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** **

 

** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 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 March 31, 2011**

 

**Or**

 

| **o** | **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: 001-32966**

 

**OSIRIS THERAPEUTICS, INC.**

(Exact name of registrant as specified in its charter)

 

| **Maryland**                                                   | ** ** | **71-0881115**                       |
|----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation or organization) |       | (I.R.S. Employer Identification No.) |

 

| **7015 Albert Einstein Drive, Columbia, Maryland** | ** ** | **21046**  |
|----------------------------------------------------|------------|------------|
| (Address of principal executive offices)           |       | (Zip Code) |

 

**443-545-1800**

(Registrant’s telephone number, including area code)

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

| Large accelerated filer o                     |   | Accelerated filer x         |
|-----------------------------------------------|--------|-----------------------------|
|                                          |   |                        |
| Non-accelerated filer o                       |   | Smaller reporting company o |
| (Do not check if a smaller reporting company) |   |                        |

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  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 at May 9, 2011** |
|------------------------------------------|------------|----------------------------------------------------|
| Common Stock, par value $0.001 per share |       | 32,821,083                                         |

 

 

 

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**OSIRIS THERAPEUTICS, INC.**

 

**INDEX**

 
| ** **                                     | ** **                                                                                   | **Page** |
|------------------------------------------------|----------------------------------------------------------------------------------------------|----------|
| **PART I —   FINANCIAL INFORMATION** |                                                                                         |
|                                           |                                                                                         |
| Item 1.                                        | Financial Statements —   Unaudited                                                      |     |
|                                           | Balance Sheets — March 31, 2011 and   December 31, 2010                       |     |
|                                           | Condensed Statements of Operations — three months   ended March 31, 2011 and 2010  |     |
|                                           | Statement of Stockholders’ Equity— three months ended   March 31, 2011        |     |
|                                           | Statements   of Cash Flows — three months ended March 31, 2011 and 2010            |     |
|                                           | Notes   to Condensed Financial Statements                                                    |     |
|                                           |                                                                                         |     |
| Item 2.                                        | Management’s   Discussion and Analysis of Financial Condition and Results of Operations |     |
|                                           |                                                                                         |     |
| Item 3.                                        | Quantitative   and Qualitative Disclosures About Market Risk                                 |     |
|                                           |                                                                                         |     |
| Item 4.                                        | Controls and   Procedures                                                                    |     |
|                                           |                                                                                         |     |
| **PART II   — OTHER INFORMATION**    |                                                                                         |
|                                           |                                                                                         |     |
| Item 1.                                        | Legal Proceedings                                                                            |     |
| Item 1A.                                  | Risk Factors                                                                                 |     |
| Item 2.                                        | Unregistered   Sales of Equity Securities and Use of Proceeds                                |     |
| Item 3.                                        | Defaults Upon   Senior Securities                                                            |     |
| Item 4.                                        | (Removed and Reserved)                                                                       |     |
| Item 5.                                        | Other Information                                                                            |     |
| Item 6.                                        | Exhibits                                                                                     |     |
|                                           |                                                                                         |     |
| Signatures                                     |                                                                                         |     |
|                                           |                                                                                         |     |
| Exhibit Index                             |                                                                                         |     |

 

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**PART I — FINANCIAL INFORMATION**

 

**Item 1.                    Financial Statements - Unaudited**

 

**OSIRIS THERAPEUTICS, INC.**

**BALANCE SHEETS**

**(amounts in thousands)**

 
| ** **                                                                                                                      | ** ** | **March 31, 2011** | ** ** | **December 31, 2010** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                      | ** ** | **(unaudited)**              | ** ** | ** **                      | ** ** |
| **Assets**                                                                                                                      |       |                         |       |                            |       |
| Current assets:                                                                                                                 |       |                         |       |                            |       |
| Cash                                                                                                                            |       | $                            | 1,437      |                            | $          | 1,442 |   |
| Investments   available for sale                                                                                                |       | 60,171                       |       | 66,166                          |       |
| Accounts   receivable                                                                                                           |       | 1,625                        |       | 1,928                           |       |
| Inventory                                                                                                                       |       | 639                          |       | 510                             |       |
| Deferred tax   asset                                                                                                            |       | 3,170                        |       | 3,170                           |       |
| Prepaid expenses   and other current assets                                                                                     |       | 625                          |       | 736                             |       |
| Total current   assets                                                                                                          |       | 67,667                       |       | 73,952                          |       |
|                                                                                                                            |       |                         |       |                            |       |
| Property and   equipment, net                                                                                                   |       | 2,963                        |       | 3,127                           |       |
| Restricted cash                                                                                                                 |       | 521                          |       | 521                             |       |
| Other assets                                                                                                                    |       | 167                          |       | 184                             |       |
| Total assets                                                                                                                    |       | $                            | 71,318     |                            | $          | 77,784 |   |
|                                                                                                                            |       |                         |       |                            |       |
| **Liabilities and Stockholders'   Equity**                                                                                      |       |                         |       |                            |       |
|                                                                                                                            |       |                         |       |                            |       |
| Current   liabilities:                                                                                                          |       |                         |       |                            |       |
| Accounts payable   and accrued expenses                                                                                         |       | $                            | 4,693      |                            | $          | 5,569 |   |
| Deferred   revenue, current portion                                                                                             |       | 34,053                       |       | 40,960                          |       |
| Total current   liabilities                                                                                                     |       | 38,746                       |       | 46,529                          |       |
|                                                                                                                            |       |                         |       |                            |       |
| Deferred   revenue, net of current portion                                                                                      |       | —                       |       | 3,333                           |       |
| Other long-term   liabilities                                                                                                   |       | 460                          |       | 465                             |       |
| Total   liabilities                                                                                                             |       | 39,206                       |       | 50,327                          |       |
|                                                                                                                            |       |                         |       |                            |       |
| Stockholders'   equity                                                                                                          |       |                         |       |                            |       |
| Common stock,   $.001 par value, 90,000 shares authorized, 32,819 shares outstanding - 2011, 32,794   shares outstanding - 2010 |       | 33                           |       | 33                              |       |
| Additional   paid-in-capital                                                                                                    |       | 275,250                      |       | 274,646                         |       |
| Accumulated   other comprehensive income (loss)                                                                                 |       | 9                            |       | (3                              | )          |
| Accumulated   deficit                                                                                                           |       | (243,180                     | )          | (247,219                        | )          |
| Total   stockholders' equity                                                                                                    |       | 32,112                       |       | 27,457                          |       |
| Total   liabilities and stockholders' equity                                                                                    |       | $                            | 71,318     |                            | $          | 77,784 |   |

 

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

 

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**OSIRIS THERAPEUTICS, INC.**

**CONDENSED STATEMENTS OF OPERATIONS**

**Unaudited**

**(amounts in thousands, except per share data)**

 
| ** **                                                                              | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                              | ** ** | **March 31,**               | ** ** |
| ** **                                                                              | ** ** | **2011**                         | ** ** | **2010** | ** ** |
|                                                                                    |       |                             |       |   |   |
| **Product sales**                                                                       |       | $                                | 37         |   | $ | — |   |
| Cost of goods sold                                                                      |       | 15                               |       | — |   |
| Gross profit                                                                            |       | 22                               |       | — |   |
|                                                                                    |       |                             |       |   |   |
| **Revenue from collaborative   research agreements, government contract and royalties** |       | 10,395                           |       | 11,377 |   |
|                                                                                    |       |                             |       |   |   |
| Operating expenses:                                                                     |       |                             |       |   |   |
| Research and development                                                                |       | 4,711                            |       | 6,560 |   |
| General and administrative                                                              |       | 1,696                            |       | 1,807 |   |
|                                                                                    |       | 6,407                            |       | 8,367 |   |
|                                                                                    |       |                             |       |   |   |
| Income from operations                                                                  |       | 4,010                            |       | 3,010 |   |
|                                                                                    |       |                             |       |   |   |
| Other income, net                                                                       |       | 29                               |       | 88 |   |
|                                                                                    |       |                             |       |   |   |
| Income before income taxes                                                              |       | 4,039                            |       | 3,098 |   |
|                                                                                    |       |                             |       |   |   |
| Income tax expense                                                                      |       | —                           |       | (682 | ) |
|                                                                                    |       |                             |       |   |   |
| **Net income**                                                                          |       | $                                | 4,039      |   | $ | 2,416 |   |
|                                                                                    |       |                             |       |   |   |
| Basic earnings per share                                                                |       | $                                | 0.12       |   | $ | 0.07 |   |
|                                                                                    |       |                             |       |   |   |
| Diluted earnings per share                                                              |       | $                                | 0.12       |   | $ | 0.07 |   |
|                                                                                    |       |                             |       |   |   |
| Weighted average common shares (basic)                                                  |       | 32,807                           |       | 32,774 |   |
|                                                                                    |       |                             |       |   |   |
| Weighted average common shares (diluted)                                                |       | 33,113                           |       | 33,088 |   |

 

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

 

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**OSIRIS THERAPEUTICS, INC.**

**STATEMENT OF STOCKHOLDERS’ EQUITY**

**For the three months ended March 31, 2011**

**Unaudited**

**(amounts in thousands, except for share and per share data)**

 
| ** **                                                      | ** ** | ** **            | ** ** | ** **  | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** **             | ** ** | ** **                | ** ** |
|-----------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-------------------|------------|------------------------|------------|------------------------|------------|---------------------------|------------|
| ** **                                                      | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**    | ** ** | **Other**              | ** ** | ** **             | ** ** | **Total**                 | ** ** |
| ** **                                                      | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Comprehensive** | ** ** | **Accumulated**        | ** ** | **Stockholders’** | ** ** |
| ** **                                                      | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**       | ** ** | **Income (Loss)** | ** ** | **Deficit**            | ** ** | **Equity (Deficit)** | ** ** |
| **Balance at January 1, 2011**                             | ** ** | **32,793,457**        | ** ** | **$**       | **33**     | ** **        | **$**      | **274,646**            | ** ** | **$**                  | **(3**     | **)**                     | **$**      | **(247,219** | **)** | **$** | **27,457** | ** ** |
|                                                            |       |                  |       |        |       |              |       |                   |       |                   |       |                      |       |
| Exercise of options to purchase common stock ($.40   per share) |       | 563                   |       | —      |       | —            |       | —                 |       | —                 |       | —                    |       |
|                                                            |       |                  |       |        |       |              |       |                   |       |                   |       |                      |       |
| Share-based payment-director services ($7.13 per   share)       |       | 25,000                |       | —      |       | 178               |       | —                 |       | —                 |       | 178                       |       |
|                                                            |       |                  |       |        |       |              |       |                   |       |                   |       |                      |       |
| Share-based payment-employee compensation                       |       | —                |       | —      |       | 426               |       | —                 |       | —                 |       | 426                       |       |
|                                                            |       |                  |       |        |       |              |       |                   |       |                   |       |                      |       |
| **Comprehensive income:**                                       |       |                  |       |        |       |              |       |                   |       |                   |       |                      |       |
| Net income                                                      |       | —                |       | —      |       | —            |       | —                 |       | 4,039                  |       | 4,039                     |       |
|                                                            |       |                  |       |        |       |              |       |                   |       |                   |       |                      |       |
| Unrealized gain on investments available for sale               |       | —                |       | —      |       | —            |       | 12                     |       | —                 |       | 12                        |       |
| **Total comprehensive income**                                  |       |                  |       |        |       |              |       |                   |       |                   |       | 4,051                     |       |
|                                                            |       |                  |       |        |       |              |       |                   |       |                   |       |                      |       |
| **Balance at March 31, 2011**                              | ** ** | **32,819,020**        | ** ** | **$**       | **33**     | ** **        | **$**      | **275,250**            | ** ** | **$**                  | **9**      | ** **                | **$**      | **(243,180** | **)** | **$** | **32,112** | ** ** |

 

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

 

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**OSIRIS THERAPEUTICS, INC.**

