Ontrak (OTRK) 10-Q 2005 Q3 Quarterly report

United States SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For The Quarterly Period EndedSeptember 30, 2005

Commission File Number 001-31932

HYTHIAM, INC.

(Exact name of registrant as specified in its charter)

Delaware	88-0464853
(State or other jurisdiction of incorporation)	(I.R.S. Employer Identification Number)

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

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

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

Yesþ Noo

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yeso Noþ

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

Yeso Noþ

As of November 14, 2005, there were 38,278,758 shares of registrant’s common stock, $0.0001 par value, outstanding.

INDEX

			Page
PART I. FINANCIAL INFORMATION
	Item 1.	Financial Statements:
		Condensed Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004		3
		Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2005 and 2004, and the Period from February 13, 2003 (Inception) to September 30, 2005		4
		Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2005 and 2004, and the Period from February 13, 2003 (Inception) to September 30, 2005		5
		Notes to Condensed Consolidated Financial Statements		6
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		10
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk		15
	Item 4.	Controls and Procedures		15
PART II. OTHER INFORMATION
	Item 1.	Legal Proceedings	II-1
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	II-1
	Item 3.	Defaults Upon Senior Securities	II-1
	Item 4.	Submission of Matters to a Vote of Security Holders	II-1
	Item 5.	Other Information	II-1
	Item 6.	Exhibits	II-2
Signatures			II-3
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1
Exhibit 32.2

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PART I — FINANCIAL INFORMATION

ITEM 1. Financial Statements

HYTHIAM, INC. AND SUBSIDIARIES
(a Development Stage Company)

CONDENSED CONSOLIDATED BALANCE SHEETS

	September 30,			December 31,
(Dollars in thousands, except share data)	2005			2004
ASSETS
Current assets
Cash and cash equivalents	$	3,450		$	4,000
Marketable securities		10,513			23,479
Restricted cash and marketable securities		65			—
Receivables, net		299			168
Prepaids and other current assets		560			446
Total current assets		14,887			28,093
Long-term assets
Property and equipment, less accumulated depreciation of $975 and $516, respectively		2,872			2,424
Intellectual property, less accumulated amortiation of $379 and $219, respectively		3,072			3,080
Deposits and other assets		779			365
	$	21,610		$	33,962
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable	$	2,239		$	609
Accrued compensation and benefits		787			826
Other accrued liabilities		182			329
Total current liabilities		3,208			1,764
Long-term liabilities
Deferred rent liability		497			364
Commitments and contingencies
Stockholders’ equity
Preferred stock, $ par value; 50,000,000 shares authorized; no shares issued and outstanding		—			—
Common stock, $ par value; 200,000,000 shares authorized; 30,271,000 and 30,111,000 shares issued and 29,911,000 and 29,751,000 shares outstanding at September 30, 2005 and December 31, 2004, respectively		3			3
Additional paid-in-capital		48,920			47,234
Deficit accumulated during the development stage		(31,018	)		(15,403	)
		17,905			31,834
	$	21,610		$	33,962

See accompanying notes to financial statements.

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HYTHIAM, INC. AND SUBSIDIARIES
(a Development Stage Company)

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

													Period from
													February 13,
	Three Months Ended						Nine Months Ended						2003 (Inception)
	September 30,						September 30,						to September 30,
(In thousands, except per share amounts)	2005			2004			2005			2004			2005
Revenues	$	361		$	41		$	794		$	113		$	1,061
Operating Expenses
Salaries and benefits		2,452			1,308			6,323			3,994			13,057
Other operating expenses		4,444			1,593			9,948			4,274			18,226
Depreciation and amortization		221			159			625			456			1,370
Total operating expenses		7,117			3,060			16,896			8,724			32,653
Loss from operations		(6,756	)		(3,019	)		(16,102	)		(8,611	)		(31,592	)
Interest income		152			39			487			116			699
Loss before provision for income taxes		(6,604	)		(2,980	)		(15,615	)		(8,495	)		(30,893	)
Provision for income taxes		—			—			—			2			1
Net loss	$	(6,604	)	$	(2,980	)	$	(15,615	)	$	(8,497	)	$	(30,894	)
Basic and diluted net loss per share	$	(0.22	)	$	(0.12	)	$	(0.52	)	$	(0.35	)

See accompanying notes to financial statements.

