Included in the granted options are options to purchase an aggregate of 314,000 shares at an exercise price of $1.0555 per share granted to employees on September 25, 2002 and options to purchase an aggregate of 60,000 shares at an exercise price of $1.00 per share granted to consultants on September 27, 2002. These grants were made subject to stockholder approval of an increase in the number of shares subject to our 1997 Stock Incentive Plan. Upon stockholder approval, the options will be considered granted for accounting purposes and therefore may result in the recognition of deferred compensation, which would be amortized over the term of the options. Also included in granted options are options to purchase an aggregate of 59,400 shares at an exercise price of $4.75 per share granted to members of our Board of Directors, options to purchase an aggregate of 3,200 shares at an exercise price of $4.00 per share granted to a key employee, options to purchase an aggregate of 11,150 shares at an exercise price of $9.75 per share granted to certain key employees and options to purchase an aggregate of 52,640 shares at an exercise price of $75.00 per share to certain key employees, which were awarded in 2001 subject to stockholder approval, but considered granted in 2002 upon approval of an increase in the size of the plan at our June 2002 stockholder meeting. We determined the exercise prices of these options based on the fair market value on the date of grant, except for the grant of 52,640 options, which we based on a 15% discount from the fair market value on the date of grant. An increase in the number of shares subject to our 1997 Stock Incentive Plan was approved on June 17,

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Notes to Condensed Consolidated Financial Statements
(continued)

September 30, 2002
(Unaudited)

2002, by a vote of our stockholders. An additional increase in the number of shares subject to our 1997 Stock Incentive Plan will be proposed at the next stockholder meeting in June of 2003.

         We granted 54,080 stock options to employees in 2000 with exercise prices less than the fair market value of our common stock at the measurement date. The intrinsic value of the option grants amounting to $959,850 was recorded as deferred compensation and is being amortized to expense over the vesting period, in accordance with APB Opinion No. 25. During the nine-month periods ended September 30, 2002 and 2001, we recorded compensation expense of $111,441 and $484,581 respectively, as a result of such amortization.

NeoGene

         Below is a summary of NeoGene stock option activity during the nine-month period ended September 30, 2002:

         We issued 140,654 stock options of our majority owned subsidiary NeoGene to our employees in 2001 with exercise prices less than the fair market value of NeoGene’s common stock at the measurement date. The intrinsic value of the option grants amounting to $2,391,118 was recorded as deferred compensation and is being amortized to expense over the vesting period, in accordance with APB Opinion No. 25. During the three-month period ended June 30, 2002, our executive officers Alvin J. Glasky, Ph.D., Rajesh Shrotriya, M.D., and Samuel Gulko held NeoGene stock options to purchase up to 40,000, 10,000 and 20,000 shares of NeoGene common stock, respectively, at an exercise price of $1.00 per share. On May 3, 2002, each of these officers, voluntarily and without any consideration, agreed to cancel their NeoGene stock options. Our condensed consolidated balance sheet as of December 31, 2001 includes deferred compensation resulting from the grant of all NeoGene stock options of $2,391,118, of which $1,190,000 is attributed to NeoGene stock options formerly held by these executive officers. The accounting effect of the option cancellation is reflected in our September 30, 2002 condensed consolidated financial statements as a reduction in deferred compensation of approximately $818,000 and resulted in reduced amortization expense beginning on the date of cancellation. During November 2002, the remaining two employees holding NeoGene options voluntarily and without any consideration, agreed to cancel their NeoGene stock options and therefore the remaining deferred compensation for NeoGene will be eliminated in the fourth quarter of 2002.

         During the nine-month periods ended September 30, 2002 and 2001, we recorded compensation expense of $264,000 and $671,000, respectively, as a result of amortization prior to the cancellation of these options.

11. Notes Receivable from Directors and Officers

         On June 6, 2002, the Board of Directors approved an amendment and restatement of all of the note receivables from officers and directors. The original interest rates that were between 7% and 9% were all changed to 4.5% and the maturity dates were extended to June 6, 2004. The notes remain secured by a pledge of the common stock purchased with the loan proceeds. These notes are classified in our balance sheet as an offset to stockholders’ equity.

         In connection with the retirement of Dr. Alvin J. Glasky and Samuel Gulko, the Company relieved Dr. Glasky of his obligation to repay a loan in the amount of approximately $390,000 in principal and accrued interest in lieu of the payment of additional contractually obligated severance benefits and Mr. Gulko repaid a loan from the Company in the amount of $75,000 of principal and accrued interest.

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Notes to Condensed Consolidated Financial Statements
(continued)

September 30, 2002
(Unaudited)

12. Segment Information

         During the nine-month period ended September 30, 2002, we shifted our strategic focus from discovery and development of neurology drugs to the in-licensing of oncology drug candidates and the further development of and strategic alliances for these drug candidates and the discovery of neurology drugs and out-licensing these drug candidates and the functional genomics technology to strategic partners. As a result of these strategic changes, the Company began to operate as one reporting segment in the third quarter of 2002.

13. Loss Per Share

         Basic and diluted loss per share for the three-month period ended September 30, 2002 and 2001 are computed using the weighted average common shares outstanding during the period, respectively.

