10-Q 1 v03240e10vq.htm FORM 10-Q Hythiam, Inc. - September 30, 2004
Table of Contents



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, 2004

Commission File Number 333-58246


HYTHIAM, INC.

(Exact name of registrant as specified in its charter)
     
     
Delaware
(State or other jurisdiction of incorporation)
  88-0464853
(I.R.S. Employer Identification Number)

11150 Santa Monica Boulevard, Suite 1500, 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 x NO o

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

As of November 12, 2004, there were 25,081,030 shares of registrant’s common stock, $0.0001 par value, outstanding.



 


Table of Contents

INDEX

             
        Page
PART I. FINANCIAL INFORMATION
 
 
Item 1.   Financial Statements:        
 
 
  Condensed Balance Sheets at September 30, 2004 and December 31, 2003     3  
 
 
  Condensed Statements of Operations for the Three Months Ended September 30, 2004 and 2003, Nine Months Ended September 30, 2004, and the Periods from February 13, 2003 (Inception) to September 30, 2003 and 2004     4  
 
 
  Condensed Statement of Stockholders’ Equity for the Period from February 13, 2003 (Inception) to September 30, 2004     5  
 
 
  Condensed Statements of Cash Flows for the Nine Months Ended September 30, 2004, and the Periods from February 13, 2003 (Inception) to September 30, 2003 and 2004     6  
 
 
  Notes to Condensed Financial Statements     7  
 
 
Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations     11  
 
 
Item 3.  Quantitative and Qualitative Disclosures about Market Risk     14  
 
 
Item 4.   Controls and Procedures     14  
 
PART II. OTHER INFORMATION
 
 
Item 1.  Legal Proceedings   II-1
 
 
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds   II-1
 
 
Item 3.  Defaults upon Senior Securities   II-1
 
 
Item 4.  Submission of Matters to a Vote of Security Holders   II-1
 
 
Item 5.   Other Information   II-1
 
 
Item 6.   Exhibits   II-2
 
      II-3
 
Certifications
 
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32.1
 Exhibit 32.2

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PART I — FINANCIAL INFORMATION

ITEM 1. Financial Statements

HYTHIAM, INC.
(a Development Stage Company)
CONDENSED BALANCE SHEETS

                 
    September 30,   December 31,
(Dollars in thousands, except share data)   2004   2003
 
ASSETS
               
Current assets
               
Cash and cash equivalents
  $ 1,074     $ 3,444  
Marketable securities
    8,515       13,196  
Receivables
    55       455  
Prepaids and other current assets
    288       249  
 
   
 
     
 
 
Total current assets
    9,932       17,344  
Long-term assets
               
Property and equipment, net
    2,144       1,981  
Intellectual property, net
    2,650       2,772  
Deposits and other assets
    440       483  
 
   
 
     
 
 
 
  $ 15,166     $ 22,580  
 
   
 
     
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities
               
Accounts payable
  $ 1,290     $ 1,259  
Accrued compensation and benefits
    884       318  
Other accrued liabilities
    206       451  
 
   
 
     
 
 
Total current liabilities
    2,380       2,028  
 
   
 
     
 
 
Long-term liabilities
               
Deferred rent liability
    86       64  
 
Commitments and contingencies
               
 
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; 24,998,000 and 24,607,000 shares issued and 24,638,000 and 24,607,000 shares outstanding, respectively
    3       3  
Additional paid-in-capital
    24,822       24,113  
Deficit accumulated during the development stage
    (12,125 )     (3,628 )
 
   
 
     
 
 
 
    12,700       20,488  
 
   
 
     
 
 
 
  $ 15,166     $ 22,580  
 
   
 
     
 
 

See accompanying notes to financial statements.

