United StatesUNITED 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 EndedSeptember 30, 2005 March 31, 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)incorporation or organization) (I.R.S. Employer Identification Number)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.
Yesþ     Noo
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, (as definedor a non-accelerated file. See definition of “accelerated file and large accelerated file” in Rule 12b-2 of the Exchange Act).Act (Check one):
YesLarge accelerated filero     NoAccelerated filerþ     Non-accelerated filero
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yeso     Noþ
As of November 14,May 8, 2005, there were 38,278,75839,808,562 shares of registrant’s common stock, $0.0001 par value, outstanding.
 
 

 


INDEXTABLE OF CONTENTS
     
Page
Item 1.Financial Statements:
Condensed Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004  3 
 
  3 
 
  3
  4 
 
  5 
 
  6 
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations  10 
 
Quantitative and Qualitative Disclosures About Market Risk  1514 
 
  14 
 Item 4.Controls and Procedures15
Item 1.Legal Proceedings II-1
 
 II-1
 
Unregistered Sales of Equity Securities and Use of Proceeds II-1
Item 3.Defaults Upon Senior SecuritiesII-1
Item 4.Submission of Matters to a Vote of Security HoldersII-1
Item 5.Other InformationII-1
Item 6.ExhibitsII-2
 
II-1
II-2
 II-3
 Exhibit 31.1EX-31.1
 Exhibit 31.2EX-31.2
 Exhibit 32.1EX-32.1
 Exhibit 32.2EX-32.2

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PART I — FINANCIAL INFORMATION
ITEM 1. Financial Statements
HYTHIAM, INC. AND SUBSIDIARIES
(a Development Stage Company)
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)
        
(In thousands, except share data)
 
            March 31,    December 31, 
 September 30, December 31,  2006 2005 
(Dollars in thousands, except share data) 2005 2004 
ASSETS
  
  
Current assets
          
Cash and cash equivalents $3,450 $4,000  $4,864 $3,417 
Marketable securities 10,513 23,479  34,428 43,583 
Restricted cash and marketable securities 65   75 44 
Receivables, net 299 168  283 249 
Prepaids and other current assets 560 446  933 427 
          
Total current assets 14,887 28,093  40,583 47,720 
  
Long-term assets
  
Property and equipment, less accumulated depreciation of $975 and $516, respectively 2,872 2,424 
Intellectual property, less accumulated amortiation of $379 and $219, respectively 3,072 3,080 
Property and equipment, less accumulated depreciation of $1,439 and $1,172, respectively 3,420 3,498 
Intellectual property, less accumulated amortization of $421 and $374, respectively 2,691 2,733 
Deposits and other assets 779 365  500 511 
          
 $21,610 $33,962  $47,194 $54,462 
          
LIABILITIES AND STOCKHOLDERS’ EQUITY
  
  
Current liabilities
  
Accounts payable $2,239 $609  $2,809 $2,652 
Accrued compensation and benefits 787 826  1,232 1,285 
Other accrued liabilities 182 329  414 364 
          
Total current liabilities 3,208 1,764  4,455 4,301 
     
Long-term liabilities
  
Deferred rent liability 497 364  380 422 
      
Commitments and contingencies 
 4,835 4,723 
     
  
Stockholders’ equity
  
Preferred stock, $ par value; 50,000,000 shares authorized; no shares issued and outstanding   
Common stock, $ par value; 200,000,000 shares authorized; 30,271,000 and 30,111,000 shares issued and 29,911,000 and 29,751,000 shares outstanding at September 30, 2005 and December 31, 2004, respectively 3 3 
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; 39,606,000 and 39,504,000 shares issued and 39,246,000 and 39,144,000 shares outstanding at March 31, 2006 and December 31, 2005, respectively 4 4 
Additional paid-in-capital 48,920 47,234  90,524 89,176 
Deficit accumulated during the development stage  (31,018)  (15,403)
Accumulated deficit  (48,169)  (39,441)
          
 17,905 31,834  42,359 49,739 
          
 $21,610 $33,962  $47,194 $54,462 
          
See accompanying notes to financial statements.

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HYTHIAM, INC. AND SUBSIDIARIES
(a Development Stage Company)
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
        
(In thousands, except per share amounts)
 
                     Three Months Ended 
 Period from  March 31, 
 February 13,  2006 2005 
 Three Months Ended Nine Months Ended 2003 (Inception) 
 September 30, September 30, to September 30, 
(In thousands, except per share amounts) 2005 2004 2005 2004 2005 
Revenues
 $361 $41 $794 $113 $1,061  $653 $203 
 
Operating Expenses
  
Salaries and benefits 2,452 1,308 6,323 3,994 13,057  3,895 1,655 
Research and development 850 95 
Other operating expenses 4,444 1,593 9,948 4,274 18,226  4,798 2,737 
Depreciation and amortization 221 159 625 456 1,370  314 196 
                
Total operating expenses 7,117 3,060 16,896 8,724 32,653  9,857 4,683 
                
Loss from operations
  (6,756)  (3,019)  (16,102)  (8,611)  (31,592)  (9,204)  (4,480)
Interest income 152 39 487 116 699  476 161 
                
Loss before provision for income taxes
  (6,604)  (2,980)  (15,615)  (8,495)  (30,893)  (8,728)  (4,319)
Provision for income taxes    2 1    
                
Net loss
 $(6,604) $(2,980) $(15,615) $(8,497) $(30,894) $(8,728) $(4,319)
                
 
Basic and diluted net loss per share
 $(0.22) $(0.12) $(0.52) $(0.35)  $(0.22) $(0.15)
                
See accompanying notes to financial statements.