14. Litigation

         We are not aware of any litigation matters pending or threatened as of September 30, 2002 that will materially affect our condensed consolidated financial statements. We are sometimes involved in matters of litigation that we consider ordinary routine litigation incidental to our business. Our policy is to accrue during a period, as a charge to operations, amounts related to legal matters if it is probable that a liability has been incurred and the amount of loss can be reasonably estimated, as required by SFAS No. 5, Accounting for Contingencies.

15. Income Taxes

         We did not provide any current or deferred federal or state income tax provision or benefit for the period presented because we have experienced operating losses since our inception. A valuation allowance has been recognized to fully offset the net deferred tax assets as of September 30, 2002 and December 31, 2001 as realization of such assets is uncertain.

16. Subsequent Events

         Our common stock was transferred from the Nasdaq National Market to the Nasdaq SmallCap Market where it began trading on October 16, 2002 under the ticker symbol NEOT. To remain listed on this market, we must meet Nasdaq’s continued listing requirements. Among other requirements, Nasdaq rules require that a SmallCap Market company maintain a minimum stockholders equity of $2.5 million or a minimum market value of listed securities of $35 million or a net income from continuing operations (in latest fiscal year or 2 of the last 3 fiscal years) of at least $500,000. We are currently not in compliance with this standard. There is no assurance that we will be able to regain compliance with this standard or maintain compliance with any of the other continued listing requirements. If we fail to do so, our common stock could be delisted from the Nasdaq SmallCap Market. Please see “Risk Factors” under “Item 2 – Management’s Discussion and Results of Operations and Financial Condition” for alternatives should our common stock be delisted.

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

Note Regarding Forward-Looking Statements

         This Quarterly Report on Form 10-Q contains certain words, not limited to, “believes,” “may,” “will,” “expects,” “intends,” “estimates,” “anticipates,” “plans,” “seeks,” or “continues,” that are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such forward-looking statements are based on the beliefs of the Company’s management as well as assumptions made by and information currently available to the Company’s management. Readers should not put undue reliance on these forward-looking statements. Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. Our actual results may differ materially from the results projected in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed below under “Subsequent Events Affecting Future Results,” “Financial Market Risks,” and “Risk Factors.”

         You should read the following discussion of the financial condition and results of our operations in conjunction with the financial statements and the notes to those statements included elsewhere in this report.

Related Party Transactions

         During 1987 and 1988, Alvin J. Glasky, Ph.D., a former Chief Executive Officer who is also a major stockholder of ours, loaned a total of $270,650 to us for working capital purposes, of which $250,000 plus $2,000 of accrued interest was canceled in December 1988 in exchange for the issuance of 28 Revenue Participation Units (or RPU’s). The RPU’s were converted into 4,480 shares of our common stock.

         From 1989 through 1993, we borrowed an additional $757,900 from Dr. Glasky, which, together with accrued interest of $300,404, aggregated $1,058,304 on December 31, 1993, at which time we issued 8,000 shares of common stock to Dr. Glasky in exchange for cancellation of $500,000 of loans made to us. The remaining $257,900 in principal and $300,404 of accrued interest were converted to a $558,304 promissory note. Interest was paid monthly at the annual rate of 9%. The note was partially repaid in 2000 when we advanced cash to Dr. Glasky to pay payroll taxes arising from his exercise of a warrant for 3,527 shares of common stock at $93.75 per share in August 2000. We made a further partial repayment of the note in 2001. The outstanding balance was repaid on August 16, 2002, in connection with Dr. Glasky’s retirement as our Chairman, Chief Executive Officer and Chief Science Officer.

Assignment of Patents by Dr. Glasky

         Dr. Glasky assigned us all of his rights in ten patents. In connection with the assignment of these patents to us, we entered into royalty agreements with Dr. Glasky (or the “Glasky Agreements”), which expire concurrently with the expiration of the underlying patents and any additional patents derived from the underlying patents. Under each of the Glasky Agreements, as amended, we are obligated to pay Dr. Glasky a royalty of two percent (2%) of all revenues derived by us from the use and sale by us of any products or methods included in the patents. In the event of Dr. Glasky’s death, the family or estate is entitled to continue to receive, under each Glasky Agreement, royalties at a rate of two percent (2%) for the duration of the respective Glasky Agreement. Under the terms of the Glasky Agreements, Dr. Glasky may terminate the Glasky Agreements and receive a reassignment of the patents if we file a petition under any bankruptcy or insolvency laws or otherwise commence liquidation or winding up of our business.

McMaster University Agreement

         On July 10, 1996, we entered into a license agreement with McMaster University (or McMaster) that allows us the use of certain technologies developed by McMaster covered in the patents filed jointly by us and McMaster (US Patent Nos. 5,447,939, 5,801,184, 6,027,936, 6,338,963, and 6,350,752), all of which are also subject to the Glasky Agreements. Under the agreement, we paid a one time licensing fee of $15,000 and are obligated to pay to McMaster an annual royalty of five percent (5%) on net sales of products containing compounds developed by McMaster. In July 1997, we began to make, and have continued making, annual minimum royalty payments of $25,000.