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Hythiam, Inc. and Subsidiaries
(a Development Stage Company)

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

							Period from
	Nine Months Ended						February 13, 2003
	September 30,						(Inception) to
(In thousands)	2005			2004			September 30, 2005
Operating activities
Net loss	$	(15,615	)	$	(8,497	)	$	(30,894	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		625			456			1,370
Provision for bad debt		10			—			10
Loss on disposition of fixed assets		20			—			20
Deferred rent liability amortization		32			22			79
Share-based expense		1,648			682			3,165
Changes in current assets and liabilities:
Receivables		(69	)		99			(237	)
Prepaids and other current assets		(279	)		(48	)		(527	)
Accounts payable		1,393			(819	)		2,002
Accrued compensation and benefits		(39	)		566			787
Other accrued liabilities		(147	)		(245	)		182
Net cash used in operating activities		(12,421	)		(7,784	)		(24,043	)
Investing activities
Purchases of marketable securities		(8,091	)		(10,819	)		(58,245	)
Proceeds from sales and maturities of marketable securities		21,414			16,000			48,089
Purchases of property and equipment		(699	)		(378	)		(3,648	)
Deposits made on property and equipment		(143	)		—			(143	)
Reimbursement received on tenant improvement costs		30			301			331
Deposit made on intellectual property amendment		—			(75	)		—
Proceeds from maturity of deposit as collateral for letter of credit		355			352			707
Cash deposited as collateral		(802	)		(350	)		(1,502	)
Cost of intellectual property		(137	)		(3	)		(801	)
Increase in restricted cash and marketable securities		(65	)		—			(65	)
Net cash provided by (used in) investing activities		11,862			5,028			(15,277	)
Financing activities
Net proceeds from sales of common and preferred stock and warrants		—			—			42,694
Costs incurred on equity financing activities		(194	)		—			(194	)
Proceeds from exercise of warrants		203			36			270
Net cash provided by financing activities		9			36			42,770
Net (decrease) increase in cash and cash equivalents		(550	)		(2,720	)		3,450
Cash and cash equivalents at beginning of period		4,000			3,444			—
Cash and cash equivalents at end of period	$	3,450		$	724		$	3,450
Supplemental disclosure of cash paid
Income taxes	$	—		$	3		$	3
Supplemental disclosure of non-cash activity
Common stock and warrants issued for intellectual property	$	—		$	—		$	2,634
Common stock, options and warrants issued for outside services		230			86			1,720
Common stock and warrants issued as commissions on private placement		—			—			265

See accompanying notes to financial statements.

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Hythiam, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

Note 1. Basis of Presentation

     The accompanying unaudited interim condensed consolidated financial statements for Hythiam, Inc. and its subsidiaries have been prepared in accordance with the Securities and Exchange Commission (“SEC”) rules for interim financial information and do not include all information and notes required for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Interim results are not necessarily indicative of the results that may be expected for the entire fiscal year. The accompanying financial information should be read in conjunction with the financial statements and the notes thereto in our most recent Annual Report on Form 10-K. The December 31, 2004 balance sheet has been derived from the audited financial statements on Form 10-K. Certain reclassifications have been made to the prior years’ condensed consolidated financial statements to conform to classifications used in the current year. All share data has been restated to reflect stock splits.

     We are considered a development stage company since most of our efforts to date have been devoted to raising capital, recruiting management and developing markets, and revenues earned to date from operations have not been significant.

Note 2. Cash Equivalents and Marketable Securities

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

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

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

Note 3. Basic and Diluted Loss per Share

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

     Common equivalent shares, consisting of 6,906,000 and 6,243,000 of incremental common shares as of September 30, 2005 and 2004, respectively, issuable upon the exercise of stock options and warrants have been excluded from the diluted earnings per share calculation because their effect is anti-dilutive.

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     A summary of the net loss and shares used to compute net loss per share is as follows (in thousands, except per share data):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2005			2004			2005			2004
Net loss	$	(6,604	)	$	(2,980	)	$	(15,615	)	$	(8,497	)
Basic and diluted loss per share	$	(0.22	)	$	(0.12	)	$	(0.52	)	$	(0.35	)
Weighted average common shares used to compute basic and diluted loss per share		29,867			24,624			29,806			24,617

Note 4. Share-Based Compensation

Stock options

     Under our 2003 Stock Incentive Plan, we have granted options to employees and directors as well as to non-employees for outside consulting services.