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Hythiam, Inc. and Subsidiaries
(a Development Stage Company)HYTHIAM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
        
(In thousands)
 
             Three Months Ended 
 Period from  March 31, 
 Nine Months Ended February 13, 2003  2006 2005 
 September 30, (Inception) to 
(In thousands) 2005 2004 September 30, 2005 
Operating activities
  
Net loss $(15,615) $(8,497) $(30,894) $(8,728) $(4,319)
Adjustments to reconcile net loss to net cash used in operating activities:  
Depreciation and amortization 625 456 1,370  314 196 
Provision for bad debt 10  10 
Loss on disposition of fixed assets 20  20 
Deferred rent liability amortization 32 22 79   (29)  (9)
Share-based expense 1,648 682 3,165  1,097 1,068 
Changes in current assets and liabilities:  
Receivables  (69) 99  (237)  (34) 32 
Prepaids and other current assets  (279)  (48)  (527)  (409)  (235)
Accounts payable 1,393  (819) 2,002  157 368 
Accrued compensation and benefits  (39) 566 787   (53)  (427)
Other accrued liabilities  (147)  (245) 182  37  (60)
            
Net cash used in operating activities  (12,421)  (7,784)  (24,043)  (7,648)  (3,386)
            
 
Investing activities
  
Purchases of marketable securities  (8,091)  (10,819)  (58,245)  (13,304)  (4,449)
Proceeds from sales and maturities of marketable securities 21,414 16,000 48,089  22,459 5,300 
Restricted cash  (31)  
Purchases of property and equipment  (699)  (378)  (3,648)  (189)  (59)
Deposits made on property and equipment  (143)   (143)
Reimbursement received on tenant improvement costs 30 301 331 
Deposit made on intellectual property amendment   (75)  
Proceeds from maturity of deposit as collateral for letter of credit 355 352 707 
Cash deposited as collateral  (802)  (350)  (1,502)
Deposits and other assets 11  
Cost of intellectual property  (137)  (3)  (801)  (5)  (66)
Increase in restricted cash and marketable securities  (65)   (65)
            
Net cash provided by (used in) investing activities 11,862 5,028  (15,277)
Net cash provided by investing activities 8,941 726 
     
        
Financing activities
  
Net proceeds from sales of common and preferred stock and warrants   42,694 
Costs incurred on equity financing activities  (194)   (194)
Proceeds from exercise of warrants 203 36 270 
Exercises of stock options and warrants 154 7 
            
Net cash provided by financing activities 9 36 42,770  154 7 
            
Net (decrease) increase in cash and cash equivalents
  (550)  (2,720) 3,450 
 
Net increase (decrease) in cash and cash equivalents
 1,447  (2,653)
Cash and cash equivalents at beginning of period
 4,000 3,444   3,417 4,000 
            
Cash and cash equivalents at end of period
 $3,450 $724 $3,450  $4,864 $1,347 
     
        
Supplemental disclosure of cash paid
  
Income taxes $ $3 $3  $ $ 
        
Supplemental disclosure of non-cash activity
  
Common stock and warrants issued for intellectual property $ $ $2,634 
Common stock, options and warrants issued for outside services 230 86 1,720  $123 $1,025 
Common stock and warrants issued as commissions on private placement   265 
See accompanying notes to financial statements.

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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 itsour 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. The10-K, from which the December 31, 20042005 balance sheet has been derived from the auditedderived.
     The condensed consolidated financial statements on Form 10-K.include the accounts of our wholly-owned subsidiaries and The PROMETA Center, Inc., a California professional corporation, which is owned and controlled by our senior vice president of medical affairs. 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 PROMETA Center up to a maximum of $1,500,000 (as amended in April 2006) to allow the medical group 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 46, “Consolidation of Variable Interest Entities — an Interpretation of ARB No. 51.” Accordingly, we are required to consolidate the revenues and expenses of the PROMETA Center.
     All intercompany transactions and balances have been eliminated in consolidation. Certain reclassifications have been made toin the prior years’ condensed consolidated financial statementsperiod to conform to classifications used in thebe consistent with current year. All share data has been restated to reflect stock splits.period presentation.
     We are considered a development stage company since most of our efforts to date have been devoted to raising capital, recruiting management and developing markets, and revenues earned to date from operations have not been significant.
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 and marketable securities 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 6,906,0007,122,000 and 6,243,0006,686,000 of incremental common shares as of September 30,March 31, 2006 and 2005, and 2004, 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.

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     A summary of the net loss and shares used to compute net loss per share is as follows (in thousands, except per share data):follows:
                   
 Three Months Ended
September 30,
 Nine Months Ended
September 30,
  Three Months Ended March 31, 
 2005 2004 2005 2004  2006 2005 
Net loss $(6,604) $(2,980) $(15,615) $(8,497) $(8,728,000) $(4,319,000)
              
Basic and diluted loss per share $(0.22) $(0.12) $(0.52) $(0.35) $(0.22) $(0.15)
              
Weighted average common shares used to compute basic and diluted loss per share 29,867 24,624 29,806 24,617  39,196,000 29,762,000 
              
