**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

** **
| **x**      | ** ** | **QUARTERLY REPORT  PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|------------|------------|-----------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                    |
| **o**      | ** ** | **TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

For The QuarterlyPeriod Ended **June 30, 2006**

 

Commission filenumber —**001-32966**

 

**OSIRIS THERAPEUTICS, INC.**

(Exact name ofregistrant as specified in its charter)

 
| **Delaware**                                                    | **71-0881115**                    |
|-----------------------------------------------------------------|-----------------------------------|
| (State or other  jurisdiction of incorporation or organization) | (IRS Employer Identification No.) |

** **

**2001 Aliceanna St. Baltimore, Maryland 21231**

(Address ofprincipal executive offices) (Zip code)

** **

**410-522-5005**

(Registrant’stelephone number, including area code)

** **

**None**

(Former name,former address and former fiscal year, if changed since last report)

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days. Yes o   No x

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer.  Seedefinition of “accelerated filer and large acceleratef iler” in Rule 12b-2 ofthe Exchange Act). (Check one):

| Large accelerated filer o | Accelerated  filer o | Non-accelerated  filer x |
|--------------------------------|---------------------------|-------------------------------|

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o   No x

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock asof the latest practicable date.

|                                          | **Class** | ** ** | ** **     | **Outstanding at September 1, 2006** | ** ** |
|------------------------------------------|-----------|------------|----------------|----------------------------------------------------------|------------|
| Common Stock, par value $0.001 per share |      | 27,198,307 |  

  |

 

 

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**OSIRIS THERAPEUTICS, INC.**

**INDEX**
|                                         | ** ** | ** **                                                                                        | ** ** | **Page** | ** ** |
|-----------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|----------|------------|
| **PART I — FINANCIAL INFORMATION** |       |                                                                                              |       |
| ** **                              | ** ** | ** **                                                                                        |       |     |       |
| Item 1.                                 |       | Financial Statements — Unaudited                                                             |       |     |       |
|                                    |       | Condensed Balance Sheets — June 30, 2006 &  December 31, 2005                            |       | 3        |       |
|                                    |       | Condensed Statements of Operations — three months  ended June 30, 2006 and 2005              |       | 4        |       |
|                                    |       | Condensed Statements of Operations — six months ended  June 30, 2006 and 2005                |       | 5        |       |
|                                    |       | Statement of Stockholders’ Deficit                                                           |       | 6        |       |
|                                    |       | Statements of Cash Flows                                                                          |       | 7        |       |
|                                    |       | Notes to Condensed Financial Statements                                                           |       | 8        |       |
|                                    |       |                                                                                              |       |     |       |
| Item 2.                                 |       |  Management’s Discussion and Analysis of Financial  Condition and Results of Operations |       | 14       |       |
|                                    |       |                                                                                              |       |     |       |
| Item 3.                                 |       | Quantitative and Qualitative Disclosures About Market  Risk                                       |       | 19       |       |
|                                    |       |                                                                                              |       |     |       |
| Item 4.                                 |       | Controls and Procedures                                                                           |       | 20       |       |
|                                    |       |                                                                                              |       |     |       |
| **PART II — OTHER INFORMATION**    |       |                                                                                              |       |
|                                    | ** ** | ** **                                                                                        |       |     |       |
| Item 1.                                 |       | Legal Proceedings                                                                                 |       | 21       |       |
| Item 1A.                                |       | Risk Factors                                                                                      |       | 21       |       |
| Item 2.                                 |       | Unregistered Sales of Equity Securities and Use of  Proceeds                                      |       | 21       |       |
| Item 3.                                 |       | Defaults Upon Senior Securities                                                                   |       | 21       |       |
| Item 4.                                 |       | Submission of Matters to a Vote of Security Holders                                               |       | 21       |       |
| Item 5.                                 |       | Other Information                                                                                 |       | 21       |       |
| Item 6.                                 |       | Exhibits                                                                                          |       | 22       |       |
|                                    |       |                                                                                              |       |     |       |
| Signature                               |       | 23                                                                                                |       |
|                                    |       |                                                                                              |       |     |       |
| Exhibit Index                           |       |                                                                                              |       |

 

2

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**PART I — FINANCIALINFORMATION**

**Item 1.**                          FinancialStatements - Unaudited

**OSIRISTHERAPEUTICS, INC.Condensed Balance Sheets**Amounts in thousands
| ** **                                                                                                                                                             | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                             | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                                             | ** ** | **(unaudited)**   | ** ** | ** **            | ** ** |
| **Assets**                                                                                                                                                             |       |              |       |                  |       |
| Current assets:                                                                                                                                                        |       |              |       |                  |       |
| Cash                                                                                                                                                                   |       | $                 | 814        |                  | $          | 597 |   |
| Short-term investments                                                                                                                                                 |       | 27,765            |       | 42,774                |       |
| Accounts receivable                                                                                                                                                    |       | 804               |       | 974                   |       |
| Inventory and other current assets                                                                                                                                     |       | 1,840             |       | 367                   |       |
| Total current assets                                                                                                                                                   |       | 31,223            |       | 44,712                |       |
|                                                                                                                                                                   |       |              |       |                  |       |
| Property and  equipment, net                                                                                                                                           |       | 3,746             |       | 3,792                 |       |
| Restricted cash                                                                                                                                                        |       | 309               |       | 190                   |       |
| Deferred  financing costs, net                                                                                                                                         |       | 1,669             |       | 2,050                 |       |
| Other assets                                                                                                                                                           |       | 268               |       | 270                   |       |
| Total assets                                                                                                                                                           |       | $                 | 37,215     |                  | $          | 51,014 |   |
|                                                                                                                                                                   |       |              |       |                  |       |
| **Liabilities  and Stockholders’ Deficit**                                                                                                                        |       |              |       |                  |       |
| Current liabilities:                                                                                                                                                   |       |              |       |                  |       |
| Accounts payable and accrued expenses                                                                                                                                  |       | $                 | 5,835      |                  | $          | 4,565 |   |
| Note payable, current portion                                                                                                                                          |       | 65                |       | 65                    |       |
| Capital lease obligations, current portion                                                                                                                             |       | 1,077             |       | 1,027                 |       |
| Deferred revenue, current portion                                                                                                                                      |       | 952               |       | 952                   |       |
| Total current liabilities                                                                                                                                              |       | 7,929             |       | 6,609                 |       |
|                                                                                                                                                                   |       |              |       |                  |       |
| Note payable,  net of current portion                                                                                                                                  |       | 47,379            |       | 47,411                |       |
| Capital lease obligations,  net of current portion                                                                                                                     |       | 1,472             |       | 2,024                 |       |
| Deferred  revenue, net of current portion                                                                                                                              |       | 873               |       | 1,349                 |       |
| Long-term  interest payable and other liabilities                                                                                                                      |       | 5,251             |       | 3,016                 |       |
| Mandatorily  redeemable convertible preferred stock Series D 3,750 shares designated,  3,213 shares issued and outstanding in 2006 and 2005                            |       | 64,267            |       | 64,267                |       |
| Total liabilities                                                                                                                                                      |       | 127,171           |       | 124, 676              |       |
|                                                                                                                                                                   |       |              |       |                  |       |
| Stockholders’ deficit:                                                                                                                                            |       |              |       |                  |       |
| Convertible Preferred Stock, issuable in series,  $0.001 par value, 16,250 shares authorized, 12,250 shares designated and  10,651 shares outstanding in 2006 and 2005 |       | 32,746            |       | 32,746                |       |
| Common stock, $.001 par value, 90,000 shares  authorized 9,176 and 9,098 shares outstanding In 2006 and 2005                                                           |       | 9                 |       | 9                     |       |
| Additional paid-in-capital                                                                                                                                             |       | 36,559            |       | 36,404                |       |
| Deferred compensation                                                                                                                                                  |       | —            |       | (277                  | )          |
| Accumulated deficit                                                                                                                                                    |       | (159,270          | )          | (142,544              | )          |
| Total stockholders’ deficit                                                                                                                                       |       | (89,956           | )          | (73,662               | )          |
| Total liabilities and stockholders’ deficit                                                                                                                       |       | $                 | 37,215     |                  | $          | 51,014 |   |
|                                                                                                                                                                   |       |              |       |                  |       |

 

The accompanying notes are an integralpart of these financial statements.

