$	(6,604,000	)	$	(15,615,000	)
Less: Share-based expense determined under fair value based method	$	(256,000	)	$	(624,000	)

Pro forma net loss	$	(6,860,000	)	$	(16,239,000	)


Net loss per share:
As reported — basic and diluted	$	(0.22	)	$	(0.52	)
Pro forma — basic and diluted	$	(0.23	)	$	(0.54	)

During the three and nine months ended September 30, 2006 and 2005, we granted options for 604,000, 1,224,000, 397,000 and 1,317,000 shares, respectively, to employees and directors at the weighted average per share exercise price of $4.86, $5.70, $6.41 and $6.49, respectively,

the fair market value of our common stock at the dates of grants. Options granted generally vest over five years.

The estimated fair value of options granted to employees and directors during the three and nine months ended September 30, 2006 and 2005 was $1.8 million, $4.2 million, $1.7 million and $5.7 million, respectively, calculated using the Black-Scholes pricing model with the following assumptions.


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
Expected volatility		58	%		63	%		58	%		63	%
Risk-free interest rate		4.99	%		4.17	%		4.73	%		4.18	%
Weighted average expected lives in years		6.5			10			6.5			10
Expected dividend yield		0	%		0	%		0	%		0	%

The expected volatility of our stock has been estimated using the average expected volatility reported by other public healthcare companies, since we have a limited history as a public company and our actual stock price volatility would not be meaningful. The weighted average expected option term for 2006 reflects the application of the simplified method set out in SEC Staff Accounting Bulletin No. 107, which defines the life as the average of the contractual term of the options and the weighted average vesting period for all option tranches.

We have elected to adopt the detailed method provided in SFAS 123R for calculating the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee share-based compensation, and to determine the subsequent impact on the APIC pool and consolidated statements of cash flows of the tax effects of employee share-based compensation awards that are outstanding upon adoption of SFAS 123R.

As of September 30, 2006, there was $7.5 million of total unrecognized compensation costs related to non-vested share-based compensation arrangements granted under the Plan. That cost is expected to be recognized over a weighted-average period of three years.

Stock Options and Warrants – Non-employees

We account for the issuance of options and warrants for services from non-employees in accordance with SFAS 123 by estimating the fair value of warrants issued using the Black-Scholes pricing model. This model’s calculations include the option or warrant exercise price, the market price of shares on grant date, the weighted average risk-free interest rate, expected life of the option or warrant, expected volatility of our stock and expected dividends.

For options and warrants issued as compensation to non-employees for services that are fully vested and non-forfeitable at the time of issuance, the estimated value is recorded in equity and expensed when the services are performed and benefit is received as provided by FASB Emerging Issues Task Force No. 96-18 “Accounting For Equity Instruments That Are Issued To Other Than Employees For Acquiring Or In Conjunction With Selling Goods Or Services.”

During the three and nine months ended September 30, 2006 and the three and nine months ended September 30, 2005, we granted options and warrants for 150,000, 265,000, 15,000 and 60,000 shares, respectively, to non-employees at weighted average prices of $5.08, $5.75, $5.78 and $5.26 respectively. Share-based expense relating to stock options and warrants granted to non-employees was $416,000, $837,000, $321,000 and $1.5 million for the three and nine months ended September 30, 2006 and 2005, respectively.

Common Stock

During the three and nine months ended September 30, 2006 and the three and nine months ended September 30, 2005, we issued 12,000, 51,000, 12,000 and 23,000 shares of common stock, respectively, for consulting services, valued at $58,000, $326,000, $69,000 and $134,000, respectively. These costs are being amortized to share-based expense on a straight-line basis over the related six month to one year service periods. Share-based expense relating to all common stock issued for consulting services was $77,000, $154,000, $35,000 and $99,000 for the three and nine months ended September 30, 2006 and three and nine months ended September 30, 2005, respectively.