Note 4. Share-Based CompensationExpense
Stock optionsOptions — Employees and Directors
     Under our 2003 Stock Incentive Plan,On January 1, 2006, we have granted optionsadopted SFAS 123 (revised 2004) (“SFAS 123(R)”), “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 123(R) 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 well asexpense over the requisite service periods in the consolidated statements of operations. Prior to non-employeesthe adoption of SFAS 123(R), we accounted for outside consulting services.
     We account for the issuance of employee stock optionsshared-based awards to employees and directors using the intrinsic value method, underin accordance with Accounting Principles Board Opinion (“APB”) No. 25, (“APB 25”), “Accounting for Stock Issued to Employees.” Had we determined compensation cost based on the fair value at the grant date for our employee stock optionsEmployees” as allowed under SFAS 123, “Accounting for Stock-Based Compensation,Compensation.Under the pro forma effectintrinsic 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 123(R) using the modified prospective method, which requires the application of the 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 123(R). As a result of adopting SFAS 123R on net lossJanuary 1, 2006, share-based compensation expense recognized under SFAS 123(R) for employees and netdirectors for the three months ended March 31, 2006 was $464,000, which impacted our basic and diluted loss per share would have been as follows (in thousands, exceptby $0.01 per share data):for the three months ended March 31, 2006. There was no share-based compensation expense related to employee or director stock options recognized during the three months ended March 31, 2005.
                 
  Three Months Ended
September 30,
  Nine Months Ended
September 30,
 
  2005  2004  2005  2004 
Net loss, as reported $(6,604) $(2,980) $(15,615) $(8,497)
Less: Share-based expense determined under fair value based method  (256)  (143)  (624)  (380)
             
Pro forma net loss $(6,860) $(3,123) $(16,239) $(8,877)
             
                 
Net loss per share                
As reported — basic and diluted $(0.22) $(0.12) $(0.52) $(0.35)
Pro forma — basic and diluted $(0.23) $(0.13) $(0.54) $(0.36)
     Share-based compensation expense recognized in our consolidated statements of operations for the three months ended March 31, 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 123(R). 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 FSAS 123 for prior periods. Share-based compensation expense recognized in our consolidated statements of operations for the three months ended March 31, 2006 is based on awards ultimately expected to vest, reduced for estimated forfeitures. SFAS 123(R) 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 fiscal 2006, we accounted for forfeitures as they occurred.

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     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 months ended March 31, 2005. For purposes of this pro-forma disclosure, the fair value of the options wasis estimated at the date of grant using the Black-Scholes pricing model withand amortized to expense over the following weighted average assumptions for the three and nine months ended September 30, 2005 and 2004:options’ contractual term.
                 
  Three Months Ended September 30, Nine Months Ended September 30,
  2005 2004 2005 2004
Expected volatility  63%  61%  63%  61%
Risk-free interest rate  4.17%  4.48%  4.18%  4.24%
Weighted average expected lives in years  10   10   10   10 
Expected dividend yield  0%  0%  0%  0%
     
  Three Months 
  Ended March 31, 
  2005 
Net loss, as reported $(4,319,000)
Less: Share-based expense determined under fair value based method  (167,000)
    
Pro forma net loss $(4,486,000)
    
Net loss per share:    
As reported — basic and diluted $(0.15)
Pro forma — basic and diluted $(0.15)
     During the three and nine months ended September 30,March 31, 2006 and 2005, and the three and nine months ended September 30, 2004, we granted options for 397,000, 1,317,000, 652,000596,400 and 1,220,000325,000 shares, respectively, to employees and directors at the weighted average per share exercise price of $5.86, $6.49, $2.80$6.44 and $4.24,$5.72, respectively, which was the fair market valuesvalue of our common stock at the dates of grant. Subsequently, in October 2005 wegrants. Options granted options for 50,000 shares to a consultant at $5.40 per share, the fair market value at date of grant.
     As of September 30, 2005, options for 445,000, shares granted to consultants and directors accounted for under SFAS 123 were outstanding. These optionsgenerally vest over periods ranging from three to four years and are being charged to expense as services are provided using the variable accounting method. Non-vested options have anfive years.
     The estimated fair value of approximately $938,000, as of September 30,options granted to employees and directors during the three months ended March, 31, 2006 and 2005 was $2,323,000 and $1,382,000, respectively, calculated using the Black-Scholes pricing model.model with the following assumptions.
         
  Three Months Ended March 31,
  2006 2005
Expected volatility  58%  63%
Risk-free interest rate  4.46%  4.17%
Weighted average expected lives in years  6.5   10 
Expected dividend yield  0%  0%
     DuringThe expected volatility of our stock has been estimated using the threeaverage expected volatility reported by other public healthcare companies, since we have a limited history as a public company and nine months ended September 30, 2005our 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 2004,the weighted average vesting period for all option traunches.
     We have elected to adopt the detailed method provided in SFAS 123(R) for calculating the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee share-based expense relatingcompensation, and to stock options amounteddetermine 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 123(R).
     As of March 31, 2006, there was $7,124,000 of total unrecognized compensation costs related to $272,000, $1.2 million, $320,000non-vested share-based compensation arrangements granted under the Plan. That cost is expected to be recognized over a weighted-average period of 3.2 years.
Stock Options and $320,000, respectively.
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.
     IfFor 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

