Tanox (TNOX) 10-Q 2006 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

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

For the quarterly period ended September 30, 2006

OR

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

For the transition period from            to            

Commission file number: 000-30231

TANOX, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware	76-0196733
(State or Other Jurisdiction of Incorporation or Organization)	(IRS Employer Identification No.)
10301 Stella Link Houston, Texas	77025
(Address of Principal Executive Offices)	(Zip Code)

(713) 578-4000

(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  ¨

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

Large accelerated filer  ¨    Accelerated filer  x    Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Number of shares of common shares outstanding at November 6, 2006: 45,251,225.

TANOX, INC.

FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2006

INDEX

	Page
Part I – Financial Information
Item 1 – Financial Statements
Condensed Consolidated Balance Sheets at September 30, 2006 (unaudited) and December 31, 2005	1
Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the Three and Nine Months Ended September 30, 2006 (unaudited) and September 30, 2005 (unaudited)	2
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2006 (unaudited) and September 30, 2005 (unaudited)	3
Notes to Condensed Consolidated Financial Statements (unaudited)	4
Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations	11
Item 3 – Quantitative and Qualitative Disclosures About Market Risk	19
Item 4 – Controls and Procedures	19
Part II – Other Information	21
Item 1 – Legal Proceedings	21
Item 1A – Risk Factors	21
Item 6 – Exhibits	34
Signatures	35
Exhibit Index	36

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PART I

FINANCIAL INFORMATION

Item 1. Financial Statements

TANOX, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In Thousands, Except Shares and Per Share Data)

	September 30, 2006			December 31, 2005
	(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	56,521		$	46,732
Short-term investments		107,672			106,228
Interest receivable		793			799
Accounts receivable		10,763			29,335
Accounts receivable from related party		627			122
Prepaid expenses and other		2,255			2,359
Total current assets		178,631			185,575
LONG-TERM INVESTMENTS		13,275			11,541
PROPERTY PLANT & EQUIPMENT, NET		29,868			31,214
OTHER ASSETS		1,239			1,606
TOTAL ASSETS	$	223,013		$	229,936
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	1,744		$	2,615
Accrued liabilities		6,356			4,913
Accrued arbitration award		2,232			8,967
Total current liabilities		10,332			16,495
LONG-TERM LIABILITIES:
Deferred revenue		1,000			—
Total long-term liabilities		1,000			—
STOCKHOLDERS’ EQUITY:
Preferred stock, $.01 par value per share; 10,000,000 shares authorized; none outstanding		—			—
Common stock, $.01 par value per share; 120,000,000 shares authorized; 45,805,551 and 45,466,957 shares issued, and 45,250,851 and 44,912,257 shares outstanding, in 2006 and 2005, respectively		458			455
Additional paid-in capital		337,642			331,822
Treasury stock, at cost; 554,700 shares in 2006 and 2005, respectively		(6,261	)		(6,261	)
Accumulated other comprehensive income		179			684
Accumulated deficit		(120,337	)		(113,259	)
Total stockholders’ equity		211,681			213,441
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	223,013		$	229,936

See accompanying notes to condensed consolidated financial statements.

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TANOX, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE

INCOME (LOSS)

(Unaudited)

(In Thousands, Except Per Share Data)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
REVENUES:
Royalties, net	$	9,672		$	7,603		$	27,674		$	20,712
Royalties from related party, net		550			67			1,165			149
Profit share from related party, net		2,401			—			4,594			—
Development agreements, license fees and manufacturing rights		2,654			663			3,382			748
Development agreements from related party		16			14			1,038			43
Total revenues		15,293			8,347			37,853			21,652
OPERATING COSTS AND EXPENSES:
Research and development		14,491			11,402			42,432			35,156
Acquired in-process research and development		—			—			—			13,680
General and administrative		2,611			1,515			8,368			5,270
Total operating expenses		17,102			12,917			50,800			54,106
LOSS FROM OPERATIONS		(1,809	)		(4,570	)		(12,947	)		(32,454	)
OTHER INCOME, NET:		2,185			1,187			5,869			3,192
NET INCOME (LOSS)	$	376		$	(3,383	)	$	(7,078	)	$	(29,262	)
BASIC AND DILUTED EARNINGS (LOSS) PER SHARE	$	0.01		$	(0.08	)	$	(0.16	)	$	(0.66	)
SHARES USED IN COMPUTING EARNINGS (LOSS) PER SHARE:
Basic		44,836			44,063			44,861			44,596
Diluted		44,924			44,063			44,861			44,596
COMPREHENSIVE INCOME (LOSS):
Net income (loss)	$	376		$	(3,383	)	$	(7,078	)	$	(29,262	)
Foreign currency translation adjustment		—			3			2			3
Unrealized gain (loss) on available-for-sale investments		(255	)		21			(507	)		(302	)
TOTAL COMPREHENSIVE INCOME (LOSS)	$	121		$	(3,359	)	$	(7,583	)	$	(29,561	)

See accompanying notes to condensed consolidated financial statements.

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TANOX, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In Thousands)

	Nine Months Ended September 30,
	2006			2005
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss	$	(7,078	)	$	(29,262	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization		3,299			2,901
Amortization of intangible		114			—
Acquired in-process research and development		—			13,680
Compensation expense related to stock options		2,947			27
Changes in operating assets and liabilities:
(Increase) decrease in receivables and other assets		18,430			(3,662	)
Decrease in current liabilities		(6,163	)		(442	)
Increase in long-term liabilities		1,000			—
Net cash (used in) provided by operating activities		12,549			(16,758	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Additions to property and equipment		(1,953	)		(8,086	)
Cash paid for acquisition of in-process research and development		—			(6,000	)
Purchases of investments		(156,891	)		(133,805	)
Maturities and sales of investments		153,206			198,809
Net cash (used in) provided by investing activities		(5,638	)		50,918
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of stock		2,876			570
Net cash provided by financing activities		2,876			570
IMPACT OF EXCHANGE RATES ON CASH AND CASH EQUIVALENTS		2			3
INCREASE IN CASH AND CASH EQUIVALENTS		9,789			34,733
CASH AND CASH EQUIVALENTS:
Beginning of period		46,732			5,284
End of period	$	56,521		$	40,017
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Unrealized loss on available-for-sale securities		(507	)		(302	)
Common stock issued for acquisition of in-process research and development		—			7,680

See accompanying notes to condensed consolidated financial statements.

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TANOX, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2006

(Unaudited)

1. Basis of Consolidation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission and include the accounts of Tanox, Inc. and its wholly owned subsidiaries (collectively, the Company or Tanox). Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles in the United States for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been made and all such adjustments are of a normal recurring nature. These condensed consolidated interim financial statements and notes thereto should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2005. Operating results for the three and nine month periods ended September 30, 2006 are not necessarily indicative of the operating results that may be expected for the entire fiscal year.

New Accounting Pronouncement

In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109,” (FIN 48). This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” The interpretation prescribes a recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return and also provides guidance on derecognition, classification, interest and penalties, accounting for interim periods, disclosure and transition. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact, if any, this statement may have on its financial statements.

2. Revenues

Xolair Collaboration. Under its collaboration agreements with Genentech, Inc. (Genentech) and Novartis Pharma AG (Novartis), Tanox receives a royalty on the net sales of Xolair worldwide and shares in Novartis’ net profits from Xolair sales in the U.S. Royalty revenues of $10.2 million and $7.7 million on the net sales of Xolair, for the three months ended September 30, 2006 and 2005, respectively, were calculated based on net sales reported to Tanox by Genentech and Novartis. For the nine months ended September 30, 2006, $28.8 million in Xolair royalty revenue was recorded compared to $20.9 million for the same period in 2005. Royalty revenue is net of amounts which are payable by Tanox to its former attorneys (see Note 7. “Commitments and Contingencies”).

Tanox recorded net profit sharing revenue of $2.4 million for the three months ended September 30, 2006, resulting from Novartis profits made in the second quarter of 2006, and $4.6 million for the nine months ended September 30, 2006, resulting from Novartis profits made in the first and second quarters of 2006 and the fourth quarter of 2005, as the profit sharing calculation is one quarter in arrears. Tanox recorded $562,000 of deferred profit sharing revenue during the third quarter of 2005 resulting from profits made in the first and second quarters of 2005. The company recorded the amount as deferred revenue due to a disagreement with Novartis as to the calculation. This disagreement was resolved in the fourth quarter of 2005.

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Tanox receives manufacturing rights revenue from Genentech and Novartis in consideration for Tanox’s relinquishment in 2004 of any rights it had to manufacture Xolair. Manufacturing rights revenue is based on the quantity of Xolair produced, as defined in our collaboration agreement, and is calculated and recorded one quarter in arrears. For the three months ended September 30, 2006, Tanox recorded manufacturing rights revenue of $2.6 million, based on the quantity of Xolair produced in the second quarter of 2006. For the nine months ended September 30, 2006, $3.3 million of manufacturing rights revenue was recorded based the quantity of Xolair produced in the first and second quarters of 2006 and the fourth quarter of 2005.

In the second quarter of 2006, Novartis submitted an application for the approval of Xolair in Japan. Under our collaboration agreement with Novartis, the filing resulted in a $2.0 million milestone payment to Tanox, of which $1.0 million was recorded as development agreement revenue from a related party in the second quarter of 2006. The remaining $1.0 million of the milestone is creditable to Novartis against future royalties due Tanox and was recorded as deferred revenue.

Novartis profit sharing and rest-of-world royalty payments are net of certain credits, all of which had been used at September 30, 2006.

Development Agreements and Licensing Fees. Development agreement revenue includes reimbursement of certain clinical trial costs. Licensing fee revenue includes payments received from various parties in exchange for rights to license and sublicense Tanox’s technology or product rights.

3. Cash, Cash Equivalents, Short-term and Long-term Investments

Cash equivalents consist of highly liquid investments with original maturities of three months or less. Management determines the appropriate classification of cash equivalents, short-term investments and long-term investments at the time of purchase. Investments consist of investment grade corporate bonds, commercial paper, asset-backed securities, auction-rate securities and government agency securities with maturities of less than three years from the balance sheet date. Certain investments are classified as held-to-maturity and carried at amortized cost in the accompanying financial statements. The Company’s available-for-sale investments are stated at fair value based on the quoted market price of the investment. Unrealized gains and losses on available-for-sale investments are reported as other comprehensive income (loss), which is a separate component of stockholders’ equity. The fair value of Tanox’s available-for-sale investments decreased by $255,000 for the three months ended September 30, 2006 and by $507,000 for the nine months ended September 30, 2006, compared to an increase in value of $21,000 for the three months ended September 30, 2005 and a decrease in value of $302,000 for the nine months ended September 30, 2005.

