Aeolus Form 10-Q for the first quarter ended December 31, 2006

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 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 December 31, 2006.

_____
  
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
0-50481

AEOLUS PHARMACEUTICALS, INC.
(Exact Name of Registrant as Specified in Its Charter)


   
Delaware
 
 56-1953785
 (State or Other Jurisdiction of Incorporation or Organization)
 
  (I.R.S. Employer Identification No.)
 
 
 
23811 Inverness Place
Laguna Niguel, California
 
 
 92677
 (Address of Principal Executive Offices)
 
  (Zip Code)
 
 
 
 (Registrant’s Telephone Number, Including Area Code) 949-481-9825
 
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:  
 
Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [X]
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES [ ] NO [X]

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
 
 Class
 Outstanding as of
February 7, 2007
 Common Stock, par value $.01 per share
 29,286,082 shares

1
AEOLUS PHARMACEUTICALS, INC.
FORM 10-Q
For the Quarter Ended December 31, 2006
Table of Contents

 
 
 
Page
 PART I.  FINANCIAL INFORMATION
 
Item 1.
Financial Statements
 
 
 
 
 
 
 
Statement Regarding Financial Information
3
 
 
 
 
 
 
Condensed Consolidated Balance Sheets as of December 31, 2006 (unaudited) and September 30, 2006
4
 
 
 
 
 
 
Condensed Consolidated Statements of Operations for the Three Months ended December 31, 2006 and 2005 (unaudited)
5
 
 
 
 
 
 
Condensed Consolidated Statements of Cash Flows for the Three Months ended December 31, 2006 and 2005 (unaudited)
6
 
 
 
 
 
 
Notes to Condensed Consolidated Financial Statements
7
 
 
 
 
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
9
 
 
 
 
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
12
 
 
 
 
 
Item 4.
Controls and Procedures
12
 
 
 
 
PART II.  OTHER INFORMATION
 
Item 1.
Legal Proceedings
12
 
 
 
 
 
Item 1A.
Risk Factors
12
 
 
 
 
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
12
 
 
 
 
 
Item 3.
Defaults Upon Senior Securities
12
 
 
 
 
 
Item 4.
Submission of Matters to a Vote of Security Holders
12
 
 
 
 
 
Item 5. 
Other Information
12
 
 
 
 
Item 6.
Exhibits
13
 
 
 
 
 
SIGNATURES
13
 
2

AEOLUS PHARMACEUTICALS, INC.
 


PART I - FINANCIAL INFORMATION

ITEM 1.   Financial Statements.

Statement Regarding Financial Information

The condensed consolidated financial statements of Aeolus Pharmaceuticals, Inc. and its wholly-owned subsidiary, Aeolus Sciences, Inc. (collectively the “Company”), included herein have been prepared by management, without audit (except for the Consolidated Balance Sheet as of September 30, 2006), pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information normally included in the consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States has been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures are adequate to make the information presented not misleading. The Company recommends that you read the consolidated financial statements included herein in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2006, filed with the SEC on December 15, 2006.

3
 
AEOLUS PHARMACEUTICALS, INC.
 
 
 
 
  
 
 
 
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except shares and per share data)
 
 
 
 
  
 
 
 
 
 
 
December 31,
  
 
September 30,
 
 
 
 
2006
  
 
2006
 
 
 
 
(Unaudited)
  
 
 
 
 ASSETS
Current assets:
 
 
 
  
 
 
 
Cash and cash equivalents
 
 
$
2,418
 
  
$
3,324
 
Prepaids and other current assets
 
 
 
54
 
  
 
104
 
Total current assets
 
 
 
2,472
 
  
 
3,428
 
 
 
 
 
 
 
  
 
 
 
Investment in CPEC LLC
 
 
 
126
 
  
 
126
 
Total assets
 
 
$
2,598
 
  
$
3,554
 
 
 
 
 
 
 
  
 
 
 
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities:
 
 
 
 
 
  
 
 
 
Accounts payable
 
 
$
583
 
  
$
868
 
Accrued expenses
 
 
 
5
 
  
 
23
 
Current maturity of long-term note payable
 
 
 