     We account for the issuance of employee stock options using the intrinsic value method under Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” Had we determined compensation cost based on the fair value at the grant date for our employee stock options under SFAS 123, “Accounting for Stock-Based Compensation,” the pro forma effect on net loss and net loss per share would have been as follows (in thousands, except per share data):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2005			2004			2005			2004
Net loss, as reported	$	(6,604	)	$	(2,980	)	$	(15,615	)	$	(8,497	)
Less: Share-based expense determined under fair value based method		(256	)		(143	)		(624	)		(380	)
Pro forma net loss	$	(6,860	)	$	(3,123	)	$	(16,239	)	$	(8,877	)
Net loss per share
As reported — basic and diluted	$	(0.22	)	$	(0.12	)	$	(0.52	)	$	(0.35	)
Pro forma — basic and diluted	$	(0.23	)	$	(0.13	)	$	(0.54	)	$	(0.36	)

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     The fair value of the options was estimated at the date of grant using the Black-Scholes pricing model with the following weighted average assumptions for the three and nine months ended September 30, 2005 and 2004:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2005			2004			2005			2004
Expected volatility		63	%		61	%		63	%		61	%
Risk-free interest rate		4.17	%		4.48	%		4.18	%		4.24	%
Weighted average expected lives in years		10			10			10			10
Expected dividend yield		0	%		0	%		0	%		0	%

     During the three and nine months ended September 30, 2005 and the three and nine months ended September 30, 2004, we granted options for 397,000, 1,317,000, 652,000 and 1,220,000 shares, respectively, to employees and directors at the weighted average per share exercise price of $5.86, $6.49, $2.80 and $4.24, respectively, the fair market values at the dates of grant. Subsequently, in October 2005 we granted options for 50,000 shares to a consultant at $5.40 per share, the fair market value at date of grant.

     As of September 30, 2005, options for 445,000, shares granted to consultants and directors accounted for under SFAS 123 were outstanding. These options vest over periods ranging from three to four years and are being charged to expense as services are provided using the variable accounting method. Non-vested options have an estimated fair value of approximately $938,000, as of September 30, 2005, using the Black-Scholes pricing model.

     During the three and nine months ended September 30, 2005 and 2004, share-based expense relating to stock options amounted to $272,000, $1.2 million, $320,000 and $320,000, respectively.

Warrants

     We account for the issuance of warrants for services from non-employees in accordance with SFAS 123, by estimating the fair value of warrants issued using the Black-Scholes pricing model.

     If warrants issued as compensation to non-employees for services are fully vested and non-forfeitable at the time of issuance, the estimated value is recorded in equity and expensed when the services are performed and benefit is received as provided by Financial Accounting Standards Board Emerging Issues Task Force No. 96-18. If warrants are issued for consideration in an acquisition of assets, the value of the warrants are recorded in equity at the time of issuance and included in the purchase price to be allocated.

     During the nine months ended September 30, 2005, we issued a warrant to purchase 25,000 shares of common stock at $5.72 per share to a management advisor for investor relations services. The warrant vested immediately and expires three years from date of grant. We also issued warrants to purchase 20,000 shares of common stock to a management consultant, of which a warrant for 10,000 shares was issued at $2.80 per share, with immediate vesting and expires in 2014, and a warrant for the remaining 10,000 shares was issued at $5.80 per share, with immediate vesting and expires in 2006. The total estimated fair value of warrants issued in the nine months ended September 30, 2005 is approximately $104,000 using the Black-Scholes pricing model.

     During the three and nine months ended September 30, 2005 and 2004, share-based expense relating to warrants amounted to $48,000, $336,000, $40,000 and $287,000, respectively.

Common Stock

     In March 2005 we issued 11,700 shares of common stock and in July 2005 we issued an additional 11,700 shares of common stock to a consultant providing investor relation services. The common stock, which is being amortized to expense on a straight-line basis over a 12 month service period, was valued at $65,000 and $69,000, respectively, the fair market values at the dates of grant.