Tanox’s net carrying value of cash and cash equivalents at September 30, 2006 and December 31, 2005, was $56.5 million and $46.7 million, respectively.

Investments consist of the following (in thousands):

	September 30, 2006		December 31, 2005
Held-to-maturity investments – short-term	$	61,232	$	61,131
Available-for-sale investments		46,440		45,097
Total short-term investments		107,672		106,228
Held-to-maturity investments – long-term		13,275		11,541
	$	120,947	$	117,769

The fair value of these investments at September 30, 2006 and December 31, 2005, was $120.8 million and $117.4 million, respectively.

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4. Acquisitions

Manufacturing Assets and Long-term Lease.Pursuant to a Lease Assignment and Asset Purchase Agreement dated December 9, 2004, between Biogen Idec, Inc. (Biogen Idec) and Tanox, on January 10, 2005, Tanox acquired from Biogen Idec certain manufacturing, process development and quality control equipment, related documentation and furniture and fixtures housed in a 76,000 square foot leased facility located in San Diego, California. The Company paid Biogen Idec approximately $5.6 million for the assets and allocated $4.6 million as property, plant and equipment and $1.0 million as an intangible asset for manufacturing equipment documentation, included in other assets on the balance sheet. Tanox also agreed to assume the obligations of Biogen Idec under a lease for the facility, which extends until September 30, 2011.

Anti-Tissue Factor Program.On March 31, 2005, the Company acquired a tissue factor antagonist program for the potential treatment of acute lung injury (ALI)/acute respiratory distress syndrome (ARDS) from Sunol Molecular Corporation (Sunol). In consideration for the tissue factor antagonist program, the Company issued an aggregate of 800,000 shares of its common stock and paid $6.0 million in cash to Sunol. Of the shares issued, 275,000 are being held in escrow for up to three years after closing to secure indemnification obligations under the Asset Purchase Agreement. Based upon the closing price of the Company’s common stock on March 31, 2005, the fair value of the acquired assets was $13.7 million, including the $6 million paid in cash. As of the acquisition date, the acquired program was still in early development stage, had not reached technological feasibility and had no alternative future use. Accordingly, the Company recorded the $13.7 million purchase price as an acquired in-process research and development expense in the first quarter of 2005.

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5. Earnings (Loss) per Share

The following is a reconciliation of basic and diluted earnings per share for the three and nine months ended September 30, 2006 and 2005 (in thousands, except per share data):

	Three Months Ended September 30,					Nine Months Ended September 30,
	2006		2005			2006			2005
Basic earnings (loss) per share	$	0.01	$	(0.08	)	$	(0.16	)	$	(0.66	)
Average shares outstanding – basic		44,836		44,063			44,861			44,596
Potential shares exercisable under stock option plans		88		—			—			—
Adjusted average shares outstanding – diluted		44,924		44,063			44,861			44,596
Diluted earnings (loss) per share	$	0.01	$	(0.08	)	$	(0.16	)	$	(0.66	)

Diluted earnings per share excluded 1.8 million shares related to stock options for the three months ended September 30, 2006. The exercise price of these options was greater than the average market price for these shares, therefore the effect would have been antidilutive. Tanox incurred net losses during the the nine month period ended September 30, 2006 and three month and nine month periods ended September 30, 2005, therefore, all options outstanding for each of these periods were excluded from the computation of diluted earnings per share because they would have been antidilutive.

6. Share-Based Compensation

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (FAS) No. 123 (revised 2004, or FAS 123R), “Share-Based Payment.” FAS 123R supersedes Accounting Principals Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and requires companies to recognize compensation expense, using a fair-value based method, for costs related to share-based payments, including stock options and employee stock purchase plans. FAS 123R permits public companies to adopt its requirements using either the modified prospective or modified retrospective transition method.

The Company adopted FAS 123R on January 1, 2006 using the modified prospective transition method which requires that share-based compensation is recognized for all awards granted, modified or settled after the effective date as well as for all awards granted to employees prior to the effective date that remain unvested as of the effective date. For the three months ended September 30, 2006, the Company recorded approximately $798,000 of share-based compensation expense, of which $411,000 was included in research and development expense and $387,000 was included in general and administrative expense. For the nine months ended September 30, 2006, the Company recorded approximately $2.9 million of share-based compensation expense, of which $1.2 million was included in research and development expense and $1.7 million was included in general and administrative expense. Included in the general and administrative expense for the nine months ended September 30, 2006, was $239,000 related to the acceleration of vesting of options previously granted to our board of directors and $340,000 related to the 2006 options granted to our board of directors, which vested immediately on the grant date. The adoption of FAS 123R resulted in a decrease in earnings of $0.02 per share and an increased loss of $0.06 per share on the Company’s net income or loss per share for the three and nine months ended September 30, 2006, respectively. The adoption of FAS 123R had no impact on cash flow from operations and cash flow from financing activities for the three and nine months ended September 30, 2006. Share-based compensation for all non-vested options outstanding as of September 30, 2006 was $8.2 million, which will be recognized over a weighted-average period of 1.5 years. The Company amortizes share-based compensation expense on a straight-line basis over the expected life of the vesting period.

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The Company estimates the fair value of stock options at the date of the grant using the Black-Scholes-Merton option pricing model, with the following weighted average assumptions:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2006		2005		2006		2005
Risk-free interest rate	4.57	%	4.24	%	4.57	% - 5.11%	3.91	% - 4.24%
Expected dividend yield	0	%	0	%	0	%	0	%
Expected life	7 years		5 years		7 years		5 years
Expected volatility	62	%	64	%	62	% - 63%	64	% -67%
Expected forfeiture rate	31	%	9	%	31	%	9	% -10%

The expected term of the options was estimated using historical option exercise data. The expected volatility was based on the Company’s historical stock price volatility. The risk-free interest rate was based on the U.S. Treasury zero-coupon issues with a remaining term equal to the expected term of the option. The Company assumed a zero percent dividend yield. Under FAS 123R, the fair value of stock options granted is recognized as expense over the service period, net of estimated forfeitures. Based on historical data, the Company calculated an estimated forfeiture rate, which it believes is a reasonable assumption to estimate forfeitures. To the extent actual forfeitures differ from our current estimates, cumulative adjustments to share-based compensation expense will be recorded in the period that estimates are revised.

Prior to the adoption of FAS 123R on January 1, 2006, Tanox accounted for its share-based compensation expense under the recognition and measurement provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Under the intrinsic value method described in APB Opinion No. 25, no compensation expense was recognized if the exercise price of the employee stock option equaled the market price of the underlying stock on the date of grant. Assuming the compensation cost for the stock option plans had been determined pursuant to the fair value method under FAS No. 123, Tanox’s pro forma net loss for the three and nine months ended September 30, 2005 would have been as follows (in thousands, except per share data):

	Three Months ended September 30, 2005			Nine Months ended September 30, 2005
Net loss:
As reported	$	(3,383	)	$	(29,262	)
Stock option compensation expense if the fair value method had been applied		(1,371	)		(4,226	)
Pro forma net loss	$	(4,754	)	$	(33,488	)
Loss per share – Basic and Diluted
As reported	$	(0.08	)	$	(0.66	)
Pro forma	$	(0.11	)	$	(0.75	)

At September 30, 2006, the Company has the following share-based compensation plans:

The 1987 Stock Option Plan (the 1987 Plan) was established to cover key employees, officers and directors of Tanox. Under the terms of the 1987 Plan, as amended, the number of shares of common stock eligible for issuance was 4,320,000. Options issued under the 1987 Plan were generally granted at a purchase price equal to the fair market value at the date of grant, generally expired ten years after date of grant and were generally completely exercisable five years after the grant date. At September 30, 2006, options to purchase 20,000 shares of common stock were outstanding under the 1987 Plan. The 1987 Plan expired in 1997.

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The 1997 Stock Plan (the 1997 Plan) was established to grant options to purchase up to 8,000,000 shares of common stock to employees, directors, advisors and consultants. The 1997 Plan provides for several types of grants including incentive stock options, non-qualified stock options, stock appreciation rights, stock awards, stock purchases and performance units. Incentive stock options provide the right to purchase common stock at a price not less than 100% of the fair value of common stock on the date of the grant. Non-qualified stock options provide the right to purchase common stock at a price not less than 50% of the fair value of the common stock on the date of the grant. The options granted under the 1997 Plan generally expire ten years after date of grant. Options granted under the 1997 Plan prior to February 2004 are generally completely exercisable five years after the grant date, while options granted in February 2004 and after are generally completely exercisable four years after the grant date. At September 30, 2006, options to purchase 2,437,849 shares of common stock were outstanding under the 1997 Plan, and 4,975,630 shares were available for future grants. The 1997 Plan will expire in 2007.

The 1992 Non-Employee Directors Stock Option Plan (the 1992 Directors Plan) was established to grant options to purchase up to 480,000 shares of common stock to non-employee directors of the Company. Options granted under the 1992 Directors Plan generally vested one-third annually from the date of grant and generally expired ten years from the date of grant. The exercise price of the options granted was determined by a committee appointed by Tanox’s board of directors. At September 30, 2006, options to purchase 17,500 shares of common stock were outstanding under the 1992 Directors Plan. The 1992 Directors Plan expired in 2002.

The 2000 Non-Employee Directors’ Stock Option Plan (the 2000 Directors Plan) was established to grant options to purchase up to 500,000 shares of common stock to non-employee directors of the Company. Under the terms of the 2000 Directors Plan, as amended, non-employee directors receive, upon initial election to the Board, an option to acquire 20,000 shares of common stock. Following each annual meeting of stockholders at which directors are elected, the non-employee directors continuing in office receive options to acquire 10,000 shares of common stock. New directors who received their initial option grant within six months prior to the first annual meeting after their appointment would not be eligible for an option following such meeting. All grants under the 2000 Directors Plan have a term of ten years, are issued at fair market value and vest 1/36 per month from the date of grant over three years, in the case of the 20,000-share options, or immediately, in the case of the 10,000-share options. At September 30, 2006, options to purchase 234,900 shares of common stock were outstanding under the 2000 Directors Plan, and 247,800 shares were available for future grants.