977
 
  
 
956
 
Total current liabilities
 
 
 
1,565
 
  
 
1,847
 
 
 
 
 
 
 
  
 
 
 
Total liabilities
 
 
 
1,565
 
  
 
1,847
 
                   
Commitments and contingences
                  
 
 
 
 
 
 
  
 
 
 
Stockholders' deficit:
 
 
 
 
 
  
 
 
 
Preferred stock, $.01 par value per share, 10,000,000 shares authorized:
 
 
 
 
 
  
 
 
 
Series B nonredeemable convertible preferred stock, 600,000 shares
 
 
 
 
 
  
 
 
 
authorized; 475,087 shares issued and outstanding at December 31,
 
 
 
 
 
  
 
 
 
2006 and September 30, 2006
 
 
 
5
 
  
 
5
 
Common stock, $.01 par value per share, 150,000,000 shares authorized;
 
 
 
 
 
  
 
 
 
    29,286,082 and 29,265,249 shares issued and outstanding at
 
 
 
 
 
  
 
 
 
   December 31, 2006 and September 30, 2006, respectively
 
 
 
293
 
  
 
293
 
Additional paid-in capital
 
 
 
154,586
 
  
 
154,311
 
Accumulated deficit
 
 
 
(153,851
)
  
 
(152,902
)
Total stockholders' deficit
 
 
 
1,033
    
 
1,707
  
Total liabilities and stockholders' deficit
 
 
$
2,598
 
  
$
3,554
 
 
 
 
 
 
 
  
 
 
 
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

4


AEOLUS PHARMACEUTICALS, INC.
 
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share data)
 
 
 
 
 
 
Three Months Ended
 
 
December 31,
 
 
2006
 
2005
 
Revenue:
 
 
 
 
Grant income
$
-
 
$
1
 
 
 
 
 
 
 
 
Costs and expenses:
 
 
 
 
 
 
Research and development
 
336
 
 
1,293
 
General and administrative
 
629
 
 
491
 
Total costs and expenses
 
965
 
 
1,784
 
 
 
 
 
 
 
 
Loss from operations
 
(965
)
 
(1,783
)
Interest expense, net
 
16
  
 
(12
)
Other income
 
-
 
 
18
 
Decrease in fair value of common stock warrants
 
-
  
 
254
 
 
 
 
 
 
 
 
Net loss attributable to common stockholders
$
(949
)
$
(1,523
)
 
 
 
 
 
 
 
Net loss per weighted share attributable to common stockholders:
 
 
 
 
 
 
(basic and diluted)
$
(0.03
)
$
(0.11
)
 
 
 
 
 
 
 
Weighted average common shares outstanding:
 
 
 
 
 
 
(basic and diluted)
 
29,269
 
 
14,038
 
 
 
 
 
 
 
 
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

5
 
AEOLUS PHARMACEUTICALS, INC.
 
 
 
 
 
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)
 
 
 
 
 
 
 
 
Three Months Ended
 
 
 
December 31,
 
 
 
2006
 
2005
 
Cash flows from operating activities:
 
 
 
 
 
Net loss
 
$
(949
)
$
(1,523
)
Adjustments to reconcile net loss to net cash used in operating activities:
 
 
 
 
 
 
 
Noncash compensation 
 
 
238
 
 
76
 
Noncash interest and financing costs
 
 
38
 
 
22
 
Decrease in fair value of common stock warrants 
 
 
-
 
 
(254
)
Change in assets and liabilities: 
 
 
 
 
 
 
 
 Accounts receivable
 
 
1
 
 
-
 
 Prepaids and other assets
 
 
48
  
 
27
  
 Accounts payable and accrued expenses
 
 
(303
)
 
727
  
Net cash used in operating activities
 
 
(927
)
 
(925
)
 
 
 
 
 
 
 
 
Cash flows from financing activities:
 
 
 
 
 
 
 
Proceeds from issuance of Series A Preferred Stock
 
 
-
 
 
2,413
 
Proceeds from exercise of stock options
 
 
21
 
 
21
 
Net cash provided by financing activities
 
 
21
 
 
2,434
 
 
 
 
 
 
 
 
 
Net (decrease) increase in cash and cash equivalents
 
 
(906
)
 
1,509
  
Cash and cash equivalents at beginning of period
 
 
3,324
 
 
626
 
Cash and cash equivalents at end of period
 
$
2,418
 
$
2,135
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
The accompanying notes are integral part of these unaudited condensed consolidated financial statements.