**STATEMENTS OF CASH FLOWS**

**Unaudited**

**(amounts in thousands)**

 
| ** **                                                                           | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                           | ** ** | **March 31,**               | ** ** |
| ** **                                                                           | ** ** | **2011**                         | ** ** | **2010** | ** ** |
| **Cash flows from operating   activities:**                                          |       |                             |       |   |   |
| **Continuing operations**                                                            |       |                             |       |   |   |
| Net income                                                                           |       | $                                | 4,039      |   | $ | 2,416 |   |
| **Adjustments to reconcile net   income to net cash used in continuing operations:** | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Depreciation and amortization                                                        |       | 189                              |       | 190 |   |
| Non cash share-based payments                                                        |       | 604                              |       | 374 |   |
| **Changes in operating assets and   liabilities:**                                   |       |                             |       |   |   |
| Accounts receivable                                                                  |       | 303                              |       | (251 | ) |
| Prepaid expenses, inventory, and other current   assets                              |       | (18                              | )          | 116 |   |
| Other assets                                                                         |       | 17                               |       | 55 |   |
| Accounts payable and accrued expenses                                                |       | (869                             | )          | (3,168 | ) |
| Deferred revenue                                                                     |       | (10,240                          | )          | (10,296 | ) |
| Net cash used in continuing operations                                               |       | (5,975                           | )          | (10,564 | ) |
| **Discontinued operations**                                                          |       |                             |       |   |   |
| **Changes in operating assets and   liabilities:**                                   |       |                             |       |   |   |
| Accounts payable and accrued expenses                                                |       | —                           |       | (412 | ) |
| Net cash used in discontinued operations                                             |       | —                           |       | (412 | ) |
|                                                                                 |       |                             |       |   |   |
| Net cash used in operating activities                                                |       | (5,975                           | )          | (10,976 | ) |
|                                                                                 |       |                             |       |   |   |
| **Cash flows from investing   activities:**                                          |       |                             |       |   |   |
| Purchases of property and equipment                                                  |       | (25                              | )          | (38 | ) |
| Proceeds from sale of investments available for   sale                               |       | 6,000                            |       | 11,097 |   |
| Purchases of investments available for sale                                          |       | (5                               | )          | (173 | ) |
|                                                                                 |       |                             |       |   |   |
| Net cash provided by investing activities                                            |       | 5,970                            |       | 10,886 |   |
|                                                                                 |       |                             |       |   |   |
| **Cash flows from financing   activities:**                                          |       |                             |       |   |   |
| Principal payments on capital lease obligations                                      |       | —                           |       | (2 | ) |
| Proceeds from the exercise of stock options                                          |       | —                           |       | 1 |   |
|                                                                                 |       |                             |       |   |   |
| Net cash used in financing activities                                                |       | —                           |       | (1 | ) |
|                                                                                 |       |                             |       |   |   |
| Net decrease in cash                                                                 |       | (5                               | )          | (91 | ) |
| Cash at beginning of period                                                          |       | 1,442                            |       | 1,306 |   |
|                                                                                 |       |                             |       |   |   |
| Cash at end of period                                                                |       | $                                | 1,437      |   | $ | 1,215 |   |

 

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

 

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**OSIRIS THERAPEUTICS, INC.**

**NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREE MONTHS ENDED MARCH 31, 2011 AND 2010**

 

**1.             Nature of Business**

 

Osiris Therapeutics, Inc. (“we,” “us,” “our,” or the “Company”) is a Maryland corporation headquartered in Columbia, Maryland. We began operations on December 23, 1992 and were a Delaware corporation until, with approval of our stockholders, we reincorporated as a Maryland corporation on May 31, 2010. We are a leading stem cell company focused on developing and marketing products to treat serious medical conditions in the inflammatory, autoimmune, orthopedic, wound care and cardiovascular areas. Our biologic drug candidates utilize adult human mesenchymal stem cells, or MSCs, which can selectively differentiate, based on the tissue environment, into various tissue lineages, such as muscle, bone, cartilage, marrow stroma, tendon or fat. In addition, MSCs have anti-inflammatory properties and can prevent fibrosis or scarring, which gives MSCs the potential to treat a wide variety of medical conditions. Historically, our operations have consisted primarily of research, development and clinical activities to bring our biologic drug candidates to the marketplace. We have several research collaboration agreements and a government contract for additional product development. During 2009, we created a Biosurgery division, which we began operating as a separate segment in 2010.  Our Biosurgery segment focus on harnessing the ability of cells and novel constructs to promote the body’s natural healing.

 

**2.             Significant Accounting Policies**

 

***Unaudited Interim Financial Statements***

 

The accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by US GAAP for complete financial statements. In the opinion of management, these statements include all adjustments (consisting of normal recurring adjustments) considered necessary to present a fair statement of our results of operations, financial position and cash flows. Operating results for any interim period are not necessarily indicative of the results that may be expected for the full year. This Quarterly Report on Form 10-Q should be read in conjunction with our financial statements and footnotes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010.

 

***Use of Estimates***

 

The preparation of financial statements in conformity with US GAAP requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Due to the inherent uncertainty involved in making those assumptions, actual results could differ from those estimates.  We believe that the most significant estimates that affect our financial statements are those that relate to revenue recognition associated with our collaborative agreements, deferred tax assets, inventory valuation, and share-based compensation.

 

***Revenue Recognition***

 

We generate revenues from collaborative agreements, research licenses, and a government contract. We evaluate revenues from agreements that have multiple elements to determine whether the components of the arrangement represent separate units of accounting. To recognize a delivered item in a multiple element arrangement, the delivered items must have value on a standalone basis, there must be objective and reliable evidence of fair value of the undelivered items, and the delivery or performance must be probable and within our control for any delivered items that have a right of return. The determination of whether multiple elements of a collaboration agreement meet the criteria for separate units of accounting requires us to exercise judgment.

 

Revenues from research licenses and government contracts are recognized as earned upon either the incurring of reimbursable expenses directly related to the particular research plan or the completion of certain development milestones as defined within the terms of the agreement. Payments received in advance of research performed are designated as deferred revenue. Non-refundable upfront license fees and certain other related fees are recognized on a straight-line basis over the development periods of the contract deliverables. Fees associated with substantive at risk performance based milestones are recognized as revenue upon their completion, as defined in the respective agreements. Incidental assignment of technology rights is recognized as revenue as it is earned and received.

 

In October 2008, we entered into a Collaboration Agreement with Genzyme Corporation, a wholly owned subsidiary of sanofi-aventis (NYSE: SYN) (“Genzyme”) for the development and commercialization of our biologic drug candidates, Prochymal® and Chondrogen®. Under the agreement, Genzyme has made non-contingent, non-refundable cash payments to us, totaling $130.0 million. The agreement provides Genzyme with certain rights to intellectual property developed by us, and requires that we continue to perform certain development work related to the subject biologic drug candidates. We have evaluated the deliverables related to these payments, and concluded that the various deliverables represent a single unit of accounting. For this reason, we have deferred the recognition of revenue related to the upfront

 

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**OSIRIS THERAPEUTICS, INC.**

**NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS****(continued)**

**THREE MONTHS ENDED MARCH 31, 2011 AND 2010**

 

payments, and are amortizing these amounts to revenue on a straight-line basis over the estimated delivery period of the required development services, which extend through the first quarter of 2012.

 

We recognized $10.0 million of revenue in the first fiscal quarters of both 2011 and 2010 related to the amortization of the upfront payments. The balance of these payments, $33.3 million, has been recorded as current deferred revenue as of March 31, 2011. The agreement also provides for contingent milestone payments of up to $1.25 billion in the aggregate, as well as royalties to be paid to us on any sales by Genzyme. Consistent with our revenue recognition policies, we will recognize revenue from these contingent milestone payments for which we have no continuing performance obligations upon achievement of the related milestone. For any milestone payments for which we have a continuing performance obligation, the milestone payments will be deferred and recognized as revenue over the term of the related performance obligations.

 

In 2007, we partnered with Genzyme to develop Prochymal as a medical countermeasure to nuclear terrorism and other radiological emergencies. In January 2008, we were awarded a contract from the United States Department of Defense (“DoD”) pursuant to which we are seeking, in partnership with Genzyme, to develop and stockpile Prochymal for the repair of gastrointestinal injury resulting from acute radiation exposure. We began recognizing revenue under this contract in 2008, and completed our work under the contract during 2010. Contract revenue is recognized as the related costs are incurred, in accordance with the terms of the contract. We recognized $86,000 in revenue from the DoD contract during the three months ended March 31, 2010. We have not pursued further opportunities pursuant to this collaboration with Genzyme. Furthermore, other than certain ancillary provisions, the agreement with Genzyme expired in July 2009.

 

In October 2007, we entered into a collaborative agreement with the Juvenile Diabetes Research Foundation (“JDRF”) to conduct a Phase 2 clinical trial evaluating Prochymal as a treatment for type 1 diabetes mellitus. This collaborative agreement provides for JDRF to provide up to $4.0 million of contingent milestone funding to support the development of Prochymal for the preservation of insulin production in patients with newly diagnosed type 1 diabetes mellitus. The contingent milestone payments under the agreement are amortized to revenue on a straight line basis over the duration of our obligations under the collaborative agreement as they are received and earned. We have received all $4.0 million of the contingent milestones, and are amortizing the funding received over the duration of our obligations, resulting in approximately $200,000 of revenue in each of the fiscal quarters of both 2011 and 2010 under the agreement with JDRF. The remaining deferred revenue under this agreement has been recorded as $720,000 of current deferred revenue as of March 31, 2011.

 

We have also entered into strategic agreements with other pharmaceutical companies focusing on the development and commercialization of our stem cell drug products. For example, in 2003, we entered into an agreement with JCR Pharmaceuticals Co., Ltd. (“JCR”) pertaining to hematologic malignancies (GvHD) drugs for distribution in Japan.  Under such agreements, we receive fees for licensing the use of our technology. We recognized $1.0 million of revenue during the first fiscal quarter of 2010 from JCR upon the achievement of a milestone event specified in the agreement.

 

We also earn royalties on the sale of human mesenchymal stem cells sold for research purposes and recognize the revenue as the sales are made. Our revenues include $40,000 and $81,000 of such royalty revenue during the three months ended March 31, 2011 and 2010, respectively.

 

During the three months ended March 31, 2011, we also received $115,000 in cost reimbursement for Prochymal used in our adult expanded access program.

 

As discussed in Note 4- *Segment Reporting* below, beginning in 2009 we began operations of our Biosurgery segment, focused on developing high-end biologic products for use in surgical procedures.  We commenced the manufacturing of our first Biosurgery product, a regenerative wound care product, during the first quarter of 2010.  During the first and second quarters of 2010, we distributed the product only for initial clinical evaluation. We launched the product for limited commercial sale during the third quarter of 2010, and revenues on such sales are recognized when the products are shipped to the customer.  Due to the nature of the products and the manufacturing process, all sales are final.  We recognized revenues of approximately $37,000 from the sales of Biosurgery products during the first quarter of 2011.

 

***Research and Development Costs***

 

We expense internal and external research and development (“R&D”) costs, including costs of funded R&D arrangements and the manufacture of clinical batches of our biologic drug candidates used in clinical trials, in the period incurred.

 

Prior to 2010, internal resources were applied interchangeably across several product candidates due to the potential applicability of our biologic drug candidates for multiple indications.

 

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**OSIRIS THERAPEUTICS, INC.**

**NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS****(continued)**

**THREE MONTHS ENDED MARCH 31, 2011 AND 2010**

 

Beginning in 2010, with the creation of our Biosurgery segment, we began to separately track research and development costs by segment. Our total research and development costs were $3.8 million for our Therapeutics segment and $866,000 for our Biosurgery segment during the three months ended March 31, 2011, and $5.4 million for our Therapeutics segment and $1.1 million for our Biosurgery segment for the three months ended March 31, 2010. We do not track internal development costs by project within the Therapeutics segment. We do, however, track external research and development costs by significant project, which were as follows:

 
| ** **                                  | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                  | ** ** | **2011**                                             | ** ** | **2010** | ** ** |
| **External R&D Costs By Indication**    | ** ** | **($000s)**                                          | ** ** | **($000s)** | ** ** |
| ** **                                  | ** ** | ** **                                           | ** ** | ** ** | ** ** |
| Acute myocardial infarction                 |       | $                                                    | 1,378      |   | $ | 827 |   |
| Treatment-resistant GvHD                    |       | 154                                                  |       | 1,435 |   |
| Refractory Crohn’s disease             |       | 403                                                  |       | 554 |   |
| Other therapeutic programs                  |       | 242                                                  |       | 613 |   |
| **Therapeutics external R&D   costs -** | ** ** | **2,177**                                            | ** ** | **3,429** | ** ** |
|                                        |       |                                                 |       |   |   |
| **Biosurgery external R&D costs   -**   | ** ** | **183**                                              | ** ** | **466** | ** ** |
|                                        |       |                                                 |       |   |   |
| **Total external R&D costs -**          | ** ** | **$**                                                | **2,360**  | ** ** | **$** | **3,895** | ** ** |

 

***Income per Common Share***

 

Basic income per common share is calculated by dividing net income by the weighted average number of common shares outstanding during the period.  Diluted income per common share adjusts basic income per share for the potentially dilutive effects of common share equivalents, using the treasury stock method, and includes the incremental effect of shares that would be issued upon the assumed exercise of stock options and warrants.

 

Diluted income per common share for the three months ended March 31, 2011 excludes approximately 1,032,000 “out-of the money” stock options and the “out-of the money” 1,000,000 shares issuable upon the assumed exercise of our outstanding warrant, as their effect is anti-dilutive.  Similarly, diluted income per common share for the three months ended March 31, 2010 excludes 630,625 “out-of the money” stock options and the “out-of the money” 1,000,000 shares issuable upon the assumed exercise of our outstanding warrant, as their effect is anti-dilutive.