Note 5. Common Stock

In May 2006, we issued 105,000 shares of our common stock valued at $738,000 to Tratamientos Avanzados de la Addiccion S.L. as initial consideration for an amendment to the Technology Purchase and Royalty Agreement dated March 2003. The amendment expands the definition of “Processes” to include additional indications for the use of the PROMETA protocol. The amendment requires us to issue 35,000 shares for each indication for which we file a patent application claim, plus an additional 50,000 shares for each indication for which we derive revenues in the future.

In June 2006, we established a qualified employee stock purchase plan (“ESPP”), approved by our shareholders, which allows qualified employees to participate in the purchase of designated shares of our common stock at a price equal to 85% of the lower of the closing price at the beginning or end of each specified stock purchase period. As of September 30, 2006, there were no shares of our common stock issued pursuant to the ESPP.

Note 6. Related Party Transactions

Andrea Grubb Barthwell, M.D., a director, is the founder and chief executive officer of a healthcare and policy consulting firm providing consulting services to us. For the nine months ended September 30, 2006, we paid or accrued $138,000 in fees to the consulting firm.

Note 7. Recent Accounting Pronouncements

In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes,” which clarifies the accounting for uncertainty in income taxes. FIN 48 requires that companies recognize in the consolidated financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. We will adopt FIN 48 on January 1, 2007, the beginning of our 2007 fiscal year. We do not expect the adoption of this statement to have a material impact on our financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”), “Topic 1N – Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” which provides guidance on quantifying prior year errors for the purpose of evaluating materiality on current year financial statements. SAB 108 is effective for fiscal years ending after November 15, 2006. We do not expect the adoption of this statement to have a material impact on our financial statements.

In September 2006, the FASB issued SFAS 157, which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles. As a result of SFAS 157, there is a common definition of fair value to be used throughout GAAP. SFAS 157 is effective for fiscal years beginning after November 15, 2007. The impact of adopting SFAS 157 on our financial position and results of operations will be to change how we estimate and measure fair values commencing in 2008.

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

The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements including the related notes, and the other financial information included in this report.

Forward-Looking Statements

The forward-looking comments contained in this report involve risks and uncertainties. Our actual results may differ materially from those discussed here due to factors such as, among others, limited operating history, difficulty in developing, exploiting and protecting proprietary technologies, intense competition and substantial regulation in the healthcare industry. Additional factors that could cause or contribute to such differences can be found in the following discussion, as well as in the “Risks Factors” set forth in Item 1A of Part I of our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 16, 2006.

Overview

Introduction

We are a healthcare services management company focused on delivering solutions for those suffering from alcoholism and other substance dependencies. We research, develop, license and commercialize innovative physiological, nutritional, and behavioral treatment protocols designed for use by healthcare providers seeking to treat individuals diagnosed with dependencies to alcohol, cocaine and methamphetamine, as well as combinations of these drugs. Our proprietary PROMETA^® treatment protocols comprise nutritional supplements, FDA-approved oral and intravenous medications used off-label and separately administered in a unique dosing algorithm, as well as psychosocial or other recovery-oriented therapy chosen by the patient and his or her treatment provider. As a result, PROMETA represents an innovative integrated approach to managing alcohol, cocaine, or methamphetamine dependence that is designed to address physiological, nutritional and psychosocial aspects of the disease, and is thereby intended to offer patients an opportunity to achieve sustained recovery.

Operations

As of September 30, 2006, we had 58 licensed commercial sites throughout the United States, 29 of which were treating patients in the third quarter of 2006. During the current quarter, we continued to increase our market penetration by entering into license agreements for 18 new licensed sites, an increase of 45% over the 40 licensed sites at June 30, 2006.

PROMETA Centers

Approximately one third of our consolidated revenues in the third quarter and to date in 2006 have been derived from our licensing and management services agreement with the PROMETA Center. The revenues and expenses of the PROMETA Center are included in our consolidated financial statements under accounting standards applicable to variable interest entities.

Based on the revenues generated to date from managing the PROMETA Center in Santa Monica, we have decided to expand this business model with additional PROMETA Centers in other major metropolitan areas. The next company-managed PROMETA Center will be in San Francisco, California, where we have leased medical space and plan to complete tenant improvements by the end of the year. We will consolidate the accounts of the San Francisco PROMETA Center under accounting standards applicable to variable interest entities.