6
AEOLUS PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

A.  Organization and Business and Basis of Presentation

Aeolus Pharmaceuticals, Inc. is biopharmaceutical company that is developing a new class of catalytic antioxidant compounds for diseases and disorders of the central nervous system, respiratory system, autoimmune system and oncology. The Company’s initial target applications are for cancer radiation therapy and amyotrophic lateral sclerosis, also known as “ALS” or “Lou Gehrig’s disease.” The Company reported positive safety results from two Phase I clinical trials of AEOL 10150, our lead drug candidate, with no serious adverse events noted. The Company plans on launching a clinical trial for AEOL 10150 as a protector of healthy normal cells in radiation therapy during the second half of fiscal year 2007. Further development of AEOL 10150 for the treatment of ALS, if any, will be dependent upon future specific financing for this development or a partnership.

The “Company” or “Aeolus” refers collectively to Aeolus Pharmaceuticals, Inc., a Delaware corporation (“Aeolus”), and its wholly owned subsidiary, Aeolus Sciences, Inc., a Delaware corporation. As of December 31, 2006, Aeolus also owned a 35.0% interest in CPEC LLC, a Delaware limited liability company (“CPEC”). The Company’s primary operations are located in Laguna Niguel, California.
 
All significant intercompany activity has been eliminated in the preparation of the condensed consolidated financial statements. The unaudited condensed consolidated financial statements have been prepared in accordance with the requirements of Form 10-Q and Rule 10-01 of Regulation S-X. Some information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to those rules and regulations. In the opinion of management, the accompanying unaudited consolidated financial statements include all adjustments (consisting only of normal recurring adjustments) necessary to present fairly the consolidated financial position, results of operations and cash flows of the Company. The consolidated balance sheet at September 30, 2006 was derived from the Company’s audited financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2006. The unaudited condensed consolidated financial statements included herein should be read in conjunction with the audited consolidated financial statements and the notes thereto included in that Annual Report on Form 10-K and in the Company’s other SEC filings. Results for the interim period are not necessarily indicative of the results for any other period.

B.  Liquidity

The Company has incurred significant losses from operations of $965,000 and $5,604,000, and cash outflows from operations of $927,000 and $4,867,000, for the three months ended December 31, 2006 and for the fiscal year ended September 30, 2006, respectively. The Company expects to incur additional losses and negative cash flow from operations during the remainder of fiscal year 2007 and for several more years.

Management believes the Company has adequate financial resources to conduct operations through the third quarter of fiscal year 2007. This raises substantial doubt about our ability to continue as a going concern, which will be dependent on our ability to generate sufficient cash flows to meet our obligations on a timely basis, to obtain additional financing and, ultimately, to achieve operating profit.

The Company intends to explore strategic and financial alternatives, including a merger or acquisition with or by another company, the sale of shares of stock, the establishment of new collaborations for current research programs that include initial cash payments and on-going research support and the out-licensing of our compounds for development by a third party. The Company believes that without additional investment capital it will not have sufficient cash to fund its activities in the near future, and will not be able to continue operating. As such, the Company’s continuation as a going concern is dependent upon its ability to raise additional financing. The Company is actively pursuing additional equity financing to provide the necessary funds for working capital and other planned activities.

If the Company is unable to obtain additional financing to fund operations beyond the third quarter of fiscal year 2007, it will need to eliminate some or all of its activities, merge with another company, sell some or all of its assets to another company, or cease operations entirely. There can be no assurance that the Company will be able to obtain additional financing on favorable terms or at all, or that the Company will be able to merge with another Company or sell any or all of its assets.
 