 

A reconciliation of basic to diluted weighted average common shares outstanding for the applicable periods is as follows:

 
| ** **                                         | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|
| ** **                                         | ** ** | **March 31,**               | ** ** |
| ** **                                         | ** ** | **2011**                         | ** ** | **2010** | ** ** |
| ** **                                         | ** ** | **(000s)**                       | ** ** | **(000s)** | ** ** |
| Basic weighted average common shares outstanding   |       | 32,807                           |       | 32,774 |   |
| Dilutive weighted average options outstanding      |       | 306                              |       | 314 |   |
| Dilutive weighted average warrants outstanding     |       | —                           |       | — |   |
|                                               |       |                             |       |   |   |
| Diluted weighted average common shares outstanding |       | 33,113                           |       | 33,088 |   |

 

***Investments Available for Sale and Other Comprehensive Income (Loss)***

 

Investments available for sale consist primarily of marketable securities with maturities less than one year. Investments available for sale are valued at their fair value, with unrealized gains and losses reported as a separate component of stockholders’ equity in accumulated other comprehensive income. All realized gains and losses on our investments available for sale are recognized in results of operations as other income.

 

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**OSIRIS THERAPEUTICS, INC.**

**NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS****(continued)**

**THREE MONTHS ENDED MARCH 31, 2011 AND 2010**

 

Investments available for sale are evaluated periodically to determine whether a decline in their value is “other than temporary.” The term “other than temporary” is not intended to indicate a permanent decline in value. Rather, it means that the prospects for near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the security. We review criteria such as the magnitude and duration of the decline, as well as the reasons for the decline, to predict whether the loss in value is other than temporary. If a decline in value is determined to be other than temporary, the carrying value of the security is reduced and a corresponding charge to earnings is recognized.

 

***Share-Based Compensation***

 

We account for share-based payments using the fair value method.

 

We recognize all share-based payments to employees in our financial statements based on their grant date fair values, calculated using the Black-Scholes option pricing model. Compensation expense related to share-based awards is recognized on a straight-line basis for each vesting tranche based on the value of share awards that are expected to vest on the grant date, which is revised if actual forfeitures differ materially from original expectations.  Awards of shares of our common stock to non-employee directors are valued at the closing price on the grant date.

 

A summary of option activity under both of our stock-based compensation plans for the three months ended March 31, 2011 is presented below.

 
| ** **                             | ** ** | **Number of   Shares** | ** ** | **Weighted Average   Exercise Price Per Share** | ** ** | **Weighted Average   Remaining Term   (in Years)** | ** ** | **Aggregate   Intrinsic Value** | ** ** |
|----------------------------------------|------------|-----------------------------|------------|---------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|--------------------------------------|------------|
|                                   |       |                        |       |                                                                |       |                                                              | ** ** | **$(000)**                           | ** ** |
| Outstanding at January 1, 2011    |       | 1,349,261                   |       | $                                                                   | 9.75       |                                                              | 6.89       |                                 | $          | 2,357 |   |
| Granted at market value                |       | 413,000                     |       | 6.98                                                                |       |                                                              |       |                                 |       |
| Exercised                              |       | (563                        | )          | 0.40                                                                |       |                                                              |       | 3                                    |       |
| Forfeited                              |       | (10,688                     | )          | 9.51                                                                |       |                                                              |       | —                               |       |
| Outstanding at March 31, 2011     |       | 1,751,010                   |       | 9.10                                                                |       | 7.47                                                              |       | 2,361                                |       |
|                                   |       |                        |       |                                                                |       |                                                              |       |                                 |       |
| Exercisable at September 30, 2010 |       | 833,695                     |       | 9.50                                                                |       | 5.70                                                              |       | 2,160                                |       |
|                                        |            |                             |            |                                                                     |            |                                                                   |            |                                      |            |  |  |

 

The weighted average grant date fair value of options granted during the three months ended March 31, 2011 was $3.58 per share.  We received less than $1,000 in cash from the exercise of options during the three months ended March 31, 2011.

 

As of March 31, 2011, approximately 381,000 shares of common stock remain available for future share awards under our Amended and Restated 2006 Omnibus Plan.

 

Share-based compensation expense (including director compensation) included in our statements of operations for the three months ended March 31, 2011 and 2010 is allocable to our research and development and general and administrative activities as follows:

 
| ** **                 | ** ** | **Three Months Ended March 31,** | ** ** |
|----------------------------|------------|------------------------------------------------------|------------|
| ** **                 | ** ** | **2011**                                             | ** ** | **2010** | ** ** |
| ** **                 | ** ** | **($000)**                                           | ** ** | **($000)** | ** ** |
| Research and development   |       | $                                                    | 243        |   | $ | 190 |   |
| General and administrative |       | 361                                                  |       | 184 |   |
| Total                      |       | $                                                    | 604        |   | $ | 374 |   |

 

As of March 31, 2011, there was approximately $2.5 million of total unrecognized share-based compensation cost related to options granted under our plans, which will be recognized over a weighted-average period of approximately one year, as the options vest.

 

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**OSIRIS THERAPEUTICS, INC.**

**NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS****(continued)**

**THREE MONTHS ENDED MARCH 31, 2011 AND 2010**

 

***Supplemental Cash Flow Information***

 
| ** **                                               | ** ** | **Three Months Ended   March 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                               | ** ** | **2011**                                          | ** ** | **2010** | ** ** |
| ** **                                               | ** ** | **($000)**                                        | ** ** | **($000)** | ** ** |
| **Supplemental disclosure of cash   flows information:** |       |                                              |       |   |   |
| Cash paid for interest                                   |       | $                                                 | —     |   | $ | — |   |
| Cash paid for income taxes                               |       | —                                            |       | 450 |   |
|                                                          |            |                                                   |            |  |  |  |  |

 

**3.             Collaboration Agreements and Government Contract**

 

We are a party to several material collaborative agreements and other contracts as fully described in Note 2 of our Annual Report on Form 10-K for the year ended December 31, 2010 (“Annual Report”).  There have not been any material changes to any of these agreements during 2011 that require disclosure.  The accounting policies related to each of these contracts, including material impact on our financial statements, is included above under the “Revenue Recognition” section of Note 2*, Significant Accounting Policies*.

 

**4.             Segment Reporting**

 

In 2010, we began to manage our business in two reportable operating segments: the Therapeutics segment and the Biosurgery segment. Our Therapeutics segment focuses on developing and marketing products to treat medical conditions in the inflammatory, autoimmune, orthopedic and cardiovascular areas. Its operations have focused on clinical trials and discovery efforts to identify additional medical indications. Our Therapeutics segment does not presently have any products approved for sale and its revenues consist primarily of collaborative research agreements and royalties as described in our Annual Report the “Revenue Recognition” section of Note 2*, Significant Accounting Policies.*

 

Our Biosurgery segment is focused on the development, manufacture and sale of biologic products designed to promote the body’s natural healing process and improve surgical outcomes.  We commenced the manufacturing of our first Biosurgery product, a regenerative wound care product, during the first quarter of 2010.  During the first and second quarters of 2010, we distributed the product only for initial clinical evaluation. Accordingly, we incurred research, development, manufacturing, general, and administrative costs related to the Biosurgery segment throughout 2010, but did not recognize revenue from sales until beginning in the third quarters of 2010.  As a result of these start up costs, any measure of segment profitability from our Biosurgery segment for 2011 is not indicative of the segment’s expected future results.

 

Substantially all of our revenues and assets are attributed to and are received from entities located in the United States.

 

The costs specifically attributable to each of our segments for the three months ended March 31, 2011 and March 31, 2010 are as follows:

 
| ** **                                                                              | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                                              | ** ** | **March 31, 2011**     | ** ** | **March 31, 2010**     | ** ** |
| ** **                                                                              | ** ** | **Therapeutics**                 | ** ** | **Biosurgery**                   | ** ** | **Total** | ** ** | **Therapeutics** | ** ** | **Biosurgery** | ** ** | **Total** | ** ** |
|                                                                                    |       |                             |       |                             |       |   |   |   |   |   |   |   |   |
| **Product sales**                                                                       |       | $                                | —     |                             | $          | 37 |   | $ | 37 |   | $ | — |   | $ | — |   | $ | — |   |
| Cost of goods sold                                                                      |       | —                           |       | 15                               |       | 15 |   | — |   | — |   | — |   |
| Gross profit                                                                            |       | —                           |       | 22                               |       | 22 |   | — |   | — |   | — |   |
|                                                                                    |       |                             |       |                             |       |   |   |   |   |   |   |   |   |
| **Revenue from collaborative   research agreements, government contract and royalties** |       | 10,395                           |       | —                           |       | 10,395 |   | 11,377 |   | — |   | 11,377 |   |
|                                                                                    |       |                             |       |                             |       |   |   |   |   |   |   |   |   |
| Operating expenses:                                                                     |       |                             |       |                             |       |   |   |   |   |   |   |   |   |
| Research and development                                                                |       | 3,845                            |       | 866                              |       | 4,711 |   | 5,431 |   | 1,129 |   | 6,560 |   |
| General and administrative                                                              |       | 1,499                            |       | 197                              |       | 1,696 |   | 1,662 |   | 145 |   | 1,807 |   |
|                                                                                    |       | 5,344                            |       | 1,063                            |       | 6,407 |   | 7,093 |   | 1,274 |   | 8,367 |   |
|                                                                                    |       |                             |       |                             |       |   |   |   |   |   |   |   |   |
| Income (loss) from operations                                                           |       | $                                | 5,051      |                             | $          | (1,041 | ) | $ | 4,010 |   | $ | 4,284 |   | $ | (1,274 | ) | $ | 3,010 |   |

 

In general, our total assets, including long-lived assets such as property and equipment, and our capital expenditures are not specifically allocated to any particular operating segment. Accordingly, capital expenditures and total asset information by reportable segment is not presented. The only assets that are allocated to the individual segments are the inventory and accounts receivable specifically related to each segment.

 

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**OSIRIS THERAPEUTICS, INC.**

**NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS****(continued)**

**THREE MONTHS ENDED MARCH 31, 2011 AND 2010**

 

**4.             Segment Reporting - continued**

 

The assets specifically attributable to each of our segments as of March 31, 2011 and December 31, 2010 are as follows:

 
| ** **           | ** ** | **March 31, 2011** | ** ** | **December 31, 2010** | ** ** |
|----------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **           | ** ** | **Therapeutics**             | ** ** | **Biosurgery**                  | ** ** | **Total** | ** ** | **Therapeutics** | ** ** | **Biosurgery** | ** ** | **Total** | ** ** |
|                 |       |                         |       |                            |       |   |   |   |   |   |   |   |   |
| **Segment assets:**  |       |                         |       |                            |       |   |   |   |   |   |   |   |   |
| Accounts Receivable  |       | $                            | 1,471      |                            | $          | 154 |   | $ | 1,625 |   | $ | 1,757 |   | $ | 171 |   | $ | 1,928 |   |
| Inventory            |       | —                       |       | 639                             |       | 639 |   | — |   | 510 |   | 510 |   |
| Total segment assets |       | $                            | 1,471      |                            | $          | 793 |   | $ | 2,264 |   | $ | 1,757 |   | $ | 681 |   | $ | 2,438 |   |

 

**5.             Income Tax Expense**

 

We calculate our interim tax provision in accordance with the guidance for accounting for income taxes in interim periods. At the end of each interim period, we estimate the annual effective tax rate and apply that tax rate to our ordinary quarterly pre-tax income. The tax expense or benefit related to significant, unusual or extraordinary discrete events during the interim period is recognized in the interim period in which those events occurred. In addition, the effect of changes in enacted tax laws or rates or tax status is recognized in the interim period in which the change occurs.

 

For income tax accounting purposes, we incurred a loss of approximately $4.6 million for the three months ended March 31, 2011, and did not record any income tax expense.  The primary difference between our net income for financial reporting purposes of $4.0 million and the loss for income tax accounting purposes relates to the recognition of $10.0 million of deferred revenue from our collaborative agreement with Genzyme in different fiscal periods. During the first quarter of 2010, we recorded $682,000 of income tax expense which represented the Federal Alternative Minimum tax.

 

At March 31, 2011, the balance of our net operating loss and tax credit carryforwards was $77.5 million.  During fiscal 2010, we released a portion of valuation allowance in the amount of $3.2 million to reflect our expectation of being able to utilize net operating loss and tax credit carryforwards in 2011. Our remaining deferred tax assets have been fully reserved in both 2011 and 2010 since their ultimate future realization cannot be assured.