The following table summarizes stock option activity for the three months ended September 30, 2006:

	Number of Shares		Weighted Average Exercise Price		Weighted Average Remaining Contractual Life	Aggregate Intrinsic Value (In 000s)
Outstanding, June 30, 2006	2,656,295		$	16.55
Granted	90,600			12.69
Exercised	(2,430	)		11.63
Cancelled	(16,666	)		15.08
Forfeited	(17,550	)		16.12
Outstanding, September 30, 2006	2,710,249		$	16.43	7.48	$	44,538
Exercisable, September 30, 2006	1,254,084		$	17.82	6.18	$	22,343

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The following table summarizes nonvested stock option activity for the three months ended September 30, 2006:

	Number of Shares		Weighted Average Fair Value
Nonvested, June 30, 2006	1,501,380		$	9.47
Granted	90,600			8.21
Vested	(118,265	)		8.33
Forfeited	(17,550	)		10.05
Nonvested, September 30, 2006	1,456,165		$	9.48

7. Commitments and Contingencies

Tanox had been engaged in litigation in connection with a fee dispute with the law firms that represented the Company in litigation with Genentech relating to, among other things, the intellectual property rights surrounding the development of anti-IgE technology. An arbitration panel issued an award entitling the attorneys to receive (1) approximately $3.5 million, including interest, (2) payments ranging from 33-1/3% to 40% of the future milestone payments, in excess of the first $1 million, that Tanox would receive from Genentech following product approval and (3) 10% of the royalties that Tanox would receive on sales of certain anti-IgE products, including Xolair. The 10% of royalties received by Tanox is required to be paid to the attorneys within 30 days after the end of the calendar quarter in which the royalty payments are received by Tanox. At September 30, 2006, Tanox had an accrued liability of $2.2 million with respect to amounts that are payable to the attorneys on royalties received or receivable by Tanox on net sales of Xolair.

Tanox is involved from time to time in legal proceedings relating to claims incidental to its business. Tanox does not believe that the outcome of any existing litigation will have a material effect on its business.

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

Overview

The following discussion and analysis should be read in conjunction with our condensed consolidated financial statements and the related notes thereto included in this Quarterly Report on Form 10-Q. The discussion and analysis contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (Exchange Act). These forward-looking statements are based on our current expectations and entail various risks and uncertainties. Our actual results could differ materially from those projected in the forward-looking statements as a result of various factors, including those set forth below under Part II, Item 1A “Risk Factors.”

Tanox discovers and develops therapeutic monoclonal antibodies to address significant unmet medical needs in the areas of immune-mediated diseases, infectious disease, inflammation and cancer. Our products are genetically engineered antibodies that target a specific molecule or antigen.

Marketed Product - Xolair

Xolair was developed in collaboration with Genentech, Inc. (Genentech) and Novartis Pharma AG (Novartis). In the U.S., Xolair is labeled for treatment of adults and adolescents (12 years of age and above) with moderate-to-severe persistent asthma who have a positive skin test orin vitro reactivity to a perennial aeroallergen and whose symptoms are inadequately controlled with inhaled corticosteroids. Xolair was approved for use in the U.S. by the Food and Drug Administration (FDA) in June 2003 and approved for use in Europe in October 2005.

Under our collaboration agreements with Genentech and Novartis, we receive royalties on the net sales of Xolair worldwide and share in Novartis’ net profits from sales of Xolair in the U.S. For the three months ended September 30, 2006, we recorded net royalty revenue of $10.2 million from sales of Xolair versus $7.7 million for the third quarter of 2005. For the three months ended September 30, 2006, we recorded net profit sharing revenue of $2.4 million, resulting from Xolair U.S. net profits recorded by Novartis in the second quarter of 2006, as the profit sharing calculation is one quarter in arrears. We recorded $562,000 of deferred profit sharing revenue in the third quarter of 2005 resulting from profits made in the first and second quarters of 2005.

For the three months ended September 30, 2006, we recorded manufacturing rights revenue of $2.6 million, compared to manufacturing rights revenue of $650,000 in the third quarter of 2005. Under the terms of the Tripartite Collaboration Agreement (TCA) among Tanox, Genentech and Novartis, we relinquished any rights to manufacture Xolair and in exchange receive payments based on the quantity of Xolair produced. Manufacturing rights revenue is based on the quantity of Xolair produced in the previous quarter, as defined in our collaboration agreement, and is calculated and recorded one quarter in arrears.

As of September 30, 2006, Xolair was approved in 52 countries and marketed in more than 20, including the U.S., Brazil, Canada, Germany, Israel, Spain and the U.K. Novartis is conducting a Phase 3 clinical trial to study the effectiveness of Xolair in pediatric allergic asthma patients. In addition, Genentech is conducting an open-label Phase 2b clinical trial of Xolair in peanut-allergic subjects. The trial is an open-label extension to the Phase 2 trial evaluating Xolair in peanut allergy in which enrollment was discontinued in October 2005.

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Clinical Development Programs

We have three products in clinical development.

TNX-355

TNX-355 is our monoclonal antibody in development to treat HIV/AIDS. On May 2, 2006, we reported positive 48-week results from the Phase 2 clinical trial of TNX-355. The results showed that TNX-355, when given in combination with an optimized background regimen (OBR) of other antiviral therapies, produced a considerably greater reduction in viral load in HIV-infected patients than did placebo in combination with OBR. These results, together with positive 24-week data reported in October 2005, demonstrate the long-term antiviral and immunologic impact of TNX-355. At both the 24-week and 48-week time points, TNX-355 was well tolerated, with no serious adverse events related to the drug as assessed by study investigators.

We have conducted a meeting with the FDA to discuss the clinical trial results and continued development of TNX-355. While the FDA indicated that TNX-355 demonstrated therapeutic potential in clinical testing, an additional dose-finding study will be needed. Tanox has received positive feedback from the FDA regarding its proposed pivotal Phase 2b protocol for the next dose-finding trial. The Agency has concurred that the trial, if appropriately designed, could be considered pivotal as part of a registration program for TNX-355 in HIV treatment-experienced patients.

TNX-650

TNX-650 is a humanized anti-IL-13 antibody being developed as a potential treatment of Hodgkin’s lymphoma. A Phase 1 clinical trial of TNX-650 was initiated in May 2006, with four patient cohorts enrolled as of September 30, 2006.

In early October 2006, we began enrolling patients in a Phase 1 clinical trial of TNX-650 as a potential treatment for moderate-to-severe asthma. The trial is a randomized, double-blind, placebo-controlled, dose-escalation study of the safety, tolerability and pharmacokinetics of single doses of TNX-650 in healthy volunteers. We expect to enroll a total of 32 subjects in four cohorts in the study, which is taking place at a single site in the U.S. Preclinical studies indicate that IL-13 is a key mediator of asthma responses, including airway inflammation, obstruction and hyper-reactivity. TNX-650 has a mechanism of action unique from currently available asthma treatments, and has the potential to be a therapeutic option for patients whose disease is not currently well controlled and for non-allergic asthmatics.

TNX-832

TNX-832 is an anti-tissue factor chimeric antibody that is in development for the treatment of acute lung injury (ALI) and acute respiratory distress syndrome (ARDS). We have completed the clinical portion of a Phase 1 trial designed to evaluate the safety and pharmacokinetics of TNX-832 and are analyzing the data as part of evaluating next steps for the program.

Preclinical Programs

TNX-234, a humanized antibody, is being developed as a potential treatment for wet age-related macular degeneration (AMD). TNX-717, a humanized antibody, is being evaluated as a potential treatment for osteoporosis. TNX-558 is being evaluated as a potential inflammatory-disease therapy. In addition, we have generated a humanized high affinity anti-IgE antibody for the potential treatment of allergic diseases, and development activities have begun with Novartis under our two-party Amended and Restated Development and Licensing Agreement.

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Manufacturing and Other Programs

Our San Diego, California manufacturing facility has received a Drug Manufacturing License from the State of California.

Critical Accounting Policies

Use of Estimates

The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and footnotes thereto. Actual results may differ from those estimates.

Revenue Recognition

Under our collaboration agreements with Genentech and Novartis, we receive a royalty on the net sales of Xolair worldwide and share in Novartis’ net profits from Xolair sales in the U.S. Royalty revenue is recorded monthly based on contractual terms and information provided by Genentech and Novartis. Royalties are reconciled and adjusted if actual results differ from those previously reported to us and are subject to audit by Tanox. Our interest in Novartis’ U.S. net profits is calculated and recorded one quarter in arrears. Manufacturing rights revenue represents amounts received from Genentech and Novartis in consideration of our relinquishment, under the collaboration agreements, of our rights to manufacture Xolair. Manufacturing rights revenue is based on the quantity of Xolair produced, as defined in our collaboration agreement, and is calculated and recorded one quarter in arrears. Revenues from development agreements include payments for milestone achievements and sponsored research and development costs. Milestone payments are received under best efforts contracts and are not refundable. They are recognized as revenue when the milestones are achieved and there are no remaining performance obligations. Revenues for sponsored research and development are recognized as revenue as we complete our obligations related to such activities. Any revenue contingent upon future performance is deferred and recognized as the performance is completed. Revenues recognized are net of certain credits and amounts due to our former attorneys under an arbitration award.

Research and Development

Research and development expense consists of direct costs and indirect overhead costs, including facilities costs, salaries, related benefit costs and material and supply costs. Expenses may also include upfront fees and milestone payments paid to licensors and collaborative partners. Such amounts are expensed as incurred. Research and development costs also include estimates for clinical trial costs, which are based on patient enrollment and clinical trial progress. Actual costs may differ from estimates.

Share-based Compensation

Tanox adopted FAS 123R, “Share-Based Payment” on January 1, 2006 using the modified prospective transition method, which requires that share-based compensation is recognized for all awards granted, modified or settled after the effective date as well as for all awards granted to employees prior to the effective date that remain unvested as of the effective date. Prior to the adoption of FAS 123R, we accounted for our share-based compensation expense under the recognition and measurement provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Under the intrinsic value method described in APB Opinion No. 25, no compensation expense was recognized if the exercise price of the employee stock option equaled the market price of the underlying stock on the date of grant.

Tanox estimates the fair value of stock options using the Black-Scholes-Merton option pricing model. The assumptions used under this model are as follows: 1) the expected term of the options is estimated using

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historical option exercise data; 2) the expected volatility is estimated based on historical stock price volatility; 3) the risk-free interest rate is based on the U.S. Treasury zero-coupon issues with a remaining term equal to the expected term of the option; and 4) a zero percent dividend yield. Under FAS 123R, the fair value of stock options granted is recognized as expense over the service period, net of estimated forfeitures, which we base on historical data. To the extent actual forfeitures differ from our current estimates, cumulative adjustments to share-based compensation expense will be recorded in the period that estimates are revised.

