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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended June 30, 2004.

For the transition period from              to             .

Commission File Number

0-50481

AEOLUS PHARMACEUTICALS, INC.

(Exact Name of Registrant as Specified in its Charter)

Registrant’s Telephone Number, Including Area Code 919-558-8688

INCARA PHARMACEUTICALS CORPORATION

(Former Name)

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 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 an accelerated filer (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.

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AEOLUS PHARMACEUTICALS, INC.

INDEX TO FORM 10-Q

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AEOLUS PHARMACEUTICALS, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except shares and per share data)

The accompanying notes are an integral part of these unaudited consolidated financial statements.

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AEOLUS PHARMACEUTICALS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except per share data)

The accompanying notes are an integral part of these unaudited consolidated financial statements.

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AEOLUS PHARMACEUTICALS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

The accompanying notes are integral part of these unaudited consolidated financial statements.

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AEOLUS PHARMACEUTICALS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The Company is developing catalytic antioxidant molecules to protect against the damaging effects of reactive oxygen-derived molecules, commonly referred to as free radicals.

The “Company” refers collectively to Aeolus Pharmaceuticals, Inc., a Delaware corporation (“Aeolus”) and its wholly owned subsidiary, Aeolus Sciences, Inc., a Delaware corporation. Prior to July 16, 2004, the Company’s name was Incara Pharmaceuticals Corporation. The Company also owns Incara Development, Ltd., an inactive Bermuda corporation (“Incara Development”) and a 35.0% interest in CPEC LLC, a Delaware limited liability company (“CPEC”). The Company uses the equity method to account for its investment in CPEC.

All significant intercompany activity has been eliminated in the preparation of the consolidated financial statements. The unaudited 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, 2003 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, 2003. The unaudited 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.

The accompanying unaudited financial statements have been prepared on a basis which assumes that the Company will continue as a going concern and which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business.

On April 19, 2004, Goodnow Capital, L.L.C. (“Goodnow”) converted a secured convertible debenture with outstanding principal of $5,000,000 (the “Debenture”) and accrued interest into 5,046,875 shares of common stock, eliminating the Debenture’s repayment obligation, and the Company completed a private placement sale of 4,104,000 shares of its common stock resulting in net proceeds of $9,359,000 (the “Financing”). The Company believes it now has adequate financial resources to conduct operations at least until the third fiscal quarter of fiscal 2005.

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In May 2003, the Financial Accounting Standards Board (the “FASB”) issued FASB Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity” (“SFAS 150”). SFAS 150 changes the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity and requires that those instruments be classified as liabilities (or assets in certain circumstances) in statements of financial position. This statement affects the issuer’s accounting for three types of freestanding financial instruments including (1) mandatorily redeemable shares that are required to be redeemed at a specified or determinable date or upon an event certain to occur, (2) put options and forward purchase contracts, which involve financial instruments embodying an obligation that the issuer must or could choose to settle by issuing a variable number of its shares or other equity instruments based solely on something other than the issuer’s own equity shares and (3) certain obligations that can be settled with shares, the monetary value of which is (i) fixed or tied solely or predominantly to a variable such as a market index, or (ii) varies inversely with the value of the issuer’s shares. SFAS 150 also requires disclosures about alternative ways of settling the instruments and the capital structure of entities - all of whose shares are mandatorily redeemable. SFAS 150 became effective on July 1, 2003 for the Company. As a result of SFAS 150, the Company classified its Series C redeemable convertible exchangeable preferred stock (“Series C Stock”) as a liability at September 30, 2003. All shares of Series C Stock were exchanged for common stock on November 20, 2003.

In 2003, the FASB Emerging Issues Task Force (“EITF”) reached a tentative conclusion on Issue 03-06, “Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings per Share” that the two-class method is an earnings allocation formula that treats a participating security as having rights to earnings that otherwise would have been available to common stockholders, but does not require the presentation of basic and diluted EPS for securities other than common stock. However, the EITF observed that the presentation of basic and diluted earnings per share for a participating security other than common stock is not precluded. The Company is currently evaluating the effect that this EITF conclusion would have on its current presentation of earnings per 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 shares attributable to common stockholders using the weighted average number of shares of common and dilutive potential common shares outstanding during the period. Potential common shares consist of stock options, restricted common stock, convertible debt, warrants and convertible preferred stock, using the treasury stock method and are excluded if their effect is antidilutive. Diluted weighted average common shares excluded incremental shares of approximately 4,525,000 as of June 30, 2004 related to stock options to purchase common stock, convertible preferred stock, convertible debt and warrants to purchase common and preferred stock. These shares were excluded due to their antidilutive effect as a result of the Company’s loss from continuing operations.