7

C.  Net Loss Per Common Share

The Company computes basic net loss per weighted average share attributable to common stockholders using the weighted average number of shares of common stock outstanding during the period. The Company computes diluted net loss per weighted average share attributable to common stockholders using the weighted average number of shares of common and dilutive potential common shares outstanding during the period. Diluted weighted average common shares excluded incremental shares of approximately 21,559,000 as of December 31, 2006 issuable upon the exercise or conversion of stock options to purchase common stock, convertible preferred stock, convertible debt and warrants to purchase common stock. These shares were excluded due to their antidilutive effect as a result of the Company’s net losses.

D.  Note Payable

In August 2002, Aeolus borrowed from Elan Corporation, plc. (“Elan”) $638,000 pursuant to the terms of a note arrangement with Elan. The note payable accrues interest at 10% compounded semi-annually. The note was convertible at the option of Elan into shares of the Company’s Series B non-voting convertible preferred stock (“Series B Stock”) at $43.27 per share. The note matured on December 21, 2006, however, in February 2007, the Company and Elan terminated the note, the Company paid $300,000 in cash to Elan, Elan and the Company entered into a new note payable in the amount of $453,000 for a period of two years under substantially the same terms as the original note and Elan forgave $225,000 of the note payable.

The remaining principal plus accrued interest will be due and payable in two years. Aeolus has the option to repay the note either in cash or in shares of Series B Stock and warrants having a then fair market value of the amount due; provided that the fair market value used for calculating the number of shares to be issued will not be less than $13.00 per share. As of December 31, 2006, the outstanding balance on the note payable to Elan was $977,000.

E.  Stock-Based Compensation

Below is a summary of Aeolus stock option activity during the three-month period ended December 31, 2006:

 
 
Shares
 
Weighted Average Exercise Price
 
Weighted Average Remaining Contractual Term
  
Aggregate Intrinsic Value
  
Outstanding at September 30, 2006
 
 
3,071,806
 
$
3.25
        
 
Granted
 
 
721,000
 
$
0.61
        
 
Exercised
 
 
(20,833
)
$
1.00
        
 
Forfeited
 
 
(1,703
)
$
0.40
        
 
Outstanding at December 31, 2006 (unaudited)
 
 
3,770,270
 
$
2.75
  
7.9
$
-
 
Exercisable at December 31, 2006 (unaudited)
 
 
2,706,935
 
$
3.57
  
7.1
$
-
 

For the three months ended December 31, 2006 and 2005, all stock options were issued with an exercise price at or above the fair market value of the Company’s common stock on the date of grant.
 
8

The details of stock options outstanding at December 31, 2006 were as follows:

 
 
Options Outstanding
 
Options Exercisable
Range of Exercise Prices
 
Number Outstanding at December 31, 2006
 
Weighted Average Exercise Price
 
Weighted Average Remaining Contractual Life
 
Number Exercisable at December 31, 2006
 
Weighted Average Exercise Price
 
  
 
 
 
 
 
 
 
 
 
 
 
$0.55
  
8,800
     
$
0.55
     
8.7 years
     
8,800
     
$
0.55
$0.60
  
665,250
     
$
0.60
     
9.9 years
     
15,250
     
$
0.60
$0.66 - $0.80
 
488,161
 
$
0.75
 
8.9 years
 
248,161
 
$
0.75
$0.81 - $0.89
 
384,035
 
$
0.85
 
8.9 years
 
211,535
 
$
0.85
$0.90 - $1.45
 
357,886
 
$
0.98
 
8.6 years
 
357,886
 
$
0.98
$1.50
 
1,256,015
 
$
1.50
 
6.6 years
 
1,256,015
 
$
1.50
$1.52 - $5.10
 
394,391
 
$
2.86
 
7.4 years
 
393,556
 
$
2.86
$6.25 - $31.90
 
166,933
 
$
20.52
 
4.3 years
 
166,933
 
$
20.53
$50.9375
 
2,999
 
$
50.94
 
3.3 years
 
2,999
 
$
50.94
$51.25
  
45,800
 
$
51.25
 
3.3 years
 
45,800
 
$
51.25
$0.55 - $51.25
  
3,770,270
 
$
2.75
 
7.9 years
 
2,706,935
 
$
3.57

For the three months ended December 31, 2006, stock-based compensation expense recognized in the statement of operations is as follows (in thousands):