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     Share-based expense relating to stock issued for outside services was $35,000, $99,000, $11,000 and $76,000, for the three and nine months ended September 30, 2005 and 2004, respectively.

Note 5. Recent Accounting Pronouncements

     In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS 123(R), “Share-Based Payment,” which addresses the accounting for employee stock options. SFAS 123(R) revises the disclosure provisions of SFAS 123 and supersedes APB 25. SFAS 123(R) requires that the cost of all employee stock options, as well as other equity-based compensation arrangements, be reflected in the financial statements based on the estimated fair value of the awards. In March 2005, the Securities & Exchange Commission (the “SEC”) issued Staff Accounting Bulletin No. 107, “Share-Based Payment”, which summarizes the views of the SEC staff regarding the interaction between SFAS 123(R) and certain SEC rules and regulations, and is intended to assist in the initial implementation. SFAS 123(R) is effective for all public companies that file as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. However, in April 2005, the SEC announced that it would permit companies to implement this statement at the beginning of their next fiscal year. We are currently evaluating the provisions of SFAS 123(R) and its effect on our financial statements. The effect of adopting this statement will be to increase our compensation expense in the future.

     In December 2004, the FASB issued SFAS 153, “Exchanges of Nonmonetary Assets, an amendment of APB 29, Accounting for Nonmonetary Transactions.” This Statement’s amendments are based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. Further, SFAS 153 eliminates the narrow exception for nonmonetary exchanges of similar productive assets and replaces it with a broader exception for exchanges of nonmonetary assets that do not have commercial substance. Provisions of this statement are effective for fiscal periods beginning after June 15, 2005. We do not expect the adoption of this statement to have a material impact on our financial statements.

     In March 2005, the FASB issued FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (“FIN 47”), which is an interpretation of SFAS 143, “Accounting for Asset Retirement Obligations.” FIN47 clarifies terminology within SFAS 143 and requires an entity to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. FIN 47 is effective for fiscal years ending after December 15, 2005. We do not expect the adoption of this statement to have a material impact on our financial statements.

     In May 2005, the FASB issued SFAS 154, “Accounting Changes and Error Corrections.” SFAS 154 replaces APB 20, “Accounting Changes” and SFAS 3, “Reporting Accounting Changes in Interim Financial Statements” and establishes retrospective application as the required method for reporting a change in accounting principle. SFAS 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The reporting of a correction of an error by restating previously issued financial statements is also addressed. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We do not expect the adoption of this statement to have a material impact on our financial statements.

Note 6. Subsequent Event

     On November 8, 2005 we completed the sale of 8.0 million shares in an underwritten follow-on offering of our common stock at a public offering price of $4.75 per share. We received approximately $35 million in net proceeds from the offering, after underwriting discounts, commissions and transaction costs. In addition, we granted the underwriters a 30-day option to purchase up to 1.2 million additional shares of common stock to cover over-allotments, if any.

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

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

Forward-Looking Statements

     The forward-looking comments contained in this report involve risks and uncertainties. Our actual results may differ materially from those discussed here due to factors such as, among others, limited operating history, difficulty in developing, exploiting and protecting proprietary technologies, intense competition and substantial regulation in the healthcare industry. Additional factors that could cause or contribute to such differences can be found in the following discussion, as well as in the “Risks Factors” set forth in Item 1 of Part I of our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 2005.

Overview

     Hythiam, Inc. is a healthcare services management company, focused on delivering alcohol and drug dependence solutions. We research, develop, license and commercialize innovative physiological treatment protocols designed for use by healthcare providers seeking to treat individuals diagnosed with dependencies to alcohol, cocaine and methamphetamine, as well as combinations of these drugs. Unlike traditional treatment methodologies, our proprietary PROMETA™ treatment protocols include medically supervised treatments designed to address both the neurochemical imbalances in the brain and some of the nutritional deficits caused or worsened by substance dependence. Changes in brain chemistry and function play an important role in the physical and behavioral symptoms of substance dependence, including tolerance, withdrawal symptoms, craving and relapse. PROMETA represents an innovative approach to managing substance dependence that is designed to address physiological, nutritional and psychosocial aspects of the disease, and is thereby intended to offer patients an opportunity to achieve sustained recovery.