3

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**OSIRISTHERAPEUTICS, INC.Condensed Statements of Operations(Unaudited)**Amounts in thousands,except per share data
| ** **                                               | ** ** | **Three Months Ended June 30,** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Revenues:                                                |       |                                                |       |   |   |
| Product Sales                                            |       | $                                                   | 1,689      |   | $ | — |   |
| Cost of goods sold                                       |       | 762                                                 |       | — |   |
| Gross profit                                             |       | 927                                                 |       | — |   |
|                                                     |       |                                                |       |   |   |
| Revenue from  collaborative research licenses and grants |       | 298                                                 |       | 1,339 |   |
|                                                     |       |                                                |       |   |   |
| Operating expenses:                                      |       |                                                |       |   |   |
| Research and development                                 |       | 10,922                                              |       | 3,592 |   |
| General and administrative                               |       | 1,209                                               |       | 487 |   |
| Total operating expenses                                 |       | 12,131                                              |       | 4,079 |   |
|                                                     |       |                                                |       |   |   |
| Loss from operations                                     |       | (10,906                                             | )          | (2,740 | ) |
|                                                     |       |                                                |       |   |   |
| Interest  expense, net                                   |       | (699                                                | )          | (654 | ) |
|                                                     |       |                                                |       |   |   |
| Net loss                                                 |       | $                                                   | (11,605    | ) | $ | (3,394 | ) |
|                                                     |       |                                                |       |   |   |
|                                                     |       |                                                |       |   |   |
|                                                     |       |                                                |       |   |   |
| Basic and diluted net loss per share                     |       | $                                                   | (1.27      | ) | $ | (0.38 | ) |
|                                                     |       |                                                |       |   |   |
| Weighted Average  Common Shares (basic and diluted)      |       | 9,158                                               |       | 8,964 |   |

 

The accompanying notes are an integralpart of these financial statements.

4

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**OSIRISTHERAPEUTICS, INC.Condensed Statements of Operations(Unaudited)**Amounts in thousands,except per share data
| ** **                                               | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| Revenues:                                                |       |                                              |       |   |   |
| Product Sales                                            |       | $                                                 | 2,794      |   | $ | — |   |
| Cost of goods sold                                       |       | 1,251                                             |       | — |   |
| Gross profit                                             |       | 1,543                                             |       | — |   |
|                                                     |       |                                              |       |   |   |
| Revenue from  collaborative research licenses and grants |       | 593                                               |       | 1,724 |   |
|                                                     |       |                                              |       |   |   |
| Operating expenses:                                      |       |                                              |       |   |   |
| Research and development                                 |       | 15,290                                            |       | 6,249 |   |
| General and administrative                               |       | 2,347                                             |       | 1,239 |   |
| Total operating expenses                                 |       | 17,637                                            |       | 7,488 |   |
|                                                     |       |                                              |       |   |   |
| Loss from operations                                     |       | (15,501                                           | )          | (5,764 | ) |
|                                                     |       |                                              |       |   |   |
| Interest  expense, net                                   |       | (1,225                                            | )          | (1,498 | ) |
|                                                     |       |                                              |       |   |   |
| Net loss                                                 |       | $                                                 | (16,726    | ) | $ | (7,262 | ) |
|                                                     |       |                                              |       |   |   |
|                                                     |       |                                              |       |   |   |
|                                                     |       |                                              |       |   |   |
| Basic and diluted net loss per share                     |       | $                                                 | (1.83      | ) | $ | (0.81 | ) |
|                                                     |       |                                              |       |   |   |
| Weighted Average  Common Shares (basic and diluted)      |       | 9,146                                             |       | 8,948 |   |

 

The accompanying notes are an integralpart of these financial statements.

5

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**OSIRISTHERAPEUTICS, INC.Statement of Stockholders’ DeficitFor the six months ended June 30, 2006(Unaudited)Amounts in thousands, except for share data**
| ** **                                                                      | ** ** | **Convertible  Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** ** | **Deferred** | ** ** | **Accumulated** | ** ** | **Total  Stockholders’** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------------------------|------------|-----------------------|------------|-------------------------|------------|--------------|------------|-----------------|------------|-------------------------------|------------|
| ** **                                                                      | ** ** | **Shares**                            | ** ** | **Amount**            | ** ** | **Shares**              | ** ** | **Amount**   | ** ** | **Capital**     | ** ** | **Compensation**              | ** ** | **Deficit** | ** ** | **Deficit** | ** ** |
| Balance at January 1, 2006                                                      |       | 10,650,544                            |       | $                     | 32,746     |                    | 9,097,506  |         | $          | 9               |       | $                             | 36,404     |   | $ | (277 | ) | $ | (142,544 | ) | $ | (73,662 | ) |
|                                                                            |       |                                  |       |                  |       |                    |       |         |       |            |       |                          |       |   |   |   |   |
| Exercise of options to purchase Common Stock ($0.40  per share)                 |       |                                  |       |                  |       | 49,789                  | ** ** | —       |       | 20              |       |                          |       |   |   | 20 |   |
| Issuance of common stock for services rendered by  directors ($11.00 per share) |       |                                  |       |                  |       | 22,807                  |       | —       |       | 198             |       |                          |       |   |   | 198 |   |
| Issuance of common stock for services rendered by  consultant ($6.84 per share) |       |                                  |       |                  |       | 6,250                   |       | —       |       | 43              |       |                          |       |   |   | 43 |   |
| Reclassification due to adoption of new accounting  standard                    |       |                                  |       |                  |       |                    |       |         |       | (277            | )          | 277                           |       |   |   | — |   |
|                                                                            |       |                                  |       |                  |       |                    |       |         |       |            |       |                          |       |   |   |   |   |
| Stock-based compensation                                                        |       |                                  |       |                  |       |                    |       |         |       | 171             |       |                          |       |   |   | 171 |   |
|                                                                            |       |                                  |       |                  |       |                    |       |         |       |            |       |                          |       |   |   |   |   |
| Net loss                                                                        |       |                                  |       |                  |       |                    |       |         |       |            |       |                          |       | (16,726 | ) | (16,726 | ) |
| Balance at June  30, 2006                                                       |       | 10,650,544                            |       | $                     | 32,746     |                    | 9,176,352  |         | $          | 9               |       | $                             | 36,559     |   | $ | — |   | $ | (159,270 | ) | $ | (89,956 | ) |

 

The accompanying notes are an integral part of thesefinancial statements.