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HYTHIAM, INC.
(a Development Stage Company)
CONDENSED STATEMENTS OF OPERATIONS

                                         
(In thousands, except per share amounts)                   Nine Months   Periods from February 13,
    Three Months Ended,   Ended   2003 (Inception) to
    September 30,   September 30,   September 30,
                2004                        2003                        2004                      2003                      2004       
Revenues
  $ 41     $ 44     $ 113     $ 44     $ 188  
Operating Expenses
                                       
General and administrative
                                       
Salaries and benefits
    1,309       475       3,994       539       5,612  
Other expenses
    1,593       404       4,274       541       6,202  
Depreciation and amortization
    159       9       456       9       531  
 
   
 
     
 
     
 
     
 
     
 
 
Total operating expenses
    3,061       888       8,724       1,089       12,345  
 
   
 
     
 
     
 
     
 
     
 
 
Loss from operations
    (3,020 )     (844 )     (8,611 )     (1,045 )     (12,157 )
Interest income
    40       3       116       3       158  
 
   
 
     
 
     
 
     
 
     
 
 
Loss before provision for income taxes
    (2,980 )     (841 )     (8,495 )     (1,042 )     (11,999 )
Provision for income taxes
                2             2  
 
   
 
     
 
     
 
     
 
     
 
 
Net loss
  $    (2,980 )   $        (841 )   $    (8,497 )   $    (1,042 )   $ (12,001 )
 
   
 
     
 
     
 
     
 
     
 
 
Basic and diluted net loss per share
  $ (0.12 )   $ (0.06 )   $ (0.35 )   $ (0.08 )        
 
   
 
     
 
     
 
     
 
         

See accompanying notes to financial statements.

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HYTHIAM, INC.
(a Development Stage Company)
CONDENSED STATEMENT OF STOCKHOLDERS’ EQUITY
For the Period from Inception (February 13, 2003) to September 30, 2004

                                                         
(In thousands)                                           Deficit    
                                            Accumulated    
Additional During  
Preferred Stock Common Stock Paid-in- Development  
       Shares          Amount          Shares          Amount         Capital       Stage        Total   
Common stock issued at inception
        $       13,740     $     $ 1     $     $ 1  
Common stock issued in merger transaction
                1,120       1       (1 )            
Preferred stock and warrants issued for cash
    1,876       2                   4,688             4,690  
Beneficial conversion feature of preferred stock
                            124       (124 )      
Common stock issued in private placement offering, net of expenses
                7,035       7       16,647             16,654  
Conversion of preferred stock to common stock
    (1,876 )     (2 )     1,876       2                    
Par value change from $0.001 to $0.0001
                      (8 )     8              
Common stock and options issued for intellectual property acquired
                836       1       2,280             2,281  
Stock options and warrants issued for outside services
                            366             366  
Net loss
                                  (3,504 )     (3,504 )
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
 

Balance at December 31, 2003
                24,607       3       24,113       (3,628 )     20,488  

Common stock, options and warrants issued for outside services
                17             86             86  
Exercise of warrants
                14             36             36  
Stock-based compensation
                            587             587  
Net loss
                                  (8,497 )     (8,497 )
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
 
Balance at September 30, 2004
              —     $           —          24,638     $             3     $    24,822     $ (12,125 )   $ 12,700  
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
 

See accompanying notes to financial statements.

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HYTHIAM, INC.
(a Development Stage Company)
CONDENSED STATEMENTS OF CASH FLOWS
                         
(In thousands)   Nine Months   Periods from February 13,
    Ended   2003 (Inception) to
    September 30,   September 30,
        2004                 2003                         2004        
Operating activities
                       
Net loss
  $    (8,497 )   $    (1,042 )   $ (12,001 )
Adjustments to reconcile net loss to net cash used in operating activities:
                       
Depreciation and amortization
    456       9       531  
Deferred rent expense
    22             86  
Stock-based expense
    682             1,027  
Changes in current assets and liabilities:
                       
Decrease (increase) in receivables
    99       (32 )     (55 )
Increase in deposits
          (352 )      
Increase in prepaids and other current assets
    (48 )     (156 )     (276 )
(Decrease) increase in accounts payable
    (469 )     1,022       790  
Increase in accrued compensation and benefits
    566       91       884  
(Decrease) increase in accrued liabilities
    (245 )     254       206  
 
   
 
     
 
     
 
 
Net cash used in operating activities
    (7,434 )     (206 )     (8,808 )
 
   
 
     
 
     
 