New Accounting Pronouncement

In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109,” (FIN 48). This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” The interpretation prescribes a recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return and also provides guidance on derecognition, classification, interest and penalties, accounting for interim periods, disclosure and transition. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact, if any, this statement may have on our financial statements.

Results of Operations

Three Months Ended September 30, 2006 and 2005

Revenues. For the three months ended September 30, 2006 and 2005, revenues consist of the following:

(in thousands)	Three months ended September 30,
	2006		2005
Royalties, net	$	9,672	$	7,603
Royalties from related party, net		550		67
Profit share from related party, net		2,401		—
Development agreements, license fees and manufacturing rights		2,654		663
Development agreements from related party		16		14
Total revenues	$	15,293	$	8,347

Revenues for the third quarter of 2006 were $15.3 million compared to revenues of $8.3 million for the third quarter of 2005. Revenues are recorded net of credits and amounts payable to our former attorneys under an arbitration award.

Net royalty revenue increased $2.5 million for the third quarter of 2006 to $10.2 million, compared to $7.7 million for the third quarter of 2005, as a result of increased Xolair sales.

In addition to Xolair royalty revenue, Tanox recorded Xolair net profit sharing revenue of $2.4 million for the third quarter of 2006. The profit sharing revenue represented Tanox’s share of Novartis’ U.S. net profits from sales of Xolair in the second quarter of 2006, as the profit sharing calculation is one quarter in arrears.

Tanox recorded manufacturing rights revenue of $2.6 million in the third quarter of 2006. Tanox receives manufacturing rights revenue from Genentech and Novartis in consideration for Tanox’s

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relinquishment in 2004 of any rights it had to manufacture Xolair. Manufacturing rights revenue is based on the quantity of Xolair produced in the previous quarter, as defined in our collaboration agreement, and calculated and recorded one quarter in arrears. Development agreement revenue, license fees and manufacturing rights revenue in 2006 also includes reimbursement of certain clinical trial costs.

Research and Development Expense. Research and development expense consists of costs incurred for product development and discovery research programs. Research and development expense consists of direct costs and indirect overhead costs, including facilities costs, clinical trial costs, salaries, related benefit costs and material and supply costs. At September 30, 2006, our research and development clinical stage programs include TNX-355 for HIV/AIDS, TNX-650 for Hodgkin’s lymphoma, TNX-650 for Asthma and TNX-832 for ALI/ARDS. Research and preclinical stage programs include TNX-234 for AMD, TNX-717 for osteoporosis and bone fracture, TNX-558 for inflammatory disease and other discovery and exploratory research projects. For the three months ended September 30, 2006 and 2005, costs associated with these research and development programs, including allocated overhead, were:

(in thousands)	Three months ended September 30,
	2006		2005
Clinical stage programs	$	12,195	$	8,685
Research and preclinical stage programs		2,296		2,717
Total research and development expense	$	14,491	$	11,402

Research and development expense increased $3.1 million for the third quarter of 2006 compared to the same period in 2005. The increase in research and development costs for the third quarter of this year was attributed primarily to expenses associated with the write-off of $1.4 million in prepaid expense related to future creditable amounts with a third party manufacturer, manufacturing activities in preparation for planned clinical trials, increased spending for preclinical programs and employee share-based compensation expense.

General and Administrative Expense.For the third quarter of 2006, general and administrative expense was $2.6 million, compared to $1.5 million for same period in 2005. The increase in general and administrative costs for the third quarter of this year was due primarily to expenses related to business-development activities and employee share-based compensation expense.

Other Income, Net. For the third quarter of 2006, other income was $2.2 million, compared to $1.2 million for the same period in 2005. The increase in other income for the third quarter of this year was attributed primarily to a rise in interest income in 2006 resulting from higher average interest rates on investments.

Income Taxes.We have not recorded an income tax provision because of a projected net loss for the year 2006.

Share-Based Compensation.We adopted FAS 123R on January 1, 2006. Prior to the adoption, we disclosed such expenses on a pro forma basis in the notes to our financial statements. For the three months ended September 30, 2006, we recorded approximately $798,000 of share-based compensation expense, of which $411,000 was included in research and development expense and $387,000 was included in general and administrative expense. The adoption of FAS 123R resulted in a decrease in net income per share of $0.02 for the three months ended September 30, 2006. Share-based compensation for all non-vested options outstanding as of September 30, 2006 is $8.2 million, which will be recognized over a weighted-average period of 1.5 years. Tanox amortizes share-based compensation expense on a straight-line basis over the expected life of the vesting period. (See Note 6 “Share-Based Compensation” in our Notes to Condensed Consolidated Financial Statements.)

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Net Income (Loss). For the third quarter of 2006, we recorded net income of $376,000, or $0.01 per share, compared to a net loss of $3.4 million, or $0.08 per share, for the third quarter of 2005. The results for the third quarter of 2006 reflect the Company’s January 1, 2006 adoption of FAS No. 123R.

Nine Months Ended September 30, 2006 and 2005

Revenues. For the nine months ended September 30, 2006 and 2005, revenues consist of the following:

(in thousands)	Nine months ended September 30,
	2006		2005
Royalties, net	$	27,674	$	20,712
Royalties from related party, net		1,165		149
Profit share from related party, net		4,594		—
Development agreements, license fees and manufacturing rights		3,382		748
Development agreements from related party		1,038		43
Total revenues	$	37,853	$	21,652

Revenues for the first nine months of 2006 were $37.9 million compared to revenues of $21.7 million for the first nine months of 2005. Revenues are recorded net of credits and amounts payable to our former attorneys under an arbitration award.

Net royalty revenue increased $7.9 million for the first nine months of 2006 to $28.8 million, compared to $20.9 million for the same period in 2005, as a result of increased Xolair sales.

In addition to Xolair royalty revenue, Tanox recorded Xolair net profit sharing revenue of $4.6 million for the nine months ended September 30, 2006. The profit sharing revenue represented Tanox’s share of Novartis’ U.S. net profits from sales of Xolair in the first two quarters of 2006 and the fourth quarter of 2005, as the profit sharing calculation is one quarter in arrears.

Tanox recorded manufacturing rights revenue of $3.3 for the first nine months of 2006. Tanox receives manufacturing rights revenue from Genentech and Novartis in consideration for Tanox’s relinquishment in 2004 of any rights it had to manufacture Xolair. Manufacturing rights revenue is based on the quantity of Xolair produced in the first two quarters of 2006 and the fourth quarter of 2005, as defined in our collaboration agreement, and recorded and calculated one quarter in arrears. Development agreement revenue, license fees and manufacturing rights revenue in 2006 also includes reimbursement of certain clinical trial costs.

Research and Development Expense. Research and development expense consists of costs incurred for product development and discovery research programs. Research and development expense consists of direct costs and indirect overhead costs, including facilities costs, clinical trial costs, salaries, related benefit costs and material and supply costs. At September 30, 2006, our research and development clinical stage programs include TNX-355 for HIV/AIDS, TNX-650 for Hodgkin’s lymphoma, TNX-650 for Asthma and TNX-832 for ALI/ARDS. Research and preclinical stage programs include TNX-234 for AMD, TNX-717 for osteoporosis and bone fracture, TNX-558 for inflammatory disease and other discovery and exploratory research projects. For the nine months ended September 30, 2006 and September 30, 2005, costs associated with these research and development programs, including allocated overhead, were:

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(in thousands)	Nine months ended September 30,
	2006		2005
Clinical stage programs	$	31,636	$	27,443
Research and preclinical stage programs		10,796		7,713
Total research and development expense	$	42,432	$	35,156

Research and development expense increased $7.3 million for the first nine months of 2006 compared to the same period in 2005. The increase in research and development costs for the first nine months of this year was attributed primarily to expenses associated with manufacturing activities in preparation for planned clinical trials, the write-off of $1.4 million in prepaid expense related to future creditable amounts with a third party manufacturer, increased spending for preclinical programs and employee share-based compensation expense.

Acquired in-process research and development. The $13.7 million expense for acquired in-process research and development recorded in the first quarter of 2005 relates to the Company’s acquisition of a tissue factor antagonist program.

General and Administrative Expense.For the nine months ended September 30, 2006, general and administrative expense was $8.4 million, compared to $5.3 million for the first nine months of 2005. The increase in general and administrative costs for the nine months ended September 30, 2006 was due primarily to expenses related to business-development activities and employee share-based compensation expense.

Other Income, Net. For the nine months ended September 30, 2006, other income was $5.9 million, compared to $3.2 million for the same period in 2005. The increase in other income for the first nine months of this year was attributed primarily to a rise in interest income in 2006 resulting from higher average interest rates on investments.

Income Taxes.We have not recorded an income tax provision because of a projected net loss for the year 2006.

Share-Based Compensation.We adopted FAS 123R on January 1, 2006. Prior to the adoption, we disclosed such expenses on a pro forma basis in the notes to our financial statements. For the nine months ended September 30, 2006, we recorded approximately $2.9 million of share-based compensation expense, of which $1.2 million was included in research and development expense and $1.7 million was included in general and administrative expense. The adoption of FAS 123R resulted in an increase in net loss per share of $0.06 for the nine months ended September 30, 2006. (See Note 6 “Share-Based Compensation” in our Notes to Condensed Consolidated Financial Statements.)

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Net Loss. For the nine months ended September 30, 2006, we recorded a net loss of $7.1 million, or $0.16 per share, compared to a net loss of $29.3 million, or $0.66 per share, for the nine months ended September 30, 2005. The results for the current year reflect the Company’s January 1, 2006 adoption of FAS No. 123R. The net loss for the nine months ended September 30, 2005 included a $13.7 million expense for acquired in-process research and development related to the Company’s acquisition of a tissue factor antagonist program.

Liquidity and Capital Resources

We have financed our operations since inception primarily through sales of equity securities, development and licensing fee revenues, interest income and, beginning in 2003, revenues from our Xolair collaboration. During the year ended December 31, 2000, we sold approximately 8.6 million shares of common stock in an initial public offering for net proceeds of $225.8 million. As of September 30, 2006, we had $177.5 million in cash, cash equivalents and investments, of which $164.2 million was classified as current assets.

Cash, cash equivalents and investments increased by $13.0 million for the nine months ended September 30, 2006 to $177.5 million from $164.5 million at December 31, 2005. The net increase in funds was attributed primarily to the receipt of a one-time net milestone payment of $12.8 million based on Xolair achieving sales of more than $300 million for the first time, and Xolair royalty, profit sharing and manufacturing rights revenue received, partially offset by the funding of operating activities.