In addition, we have entered into a licensing and administrative services agreement with Canterbury Institute, LLC, which has deposited $2 million into escrow toward opening PROMETA Centers in two additional locations, one in Northern New Jersey and the other in Southern Florida. As part of the agreement, we will receive a 10% share of the profits in each licensed center, in addition to fees for services and technology licensing.

We anticipate these additional PROMETA Centers to be operational in the first half of 2007.

Clinical Data from Research and Pilot Studies

We believe that a key to our success will be the publication of additional positive results from research studies and commercial pilots evaluating the PROMETA protocols. To date, we have spent approximately $4.9 million on research grants for studies by preeminent researchers in the field of substance dependence to evaluate the efficacy of PROMETA in treating alcohol and stimulant dependence and commercial pilots with state programs and drug court systems to study the efficacy of the PROMETA protocols. We plan to spend an additional $5.5 million in the remainder of 2006 and 2007 for these and other studies. We believe the results from these studies will validate PROMETA as a method of care for treating alcoholism and stimulant dependence and serve to accelerate our growth.

The City Court of Gary, Indiana, and Washington’s Pierce County Alliance (“PCA”) each recently reported positive 6 month follow up results from pilot studies conducted to evaluate the PROMETA protocol in the drug court system. PCA is the largest substance abuse treatment provider for criminal justice in Pierce County, Washington, which conducted a 40-patient pilot to evaluate the PROMETA protocol for the treatment of methamphetamine and cocaine dependence within the felony and family drug court system. The PROMETA protocol for the treatment of methamphetamine and cocaine dependence was adopted as a treatment by PCA earlier this year when it was concluded that PCA’s success in using PROMETA with offenders had far surpassed that of any other treatment model previously used. The City Court of Gary adopted the PROMETA protocol for stimulants earlier this year after it had conducted a successful commercial 30-patient pilot that was terminated prior to completion when PROMETA’s results with stimulant dependent drug court participants surpassed the Court’s historical success rates.

International

We have received allowances, issuances or notices that patent grants are intended for our core intellectual property for the treatment of alcohol and stimulant dependence in Mexico, Australia, New Zealand, South Africa and Europe.

In July 2006, our Swiss foreign subsidiary signed PROMETA license and services agreements with three sites in Switzerland to serve the international market. Our international operations to date have not yet been significant, consisting primarily of legal and other consulting services, development and start-up activities.

Results of Operations

Revenues

Our net revenues for the three months ended September 30, 2006 increased by $710,000, or 197%, to $1.1 million from $361,000 for the three months ended September 30, 2005. The increase was primarily due to revenue contributions from new licensees, including the PROMETA Center. In the third quarter of 2006, 156 patients were treated by 29 licensee sites, compared to 72 patients treated by 11 sites in the third quarter of last year. Our average revenue per patient treated by our commercial licensees increased by 35% to $6,764 in the current quarter compared to $5,014 for the same period last year. This increase was primarily attributable to patients treated by the PROMETA Center, which generates higher average revenues per patient than our other licensed sites due to consolidation of its gross revenues in our financial statements, and lower average discounts granted by our licensees in the current quarter than in the same period last year.

For the nine months ended September 30, 2006, our net revenues increased by $2.1 million, or 265%, to $2.9 million from $794,000 in the same period last year, due to revenue generated by the PROMETA Center and other new licensees, as well as an increase in revenue generated by the licensees in existence during the same period last year. For the nine months ended September 30, 2006, 427 patients were treated by 34 licensee sites, compared to 152 patients treated by 11 sites in the same period last year. Our average revenue per patient treated during the nine months ended September 30, 2006 increased by 29% to $6,747 compared to $5,224 for the nine months ended September 30, 2005. As in the current quarter, the year to date increase was primarily attributable to patients treated by the PROMETA Center and lower average discounts granted by our licensees.