6

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**OSIRISTHERAPEUTICS, INC.Statements of Cash Flows(Unaudited)Amounts in thousands**
| ** **                                                                       | ** ** | **Six Months Ending June 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2006**                                           | ** ** | **2005** | ** ** |
|                                                                             |       |                                               |       |   |   |
| Cash flows from  operations:                                                     |       |                                               |       |   |   |
| Net loss                                                                         |       | $                                                  | (16,726    | ) | $ | (7,262 | ) |
| Adjustments to  reconcile net loss to net cash used in operations:               |       |                                               |       |   |   |
| Depreciation and amortization                                                    |       | 743                                                |       | 720 |   |
| Non cash compensation expense                                                    |       | 412                                                |       | 44 |   |
| Non cash interest expense                                                        |       | 381                                                |       | 900 |   |
| Increase  (decrease) in cash resulting from changes in assets and liabilities:   |       |                                               |       |   |   |
| Accounts receivable                                                              |       | 170                                                |       | (624 | ) |
| Inventory and other current assets                                               |       | (1,473                                             | )          | (42 | ) |
| Other assets                                                                     |       | 2                                                  |       | (294 | ) |
| Accounts payable and accrued expenses                                            |       | 1,270                                              |       | 796 |   |
| Deferred revenue                                                                 |       | (476                                               | )          | (476 | ) |
| Other long-term liabilities                                                      |       | 2,235                                              |       | (231 | ) |
| Net cash used in  operations:                                                    |       | (13,462                                            | )          | (6,469 | ) |
|                                                                             |       |                                               |       |   |   |
| Cash flows from  investing activities:                                           |       |                                               |       |   |   |
| Purchases of property and equipment                                              |       | (697                                               | )          | (138 | ) |
| Proceeds from sale of short-term investments                                     |       | 15,009                                             |       | — |   |
| Net cash provided by (used in) investing activities                              |       | 14,312                                             |       | (138 | ) |
|                                                                             |       |                                               |       |   |   |
|                                                                             |       |                                               |       |   |   |
| Cash flows from  financing activities:                                           |       |                                               |       |   |   |
| Principal payments on capital lease obligations and notes  payable               |       | (534                                               | )          | (429 | ) |
| Restricted cash                                                                  |       | (119                                               | )          | 11 |   |
| Proceeds from notes payable                                                      |       | —                                             |       | 6,919 |   |
| Proceeds from the issuance of preferred and common  stock, net of offering costs |       | 20                                                 |       | 8,088 |   |
| Net cash (used in) provided by financing activities                              |       | (633                                               | )          | 14,589 |   |
|                                                                             |       |                                               |       |   |   |
|                                                                             |       |                                               |       |   |   |
| Net increase in  cash                                                            |       | 217                                                |       | 7,982 |   |
| Cash at  beginning of period                                                     |       | 597                                                |       | 488 |   |
|                                                                             |       |                                               |       |   |   |
| Cash at end of period                                                            |       | $                                                  | 814        |   | $ | 8,470 |   |

 

The accompanying notes are an integral part of thesefinancial statements.

7

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**OSIRISTHERAPEUTICS, INC.NOTES TO CONDENSED FINANCIAL STATEMENTSAmounts in thousands, except for share and per share data**

**1.             Basis of Presentation**

The accompanyingunaudited financial statements of Osiris Therapeutics, Inc. have been preparedin accordance with generally accepted accounting principles in the UnitedStates and the rules and regulations of the Securities and Exchange Commission,(the “SEC”), for interim financial information. Accordingly, they do not include all the information and footnotesrequired by generally accepted accounting principles for complete financialstatements and should be read in conjunction with the Company’s RegistrationStatement on Form S-1, as amended (Registration No. 333-134037), which wasdeclared effective by the SEC on August 3, 2006.  The financial information as of June 30, 2006and 2005 and for the three and six months then ended is unaudited, but in theopinion of management all adjustments, consisting only of normal recurringaccruals, considered necessary for a fair statement of the results of theseinterim periods have been included.  Theresults of the Company’s operations for any interim period are not necessarilyindicative of the results that may be expected for any other interim period orfor a full fiscal year.

**2.             Initial Public Offering and ReverseStock Split**

On August 9, 2006,the Company consummated its initial public offering, consisting of 3,500,000shares of common stock at a public offering price of $11.00, resulting in netproceeds to the Company of approximately $34.2 million (after deducting paymentof underwriters discounts and commissions, as well as offering expenses).

In connection withthe initial public offering, the Company effected a 1-for-4 reverse stock splitof the issued and outstanding common stock. Information relating to common stock and common stock-equivalents setforth in this report (including the share numbers in the preceding paragraph)have been restated to reflect this split for all periods presented.  Upon consummation of the initial publicoffering, all shares of the Company’s Class I, Series 2003, Series B, Series C,Series E and the Mandatorily Redeemable Series D convertible preferred stockwere converted into an aggregate of 10,867,284 shares of our common stock.  In addition, approximately $21.8 million ofour convertible notes payable, together with accrued interest, were convertedinto an aggregate of 2,774,076 shares of our common stock.

Immediatelyfollowing the initial public offering, we had 27,198,307 shares of common stockoutstanding.

**3.             SignificantAccounting Policies and Recent Accounting Pronouncements**

***Use of estimates***

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect the amounts reportedin the financial statements and accompanying notes. Due to the inherentuncertainty involved in making those assumptions, actual results could differfrom those estimates. We believe that the most significant estimates thataffect our financial statements are those that relate to revenue recognition,deferred tax assets, and stock-based compensation.

***Revenue recognition***

Our revenue recognition policies are in accordancewith the SEC’s Staff Accounting Bulletin No. 101, *Revenue Recognition in Financial Statements*,as amended by SEC Staff Accounting Bulletin No. 104, *Revenue Recognition*.

In July 2005, we launched Osteocel, our firstcommercial product. We recognize revenue on Osteocel sales when legal title tothe product has passed to the customer, which is generally when the product isshipped from our Baltimore, MD facilities. We have agreements with ourcustomers that specify the terms of sale, including price.

8

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***Cost of Goods Sold***

Costs of goods sold consists primarily of the costs toobtain the tissue, direct labor and other chemicals and supplies for Osteocel,which we launched in July 2005.  Beginning in 2006, we estimate the portion of our facilities and generaland administrative expenses that are directly attributable to our manufacturingactivities, and include these costs in cost of goods sold.

***Loss per Common Share***

Basic loss per common share is calculated by dividingnet loss by the weighted average number of common shares outstanding during theperiod. Diluted loss per common share adjusts basic loss per share for thepotentially dilutive effects of shares issuable under our stock option plan,and the conversion of our preferred stock and convertible debt, using thetreasury stock method. Common equivalent shares from the conversion ofpreferred stock and convertible debt and the exercise of stock options andwarrants are excluded from the computation of diluted loss per share as theireffect is antidilutive.

***Stock-Based Compensation***

On January 1, 2006, we adopted the provisions ofFinancial Accounting Standards Board Statement No. 123R, *Share-Based Payment* (Statement 123R).Statement 123R sets accounting requirements for “share-based” compensation toemployees, and requires companies to recognize in the statement of operationsthe grant-date fair value of stock options and other equity-based compensation.

In 1994, the Company adopted the Amended and Restated1994 Stock Incentive Plan (the 1994 Plan) under which 875,000 shares of commonstock have been reserved for issuance upon the exercise of options or otherequity grants that we issue from time to time. In 2006, we adopted the 2006 Omnibus Plan, under which we reserved850,000  of common stock for issuanceupon the exercise of stock options or other equity grants.  We stopped granting options under the 1994Plan upon the completion of our initial public offering in August 2006.   As of June 30, 2006, we have not granted anyoptions under the 2006 Omnibus Plan.