 
Investing activities
                       
Purchases of marketable securities
    (10,819 )           (29,059 )
Proceeds from sales and maturities of marketable securities
    16,000             21,044  
Purchases of property and equipment
    (378 )     (332 )     (2,520 )
Refund received on leasehold improvement costs
    301              
Deposit made on intellectual property amendment
    (75 )           (75 )
Proceeds from maturity of deposit as collateral for letter of credit
    352             352  
Cash deposited as collateral for letter of credit
    (350 )           (700 )
Cost of intellectual property
    (3 )     (510 )     (541 )
 
   
 
     
 
     
 
 
Net cash provided by (used in) investing activities
    5,028       (842 )     (11,499 )
 
   
 
     
 
     
 
 
Financing activities
                       
Net proceeds from the sale of common and preferred stock and warrants
          21,214       21,345  
Proceeds from exercise of warrants
    36             36  
 
   
 
     
 
     
 
 
Net cash provided by financing activities
    36       21,214       21,381  
 
   
 
     
 
     
 
 
Net (decrease) increase in cash and cash equivalents
    (2,370 )     20,166       1,074  
Cash and cash equivalents at beginning of period
    3,444              
 
   
 
     
 
     
 
 
Cash and cash equivalents at end of period
  $ 1,074     $ 20,166     $ 1,074  
 
   
 
     
 
     
 
 
Supplemental disclosure of cash paid
                       
Income taxes
  $ 3     $     $ 3  
 
   
 
     
 
     
 
 
Supplemental disclosure of non-cash activity
                       
Common stock and options issued for intellectual property
  $     $ 2,281     $ 2,281  
Common stock and warrants issued to consultants
    86       139       225  
Common stock and warrants issued as commissions on private placement
          265       265  
Common stock issued for stock subscription receivable
          150        
 
   
 
     
 
     
 
 

See accompanying notes to financial statements.

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Hythiam, Inc.
Notes to Condensed Financial Statements

(Unaudited)

Note 1. Basis of Presentation

     The accompanying unaudited interim condensed financial statements for Hythiam, Inc. (“Hythiam” or the “Company”), a development stage company, have been prepared in accordance with accounting principles generally accepted in the United States of America 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 the Company’s most recent Annual Report on Form 10-K. The December 31, 2003 balance sheet has been derived from the audited financial statements on Form 10-K. All share data has been restated to reflect stock splits. Certain reclassifications have been made in prior periods to be consistent with current period presentation.

     The Company is considered a development stage company since revenues earned to date from operations have not been significant. The Company may continue to incur negative cash flows and net losses for at least the next twelve months. Based upon current plans, the Company believes that existing cash reserves will not be sufficient to meet operating expenses and capital requirements before profitability can be achieved. Accordingly, the Company intends to raise additional funds through public or private placement of shares of preferred or common stock or through public or private financing. The ability to meet cash obligations as they become due and payable will depend on the Company’s ability to sell securities, borrow funds, reduce operating costs or some combination thereof. The Company may not be successful in raising necessary funds on acceptable terms, or at all.

     Unless the Company is able to raise additional capital sufficient to support the operations beyond December 31, 2005 before the Company’s audit report for the year ended December 31, 2004 is issued in March 2005, the Company’s auditors have indicated that it is likely their report will express substantial doubt about the Company’s ability to continue as a going concern.

Note 2. Cash Equivalents and Marketable Securities

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

     Investments 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 September 30, 2004, the carrying value approximated fair market value.

Note 3. Basic and Diluted Loss per Share

     In accordance with Statement of Financial Accounting Standards (“SFAS”) 128, “Computation of Earnings Per Share,” basic earnings (loss) per share is computed by dividing the net earnings (loss) available to common stockholders for the period by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share is computed by dividing the net earnings (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 6,243,000 of incremental common shares as of September 30, 2004 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.