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On July 28, 2003, the Company entered into a $3,000,000 secured bridge loan facility (the “$3M Note”) with Goodnow. Through September 30, 2003, the Company borrowed $2,000,000 of the $3M Note. The remaining $1,000,000 was borrowed in October and November 2003. On November 20, 2003, the Company’s stockholders approved a reorganization and merger (the “Reorganization”) of the Company with and into its wholly owned subsidiary, Incara, Inc., pursuant to which the Company’s stockholders became stockholders of Incara, Inc. The Reorganization was completed on November 20, 2003 and Incara, Inc. changed its name to Incara Pharmaceuticals Corporation. The Reorganization was accounted for at historical cost and there was no change in the basis of the Company’s assets and liabilities. Pursuant to the terms of the respective agreements, the Reorganization resulted in the conversion of the $3M Note into 3,060,144 shares of common stock and a $35,000 note payable owed to another party into 35,000 shares of common stock. Pursuant to the terms of the Company’s Certificate of Incorporation, the Reorganization resulted in the conversion of all 12,015 shares of outstanding Series C Stock into 225,533 shares of common stock.

In January 2004, the Company closed on a secured convertible debenture facility of $5,000,000 with Goodnow. The Debenture had a due date of December 24, 2004, an interest rate of 10% and was secured by all of the assets of the Company. The Debenture, including interest, was convertible into common stock at a price of $1.00 per share. In connection with the issuance of the $3M Note and the Debenture, the Company agreed to various covenants and restrictions on its operations. The Company borrowed $5,000,000 under the Debenture during the period from January 2004 through April 16, 2004. Since the conversion rate of the Debenture of $1.00 per share was less than the market value of the Company’s common stock at the time of the advances, accounting principles require that a portion of the proceeds be allocated to additional paid-in-capital for this beneficial conversion feature. As the amount of the beneficial conversion feature exceeded the proceeds of the Debenture, the amount of the beneficial conversion feature recorded was limited to the $5,000,000 proceeds from the Debenture. On April 19, 2004, Goodnow voluntarily converted the principal and interest into 5,046,875 shares of the Company’s common stock at a price of $1.00 per share. As the Debenture was terminated early and converted to common stock in April 2004, nearly all of the $5,000,000 beneficial conversion feature of the Debenture was recognized as noncash interest expense during the three months ended June 30, 2004.

In connection with the Debenture, Incara issued to Goodnow a warrant to purchase 1,250,000 shares of common stock. Pursuant to its terms, the warrant expired unexercised as a result of the Financing.

On April 19, 2004, Incara completed a private placement sale of 4,104,000 shares of common stock at $2.50 per share, resulting in net proceeds of $9,359,000 (after deducting costs of the sale). The Company issued warrants to the investors to purchase an aggregate of

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1,641,600 shares of common stock with an exercise price of $4.00 per share and issued a warrant to the placement agent to purchase 410,400 shares of common stock with an exercise price of $2.50 per share.

In January 2001, the Company closed on a collaborative transaction with Elan Corporation, plc and several of its affiliated companies (“Elan”). As part of the transaction, Elan and the Company formed a Bermuda corporation, Incara Development, Ltd., to develop deligoparin, a compound that was being investigated as a drug treatment for inflammatory bowel disease. As part of the transaction, Elan and the Company entered into license agreements under which the Company licensed to Incara Development rights to deligoparin and Elan licensed to Incara Development proprietary drug delivery technology. In September 2002, Incara Development ended its Phase 2/3 clinical trial and the development of deligoparin due to an analysis of the clinical trial results, which showed that treatment with deligoparin did not meet the primary or secondary endpoints of the study. The results of the trial did not justify further development of deligoparin for treatment of ulcerative colitis and the development of deligoparin was terminated. Elan and the Company ended their collaboration in the joint venture in November 2003 and the Company became the sole owner of Incara Development. As a result, Incara Development’s operations are now consolidated with the Company’s operations. The Company is currently in the process of liquidating Incara Development.