8


performed and benefit is received as provided by Financial Accounting Standards BoardFASB Emerging Issues Task Force No. 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.
     During the nine months ended September 30, 2005, we issued a warrant to purchase 25,000 shares of common stock at $5.72 per share to a management advisor for investor relations services. The warrant vested immediately and expires three years from date of grant. We also issued warrants to purchase 20,000 shares of common stock to a management consultant, of which a warrant for 10,000 shares was issued at $2.80 per share, with immediate vesting and expires in 2014, and a warrant for the remaining 10,000 shares was issued at $5.80 per share, with immediate vesting and expires in 2006. The total estimated fair value of warrants issued in the nine months ended September 30, 2005 is approximately $104,000 using the Black-Scholes pricing model.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,March 31, 2006 and 2005, we granted options and 2004, share-basedwarrants for 60,000 and 45,000 shares, respectively, to non-employees at weighted average prices of $6.42 and $5.09, respectively. Share-based expense relating to stock options and warrants amountedgranted to $48,000, $336,000, $40,000non-employees was $610,000 and $287,000,$1,036,000 for the three months ended March 31, 2006 and 2005, respectively.
Common Stock
     InDuring the three months ended March 31, 2006 and 2005, we issued 11,700 shares of common stock and in July 2005 we issued an additional 11,700 shares of common stockeach period to a consultant providing investor relation services. The common stock,relations services, valued at $71,000 and $65,000, respectively, which is being amortized to expense on a straight-line basis over a 12the related six month service period, was valued at $65,000 and $69,000, respectively, the fair market values at the dates of grant.

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period. Share-based expense relating to all common stock issued for outsideconsultants for services was $35,000, $99,000, $11,000$24,000 and $76,000,$32,000 for the three and nine months ended September 30,March 31, 2006 and 2005, and 2004, respectively.
Note 5. Recent Accounting Pronouncements
     In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS 123(R), “Share-Based Payment,” which addresses the accounting for employee stock options. SFAS 123(R) revises the disclosure provisions of SFAS 123 and supersedes APB 25. SFAS 123(R) requires that the cost of all employee stock options, as well as other equity-based compensation arrangements, be reflected in the financial statements based on the estimated fair value of the awards. In March 2005, the Securities & Exchange Commission (the “SEC”) issued Staff Accounting Bulletin No. 107, “Share-Based Payment”, which summarizes the views of the SEC staff regarding the interaction between SFAS 123(R) and certain SEC rules and regulations, and is intended to assist in the initial implementation. SFAS 123(R) is effective for all public companies that file as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. However, in April 2005, the SEC announced that it would permit companies to implement this statement at the beginning of their next fiscal year. We are currently evaluating the provisions of SFAS 123(R) and its effect on our financial statements. The effect of adopting this statement will be to increase our compensation expense in the future.
     In December 2004, the FASB issued SFAS 153, “Exchanges of Nonmonetary Assets, an amendment of APB 29, Accounting for Nonmonetary Transactions.” This Statement’s amendments are based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. Further, SFAS 153 eliminates the narrow exception for nonmonetary exchanges of similar productive assets and replaces it with a broader exception for exchanges of nonmonetary assets that do not have commercial substance. Provisions of this statement are effective for fiscal periods beginning after June 15, 2005. We do not expect the adoption of this statement to have a material impact on our financial statements.
     In March 2005, the FASB issued FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (“FIN 47”), which is an interpretation of SFAS 143, “Accounting for Asset Retirement Obligations.” FIN47 clarifies terminology within SFAS 143 and requires an entity to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. FIN 47 is effective for fiscal years ending after December 15, 2005. We do not expect the adoption of this statement to have a material impact on our financial statements.
     In May 2005, the FASB issued SFAS 154, “Accounting Changes and Error Corrections.” SFAS 154 replaces APB 20, “Accounting Changes” and SFAS 3, “Reporting Accounting Changes in Interim Financial Statements” and establishes retrospective application as the required method for reporting a change in accounting principle. SFAS 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The reporting of a correction of an error by restating previously issued financial statements is also addressed. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We do not expect the adoption of this statement to have a material impact on our financial statements.
Note 6. Subsequent Event
     On November 8, 2005 we completed the sale of 8.0 million shares in an underwritten follow-on offering of our common stock at a public offering price of $4.75 per share. We received approximately $35 million in net proceeds from the offering, after underwriting discounts, commissions and transaction costs. In addition, we granted the underwriters a 30-day option to purchase up to 1.2 million additional shares of common stock to cover over-allotments, if any.