 

**6.             Investments Available for Sale**

 

Investments available for sale consisted of the following as of March 31, 2011 and December 31, 2010:

 
| ** **                                              | ** ** | **March 31, 2011** | ** ** | **December 31, 2010** | ** ** |
|---------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                                              | ** ** | **$000**                     | ** ** | **$000**                        | ** ** |
| ** **                                              | ** ** | ** **                   | ** ** | **Unrealized**                  | ** ** | ** ** | ** ** | ** ** | ** ** | **Unrealized** | ** ** | ** ** | ** ** |
| ** **                                              | ** ** | **Cost**                     | ** ** | **Gain**                        | ** ** | **Loss** | ** ** | **Fair Value** | ** ** | **Cost** | ** ** | **Gain** | ** ** | **Loss** | ** ** | **Fair Value** | ** ** |
| **Cash equivalents:**                                   |       |                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Money market funds & certificates of   deposit |       | $                            | 8,907      |                            | $          | — |   | $ | — |   | $ | 8,907 |   | $ | 10,299 |   | $ | 1 |   | $ | — |   | $ | 10,300 |   |
| Commercial paper                                        |       | 10,923                       |       | 1                               |       | — |   | 10,924 |   | 18,589 |   | — |   | — |   | 18,589 |   |
|                                                    |       | 19,830                       |       | 1                               |       | — |   | 19,831 |   | 28,888 |   | 1 |   | — |   | 28,889 |   |
| **Investments:**                                        |       |                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Municipal Securities                                    |       | 4,006                        |       | —                          |       | — |   | 4,006 |   | — |   | — |   | — |   | — |   |
| Corporate notes and bonds                               |       | 35,117                       |       | 15                              |       | (8 | ) | 35,124 |   | 36,081 |   | 7 |   | (12 | ) | 36,076 |   |
| US government agencies                                  |       | 1,209                        |       | 1                               |       | — |   | 1,210 |   | 1,200 |   | 1 |   | — |   | 1,201 |   |
|                                                    |       | 40,332                       |       | 16                              |       | (8 | ) | 40,340 |   | 37,281 |   | 8 |   | (12 | ) | 37,277 |   |
|                                                    |       |                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Total investments available for   sale**              | ** ** | **$**                        | **60,162** | ** **                      | **$**      | **17** | ** ** | **$** | **(8** | **)** | **$** | **60,171** | ** ** | **$** | **66,169** | ** ** | **$** | **9** | ** ** | **$** | **(12** | **)** | **$** | **66,166** | ** ** |

 

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**OSIRIS THERAPEUTICS, INC.**

**NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS****(continued)**

**THREE MONTHS ENDED MARCH 31, 2011 AND 2010**

 

**6.             Investments Available for Sale - continued**

 

The following table summarizes maturities of our investments available for sale as of March 31, 2011 and December 31, 2010:

 
| ** **                                 | ** ** | **March 31, 2011** | ** ** | **December 31, 2010** | ** ** |
|--------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                                 | ** ** | **$000**                     | ** ** | **$000**                        | ** ** |
| ** **                                 | ** ** | **Cost**                     | ** ** | **Fair Value**             | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| **Maturities:**                            | ** ** | ** **                   | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Within 3-months                            |       | $                            | 44,435     |                            | $          | 44,440 |   | $ | 52,607 |   | $ | 52,601 |   |
| Between   3—12 months            |       | 5,362                        |       | 5,362                           |       | 4,870 |   | 4,870 |   |
| Between   1—2 years              |       | 10,365                       |       | 10,369                          |       | 8,692 |   | 8,695 |   |
| **Total   investments available for sale** | ** ** | **$**                        | **60,162** | ** **                      | **$**      | **60,171** | ** ** | **$** | **66,169** | ** ** | **$** | **66,166** | ** ** |

 

Realized gains and losses and investment income earned on investments available for sale were $29,000 for the three months ended March 31, 2011, and have been included as a component of “Other income, net” in the accompanying financial statements.

 

**7.             Fair Value**

 

Fair value is defined as the price at which an asset could be exchanged or a liability transferred (an exit price) in an orderly transaction between knowledgeable, willing parties in the principal or most advantageous market for the asset or liability. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available, valuation models are applied.

 

Financial assets recorded at fair value in the accompanying financial statements are categorized based upon the level of judgment associated with the inputs used to measure their fair value. The levels are directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities, and are as follows:

 

*Level 1**                                *Inputs are unadjusted, quoted prices in active markets for identical assets at the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis.

 

The fair valued assets we hold that are generally included in this category are money market securities where fair value is based on publicly quoted prices.

 

*Level 2**                                *Inputs are other than quoted prices included in Level 1, which are either directly or indirectly observable for the asset or liability through correlation with market data at the reporting date and for the duration of the instrument’s anticipated life.

 

The fair valued assets we hold that are generally included in this category are investment grade short-term securities.

 

*Level 3**                                *Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities and which reflect management’s best estimate of what market participants would use in pricing the asset or liability at the reporting date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

 

We carry no investments classified as Level 3.

 

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**OSIRIS THERAPEUTICS, INC.**

**NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS****(continued)**

**THREE MONTHS ENDED MARCH 31, 2011 AND 2010**

 

**7.****                                                             ****Fair Value - continued**

 

When quoted prices in active markets for identical assets are available, we use these quoted market prices to determine the fair value of financial assets and classify these assets as Level 1. In other cases where a quoted market price for identical assets in an active market is either not available or not observable, we obtain the fair value from a third party vendor that uses pricing models, such as matrix pricing, to determine fair value. These financial assets would then be classified as Level 2. In the event quoted market prices were not available, we would determine fair value using broker quotes or an internal analysis of each investment’s financial statements and cash flow projections. In these instances, financial assets would be classified based upon the lowest level of input that is significant to the valuation. Thus, financial assets might be classified in Level 3 even though there could be some significant inputs that may be readily available. To date, we have never had any assets that were required to be classified as Level 3.

 

Assets and liabilities measured at fair value on a recurring basis are summarized below as of March 31, 2011 and December 31, 2010:

 
| ** **                                              | ** ** | **March 31, 2011** | ** ** |
|---------------------------------------------------------|------------|------------------------------|------------|
| ** **                                              | ** ** | **($000s)**                  | ** ** |
| ** **                                              | ** ** | **Level I**             | ** ** | **Level II** | ** ** | **Level III** | ** ** | **Total** | ** ** |
| **Assets**                                              |       |                         |       |   |   |   |   |   |   |
| Cash Equivalents                                        |       | $                            | 8,407      |   | $ | — |   | $ | — |   | $ | 8,407 |   |
| Government Obligations                                  |       | 1,210                        |       | — |   | — |   | 1,210 |   |
| Certificates of Deposit                                 |       | —                       |       | 500 |   | — |   | 500 |   |
| Agency Obligations                                      |       | —                       |       | 25,523 |   | — |   | 25,523 |   |
| Corporate Debt Securities & Commercial   Paper |       | —                       |       | 18,817 |   | — |   | 18,817 |   |
| Municipal Securities                                    |       | —                       |       | 4,006 |   | — |   | 4,006 |   |
| Foreign Bonds                                           |       | —                       |       | 1,708 |   | — |   | 1,708 |   |
|                                                    |       |                         |       |   |   |   |   |   |   |
| **Short Term Investments Available   for Sale**         | ** ** | **$**                        | **9,617**  | ** ** | **$** | **50,554** | ** ** | **$** | **—** | ** ** | **$** | **60,171** | ** ** |

 
| ** **                                              | ** ** | **December 31, 2010** | ** ** |
|---------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                              | ** ** | **($000s)**                     | ** ** |
| ** **                                              | ** ** | **Level I**                | ** ** | **Level II** | ** ** | **Level III** | ** ** | **Total** | ** ** |
| **Assets**                                              |       |                            |       |   |   |   |   |   |   |
| Cash Equivalents                                        |       | $                               | 9,449      |   | $ | — |   | $ | — |   | $ | 9,449 |   |
| Government Obligations                                  |       | 1,201                           |       | — |   | — |   | 1,201 |   |
| Certificates of Deposit                                 |       | —                          |       | 851 |   | — |   | 851 |   |
| Agency Obligations                                      |       | —                          |       | 27,545 |   | — |   | 27,545 |   |
| Corporate Debt Securities & Commercial   Paper |       | —                          |       | 26,201 |   | — |   | 26,201 |   |
| Foreign Bonds                                           |       | —                          |       | 919 |   | — |   | 919 |   |
|                                                    |       |                            |       |   |   |   |   |   |   |
| **Short Term Investments Available   for Sale**         | ** ** | **$**                           | **10,650** | ** ** | **$** | **55,516** | ** ** | **$** | **—** | ** ** | **$** | **66,166** | ** ** |

 

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**OSIRIS THERAPEUTICS, INC.**

**NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS****(continued)**

**THREE MONTHS ENDED MARCH 31, 2011 AND 2010**

 

**9**.                                                              **Subsequent Events**

 

At December 31, 2010, we had an outstanding warrant to purchase 1,000,000 shares of our common stock at an exercise price of $11.00 per share as described in Note 9 to our financial statements included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010.  This warrant is held by Peter Friedli, who serves as the Chairman of our Board of Directors, and had an expiration date of May 24, 2011.  As detailed in our Definitive Proxy Statement filed pursuant to Section 14(a) of the Securities Exchange Act of 1934, on April 14, 2011, we are seeking stockholder approval of the extension of the expiration date of the warrant, until May 24, 2015.

 

Under the Listing Rules of the NASDAQ Stock Market on which our common stock is listed for trading, the extension of the expiration date of the warrant constitutes a material amendment to a director compensation plan or arrangement, and therefore requires the approval of our stockholders.  More specifically, our Board has approved the extension of the expiration date subject to the condition that the warrant not be exercisable at any time after May 24, 2011, unless stockholder approval of the extension of the expiration date is first obtained and provided that such approval is obtained prior to September 1, 2011.

 

Upon approval by the stockholders, we would incur and record a non-cash charge against earnings on account of the extension of the warrant expiration date in the amount of its net increase in dollar value of approximately $1.7 million.

 

We evaluated our March 31, 2011 financial statements for subsequent events through the date the financial statements were issued. Other than seeking shareholder approval for the extension of the warrant detailed above, we are not aware of any subsequent events which would require recognition or disclosure in the financial statements.

 

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** **

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

 

**CAUTIONARY STATEMENTS ABOUT FORWARD-LOOKING INFORMATION**

 

This Quarterly Report on Form 10-Q includes “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, or the Exchange Act. Statements included or incorporated herein which are not historical facts are forward looking statements. When used in this Annual Report, the words *estimates, expects, anticipates, projects, plans, intends, believes, forecasts* and variations of such words or similar expressions are intended to identify forward-looking statements, but these terms are not the exclusive means of identifying forward looking statements.

 

Forward looking statements reflect management’s current views with respect to future events and performance and are based on currently available information and management’s assumptions regarding future events. While management believes that its assumptions are reasonable, forward-looking statements are subject to various known and unknown risks and uncertainties and actual results may differ materially from those expressed or implied herein. In connection with the “safe harbor provisions” of the Private Securities Litigation Reform Act of 1995, the Company notes that certain factors, among others, which could cause future results to differ materially from the forward-looking statements, expectations and assumptions expressed or implied herein are discussed in greater detail in our Annual Report on Form 10-K under Part I — Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 1A “Risk Factors,” and may be discussed elsewhere herein or in other documents we file with the Securities and Exchange Commission, or SEC. Examples of forward-looking statements may include, without limitation, statements regarding any of the following: our product development efforts; our clinical trials and anticipated regulatory requirements, and our ability to successfully navigate these requirements; the success of our product candidates in development; status of the regulatory process for our biologic drug candidates; implementation of our corporate strategy; our financial performance; our product research and development activities and projected expenditures, including our anticipated timeline and clinical strategy for mesenchymal stem cells (MSCs) and biologic drug candidates (including Prochymal® and Chondrogen®); our cash needs; patents, trademarks and other proprietary rights; the safety and ability of our potential products to treat disease; our ability to supply a sufficient amount of our product candidates and, if approved, products to meet demand; our costs to comply with governmental regulations; our relationship with collaborating partners; our ability to maintain and benefit from our collaborative arrangements; our ability to benefit from government contracts; our plans for sales and marketing; our plans regarding facilities; types of regulatory frameworks we expect will be applicable to our potential products; and results of our scientific research.

 

Readers are cautioned that all forward-looking statements attributable to us or persons acting on our behalf apply only as of the date of this Quarterly Report and are expressly qualified in their entirety by the cautionary statements included herein. We undertake no obligation to publicly update or revise any forward-looking statements to reflect subsequent events or circumstances and do not intend to do so.

 

You should read the following management’s discussion and analysis of our financial condition and results of operations in conjunction with our audited Financial Statements and related notes thereto and other disclosures included as part of our Annual Report on Form 10-K for the year ended December 31, 2010, and our unaudited Condensed Financial Statements for the three months ended March 31, 2011 and 2010 and other disclosures included in this Quarterly Report on Form 10-Q.  Our Condensed Financial Statements have been prepared in accordance with U.S. generally accepted accounting principles and are presented in U.S. dollars.

 

There are a number of risks and uncertainties that could cause our actual results to differ materially from the forward-looking statements contained in this report. Some of the important factors that could cause our actual results to differ materially from the forward-looking statements we make in this report are set forth in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010 under Part I — Item 1A “Risk Factors.” There may be other factors that may cause our actual results to differ materially from the forward-looking statements.