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     A summary of the net loss and shares used to compute net loss per share is as follows:

                                 
                            Period from
    Three Months Ended   Nine Months   February 13, 2003
    September 30,   Ended September 30,   (Inception) to
                       2004                             2003                  2004       September 30, 2003
Net loss
  $ (2,980,000 )   $ (841,000 )   $ (8,497,000 )   $ (1,042,000 )
 
   
 
     
 
     
 
     
 
 
Basic and diluted net loss per share
  $ (0.12 )   $ (0.06 )   $ (0.35 )   $ (0.08 )
 
   
 
     
 
     
 
     
 
 
Weighted average common shares used to compute basic net loss per share
    24,624,000       13,830,000       24,617,000       13,787,000  
Effect of dilutive securities
                       
 
   
 
     
 
     
 
     
 
 
Weighted average common shares used to compute diluted net loss per share
    24,624,000       13,830,000       24,617,000       13,787,000  
 
   
 
     
 
     
 
     
 
 

Note 4. Stock, Stock Options and Warrants

Common Stock

     On June 29, 2004, the SEC declared effective the Company’s registration of 10,967,528 shares of its common stock on Form S-1. The Registration Statement was filed pursuant to a registration rights agreement entered into in September 2003 in conjunction with a private placement to certain institutional and accredited investors. The shares of common stock were offered in connection with a distribution by such selling shareholders, and was not a new financing or refunding by the Company.

     In August 2003, the Company acquired a patent for a treatment method for opiate addiction from a medical technology development company. As partial consideration, the Company agreed to issue 360,000 shares of its common stock at a future date conditional upon the occurrence of certain events, including the registration of the shares to be issued and a full release of claims by all of the technology development company’s creditors. In May 2004, the Company issued the 360,000 shares subject to a pledge agreement. Such shares have been pledged and are being held by the Company to secure the remaining obligations to the Company and may not be released or sold until such obligations are satisfied. Under the terms of the pledge agreement, the Company has been assigned all rights, title and interest in the shares, including dividends and voting rights, and, accordingly, for financial reporting purposes such shares are considered issued but not outstanding as of September 30, 2004, and have been excluded from the calculation of loss per share. The value of the stock, if and when released, will be accounted for as additional cost of the intellectual property at the time of release by the Company.

     In October 2004, the Board of Directors approved an amendment (the “Amendment”) to the Technology Purchase and Royalty agreement between the Company and Tratamientos Avanzados de la Addiccion S.L. owned and controlled by Juan Jose Legarda, a former director, to expand the definition of “Processes”, limited to alcohol and cocaine in the original agreement dated March 2003, to also include crack cocaine and methamphetamine detoxification and treatment processes, and the term “Intellectual Property” was expanded to include all improvements through September 14, 2004. As consideration for the Amendment, the Company agreed to pay $75,000 and issue 83,221 shares of the Company’s common stock, valued at $354,000 which will be capitalized to intellectual property in the fourth quarter of 2004 and amortized over the remaining life of the pending patents.

Stock Options

     In September 2003 the Company's directors and shareholders approved the 2003 Stock Incentive Plan (“the Plan”) to reserve 5.0 million shares of common stock for issuance to employees, officers, directors and consultants of the Company. At December 31, 2003, options for 3,940,000 shares were outstanding.

     In June 2004, the Company’s directors and shareholders approved an amendment to the Plan to increase the total number of shares issuable under the Plan from 5.0 million to 6.0 million shares. At September 30, 2004, options for 4,853,000 shares were outstanding.

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     The Company accounts for the issuance of employee stock options using the intrinsic value method under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). In 1995, the Financial Accounting Standards Board (“FASB”) issued SFAS 123, “Accounting for Stock-Based Compensation”, which defines fair-value-based method of accounting for stock compensation plans. However, it also allows an entity to continue to measure compensation costs for options issued to employees and directors using APB 25. Had the Company determined compensation cost based on the fair value at the grant date for such stock options under SFAS 123, the pro forma effect on net loss and net loss per share would have been as follows:

                                   
                            Period from
                            February 13,
    Three Months Ended September 30,   Nine Months Ended   2003 (Inception)
2004 2003 September 30, 2004 to September 30, 2003
Net loss:
                               
As reported
  $ (2,980,000 )   $     (841,000 )   $ (8,497,000 )   $  (1,042,000 )
Less: Stock based compensation expense determined under fair value method
  (143,000 )     (1,000 )     (380,000 )     (1,000 )
 
   
 
     
 
     
 
     
 
 
Pro forma net loss
  $ (3,123,000 )   $ (842,000 )   $ (8,877,000 )   $ (1,043,000 )
 
   
 
     
 
     
 
     
 
 
Net loss per share:
                               