In October 2003, CPEC, the Company’s 35% owned equity investee, licensed bucindolol, a drug previously under development by the Company for the treatment of heart failure, to ARCA Discovery, Inc. in return for possible future royalty and milestone payments.

On October 31, 2002, the Company sold substantially all of the assets and operations of its liver cell program to Vesta Therapeutics, Inc. (“Vesta”) and recognized a gain of $1,912,000 on the sale. The Company received a right to royalties on products developed using intellectual property transferred to Vesta and proceeds of $3,422,000, which consisted of $2,955,000 of cash payments and $467,000 of reduction in the Company’s notes payable and capital lease obligations. As part of the transaction, the Company sold to Vesta property and equipment with a net book value of $572,000 and assigned certain related licenses and other agreements to Vesta. The Company wrote off $492,000 for impaired laboratory facilities and established a reserve of $446,000 for the future net rent costs of the laboratory facility. The balance of the reserve was $285,000 at June 30, 2004. Net expenses of the liver cell program of $38,000 for the nine months ended June 30, 2003 are shown as discontinued operations on the statements of operations.

Under the principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees”, the Company does not recognize compensation expense associated with the grant of

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stock options to employees unless an option is granted with an exercise price at less than fair market value. SFAS 123 requires the use of option valuation models to recognize as expense stock option grants to consultants and to provide supplemental information regarding options granted to directors and employees.

The Company recognized noncash charges totaling $2,327,000 during the three months ended June 30, 2004 for accelerated vesting of stock options as a result of a change in the Board of Directors and the resignation of the Company’s former Chief Executive Officer. For the nine months ended June 30, 2004 and 2003, all stock options granted to directors, employees and consultants were issued at or above the fair market value of a share of common stock. During the nine months ended June 30, 2004, a fully vested stock option with a fair market value of $64,000 was granted to a consultant and was expensed. No stock options were granted to consultants in fiscal 2003.

The Company’s pro forma information utilizing the Black-Scholes option valuation model is as follows (in thousands, except for net loss per share information):

Pro forma information regarding the Company’s net loss was determined as if the Company had accounted for its employee stock options and shares sold under its Employee Stock Purchase Plan under the fair value method of SFAS 123. The fair value of each option grant for employees and consultants is estimated on the date of the grant using the Black-Scholes option valuation model with the following weighted-average assumptions used for grants:

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At June 30, 2004, the Company had future contractual operating lease commitments of $857,000 for its administrative office and laboratory facilities, of which $285,000 had been accrued as a liability for discontinued operations. In December 1999, the Company sold IRL, its anti-infectives division, to a private pharmaceutical company. The Company remains contingently liable through May 2007 for a lease obligation of approximately $3,747,000 assumed by the purchaser on the former IRL facility in Cranbury, New Jersey.

On July 16, 2004, the Company effected a one-for-ten reverse stock split of its common stock and changed its name from Incara Pharmaceuticals Corporation to Aeolus Pharmaceuticals, Inc. All common stock amounts in this Form 10-Q have been adjusted for the reverse stock split.

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

Introduction

Unless otherwise noted, the phrase “we” or “our” refers collectively to Aeolus Pharmaceuticals, Inc. and our wholly owned subsidiary, Aeolus Sciences, Inc.

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 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. Actual results could differ materially from those currently anticipated or suggested due to a number of factors, including those set forth herein, those set forth in our Annual Report on Form 10-K for the fiscal year ended September 30, 2003 and in our other SEC filings, and including risks relating to the need to conserve and obtain funds for operations, uncertainties relating to clinical trials, the early stage of products under development and regulatory reviews, and competition. 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.

Operations Summary

We are developing a new class of small molecule catalytic antioxidants that destroy oxygen-derived free radicals, believed to be an important contributor to the pathogenesis of many diseases. Our catalytic antioxidants have been shown to reduce damage to tissue in animal studies of neurological disorders such as amyotrophic lateral sclerosis (ALS, also known as Lou Gehrig’s disease) and stroke, and in other non-neurological indications such as cancer radiation therapy, chronic bronchitis and asthma. We have submitted an IND with the Food and Drug Administration to initiate Phase 1 clinical trials with our lead compound as a treatment for ALS.