 

When we use the terms “Osiris,” “we,” “us,” and “our” we mean Osiris Therapeutics, Inc., a Maryland corporation.

 

**Introduction and Overview**

 

The following is a discussion and analysis of our financial condition and results of operations for the three month periods ended March 31, 2011 and 2010.  You should read this discussion together with the accompanying unaudited condensed financial statements and notes and with our Annual Report on Form 10-K for the year ended December 31, 2010.  Historical results and any discussion of prospective results may not indicate our future performance.  See “Cautionary Statements About Forward-Looking Information.”

 

We are a leading stem cell company, headquartered in Columbia, Maryland, and focused on developing and marketing products to treat serious medical conditions in the inflammatory, autoimmune, orthopedic, and cardiovascular areas. We believe our stem cell products have significant therapeutic potential because of their ability to regulate inflammation, promote tissue regeneration and prevent pathological scar formation. We were incorporated in Maryland in May 2010. We began operations on December 23, 1992 and were a Delaware corporation until, with approval of our stockholders, we reincorporated as a Maryland corporation on May 31, 2010.

 

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We have two business segments, Therapeutics and Biosurgery. Our Therapeutics business is focused on developing biologic stem cell drug candidates from a readily available and non-controversial source—adult bone marrow. Our Biosurgery business works to harness the ability of cells and novel constructs to promote the body’s natural healing with the goals of improving surgical outcomes and offering better treatment options for patients and physicians. During the third quarter of 2010, we launched limited commercial sales of several products developed and manufactured by our Biosurgery segment, including Grafix®, a cellular wound care biomatrix used in the limb salvage and recalcitrant wound setting. Grafix is a living skin substitute comprised of a biologic membrane containing endogenous mesenchymal stem cells that is used to promote healing in chronic wounds, limb salvage procedures and burns.

 

Our lead therapeutic biologic drug candidate, Prochymal (remestemcel-L), is being evaluated in clinical trials for a number of indications, including acute graft versus host disease (“GvHD”), Crohn’s disease, acute myocardial infarction, type 1 diabetes, pulmonary disease and gastrointestinal injury resulting from radiation exposure (animal rule). Prochymal is the only stem cell therapeutic currently granted both Orphan Drug and Fast Track status by the United States Food and Drug Administration (“FDA”). Our pipeline of internally developed biologic drug candidates under evaluation also includes Chondrogen for osteoarthritis in the knee.

 

In the fourth quarter of 2008, we entered into a collaboration agreement with Genzyme Corporation, now a wholly owned subsidiary of sanofi-aventis (NYSE: SYN) for the development and commercialization of Prochymal and Chondrogen. Under the terms of the agreement, we retained the rights to commercialize Prochymal and Chondrogen in the United States and Canada and Genzyme has been granted exclusive rights to commercialize Prochymal and Chondrogen in all other countries, except with respect to GvHD in Japan, where Prochymal has previously been licensed to JCR Pharmaceuticals Co., Ltd. Under the agreement, we were paid $130.0 million for these rights. The agreement also provides for contingent milestone payments of up to $1.25 billion in the aggregate in addition to royalties on any sales by Genzyme to be paid by Genzyme to us. The royalties payable by Genzyme to us upon commercialization range from the single digits to within the twenties percent of sales, depending upon several factors.

 

The collaboration agreement provides that it will expire upon the completion of all development plans stipulated in the agreement and the expiration of all payment obligations; however, in addition to its opt out rights, Genzyme may terminate the agreement early and without further obligation at any time, and either party may terminate the agreement due to non-performance, material breach or insolvency, in each case in accordance with and subject to the specific terms of the agreement.

 

We have also partnered with the Juvenile Diabetes Research Foundation (“JDRF”) for the development of Prochymal as a treatment for the preservation of insulin production in patients with newly diagnosed type 1 diabetes mellitus.

 

In August 2009, we announced the creation of a Biosurgery division focused on developing and marketing high-end biological products for use in surgical procedures. We intend to build on the success of our first generation implantable product, Osteocel, which generated over $40 million of revenue for us before being sold for $85.0 million in 2008. We introduced our first biologic product from the Biosurgery division during March 2010 for clinical evaluation and began limited commercial sales during the third fiscal quarter of 2010.

 

We are a fully integrated company, having developed capabilities in research, development, manufacturing, marketing and distribution of stem cell products. We have developed an extensive intellectual property portfolio to protect our technology including 47 U.S. and 322 foreign patents owned or licensed. We have 35 U.S. patent applications pending and 101 foreign patent applications pending.

 

Our two biologic drug candidates, Prochymal and Chondrogen, utilize human mesenchymal stem cells, or MSCs. MSCs can selectively differentiate, based on the tissue environment, into various tissue lineages such as bone, muscle, fat, tendon, ligament, cartilage and bone marrow stroma. In addition, MSCs have anti-inflammatory properties and can prevent fibrosis or scarring. These characteristics give MSCs the potential to treat a wide variety of medical conditions. We believe that our biologic drug candidates have advantages over other stem cell therapeutics in development for the following reasons:

 

·                  **Stem Cell Source. **Our stem cells are obtained from adult bone marrow, a readily available source. The cells are drawn from the hips of volunteer donors between the ages of 18 and 30 years, using a simple needle and syringe aspiration. Because the cells are obtained from consenting adult donors, we are able to largely avoid the ethical controversy surrounding embryonic and fetal stem cell research.

 

·                  **Ability to Mass Produce. **Through our proprietary manufacturing methods, we can grow MSCs in a controlled fashion to produce up to 10,000 treatments of our biologic drug candidates from a single bone marrow donation. Our ability to produce a large quantity of treatments from one donation provides us with manufacturing efficiencies and product consistency that are essential to commercialization.

 

·                  **Universal Compatibility. **Many stem cell therapies under development can elicit a rejection response in the recipient and therefore require donor-to-recipient matching or potentially harmful immunosuppression. This greatly reduces manufacturing efficiencies and creates a risk of mismatch which can result in an acute inflammatory response leading to serious medical complications and can even be fatal. Based on our clinical experience, we believe that our biologic drug candidates are not rejected by the patient’s immune system and so, like type O negative blood, do not require matching. This universal compatibility allows us to produce a standardized product available to all patients in almost any medical setting.

 

·                  **Treatment on Demand. **Our biologic drug candidates can be stored frozen at end-user medical facilities until they are needed. We anticipate that medical facilities will be able to prescribe and dispense these products in much the same way as conventional drugs. In

 

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contrast, other stem cell technologies under development require weeks to prepare after a patient’s need is identified. This is a key feature of our technology, as many patients in the critical care setting require prompt treatment. 

 

The following table summarizes key information about our biologic drug candidates.

 
| **Drug Candidate** | ** ** | **Indication**                                   | ** ** | **Status**                   |
|-------------------------|------------|--------------------------------------------------|------------|------------------------------|
| **Prochymal**           |       | Steroid   Refractory Acute GvHD                  |       | Phase 3   Complete      |
|                    |       | First   Line Treatment of Acute GvHD             |       | Phase 3   Complete      |
|                    |       | Treatment-Resistant   Acute GvHD                 |       | Expanded   Access            |
|                    |       | Biologics   Refractory Crohn’s Disease      |       | Phase 3                 |
|                    |       | Type I   Diabetes Mellitus                  |       | Phase 2                 |
|                    |       | Acute   Myocardial Infarction                    |       | Phase 2                 |
|                    |       | Pulmonary   Disease                              |       | Phase 2                 |
|                    |       | Acute   Radiation Syndrome                       |       | Phase 3   (Animal Rule) |
| **Chondrogen**          |       | Osteoarthritis &   Cartilage Protection |       | Phase 2                 |

 

**Clinical Programs**

 

***Prochymal,*** our lead biologic drug candidate, is being evaluated in clinical trials for a number of indications including acute graft versus host disease (“GvHD”), Crohn’s disease, acute myocardial infarction, type 1 diabetes, pulmonary disease and gastrointestinal injury resulting from radiation exposure (animal rule). Prochymal is the only stem cell therapeutic currently designated by the FDA as both an Orphan Drug and Fast Track product.

 

***Prochymal for Treatment-Resistant GvHD***

 

GvHD is a life threatening immune system reaction that commonly affects one or more of the following organs: skin, gastrointestinal tract, and liver, in patients who have received a bone marrow transplant. We estimate that there are approximately 3,000 instances of GvHD in the United States each year.

 

Bone marrow transplantation is a treatment of last resort for patients with certain cancers and some genetic diseases. This procedure can result in a particularly serious type of rejection referred to as acute GvHD. This condition gets its name because the bone marrow transplant, or the graft, begins to attack the recipient, or the host. As noted in an article published in the journal *Biology of Blood and Marrow Transplantation* in 2005, acute GvHD is one of the most common complications of allogeneic bone marrow or hematopoietic stem cell transplantation, affecting approximately 50% of transplant patients. Acute GvHD is graded for prognostic and treatment purposes on a four grade scale, with Grade I considered mild, Grade II moderate, and Grades III-IV considered severe and life-threatening. The onset of GvHD in patients who have received a bone marrow transplant leads to a poor prognosis because of the already weakened state of these patients. According to a 2002 article published in *Biology of Blood and Marrow Transplantation*, the estimated one-year survival rate for patients with acute GvHD decreases drastically with increasing disease severity, as illustrated below:

 
| **Acute GvHD** | ** ** | **Estimated One   Year Survival** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| Grade I             |       | 65                                          | %          |
| Grade II            |       | 60                                          | %          |
| Grade III           |       | 39                                          | %          |
| Grade IV            |       | 22                                          | %          |

 

Typically, patients are treated aggressively with steroids when their GvHD reaches Grade II. A 2001 article published in the journal *Blood* noted that approximately 50% of these patients will not respond to treatment with steroids and approximately 50-80% of steroid refractory GvHD patients die of the disease.

 

The current treatments available for acute GvHD are inadequate in two primary ways. First, mortality in patients with acute GvHD who are undergoing current treatments is extremely high. Second, most treatments for acute GvHD suppress or destroy the immune system. This can lead to a number of debilitating side effects, including severe and life threatening infection. Unlike steroids or other immunosuppressant drugs, which have a systemic effect, Prochymal’s mechanism of action is designed to specifically target areas of inflammation. Therefore, we believe the use of Prochymal will result in a higher survival rate.

 

Although in the U.S. there are no drugs approved for treating GvHD, the disease is commonly treated off-label with steroids. GvHD that does not respond to this treatment is known as steroid refractory GvHD. A large majority of steroid refractory GvHD patients die within six months. In a Phase 2 trial for treatment refractory GvHD, we enrolled patients that did not respond to treatment with steroids and at least one second line therapy. Of these patients, all responded to treatment with Prochymal, and 59% achieved complete resolution of their disease. Prochymal has been granted Fast Track status by FDA as well as Orphan Drug status by FDA and the European Medicines Agency, for GvHD.

 

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In May 2008, we received clearance from the FDA to initiate an expanded access treatment program making Prochymal available to children with life threatening GvHD. Under the program, children, 2 months to 17 years of age, with Grades B-D acute GvHD that hasn’t responded to steroids, are eligible for treatment. Upon completion of enrollment of the two Phase 3 trials evaluating Prochymal in adults with GvHD, as described below, the expanded access program was broadened to include patients 18 to 70 years of age. The expanded access programs for Prochymal in treating adult and pediatric patients with refractory GvHD are ongoing.

 

In September 2009, we announced the preliminary results for the two Phase 3 trials evaluating Prochymal in patients with GvHD, as more fully described below. While the trials did not reach significance in their primary endpoints, the studies did reveal several important findings:

 

·                  The primary endpoint for the steroid-refractory GvHD trial (durable complete response) for the per protocol population approached statistical significance (40% Prochymal vs. 28%, standard of care, p=0.087, n=179);

 

·                  Prochymal significantly improved response in steroid-refractory liver GvHD (76% vs. 47%, p=0.03) and gastrointestinal GvHD (82% vs. 64%, p=0.03);

 

·                  In the sickest patients—those with GvHD affecting all three organs, skin, liver and gastrointestinal tract—treatment with Prochymal resulted in a 63% overall response rate, while none of the placebo-treated patients responded (p<0.05);

 

·                  Children receiving Prochymal had an overall response rate of 64% compared to 36% in patients receiving placebo; and

 

·                  In children with steroid-refractory GvHD, Prochymal more than doubled complete response rates (64% vs. 29%) and reduced disease progression by half (21% vs. 43%).