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

Director and Officer Notes for the Exercise of Equity Instruments

         We made loans to certain of our directors and officers for the exercise of stock options or for the purchase of stock. We loaned $286,560 in 1998, and $435,649 in 2000. During 2000, one individual paid $61,560 back to us and during 2001, in connection with the settlement of a litigation matter, we forgave a $45,000 note to one individual. During the three months ended September 30, 2002, loans made to Dr. Glasky totaling approximately $390,000 were repaid by the offset of certain liabilities incurred in connection with Dr. Glasky’s retirement and Sam Gulko repaid his loan in connection with his retirement. At September 30, 2002, $225,000 plus accrued interest remained due to us from directors and officers for the exercise of stock options or for the purchase of shares of common stock. In June 2002, the original interest rates that were between 7% and 9% were all changed to 4.5% and the maturity dates were extended to June 6, 2004. The notes remain secured by a pledge of the common stock purchased with the loan proceeds. The principal balance of these notes are classified in our balance sheet as an offset to stockholders’ equity. Accrued interest related to these notes are classified in our balance sheet as an other asset. The loans to directors and offices are permitted under Section 13 of the Securities and Exchange Act of 1934, as amended by Section 402 of the Sarbanes-Oxley Act on July 30, 2002, because they were outstanding on that date, however, their terms may not be renewed or materially modified in the future.

Critical Accounting Polices and Estimates

         Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (GAAP). The preparation of these condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including cash requirements resulting from estimating: planned research and development activities and general and administrative requirements, the retention of key personnel, certain clinical trial results, maintained market need for our product candidates and other major business assumptions.

         We believe that our most significant accounting policies that affect our more significant judgments and estimates used in the preparation of our condensed consolidated financial statements are as follows:

Basis of Presentation

         Our independent auditors issued a report on our consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2001, that included an explanatory paragraph regarding our ability to continue as a going concern. We have prepared the accompanying unaudited condensed consolidated financial statements under the assumption that we are a going concern. Accordingly, they do not include adjustments relating to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that would be required if we were not able to continue as a going concern. Additionally, the accompanying unaudited condensed consolidated financial statements are prepared on a consistent basis in accordance with accounting principles generally accepted in the United States (GAAP) for interim financial information and with the instruction to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals and consolidation and elimination entries) considered necessary for a fair presentation have been included. Operating results for the three-month and nine-month periods ended September 30, 2002 are not necessarily indicative of the results that may be expected for the year ended December 31, 2002. The balance sheet at December 31, 2001 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by GAAP for complete financial statements. For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2001.

         Certain quarterly amounts have been reclassified to conform to the current period presentation. All share and per share information has been restated to affect for the 25-for-1 reverse split of our common stock executed on September 6, 2002.

Liquidity and Going Concern

         On August 20, 2002, we announced a shift in our strategic focus from discovery and development of neurology drugs to the in-licensing of oncology drug candidates and the further development of and strategic alliances for these drug candidates and the discovery of neurology drugs and out-licensing these drug candidates to strategic partners. As a result of these changes and the completion of a large Alzheimer’s disease clinical trial, our burn rate fell from approximately $7 million per quarter

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

to approximately $5 million during the three-month period ended June 30, 2002 to approximately $3 million (excluding the restructuring charge and the GPC Biotech AG license fee revenue) during the three-month period ended September 30, 2002 and we expect it to continue to fall to approximately $1.5 million, or lower, per quarter beginning in the fourth quarter of 2002. The recent and the prospective reduction in the burn rate is principally due to reductions in clinical, research and administrative personnel representing an approximate 77% reduction in personnel since December 2001, the termination of a facility lease for office space used to administer the Alzheimer’s disease clinical trial, the reduction of expenses for the manufacturing of Neotrofin supplies, a reduction in our research and fellowship grant commitments, and the elimination of the research operations of our functional genomics business.

         During the three-month period ended September 30, 2002, we sold 258,824 shares of our common stock for net cash proceeds of approximately $1.0 million and issued warrants to purchase 120 shares of our common stock at an exercise price of $7.50 per share.

         On September 5, 2002, our stockholders approved an amendment to our certificate of incorporation to effect a 25-for-1 reverse split of our outstanding common stock at a Special Meeting of our stockholders.

         As of the filing of this quarterly report on Form 10-Q, approximately 2.3 million shares of our 50 million shares of authorized common stock are outstanding or subject to warrants or reserved under stock option plans.

         On September 30, 2002, we entered into a co-development and license agreement with GPC Biotech AG for the development and commercialization of our lead drug candidate, satraplatin. Under the co-development and licensing agreement, NeoTherapeutics may receive up to $22 million in license fees and milestone payments. The license fee consists of a total of $4 million; $2 million upon signing (which was received in October of 2002) and $1 million in cash and a $1 million equity investment within 30 days after the first dosing of a patient in a registrational study. GPC Biotech has agreed to make additional payments totaling up to $18 million upon achieving agreed upon milestones. However, there can be no assurance that this or any milestone will be achieved. Furthermore, GPC Biotech has agreed to fully fund development and commercialization expenses for satraplatin. Upon commercial sale of satraplatin, if any, NeoTherapeutics will be entitled to receive royalty payments based upon net sales.