     We generate revenues by charging fees to licensed healthcare providers for access to our proprietary protocols for use in treating their patients. We also provide administrative services to assist physicians and facilities with staff education, marketing and sales support, and outcomes tracking for data analysis.

     In the first nine months of 2005, we entered into 16 new licensing agreements, bringing the total number of licensees to 23 at September 30, 2005. In the same period 152 patients were treated using our Prometa protocols. We expanded our corporate office space during the second quarter to accommodate our increasing staff and have leased and are building out medical office space that will be occupied by a medical group to which we have agreed to provide turn-key business management services and a license to use our protocol beginning in the fourth quarter of this year, in exchange for management and licensing fees.

     In the first nine months of 2005, we have announced a number of clinical studies by preeminent researchers in the field of substance dependence, and we are currently in the process of awarding additional grants to investigators to test the efficacy of the Prometa protocol through the conduct of double-blind, placebo controlled studies as well as open label studies for alcohol and methamphetamine dependence. We have also announced that a drug court in Indiana will evaluate the use of the Prometa protocols for drug court participants in a pilot endorsed by the National Association of Drug Court Professionals.

     We established several wholly-owned foreign subsidiaries for the purpose of licensing our intellectual property in foreign markets, and entered into an agreement to acquire protocols for the treatment of nicotine and drug dependence in Europe. Although we have not commenced any significant foreign operations to date, we are planning to open several clinics in Europe for the treatment of smoking cessation in the fourth quarter of 2005.

Results of Operations

     We have a limited history of operations, have not yet commenced substantial marketing activities, and have not generated significant revenues from operations. Our revenues are generated from fees that we charge to hospitals, healthcare facilities and other healthcare providers that license our Prometa protocols. Our license agreements provide for a fee for the licensed technology and related services, set on a per-patient basis, and thus our revenues are generally related to the number of patients treated. Key indicators of our financial performance will be the number of facilities

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and healthcare providers that contract with us to license our technology and the number of patients that are treated by those providers using our Prometa protocols. We believe that the number of patients treated by our licensees will increase over time as our marketing, advertising and branding activities are implemented and clinical outcomes data from research studies become available.

Revenues

     Our revenues for the three and nine month periods ended September 30, 2005 were $361,000 and $794,000, respectively, compared to $41,000 and $113,000 in the comparable periods last year. The increase in revenues was driven by licensing fees earned from healthcare sites which completed treatment of a total of 72 and 152 patients for the three and nine months. By the end of the third quarter of 2005, there were 11 operational licensee sites contributing to revenues at some level, compared to just one operational site in the same period last year. In the third quarter of 2005, we entered into five new licensing agreements with hospitals and healthcare providers, bringing the total number of licensees to 23 at September 30, 2005. During the first nine months of 2005, 152 patients were treated using our Prometa protocols, compared to 25 patients in the same period last year. As we look forward to the fourth quarter, we now have 25 contracted licensees, of which 15 to 20 should be operational and contributing towards revenues by the end of the quarter. As we deploy our new Prometa brand identity and accelerate local marketing activity, we should see a continued increase in patient traffic toward the end of this calendar year and into 2006. However, until each of the licensed treatment centers becomes fully operational and local marketing programs are in place to increase public awareness, we do not expect a significant increase in patient activity in the fourth quarter of 2005. Thus far, new sites have typically started generating revenues after an initial four to six-month training and start-up period following contract signing. Pre-operational site initiation activities include the hiring and training of a local site manager, the education and training of the licensee physicians and staff in the Prometa protocols, the development of a local marketing plan and the mutual approval by both parties in the implementation plan for site launch.

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

Expenses

     We have devoted a substantial portion of our financial resources to the payment of salaries and benefits, legal and professional services, and other general and administrative expenses during our start-up period.

     Our operating expenses during the three and nine month periods ended September 30, 2005 were $7.1 million and $16.9 million, respectively, compared to $3.1 million and $8.7 million, respectively, for the same periods last year. The increase in operating expenses in 2005 over 2004 reflects the continued development of our company and the execution of our business plan, including a national and international expansion strategy, hiring of key management personnel, investing in clinical research and the marketing of our Prometa protocols.