 

In February 2010, we reported the results of a study evaluating Prochymal as a rescue therapy in 59 pediatric patients with severe, treatment-resistant acute GvHD. The trial enrolled patients with Grades B-D acute GvHD who had failed steroids and other immunosuppressive agents. Patients in the study received two intravenous infusions of Prochymal per week for a total of four weeks. Patients who experienced a partial response by day 28 were eligible for continued treatment. GvHD assessments were used in the study to detect improvements in patients treated with Prochymal. At study entry, 88% of children had Grade C/D GvHD, the most severe forms of GvHD and were unresponsive to an average of three lines of therapy. Overall response to treatment with Prochymal at 28 days was 63%. Response to Prochymal at day 28 significantly improved survival over those patients who progressed (78% vs. 9%, p<0.05). Patients in the trial were treated at 31 pediatric transplant centers across the U.S., Canada, Europe and New Zealand.

 

In July 2010, we announced that the Biologics and Genetic Therapies Directorate of Health Canada had completed its initial evaluation and accepted for full review our New Drug Submission of Prochymal for the treatment of GvHD. We were informed by Health Canada that the application had been granted Priority Review, shortening the scheduled examination period from 300 to 180 days. Heath Canada also informed us of plans to add Prochymal to its Register of Innovative Drugs, subject to a final review upon approval. This registration would confer eight years of market exclusivity, beginning on the date of Prochymal’s approval for commercial sale in Canada. This registration also generally provides that, during such period of market exclusivity, no submission for a generic version of Prochymal would be approved by Health Canada for GvHD.

 

In January 2011, Health Canada requested additional information to support our New Drug Submission for Prochymal as a treatment for GvHD. The agency determined that the application in its initial form was not in full compliance with the current Canadian Food and Drug Regulations and we were given 90 days to answer certain questions that were raised during the review. We submitted answers to Health Canada’s questions in March 2011.

 

***Phase 3 Clinical Trial—Steroid Refractory Acute GvHD.***

 

Our Phase 3 trial evaluated the safety and efficacy of Prochymal in conjunction with standard of care for the treatment of patients who had failed to respond to corticosteroid treatment for acute GvHD. This clinical trial was a double-blind, placebo-controlled study. Patients six months to 70 years of age were randomized to receive Prochymal or placebo at a 2:1 ratio in addition to standard of care. The trial completed enrollment with 260 patients in 2009 and treated 244 patients from 72 leading bone marrow transplant centers in the United States, Canada, Europe and Australia.

 

The primary endpoint, durable complete response, for the per-protocol population in the Phase 3 trial evaluating Prochymal in steroid-refractory GvHD approached but did not reach statistical significance, with 40% of patients receiving Prochymal, as compared to 28% of placebo patients, achieving a durable complete response. The per-protocol patient population refers to the group of patients that met all of the study protocol requirements, such as inclusion and exclusion criteria. The addition of Prochymal to standard of care significantly improved response in steroid-refractory liver (76% vs. 47%, p=0.03) and gastrointestinal (82% vs. 64%, p=0.03) GvHD. In the sickest patients—those with GvHD affecting all three organs—skin, liver and gastrointestinal tract—treatment with Prochymal resulted in a 63% overall response rate, while none of the placebo-treated patients responded (p<0.05). Pediatric patients receiving Prochymal had an overall response rate of 64% compared to 36% in pediatric patients receiving placebo. In children with steroid-refractory GvHD, Prochymal more than doubled complete 

 

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response rates (64% vs. 29%) and reduced disease progression by half (21% vs. 43%). Prochymal also demonstrated a positive safety profile relative to placebo.

 

***Phase 3 Clinical Trial—First Line Treatment of Acute GvHD.***

 

Our previous Phase 2 trial for treatment of newly diagnosed acute GvHD completed enrollment in 2006 and indicated that patients were twice as likely to have total clinical resolution of their disease when Prochymal was added to steroid therapy, compared to reported results for treatment with steroids alone. Twenty-nine of 31 patients, or 94%, responded in the Phase 2 trial, after receiving two infusions of Prochymal, with 24 patients, or 77% achieving a complete response, meaning the patients had experienced total clinical resolution of the disease. At ninety days, 61% of all patients treated with Prochymal still had a durable response requiring no additional immunosuppressive therapy, clinical intervention, or increased steroid use. Of these, 95% were alive at six months.

 

The Phase 3 trial to evaluate Prochymal as a first line treatment for GvHD is a randomized, double-blind, placebo-controlled study that completed enrollment in 2009 with 192 patients from 52 leading transplant centers across the United States, Canada and Australia. Patients received a total of six infusions during the first four weeks of the study. The majority of patients enrolled in this trial were suffering from skin GvHD, which was well-controlled with steroids, particularly when given at a uniform controlled dose as prescribed in the protocol. The high response rates diminished the potential for Prochymal to demonstrate an effect.

 

***Phase 3 Clinical Trial—Biologics Refractory Crohn’s Disease.***

 

Based on our clinical observations of the effects of Prochymal on the gastrointestinal symptoms of patients with GvHD, we are developing Prochymal for the treatment of Crohn’s disease. Crohn’s disease is a chronic condition that results in inflammation of the gastrointestinal tract. We received Fast Track designation from the FDA for the development of Prochymal for patients with moderate to severe biologics refractory Crohn’s disease.

 

We completed a Phase 2 trial in 2006 studying Prochymal as a treatment for moderate to severe Crohn’s disease that is refractory to steroids and other immunosuppressants. Four leading centers in the United States enrolled ten patients for the prospective, randomized, open label trial. Patients with moderate to severe Crohn’s disease, with a Crohn’s Disease Activity Index, or CDAI, of at least 220, who had previously failed treatment with steroids and other immunosuppressive agents were given two infusions of Prochymal, seven days apart. The average CDAI at baseline was 341 for patients enrolled in the study. Patients had suffered from Crohn’s disease for an average of 14.2 years, and 80% of the patients required prior surgical intervention to treat their Crohn’s disease prior to study entry. Within 14 days of treatment with Prochymal, one-third of the patients had a reduction of CDAI of greater than 100 points. Mean Inflammatory Bowel Disease Questionnaire, or IBDQ, scores improved significantly from baseline to Day 28 (113 to 146, p=0.008) and one-third of the patients reported IBDQ scores of at least 170, indicating they had achieved clinical remission of their disease. There were no infusional toxicities, and no treatment-related severe adverse events.

 

As a result of the positive data from the Phase 2 trial, a Phase 3 trial evaluating Prochymal for the treatment of refractory, moderate to severe Crohn’s disease was initiated. The placebo-controlled, double-blind study was designed to enroll 270 patients, 18 to 70 years of age with a CDAI greater than 250. The primary endpoint of this trial is the proportion of patients with CDAI of less than 150 (clinical remission) at day 28. Patients were enrolled at approximately 60 leading centers in the U.S. and Canada. In 2009, this program was suspended on account of concerns about the trial design, as discussed below.

 

In April 2010, we announced that we would resume enrollment in our Phase 3 Crohn’s program, following its suspension in 2009 over concerns about the trial design. The Crohn’s program had initially consisted of two linked trials—one aimed at inducing remission (Protocol 603) and the other at maintaining response (Protocol 610) in patients who had failed other available treatments for the disease. The primary endpoint for Protocol 603, which initially included a placebo and two Prochymal dose arms, is the proportion of patients experiencing disease remission within 28 days of initiation of therapy with Prochymal, compared to those patients receiving placebo. For a patient to reach the primary end-point of disease remission, their CDAI score must fall to below 150. Concerns that the trial design would make it difficult to detect a treatment effect led to the April 2009 suspension. The trial remained blinded following suspension, however, to permit an interim analysis of the 207 patients enrolled in the study at that time. There were no differences in average Crohn’s Disease Activity Index (CDAI) scores at entry, which exceeded 350 in all arms prior to treatment, indicating the patients had very debilitating disease. For the primary endpoint of disease remission, the interim analysis revealed that one dose arm for Prochymal approached statistical significance in the intent to treat (ITT) population, and reached significance in the per protocol population. Additionally, the analysis showed that Prochymal continued to demonstrate a benign safety profile with no significant differences in any of the pre-defined safety outcomes compared to placebo. These results showed that, despite the initial concerns, the effect size or the difference between the Prochymal and placebo response rates of one dose arm of Prochymal is consistent with the original statistical assumptions of the protocol and significantly outperformed placebo. As a result, enrollment in this clinical trial evaluating Prochymal for patients with treatment resistant Crohn’s disease was resumed.

 

The decision to resume enrollment was made following discussions with FDA about the results of the interim analysis. Enrollment is now ongoing with the best-performing Prochymal dose arm and the placebo arm, according to the pre-specified, adaptive trial design. The trial has been repowered to compensate for the statistical penalty incurred by the interim analysis in the ITT population. The follow-on maintenance trial (Protocol 610) has been discontinued to remove the potential for bias.

 

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*** ***

***Phase 2 Clinical Trial—Acute Myocardial Infarction.***

 

Prochymal is also being evaluated as a therapy to improve heart function in patients who have suffered a heart attack. A heart attack, or acute myocardial infarction, or AMI, occurs when coronary arteries become blocked with fatty deposits, depriving the heart muscle of oxygen and nutrients. Based on statistics published in 2005 by the American Stroke Association and the American Heart Association, approximately 700,000 individuals in the United States each year experience their first heart attack. According to these same statistics, approximately 20% of these patients suffer extensive damage to their heart muscle leading to heart failure within six years. Furthermore, we believe the statistics indicate that despite improvements in the standard of care, this progression from myocardial infarction to heart failure remains largely unavoidable in patients with AMIs.

 

Prochymal is being developed for the treatment of heart muscle damage following AMI. Its primary indication is to treat post-AMI complications and prevent the formation of scar tissue and associated cardiac dysfunction. Our preclinical studies indicate that the mechanism by which Prochymal improves myocardial function includes the prevention of pathological scarring of the heart muscle and the formation of new blood vessels. We are developing Prochymal as a therapy to be delivered through a standard intravenous line up to 10 days post-myocardial infarction.

 

In preclinical studies, Prochymal selectively targeted the damaged area of the heart when a single infusion was administered. These studies also indicated that Prochymal has the effect of retarding or stopping the progression of further cardiac tissue deterioration and limiting the damage caused by an AMI. Significant improvements in cardiac function as demonstrated by increased ejection fraction, reduced end diastolic pressures, and reduced wall stress were observed eight to ten weeks after administration of Prochymal. A preclinical study was performed to determine if an intravenous infusion of MSCs following myocardial infarction would result in an improvement in cardiac function. Significant improvement in cardiac function as indicated by left ventricular ejection fraction (LVEF) was observed three months after infarct in those animals receiving intravenous delivery of MSCs compared to control animals. MSCs were detected in the damaged area of the heart muscle of Prochymal treated animals, but not in the remote, undamaged regions.

 

In March 2006, we completed enrollment of a 53-patient Phase 1 randomized, double-blind, placebo-controlled clinical study to evaluate Prochymal in patients following AMI. The trial was designed to investigate patient response to three different doses of Prochymal versus placebo. Exploratory efficacy endpoints included overall improvement in the function and remodeling of the heart muscle six months after treatment. A safety evaluation for each subject was conducted two years after the subject was enrolled in the trial.

 

In March 2007, we reported six-month results in this trial. Heart attack patients receiving Prochymal had significantly lower rates of adverse events, such as cardiac arrhythmias, as well as significant improvements in heart, lung and global function. Administration of Prochymal was found to be well tolerated at all dose levels. Patients in the Prochymal group were four times less likely to experience an arrhythmic event compared to those receiving placebo (9% vs. 37%, p=0.025). The percentage of patients who experienced clinically significant premature ventricular contractions was significantly less after receiving Prochymal as compared to placebo at the one month (6% vs. 32%, p<0.05) and two month (9% vs. 38%, p<0.05) time points. Patients with anterior wall myocardial infarctions had a statistically significant 7.0 point (24%) improvement in ejection fraction at three months and a 7.3 point (25%) improvement at six months over baseline (p<0.05). In comparison, placebo patients in this group did not have a significant increase. Patients receiving Prochymal had significantly improved pulmonary function as measured by improvement in FEV1% predicted values (17 point Prochymal vs. 6 point placebo, p<0.05). FEV1 or forced expired volume in one second is the amount of air that can be exhaled in a patient’s first second of expiration. Comparing the patient’s FEV1 reading with normal predicted values (FEV1% predicted) provides a measure of the severity of pulmonary disease. Significantly more patients who received Prochymal experienced improvement in their overall condition at six months as compared to those receiving placebo (42% vs. 11%, p=0.027).

 

In February 2008, we reported one-year results in the Phase 1 trial. The trial continued to demonstrate Prochymal’s strong safety profile as well as continued statistically significant improvement in heart function. One year magnetic resonance imaging (MRI) data on LVEF was collected and patients treated with Prochymal showed a statistically significant 5.2 point increase over baseline (p=0.021). Patients receiving placebo showed only a 1.8 point improvement over baseline, which was not statistically significant. Patients with more severe myocardial infarction, defined as a baseline LVEF of 45% or less, demonstrated even greater effects. The Prochymal treatment group showed a 6.5-point improvement one year post-treatment, compared to a 1.9-point increase in the placebo group. Prochymal treated patients continued to experience fewer adverse events at a rate of 6.1 per patient, compared to 8.0 per patient in the placebo group. This one-year interim analysis was performed as a part of the full two-year follow-up, and as a result, contains only limited data.