As reported — basic and diluted
$ (0.12 )   $ (0.06 )   $ (0.35 )   $ (0.08 )
Pro forma — basic and diluted
  $ (0.13 )   $ (0.06 )   $ (0.36 )   $ (0.08 )

     The fair value of the options was estimated at the date of grant using the Black-Scholes pricing model with the following weighted average assumptions for the three and nine months ended September 30, 2004, and the three months ended September 30, 2003, and the period from inception to September 30, 2003:

                                 
                            Period from
                            February 13,
    Three Months Ended September 30,   Nine Months Ended   2003 (Inception)
                                2004                                   2003                       September 30, 2004           to September 30, 2003
Expected volatility
    61%       0%       61%       0%  
Risk-free interest rate
    4.48%       4.09%       4.24%       4.09%  
Expected lives
  10 years   10 years   10 years   10 years
Expected dividend yield
    0%       0%       0%       0%  

     During the three and nine months ended September 30, 2004, and the three months ended September 30, 2003, and the period from inception to September 30, 2003, options for 652,000, 1,220,000, 3,555,000, and 3,555,000 shares, respectively, were granted to employees and directors at the weighted average per share exercise price of $2.80, $4.24, $2.57 and $2.57, respectively, the fair market values at the dates of grant. Subsequently, in October 2004, options for 184,000 shares were granted at $4.25 per share, the fair market value at the date of grant. For the periods ended September 30, 2003, the volatility was determined to be zero, since all options were granted when the Company was privately held. Options granted to employees and directors generally vest over periods from four to five years from date of grant.

     At September 30, 2004 and 2003, there were options outstanding for 520,000 and 445,000 shares, respectively, granted to consultants and directors providing consulting services. These options vest over periods ranging from three to four years and are expensed when the services are performed and benefit is received as provided by FASB Emerging Issues Task Force No. 96-18 (“EITF 96-18”). During the three and nine months ended September 30, 2004, and the three months ended September 30, 2003, and the period from inception to September 30, 2003, stock-based expense relating to such stock options amounted $320,000, $320,000, $ -0- and $ -0-, respectively. Non-vested options had an estimated fair value of approximately $1,204,000 and $99,000, respectively, as of September 30, 2004 and 2003, using the Black-Scholes pricing model. During the nine months ended September 30, 2004, and the three months ended September 30, 2003, and the period from inception to September 30, 2003, such options granted to consultants were 75,000, 445,000 and 445,000, respectively, at weighted average exercise prices of $5.56, $2.50 and $2.50 per share, respectively, the fair market values at the dates of grant. No such options were granted during the three months ended September 30, 2004.

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Warrants

     The Company accounts for the issuance of 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 warrant exercise price, the market price of shares on grant date and the weighted average information for risk-free interest, expected life of warrant, expected volatility of the Company’s stock and expected dividends.

     If warrants issued as compensation to non-employees for services 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 EITF 96-18. If warrants are issued for consideration in an acquisition of assets, the value of the warrants are recorded in equity at the time of issuance and included in the purchase price to be allocated.

     In January 2004, warrants to purchase 150,000 shares of common stock at $7.00 per share were issued to a management advisor for investor relations services. In July 2004, warrants to purchase 20,000 shares of common stock at $2.80 were issued to a consultant for legal services. These warrants vest monthly over a 12-month and 36-month period, respectively, and expire five years from date of issue. In September 2004, warrants were exercised for 14,280 shares of common stock at the exercise price of $2.50 per share. The $35,700 in cash proceeds were recorded in stockholders’ equity with the excess over par value recorded in additional paid-in-capital. Warrant activity for the nine months ended September 30, 2004 is summarized as follows:

                         
            Weighted    
            Average    
            Remaining   Weighted
            Contractual   Average
                  Shares             Life (yrs)       Exercise Price
Warrants outstanding, December 31, 2003
    1,234,000       5.7     $ 2.54  
Issued
    170,000       4.3       6.51  
Exercised
    (14,000 )           2.50  
 
   
 
     
 
     
 
 
Warrants outstanding, September 30, 2004
    1,390,000                   5.1     $          3.02  
 
   
 
     
 
     
 
 

     At September 30, 2004, unvested warrants had an estimated value of approximately $296,000 using the Black-Scholes pricing model. During the three and nine months ended September 30, 2004, stock-based expense relating to warrants amounted to $40,000 and $287,000, respectively. There was no stock-based expense for the periods ended September 30, 2003.