         At September 30, 2002 our cash and investment balance was approximately $296,000. Subsequent to September 30, 2002 we received net cash proceeds from a licensing agreement with GPC Biotech AG of $2 million. We will not be able to continue as a going concern after December 2002 unless we succeed in raising additional funds through public or private financings, including equity financings, or through other arrangements, merge with another company that has sufficient resources for us to continue our planned operations, or successfully out-license some or all of our technology. We may not be successful in raising additional funds, selling the company, or out-licensing our technology, or we may not be able to do so at terms that are favorable to us. We do not know whether we will be able to secure sufficient new funds to continue our businesses. If we are not able to obtain sufficient funding within the time frame estimated by us, we will have to take other actions that we otherwise would not take, such as selling some or all of our intellectual property rights or further restructuring our operations or a combination of these activities including the possibility of a restructuring or liquidation provided for by one of the sections of the United States Bankruptcy Code.

         Our common stock was transferred from the Nasdaq National Market to the Nasdaq SmallCap Market where it began trading on October 16, 2002 under the ticker symbol NEOT. To remain listed on this market, we must meet Nasdaq’s continued listing requirements. Among other requirements, Nasdaq rules require that a SmallCap Market company maintain a minimum stockholders' equity of $2.5 million or a minimum market value of listed securities of $35 million or a net income from continuing operations (in latest fiscal year or 2 of the last 3 fiscal years) of at least $500,000. We are currently not in compliance. There is no assurance that we will be able to regain compliance with this standard or maintain compliance with any of the other continued listing requirements. If we fail to do so, our common stock could be delisted from the Nasdaq SmallCap Market. Please see “Risk Factors” under “Item 2 – Management’s Discussion and Results of Operations and Financial Condition” for alternatives should our common stock be delisted.

         In June 2002, we retained an investment banker and financial advisor to assist us in searching out strategic alternatives, including the sale or merger of the Company or any of our businesses. In September 2002, we terminated the services of the investment banker, however, we continue to discuss strategic alternatives with several pharmaceutical companies including the out-licensing of some of our neurology technology platforms or oncology drug products or a sale of the Company.

         As shown in the accompanying condensed consolidated financial statements, we continue to incur significant losses and negative cash flow from operations. During the nine-month period ended September 30, 2002, we incurred a loss of approximately $13.8

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

million. Our burn rate during the three-month period ended September 30, 2002 was approximately $3.0 million, excluding the charges related to the restructuring and the revenue related to the GPC Biotech AG licensing agreement. We anticipate that our burn rate will be reduced to approximately $1.5 million, or lower, per quarter starting with the fourth quarter.

Use of Estimates

         The preparation of these condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including, but not limited to, estimated cash requirements resulting from anticipated research and development activities and general and administrative requirements, the retention of key personnel, certain clinical trial results, maintained market need for our product candidates and other major business assumptions. Based on these and other estimates, we have estimated that our current working capital plus funds we are seeking to raise subsequent to the nine-month period ended September 30, 2002 will be sufficient for us to continue as a going concern and therefore have prepared the financial statements on that basis. Actual results could differ from our estimates. If these estimates prove to be wrong, we may not be able to continue as a going concern.

Cash and Cash Equivalents

         Cash and cash equivalents consist of cash and highly liquid investments of commercial paper and demand notes with original maturities of 90 days or less.

Marketable Securities and Short-Term Investments

         We classify investments in debt and equity securities among three categories: held-to-maturity, trading, and available-for-sale. As of September 30, 2002, all of our debt and equity securities holdings were categorized as available-for-sale. We carry available-for-sale securities at fair value, with unrealized gains and losses included as a component of accumulated other comprehensive income in stockholders’ equity. We use quoted market prices to determine the fair value of these investments.

Property and Equipment Purchased or Leased

         We carry property and equipment at historical cost, less accumulated depreciation and amortization. When property and equipment are disposed of, the related cost and accumulated depreciation are removed from the accounts and any resulting gain or loss is reflected in income. Depreciation and amortization are computed using the straight-line method over the following estimated useful lives:

         We assess the recoverability of the affected long-lived assets by determining whether the carrying value of such assets can be recovered through undiscounted future operating cash flows. If impairment is indicated, we reduce the carrying value of the asset to fair value. While our current and historical operating and cash flow losses are potential indicators of impairment, we are in the process of determining whether the future cash flows to be received from the long-lived assets subsequent to our restructuring will exceed the assets’ carrying value. We expect to complete this analysis in the fourth quarter of 2002.

Research and Development

         Since our inception, virtually all of our activities have consisted of research and development efforts related to developing our technologies. Accordingly, the large majority of our transactions to date have related to research and development spending. We expense all such expenditures in the period incurred.

Stock-Based Compensation

         We account for stock-based awards to employees in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and have adopted the disclosure-only alternative of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”). Options granted to non-employees, as defined, have been accounted for at fair market value in accordance with SFAS 123.

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

Revenue Recognition

         we have adopted a strategy of co-developing or licensing our drug product candidates. Accordingly, we have entered into collaborative research and development agreements and have received funding for pre-clinical research and clinical trials. Payments under these agreements, which are non-refundable, are recorded as revenue as the related research expenditures are incurred pursuant to the terms of the agreement and provided collectibility is reasonably assured. If no further commitments are required of us, the revenue is recognized when the license fee is payable.

         License fees comprise initial fees and milestone payments derived from collaborative licensing arrangements. Non-refundable milestone payments continue to be recognized upon (i) the achievement of specified milestones when we have earned the milestone payment, (ii) the milestone payment is substantive in nature and the achievement of the milestone was not reasonably assured at the inception of the agreement. We defer payments for milestone events which are reasonably assured and recognize them ratably over the minimum remaining period of our performance obligations. Payments for milestones which are not reasonably assured are treated as the culmination of a separate earnings process and are recognized as revenue when the milestones are achieved.