Research and development expenses
 
$
73
 
General and administrative expenses
 
 
165
 
Total stock-based compensation expense
 
$
238
 
 
The total deferred compensation expense for outstanding and unvested stock options was $494,000 as of December 31, 2006, which will be recognized over the next twelve months. The fair value of the options associated with the above compensation expense for the three months ended December 31, 2006, was determined at the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions:

   
For the three months December 31,
   
2006
  
2005
Dividend yield
  
0%
  
0%
Expected volatility
  
191%
  
189%
Risk-free interest rate
  
4.5% - 5.0%
  
4.3% - 4.6%
Expected option life after shares are vested
  
10 years
  
10 years


F.  Commitments and Contingencies
 
In December 1999, the Company sold its anti-infectives division (“IRL”) to a private pharmaceutical company. The Company remains contingently liable through May 2007 for a lease obligation of approximately $431,000 assumed by the purchaser on the former IRL facility in Cranbury, New Jersey. No amounts are recorded in the accompanying financial statements for this contingent liability.

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

Introduction

Unless otherwise noted, the terms “we,” “our” or “us” refer collectively to Aeolus Pharmaceuticals, Inc. and our wholly owned subsidiary, Aeolus Sciences, Inc.
9
This report contains, in addition to historical information, statements by us with respect to expectations about our business and future results which are “forward-looking” statements under the Private Securities Litigation Reform Act of 1995. These statements and other statements made elsewhere by us or by our representatives, which are identified or qualified by words such as “likely,” “will,” “suggests,” “expects,” “might,” “believe,” “could,” “should,” “may,” “estimates,” “potential,” “predict,” “continue,” “would,” “anticipates,” “plans,” or similar expressions, are based on a number of assumptions that are subject to risks and uncertainties. Such statements include, but are not limited to, those relating to Aeolus’ product candidates, as well as its proprietary technologies and uncertainties and other factors that may cause Aeolus’ actual results to be materially different from historical results or from any results expressed or implied by such forward-looking statements. Important factors that could cause results to differ include risks associated with uncertainties of progress and timing of clinical trials, scientific testing, obtaining regulatory approval, the need to obtain funding for pre-clinical and clinical trails and operations, the scope and validity of intellectual property protection for Aeolus’ product candidates, proprietary technologies and their uses, new accounting and SEC requirements and competition from other biopharmaceutical companies. Certain of these factors and others are more fully described in Aeolus’ filings with the SEC, including, but not limited to, Aeolus’ Annual Report on Form 10-K for the fiscal year ended September 30, 2006. All forward-looking statements are based on information available as of the date hereof, and we do not assume any obligation to update such forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.

Operations Summary

We are developing a series of catalytic antioxidant molecules to protect against the damaging effects of reactive oxygen derived molecules, commonly referred to as free radicals. Free radicals cause damage in a broad group of diseases and conditions. Our initial target applications will be the use of our catalytic antioxidants for cancer radiation therapy and amyotrophic lateral sclerosis, also known as “ALS” or “Lou Gehrig’s disease.” We have reported positive safety results from two Phase I clinical trials of AEOL 10150 in patients diagnosed with ALS with no serious adverse events noted. We plan on launching a clinical trial for AEOL 10150 during the second half of fiscal year 2007. 

We do not have any revenue, other than grant income, and therefore we must rely on public or private equity offerings, debt financings, collaboration arrangements or grants to finance our operations.

Need for Additional Funds

We believe we have adequate financial resources to fund our operations through the third quarter of fiscal year 2007, but in order to fund on-going operating cash requirements beyond the third quarter of fiscal year 2007, or to accelerate or expand our programs, we will need to raise significant additional funds. Our need for additional financing is discussed under “Liquidity and Capital Resources.”

Results of Operations

Three months ended December 31, 2006 versus three months ended December 31, 2005

We had net losses attributable to common stockholders of $949,000 for the three months ended December 31, 2006, versus net losses attributable to common stockholders of $1,523,000 for the three months ended December 31, 2005.