     Subsequent to September 30, 2004, warrants for 100,000 shares of common stock were approved by the board of directors for issuance to a consultant for investor relations services. These warrants vested immediately and will expire on August 2, 2009.

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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 and the related notes, and the other financial information included in this report.

Forward-Looking Statements

     The forward-looking comments contained in the following discussion 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 1 of Part I of our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 29, 2004 and in our Registration Statement on Form S-1 filed with the SEC on June 23, 2004.

Overview

     Hythiam, Inc. is a healthcare services management company dedicated to the goal of delivering treatment solutions for those suffering from alcoholism and addiction. We seek to accomplish this by researching, developing, licensing and commercializing innovative physiological protocols. Additionally, we provide proprietary administrative services to assist physicians and facilities with staff education, clinical services, marketing and sales support and outcomes tracking methodologies for data analysis.

     Our HANDSTM Protocols are designed for use by healthcare providers to treat those diagnosed with dependencies to alcohol, cocaine, methamphetamine and other addictive stimulants, as well as combinations of these drugs. Our HANDS Protocols include medically supervised procedures designed to target receptor sites in the brain that regulate certain neurotransmitters implicated in brain processes of substance dependency. Changes in the neurochemistry of the brain underlie the hallmarks of substance dependency, including craving, tolerance, withdrawal symptoms and relapse. Our HANDS Protocols also provide for a maintenance program that includes medications and, in addition, we provide incentives for patients to continue with their recovery process through individualized continuing care programs. As a result, our HANDS Protocols represent a comprehensive approach to managing substance dependence that is designed to address both the physiological and psychological aspects of the disease, thereby offering patients an opportunity to transition into a healthier lifestyle.

     We are a development stage company, have been unprofitable since our inception and may incur substantial additional operating losses for at least the next twelve months as we incur expenditures on research and development, implement commercial operations and allocate significant and increasing resources to sales, marketing and other start-up activities. Accordingly, our activities to date are not as broad in depth or scope as the activities we may undertake in the future, and our historical operations and financial information are not necessarily indicative of the future operating results or financial condition or ability to operate profitably as a commercial enterprise.

     We generate revenues by charging fees to licensed healthcare providers for access to our proprietary protocols for use in treating their patients, and for providing administrative management services in connection with such treatments. The administrative services offered by us include provision of an on-site liaison, education and training, patient registration, continuing care information, marketing and sales support, and data collection and aggregation.

Results of Operations

Revenues

     From February 13, 2003 (inception of Hythiam) through September 30, 2004, we have recognized $188,000 in license fee revenues for a limited number of patients commencing in the third quarter 2003 who have been treated at one hospital in Los Angeles using the HANDS Protocols. In May 2004 we signed our second license agreement with a hospital in Washington, which is expected to begin treating patients in the fourth quarter of 2004. Subsequent to September 30, 2004, we have entered into five additional license agreements with licensed healthcare providers, several of whom we anticipate will commence treating patients in the fourth quarter of 2004. As we implement commercial operations and allocate significant and increasing resources to business development, sales and marketing, we intend to enter into similar agreements with additional licensed healthcare facilities and providers and increase the number of patients treated.

     Our license agreements provide for a combined fee for the licensed protocols and related administrative and management services, set on a per patient treated or range of patients treated basis, and thus our revenues are generally related to the number of patients treated. Key indicators of our financial performance in the future will be the number of facilities and healthcare providers that contract with us to license our protocols and the number of patients that are treated by those providers using the HANDS Protocols.

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Expenses

     We have devoted a substantial portion of our resources to the payment of salaries and benefits, legal and professional and other general and administrative expenses during our start-up period. From inception to September 30, 2004, we have incurred $5.6 million in salaries and benefits and $6.2 million in other general and administrative costs, including $1.0 million in stock-based expense.