Results of Operations

         For the nine months ended September 30, 2002, we incurred a net loss of approximately $13.8 million. We expect that our operating expenses will decrease in the immediate future as compared to the same period last year due to the shift in our strategic focus and the reduction of the operations during the three months ended September 30, 2002. If we are able to raise sufficient additional funds, further development of our in-licensed anti-cancer drug candidates will likely cause our operational expenses to increase over the next several years. We expect to incur significant additional operating losses for AG the next several years unless such operating losses are offset, if at all, by licensing revenues under our agreement with GPC Biotech and strategic alliances with larger pharmaceutical companies that we are currently seeking. During the quarter, our functional genomics operations was reduced, restructured and merged with the pharmaceutical business, and we currently operate as one segment. The following is unaudited financial information for the three and nine-months ended September 30, 2002:

Results of Operations for the Three-Month Period Ended September 30, 2002 Compared to the Three-Month Period Ended September 30, 2001

         Revenue for the three-month period ended September 30, 2002 resulted from the recognition of the first licensing fee of $2 million from the co-development and licensing agreement with GPC Biotech AG and the technology out-licensing agreements with Pfizer entered into during the second and fourth quarter of 2001. In 2001, we entered into strategic alliances with Pfizer for investigating potential drug targets. We are obligated to pay to UCI 25% of all payments received under these agreements. In accordance with our revenue recognition policy the initial payments, less amounts owed to UCI, will be recognized as revenue over a three-year period from the date of inception of the respective agreement as we have outstanding commitments under the agreement, whereas substantive milestone payments will be recognized as revenue upon receipt, less amounts owed to UCI. The two Pfizer agreements will remain in effect, if we are successful in our negotiations with UCI to extend the rights to the receptors underlying the two Pfizer agreements, following the reduction of operations at our NeoGene subsidiary.

         Research and development expenses for the three-month period ended September 30, 2002 compared to the same period in 2001 decreased due primarily to the reduction of costs related to our clinical trial for Neotrofin in the treatment of patients with Alzheimer’s disease that ended in April 2002, causing a decrease in outside clinical research site costs, a decrease in product manufacturing costs, a decrease in salary and related benefit costs due to a reduction in research and development personnel, and a decrease in research grant expense due to a decrease in the commitments maintained by us. In addition, as a result of a restructuring, all research activities

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

related to Neotrofin and functional genomics were eliminated and our neurology pre-clinical research was reduced. During 2002, we incurred lower compensation charges associated with stock and stock options granted to employees and officers below fair market value compared to 2001 as a result of the reduction in the work force and the cancellation of certain options by three senior executives during the second quarter of 2002. These decreases were partially offset by increases in cost related to our clinical trial for Neotrofin in the treatment of patients with neuropathy, general business expenses related to the development of our oncology related drug candidates and increases in occupancy and facility costs due to the building sub-lease entered into in November 2001.

         General and administrative expenses for the three-month period ended September 30, 2002 compared to the same period in 2001 decreased due primarily to a general decrease in personnel during the three-month period ended September 30, 2002, an early termination fee paid in 2001, a license fee paid for the in-license of one of our oncology drug candidates in 2001, decreases in consulting expenses, travel and lodging expenses, officer relocation expenses, a decrease in business activities in our functional genomics business and a decrease in deferred compensation related to stock options in NeoGene granted to employees and officers below fair market value at an exercise price of $1.00 per share. The decrease was offset by an increase in depreciation expense due to the acquisition of property and equipment during the last quarter of 2001 and the first six months of 2002.

         Restructuring expenses were incurred during the three-month period ended September 30, 2002 as a result of a shift in our strategic focus from discovery and development of neurology drugs to the in-licensing of oncology drug candidates and the further development of and strategic alliances for these drug candidates, the discovery of neurology drugs and out-licensing of these drug candidates to strategic partners. As a result of these changes, we laid off 21 employees, two senior executives retired and we incurred significant administrative and legal expenses. The restructuring charge includes legal fees related to the restructuring in the amount of $231,000, a loss on the exchange of assets for certain payables to the University of California, Irvine in the amount of $312,000, retirement benefits offset against a loan to Dr. Glasky, the Company’s former CEO and current board member, in the amount of $390,000, $114,000 in severance benefits to Dr. Glasky, $200,000 in severance benefits to Samuel Gulko, the Company’s former Chief Financial Officer, Board of Directors fees of $71,000 for special meetings related to the restructuring and personnel severance related expenses of $59,000.

         Other income for the three-month period ended September 30, 2002 compared to the same period in 2001 increased due primarily to the receipt of a $250,000 exclusivity payment from a party negotiating a potential corporate transaction with the Company. During the quarter, the exclusivity period expired and we are no longer in discussions with the party. The increase was offset by a decrease in interest income resulting from lower average marketable securities balances and lower interest rates.