Net cash provided by operating activities was $12.5 million for the nine months ended September 30, 2006 compared to net cash used in operating activities of $16.8 million for the same period in 2005. The increase in cash during the 2006 period was due primarily to the receipt of the one-time Xolair net milestone payment of $12.8 million, partially offset by a net loss of $7.1 million. The net cash used in the 2005 period was comprised mainly of a net loss of $29.3 million and an increase in receivables and other assets of $3.7 million, partially offset by the acquisition of in-process research and development of $13.7 million related to the tissue factor program acquisition.

Net cash used in investing activities was $5.6 million for the nine months ended September 30, 2006 compared to net cash provided by investing activities of $50.9 million for the same period in 2005. In the 2006 period, investment purchases increased by $3.7 million over maturities, compared to a decrease of $65.0 million for the same period in 2005. In the 2005 period, $6.0 million of cash was paid for acquired in-process research and development and $5.6 million was paid to purchase manufacturing assets from Biogen Idec.

Net cash provided by financing activities was $2.9 million for the nine months ended September 30, 2006 compared to $570,000 for the same period in 2005. The increase in cash was due to stock option exercises.

Tanox and a third party manufacturer began discussions in the fourth quarter of 2004 related to revisions to a manufacturing and supply agreement because we determined that we would produce TNX-355 clinical trial materials in the newly-leased San Diego manufacturing facility. In February 2005, a letter agreement with the third party manufacturer was reached to suspend all provisions of the manufacturing and supply agreement for a period to be determined by us, but not to exceed 30 months. Under the terms of the letter agreement, Tanox has paid a total of $1.7 million, and recorded $1.4 million as prepaid expense which would have been creditable against future work performed by the third party manufacturer on or before August 30, 2007, subject to certain limitations. During the period ended September 30, 2006, we expensed the $1.4 million as it is unlikely that we will have contract manufacturing needs for TNX-355 before August 2007.

Our current and anticipated development projects require substantial additional capital to complete. We do not expect to generate positive cash flow from operations in the near term because we anticipate that the amount of cash we need to fund operations, including research and development, manufacturing and other

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costs, and for capital expenditures, will increase in the future as our projects move from research to clinical development to commercialization. We may make additional acquisitions of businesses or intellectual property assets and also expect that we will need to expand our clinical development, manufacturing capacity, facilities, business development and marketing activities to support the future development of our programs. Based on cash projections, we expect that cash on hand and revenue from operations will be sufficient to fund our existing operations for the next four years. However, our future capital needs will depend on many factors, including the continued successful commercialization of Xolair, availability of financing for clinical trials through collaboration or joint venture arrangements, progress in our research and product development activities, the size and design of our clinical trials, commercialization activities, the costs and magnitude of product or technology acquisitions, the cost of preparing, filing, prosecuting, maintaining and enforcing patent claims and other intellectual property rights, competing technological and market developments, changes in or terminations of existing collaboration and licensing arrangements, establishing additional collaboration and licensing arrangements, potential merger and acquisition activities, potential litigation surrounding any of the foregoing or other business issues, and manufacturing scale-up costs and marketing activities, if we undertake those activities. Consequently, we may need to raise additional funds and we may issue additional shares of common stock or other equity securities.

We filed a universal shelf Registration Statement with the Securities and Exchange Commission (SEC) in May 2005, which permits us to sell up to $100 million of equity or debt securities in one or more offerings. We would expect to use the net proceeds from any sales of securities under this shelf registration statement to provide funds for development of products in our drug development pipeline, potential product acquisition or licensing opportunities and general corporate purposes. The terms of any offering of securities will be made public in a subsequent filing with the SEC at the time of any such sale.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We are exposed to a variety of risks, including changes in interest rates and foreign currency exchange rate fluctuations. In the normal course of business, we have established policies and procedures to manage these risks.

Foreign Currency Exchange Rates. We are subject to foreign currency exchange risk because we conduct minimal operations through one foreign subsidiary in China.

Interest Rate Risk.Cash, cash equivalents and investments were approximately $177.5 million at September 30, 2006. These assets were primarily invested in investment grade corporate bonds, commercial paper, government agency securities and money market funds with maturities of less than three years, which we have the ability and intent to hold to maturity. We also invest in auction securities which are classified as available for sale securities. We do not invest in derivative securities. Although our portfolio is subject to fluctuations in interest rates and market conditions, no gain or loss on any security would actually be recognized in earnings unless we sell the asset.

Item 4. Controls and Procedures

Our management evaluated, with the participation of our Chief Executive Officer and Vice President of Finance, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Vice President of Finance have concluded that our disclosure controls and procedures (as defined in the Exchange Act Rules 13a-15(e) and 15d-15(e)) are effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.

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There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II

OTHER INFORMATION

Item 1. Legal Proceedings

We are involved from time to time in legal proceedings relating to claims arising out of our operations in the ordinary course of business. We do not believe that the outcome of any existing litigation will have a material effect on our business.

Item 1A. Risk Factors

The information in this Quarterly Report on Form 10-Q contains forward-looking statements. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to inherent risks and uncertainties, including but not limited to the risk factors set forth below, and actual results could differ materially from those projected or assumed in the forward-looking statements due to a number of factors, including:

• our ability to develop safe and effective drugs;

• failure to achieve positive results in preclinical and toxicology studies in animals or clinical trials in humans;

• failure to economically and timely manufacture sufficient amounts of our products with the requisite quality for clinical trials and commercialization activities;

• failure to receive, or delay in receiving, marketing approval for our products;

• failure to successfully finance and commercialize our products, including gaining market acceptance;

• our ability to manage relationships with collaboration partners;

• our ability to obtain, maintain and successfully enforce patent and other proprietary rights protection of our products;

• variability of royalty, license and other revenues, and potential adjustments and changes in amounts paid to us and amounts we may be required to pay to third parties, including our former attorneys under an adverse arbitration award;

• our ability to use our manufacturing capacity and facilities costs effectively and in accordance with regulatory requirements;

• our ability to establish comparability of our bulk drug substances before and after manufacturing changes;

• our ability to enter into future collaboration agreements to support our research and development activities;

• drug withdrawal from the market due to serious adverse reactions caused by the marketed drug;

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• our ability to secure licenses from third parties holding patents that may affect the manufacture or marketing of our products;

• competition and technological change;

• existing and future regulations affecting our business, including the content, timing of submissions and decisions made by the FDA and other regulatory agencies;

• governmental changes affecting Medicare and the healthcare and pharmaceutical industries including policies that affect coverage and levels of reimbursement for sales of our products; and

• our ability to hire and retain experienced managers and scientists.

The following section discusses important risks and uncertainties that could materially and adversely affect our business, results of operations and financial condition, which in turn could materially and adversely affect the trading price of our common stock.

Regulatory Risks

Developing therapeutic monoclonal antibodies is expensive and highly uncertain.

Successful development of therapeutic monoclonal antibodies is highly uncertain. First, we must discover or otherwise acquire drug candidates. Then we must demonstrate through preclinical studies and clinical trials that our products are safe and effective for use in a particular target indication before we can obtain regulatory approvals to sell our products commercially to that patient group. These studies and trials tend to be very costly and time consuming. Furthermore, the results of preclinical studies and initial clinical trials of our products do not necessarily predict the results from later-stage clinical trials, which must demonstrate the desired safety and efficacy traits.

Products that appear promising in research or early phases of development may not reach later stages of development or be submitted for marketing approval for a number of reasons, including:

• Preclinical tests indicate that the product is toxic or otherwise lacks efficacy in animals;

• The product is found to be less effective than required or causes serious adverse reactions or side effects in patients participating in clinical trials; often these reactions may not be detectable in small, early stage trials and can only be identified when the product is administered to a larger patient base, as in Phase 3 trials or following market approval;

• The commercial introduction of competitive drugs that may have greater efficacy or safety than our product or otherwise adversely impact the risk/benefit profile of our product;

• We are unable to develop manufacturing methods that are efficient, cost-effective and capable of meeting stringent regulatory standards; and

• Proprietary rights of third parties may cover our products, and we are not able to secure licenses on reasonable terms.

Our products other than Xolair require significant additional laboratory development or clinical trials before they can be submitted for marketing approval. We have limited capacity to conduct and manage clinical trials, and we rely on third parties, potentially including collaborative partners and contract research

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organizations, to assist us in these efforts. Our reliance on third parties may result in delays in completing, or failing to complete, clinical trials if our collaborators or contractors fail to perform under our agreements with them. If our large-scale trials are not successful or we are otherwise unable to satisfy the BLA filing requirements, we would not be able to recover our substantial investment in developing the product.

We may be unable to enroll sufficient patients in a timely manner in order to complete our clinical trials.

The speed with which we are able to enroll patients in clinical trials is an important factor in determining how quickly we may complete clinical trials and the cost of running those trials. Many factors affect patient enrollment, including the size of the patient population, the proximity of patients to clinical sites, the eligibility criteria for the study, perceived risks and benefits of the drug under study, whether the drug will continue to be made available to the patient following completion of the trial, the success of our personnel in making the arrangements with potential clinical sites and other ongoing trials directed at the same indication. Any of these factors may make it difficult for us to enroll enough patients to complete trials.

Delays in patient enrollment will result in increased costs and program delays, which could slow down our product development and approval process. Even if the trials are ultimately completed and the product is approved for sale, a program delay could compromise the commercial viability of our drug relative to competitive therapies, which could materially harm our business and results of operations.

If we do not receive and maintain regulatory approvals, we will not be able to market our products.

The biotechnology and pharmaceutical industries are subject to stringent regulation with respect to product safety and efficacy by various international, federal, state and local authorities. Of particular significance are the FDA’s requirements covering R&D, testing, manufacturing, quality control, labeling and promotion of drugs for human use. A biotherapeutic cannot be marketed in the U.S. until it has been approved by the FDA, and then can only be marketed for the indications approved by the FDA. As a result of these requirements, the length of time, the level of expenditures and the laboratory and clinical information required for approval of a BLA, are substantial and can require a number of years.

Our collaboration partners have secured approval to market Xolair in 52 countries, including the U.S. and the European Union. There can be no assurance that Xolair will be approved for sale in other markets.