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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 andincluding 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 11A of Part I of our Annual Report onForm 10-K filed with the Securities and Exchange Commission on March 31, 2005.16, 2006.
Overview
     Hythiam, Inc. is a healthcare services management company, focused on delivering alcohol and drug dependence solutions.Introduction
     We research, develop, license and commercialize innovative physiological 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. Unlike traditional treatment methodologies, our proprietary PROMETA™ treatment protocols include medically supervised treatments designed to address both the neurochemical imbalances in the brain and some of the nutritional deficits caused or worsened by substance dependence. Changes in brain chemistry and function play an important role in the physical and behavioral symptoms of substance dependence, including tolerance, withdrawal symptoms, craving and relapse. PROMETA represents an innovative approach to managing substance 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
     We generate revenues by charging fees tocurrently have 34 licensed healthcare providers for access to our proprietary protocols for usecommercial sites throughout the United States. In addition, in treating their patients. We also provide administrative services to assist physicians and facilities with staff education, marketing and sales support, and outcomes tracking for data analysis.
     In the first nine months of 2005,quarter 2006 we entered into 16 newa licensing agreements, bringingagreement with CompCare, a leading managed care behavioral health organization, to market the total number of licenseesPROMETA protocols to 23 at September 30, 2005. In the same period 152 patients were treated using our Prometa protocols. We expanded our corporate office space during the second quarter to accommodate our increasing staff and have leased and are building out medical office space thatits managed care network providers. Through this agreement, we will be occupied by a medical group to which we have agreed to provide turn-key business management services and a license to use our protocol beginning in the fourth quarter of this year, in exchange for management and licensing fees.
     In the first nine months of 2005, we have announced a number of clinical studies by preeminent researchers in the field of substance dependence, and we are currently in the process of awarding additional grants to investigators to test the efficacyextend awareness of the Prometa protocol through the conduct of double-blind, placebo controlled studies as well as open label studies for alcohol and methamphetamine dependence. We have also announced that a drug court in Indiana will evaluate the use of the PrometaPROMETA protocols for drug court participants in a pilot endorsed by the National Association of Drug Court Professionals.
     We established several wholly-owned foreign subsidiaries for the purpose of licensing our intellectual property in foreign markets, and entered into an agreement to acquire protocols for the treatment of nicotine and drug dependence in Europe. Although we have not commenced any significant foreign operations to date, we are planning to open several clinics in Europe for the treatment of smoking cessation in the fourth quarter of 2005.
Results of Operations
     We have a limited history of operations, have not yet commenced substantial marketing activities, and have not generated significant revenues from operations. Our revenues are generated from fees that we charge to hospitals, healthcare facilities and other healthcare providers that license our Prometa protocols. Our license agreements provide for a fee for the licensed technology and related services, set on a per-patient basis, and thus our revenues are generally related to the number of patients treated. Key indicators of our financial performanceemployer groups and third party payors serviced by CompCare, and its strategic marketing partner will be the number of facilities

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work with CompCare to market PROMETA to additional large employers, government groups and healthcare providers that contract with us to license our technology and the number of patientsthird party payers that are treated by those providers using our Prometa protocols.not current CompCare customers. We believe that the number of patients treated by our licensees will continue to increase over time as our marketing, advertising and branding activities are implemented and clinical outcomes data from research studies become available.
     In December 2005, we commenced management of The PROMETA Center, Inc., a new medical practice operating in a state-of-the-art outpatient facility located in Santa Monica, California. Under the terms of a full service management agreement, we manage the medical practice in exchange for management and licensing fees. The practice has a primary focus on using the PROMETA protocols for dependencies on alcohol, cocaine and methamphetamines but will also offer medical interventions for other substance dependencies. The revenues and expenses of the PROMETA center are included in our consolidated financial statements under accounting standards applicable to variable interest entities.
Research and Development
     To date, we have spent $3.7 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, commercial pilots with state programs and drug court systems to study the efficacy of the PROMETA protocols, and clinical outcomes registry for the monitoring and evaluation of up to 750 patients undergoing treatment using PROMETA at our commercial licensee sites. We plan to spend an additional $8 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, as well as serve to accelerate our growth.

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     We have announced that on May 16, 2006 clinical investigator Harold Urschel will report preliminary results from a clinical study on PROMETA for methamphetamine dependence. Also in May 2006, we announced that the PROMETA protocol for stimulants was adopted by the City Court of Gary, Indiana, following a successful commercial pilot that was terminated prior to completion when PROMETA’s results with stimulant dependent drug court participants overwhelmingly surpassed the Court’s historical success rates. We view the acceptance of PROMETA by this drug court as an important milestone and a demonstration of the effectiveness of PROMETA in the criminal justice system.
International Licensing
     In April 2006, we announced that the European Patent Office has stated on its website that grant of a patent is intended for our European patent application, which contains claims for the use of a composition of matter for the treatment of alcohol dependence. Our wholly-owned foreign subsidiaries’ activities to date have consisted of funding of legal and other consulting services, development and start-up activities for potential business opportunities in Europe. As of March 31, 2006, we had not commenced treatment of patients in any foreign markets.
Results of Operations
Revenues
     OurDuring the first quarter of 2006, our revenues for the three and nine month periods ended September 30, 2005 were $361,000 and $794,000, respectively,increased more than three-fold to $653,000, compared to $41,000 and $113,000$203,000 recorded in the comparable periods last year.first quarter of 2005 and increased by 76% over the fourth quarter of 2005. The increase in revenues was driven by licensing fees earned from our licensed healthcare provider sites which completed treatment of a total of 72 and 152treated 96 patients, forversus 40 patients in the three and nine months. Bycomparable period last year. During the end of the thirdcurrent quarter, of 2005, there were 11 operational19 licensee sites contributing to revenues at some level compared to just one operational siteversus 4 in the same period last year. InOur average revenue per patient treated increased by 34% to $6,801 in the thirdcurrent quarter of 2005, we entered into five new licensing agreements with hospitals and healthcare providers, bringing the total number of licensees to 23 at September 30, 2005. During the first nine months of 2005, 152 patients were treated using our Prometa protocols, compared to 25$5,085 for the same period last year. This increase was primarily attributable to patients treated by the newly-opened 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, as well as lower average discounts granted by our licensees in the current quarter than in the same period last year. As we look forward to the fourth quarter, we now have 25 contracted licensees, of which 15 to 20 should be operational and contributing towards revenues by the end of the quarter.
     As we deploy our new PrometaPROMETA brand identity, and accelerate local marketing activity, and see our newer licensees mature past the initial training and startup phase, we should see a continued increaseanticipate seeing continuing increases in patient traffic toward the end of this calendar year and into 2006. However, until each of the licensed treatment centers becomes fully operational and local marketing programs are in place to increase public awareness, we do not expect a significant increase in patient activity in the fourth quarter of 2005. Thus far, new sites have typically started generating revenues after an initial four to six-month training and start-up period following contract signing. Pre-operational site initiation activities include the hiring and training of a local site manager, the education and training of the licensee physicians and staff in the Prometa protocols, the development of a local marketing plan and the mutual approval by both parties in the implementation plan for site launch.
     Our license agreements provide for a fee for the licensed technology and related services, set on a per patient 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 proprietary protocols and the number of patients that are treated by those providers using the Prometa protocols.revenues.
Operating Expenses
     We have devoted a substantial portion of our financial resources to the payment of salaries and benefits, legal and professional services, and other general and administrative expenses during our start-up period.
     Our operating expenses during the three and nine month periodsfirst quarter ended September 30,March 31, 2006 were $9.9 million versus $4.7 million in the first quarter of 2005, were $7.1an increase of $5.2 million and $16.9 million, respectively, compared to $3.1 million and $8.7 million, respectively, for the same periods last year.or 111%. The increase in operating expenses in 20052006 over 20042005 reflects the continued development and expansion of our company, and the execution of our business plan, including a national and international expansion strategy, hiring of key management personnel, investinginvestments in clinical research and the marketingexpansion of our Prometamarketing efforts for our PROMETA protocols.
     Salaries and benefits expenses were $2.5increased by 135% to $3.9 million and $6.3 million forduring the three and nine month periodsfirst quarter ended September 30, 2005,March 31, 2006, compared to $1.3 million and $4.0$1.7 million for the same periods in 2004.period last year. The increase for both periods was due to increased staffingreflects the more than doubling of our staff from the prior year to serve our growing number of licensees, as well as the strengtheningincreased corporate staff to support our rapid growth in operations, research, sales and marketing efforts, new business initiatives and general administrative functions. The increase also includes $464,000 of share-based compensation recorded in the first quarter 2006 as a result of our executive management teamadoption of the accounting provisions of SFAS 123(R) to implementrecognize share-based compensation for employee and director stock option awards in our business plan.statements of operations, effective January 1, 2006.
     We increased our research and development expense to $850,000 in the first quarter 2006, versus $95,000 in the comparable period last year. This significant increase reflects the funding of unrestricted grants for research studies to evaluate our PROMETA protocols, initiation of the patient outcomes registry and commencement of commercial pilot studies.