A summary of option activity as of June 30, 2006and changes during the six months then ended is presented below.

 
| ** **                             | ** ** | **Number of  Shares** | ** ** | **Weighted Average  Exercise Price at  Grant Date** | ** ** | **Weighted Average  Remaining Term  (Years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|----------------------------------------|------------|----------------------------|------------|-------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding at December 31,  2005 |       | 556,480                    |       | $                                                                       | 0.40       |                                                    |       |                                |       |   |
| Granted                                |       | 226,000                    |       | 3.98                                                                    |       |                                                    |       |                                |       |
| Exercised                              |       | (49,789                    | )          | 0.40                                                                    |       |                                                    |       |                                |       |
| Forfeited or expired                   |       | (3,813                     | )          | 0.40                                                                    |       |                                                    |       |                                |       |
| Outstanding at  June 30, 2006     |       | 738,878                    |       | $                                                                       | 1.11       |                                                    | 8.55       |                                | $          | 7,307 |   |
| Exercisable at  June 30, 2006     |       | 173,400                    |       | $                                                                       | 0.41       |                                                    | 7.22       |                                | $          | 1,837 |   |

 

The weighted average grant date fair value of optionsgranted during the six months ended June 30, 2006 was $7.36 pershare. The total intrinsic value of options exercised during the six monthsended June 30, 2006 was $351. We received a total of $20 in cash from theexercises of options during the six months ended June 30, 2006.

Share-based compensation included in the statements ofoperations for the three and six months ended June 30, 2006 was approximately$144 and $171, respectively.  As of June30, 2006, there was approximately $1.8 million of total unrecognizedshare-based compensation cost related to options granted under our plans thatwill be recognized over a weighted-average period of approximately 3-years.

*Pro Forma Information underSFAS 123 for Periods Prior to January 1, 2006*

Through fiscal year 2005, the Company accounted forstock-based awards to employees using the intrinsic value method in accordancewith APB 25 and related interpretations and provided the required proforma disclosures of SFAS 123. Under APB 25 the compensation expenseis calculated as the difference between the fair value of the common stock onthe date such options were granted and their exercise price.

9

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The followingtable summarizes the pro forma effect on the net loss and per share data if theCompany had applied the fair value recognition provisions of SFAS 123 tostock-based employee compensation for the six-month period ended June 30,2005.

 

|                                                                                 | ** ** | **Six Months  Ended  June 30, 2005** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Net loss                                                                        |       | $                                                   | (7,262     | ) |
| Add: Stock-based employee compensation expense  included in net loss            |       | 44                                                  |       |
| Less: Stock-based employee compensation expense  determined under SFAS 123 |       | (67                                                 | )          |
|                                                                            |       |                                                |       |
| Pro forma net  loss                                                             |       | $                                                   | (7,285     | ) |
|                                                                            |       |                                                |       |
| Net loss per  share:                                                            |       |                                                |       |
| Basic and diluted, net loss as reported                                         |       | $                                                   | (0.81      | ) |
|                                                                            |       |                                                |       |
| Pro forma basic  and diluted, net loss                                          |       | $                                                   | (0.81      | ) |

 

The weighted average fair value of options grantedduring the six months ended June 30, 2005 was $2.95 per share.

***Significant New Accounting Pronouncement***

On July 13, 2006, the FASB issued Interpretation,or FIN, No. 48, “Accounting for Uncertainty in Income Taxes — AnInterpretation of FASB Statement No. 109.” FIN No. 48 clarifies theaccounting for uncertainty in income taxes recognized in our financialstatements. It also prescribes a recognition threshold and measurementattribute for the financial statement recognition and measurement of a taxposition taken or expected to be taken in a tax return, among other things. Theprovisions of FIN No. 48 are effective for us beginning January 1,2007. We do not believe the adoption of this accounting pronouncement will havea material effect on our financial position, results of operations or cashflows.

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**5.             Long-Term Debt and Capital LeaseObligations**

|                                                                                                                             | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                  | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| Bank Loan,  payable in quarterly installments and bearing interest at LIBOR plus  applicable margins, 6.64% - 7.14% in 2006 |       | $                 | 82         |                  | $          | 114 |   |
| Line of Credit,  8%, to be repaid from future product sales                                                                 |       | 5,000             |       | 5,000                 |       |
| Term Note, 6%  redeemable at the option of the holder after the IPO, due in 2008                                       |       | 20,600            |       | 20,600                |       |
| **Long-term debt that did not convert at the  initial public offering**                                                     | ** ** | **25,682**        | ** ** | **25,714**            | ** ** |
| Term Note, 5%  convertible into Common stock at $6.00/share                                                                 |       | 2,000             |       | 2,000                 |       |
| Term Notes, 6%  convertible into common stock at initial public offering at specified prices                                |       | 19,762            |       | 19,762                |       |
| **Long-term debt that converted upon the initial  public offering**                                                         | ** ** | **21,762**        | ** ** | **21,762**            | ** ** |
| Total long-term  debt                                                                                                       |       | 47,444            |       | 47,476                |       |
| Less current portion                                                                                                        |       | (65               | )          | (65                   | )          |
| Long-term debt                                                                                                              |       | $                 | 47,379     |                  | $          | 47,411 |   |
|                                                                                                                        |       |              |       |                  |       |
| Total capital  lease obligations                                                                                            |       | 2,549             |       | 3,051                 |       |
| Less current portion                                                                                                        |       | (1,077            | )          | (1,027                | )          |
| Capital lease  obligations, long-term                                                                                       |       | $                 | 1,472      |                  | $          | 2,024 |   |

 

During June 1995, we borrowed $750 thousand from acommercial bank in connection with the acquisition and renovation of ourBaltimore, Maryland facilities.  Thisloan is partially guaranteed by an agency of the State of Maryland and maturesin September 2007.  This loan bearsinterest at LIBOR plus 2.0% to 2.5% (6.64% to 7.14% at June 30, 2006).  Compensating balance arrangements withWachovia Bank require us to maintain a cash balance of 105% of thenon-guaranteed portion of this loan, which is shown as a component of restrictedcash in the accompanying balance sheet. At June 30, 2006, this compensating balance requirement was $27.2.

At June 30, 2006, we had issued convertible promissorynotes outstanding to twenty-six shareholders for a total of $19.8 million.  These notes accrue interest at 6% per annum, and provide for redemptionpremiums starting at 9% of the principal amount and escalating up to 27% of theprincipal amount, depending upon the date of redemption or conversion to CommonStock.  At June 30, 2006, we accrued theredemption premium that we were presently liable for as long-term interestpayable.  All twenty-sixconvertible promissory notes, together with accrued interest were subsequentlyconverted into 2,376,223 shares of our common stock upon the completion of ourinitial public offering on August 9, 2006.

In December 2004, we issued a convertible promissorynote to a foreign investor for $2.0 million. This note bore interest at 5% and the principal and accrued interest wasconverted into 397,853 shares of our common stock upon the completion of ourinitial public offering on August 9, 2006.

In November 2005, we issued a $20.6 million promissorynote to a foreign investor.  This Notebears interest at 6% and has redemption premiums that start at 9% and increaseover time up to 27%.  Interest paymentsare due in November 2006, 2007 and upon maturity in November 2008.  This note was convertible into our commonstock only if the initial public offering took place after December 2006.  The note also contains demand featureswhereby the holder can request redemption and early repayment at any time afterthe completion of an initial public offering.