Tanox has not prepared or submitted any marketing approval applications to the FDA or any other regulatory agency for any of its products. The FDA can delay, limit or not grant marketing approval for our products for many reasons, including:

• their belief that a product candidate is not safe and effective;

• their interpretation of data from preclinical testing and clinical trials may be different than our interpretation;

• failure of our manufacturing processes or facilities to meet cGMP standards; and

• changes in approval policies and guidelines or adoption of new regulations.

The process of obtaining approvals to manufacture and market our products in foreign countries is subject to delay and failure for similar reasons.

Even if we or our collaboration partners secure marketing approval for a product, the approval may be conditioned, as is Xolair’s, on our successful completion of post-marketing clinical studies or may impose limitations on the indicated uses for which our products may be marketed. In addition, each marketed product

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and its manufacturer continue to be subject to strict conditions and regulation after approval. Any unforeseen problems with an approved product or any violation of regulations could result in restrictions on the product, including, for example, changes in its labeling, written notices to physicians or a product recall. An approval for a limited indication reduces the size of the potential market for the product.

Delays in receiving or failing to receive regulatory approvals, or losing previously received approvals to market Xolair, would delay or preclude product commercialization, which would adversely affect our business, financial condition and results of operations.

We are subject to the uncertainty related to reimbursement policies and healthcare reform measures.

In recent years, there has been legislation and numerous proposals to change the healthcare system in the U.S. Some of these measures limit or eliminate payments for medical procedures and treatments or subject pharmaceutical product pricing to government control. In addition, as a result of marketplace pressures, third-party payors are increasingly attempting to contain healthcare costs by limiting both coverage and the level of reimbursement of new drug products. Consequently, significant uncertainty exists as to the reimbursement status of newly approved healthcare products. If we succeed in bringing one or more of our products to market, we cannot assure you that third-party payors will consider them cost effective or allow reimbursement to the consumer at price levels sufficient for us to realize an appropriate return on our investment in product development or to even realize a profit.

Significant changes in the healthcare system in the U.S. or elsewhere, including changes resulting from adverse trends in third-party reimbursement programs, could materially reduce our potential profitability and harm our ability to raise the capital we would need to continue our operations. Furthermore, any decreases in third-party reimbursement may negatively affect our collaborators’ commercialization of Xolair, which would also adversely affect our business, financial condition and results of operations.

New accounting pronouncements or regulatory rulings may impact our future financial position or results of operations.

There may be new accounting pronouncements or regulatory rulings which may have an impact on our future financial position or results of operations. In December 2004, the Financial Accounting Standards Board (“FASB”) issued a revision of Statement of Financial Accounting Standards (or “FAS”) No. 123, “Accounting for Stock-Based Compensation.” The revision is referred to as “FAS 123R — Share-Based Payment” (or “FAS 123R”), which supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” (or “APB 25”) and will require companies to recognize compensation expense, using a fair-value based method, for costs related to share-based payments including stock options and stock issued under employee stock plans. Tanox adopted FAS 123R using the modified prospective basis on January 1, 2006. The adoption of FAS 123R is expected to result in compensation expense that will reduce diluted net income per share by approximately $0.08 to $0.12 per share for 2006. The actual 2006 stock compensation expense will dependent on the number of options granted, employee turnover and the volatility of our stock price.

Risks Relating to Our Industry, Business and Strategy

Our ability to become a profitable fully integrated biopharmaceutical company will depend on the continued commercial success of Xolair and on the success of our products in clinical development or our success in securing, developing and commercializing new clinical candidates.

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We anticipate that, in the near term, our ability to become profitable will depend in large part on the success of our collaboration partners in generating significant levels of sales of Xolair. In the longer term, an important part of our strategy is to become a fully integrated biopharmaceutical company. Our ability to do so will depend on the successful development, approval and commercialization of TNX-355, TNX-832, TNX-650, or of potential new clinical-stage drug candidates that we may develop or otherwise in-license or acquire.

All of our product candidates, other than TNX-355 TNX-832 and TNX-650, are in preclinical development or in research, and we do not expect to seek regulatory approval of these candidates for many years, if ever. A significant portion of the research that we are conducting involves new and unproven technologies. Research programs to identify new disease targets and product candidates require substantial technical, financial and human resources whether or not we ultimately identify any candidates. Our research programs may show promise initially in identifying potential product candidates, yet fail to yield product candidates for clinical development.

In addition, if we do not achieve the clinical endpoints in our clinical studies of TNX-355, TNX-832 and TNX-650, we may decide to terminate development of those products. Even if we reach our endpoints, the results of the trials may indicate that further development or commercialization of TNX-355, TNX-832 and TNX-650 would not be economically viable. In that event, we would need to in-license or acquire suitable product candidates or products from third parties, and we may not be able to so for a number of reasons. The licensing and acquisition of pharmaceutical products is highly competitive. A number of more established companies, including large pharmaceutical companies, are aggressively pursuing strategies to license or acquire products in the fields in which we are interested. These established companies have a competitive advantage over us due to their size, cash and other resources, and greater clinical development and commercialization capabilities and experience. Other factors that may prevent us from licensing or otherwise acquiring suitable product candidates include the following:

• we may be unable to license or acquire the relevant technology on terms that would allow us to make an appropriate return from the product;

• companies that perceive us to be their competitors may be unwilling to assign or license their product rights to us; or

• we may be unable to identify suitable products or product candidates within our areas of expertise.

Even if we are successful in developing and securing marketing approval of TNX-355, TNX-832, TNX-650 or other in-licensed or acquired product candidates, we may be unable to successfully launch, market or otherwise commercialize the product.

If we are unable to secure suitable potential product candidates through internal research programs or by acquiring drugs or drug candidates from third parties, or if we are unable to successfully develop, launch, market or commercialize the product(s), our goal of becoming a fully integrated biopharmaceutical company will not materialize, and our profit potential will be harmed.

Failure to secure future collaboration partners for our products or failure by those partners to develop, manufacture, market or distribute those products, or pay the royalties and other payments we expect, may delay or significantly impair our ability to generate revenues or profit.

We intend to rely on future collaboration partners to develop, manufacture, commercialize, market or distribute certain of our product candidates, both to allocate financial risk and to secure the expertise that those partners may have in one or more of the foregoing areas. Many of our competitors are similarly seeking to develop or expand their collaboration and license arrangements with pharmaceutical companies. The success of these efforts by our competitors could have an adverse impact on our ability to form future collaboration arrangements. Also, the pharmaceutical companies that we may target for one or more of our product candidates might require a profit return that is greater than what our product may be able to deliver. The process of establishing collaborative relationships is difficult and time consuming and involves significant uncertainty. We cannot assure you that we will be able to negotiate acceptable collaboration agreements in the future. To

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the extent that we are unable to enter into future collaboration agreements, we would encounter increased capital requirements to undertake research, development and marketing at our own expense, and, in some cases, may have to discontinue development of one or more products. Assuming we are able to continue to develop certain products on our own, we may experience significant delays in introducing our product candidates or find that the absence of these collaboration agreements adversely affects our ability to manufacture or sell our product candidates, particularly outside the U.S.

Even if we enter into future collaborative agreements, we cannot assure you that efforts under these agreements will succeed because:

• the contracts may fail to provide significant protection or may become unenforceable if the partners fail to perform;

• our partners may not commit enough capital or other resources to successfully develop, market or distribute our products;

• our partners may not continue to develop and commercialize products resulting from our collaborations; and

• disputes with our partners may arise that could delay or terminate our product candidates’ research, development or commercialization or result in significant litigation or arbitration.

If any of these contingencies occur, our revenues, results of operations, product development, productivity and business may suffer.

We face intense competition and rapid technological change that could result in products superior to the products we are developing.

The biotechnology and pharmaceutical industries are subject to rapid and significant technological change. We have numerous competitors in the U.S. and abroad, including, among others, major pharmaceutical and chemical companies, specialized biotechnology firms, universities and other research institutions. These competitors may develop technologies and products that are more effective or less costly than, or otherwise preferable to, any of our current or future products, and that could render our technologies and products obsolete or noncompetitive. Many of these competitors have substantially more resources and product development, production and marketing capabilities than we do. We cannot be certain that one or more companies will not receive patent protection that dominates, blocks or otherwise adversely affects our product development or business. In addition, many of our competitors have significantly greater experience than we do in undertaking preclinical testing and clinical trials of pharmaceutical products and obtaining FDA and other regulatory approvals of products. If we succeed in achieving commercial sales of our products, we also will be competing in commercial manufacturing efficiency and marketing capability, areas in which we have no experience. Our competitors may obtain FDA approval for products sooner or be more successful in manufacturing and marketing their products than are we or our collaborators.

Xolair competes, and our drug candidates that are successfully developed and approved for marketing will compete, with numerous existing therapies, as well as a significant number of drugs that are currently under development and will become available in the future for the treatment of allergic asthma, HIV and other diseases targeted by our product candidates. The introduction of new products or follow-on biologics or new information about existing products may result in lost market share or lower prices. Our collaborators’ abilities to successfully market Xolair or expand its usage and our ability to bring new products to the marketplace and successfully compete for market acceptance and market share among physicians, patients, healthcare payors and the medical community, will depend on many factors:

• relative efficacy and safety of our products;

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• timing and scope of regulatory approval;

• product availability;

• potential advantages over alternative treatment methods;

• development, marketing, distribution and manufacturing capabilities and support of our collaborators, if any;

• reimbursement coverage from Medicare/Medicaid, insurance companies and others;

• price and cost-effectiveness of our products;

• ability to produce drug candidates in commercial quantities at a reasonable cost;

• scope of patent protection for our products; and

• availability of licenses under third party technology and patent rights.

For instance, in mid-October 2005, Critical Therapeutics, Inc. launched Zyflo for the prevention and chronic treatment of asthma in patients 12 years of age and older. While not a direct competitor to Xolair, we understand that Critical Therapeutics’ marketing efforts are directed at the use of Zyflo prior to Xolair. We are also aware of other asthma therapies that may compete with Xolair.

If our products are not competitive based on the foregoing or other factors, our business, financial condition and results of operations will be materially harmed.

We may be unable to attract and retain key personnel and principal members of our scientific and management staff.

Our success depends greatly on our ability to attract and retain qualified scientific, manufacturing, clinical and other technical personnel, as well as to retain the services of our existing technical management staff. To pursue our research and development programs and product development plans, we will be required to hire additional qualified clinical, scientific, manufacturing, QA/QC and other technical personnel. There is intense competition for qualified staff, and we cannot assure you that we will be able to attract and retain the necessary qualified staff to develop our business. The failure to attract and retain these key personnel and management staff, or the loss of any of our current management team and our inability to replace him or her on a timely basis, could materially harm our business and financial condition.