In August 2003, we were awarded a $100,000 Small Business Innovation and Research (“SBIR”) Phase I grant from the National Cancer Institute, a division of the National Institutes of Health. In March 2004, we were awarded up to $375,000 for the first year of a SBIR Phase II grant and received approval for a second year of the Phase II grant program in January 2005. Pursuant to the grants, we studied the antitumor and radiation-protective effects of our catalytic antioxidants. The study is a collaboration between us and the Department of Radiation Oncology at Duke University Medical Center. The grant ended in March 2006. We recognized zero and $1,000 of grant income during the three months ended December 31, 2006 and 2005, respectively. We do not expect to earn further grant revenues as work under our SBIR grant has been completed.

Research and development (“R&D”) expenses decreased $957,000, or 74%, to $336,000 for the three months ended December 31, 2006 from $1,293,000 for the three months ended December 31, 2005. Research and development activities were focused on analyzing the results and preparing the final report of our Phase I multiple dose clinical trial for the treatment of ALS and preparing for a proposed clinical trial for AEOL 10150 as a radiation protection agent. During the three months ended December 31, 2005, our primary operational focus and R&D spending was on conducting our Phase I multiple dose clinical trial for the treatment of ALS and the advancement of the Aeolus Pipeline Initiative.

R&D expenses for our antioxidant program have totaled $32,489,000 from inception through December 31, 2006. Because of the uncertainty of our research and development and clinical studies, we are unable to predict the level of spending and the anticipated program completion date, if any. However, we expect that R&D expenses during the remainder of fiscal year 2007 will be higher than those incurred in the quarter ended December 31, 2006 as we continue the clinical development of AEOL 10150 and expand our pre-clinical testing activities.
10

General and administrative (“G&A”) expenses increased $138,000, or 28%, to $629,000 for the three months ended December 31, 2006 from $491,000 for the three months ended December 31, 2005. G&A expenses were higher during the three months ended December 31, 2006 versus December 31, 2005 due to increased stock compensation expense of $100,000, as the Company hired two additional employees during the quarter and both were granted stock options as part of their employment, and severance benefits in the amount of $50,000 paid to our former Chief Executive Officer.

During the three months ended December 31, 2005 and in accordance with EITF 00-19, “Accounting for Derivative Financial Instruments Indexed To, and Potentially Settled In a Company’s Own Stock,” and the terms of the warrants and the transaction documents related to our November 2005 Series A Preferred Stock financing, at the closing date, November 21, 2005, the fair value of the warrants issued in the private placement were accounted for as a liability. Until the date in which the registration statement registering the shares underlying the warrants was declared effective, the warrant liability was revalued at each balance sheet date and any changes in fair value were charged to the statement of operations. Between November 21, 2005 and December 31, 2005, the fair value of the warrant decreased by $254,000 which was credited to the statement of operations. The warrant liability and revaluations have not and will not have any impact on the Company’s working capital, liquidity, or business operations. During the three months ended December 31, 2006, all warrants had been registered with the U.S. Securities and Exchange Commission and thus there were no warrant liability or revaluations of such liability.

Liquidity and Capital Resources

We do not have any revenue and therefore we rely on investors, grants, collaborations and licensing of our compounds to finance our operations. At December 31, 2006, we had $2,418,000 of cash, an decrease of $906,000 from September 30, 2006. The decrease in cash was primarily due to the $949,000 loss from operations for the three months ended December 31, 2006. We believe we have adequate financial resources to conduct operations through the third quarter of fiscal year 2007, but in order to fund on-going operating cash requirements beyond that point, or to further accelerate or expand our programs, we need to raise significant additional funds.

We incurred significant losses from operations of $965,000 and $5,604,000, and cash outflows from operations of $927,000 and $4,867,000, for the three months ended December 31, 2006 and for the fiscal year ended September 30, 2006, respectively. Our ongoing future cash requirements will depend on numerous factors, particularly the progress of our catalytic antioxidant program and clinical trials and our ability to negotiate and complete collaborative agreements or out-licensing arrangements. In order to help fund our on-going operating cash requirements, we intend to seek new collaborations for our antioxidant research program that include initial cash payments and on-going research support. In addition, we might sell additional shares of our stock and explore other strategic and financial alternatives, including a merger with another company, the sale of stock, the establishment of new collaborations for current research programs, that include initial cash payments and ongoing research support and the out-licensing of our compounds for development by a third party.