 

Data from the final two-year time point was reported in February 2009 and indicated a continuing benefit from treatment with Prochymal. The trial met its primary endpoint demonstrating the safety of Prochymal in the acute myocardial infarction setting. Patients receiving Prochymal continued to experience fewer adverse events than that of placebo (8 vs. 11 per patient). During the trial, patients receiving Prochymal experienced fewer arrhythmias as compared to patients receiving placebo. This effect was maintained for the duration of the study, with 47.4% of placebo patients experiencing cardiac arrhythmia compared to only 11.8% of Prochymal patients (p=0.006). Ventricular arrhythmias are associated with tissue damage and scar formation in the heart resulting from infarction and can be a sign of poorer prognosis. Two year MRI demonstrated that there was statistically significant improvement in LVEF over baseline, 6.6 point in Prochymal relative to a 3.9 point improvement in placebo. For patients with more severe myocardial infarction, defined as a baseline LVEF of 45% or less, 

 

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even greater effects were observed. The Prochymal group showed a significant 9.5 point improvement over baseline two years post-treatment (p<0.05). This compares favorably to the 3.1 point increase observed for the placebo group. No serious adverse events were attributed to Prochymal, and all-cause hospitalizations trended lower in the Prochymal group (38.2%) as compared to the placebo group (47.4%).

 

Based upon the positive results from the Phase 1 trial, we received approval from the FDA to initiate a Phase 2 trial. The Phase 2 double-blind, placebo-controlled trial is evaluating the safety and efficacy of Prochymal in conjunction with standard of care for improving heart function in patients who experienced a first heart attack. This trial focuses on patients who have suffered a severe myocardial infarction, defined as LVEF between 20% and 45% at baseline. Enrollment of 220 patients was completed in March 2011 at 33 leading centers in the United States and Canada. Patients were randomized to either Prochymal or placebo at a 1:1 ratio. Efficacy endpoints determined from cardiac MRI include end systolic volume, LVEF and the ability of Prochymal to preserve functional heart tissue, or limit scar formation following a heart attack. In addition, functional and quality of life assessments are being performed.

 

***Phase 2 Clinical Trial—Early Onset Type 1 Diabetes Mellitus.***

 

We are also investigating Prochymal as a treatment for the preservation of insulin production in patients with newly diagnosed type 1 diabetes mellitus. Type 1 diabetes, commonly known as juvenile diabetes or insulin-dependent diabetes, is an autoimmune disorder that attacks and destroys insulin producing islet cells in the pancreas causing glucose accumulation in the blood. As a result, those suffering from type 1 diabetes must take insulin to regulate blood sugar levels. Over time, poorly controlled diabetes can lead to serious health conditions, including heart disease, stroke, blindness, amputations, kidney disease and nerve damage. Currently, there are no preventative measures for type 1 diabetes. In preclinical research, both animal and human bone marrow-derived MSCs were shown to preserve beta cell function in animal models of diabetes.

 

In October 2007, we reported the initiation of a Phase 2 trial evaluating the safety and efficacy of Prochymal in conjunction with standard of care in preserving insulin production in patients recently diagnosed with type 1 diabetes mellitus. Patients in the double-blind, placebo-controlled study received three intravenous infusions of Prochymal over the course of sixty days. The primary efficacy endpoint of the trial is the measurement of C-peptide produced during a Mixed Meal Tolerance Test in patients treated with Prochymal, compared to those receiving placebo. This test is frequently used in diabetic patients to determine how much insulin is being produced by the pancreas in response to glucose stimulation. The patients in the trial will be followed for safety and efficacy for two years.

 

In early 2010, enrollment was completed for 63 patients in our Phase 2, double-blind, placebo-controlled study evaluating Prochymal for the treatment of early onset type 1 diabetes in individuals 12 to 35 years old. We believe that based upon their mechanism of action, MSCs may home to the pancreas and inhibit the local immune and inflammatory responses, preventing the destruction of pancreatic islets and promoting the repair of pancreatic tissue damage. Patients were enrolled within 2 to 20 weeks of being diagnosed with type 1 diabetes and received three infusions of Prochymal over the course of 60 days. The primary efficacy endpoint, the measurement of C-peptide produced after glucose stimulation, will be measured at one year. We have entered into a collaborative agreement with the Juvenile Diabetes Research Foundation, or JDRF, for this study. This agreement provides for the JDRF to fund $4.0 million of clinical study costs, and we had achieved all of the contingent milestones as of December 31, 2010.

 

***Phase 2 Clinical Trial—Chronic Obstructive Pulmonary Disease.***

 

Enrollment in the 62-patient Phase 2 clinical trial evaluating the safety and efficacy of Prochymal in conjunction with standard of care for improving pulmonary function in patients with moderate to severe Chronic Obstructive Pulmonary Disease, or COPD, was completed in the second half of 2008. Patients in the double-blind, placebo-controlled study were randomized to either Prochymal or placebo at a 1:1 ratio and received 4 infusions over the course of 90 days. Measurements used in the trial to detect potential improvements in subjects treated with Prochymal include pulmonary function tests, exercise capability, systemic inflammation and quality of life assessments. In addition, exacerbations and hospitalizations due to COPD will be monitored for both safety and efficacy. Patients were evaluated over the course of two years following initial Prochymal or placebo infusion.

 

At the six-month interim analysis, the trial met its primary goal of demonstrating the safety of Prochymal in patients with compromised pulmonary function. Prochymal significantly decreased systemic inflammation in patients when compared to those receiving placebo, as determined by C-reactive protein. Despite this reduction in inflammation, however, pulmonary function in patients receiving Prochymal was not significantly improved compared to those receiving placebo.

 

***Phase 3 Development—Animal Rule—Acute Radiation Syndrome.***

 

In 2007, we partnered with Genzyme Corporation to develop Prochymal as a medical countermeasure to nuclear terrorism and other radiological emergencies. In January 2008, we were awarded a contract from the United States Department of Defense (“DoD”) for the development and stockpiling of Prochymal for the treatment of acute radiation syndrome (“ARS”). Assuming FDA approval of Prochymal for ARS, the DoD may exercise purchase options for up to 20,000 doses of Prochymal at a price of $10,000 per dose.

 

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***Chondrogen***

 

Chondrogen is our biologic drug candidate for knee repair. Chondrogen, a preparation of adult mesenchymal stem cells formulated for direct injection into the knee, regenerated meniscus and prevented osteoarthritis in animal models. As described further below, we completed a Phase 1/2 clinical trial for Chondrogen, designed to evaluate the safety and preliminary efficacy in patients following surgery to remove torn meniscus. The current standard of care for significant injuries to the meniscus is partial meniscectomy surgery, in which the damaged portion of the meniscus is permanently removed. According to a 2005 article in the *American Journal of Sports Medicine*, approximately 1.0 million people have surgery to remove damaged or torn meniscus in the United States each year. As noted in a 1999 article in the journal *Sports Medicine*, these patients are 10 to 15 times more likely to develop osteoarthritis, a highly debilitating orthopedic condition. As a result, a significant medical need exists for a product that can prevent cartilage degeneration.

 

In the randomized double-blind, placebo-controlled Phase 1/2 clinical trial evaluating Chondrogen, 55 patients received one of two doses of Chondrogen or placebo. At six-months, there was no significant change in the volume of meniscus on MRI in patients that received Chondrogen compared to those patients receiving placebo. However, about 30% of patients treated with Chondrogen demonstrated an improvement in their baseline cartilage or joint condition, while no patients in the placebo group demonstrated similar improvement. At one-year, the data showed improvements in joint condition that correlated with a clinically and statistically significant improvement in pain in patients with osteoarthritis (“OA”) who received Chondrogen as compared to those treated with the control, hyaluronic acid (“HA”). The effects were dose dependent and pain scores improved from six months to one year following treatment. The two-year follow-up showed that Chondrogen continued to demonstrate a positive safety profile. Chondrogen was well tolerated and was not associated with serious adverse events. Also, it did not result in any adverse hematological events nor in the formation of any abnormal or ectopic tissue. Long term 5-year follow-up of the study participants for safety is ongoing.

 

In studies requiring patient-reported outcomes, such as Chondrogen, high placebo rates are observed with a stem cell agent. We have seen similar effects in Crohn’s disease. We continue to evaluate ways to overcome or compensate for this elevated placebo rate. We will initiate our next clinical trials in this area once better techniques or outcomes are available to control for the placebo effect.

 

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**Financial Operations Overview**

 

*Revenue*

 

In 2008, we entered into a Collaboration Agreement with Genzyme for the development and commercialization of Prochymal and Chondrogen that provides for non-contingent, non-refundable up front payments of $130.0 million and contingent milestone payments. This Collaboration Agreement has multiple deliverables, and consistent with our accounting policy for such transactions, we are amortizing these amounts into revenue on a straight-line basis over the estimated completion period of the deliverables, which extend through the first quarter of 2012. We recognized $10.0 million of revenue in each of the fiscal quarters ending March 31, 2011 and 2010 related to this agreement. Contingent milestone payments earned and for which we have no continuing performance obligations, will be recognized as revenue upon achievement of the related milestone, while milestone payments for which we have a continuing performance obligation will be deferred when received and amortized to revenue over the term of the related performance obligations.

 

In prior years, we have entered into strategic agreements with other companies for the development and commercialization of select stem cell biologic drug candidates for specific indications and geographic markets. In 2007, we entered into a collaborative agreement with the Juvenile Diabetes Research Foundation to conduct a Phase 2 clinical trial evaluating Prochymal as a treatment for type 1 diabetes mellitus. This collaborative agreement provides for JDRF to provide $4.0 million of contingent milestone funding to support the development of Prochymal for the preservation of insulin production in patients with newly diagnosed type 1 diabetes mellitus. The contingent milestone payments under the agreement are amortized into revenue on a straight line basis over the duration of our obligations under the collaborative agreement as they are earned. As of December 31, 2010, we had achieved all $4.0 million of the milestones available under the contract. In the first quarter of fiscal 2011, we recognized $240,000 in revenue from this agreement. During the first fiscal quarter of 2010, we recognized $210,000 in revenue from this collaborative agreement.

 

In 2003, we entered into an agreement with JCR Pharmaceuticals, granting it exclusive rights to Prochymal for the treatment of GvHD and other hematological malignancies in Japan. During the first quarter of 2010, we achieved a $1 million milestone from JCR for development progress in Japan. The collaboration with JCR also provides for additional milestone payments of up to $5.5 million for regulatory and sales milestones, as well as royalty payments on sales of the drug in Japan.

 

*Research and Development Costs*

 

Our research and development costs consist of expenses incurred in identifying, developing and testing biologic drug candidates. These expenses consist primarily of salaries and related expenses for personnel, fees paid to professional service providers for independent monitoring and analysis of our clinical trials, costs of contract research and manufacturing, costs of facilities, and the costs of manufacturing clinical batches of biologic drug candidates, quality control supplies and material to expand biologic drug candidates.

 

Consistent with our focus on the development of biologic drug candidates with potential uses in multiple indications, many of our costs are not attributable to a specifically identified product. We use our employee and infrastructure resources across several projects. Accordingly, we do not account for internal research and development costs on a project-by-project basis. From inception in December 1992 through March 31, 2011, we incurred aggregate research and development costs of approximately $395 million.

 

Prior to 2010, internal resources were applied interchangeably across several product candidates due to the potential applicability of our biologic drug candidates for multiple indications. Beginning in 2010, with the creation of our Biosurgery segment, we began to separately track research and development costs by segment. During the first fiscal quarter of 2011, our total research and development costs were $3.8 million for our Therapeutics segment and $866,000 for our Biosurgery segment.

 

We expect our research and development expenses to continue to be substantial in the future, as we continue our clinical trial activity for our existing biologic drug candidates as they advance through the development cycle, and as we invest in additional product opportunities and research programs. Clinical trials and preclinical studies are time-consuming and expensive. Our expenditures on current and future preclinical and clinical development programs are subject to many uncertainties. We test our products in several preclinical studies, and we then conduct clinical trials for those biologic drug candidates that we determine to be the most promising. As we obtain results from clinical trials, we may elect to discontinue or delay trials for some biologic drug candidates in order to focus our resources on more promising biologic drug candidates. Completion of clinical trials may take several years or more, but the length of time generally varies substantially according to the type, size of trial and intended use of a biologic drug candidate. The cost of clinical trials may vary significantly over the life of a project as a result of a variety of factors, including:

 

·                  the number of patients who participate in the trials;

 

·                  the number of sites included in the trials;

 

·                  the length of time required to enroll trial participants;

 

·                  the duration of patient treatment and follow-up;

 

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·                  the costs of producing supplies of the biologic drug candidates needed for clinical trials and regulatory submissions;

 

·                  the efficacy and safety profile of the biologic drug candidate; and

 

·                  the costs and timing of, and the ability to secure, regulatory approvals.