We may be subject to product liability and other claims, and our insurance coverage may not be adequate to cover these claims.

Our business exposes us to potential product liability risks, which are inherent in testing, manufacturing, marketing and selling pharmaceutical products. We may be held liable if any product we develop, or any product that uses or incorporates any of our technologies, causes side effects, injury or is found otherwise unsuitable during clinical testing, manufacturing, marketing or sale. We cannot assure you that we will be able to avoid product liability exposure.

Product liability insurance for the biopharmaceutical industry is generally expensive. Although we currently maintain product liability insurance covering our products in amounts we believe to be commercially reasonable, we cannot assure you that our coverage is adequate or that continued coverage will be available at

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acceptable costs. In addition, some of our license and collaboration agreements require us to obtain product liability insurance. Future license and collaboration agreements may also include such a requirement. Our inability to obtain sufficient insurance coverage at an acceptable cost or otherwise to protect against potential product liability claims could prevent or inhibit us or our collaborators from commercializing our products. A successful claim in excess of our insurance coverage could materially harm our business, financial condition and results of operations. In addition, any such claim could materially reduce our future revenues from sales of those products.

Our insurance coverage may not be adequate to cover other claims and losses resulting from operating, manufacturing and business hazards, including natural disasters.

We deal with hazardous materials and must comply with environmental laws and regulations, which can be expensive and restrict how we do business.

Our research and development work and manufacturing processes involve the controlled use of hazardous materials, including chemical, radioactive and biological materials. Our operations also produce hazardous waste products. We are subject to federal, state and local laws and regulations governing how we use, manufacture, store, handle and dispose of these materials. Although we believe that we comply in all material respects with applicable environmental laws and regulations, we cannot assure you that we will not incur significant costs to comply with environmental laws and regulations in the future. In addition, current or future environmental laws and regulations may impair our research, development or production efforts.

We could be liable for damages, penalties or other forms of censure if we are involved in a hazardous waste spill or other accident.

Despite precautionary procedures that we implement for handling and disposing of hazardous materials, we cannot eliminate the risk of accidental contamination or discharge or any resultant injury from these materials. If a hazardous waste spill or other accident occurs, and we are held liable for damages, the liability could exceed our financial resources.

Risks Associated with Manufacturing and Marketing

Our revenues are dependent on the continued market acceptance and successful commercialization of Xolair.

Our results of operations and future prospects are highly dependent on increasing the sales of our only commercial product, Xolair. Our revenues consisted largely of revenue relating to sales of Xolair, and we expect that revenues from sales of Xolair and from payments based on the quantity of Xolair manufactured will constitute a larger percentage of our revenue in the next several years. Even though initial insurance and Medicare/Medicaid coverage of Xolair is encouraging, we cannot be certain that physicians, patients and payors will continue to widely accept Xolair as a treatment for its approved indication in the U.S. or in any foreign markets. A number of factors may affect the rate and level of Xolair’s ultimate market acceptance, including:

• the effectiveness of Novartis’ and Genentech’s sales and marketing efforts;

• the perception by physicians and other members of the healthcare community of Xolair’s safety, efficacy and benefits compared to those of competing products or therapies;

• the willingness of additional physicians to adopt a new asthma treatment regimen;

• Xolair’s price relative to other products or competing treatments;

• the availability of third-party reimbursement;

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• the ability to conduct the Xolair post marketing commitment studies and the impact of the study results on the labeling of Xolair;

• the ability to secure marketing approval for Xolair in Asia;

• regulatory developments related to manufacturing or using Xolair;

• the results of clinical development efforts for potential new indications for Xolair, and the scope and timing of additional marketing approvals and favorable reimbursement programs for any such expanded use;

• availability of sufficient quantities of Xolair for commercial and clinical purposes;

• increased competition for Xolair from new or existing products, which may demonstrate better safety, efficacy, cost-effectiveness or ease of administration than Xolair; and

• adverse side effects or unfavorable publicity concerning Xolair.

If the level of Xolair sales declines or fails to increase, our financial condition, results of operations and future potential would be significantly harmed.

We have limited experience in manufacturing, and manufacturing problems or delays could result in delayed clinical trials.

Manufacturing biopharmaceuticals is difficult and complex, and requires facilities specifically designed and validated for this purpose. It can take years to design, construct, validate, and license a new biopharmaceutical manufacturing facility.

To develop products, we require sufficient quantity and quality of manufactured product for clinical trials. Regulatory or technical manufacturing issues that we may encounter could delay clinical development of our products. Any failure to produce these clinical requirements, either as a result of our inability to produce in accordance with cGMP or due to inadequate manufacturing capacity, can delay the commencement or continuation of our clinical trials. We own a pilot manufacturing facility in Houston, Texas, and, in January 2005, we assumed the long-term lease on, and purchased manufacturing equipment with respect to, a manufacturing facility with two 2,750L bioreactors in San Diego, California. We secured the facility in San Diego with the intent of manufacturing clinical trial materials and potentially initial commercial launch products, and we have been working to re-commission the facility for the cGMP manufacture of Phase 3 supplies of TNX-355. The facility was built in 1992 and had been idled by Biogen Idec for at least a year prior to our acquisition. While we believe that the majority of the issues associated with the re-commissioning have been resolved, we may have problems that may delay or prevent us from manufacturing the clinical supplies of TNX-355 we need. If we are unable to manufacture the required supplies ourselves, we may have to pursue contract manufacturing, which would result in a significant delay and increase in cost of the development program.

Our own ability to manufacture products on a commercial scale is uncertain.

To commercialize our products successfully, we must manufacture our products in commercial quantities in compliance with regulatory requirements and at an acceptable cost. If the manufacturing facilities used to produce our products cannot pass pre-approval or periodic plant inspections, the FDA and other regulatory agencies may not approve our products for sale or may delay or bar their further sale. In order to obtain regulatory approvals and to create capacity to produce our products in sufficient quantities for commercial sale at an acceptable cost, we will have to develop or acquire additional technology for commercial

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scale manufacturing and build or otherwise obtain access to adequate facilities such as contract manufacturing organizations, which will require substantial additional funds. Third-party manufacturers of biopharmaceutical products often encounter difficulties in scaling up production, including problems involving production yields, quality control and assurance, shortage of qualified personnel, compliance with FDA regulations, production costs, demonstration of the ability to manufacture the product using controlled, reproducible processes, and development of advanced manufacturing techniques and process controls. To the extent we utilize contract manufacturers, we must rely on them to perform in accordance with the contract terms. Furthermore, because of the size of the dose of TNX-355 that may be required to see a therapeutic benefit, it may be difficult for us to find one or more contractors who have the expertise and facilities to produce bulk drug substance of TNX-355 in commercial quantities. We cannot assure you that we, operating alone or with the assistance of others, can develop the necessary manufacturing technology or that we will be able to fund or build an adequate commercial manufacturing facility necessary to obtain regulatory approvals and to produce adequate commercial supplies of our potential products on a timely basis.

We also must rely on third-party contract manufacturers to fill and finish and label and package our product for clinical trials. We cannot guarantee that we will be able to secure these services on a timely basis or that the services will be performed in a manner that passes our quality assurance standards. Any failure or delay by these third parties could delay our filing for an IND or impede the progress of a clinical trial and would increase our development costs.

Manufacturing changes may result in delays in obtaining regulatory approval or marketing for our products.

If we make any changes in the manufacturing process for our products and product candidates once we begin clinical development, we may be required to demonstrate to the FDA and corresponding foreign authorities that the changes have not caused the resulting drug material to differ significantly from the drug material previously produced. Any significant manufacturing changes for the production of our product candidates could result in delays in development or regulatory approval.

Changing the manufacturing site is considered to be a change in the manufacturing process; therefore, moving TNX-355 production to our San Diego manufacturing facility from our Houston pilot plant entailed manufacturing changes. In addition, we made other changes to the TNX-355 manufacturing process to increase cell-line yield. Accordingly, we will need to show that the drug material we produce in the San Diego manufacturing facility for future trials is sufficiently similar to the product that was used for the Phase 2 study in order to avoid delays in development or regulatory approval for this antibody product. If we are unable to demonstrate comparability between the material we produce before and after manufacturing changes, we may not be able to rely on the results of prior preclinical studies and clinical trials performed using the previously produced drug material. Depending upon the type and degree of differences between the newer and older drug material, we may be required to conduct additional animal studies or human clinical trials to demonstrate that the newly produced drug material is sufficiently similar to the previously produced drug material.

We may make manufacturing changes for the production of TNX-832, our other product currently in clinical development, as well as future product candidates. An inability to show comparability between the older material and the newer material after making manufacturing changes could result in significant delays in development or regulatory approvals of our product candidates.

We lack sales and marketing experience, and we depend on third parties for their expertise in this area.

Under the terms of our collaboration agreements, Novartis and Genentech have exclusive marketing rights to Xolair and other collaboration anti-IgE products, and the revenues we receive from Xolair will depend primarily on the marketing and sales efforts of our collaboration partners. However, commercialization rights may revert back to us if our collaborators terminate our relationship. Furthermore, we may retain marketing rights, particularly in the U.S. and selected Asian countries, for other potential products that we can develop and sell effectively with a small, targeted sales force. We have not yet commercialized any of our internal or in-licensed product candidates, and we currently have no sales, marketing or distribution capabilities. Our

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commercialization of products that may be approved for marketing is subject to several risks, including but not limited to: difficulties in manufacturing the product on a large scale; difficulties in planning, coordinating and executing the commercial launch of the product; difficulties in marketing, distribution or sale of the product; competition from superior products; or third party patents that may preclude us from marketing the product.

If Xolair marketing rights revert to us or if we elect to market other products directly, we would require significant additional management expertise and have to make significant additional expenditures to develop an internal marketing function and a sales force. We cannot assure you that we would be able to establish a successful marketing and sales force should we choose to do so. If we are unsuccessful in hiring and retaining sales and marketing personnel with appropriate technical and sales expertise or in developing an adequate distributions capability to support them, our ability to generate product revenues will be adversely affected. To the extent we cannot or choose not to use internal resources for the marketing, sales or distribution of any potential products in the U.S. or elsewhere, we intend to rely on collaboration partners or licensees. We may not be able to establish or maintain such relationships or, if we are able to establish them, we will depend upon their efforts, which may not be successful.

Risks Related to Financial Results and Need for Financing

We have a history of net losses; we expect to continue to incur net losses and we may never achieve or maintain profitability.