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     In the three and nine month periodsfirst quarter ended September 30, 2005,March 31, 2006, our other operating expenses were $4.4$4.8 million and $9.9versus $2.7 million respectively, versus $1.6 million and $4.3 million, respectively,in the same period last year, includingyear. Included in these amounts were non-cash charges of $355,000, $1.6 million, $371,000$633,000 and $682,000, respectively, relating to share-based expense. Other operating expenses payable in cash for the three and nine months ended September 30, 2005 were $4.1 million and $8.3 million, respectively, compared to $1.2 million and $3.6$1.1 million, respectively, for the same periods last year.share-based expense related to options, warrants and common stock issued to consultants and directors. Major components of our other operating expenses include legal, audit, insurance, travel, and entertainment, rent, investor and public relations, clinical research, marketing and advertising, and other professional consulting costs. The increasesincrease in 20052006 over the comparable periodsperiod in 20042005, in most expense categories, arewas generally proportionate to the overall increase in staffing and infrastructure of our company, with additionalcompany. In the first quarter of 2006 we increased spending in 2005marketing and direct-to-consumer advertising in the major metropolitan service areas where we have established a market presence. We also increased spending for clinical research studies, legal and consulting costs for international expansion, accountingauditing and consulting costs for Sarbanes-Oxley Section 404 compliance, international expansion activities, and new marketinginitiatives for expanding our business to managed care, statewide agencies, criminal justice systems and business development activities.the gay community.