Operating Expenses

Our operating expenses during the three and nine month periods ended September 30, 2006 were $11.3 million and $31.7 million, respectively, compared to $7.1 million and $16.9 million, respectively, for the same periods last year. The increase in operating expenses in 2006 over 2005 reflects the continued development of our company and the execution of our business plan, including a national and international expansion strategy, hiring of key management personnel, spending for clinical research and the marketing of our PROMETA protocols.

Salaries and benefits expenses were $3.8 million and $11.5 million for the three and nine month periods ended September 30, 2006, respectively, compared to $2.5 million and $6.4 million, respectively, for the same periods in 2005. The increase for both periods reflect increased staffing to serve our growing number of licensees and staffing for the PROMETA Center, as well as the strengthening of our executive management and corporate services team. Additionally, the increases in 2006 include $577,000 and $1.5 million for the three and nine months ended September 30, 2006, respectively, for employee and director non-cash share-based expense resulting from our adoption of SFAS 123R on January 1, 2006.

Our research and development expenses were $773,000 and $2.1 million for the three and nine months ended September 30, 2006, respectively, compared to $796,000 and $1.2 million in the comparable periods last year. The significant increase for the nine month period reflects increased funding for additional unrestricted grants for research studies and commercial pilots to evaluate our PROMETA protocols, and an increase in the related patient accruals in the studies.

In the three and nine month periods ended September 30, 2006, our other operating expenses were $6.4 million and $17.2 million, respectively, versus $3.6 million and $8.7 million, respectively, for the same periods in 2005, including non-cash charges of $493,000, $991,000, $355,000 and $1.6 million, respectively, relating to non-employee share-based expense. Major components of our other operating expenses include legal, audit, insurance, travel, rent, public relations, marketing, advertising and other professional consulting costs. The increases in 2006 over the comparable periods in 2005 in most expense categories are generally proportionate to the overall increase in staffing and infrastructure of our company. In 2006, we increased spending in marketing and direct-to-consumer advertising in some of the major metropolitan service areas where we have established a market presence. We also increased spending for auditing and consulting costs for Sarbanes-Oxley Section 404 compliance and new initiatives for expanding our business to managed care, statewide agencies, government affairs, the gay community and international start-up activities.

Interest Income

Interest income for the three and nine months ended September 30, 2006 increased by 153% and 166%, respectively, over the comparable periods last year. The increase in both periods was due primarily to higher interest rates in the current year, combined with higher average investment balances resulting from additional proceeds from our equity offering of $40 million in November 2005.

Liquidity and Capital Resources

We have financed our operations since inception primarily through the sale of shares of our stock. As of September 30, 2006, we had $25.2 million in cash, cash equivalents and marketable securities.

Since we are a rapidly growing business, our prior operating costs are not representative of our expected on-going costs. As we continue to implement commercial operations and allocate significant and increasing resources to sales, marketing and new initiatives, we expect our monthly cash operating expenditures to increase in future years. However, for the remainder of 2006, we anticipate that our cash operating expenditures will approximate our second and third quarter average of approximately $3.1 million per month, excluding research and development costs. We plan to spend approximately $1.3 million in the remainder of 2006 for research and development.

For the remainder of 2006, we expect our capital expenditures will be approximately $1.1 million, including approximately $600,000 for the build-out and equipping of the San Francisco PROMETA Center. Additionally, we will continue to invest in the infrastructure we believe

we will need, both in management as well as systems and equipment, to develop, market and implement our business plan.

We expect to continue to incur negative cash flows and net losses for at least the next twelve months. Based upon our current plans, including anticipated revenues and increased expenses of expanding our business into managed care and government sponsored programs, we believe that our existing cash reserves may not be sufficient to meet our operating expenses and capital requirements before we begin to generate positive cash flows. Accordingly, we most likely will seek additional funds through the sale of shares of preferred or common stock or through public or private financing. Our ability to meet our obligations as they become due and payable will depend on our ability to generate increased revenues over current levels, reduce operating costs, sell securities, borrow funds, or some combination thereof. We may not be successful in raising necessary funds on acceptable terms, or at all.