     Salaries and benefits expenses were $2.5 million and $6.3 million for the three and nine month periods ended September 30, 2005, compared to $1.3 million and $4.0 million for the same periods in 2004. The increase for both periods was due to increased staffing to serve our growing number of licensees as well as the strengthening of our executive management team to implement our business plan.

     In the three and nine month periods ended September 30, 2005, our other operating expenses were $4.4 million and $9.9 million, respectively, versus $1.6 million and $4.3 million, respectively, last year, including non-cash charges of $355,000, $1.6 million, $371,000 and $682,000, respectively, relating to share-based expense. Other operating expenses payable in cash for the three and nine months ended September 30, 2005 were $4.1 million and $8.3 million, respectively, compared to $1.2 million and $3.6 million, respectively, for the same periods last year. Major components of our other operating expenses include legal, audit, insurance, travel and entertainment, rent, investor and public relations, clinical research, marketing, and other professional consulting costs. The increases in 2005 over the comparable periods in 2004 in most expense categories are generally proportionate to the overall increase in staffing and infrastructure of our company, with additional spending in 2005 for clinical research studies, legal and consulting costs for international expansion, accounting and consulting costs for Sarbanes-Oxley compliance and new marketing and business development activities.

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     As of September 30, 2005, we have substantially completed the hiring of our senior management team and a substantial portion of our corporate management and supporting staff. As we enter into new licensing agreements, we will continue to hire additional site managers and supporting operational staff. Accordingly, our salaries, benefits and travel related expenses will continue to increase with the growth in our business. Additionally, we are planning to significantly increase our marketing efforts in the fourth quarter of 2005 to provide for local marketing and advertising as well as brand awareness on both a local and national level. We will also allocate up to $1.5 million in the fourth quarter of 2005 towards clinical studies and our patient outcomes registry.

Research Studies and Pilot Programs

     We have announced a number of clinical studies by preeminent researchers in the field of substance dependence, and we are currently in the process of awarding additional grants to investigators to test the efficacy of the Prometa protocol through the conduct of double-blind, placebo controlled studies as well as open label studies for alcohol and methamphetamine dependence. In the second quarter, we signed two contracts with independent researchers to provide unrestricted grants for the study of the Prometa protocol: one for a randomized, controlled study comparing our Prometa protocols to standard medical treatment for alcohol dependence, and the second for a controlled study to investigate our Prometa protocols for the treatment of methamphetamine dependence. In the third quarter we announced that the University of California, Los Angeles will conduct a multi-site, double-blind placebo controlled study on the Prometa treatment protocol for methamphetamine dependence. In October, 2005, we signed a contract with the Medical University of South Carolina for an unrestricted grant to conduct a double-blind, placebo controlled clinical study of the Prometa treatment protocol for alcoholism.

     In the third quarter, a drug court in Indiana announced it will evaluate the use of the Prometa protocols for drug court participants in a pilot endorsed by the National Association of Drug Court Professionals.

     In addition, we have initiated a patient outcomes registry to be conducted by a Contract Research Organization to monitor and evaluate outcomes of approximately 750 patients undergoing treatment using the Prometa protocol at our commercial licensee sites

Prometa Center

     In the fourth quarter 2005, we are planning to commence management for a medical practice that will occupy medical office space provided by us and license our Prometa protocols for the treatment of individuals diagnosed with dependencies to alcohol, cocaine and methamphetamine. The medical practice is located in Santa Monica, California. We are currently building out the leased space at an estimated total cost of approximately $1.1 million, including tenant improvements, furniture and medical and office equipment. Our management and licensing agreements will provide turn-key business management services to the medical group in exchange for management and licensing fees.

International Operations

     In June 2005, we and our international subsidiary Hythiam International (Cayman) Ltd. entered into an asset purchase agreement to obtain the worldwide rights to trade secret protocols for the treatment of nicotine and drug dependence, in exchange for a percentage of future net profits from exploitation of the protocols. In addition, as part of our European expansion strategy, we have incorporated several wholly owned foreign subsidiaries and have engaged consultants to explore opportunities to start up clinic operations for the treatment of nicotine dependence in Europe. As of September 30, 2005, we had not begun any significant international operations. We are currently evaluating the market opportunity and preparing to open clinics in Europe for the treatment of smoking cessation in the future.