Results of Operations for the Nine-Month Period Ended September 30, 2002 Compared to the Nine-Month Period Ended September 30, 2001

         Revenue for the nine-month period ended September 30, 2002 resulted from the recognition of the first licensing fee of $2 million from the co-development and licensing agreement with GPC Biotech AG and the technology out-licensing agreements with Pfizer entered into during the second and fourth quarter of 2001. We received initial payments of $300,000 aggregate cash proceeds from entering into these agreements. Additionally, during the three-month period ended June 30, 2002, we received the first milestone payment of $250,000 from Pfizer under our March 15, 2001 technology out-license agreement with them. This milestone payment became due at the time Pfizer formally approved the funding and implementation of a research program with respect to a pharmaceutical lead based on our technology that we licensed to Pfizer. Under these agreements, we entered into strategic alliances with Pfizer for investigating potential drug targets. We are obligated to pay UCI 25% of all payments received under these agreements. In accordance with our revenue recognition policy the initial payments, less amounts owed to UCI, will be recognized as revenue over a three-year period from the date of inception of the respective agreement, whereas substantive milestone payments will be recognized as revenue upon receipt, less amounts owed to UCI.

         Research and development expenses for the nine-month period ended September 30, 2002 compared to the same period in 2001 decreased primarily to the reduction of costs related to our clinical trial for Neotrofin in the treatment of patients with Alzheimer’s disease that ended in April 2002, causing a decrease in outside clinical research site costs, a decrease in product manufacturing costs, a decrease in salary and related benefit costs due to a decrease in research and development personnel following the completion of the trial. In addition, as a result of a restructuring, all research activities related to Neotrofin and functional genomics were eliminated and our neurology pre-clinical research was reduced during the three months ended September 30, 2002. The decrease was also a result of lower compensation charges associated with stock and stock options granted to employees and officers below fair market value during 2002 as a result of the reduction in force and the cancellation of certain options by three senior executives during the second quarter of

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

2002.     The decrease was partially offset by an increase in salaries and related benefit costs due to additions of research and development personnel in 2002 compared to the same period in 2001, an increase in depreciation related to acquisitions of equipment and leasehold improvements, an increase in lab supplies and outside contract research due to increased business activities in the first half of 2002 compared to 2001, an increase in general business expenses related to the development of our oncology related drug candidates, increases in occupancy and facility costs due to the building sub-lease entered into in November 2001, a charge of $102,997 for personnel severance related expenses in the six month period ended June 30, 2002, and a license fee paid for the in-license of one of our oncology drug candidates in 2001. The decrease was also offset by costs related to our clinical trials for Neotrofin in the treatment of patients with Parkinson’s disease, spinal cord injuries and neuropathy. The clinical trials for the treatment of Parkinson’s disease and spinal cord injuries were completed in June and August of 2002, respectively. The clinical trial for the treatment of neuropathy should be completed during the fourth quarter of 2002.

         General and administrative expenses for the nine-month period ended September 30, 2002 compared to the same period in 2001 decreased primarily to a general decrease in personnel during the nine-month period ended September 30, 2002, an early termination fee paid in 2001, decreases in consulting, travel and lodging expenses, officer relocation expenses, and a decrease in deferred compensation related to stock options in NeoGene granted to employees and officers below fair market value at an exercise price of $1.00 per share. These decreases were partially offset by an increase in depreciation expense due to the acquisition of equipment during the fourth quarter of 2001 and the first six months of 2002, a charge of $76,763 related to personnel severance related expenses and an increase in corporate business expenses related to the development of our oncology related drug candidates.

         Restructuring expenses were incurred during the three-month period ended September 30, 2002 as a result of a shift in our strategic focus from discovery and development of neurology drugs to the in-licensing of oncology drug candidates and the further development of and strategic alliances for these drug candidates, the discovery of neurology drugs and out-licensing of these drug candidates to strategic partners. As a result of these changes, we laid off 21 employees, two senior executives retired and we incurred significant administrative and legal expenses. The restructuring charge includes legal fees in the amount of $231,000, a loss on the exchange of assets for certain payables to the University of California, Irvine in the amount of $312,000, retirement benefits offset against a loan to Dr. Glasky, the Company’s former CEO and current board member, in the amount of $390,000, $114,000 in severance benefits to Dr. Glasky, $200,000 in severance benefits to Samuel Gulko, the Company’s former Chief Financial Officer, board of directors fees of $71,000 for special meetings related to the restructuring and personnel severance related expenses of $59,000.

         Other income for the nine-month period ended September 30, 2002 compared to the same period in 2001 decreased due primarily to a decrease in the fair market value of a marketable security investment that we determined to be other than temporary of approximately $51,000 and a decrease in interest income resulting from lower average marketable securities balances and lower interest rates. These decreases were offset by a receipt of a $250,000 exclusivity payment from a party negotiating a potential corporate transaction with the Company. During the quarter, the exclusivity period expired and the Company is no longer in discussions with the party.

Subsequent Events Affecting Future Results

         On October 9, 2002, we received payment on our receivable of $2 million for the first licensing fee due on our licensing agreement with GPC Biotech AG for satraplatin.

         Our common stock was transferred from the Nasdaq National Market to the Nasdaq SmallCap Market where it began trading on October 16, 2002 under the ticker symbol NEOT. To remain listed on this market, we must meet Nasdaq’s continued listing requirements. Among other requirements, Nasdaq rules require that a SmallCap Market company maintain a minimum stockholders equity of $2.5 million or a minimum market value of listed securities of $35 million or a net income from continuing operations (in latest fiscal year or 2 of the last 3 fiscal years) of at least $500,000. We are currently not in compliance with this standard. There is no assurance that we will be able to regain compliance with this standard or maintain compliance with any of the other continued listing requirements. If we fail to do so, our common stock could be delisted from the Nasdaq SmallCap Market. Please see “Risk Factors” under “Item 2 – Management’s Discussion and Results of Operations and Financial Condition” for alternatives should our common stock be delisted.