     Salaries and benefits expenses were $1.3 million and $4.0 million for the three-month and nine-month periods ended September 30, 2004, compared to $475,000 and $539,000 for the comparable periods in 2003. Other general and administrative expenses were $1.6 million and $4.3 million for the three-month and nine-month periods ended September 30, 2004, compared to $404,000 and $541,000 for the comparable periods in 2003. Included in other general and administrative expenses for the three-month and nine-month periods ended September 30, 2004, were non-cash charges of $371,000 and $682,000, respectively, related to options, warrants and common stock issued to consultants and directors for providing consulting services. Excluding non-cash charges, other general and administrative expenses for the three-month and nine-month periods ended September 30, 2004 were $1.2 million and $3.6 million, respectively, consisting primarily of legal, audit, insurance, rent, investor relations, marketing and business development, and other professional consulting costs. There were no significant variances in these expenses between the second and third quarters in 2004.

Liquidity and Capital Resources

     We have financed our operations since inception primarily through the sale of shares of our stock. In September 2003 we received net proceeds of approximately $21 million from the private placement of equity securities. During 2003 and through September 30, 2004, we used approximately $9 million in operations and approximately $3 million in capital expenditures and acquisition of intellectual property, leaving a balance of approximately $9 million in cash, cash equivalents and marketable securities at September 30, 2004.

     Since we are a developing business, our prior operating costs are not representative of our expected on-going costs. In the first quarter of 2004 we focused on completing the hiring of our senior management team and supporting staff, and in the second quarter we began to devote greater resources to marketing and business development which we continued into the third quarter of 2004. As we continue to implement commercial operations and allocate significant and increasing resources to sales, marketing and other start-up activities, we expect our monthly cash operating expenditures to average approximately $1.2 million per month for the fourth quarter 2004. In the first nine months of 2004, we expended approximately $400,000 to complete the build-out, furnishing and equipping of our new corporate offices. We plan to spend approximately $200,000 in additional capital expenditures in the fourth quarter 2004 as we develop information systems, increase our staff and purchase equipment for new treatment sites opened by licensees. We 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.

     In October, 2004 we entered into a license agreement which provides for us to offer a line of credit to the licensee, and we have agreed to negotiate the amount and terms of the line of credit in good faith. If the licensee elects to negotiate such a credit line with us, we may agree to lend up to $500,000 in 2005 under this arrangement.

     Although we have not yet entered into any agreement to do so, in 2005 and 2006 we plan to provide funding for unrestricted grants to academic and affiliated research institutions and other research organizations interested in conducting formal scientific studies of our HANDS Protocols. In addition, we are planning to engage a contract research organization (CRO) to assist us in creating a patient registry over a two year period to capture certain outcomes data for patients treated with our HANDS Protocols. We estimate the grants for scientific studies and estimated cost of the patient registry will range from approximately $500,000 to $3.0 million each, at a total estimated cost of approximately $7.0 million to $8.0 million over the next two years.

     Our future capital requirements will depend upon many factors, including progress with marketing our protocols, the time and costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims and other proprietary rights, the necessity of, and time and costs involved in obtaining, regulatory approvals, competing technological and market developments, and our ability to establish collaborative arrangements, effective

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commercialization, marketing activities and other arrangements. We may continue to incur negative cash flows and net losses for at least the next twelve months.

     Based upon our current plans, we believe that our existing cash reserves will not be sufficient to meet our operating expenses and capital requirements before we achieve profitability. Accordingly, we intend to raise additional funds through public or private placement of shares of preferred or common stock or through public or private financing. Our ability to meet our cash obligations as they become due and payable will depend on our ability to sell securities, borrow funds, reduce operating costs or some combination thereof. We may not be successful in raising necessary funds on acceptable terms, or at all.

     Unless we are able to raise additional capital sufficient to support our operations beyond December 31, 2005 before our audit report for the year ended December 31, 2004 is issued in March 2005, our auditors have indicated that it is likely their report will express substantial doubt about our ability to continue as a going concern.

Off-Balance Sheet Arrangements

     As of September 30, 2004 we had no off-balance sheet arrangements.