Liquidity and Capital Resources

     We have financed our operations since inception primarily through the sale of shares of our stock. At September 30, 2005 we had approximately $14 million in cash, cash equivalents and marketable securities. In November 2005, we raised an additional $35 million in net proceeds from a follow-on underwritten offering of 8.0 million shares of our common stock. In addition, we have granted to the underwriters a 30-day option to purchase an additional 1.2 million shares to cover over-allotments, if any.

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     Since we are a developing business, both our current and prior operating costs are not representative of our expected future costs. As we continue to implement commercial operations and allocate significant and increasing resources to business development, hire additional personnel, expand our market and engage in other start-up activities, we expect our cash operating expenses in the fourth quarter of 2005 to increase from our current average of approximately $2.2 million per month as we enter into additional licensing agreements and increase our marketing efforts to provide for local marketing and advertising as well as brand awareness on both a local and national level. As of October 31, 2005, we have remaining commitments of approximately $4.3 million to provide funding for unrestricted grants for research studies for our Prometa protocol. In addition, we have initiated a patient outcomes registry to be conducted by a Contract Research Organization to monitor and evaluate outcomes of approximately 750 patients undergoing treatment using the Prometa protocol at our commercial licensee sites. The combined cost of the studies and patient registry is estimated at approximately $8 million over the next two years.

     In April 2005, we signed a five year lease for medical office space in Santa Monica, California, at an initial base rent of $19,000 per month commencing in August 2005. We estimate our total build-out costs for tenant improvements, furniture and equipment will be approximately $1.1 million. We plan to provide use of this space to a medical group for whom we have agreed to provide turn-key business management services and a license to use our protocol beginning in the fourth quarter of this year in exchange for a management and licensing fee.

     We continue to invest in the infrastructure we believe we will need, both in management as well as systems and equipment, to develop, market and implement our business plan. Our future capital requirements will depend upon many factors, including costs associated with the effectiveness of marketing our protocols, obtaining regulatory approvals and preparing, filing, prosecuting, maintaining and enforcing patent claims and other proprietary rights. Additionally, our future expenditures will depend on competing technological and market developments and our ability to establish collaborative arrangements, effective commercialization, marketing activities and other arrangements.

     We expect to continue to incur negative cash flows and net losses for at least the next twelve months. Based upon our current business plan, we believe that our existing cash reserves plus the $35 million in net proceeds from the completion of our recent stock offering in November will be sufficient to meet our operating expenses and capital requirements until we achieve profitability. However, changes in our business strategy, technology development or marketing plans or other events affecting our operating plans and expenses may result in the expenditure of existing cash before that time. If this occurs, our ability to meet our cash obligations as they become due and payable will depend on our ability to sell securities, borrow funds or some combination thereof. We may seek additional funding through public or private financing or through collaborative arrangements with strategic partners. We may also seek to raise additional capital through public or private financing in order to increase the amount of our cash reserves on hand. We may not be successful in raising necessary funds on acceptable terms, or at all.

Contractual Obligations and Commercial Commitments

     The following table sets forth a pro forma summary of our material minimum contractual obligations and commercial commitments as of September 30, 2005 (in thousands):

			Less than 1						More than 5
Contractual Obligations	Total		year		1 - 3 years		3 - 5 years		years
Operating lease obligations (1)	$	4,214	$	777	$	1,624	$	1,686	$	127
Contractual commitments for clinical studies (2)		1,287		716		571		—		—
	$	5,501	$	1,493	$	2,195	$	1,686	$	127

(1)	Consists of our current lease obligations for our corporate office and a medical office.
(2)	Subsequent to September 30, 2005, entered into additional commitments of $3.9 million over a two-year period.

Off-Balance Sheet Arrangements

     As of September 30, 2005 we had no off-balance sheet arrangements.

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Critical Accounting Policies and Estimates

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

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

Revenue recognition

     Our revenues are derived from licensing our treatment protocols and providing administrative services to hospitals, treatment facilities and other healthcare providers. We determine revenues earned based on the terms of these contracts, which determination requires the use of judgment, including the assessment of the collectibility of receivables. Licensing agreements typically provide for a fixed fee on a per-patient basis, payable to us upon commencement of the patient’s initial treatment using our protocol. For revenue recognition purposes, we treat the protocol licensing and related administrative services as one unit of accounting. We record the fees owed to us under the terms of the agreements at the time we have performed substantially all required services for each patient’s treatment, which for substantially all of our license agreements is in the period in which the patient’s medically supervised treatment has commenced, and, in other cases, is at the time the initial medical treatment has been completed.