Financial Condition

         From inception through September 30, 2002, we financed our operations primarily through sales of securities, borrowings, grants, deferred payment of salaries and other expenses from related parties and payments received from technology out-license agreements.

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

         On September 30, 2002, the Company settled its outstanding obligations with its primary manufacturer of Neotrofin for a cash payment of $332,000 and the transfer of our rights in a patent to the manufacturer resulting in a reduction formulation expense of $409,000.

         At September 30, 2002, we had a net working capital deficiency of approximately $1.1 million. Our working capital included cash and cash equivalents of approximately $41,000 and marketable securities and short-term investments of approximately $255,000. In comparison, at December 31, 2001, we had positive net working capital of approximately $2.8 million, which included cash and cash equivalents of approximately $0.75 million and short-term investments of approximately $6.4 million. The $3.9 million decrease in net working capital during the nine-month period ended September 30, 2002 is attributable primarily to the loss of approximately $13.8 million, less non-cash compensation, the receivable from GPC Biotech and other items of approximately $2.2 million. Additionally, we used $0.6 million to pay capital lease obligations and other items. These uses of working capital were offset by net cash proceeds of approximately $8.3 million from the sale of shares of our common stock.

         We devote substantially all of our efforts to research and development. We incurred net losses of approximately $13.8 million through September 30, 2002, and expect to incur substantial losses over the next several years. We have historically funded our operations with funds from public offerings and private placement equity offerings. We will require substantial additional funds by December 2002, or sooner, in order to continue and complete the research and development activities currently contemplated and to commercialize our proposed products. Our future capital requirements and availability of capital will depend upon many factors, including continued scientific progress in research and development programs, the scope and results of pre-clinical studies and clinical trials, the time and costs involved in obtaining regulatory approvals, the cost involved in filing, prosecuting and enforcing patent claims, the effect of competing technological developments, the cost of manufacturing scale-up, the cost of commercialization activities, and other factors which may not be within our control.

Contractual and Commercial Obligations

Debt and Capital Leases

         Future installments of debt principal on capital lease obligations are as follows:

Facility, Property and Equipment Operating Leases

         Minimum lease requirements for the remainder of the year ending December 31, 2002 and for the years ending December 31, 2003 through 2006 under the property and equipment leases are as follows:

Research and Fellowship Grants

         We periodically make non-binding commitments to various universities and not-for-profit research organizations to fund scientific research and fellowship grants that may further our research programs. During the three-month period ended September 30, 2002, several grants were terminated. At September 30, 2002, we had no non-binding commitments to pay research or fellowship grants.

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

Joint Ventures

         In September 1999, we entered into a three-year joint venture agreement with the University of California, Irvine (or UCI) to assist in the marketing and commercialization of discoveries made by certain members of its functional genomics science department. We were obligated under the agreement to fund the joint venture for three years with minimum payments of $2.0 million over the life of the agreement, all of which has been paid. During the three months ended September 30, 2002, we shifted our focus from the marketing and commercialization of discoveries made by the functional genomics team to the out-licensing of these discoveries and the administration of the two Pfizer collaboration agreements that will remain in effect, if we are successful in our negotiations with UCI to extend the rights to the receptors underlying the two Pfizer agreements. We have canceled the joint venture agreement.

         On April 17, 2002, we formed a joint venture with J.B. Chemicals & Pharmaceuticals, Ltd. of Mumbai, India (“JBCPL”) and created a new entity, NeoJB, LLC, a Delaware limited liability company (“NeoJB”). We will own 80% of NeoJB and a JBCPL subsidiary will own 20% of NeoJB. The business operations of NeoJB will initially be to seek U.S. regulatory approval on JBCPL pharmaceutical products and to subsequently market these products in the U.S. and possibly other countries. We will initially fund 100% of NeoJB’s operating expenses. Minimal activity has occurred under this joint venture because we have not had sufficient funds available. Following the change in management on August 19, 2002, we have continued to develop the joint venture but have not entered into any commitments at this time.

         We are also reviewing other possible joint ventures to promote our strategic focus.

Financial Market Risks

         We are exposed to certain market risks associated with interest rate fluctuations and credit risk on our marketable securities and borrowing arrangements. All investments in marketable securities and borrowing arrangements are entered into for purposes other than trading. The primary objective of our investment activities is to preserve principal while at the same time maximizing yields without significantly increasing risk. We do not utilize hedging contracts or similar instruments.

         Our investments during the nine-month period ended September 30, 2002 and as of September 30, 2002 are fixed rate, short-term corporate and government notes and bonds, which are available for sale. Because the interest rates are fixed, changes in interest rates affect the fair market value of these investments but do not affect the interest earnings. Because these financial instruments are considered “available for sale,” we record all changes in fair market value in stockholders’ equity as “Accumulated other comprehensive income” until the investment is either sold or matures, at which time the gain or loss, if any, is recognized as a realized gain or loss in the statement of operations. If a 10% change in interest rates were to have occurred on September 30, 2002, any decline in the fair value of our investments would not be material. In addition, we are exposed to certain market risks associated with the credit ratings of corporations whose bonds we have purchased. If these companies were to experience a significant detrimental change in their credit ratings, the fair market value of these corporate bonds may significantly decrease. If these companies were to default on their corporate bonds, we may lose part or all of the principal amount of our investment. We believe that we effectively manage this market risk by diversifying our corporate bond investments by purchasing a few bonds of many large, well-known, companies in a variety of industries.

