FORM 10-Q

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

For The Quarterly Period Ended September 30, 2004

Commission File Number 333-58246

HYTHIAM, INC.

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

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO o

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

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

INDEX

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PART I — FINANCIAL INFORMATION

ITEM 1. Financial Statements

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

See accompanying notes to financial statements.

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

See accompanying notes to financial statements.

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

See accompanying notes to financial statements.

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See accompanying notes to financial statements.

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Hythiam, Inc.
Notes to Condensed Financial Statements
(Unaudited)

Note 1. Basis of Presentation

     The accompanying unaudited interim condensed financial statements for Hythiam, Inc. (“Hythiam” or the “Company”), a development stage company, have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and do not include all information and notes required for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Interim results are not necessarily indicative of the results that may be expected for the entire fiscal year. The accompanying financial information should be read in conjunction with the financial statements and the notes thereto in the Company’s most recent Annual Report on Form 10-K. The December 31, 2003 balance sheet has been derived from the audited financial statements on Form 10-K. All share data has been restated to reflect stock splits. Certain reclassifications have been made in prior periods to be consistent with current period presentation.

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

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

Note 2. Cash Equivalents and Marketable Securities

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

     Investments with maturity dates greater than three months when purchased which have readily determined fair values are classified as available-for-sale investments and reflected in current assets as marketable securities. At September 30, 2004, the carrying value approximated fair market value.

Note 3. Basic and Diluted Loss per Share

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

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

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

Note 4. Stock, Stock Options and Warrants

Common Stock

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

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

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

Stock Options

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

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

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

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

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

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

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Warrants

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

     If warrants issued as compensation to non-employees for services are fully vested and non-forfeitable at the time of issuance, the estimated value is recorded in equity and expensed when the services are performed and benefit is received as provided by EITF 96-18. If warrants are issued for consideration in an acquisition of assets, the value of the warrants are recorded in equity at the time of issuance and included in the purchase price to be allocated.

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