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**6.             Preferred Stock Rights andPreferences**

Our Convertible Preferred Stock consisted of the followingdesignated shares at June 30, 2006 and December 31, 2005:

 

|                                                                                                                                 | ** ** | **December 31, 2005** | ** ** | **No. Shares of  Common Stock  Issued Upon  Conversion at IPO  (Aggregate  Liquidation  Preference /** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                      | ** ** | **and**                         | ** ** | **Conversion Price**                                                                                                                 | ** ** |
| ** **                                                                                                                      | ** ** | **June 30, 2006**     | ** ** | **Per Share**                                                                                                                        | ** ** |
| Convertible  preferred stock, Class I,Series 2003, $0,001 par value, 2,000,000 shares  designated, issued and outstanding       |       | $                               | 10,000     |                                                                                                                                      | 500,000    |   |
| Convertible  preferred stock, Series B, $0.001 par value, 750,000 shares designated,  545,454 shares issued and outstanding     |       | 3,000                           |       | 136,364                                                                                                                                   |       |
| Convertible  preferred stock, Series C, $0.001 par value, 3,500,000 shares designated,  548,090 shares issued and outstanding   |       | 2,243                           |       | 308,300                                                                                                                                   |       |
| Convertible  preferred stock, Series E, $0.001 par value, 8,000,000 shares designated,  7,557,000 shares issued and outstanding |       | 17,503                          |       | 1,889,250                                                                                                                                 |       |
|                                                                                                                            |       | $                               | 32,746     |                                                                                                                                      | 2,833,914  |   |

 

We issued 2,000,000 shares of our Class I, Series 2003convertible preferred stock to a collaborative partner as part of an agreementrelated to product development, clinical trials and FDA approval.  These shares were converted into 500,000shares of our common stock at the conversion price of $20.00 per share (afteradjustment for the 1-for 4 reverse stock split) upon the completion of ourinitial public offering.

We issued 545,454 shares of our Series B convertiblepreferred stock in 2003, as part of a collaborative agreement.  These shares were converted into 136,364shares of our common stock at the conversion price of $22.00 per share (afteradjustment for the 1-for 4 reverse stock split) upon the completion of ourinitial public offering.

We issued 548,090 shares of our Series C convertiblepreferred stock in 2004 at the price of $4.50 per share.  These shares were converted into 308,300shares of our common stock at the conversion price of $8.00 per share (afteradjustment for the 1-for 4 reverse stock split) upon the completion of ourinitial public offering.

We issued 7,557,000 shares of our Series E convertiblepreferred stock in 2005 at a price of $2.50 per share.  These shares were converted into 1,889,250shares of our common stock at the conversion price of $10.00 per common share(after adjustment for the 1-for 4 reverse stock split) upon the completion ofour initial public offering.

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Also in 2005, we issued 3,213,335 shares ofSeries D Mandatorily Redeemable Convertible Preferred Stock at a price of$2.00 per share. These shares were converted into 8,033,370 shares of ourcommon stock at the conversion price of $0.80 per share (after adjustment forthe 1-for 4 reverse stock split) upon the completion of our initial publicoffering.

These Series D shares included a mandatory redemptionfeature whereby if the Company did not complete an initial public offeringprior to June 1, 2007 and the shares are not previously converted intocommon stock, the Company must then redeem the shares at a price of $20.00 pershare. The Series D Mandatorily Redeemable Convertible Preferred Stock isrecorded as a liability in the balance sheet at June 30, 2006 and December 31,2005, in accordance with SFAS No. 150 “Accounting for Certain FinancialInstruments with Characteristics of Both Liabilities and Equity.” In additionto the initial net proceeds of $5,962 from the Series D offering, aredemption premium of $58,305 was recorded as a liability.

**7.      Warrants**

At June 30, 2006, the Company had warrants to purchaseits common stock outstanding as shown in the following table.

 

|                                        | ** ** | **Common Stock** | ** ** |
|----------------------------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **# of**         | ** ** | **Weighted Average** | ** ** |
| ** **                             | ** ** | **Shares**            | ** ** | **Price Per Share** | ** ** |
| Warrants  outstanding, January 1, 2006 |       | 2,125,000             |       | $ | 0.40 |   |
| Warrants granted                       |       | 1,000,000             |       | 11.00 |   |
| Warrants exercised                     |       | —                |       | — |   |
| Warrants cancelled                     |       | (1,250,000            | )          | 0.40 |   |
| Warrants  outstanding, June 30, 2006   |       | 1,875,000             |       | $ | 6.05 |   |
|                                   |       |                  |       |   |   |
| Warrants outstanding  after the IPO    |       | 1,000,000             |       | $ | 11.00 |   |

 

In connection with a 2004 financing arrangement, weissued warrants to purchase 1,250,000 shares of our common stock at $0.40per share.  In the first half of 2006,these warrants were cancelled.  In May2006, we issued warrants to Peter Friedli, the chairman of our board ofdirectors, to purchase 1,000,000 shares of our common stock at the price ourstock was offered to the public in the initial public offering.  These warrants have a five-year life andentitle Mr. Friedli to purchase up to 1,000,000 shares of our common stock for$11.00 per share at any time prior to expiration.

The 875,000 warrants that were exercisable at $0.40per share as of June 30, 2006 were all exercised concurrent with the closingof our initial public offering in August 2006.

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**ITEM2.**                    MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

***Introduction and Overview.***

**Forward-lookingStatements**

This report contains forward-looking statements.Forward-looking statements provide our current expectations or forecasts offuture events. Forward-looking statements include statements about ourexpectations, beliefs, plans, objectives, intentions, assumptions and otherstatements that are not historical facts. Words or phrases such as “anticipate,”“believe,” “continue,” “ongoing,” “estimate,” “expect,” “intend,” “may,” “plan,”“potential,” “predict,” “project” or similar words or phrases, or the negativesof those words or phrases, may identify forward-looking statements, but theabsence of these words does not necessarily mean that a statement is notforward-looking. Examples of forward-looking statements include, but are notlimited to, statements regarding the following: our product development efforts; our clinical trials and anticipatedregulatory requirements; status of the regulatory process for our biologic drugcandidates; implementation of our corporate strategy; our financialperformance; our product research and development activities and projectedexpenditures, including our anticipated timeline and clinical strategy for MSCsand biologic drug candidates; our cash needs; patents and proprietary rights;ability of our potential products to treat disease; our plans for sales andmarketing; our plans regarding our facilities; types of regulatory frameworks we expect will be applicable to ourpotential products; and results of our scientific research.   Forward-looking statements are subject toknown and unknown risks and uncertainties and are based on potentiallyinaccurate assumptions that could cause actual results to differ materiallyfrom those expected or implied by the forward-looking statements. Our actualresults could differ materially from those anticipated in forward-lookingstatements for many reasons, including the factors described in the sectionentitled “Risk Factors” in our Registration Statement on Form S-1, File No:333-134037, as filed with the United States Securities and Exchange Commissionand declared effective on August 3, 2006. Accordingly, you should not unduly rely on these forward-lookingstatements. We undertake no obligation to publicly revise any forward-lookingstatement to reflect circumstances or events after the date of this report orto reflect the occurrence of unanticipated events.

**Overview**

We are a leading stem cell therapeutic company focusedon developing and marketing products to treat medical conditions in theinflammatory, orthopedic and cardiovascular areas. Our marketed product,Osteocel, and our biologic drug candidates utilize mesenchymal stem cells, or MSCs.In July 2005, we launched Osteocel for regenerating bone in orthopedicindications. We currently have five clinical trials ongoing. We are currentlyenrolling patients in a Phase III clinical trial for Prochymal, our leadbiologic drug candidate, for the treatment of steroid refractory Graft versusHost Disease, or GvHD. Prochymal is also in Phase II clinical trials for acuteGvHD and Crohn’s Disease. In addition, we have two other clinical stagebiologic drug candidates, Chondrogen for regenerating cartilage in the knee,and Provacel for repairing heart tissue following a heart attack. We havedeveloped stem cell capabilities in research and development, manufacturing,marketing and distribution. We manufacture Osteocel and clinical batches of ourbiologic drug candidates. We distribute Osteocel in orthopedic indications andjointly distribute Osteocel with Blackstone Medical, Inc. for spinalprocedures.