         As of September 30, 2002, we had one investment of approximately $61,000 in WorldCom, Inc. corporate bonds that matures on May 15, 2003. The fair market value of these corporate bonds at September 30, 2002 was approximately $7,000, based on a market quotation. In July 2002, WorldCom, Inc. and its subsidiaries filed a voluntary jointly administered petition under the U.S. Bankruptcy Code in the United States Bankruptcy Court for the Southern District of New York. We believe that it is probable that we will be unable to collect all amounts due to us according to the contractual terms of the corporate bonds, therefore, we consider the impairment as other than temporary and have recorded a loss for approximately $51,000 in other expense during the three-month period ended June 30, 2002.

         Our primary market risk exposures relate to (1) interest rate risk on borrowings, (2) our ability to pay or refinance our borrowings at maturity at market rates, (3) interest rate risk on our investment portfolio, and (4) credit risk of the companies’ bonds in which we invest. We manage interest rate risk on our investment portfolio by matching scheduled investment maturities with our cash requirements. We manage interest rate risk on our outstanding borrowings by using fixed rate debt. While we cannot predict or manage our ability to refinance existing borrowings and our interest rate risk on our investment portfolio, we evaluate our financial position on an ongoing basis.

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

         Our borrowings bear interest at fixed rates. Changes in interest rates affect the fair value of our borrowings, but do not have an impact on interest expense. Because of the relatively short-term nature of our borrowings, fluctuations in fair value are not deemed to be material.

Business Outlook

         Our future operating results are highly uncertain, and the following factors should be carefully reviewed in addition to the other information and references contained in this quarterly report on Form 10-Q:

         The results of a completed pivotal clinical trial of Neotrofin in patients with mild to moderate Alzheimer’s disease indicated that there was no statistical difference in the performance of patients taking Neotrofin when compared to patients taking placebo. Preliminary results from our studies of Neotrofin in patients with Parkinson’s disease and spinal cord injury indicated that there was no meaningful improvement in the performance of patients taking Neotrofin. No further resources will be used for the development of Neotrofin.

         On August 20, 2002, we announced a shift in our strategic focus from discovery and development of neurology drugs to the in-licensing of oncology drug candidates and the further development of and strategic alliances for these drug candidates and the discovery of neurology drugs and out-licensing these drug candidates to strategic partners. As a result of these changes and the completion of a large Alzheimer’s disease clinical trial, our burn rate fell from approximately $7 million per quarter to approximately $5 million during the three-month period ended June 30, 2002 to approximately $3 million (excluding the restructuring charge and the GPC Biotech AG license fee revenue) during the three-month period ended September 30, 2002 and we expect it to continue to fall to approximately $1.5 million, or lower, per quarter beginning in the fourth quarter of 2002. The recent and the prospective reduction in the burn rate is principally due to reductions in clinical, research and administrative personnel representing an approximate 77% reduction in personnel since December 2001, the termination of a facility lease for office space used to administer the Alzheimer’s disease clinical trial, the reduction of expenses for the manufacturing of Neotrofin supplies, a reduction in our research and fellowship grant commitments, and the elimination of the research operations of our functional genomics business.

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

ONCOLOGY

         Our oncology program’s drug candidates, target indications and phase of development based on our shift in strategic focus is summarized in the following table:

         On September 30, 2002, we entered into a co-development and license agreement with GPC Biotech AG for the development and commercialization of our lead drug candidate, satraplatin. Under the co-development and licensing agreement, NeoTherapeutics may receive up to $22 million in license fees and milestone payments. The license fee consists of a total of $4 million; $2 million upon signing (which was received in October of 2002) and $1 million in cash and a $1 million equity investment within 30 days after the first dosing of a patient in a registrational study. GPC Biotech has agreed to make additional payments totaling up to $18 million upon achieving agreed upon milestones. However, there can be no assurance that any milestone will be achieved. Furthermore, GPC Biotech has agreed to fully fund development and commercialization expenses for satraplatin. Upon commercial sale of satraplatin, if any, NeoTherapeutics will be entitled to receive royalty payments based upon net sales.

         We do not intend to initiate new clinical trials on our other oncology drug candidates unless financial resources become available. All of these drugs are in the late stage of development.

         We are working towards developing additional strategic alliances with other pharmaceutical companies to further develop our other anti-cancer compounds and are currently in negotiations with several potential strategic alliance partners. We believe that if we are successful in our negotiations and are able to establish a strategic alliance for one or more of our other anti-cancer compounds, we may receive initial and milestone payments related to further product candidate development and rights to royalty payments on product sales if the compounds are ever approved for marketing and are sold. However, we cannot be certain that we will be able to establish any additional strategic alliances, or if so, on what terms.

         Our nervous system drug platforms’ drug candidates, target indications and phase of development based on our shift in strategic focus are summarized in the following tables:

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

NERVOUS SYSTEM