We do not have any revenue, other than grant income, and therefore we must rely on outside investors, grants or collaborations to finance our operations.

The following management and reorganizational changes have occurred since March 31, 2004.

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Results of Operations

We had net losses attributable to common stockholders of $10,468,000 and $15,254,000 for the three and nine months ended June 30, 2004, respectively, versus net losses attributable to common stockholders of $1,216,000 and $2,610,000 for the three and nine months ended June 30, 2003, respectively. The net loss for the nine months ended June 30, 2003 was reduced by a $1,912,000 gain on the sale of our liver cell operations to Vesta Therapeutics, Inc. in October 2002.

In August 2003, we were awarded a $100,000 Small Business Innovation and Research, or SBIR, Phase I grant from the National Cancer Institute, a division of the National Institutes of Health, or NIH, and in March 2004, we were awarded a SBIR Phase II grant from the NIH. Pursuant to the grants, we are studying the antitumor and radiation-protective effects of our catalytic antioxidants. We have completed Phase I and have received $100,000 of Phase I grant income. The Phase II grant is payable over two years and will explore the ability of the selected compound to inhibit tumors from becoming channels for further cancerous growth and block damage to normal tissue from radiation therapy. The initial grant amount of $375,000 of Phase II was awarded in March 2004 by the NIH. The $375,000 for the second part of the Phase II grant is expected to be awarded in early 2005 and is contingent upon the NIH’s availability of funds and satisfactory progress of the project. The study is a collaboration between us and the Department of Radiation Oncology at Duke University Medical Center. We recognized $74,000 of Phase II grant income through June 30, 2004.

During fiscal 2003 we decreased our spending on research and development, or R&D, activities because of our lack of financial resources. With the financing we received beginning in July 2003, we were able to move forward with our preclinical catalytic antioxidant programs. Our R&D expenses increased $2,581,000, or 456%, to $3,147,000 for the three months ended June 30, 2004 from $566,000 for the three months ended June 30, 2003. R&D expenses increased $4,479,000, or 198%, to $6,744,000 for the nine months ended June 30, 2004 from $2,265,000 for the nine months ended June 30, 2003. Our primary operational focus and R&D spending during the nine months ended June 30, 2004 was on preclinical pharmacology and toxicology tests on our lead compound for the treatment of ALS. We also incurred approximately $4,186,000 of outside drug development costs during the nine months ended June 30, 2004 versus only $464,000 of outside drug development costs for the nine months ended

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June 30, 2003. In addition, we recognized an $816,000 noncash charge for accelerated vesting of stock options for R&D employees during the three months ended June 30, 2004 as a result of the change in our Board of Directors on April 30, 2004. R&D expenses for our antioxidant program have totaled $23,554,000 from inception through June 30, 2004. 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.

General and administrative, or G&A, expenses increased $1,896,000, or 391%, to $2,381,000 for the three months ended June 30, 2004 from $485,000 for the three months ended June 30, 2003. G&A expenses increased $1,834,000, or 114%, to $3,438,000 for the nine months ended June 30, 2004 from $1,604,000 for the nine months ended June 30, 2003. We recognized $1,510,000 of noncash G&A expenses for the three months ended June 30, 2004 for accelerated vesting of stock options for G&A employees as a result of the change in our Board of Directors and the resignation of our former Chief Executive Officer. In addition we incurred severance costs in conjunction with the resignation of our former Chief Executive Officer and increased legal, accounting and filing fees incurred in connection with our financing and reorganization activities.

On October 31, 2002, we sold substantially all the assets and operations of our liver cell program to Vesta and recognized a gain of $1,912,000 on the sale. We received a right to royalties on products developed using intellectual property transferred to Vesta and proceeds of $3,422,000, which consisted of $2,955,000 of cash payments and $467,000 of reduction in our notes payable and capital lease obligations. As part of the transaction, we sold to Vesta property and equipment with a net book value of $572,000 and assigned certain related licenses and other agreements to Vesta. We wrote off $492,000 for impaired laboratory facilities and established a reserve of $446,000 for the future net rent costs of our exited laboratory facility. Net expenses of the liver cell program of $38,000 for the nine months ended June 30, 2003 are shown as discontinued operations on the statements of operations.