We have incurred annual operating losses sinceinception and expect to incur substantial operating losses in the future inconnection with the development of our core products. As of June 30, 2006, wehad an accumulated deficit of $159.3 million.

**FinancialOperations Overview**

# *Revenue*

Osteocel is our only commercial product. Sales ofOsteocel generated revenue of approximately $2.8 million for the six monthsended June 30, 2006. In prior years, we have entered into strategic agreementswith other companies for the development and commercialization of select stemcell biologic drug candidates for specific indications and geographic markets.In 2003, we entered into an agreement with a major pharmaceutical companyrelating to the development of our cardiac biologic drug candidate, and wereceived a $5.0 million fee for licensing the use of our technology. This feeis being recognized as revenue over a 63-month period, $476 of which wasrecognized in the first six months of 2006 and 2005. Also in 2003, we enteredinto an agreement with a foreign pharmaceutical company granting it exclusiverights to Prochymal for the 

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treatment of GvHD in Japan. We recognized $0.5 millionof revenue in the first half of 2005 related to this agreement. We do notexpect to enter into collaborations in the future.

Historically, we have also recognized revenue fromgovernmental grants for research and in the first six months of 2005, werecorded $644 in grant revenues from two separate grants. Revenue from researchgrants is recognized as the related research expenditures are incurred. During2006, we did not have any active government grants and, we do not expect tosolicit governmental grants in the future.

Other than Osteocel, we have no commercial productsfor sale and do not anticipate that we will have any other commercial productsfor sale for at least the next several years. A substantial portion of ourrevenue in the future will be dependent on the approval and sale of ourbiologic drug candidates. Our revenue may vary substantially from quarter toquarter and from year to year. We believe that period-to-period comparisons ofour results of operations are not meaningful and should not be relied upon asindicative of our future performance.

# *Cost of Goods Sold*

Our cost of goods sold relate to direct costs ofproducing Osteocel, which we launched in July 2005. Cost of goods sold consistprimarily of the costs of obtaining tissue and other chemicals and supplies,direct labor and allocated costs of our facilities and overhead.

# *Research and Development Costs*

Our research and development costs consist of expensesincurred in identifying, developing and testing biologic drug candidates. Theseexpenses consist primarily of salaries and related expenses for personnel, feespaid to professional service providers for independent monitoring and analysisof our clinical trials, costs of contract research and manufacturing, costs offacilities, and the costs of manufacturing clinical batches of biologic drugcandidates, quality control supplies and material to expand biologic drugcandidates.

Consistent with our focus on the development of biologicdrug candidates with potential uses in multiple indications, many of our costsare not attributable to a specifically identified product. We use our employeeand infrastructure resources across several projects. Accordingly, we do notaccount for internal research and development costs on a project-by-projectbasis. As a result, we cannot state precisely the total costs incurred for eachof our clinical and preclinical projects on a project-by-project basis. Frominception through June 30, 2006, we incurred aggregate research and developmentcosts of approximately $159 million.

We expect ourresearch and development expenses to increase substantially in the future, aswe expand our clinical trial activity, as our biologic drug candidates advancethrough the development cycle and as we invest in additional productopportunities and research programs. Clinical trials and preclinical studiesare time-consuming and expensive. Our expenditures on current and futurepreclinical and clinical development programs are subject to manyuncertainties. We test our products in several preclinical studies, and we thenconduct clinical trials for those biologic drug candidates that we determine tobe the most promising. As we obtain results from clinical trials, we may electto discontinue or delay trials for some biologic drug candidates in order tofocus our resources on more promising biologic drug candidates. Completion ofclinical trials may take several years or more, but the length of timegenerally varies substantially according to the type, size of trial andintended use of a biologic drug candidate. The cost of clinical trials may varysignificantly over the life of a project as a result of a variety of factors,including:

·                    thenumber of patients who participate in the trials;

·                    thenumber of sites included in the trials;

·                    thelength of time required to enroll trial participants;

·                    theduration of patient treatment and follow-up;

·                    thecosts of producing supplies of the biologic drug candidates needed for clinicaltrials and regulatory submissions;

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

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

As a result of the uncertainties discussed above, we areunable to determine with any significant degree of certainty the duration andcompletion costs of our research and development projects or when and to whatextent we will generate revenues from the commercialization and sale of any ofour biologic drug candidates.

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# *General and Administrative Expenses*

General and administrative expenses consist primarilyof the costs associated with our general management, including salaries,allocations of facilities and related costs, and professional fees such aslegal and accounting expenses. Following the initial public offering, weanticipate increases in our general and administrative expense for legal andaccounting compliance costs, investor relations and other activities associatedwith operating as a publicly traded company. These increases will also likelyinclude the hiring of additional operational, financial, accounting, facilitiesengineering and information systems personnel.

# *Interest and Other Income (Expense),Net*

Interest income consists of interest earned on ourcash and short-term investments. Interest expense consists of interest incurredon capital leases and other debt financings. We pay interest on our bank loanand capital leases and accrue non-cash interest on some of our convertiblelong-term debt.

*Income Taxes*

We have not recognized any deferred tax assets orliabilities in our financial statements since we cannot assure their futurerealization. Because realization of deferred tax assets is dependent upon futureearnings, a full valuation allowance has been recorded on the net deferred taxassets, which relate primarily to net operating loss carryforwards. In theevent that we become profitable within the next several years, we have netdeferred tax assets of approximately $60 million that may be utilized prior tous having to recognize any income tax expense or make payments to the taxingauthorities. Utilization of our net operating loss carryforwards in any oneyear may be limited however, and we could be subject to the alternative minimumtax.

**CriticalAccounting Policies**

The preparation of our consolidated financialstatements requires us to make estimates and assumptions that affect thereported amounts of assets and liabilities and the disclosure of contingentassets and liabilities as of the date of our financial statements as well asthe reported revenues and expenses during the reported periods.  We base our estimates on historicalexperience and on various other factors that we believe are reasonable underthe circumstances, the results of which form the basis for making judgmentsabout the carrying value of assets and liabilities that are not apparent fromother sources.  Actual results may differfrom these estimates under different assumptions or conditions.

Our significant accounting policies are described inthe notes to our audited financial statements for the year ended December 31,2005 included in the final prospectus relating to our initial public offering.

**Results OfOperations**

*Comparison of Quartersended June 30, 2006 and 2005*

*Revenue*

Total revenues increased 48% to $2.0 million forthe quarter ended June 30, 2006, compared to $1.3 million in the secondquarter of 2005. Our revenues in 2006 resulted primarily from $1.7 milliongenerated from the sale of Osteocel and the recognition of $0.3 million inlicensing fees and royalties. In the quarter ended June 30, 2005, we recognized$1.3 million in license fees and grants. We did not have any revenue fromour Osteocel product in the second quarter of 2005, as the product had not beenlaunched.

*Cost of GoodsSold*

Cost of goods sold were $0.8 million for thequarter ended June 30, 2006 compared to $0.0 in the second quarter of 2005. Thecost of goods sold associated with sales of Osteocel was comprised of paymentsto tissue banks, direct labor costs and the costs of processing, testing andpreserving Osteocel. We did not have any cost of goods sold from our Osteocelproduct in the second quarter of 2005, as the product had not been launched.