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Interest Income


     As of September 30, 2005, we have substantially completed the hiring of our senior management team and a substantial portion of our corporate management and supporting staff. As we enter into new licensing agreements, we will continue to hire additional site managers and supporting operational staff. Accordingly, our salaries, benefits and travel related expenses will continue toThe increase with the growth in our business. Additionally, we are planning to significantly increase our marketing effortsinterest income from $161,000 in the fourthfirst quarter of 2005 to provide for local marketing and advertising as well as brand awareness on both a local and national level. We will also allocate up$476,000 in the first quarter 2006 is primarily due to $1.5additional proceeds from our equity offering of $40 million in the fourth quarter ofNovember 2005, towards clinical studies and our patient outcomes registry.
Research Studies and Pilot Programs
     We have announced a number of clinical studies by preeminent researchersan increase in the field of substance dependence, and we are currently inweighted average interest rate from the process of awarding additional grants to investigators to test the efficacy of the Prometa protocol through the conduct of double-blind, placebo controlled studies as well as open label studies for alcohol and methamphetamine dependence. In the second quarter, we signed two contracts with independent researchers to provide unrestricted grants for the study of the Prometa protocol: one for a randomized, controlled study comparing our Prometa protocols to standard medical treatment for alcohol dependence, and the second for a controlled study to investigate our Prometa protocols for the treatment of methamphetamine dependence. In the third quarter we announced that the University of California, Los Angeles will conduct a multi-site, double-blind placebo controlled study on the Prometa treatment protocol for methamphetamine dependence. In October, 2005, we signed a contract with the Medical University of South Carolina for an unrestricted grant to conduct a double-blind, placebo controlled clinical study of the Prometa treatment protocol for alcoholism.
     In the third quarter, a drug court in Indiana announced it will evaluate the use of the Prometa protocols for drug court participants in a pilot endorsed by the National Association of Drug Court Professionals.
     In addition, we have initiated a patient outcomes registry to be conducted by a Contract Research Organization to monitor and evaluate outcomes of approximately 750 patients undergoing treatment using the Prometa protocol at our commercial licensee sites
Prometa Center
     In the fourth quarter 2005, we are planning to commence management for a medical practice that will occupy medical office space provided by us and license our Prometa protocols for the treatment of individuals diagnosed with dependencies to alcohol, cocaine and methamphetamine. The medical practice is located in Santa Monica, California. We are currently building out the leased space at an estimated total cost of approximately $1.1 million, including tenant improvements, furniture and medical and office equipment. Our management and licensing agreements will provide turn-key business management services to the medical group in exchange for management and licensing fees.
International Operations
     In June 2005, we and our international subsidiary Hythiam International (Cayman) Ltd. entered into an asset purchase agreement to obtain the worldwide rights to trade secret protocols for the treatment of nicotine and drug dependence, in exchange for a percentage of future net profits from exploitation of the protocols. In addition, as part of our European expansion strategy, we have incorporated several wholly owned foreign subsidiaries and have engaged consultants to explore opportunities to start up clinic operations for the treatment of nicotine dependence in Europe. As of September 30, 2005, we had not begun any significant international operations. We are currently evaluating the market opportunity and preparing to open clinics in Europe for the treatment of smoking cessation in the future.prior period.
Liquidity and Capital Resources
     We have financed our operations since inception primarily through the sale of shares of our stock. At September 30, 2005 we had approximately $14 million in cash, cash equivalents and marketable securities. In November 2005, we raised an additional $35$40 million in net proceeds from a follow-on underwritten offering of 8.09.2 million shares of our common stock. In addition,As of March 31, 2006, we have granted to the underwriters a 30-day option to purchase an additional 1.2had $39.3 million shares to cover over-allotments, if any.in cash, cash equivalents and marketable securities.

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     Since we are a developingrapidly growing business, both our current and prior operating costs are not representative of our expected futureon-going costs. As we continue to implement commercial operations and allocate significant and increasing resources to business development, hire additional personnel, expand our marketsales, marketing and engage in other start-up activities,new initiatives, we expect our monthly cash operating expenses in the fourth quarter of 2005expenditures to increase from our currentfirst quarter average of approximately $2.2$2.5 million per month as we enter into additional licensing agreementsto approximately $2.8 to $3.0 million per month over the next twelve months, excluding research and increase our marketing effortsdevelopment costs. We plan to provide for local marketing and advertising as well as brand awareness on both a local and national level. As of October 31, 2005, we have remaining commitments of approximately $4.3 million to provide funding for unrestricted grants for research studies for our Prometa protocol. In addition, we have initiated a patient outcomes registry to be conducted by a Contract Research Organization to monitor and evaluate outcomes of approximately 750 patients undergoing treatment using the Prometa protocol at our commercial licensee sites. The combined cost of the studies and patient registry is estimated atspend approximately $8 million overin the next two years.remainder of 2006 and 2007 for research and development.
     In April 2005,2006, we signed a five year lease for medical office space in Santa Monica, California, at an initial base rent of $19,000 per month commencing in August 2005. We estimateexpect our total build-out costs for tenant improvements, furniture and equipment willcapital expenditures to be approximately $1.1$1.5 million. We plan to provide use of this space to a medical group for whomAdditionally, we have agreed to provide turn-key business management services and a license to use our protocol beginning in the fourth quarter of this year in exchange for a management and licensing fee.
     Wewill 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. Our future capital requirements will depend upon many factors, including costs associated with the effectiveness of marketing our protocols, obtaining regulatory approvals and preparing, filing, prosecuting, maintaining and enforcing patent claims and other proprietary rights. Additionally, our future expenditures will depend on competing technological and market developments and our ability to establish collaborative arrangements, effective commercialization, marketing activities and other arrangements.
     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 growth in our revenues and the expansion of our business plan,into managed care and government sponsored programs, we believe that our existing cash reserves plus the $35totaling approximately $39.3 million in net proceeds from the completionas of our recent stock offering in NovemberMarch 31, 2006 will be sufficient to meet our operating expenses and capital requirements until we achieve profitability. However, changes in our business strategy, technology development or marketing plans or other events affecting our operating plans and expenses may result in the expenditure of existing cash before that time. If this occurs, our ability to meet our cash obligations as they become due and payable will depend on our ability to sell securities, borrow funds or some combination thereof. We may seek additional funding through public or private financing or through collaborative arrangements with strategic partners. We may also seek to raise additional capital through public or private financing in order to increase the amount of our cash reserves on hand. 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.

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Contractual Obligations and Commercial Commitments
     The following table sets forth a pro forma summary of our material minimum contractual obligations and commercial commitments as of September 30, 2005March 31, 2006 (in thousands):
                                    
 Less than 1 More than 5  Less than     
Contractual Obligations Total year 1 - 3 years 3 - 5 years years  Total 1 year 1 - 3 years 3 - 5 years 
Operating lease obligations (1) $4,214 $777 $1,624 $1,686 $127  $3,830 $789 $1,648 $1,393 
 
Contractual commitments for clinical studies (2) 1,287 716 571   
Contractual commitments for clinical studies 5,347 2,983 2,364  
                    
 $5,501 $1,493 $2,195 $1,686 $127  $9,177 $3,772 $4,012 $1,393 
                    
 
(1) Consists of our current lease obligations for our corporate office and a medical office.
(2)Subsequent to September 30, 2005, entered intoMarch 31, 2006, we signed an amendment to our corporate office lease agreement to acquire additional administrative space. The impact of this amendment to our lease commitments above is a net increase of $3.9 million$840,000, over a two-year period.five-year period ($119,000 in the first year, $371,000 in the second and third year and $350,000 in the fourth and fifth year).
Off-Balance Sheet Arrangements
     As of September 30, 2005March 31, 2006, we had no off-balance sheet arrangements.