There are significant uncertainties as to our ability to access potential sources of capital. We may not be able to enter into any collaboration on terms acceptable to us, or at all, due to conditions in the pharmaceutical industry or in the economy in general or based on the prospects of our catalytic antioxidant program. Even if we are successful in obtaining a collaboration for our antioxidant program, we may have to relinquish rights to technologies, product candidates or markets that we might otherwise develop ourselves. These same risks apply to any attempt to out-license our compounds.

Similarly, due to market conditions, the illiquid nature of our stock and other possible limitations on equity offerings, we may not be able to sell additional securities or raise other funds on terms acceptable to us, if at all. Any additional equity financing, if available, would likely result in substantial dilution to existing stockholders.

Our forecast of the period of time through which our financial resources will be adequate to support our operations is forward-looking information, and actual results could vary.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. We do have operating leases, which are generally for office and laboratory space. In accordance with accounting principles generally accepted in the United States, operating leases are not reflected in the accompanying consolidated balance sheets. We do not have any capital leases.
11

ITEM 3.   Quantitative and Qualitative Disclosures About Market Risk.

Our exposure to market risk is presently limited to the interest rate sensitivity of our cash and cash equivalents, which is affected by changes in the general level of U.S. interest rates. However, we believe that we are not subject to any material market risk exposure and do not expect that changes in interest rates would have a material effect upon our financial position. A hypothetical 10% change in interest rates would not have a material effect on our Statement of Operations or Cash Flows for the three months ended December 31, 2006. We do not have any foreign currency or other derivative financial instruments. Our debt bears interest at a fixed rate.

ITEM 4.  Controls and Procedures.

As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Accounting Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e)) pursuant to Rule 13a-15 of the Securities and Exchange Act of 1934 as amended. Based upon their evaluation, our Chief Executive Officer and Chief Accounting Officer have concluded that our disclosure controls and procedures are effective.

No change in our internal control over financial reporting occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Management is aware that there is a lack of segregation of duties due to the small number of employees and consultants addressing the Company’s general administrative and financial matters. However, management has determined that, considering the employees involved and the control procedures in place, risks associated with such lack of segregation are not significant and any potential benefits of adding employees or consultants to clearly segregate duties do not justify the expenses associated with such increases at this time.

PART II. - OTHER INFORMATION

ITEM 1.   Legal Proceedings.

None.

ITEM 1A.   Risk Factors.

None.

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

None.

ITEM 3.   Defaults Upon Senior Securities.

None.
 
ITEM 4.   Submission of Matters to a Vote of Security Holders.

A Special Meeting of Stockholders of Aeolus Pharmaceuticals was held on October 27, 2006. The stockholders approved the amendment of the Company’s Amended and Restated Certificate of Incorporation to increase the authorized number of shares of Common Stock of Aeolus from 50,000,000 shares to 150,000,000 shares, with 26,264,249 shares voting for approval, 216,393 shares voting against and 22,887 shares abstained.

ITEM 5.   Other Information.
 
None.

12

ITEM 6.  Exhibits

Exhibit #
 
Description
3.1
  
Certificate of Amendment of Amended and Restated Certificate of Incorporation (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed dated October 27, 2006).
10.1
 
Separation Agreement between Aeolus Pharmaceuticals, Inc. and Richard P. Burgoon, Jr. dated December 6, 2006 (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed dated November 30, 2006).
31.1
  
Certification of the Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a).
     
31.2
  
Certification of the Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a).
32.1
  
Certification by the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. §1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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.
 
AEOLUS PHARMACEUTICALS, INC.


Date:  February 9, 2007  
By:
/s/ John L. McManus
 
 
John L. McManus
President and Chief Operating Officer
(Principal Executive Officer)
 
 
 
Date:  February 9, 2007  
By:
/s/ Michael P. McManus
 
 
Michael P. McManus
Chief Financial Officer, Treasurer and Secretary
(Principal Financial and Accounting Officer)