Our expenses associated with Incara Development and development of deligoparin of $81,000 were included in “Equity in loss of Incara Development” for the nine months ended June 30, 2003. The Phase 2/3 clinical trial of deligoparin for the treatment of inflammatory bowel disease ended in September 2002 along with the development of deligoparin, due to an analysis of the clinical trial results, which showed that treatment with deligoparin did not meet the primary or secondary endpoints of the study. We terminated our collaboration with Elan in November 2003 and we became the sole owner of Incara Development. As a result, we now consolidate Incara Development’s operations. We are in the process of liquidating Incara Development.

Other income of $221,000 for the nine months ended June 30, 2003 related to sublease rental income of our leased laboratory facility.

We accreted $135,000 and $706,000 of dividends on our Series C preferred stock during the nine months ended June 30, 2004 and 2003, respectively. As part of the reorganization on November 20, 2003, all shares of Series C preferred stock were converted into common stock and we no longer accrete dividends on the Series C preferred stock.

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Liquidity and Capital Resources

At June 30, 2004, we had $9,055,000 of cash, an increase of $8,469,000 from September 30, 2003. We believe we now have adequate financial resources to conduct operations at least until the third fiscal quarter of fiscal 2005. The increase in cash was primarily due to the following financing transactions, offset by fiscal 2004 cash operating expenses.

Since the convertible debenture conversion rate of $1.00 per share was less than the market value of our common stock at the time of the advances, accounting regulations require that the convertible debenture proceeds be allocated to the beneficial conversion feature. The resulting $5,000,000 of discount on the $5,000,000 that we borrowed under the convertible debenture was recognized as $5,000,000 of noncash interest expense primarily on April 19, 2004, when the convertible debenture was converted to common stock.

We incurred operational losses of $5,456,000 and $10,008,000 during the three and nine months ended June 30, 2004, respectively. Due to the nonrecurring noncash charges for stock options recognized in the third quarter of fiscal 2004, we anticipate our operational costs will be lower during the fourth quarter of fiscal 2004. Our ongoing cash requirements will depend on numerous factors, particularly the progress of our catalytic antioxidant program and our ability to negotiate and complete collaborative agreements. 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 may sell additional shares of our stock and explore other strategic and financial alternatives, including a merger with another company.

There are uncertainties as to these potential sources of capital. Our access to capital might be restricted because we might not be able to enter into any collaboration on terms acceptable or favorable to us due to conditions in the pharmaceutical industry or in the economy

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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 might have to relinquish rights to technologies, product candidates or markets that we might otherwise develop ourselves.

Similarly, due to market conditions, the illiquid nature of our stock, and other possible limitations on stock offerings, we might not be able to sell additional securities or raise other funds on terms acceptable or favorable to us. It can be difficult for small biotechnology companies such as us to raise funds in the equity markets. Any additional equity financing, if available, would likely result in substantial dilution to existing stockholders.

At June 30, 2004, we had a $768,000 debt obligation owed to Elan that is due in December 2006. We also had future contractual operating lease commitments of $857,000 for our administrative office and laboratory facilities, of which $285,000 has been accrued as a liability. In addition, in December 1999, we sold IRL, our anti-infectives division, to a private pharmaceutical company. We remain contingently liable through May 2007 for a lease obligation of approximately $3,747,000 assumed by the purchaser on the former IRL facility in Cranbury, New Jersey.

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Item 4. Controls and Procedures.

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

(b) No change in the Company’s internal control over financial reporting occurred during the Company’s last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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Part II. OTHER INFORMATION

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

On April 19, 2004, the Company completed a private placement to accredited investors of 4,104,000 shares of common stock at $2.50 per share, which included the issuance of warrants to purchase 1,641,600 shares of common stock at $4.00 per share. In addition, the Company issued to the placement agent, SCO Securities LLC, a warrant to purchase 410,400 shares of common stock at $2.50 per share. These transactions were exempt under Section 4(2) of the Securities Act of 1933, as amended.

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

On April 30, 2004, the Company’s majority stockholder, Goodnow Capital, L.L.C., approved the following resolutions by written consent:

On June 24, 2004, Goodnow approved the following resolutions by written consent:

The Company sent notice of these actions to all stockholders.

Item 6. Exhibits and Reports on Form 8-K.

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SIGNATURES

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

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