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*Research andDevelopment Expenses*

Research and development expenses were approximately$10.9 million for the quarter ended June 30, 2006 compared to$3.6 million in the prior year. The increase in research and developmentexpenses in 2006 reflects the increased number of clinical trials in processverses the prior year. In 2006, we incurred costs associated with theenrollment of a Phase II trial for Prochymal as an add-on therapy to steroidsfor the first-line treatment of acute GvHD, a Phase II trial for Prochymal fortreatment of steroid refractory GvHD, a Phase II trial for Prochymal fortreatment of Crohn’s Disease, a Phase I/II clinical trial for Chondrogen, and aPhase I clinical trial for Provacel.

## *General and Administrative Expenses*

General and administrative expenses including fees,were $1.2 million for the quarter ended June 30, 2006 compared to$0.5 million in the second quarter of 2005.  The increase was attributable to additionalpersonnel and related costs to support the company’s growth and in preparationof our initial public offering.

*InterestExpense, Net*

Interest expense, net was $0.7 million for bothquarters ended June 30, 2006 and 2005.

*Comparison ofSix Months ended June 30, 2006 and 2005*

*Revenue*

Total revenues increased 96% to $3.4 million forthe six months ended June 30, 2006, compared to $1.7 million in thecorresponding period in 2005. Our revenues in 2006 resulted primarily from$2.8 million generated from the sale of Osteocel and the recognition of$0.6 million in licensing fees and royalties. In the six months ended June30, 2005, we recognized $1.7 million in license fees and grants. We didnot have any revenue from our Osteocel product in the six months ended June 30,2005, as the product had not been launched.

*Cost of GoodsSold*

Cost of goods sold were $1.3 million for the sixmonths ended June 30, 2006 compared to $0.0 in the prior year. The cost ofgoods sold associated with sales of Osteocel was comprised of payments totissue banks, direct labor costs and the costs of processing, testing andpreserving Osteocel, plus allocated costs of our facilities and overhead. Wedid not have any cost of goods sold from our Osteocel product in the prioryear, as the product had not been launched.

*Research andDevelopment Expenses*

Research and development expenses were approximately$15.3 million for the six months ended June 30, 2006 compared to$6.2 million in the prior year. The increase in research and developmentexpenses in 2006 reflects the increased number of clinical trials in processverses the prior year. In 2006, we incurred costs associated with theenrollment of a Phase II trial for Prochymal as an add-on therapy to steroidsfor the first-line treatment of acute GvHD, a Phase II trial for Prochymal fortreatment of steroid refractory GvHD, a Phase II trial for Prochymal fortreatment of Crohn’s Disease, a Phase I/II clinical trial for Chondrogen, and aPhase I clinical trial for Provacel.

*General andAdministrative Expenses*

General and administrative expenses were$2.3 million for the six months ended June 30, 2006 compared to$1.2 million in the prior year.  Theincrease was attributable to additional personnel and related costs to supportthe company’s growth and in preparation of the initial public offering.

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*InterestExpense, Net*

Interest expense, net was $1.2 million for thesix months ended June 30, 2006 compared to $1.5 million in the prior year.The decrease was driven by higher interest income in 2006.

**Liquidity andCapital Resources**

***Liquidity***

At June 30, 2006, we had $0.8 million in cash and$27.8 million in short-term investments. In addition to the sources described above, at June 30, 2006, we haddrawn only $5.0 million of the $50.0 million line of credit availablefor the development of Provacel under a loan agreement with Boston Scientific.In connection with this line of credit, we have granted Boston Scientific asecurity interest in the intellectual property, equipment and books and recordsinvolved in the development, manufacture and distribution of Provacel. BostonScientific is also obligated to make additional investments in our Company andpay licensing fees up to $45.0 million to us upon completion of certainmilestones.

In addition to the $5.0 balance on the line ofcredit, at June 30, 2006 our long term debt included approximately$42.3 million of convertible promissory notes due in 2008. SinceJune 30, 2006, upon closing of our initial public offering, approximately$21.8 million of the convertible promissory notes, together with accruedinterest of approximately $2.0 million, converted into shares of our commonstock. The remaining $20.6 million is evidenced by a convertiblepromissory note issued to a foreign investor in 2005, which bears interest at a6% per annum and has redemption premiums that start at 9% and increase overtime to 27%. Interest payments are due in November 2006, 2007 and upon maturityin November 2008. This note was convertible into common stock only if theinitial public offering took place after December 2006. The note also containsdemand features whereby the holder can request redemption and early repaymentat any time after the completion of the initial public offering.

***Cash Flows***

Net cash used in operating activities was$13.5 million for the six months ended June 30, 2006 primarily reflectingour net loss of $16.7 million, partially offset by $1.7 million infavorable working capital, $0.8 million in non-cash interest andstock-based compensation expense and $0.7 million in depreciation andamortization. Net cash used for operating activities was $6.5 million for thesix months ended June 30, 2005. Net cash used in operating activities for 2005primarily reflects our net loss of $7.3 million, partially offset by $0.9million in non-cash interest expense.

Net cash provided by investing activities was $14.3million for the six months ended June 30, 2006. Net cash used in investing activity for the six months ended June 30,2005 was $0.1 million. Net cash provided by investing activities in 2006includes cash flows from the sale of $15.0 million of short-terminvestments.

Net cash used by financing activities was $0.6 millionfor the six months ended June 30, 2006. Net cash provided by financingactivities was $14.6 million for the six months ended June 30, 2005 andconsisted principally of $6.9 million in net proceeds from the issuance ofconvertible notes and $8.1 million in net proceeds from the issuance of commonand preferred stock.

***Capital Resources.***

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

·                    the level of cash flows fromOsteocel sales;

·                    the scope and results of ourresearch and preclinical development programs;

·                    the scope and results of ourclinical trials, particularly regarding the number of patients required for ourPhase III trial for Prochymal;

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

·                    the costs of building and operatingour manufacturing facilities, both in the near term to support Osteocel salesand our clinical activities and also in anticipation of expanding ourcommercialization activities;

·                    the costs of maintaining, expandingand protecting our intellectual property portfolio, including litigation costsand liabilities;

·                    the costs of repaying our debt; and

·                    the costs of enlarging our workforce consistent with expanding our business and operations and status as apublic company, and as necessary to enhance and train our sales network inanticipation of the approval of our biologic drug candidates for commercialsale.

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As a result ofthese factors, we may need or choose to seek additional funding prior to ourbecoming cash flow positive on an operational basis. We would likely seek suchfunding through public or private financings or some combination of them.Although not our current focus, we might also seek funding throughcollaborative arrangements if determined to be necessary or appropriate.Additional funding may not be available to us on acceptable terms, or at all.If we obtain capital through collaborative arrangements, these arrangementscould require us to relinquish rights to our technologies or biologic drug candidates.If we raise capital through the sale of equity, or securities convertible intoequity, dilution to our then existing stockholders would result. If we raiseadditional capital through the incurrence of debt, we would likely becomesubject to covenants restricting our business activities, and holders ofdebt  instruments would have rights andprivileges senior to those of our equity investors. In addition, servicing theinterest and repayment obligations under these borrowings would divert funds thatwould otherwise be available to support research and development, clinical orcommercialization activities.

If we are unableto obtain adequate financing on a timely basis, we may be required to delay,reduce the scope of or eliminate one or more of our programs, any of whichcould have a material adverse effect on our business, financial condition andresults of operations.

We expect that ouravailable cash and interest income, including that raised in the initial publicoffering of our common stock, will be sufficient to finance currently plannedactivities through early 2008, although no assurance can be given that changeswill not occur that would consume available capital resources before such timeand we may need or want to raise additional financing within this period oftime. These estimates are based on certain assumptions, which could benegatively impacted by the factors discussed above and under “Risk Factors”included in the Registration Statement on Form S-1, as amended (RegistrationNo. 333-134037), which was declared effective by the SEC on August 3, 2006.