Critical Accounting Policies and 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 results may differ from those estimates. We consider our critical accounting policies to be those that involve significant uncertainties, require judgments or estimates that are more difficult for management to determine or that may produce materially different results when using different assumptions. We consider the following accounting policies to be critical:

Revenue recognition

     Our revenues are derived from licensing our protocols and providing administrative services to hospitals, treatment facilities and other healthcare providers. We recognize revenues as licensing fees are earned, the services are performed and collectibility is reasonably assured. Our licensing fees relate to the use of our proprietary treatment protocols for each patient completing treatment. Under the terms of our current contract, administrative services consists of education services (initial training in the use of the protocols) and data reports (principally pre-registration information, clinical screening data and patient satisfaction reports completed prior to or at the completion of treatment). The protocol license, education services and data reports represent multiple service arrangements under the contract, as all of the fees for licensing and provision of services are included in one fee determined on a per patient basis. The per-patient fees have not been allocated to each of the multiple service elements, since substantially all of the licensing fees and other service elements are earned at the time of completion of patient treatment, and we recognize revenues only upon completion of the patient’s prescribed course of treatment.

Stock-based expense

     We account for the issuance of options and warrants for services from non-employees in accordance with SFAS 123, “Accounting for Stock-Based Compensation” by estimating 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, the weighted average information for risk-free interest, expected life of the option or warrant, expected volatility of the company’s stock and expected dividends. The amounts recorded in the financial statements for stock-based compensation expense could vary significantly if we were to use different assumptions.

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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 need 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 are a development stage company and 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.

     Our accounting policies are more fully described in Note 2 to our audited financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2003.

Recent Accounting Pronouncements

     On October 13, 2004, the Financial Accounting Standards Board (FASB) concluded that Statement 123R, Share-Based Payment, which would require all companies to measure compensation cost for all share-based payments (including employee stock options) at fair value, would be effective for interim or annual periods beginning after June 15, 2005. We are in the process of determining the impact this will have on our financial statements.

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

     There have been no material changes in market risks since the filing of our Annual Report on Form 10-K for the year ended December 31, 2003.

ITEM 4. Controls and Procedures

     We have evaluated, under the supervision and 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. During the third quarter, our system of internal controls has evolved consistent with the development of the Company. There are no changes in our internal controls over financial reporting during the quarter ended September 30, 2004 that have materially effected, or are reasonably likely to materially affect, our internal controls over financial reporting.

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PART II — OTHER INFORMATION

ITEM 1. 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 report, 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.

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

     In July 2004, we issued to a financial advisor 8,322 shares of common stock at an exercise price of $2.57 per share in exchange for investor relations services. The securities were issued without registration pursuant to the exemption afforded by Section 4(2) of the Securities Act of 1933.

     In July 2004, we issued warrants to purchase 20,000 shares of common stock at an exercise price of $2.80 per share in exchange for legal services. The securities were issued without registration pursuant to the exemption afforded by Section 4(2) of the Securities Act of 1933.

     In July 2004, we granted to employees and a director options to purchase 652,000 common stock at the exercise price of $2.80 per share. The securities were issued without registration pursuant to the exemption afforded by Section 4(2) of the Securities Act of 1933.

ITEM 3. Defaults upon Senior Securities

     Not Applicable.

ITEM 4. Submission of Matters to a Vote of Security Holders

     Not Applicable.

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 and our Registration Statement on Form S-1 filed with the SEC on June 23, 2004, 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:

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    general economic conditions,
 
    the effectiveness of our protocols, advertising, marketing and promotional campaigns,
 
    healthcare providers and patient acceptance of our products and services, including newly introduced products,
 
    competition among addiction treatment centers and healthcare providers,
 
    anticipated trends and conditions in the industry in which we operate, including regulatory changes,
 
    development of new treatment modalities,
 
    our future capital needs and our ability to obtain financing, and
 
    other risks and uncertainties as may be detailed from time to time in our public announcements and filings with the SEC.

     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, which may have a material adverse effect on our business and results of operation.

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

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SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
         
  HYTHIAM, INC.
 
 
Date: November 12, 2004  By:   /S/ TERREN S. PEIZER    
    Terren S. Peizer   
    President and Chief Executive Officer   
 
     
Date: November 12, 2004  By:   /S/ CHUCK TIMPE    
    Chuck Timpe   
    Chief Financial Officer   
 

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