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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 future results may differ from those estimates.
     We consider our critical accounting policiesestimates to be those that (1) involve significant judgments and uncertainties, (2) require judgments or estimates that are more difficult for management to determine, or thatand (3) may produce materially different results when using different assumptions. We considerManagement 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 accounting policies to be critical:
Revenue recognition
     Our revenues are derived from licensing our treatment protocols and providing administrative services to hospitals, treatment facilities and other healthcare providers. We determine revenues earned based on the terms of these contracts, which determination requires the use of judgment, including the assessment of the collectibility of receivables. Licensing agreements typically provide for a fixed fee on a per-patient basis, payable to us upon commencement of the patient’s initial treatment using our protocol. For revenue recognition purposes, we treat the protocol licensing and related administrative services as one unit of accounting. We record the fees owed to us under the terms of the agreements at the time we have performed substantially all required services for each patient’s treatment, which for substantially all of our license agreements is in the period in which the patient’s medically supervised treatment has commenced, and, in other cases, is at the time the initial medical treatment has been completed.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 accountaccounted for the issuance of options and warrants for services from non-employees in accordance with SFAS 123, “Accounting for Stock-Based Compensation,Compensation.by estimatingWe 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%.

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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 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 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 1 to our audited financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2004.
Recent Accounting Pronouncements
     In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS 123(R), “Share-Based Payment,” which addresses the accounting for employee stock options. SFAS 123(R) revises the disclosure provisions of SFAS 123 and supersedes APB 25. SFAS 123(R) requires that the cost of all employee stock options, as well as other equity-based compensation arrangements, be reflected in the financial statements based on the estimated fair value of the awards. In March 2005, the Securities & Exchange Commission (the “SEC”) issued Staff Accounting Bulletin No. 107, “Share-Based Payment”, which summarizes the views of the SEC staff regarding the interaction between SFAS 123(R) and certain SEC rules and regulations, and is intended to assist in the initial implementation. SFAS 123(R) is effective for all public companies that file as of the beginning of the first interim or annual reporting

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period that begins after June 15, 2005. However, in April 2005, the SEC announced that it would permit companies to implement this statement at the beginning of their next fiscal year. We are currently evaluating the provisions of SFAS 123(R) and its effect on our financial statements. The effect of adopting this statement will be to increase our compensation expense in the future.
     In December 2004, the FASB issued SFAS 153, “Exchanges of Nonmonetary Assets, an amendment of APB 29, Accounting for Nonmonetary Transactions.” This Statement’s amendments are based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. Further, SFAS 153 eliminates the narrow exception for nonmonetary exchanges of similar productive assets and replaces it with a broader exception for exchanges of nonmonetary assets that do not have commercial substance. Provisions of this statement are effective for fiscal periods beginning after June 15, 2005. We do not expect the adoption of this statement to have a material impact on our financial statements.
     In March 2005, the FASB issued FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (“FIN 47”), which is an interpretation of SFAS 143, “Accounting for Asset Retirement Obligations.” FIN 47 clarifies terminology within SFAS 143 and requires an entity to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. FIN 47 is effective for fiscal years ending after December 15, 2005. We do not expect the adoption of this statement to have a material impact on our financial statements.
     In May 2005, the FASB issued SFAS 154, “Accounting Changes and Error Corrections.” SFAS 154 replaces APB 20, “Accounting Changes” and SFAS 3, “Reporting Accounting Changes in Interim Financial Statements” and establishes retrospective application as the required method for reporting a change in accounting principle. SFAS 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The reporting of a correction of an error by restating previously issued financial statements is also addressed. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. 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, 2005,March 31, 2006, our investment portfolio consisted of investments in highly liquid, high grade commercial paper, variable rate securities and certificates of deposit. TheDuring the first quarter of 2006, the weighted average interest rate of cash equivalents and marketable securities held at September 30, 2005March 31, 2006 was 3.75%.4.5 %.
     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, 2005March 31, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II — OTHER INFORMATION
ITEM 1. Legal Proceedings1A. Risk Factors
     From timeOur results of operations and financial condition are subject to time, we may be involvednumerous risks and uncertainties described in litigation relating to claims arising outour 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 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 onthese risks materialize, our business, financial condition or operating results.and future prospects could be negatively impacted. As of March 31, 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
     Not Applicable.In February 2006, we issued 11,700 shares of common stock to a consultant providing investor relations services valued at $71,000. 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 3. Defaults Upon Senior Securities
     Not Applicable.
ITEM 4. Submission of Matters to a Vote of Security Holders
     Not Applicable.
ITEM 5. Other Information.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

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  anticipated trends and conditions in the industry in which we operate, including regulatory changes
 
  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 31.1Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 31.2Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 32.1Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
Exhibit 32.2     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 14, 2005May 10, 2006 By: /S/s/ TERREN S. PEIZER
     Terren S. Peizer  
         President and     Chief Executive Officer  
       
Date: November 14, 2005May 10, 2006 By: /S/s/ CHUCK TIMPE
     Chuck Timpe  
         Chief Financial Officer  

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