Share-based expense

     We account for the issuance of options and warrants for services from non-employees in accordance with SFAS 123, “Accounting for Stock-Based Compensation,” by estimating the fair value of options and warrants issued using the Black-Scholes pricing model. This model’s calculations include the exercise price, the market price of shares on grant date, weighted average assumptions for risk-free interest rates, expected life of the option or warrant, expected volatility of our stock and expected dividend yield. The amounts recorded in the financial statements for share-based expense could vary significantly if we were to use different assumptions.

Impairment of intangible assets

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

     Our accounting policies are more fully described in Note 1 to our audited financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2004.

Recent Accounting Pronouncements

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

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period that begins after June 15, 2005. However, in April 2005, the SEC announced that it would permit companies to implement this statement at the beginning of their next fiscal year. We are currently evaluating the provisions of SFAS 123(R) and its effect on our financial statements. The effect of adopting this statement will be to increase our compensation expense in the future.

     In December 2004, the FASB issued SFAS 153, “Exchanges of Nonmonetary Assets, an amendment of APB 29, Accounting for Nonmonetary Transactions.” This Statement’s amendments are based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. Further, SFAS 153 eliminates the narrow exception for nonmonetary exchanges of similar productive assets and replaces it with a broader exception for exchanges of nonmonetary assets that do not have commercial substance. Provisions of this statement are effective for fiscal periods beginning after June 15, 2005. We do not expect the adoption of this statement to have a material impact on our financial statements.

     In March 2005, the FASB issued FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (“FIN 47”), which is an interpretation of SFAS 143, “Accounting for Asset Retirement Obligations.” FIN 47 clarifies terminology within SFAS 143 and requires an entity to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. FIN 47 is effective for fiscal years ending after December 15, 2005. We do not expect the adoption of this statement to have a material impact on our financial statements.

     In May 2005, the FASB issued SFAS 154, “Accounting Changes and Error Corrections.” SFAS 154 replaces APB 20, “Accounting Changes” and SFAS 3, “Reporting Accounting Changes in Interim Financial Statements” and establishes retrospective application as the required method for reporting a change in accounting principle. SFAS 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The reporting of a correction of an error by restating previously issued financial statements is also addressed. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We do not expect the adoption of this statement to have a material impact on our financial statements.

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

     We invest our cash in short term commercial paper, certificates of deposit, money market accounts and marketable securities. We consider any liquid investment with an original maturity of three months or less when purchased to be cash equivalents. We classify investments with maturity dates greater than three months when purchased as marketable securities, which have readily determined fair values as available-for-sale securities. Our investment policy requires that all investments be investment grade quality and no more than ten percent of our portfolio may be invested in any one security or with one institution. At September 30, 2005, our investment portfolio consisted of investments in highly liquid, high grade commercial paper, variable rate securities and certificates of deposit. The weighted average interest rate of cash equivalents and marketable securities held at September 30, 2005 was 3.75%.

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

ITEM 4. Controls and Procedures

     We have evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our system of disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation our Chief Executive Officer and our Chief Financial Officer have determined that they are effective in connection with the preparation of this report. There were no changes in the internal controls over financial reporting that occurred during the quarter ended September 30, 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II — OTHER INFORMATION

ITEM 1. Legal Proceedings

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

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

     Not Applicable.

ITEM 3. Defaults Upon Senior Securities

     Not Applicable.

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

     Not Applicable.

ITEM 5. Other Information.

CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING INFORMATION

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

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

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

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

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

• marketing plans to raise awareness of our PROMETA protocols

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

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

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

ITEM 6.Exhibits

Exhibit 31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 32.1	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
Exhibit 32.2	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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SIGNATURES

          Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

		HYTHIAM, INC.
Date: November 14, 2005	By:	/S/ TERREN S. PEIZER     Terren S. Peizer
		President and Chief Executive Officer
Date: November 14, 2005	By:	/S/ CHUCK TIMPE     Chuck Timpe
		Chief Financial Officer

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