We have incurred net losses since our inception. As of September 30, 2006, we had an accumulated deficit of approximately $120.3 million, including a net loss of $7.1 million for the nine months ended September 30, 2006. Our losses primarily have been the result of costs incurred in our research and development programs and from our general and administrative costs.

We have funded our operations to date principally from licensing fees, royalties, profit-sharing, milestone and manufacturing-rights payments under our current or former collaborations, as well as with proceeds from private placements and an initial public offering of our common stock. We expect to continue to incur substantial operating losses until such time, if ever, that we are able to generate sufficient revenue from royalties, profit sharing, and manufacturing rights from Xolair and, potentially, revenues from an additional product or products to cover our expenses. Our revenues may be reduced by adjustments and changes in amounts paid to us and amounts we may be required to pay to third parties.

Our ability to achieve and maintain long-term profitability depends to a significant extent on the continued successful commercialization of Xolair. It will also depend on our successfully completing preclinical and clinical trials, obtaining required regulatory approvals and successfully manufacturing and marketing our other current and future product candidates. We cannot assure you that we will be able to achieve any of the foregoing or that we will be profitable even if we successfully commercialize our products.

The market price of our common stock has been volatile.

Like other stocks of biopharmaceutical companies, the market price for our common stock has been and may continue to be volatile. Since January 1, 2004, our stock price ranged from $9.39 to $20.66. Factors that may have contributed to the volatility of our stock during this period included:

• Reported sales volume of Xolair;

• Results of clinical trials; and

• General market conditions, including particularly the biotechnology company segment.

Other factors that may have a significant impact on the market price of our common Stock include:

• Announcements of technological innovations by us or our competitors;

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• Publicity regarding actual or potential medical results relating to Xolair or products being developed by us;

• Potential litigation or material contracts to which we may be a party;

• Regulatory developments or delays concerning our products; and

• Issues concerning the safety or commercial viability of our products.

Failure by Novartis or Genentech to develop, manufacture, market or distribute Xolair would impair our ability to generate revenues.

Under the terms of our collaboration agreements, Novartis and Genentech are generally responsible for conducting clinical trials on, obtaining regulatory approval for, and manufacturing, marketing and distributing Xolair. As a result, our ability to profit from Xolair and any other anti-IgE products covered by our collaboration agreements with Genentech and Novartis depends in large part on their performance. We cannot control the amount and timing of resources Novartis and Genentech will devote to any of our products. If Novartis or Genentech experiences manufacturing or distribution difficulties, does not actively market Xolair or other partnered anti-IgE products or does not otherwise perform under our collaboration agreements, our potential for revenue from these products will be dramatically reduced. Novartis and Genentech may terminate our collaboration agreements, and, in that event, we would experience increased capital requirements to undertake development and marketing at our expense. We cannot assure you that we would be able to manufacture, market and distribute Xolair on our own.

We may need additional financing, but our access to capital funding is uncertain, and issuance of additional common stock could dilute existing stockholders.

Our current and anticipated development projects require substantial additional capital. While we expect that our cash on hand, together with our revenue from Xolair, will fund our existing operations for the next four years, our future cash needs will depend on many factors, including the commercial success of Xolair, receiving royalty, profit-sharing, milestone and manufacturing-rights payments from our collaboration partners, making progress in our clinical development of TNX-355, TNX-832, TNX-650 and in our preclinical efforts, other research and development activities, and entering into additional collaboration agreements. Our capital requirements may also depend on the progress and level of costs associated with preclinical studies and clinical trials, the costs associated with acquisitions of new product candidates by licensing or otherwise, the costs of preparing, filing, prosecuting, maintaining and enforcing patent claims and other intellectual property rights, competing technological and market developments, changes in or terminations of existing collaboration and licensing arrangements and the cost of manufacturing scale-up and development of marketing activities, if undertaken by us. We do not have committed external sources of funding and we cannot assure you that we will be able to obtain additional funds on acceptable terms, if at all. If adequate funds are not available, we may be required to:

• delay, reduce the scope of or eliminate one or more of our development programs;

• obtain funds through arrangements with collaboration partners or others that may require us to relinquish rights to technologies, product candidates or products that we would otherwise seek to develop or commercialize ourselves; or

• license rights to technologies, product candidates or products on terms that are less favorable to us than might otherwise be available.

We may raise additional funds by issuing shares of our stock, which would cause dilution to our stockholders and may adversely affect the market price of our common stock. New investors could have rights superior to existing stockholders. If funding is insufficient at any time in the future, we may be unable to develop or commercialize our products, take advantage of business opportunities or respond to competitive pressures, and our business and financial condition may be harmed.

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Risks Relating to Intellectual Property

The patentability, validity, enforceability and commercial value of our patents are highly uncertain. If our intellectual property positions are challenged, invalidated or circumvented and we fail to prevail in resulting intellectual property litigation, our business could be adversely affected.

Our success depends in part on obtaining, maintaining and enforcing patents and maintaining trade secrets. While we file and prosecute patent applications to protect our inventions, our pending patent applications may not result in the issuance of valid patents and our issued patents may not provide competitive advantages. Also, our patents may not prevent others from developing competitive products using related or the same technology. We cannot assure you that pending patent applications developed by or licensed to us will result in patents being issued or that, if issued, the patents will give us an advantage over competitors with similar technology.

We own or have licenses to certain issued patents. The patents we own that are most material to our business are five U.S. patents and six foreign patents relating to anti-IgE antibodies. However, the patent position of biotechnology and pharmaceutical firms is highly uncertain and involves many complex legal and technical issues. There is no clear policy involving the breadth of claims allowed or the degree of protection afforded under such patents. Issued patents can be challenged in litigation in the courts and in proceedings in the United States Patent and Trademark Office and in courts and patent offices in foreign countries. Issuance of a patent is not conclusive as to its validity, enforceability or the scope of its claim. We cannot assure you that our patents will not be successfully challenged as to enforceability, invalidated or limited in the scope of their coverage. Moreover, litigation to uphold the validity of patents and to prevent infringement can be very costly and can result in diverting technical and management personnel’s time and attention, which may materially harm our business, financial condition and results of operations. If the outcome of litigation is adverse to us, third parties may be able to use our patented technology without paying us. Moreover, we cannot assure you that our patents will not be infringed or successfully avoided through design innovation. Any of these events may materially and adversely affect our business.

In addition to the intellectual property rights described above, we also rely on unpatented technology, trade secrets and confidential information. We cannot assure you that others will not independently develop substantially equivalent information and techniques or otherwise gain access to our technology or disclose such technology, or that we can effectively protect our rights in unpatented technology, trade secrets and confidential information. We require each of our employees, consultants and advisors to execute a confidentiality agreement at the commencement of an employment or consulting relationship with us. We cannot assure you, however, that these agreements will provide effective protection if an unauthorized use or disclosure of this confidential information occurs.

If we fail to obtain any required patent license from third parties, our product development efforts could be limited.

Our commercial success depends on our ability to operate without infringing the patents and other proprietary rights of third parties. Other companies, some of which may be our competitors, have filed applications for or have been issued patents, and may obtain additional patents and proprietary rights, relating to products or processes used in, necessary to, or otherwise related to our products and product candidates.

For example, we are aware of broad patents owned by others relating to the manufacture, use and sale of recombinant humanized antibodies. Many of our product candidates are genetically engineered recombinant humanized antibodies. If our antibody products or their commercial use or production meet all of the requirements of any of the claims of the aforementioned patents, or other third party patents or patent applications, then we may need a license to one or more of these patents. We expect to seek to obtain patent licenses when, in our judgment, such licenses are needed. Even if we determine that a license is not necessary,

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a patent holder could disagree and sue us for damages and seek to prevent us from manufacturing, selling or developing our products. Legal disputes can be costly and time consuming to defend. If any patent holder successfully challenges our judgment that our products do not infringe their patents or that their patents are invalid, we could be required to pay costly damages or to obtain a license to sell or develop our drugs. If we determine that a license is required, there can be no assurance that we will be able to obtain the license on commercially reasonable terms, if at all. If we are unable to secure a required license, we might be prevented from using certain of our technologies for the generation and manufacture of our recombinant antibody products or from pursuing product development, manufacturing or commercialization in a particular field, and this may materially harm our business and financial prospects.

In addition to patents, we rely on trade secrets and proprietary know-how. We seek protection in part through confidentiality agreements. We cannot assure you, however, that these agreements will provide meaningful protection of our proprietary information or trade secrets in the event of an unauthorized use or disclosure or that our valuable trade secrets will not become known to, or independently developed, by our competitors.

Item 6. Exhibits

(a) Exhibits.

10.1	Employment Agreement between Tanox, Inc. and Danong Chen, Chief Executive Officer, dated September 8, 2006.
10.2	Employment Agreement between Tanox, Inc. and Nancy T. Chang, Phd., dated September 12, 2006.
10.3	Form of Agreement Regarding Change of Control or Separation of Service dated September 8, 2006 (entered into between Tanox Inc. and each of Edward Hu, Senior Vice President and Chief Operating Officer; Zhengbin Yao, Vice President – Research; Gregory Guidroz, Vice President – Finance; Katie-Pat Bowman, Vice President and General Counsel; Brian Kim, Vice President – Quality; and Hugo Santos, Vice President – Human Resources).
31.1	Certification of Principal Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Principal Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32	Certification of Principal Executive Officer and Principal Financial Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted 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 Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned thereunto duly authorized.

	TANOX, INC.
Date: November 8, 2006	By:	/s/ Danong Chen
		Danong Chen
		President and Chief Executive Officer
Date: November 8, 2006	By:	/s/ Gregory P. Guidroz
		Gregory P. Guidroz
		Vice President of Finance

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EXHIBIT INDEX

Exhibit Number	Description of Document
10.1	Employment Agreement between Tanox, Inc. and Danong Chen, Chief Executive Officer, dated September 8, 2006.
10.2	Employment Agreement between Tanox, Inc. and Nancy T. Chang, Phd., dated September 12, 2006.
10.3	Form of Agreement Regarding Change of Control or Separation of Service dated September 8, 2006 (entered into between Tanox Inc. and each of Edward Hu, Senior Vice President and Chief Operating Officer; Zhengbin Yao, Vice President – Research; Gregory Guidroz, Vice President – Finance; Katie-Pat Bowman, Vice President and General Counsel; Brian Kim, Vice President – Quality; and Hugo Santos, Vice President – Human Resources).
31.1	Certification of Principal Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Principal Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32	Certification of Principal Executive Officer and Principal Financial Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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