 

As a result of these uncertainties, we are unable to determine with any significant degree of certainty the duration and completion costs of our research and development projects or when and to what extent we will generate revenues from the commercialization and sale of any of our biologic drug candidates.

 

*General and Administrative Expenses*

 

General and administrative expenses consist primarily of the costs associated with our general management, including salaries, allocations of facilities and related costs, and professional fees such as legal and accounting expenses. We have increased our general and administrative expense for legal and accounting compliance costs, investor relations and other activities associated with operating as a publicly traded company and strengthened our administrative capabilities as we approach the commercial launch of Prochymal for an initial indication. Continued increases will also likely result from the hiring of additional operational, financial, accounting, facilities engineering and information systems personnel.

 

*Other Income, Net*

 

Other income (expense) consists of interest earned on our cash and investments available for sale and realized gains and losses incurred on the sale of these investments. Interest expense consists of interest incurred on capital leases and other debt financings. We do not expect to incur material interest expense in the future as we had extinguished all of our outstanding debt prior to fiscal 2009.

 

*Income Taxes*

 

Historically, we have not recognized any deferred tax assets or liabilities in our financial statements since we cannot assure their future realization. Because realization of deferred tax assets is dependent upon future earnings, a full valuation allowance has been recorded on the net deferred tax assets, which relate primarily to net operating loss and research and development carry-forwards. In the event that we become profitable within the next several years, we have net deferred tax assets (before a valuation allowance) of approximately $77.5 million that may be utilized prior to us having to recognize any income tax expense or make payments to the taxing authorities other than the alternative minimum tax. The income tax accounting for the upfront fees we received from Genzyme Corporation require us to recognize revenue for income tax purposes several years earlier than we recognize this revenue for financial statement purposes, resulting in current income tax liabilities that we expect to exceed our ultimate aggregate income tax expense. During 2010, we released a portion of the valuation allowance in the amount of $3.2 million to reflect our expectation of being able to utilize net operating loss and tax credit carryforwards in 2011.

 

In the first fiscal quarter of 2011, we incurred a taxable loss of approximately $4.6 million, primarily because the $10.0 million of revenue recognized for financial reporting purposes from our collaborative agreement with Genzyme was recognized in prior years for income tax accounting purposes. In the first fiscal quarter of 2010, we recorded a provision for income taxes of $682,000 to recognize the U.S. Federal alternative minimum tax on our taxable income.

 

**Critical Accounting Policies**

 

There have been no material changes in our critical accounting policies, estimates and judgments during the three months ended March 31, 2011 compared to the disclosures in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2010, other than as disclosed herein.

 

**Results of Operations**

 

***Comparison of Three Months Ended March 31, 2011 and 2010***

 

*Revenues from Collaborative Research Licenses & Grants*

 

Revenues from collaborative research licenses and grants were $10.2 million for the three months ended March 31, 2011 compared to $11.2 million for the first quarter of fiscal 2010.  During the three months ended March 31, 2011, we recognized $10.0 million in revenue from our collaborative agreement with Genzyme and $240,000 from our collaborative agreement with JDRF. Our revenues for the first quarter of 2011 also include $115,000 of cost recovery from our adult patient expanded access program for Prochymal for the treatment of treatment-resistant GvHD, plus royalties on MSCs sold for research purposes.  Revenues for the three months ended March 31, 2010 consisted of $10.0 million from the Genzyme agreement, $210,000 from the JDRF collaboration, $1.0 million from the milestone payment received from JCR and $86,000 from the DoD contract for Prochymal for the treatment of acute radiation syndrome, plus other minor royalties.

 

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*Biosurgery Product Sales*

 

During the three months ended March 31, 2011, we continued limited commercial sales of wound care products manufactured by our Biosurgery Division and recognized $37,000 in revenue and gross profit of $22,000. We are continuing to distribute the majority of these products for clinical evaluation and expect commercial sales to ramp up slowly until such time as the cost to consumers for these products becomes reimbursable by third party payers, including government health administrative authorities, health insurers, and benefit managers. Until such time as we determine it to be appropriate, and we ramp up our biosurgery manufacturing activities to fully utilize our manufacturing facilities, our costs to manufacture these products are likely to vary significantly.

 

*Research and Development Expenses*

 

Research and development expenses for the three months ended March 31, 2011 were $4.7 million as compared to research and development expenses of $6.6 million for the same period of 2010.  The first quarter 2011 expenses include $866,000 of development and initial manufacturing costs associated with our Biosurgery segment. During the first quarter of 2010, we incurred $1.1 million of research and development expenses in our Biosurgery operations. In our Therapeutics segment, we incurred $3.8 million of research and development expenses during the first quarter of 2011 compared to $5.4 million in the first quarter of 2010. The reduction in research and development expenses during the first quarter of 2011, when compared to the corresponding period of the prior year, reflects the completion of enrollment in our Phase 3 clinical trials and the associated reduction of treatment site and patient costs.  We also incur research and development expenses in connection with the preparation of our applications for marketing approval as we work towards the commercialization of Prochymal for an initial indication.

 

*General and Administrative Expenses*

 

General and administrative expenses were $1.7 million for the three months ended March 31, 2011 compared to $1.8 million for the corresponding period in fiscal 2010.  During the first quarter of 2011, we recognized $214,000 of compensation expense paid to members of our Board of Directors. The non cash charge for share-based compensation allocated to general and administrative expenses during the fiscal quarter ended March 31, 2011 was $361,000 (including $178,000 of director compensation) as compared to $184,000 for the same period last year.

 

*Other Income, Net*

 

Investment income, net was $29,000 for the three months ended March 31, 2011, compared to $88,000 in the corresponding period in fiscal 2009.  During the first quarter of 2010, we recognized $25,000 gain on the sale of stock we received as the final milestone payment from the sale of our Osteocel business that was received in 2009. Our investments available for sale consist primarily of short-term, investment grade securities with a focus on avoiding market risk. We did not incur any interest expense during the first quarter of either 2011 or 2010.

 

**Liquidity and Capital Resources**

 

***Liquidity***

 

At March 31, 2011, we had $61.6 million in cash and investments available for sale.  We did not have any outstanding debt at any time since fiscal 2008. Although there can be no assurance, we believe that we have sufficient liquidity on hand as of March 31, 2011 to fund our operations through the commercialization of our first biological drug candidate.

 

***Cash Flows***

 

***Comparison of Three Months Ended March 31, 2011 and 2010***

 

Cash used in operating activities for the three months ended March 31, 2011 was $6.0 million compared to $10.0 million in the corresponding fiscal period of the prior year.  The 2011 net income of $4.0 million was offset by net decreases in working capital, primarily reductions in deferred revenue and accounts payable and accrued expenses, which was partially offset by $793,000 of non-cash expenses.  Cash used in operating activities during the first three months of 2010 reflect our net income of $2.4 million, which was offset primarily by reductions in deferred revenue and accounts payables and accrued expenses. Non-cash expenses incurred during the first quarter of 2010 were $564,000.

 

Cash provided by investing activities during the first three months of 2011 was $6.0 million compared to $10.9 million in the same period of the prior year.  Cash provided by investing activities during both fiscal periods was primarily the result of the net sales of investment available for sale to provide funds for operating activities.

 

Cash provided by (used in) financing activities during the first three months of 2011 and 2010 was immaterial.

 

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***Capital Resources***

 

Our future capital requirements will depend on many factors, including:

 

·                  the scope and results of our research and preclinical development programs;

 

·                  the scope and results of our clinical trials, particularly regarding the number of patients required for our Phase 3 trials;

 

·                  the timing of and the costs involved in obtaining regulatory approvals for our biologic drug candidates, which could be more lengthy or complex than obtaining approval for a new conventional drug, given the FDA’s limited experience with late-stage clinical trials and marketing approval for stem cell therapeutics;

 

·                  the timing and achievement of contingent milestone payments under the Genzyme collaboration agreement;

 

·                  the costs of maintaining, expanding and protecting our intellectual property portfolio, including possible litigation costs and liabilities; and

 

·                  the costs of expanding our work force consistent with expanding our business and operations and status as a public company.

 

**Off-Balance Sheet Arrangements.**

 

We have no off-balance sheet financing arrangements and we have not entered into any transactions involving unconsolidated subsidiaries or special purpose entities.

 

**Item 3.****                                  ****Quantitative and Qualitative Disclosures About Market Risk**.

 

*Interest Rate Risk*

 

Due to the short duration of our investment portfolio and the high quality of our investments, an immediate 10% change in interest rates would not have a material effect on the value of our portfolio. Therefore, we would not expect our operating results or cash flows to be affected to any material degree by the effect of a sudden change in market interest rates on our securities portfolio.

 

We believe that the interest rate risk related to our accounts receivable is not significant. We manage the risk associated with these accounts through periodic reviews of the carrying value for non-collectability and establishment of appropriate allowances in connection with our internal controls and policies.

 

*Foreign Current Exchange Rate Risk*

 

We conduct clinical trial activities in areas that operate in a functional currency other than the United States dollar (USD). As a result, when the USD rises and falls against the functional currencies of these other nations, our costs will either increase or decrease by the relative change in the exchange rate. Foreign currency gains and losses were not significant during the three months ended March 31, 2011 or 2010, and at the present time, we have elected not to hedge our exposure to foreign currency fluctuations.

 

*Derivative Instruments*

 

We do not enter into hedging or derivative instrument arrangements.

 

**Item 4****.**                                   **Controls and Procedures.**

 

***Evaluation of Disclosure Controls and Procedures.*** An evaluation of the effectiveness of the design and operation of our “disclosure controls and procedures” (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended), as of the end of the period covered by this Quarterly Report on Form 10-Q was made under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer.  A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met.  Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (a) are effective to ensure that information required to be disclosed by us in reports filed or submitted under the Securities Exchange Act of 1934 is timely recorded, processed, summarized and reported and (b) include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in reports filed or submitted under the Securities Exchange Act of 1934 is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

 

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***Changes in Internal Control over Financial Reporting.*** There have not been any changes in our internal control over financial reporting that occurred during the quarter ended March 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

**PART II - OTHER INFORMATION**

 

**Item 1.****                                  ****Legal Proceedings**.

 

From time to time, we receive threats or may be subject to routine litigation matters related to our business.  However, we are not currently a party to any material pending legal proceedings.

 

**Item 1A.****                         ****Risk Factors**.

 

There have not been any material changes in the risk factors previously disclosed under the heading “Risk Factors” in Part I — Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2010, as filed with the Securities and Exchange Commission on March 14, 2011.

 

**Item 2****.**                                   **Unregistered Sales of Equity Securities and Use of Proceeds**.

 

None.

 

**Item 3.****                                  ****Defaults Upon Senior Securities**.

 

None.

 

**Item 4.**                                   ( **Removed and Reserved** ).

 

**Item 5****.**                                   **Other Information**.

 

None.

 

**Item****6.****                                  ****Exhibits.**

 
| **Exhibit   Number** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                     |
|----------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                                                                                                                                                                     |
| 10.1                 |       | Employment   Agreement by and between Osiris Therapeutics, Inc. and Stephen W. Potter   entered into as of February 7, 2011. (Incorporated herein by reference   to Exhibit 10.1 to the Current Report on Form 8-K filed by the   Registrant with the SEC on February 8, 2011.) |
|                 |       |                                                                                                                                                                                                                                                                                                     |
| 31.1.1               |       | Certification   of Principal Executive Officer pursuant to Rule 13a-14(a) and   15d-14(a) under the Securities Exchange Act of 1934, as amended   (Section 302 of the Sarbanes-Oxley Act of 2002).                                                                                   |
|                 |       |                                                                                                                                                                                                                                                                                                     |
| 31.2.1               |       | Certification   of Principal Financial Officer pursuant to Rule 13a-14(a) and   15d-14(a) under the Securities Exchange Act of 1934, as amended   (Section 302 of the Sarbanes-Oxley Act of 2002).                                                                                   |
|                 |       |                                                                                                                                                                                                                                                                                                     |
| 32.1                 |       | Certification   of Principal Executive Officer and Principal Financial Officer pursuant to 18   U.S.C. Section 1350, as adopted pursuant to Section 906 of the   Sarbanes-Oxley Act of 2002.                                                                                                   |

 

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**SIGNATURES**

 

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

 
|                     | **Osiris Therapeutics, Inc.**                      |
|--------------------------|---------------------------------------------------------|
|                     |                                                    |
| Date:   May 9, 2011 | /s/   PHILIP R. JACOBY, JR.                             |
|                     | Philip   R. Jacoby, Jr.                            |
|                     | Chief   Financial Officer (Principal Financial Officer) |
|                     |                                                    |
| Date:   May 9, 2011 | /s/   MATTHEW NEUMAYER                                  |
|                     | Matthew   Neumayer                                      |
|                     | Corporate   Controller (Principal Accounting Officer)   |

 

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