***Off-Balance Sheet Arrangements***.

We have no off-balance sheet financing arrangementsother than operating leases and we have not entered into any transactionsinvolving unconsolidated subsidiaries or special purpose entities.

**Item 3.         Quantitativeand Qualitative Disclosures About Market Risk**

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

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We believe thatthe interest rate risk related to our accounts receivable is not significant.We manage the risk associated with these accounts through periodic reviews ofthe carrying value for non-collect ability and establishment of appropriateallowances in connection with our internal controls and policies.

We do not enterinto hedging or derivative instrument arrangements.

**Item 4.**                          Controls and Procedures

***Evaluation ofDisclosure Controls and Procedures.***An evaluation of theeffectiveness of the design and operation of our “disclosure controls andprocedures” (as defined in Rule 13a-15(e) under the Securities Exchange Act of1934, as amended), as of the end of the period covered by this quarterly reporton Form 10-Q was made under the supervision and with the participation of ourmanagement, including our Chief Executive Officer and Chief Financial Officer.Based upon this evaluation, our Chief Executive Officer and Chief FinancialOfficer have concluded that our disclosure controls and procedures (a) areeffective to ensure that information required to be disclosed by us in reportsfiled or submitted under the Securities Exchange Act of 1934 is timelyrecorded, processed, summarized and reported and (b) include, withoutlimitation, controls and procedures designed to ensure that informationrequired to be disclosed by us in reports filed or submitted under theSecurities Exchange Act of 1934 is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate to allow timely decisions regarding required disclosure.

***Changes in InternalControl over Financial Reporting.***There have not been anychanges in our internal control over financial reporting that occurred duringthe quarter ended June 30, 2006 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

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**PART II — OTHER INFORMATION**

**Item 1.**                          Legal Proceedings

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

**Item 1A.**                 Risk Factors

There have not been any material changes from the riskfactors previously disclosed in “Risk Factors” of our Registration Statement onForm S-1, as amended (Registration No. 333-134037), which was declaredeffective by the SEC on August 3, 2006.

**Item 2.**                          Unregistered Sales of EquitySecurities and Use of Proceeds

***Recent Sales of Unregistered Securities***

This informationwas previously reported under the heading “Recent Sales of UnregisteredSecurities” in our Registration Statement on Form S-1, as amended (File No.333-13407), declared effective by the SEC on August 3, 2006.

***Initial Public Offering and Use of Proceeds from Sales ofRegistered Securities***

On August 9, 2006,we sold 3,500,000 shares of our common stock in our initial public offering atthe price to the public of $11.00 per share. The offer and sale of all of the shares in the offering were registeredunder the Securities Act of 1933, as amended, pursuant to a registration statementon Form S-1 (File No. 333-13407), which was declared effective by theSecurities and Exchange Commission on August 3, 2006. The underwriters of theoffering were Jefferies & Company, Inc., Lazard Capital Markets, LLC andLeerink Swann & Co., Inc.  There wereno selling stockholders in the offering.

We registered3,500,000 shares of our common stock in connection with the initial publicoffering and the aggregate offering amount was $38.5 million.  We paid approximately $2.7 million inunderwriting discounts and commissions to the underwriter.  We also incurred other expenses in connectionwith the offering of approximately $1.6 million, including registration fees,accounting and legal, printing and engraving and other expenses.

None of theunderwriting discounts and commissions or offering expenses were incurred orpaid to directors or officers of ours or their associates, to persons owning 10percent or more of our commons stock or to any affiliates of ours.

After deductingthe underwriting discounts and commissions and these other estimated offeringexpenses, our net proceeds from the offering were approximately $34.2million.  We have deposited the netproceeds in two highly rated financial institutions in the United States. 

There has been nomaterial change in our planned use of proceeds from our initial public offeringas described in our final prospectus filed with the Securities and ExchangeCommission pursuant to Rule 424(b).

**Item 3.**                          Defaults Upon Senior Securities

None

**Item 4.**                          Submission of Matters to a Vote ofSecurity Holders

None

**Item 5.**                          Other Information

None

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**Item 6.**                          Exhibits
| Exhibit   Number | ** ** | **Description of Exhibit**                                                                                                                                                                     |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1†        |       | Form of Amended and Restated Certificate of  Incorporation of the Registrant to be effective upon consummation of this  offering.                                                              |
|             |       |                                                                                                                                                                                           |
| 3.2†        |       | Form of Amended and Restated Bylaws of the  Registrant to be effective upon consummation of this offering.                                                                                     |
|             |       |                                                                                                                                                                                           |
| 4.1              |       | Form of Common Stock Certificate.                                                                                                                                                              |
|             |       |                                                                                                                                                                                           |
| 10.1†       |       | Amended and Restated 1994 Stock Incentive Plan, as  amended.                                                                                                                                   |
|             |       |                                                                                                                                                                                           |
| 10.2†       |       | 2006 Omnibus Plan                                                                                                                                                                              |
|             |       |                                                                                                                                                                                           |
| 10.3†       |       | Director Compensation Policy.                                                                                                                                                                  |
|             |       |                                                                                                                                                                                           |
| 10.7†       |       | Employment Agreement by and between the Registrant  and Earl R. Fender, dated as of June 12, 2006.                                                                                        |
|             |       |                                                                                                                                                                                           |
| 10.26†      |       | Sublease Agreement by and between the Registrant and  Broadwing Corporation, dated as of June 2, 2006.                                                                                    |
|             |       |                                                                                                                                                                                           |
| 10.27†      |       | Agreement of Lease by and between the Registrant and  Columbia Gateway S-28, L.L.C., dated June 6, 2006.                                                                                  |
|             |       |                                                                                                                                                                                           |
| 10.29†      |       | Termination Letter from Friedli Corporate  Finance, Inc., f/k/a Friedli Corporate Finance AG, to the Registrant,  dated May 10, 2006.                                                |
|             |       |                                                                                                                                                                                           |
| 10.30†      |       | Indemnification Letter from Friedli Corporate  Finance, Inc., f/k/a Friedli Corporate Finance AG, and Peter Friedli to  the Registrant, dated May 19, 2006.                          |
|             |       |                                                                                                                                                                                           |
| 10.31†      |       | Warrant to Purchase up to 4,000,000 shares of Common  Stock granted by Registrant to Peter Friedli, dated May 24, 2006.                                                                   |
|             |       |                                                                                                                                                                                           |
| 31.1   |       | 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   |       | 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     |       | Certification of Principal Executive Officer and  Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 905 of the Sarbanes-Oxley Act of 2002.       |

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†                                        Incorporatedherein by reference to the exhibit of the same number in the Company’sRegistration Statement on Form S-1 (Commission File No. 333-134037).

 

The certification attached as Exhibit 32that accompanies this Quarterly Report on Form 10-Q is not deemed filed withthe Securities and Exchange Commission and is not to be incorporated byreference into any filing of Osiris Therapeutics, Inc. under the Securities Actof 1933, as amended, or the Securities Exchange Act of 1934, as amended,whether made before or after the date of this Quarterly Report on Form 10-Q,irrespective of any general incorporation language contained in such filing.

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** **

**SIGNATURE**

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.
|                          | ** ** | ** ** | ** ** | **Osiris  Therapeutics, Inc.** |
|--------------------------|------------|------------|------------|--------------------------------|
| ** **               | ** ** | ** ** | ** ** | ** **                     |
| ** **               | ** ** | ** ** | ** ** | ** **                     |
| Date: September 15, 2006 |       |       |       | /s/ Cary J.  Claiborne         |
|                     |       |       |       | Cary J.  Claiborne             |
|                     |       |       |       | Chief Financial  Officer       |

 

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