Legal Proceedings

From time to time, we may be involved in litigation relating to claims arising out of our operations in the normal course of business. As of the date of this filing, we are not currently involved in any legal proceeding that we believe would have a material adverse effect on our business, financial condition or operating results.

Contractual Obligations and Commercial Commitments

The following table sets forth a summary of our material minimum contractual obligations and commercial commitments as of September 30, 2006 (in thousands):


			Less than
Contractual Obligations	Total		1 year		1 - 3 years		3 - 5 years
Operating lease obligations (1)	$	4,284	$	998	$	2,068	$	1,218
Contractual commitments for clinical studies		4,467		2,786		1,681		—

	$	8,751	$	3,784	$	3,749	$	1,218


(1)		Consists of our current lease obligations for our corporate office facilities and the PROMETA Center.

Off-Balance Sheet Arrangements

As of September 30, 2006, we had no off-balance sheet arrangements.

Critical Accounting Estimates

The discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. Generally accepted accounting principles require management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities. We base our estimates on experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that may not be readily apparent from other sources. Our actual future results may differ from those estimates.

We consider our critical accounting estimates to be those that (1) involve significant judgments and uncertainties, (2) require estimates that are more difficult for management to determine, and (3) may produce materially different results when using different assumptions. Management has discussed these critical accounting estimates, the basis for their underlying assumptions and estimates and the nature of our related disclosures herein with the Audit Committee of the Board of Directors. Our critical accounting estimates cover the following areas:

Share-based expense

Commencing January 1, 2006, we implemented the accounting provisions of SFAS 123R on a modified-prospective basis to recognize share-based compensation for employee stock option awards in our statements of operations for future periods. We accounted for the issuance of stock, stock options and warrants for services from non-employees in accordance with SFAS 123, “Accounting for Stock-Based Compensation.” We estimate the fair value of options and warrants issued using the Black-Scholes pricing model. This model’s calculations include the exercise price, the market price of shares on grant date, weighted average assumptions for risk-free interest rates, expected life of the option or warrant, expected volatility of our stock and expected dividend yield.

The amounts recorded in the financial statements for share-based expense could vary significantly if we were to use different assumptions. For example, the assumptions we have made for the expected volatility of our stock price have been made using volatility averages of other public healthcare companies, since we have a limited history as a public company and our actual stock price volatility would not be meaningful. If we were to use the actual volatility of our stock price, there may be a significant variance in the amounts of share-based expense from the amounts reported. For example, based on the 2005 assumptions used for the Black-Scholes pricing model, a 50% increase in stock price volatility would have increased the fair values of options by approximately 25%.

Impairment of intangible assets

We have capitalized significant costs, and plan to capitalize additional costs, for acquiring patents and other intellectual property directly related to our products and services. We will continue to evaluate our intangible assets for impairment on an ongoing basis by assessing the future recoverability of such capitalized costs based on estimates of our future revenues less estimated costs. Since we have not recognized significant revenues to date, our estimates of future revenues may not be realized and the net realizable value of our capitalized costs of intellectual property may become impaired.

Recent Accounting Pronouncements

In June 2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes,” which clarifies the accounting for uncertainty in income taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 requires that companies recognize in the consolidated financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. We will adopt FIN 48 on January 1, 2007, the beginning of our 2007 fiscal year. We do not expect the adoption of this statement to have a material impact on our financial statements.

In September 2006, the SEC issued SAB 108, “Topic 1N – Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” which provides guidance on quantifying prior year errors for the purpose of evaluating materiality on current year financial statements. SAB 108 is effective for fiscal years ending after November 15, 2006. We do not expect the adoption of this statement to have a material impact on our financial statements.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We invest our cash in short term commercial paper, certificates of deposit, money market accounts and marketable securities. We consider any liquid investment with an original maturity of three months or less when purchased to be cash equivalents. We classify investments with maturity dates greater than three months when purchased as marketable securities, which have readily determined fair values as available-for-sale securities. Our investment policy requires that all investments be investment grade quality and no more than ten percent of our portfolio

may be invested in any one security or with one institution. At September 30, 2006, our investment portfolio consisted of investments in highly liquid, high grade commercial paper, variable rate securities and certificates of deposit.

Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities with shorter maturities may produce less income if interest rates fall. The market risk associated with our investments in debt securities is substantially mitigated by the frequent turnover of the portfolio.

Item 4. Controls and Procedures

We have evaluated, with the participation of our chief executive officer and our chief financial officer, the effectiveness of our system of disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation our chief executive officer and our chief financial officer have determined that they are effective in connection with the preparation of this report. There were no changes in the internal controls over financial reporting that occurred during the quarter ended September 30, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II – OTHER INFORMATION

Item 1A. Risk Factors

Our results of operations and financial condition are subject to numerous risks and uncertainties described in our Annual Report on Form 10-K for 2005, filed on March 16, 2006, and incorporated herein by reference. You should carefully consider these risk factors in conjunction with the other information contained in this report. Should any of these risks materialize, our business, financial condition and future prospects could be negatively impacted. As of September 30, 2006, there have been no material changes to the disclosures made on the above-referenced Form 10-K.

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

In July 2006, we issued 11,700 shares of common stock to a consultant providing investor relations services valued at $58,000. These securities were issued without registration pursuant to the exemption afforded by Section 4(2) of the Securities Act of 1933, as a transaction by us not involving any public offering.

Item 5. Other Information

CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING INFORMATION

This report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 with respect to the financial condition, results of operations, business strategies, operating efficiencies or synergies, competitive positions, growth opportunities for existing products, plans and objectives of management, markets for stock of Hythiam and other matters. Statements in this report that are not historical facts are hereby identified as “forward-looking statements” for the purpose of the safe harbor provided by Section 21E of the Exchange Act and Section 27A of the Securities Act. Such forward-looking statements, including, without limitation, those relating to the future business prospects, revenues and income of Hythiam, wherever they occur, are necessarily estimates reflecting the best judgment of the senior management of Hythiam on the date on which they were made, or if no date is stated, as of the date of this report. These forward-looking statements are subject to risks, uncertainties and assumptions, including those described in the “Risk Factors” in Item 1 of Part I of our most recent Annual Report on Form 10-K, filed with the SEC, that may affect the operations, performance, development and results of our business. Because the factors discussed in this report could cause actual results or outcomes to differ materially from those expressed in any forward-looking statements made by us or on our behalf, you should not place undue reliance on any such forward-looking statements. New factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

You should understand that the following important factors, in addition to those discussed above and in the “Risk Factors” could affect our future results and could cause those results to differ materially from those expressed in such forward-looking statements:

	•		the anticipated results of clinical studies on the efficacy of our protocols, and the publication of those results in medical journals

	•		plans to have our protocols approved for reimbursement by third-party payors

	•		plans to license our protocols to more hospitals and healthcare providers

	•		marketing plans to raise awareness of our PROMETA protocols

	•		anticipated trends and conditions in the industry in which we operate, including regulatory changes

II-1

•

our future operating results, capital needs, and ability to obtain financing

We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or any other reason. All subsequent forward-looking statements attributable to the Company or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to herein. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report may not occur.

Item 6. Exhibits

Exhibit 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 32.1 Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 32.2 Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

II-2


PART I — FINANCIAL INFORMATION		3

ITEM 1. Financial Statements		3

Condensed Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005		3

Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2006 and 2005		4

Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2006 and 2005		5

Notes to Condensed Consolidated Financial Statements		6

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		10

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk		14

ITEM 4. Controls and Procedures		15

PART II – OTHER INFORMATION	II-1

ITEM 1A. Risk Factors	II-1

ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds	II-1

ITEM 5. Other Information	II-1

ITEM 6. Exhibits	II-2

SIGNATURES	II-3
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2


	HYTHIAM, INC.
Date: November 9, 2006	By:	/S/ TERREN S. PEIZER
		Terren S. Peizer
		Chief Executive Officer


Date: November 9, 2006	By:	/S/ CHUCK TIMPE
		Chuck Timpe
		Chief Financial Officer

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