Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

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

 

**For the quarterly period ended September 30, 2010**

 

**Or**

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

 

**For the transition period from                   to                 **

 

**Commission File Number: 001-32966**

 

**OSIRIS THERAPEUTICS, INC.**

(Exactname of registrant as specified in its charter)

 

| **Maryland**                                                    | ** ** | **71-0881115**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State  or other jurisdiction of incorporation or organization) |       | (I.R.S.  Employer Identification No.) |
|                                                            |       |                                  |
| **7015 Albert Einstein Drive, Columbia, Maryland**              | ** ** | **21046**                             |
| (Address  of principal executive offices)                       |       | (Zip  Code)                           |

 

**443-545-1800**

(Registrant’stelephone number, including area code)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes x  No o

 

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

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See definitions of “largeaccelerated filer,” “accelerated filer,” and “smaller reporting company” inRule 12b-2 of the Exchange Act. (Check one):

 

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

 

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

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date.

 

| **Class**                                 | ** ** | **Outstanding at November 4, 2010** |
|-------------------------------------------|------------|---------------------------------------------------------|
| Common  Stock, par value $0.001 per share |       | 32,790,019                                              |

 

 

 

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**OSIRIS THERAPEUTICS, INC.**

 

**INDEX**

 
| ** **                                   | ** ** | ** **                                                                                               | ** ** | **Page** |
|----------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|----------|
| **PART I — FINANCIAL INFORMATION** | ** ** | **3**                                                                                                    |
|                                         |       |                                                                                                     |       |     |
| Item 1.                                      |       | Financial Statements —  Unaudited                                                                   |       | 3        |
|                                         |       | Balance Sheets —  September 30, 2010 and December 31, 2009                                |       | 4        |
|                                         |       | Condensed  Statements of Operations — three and nine months ended September 30,  2010 and 2009 |       | 5        |
|                                         |       | Condensed Statement of Stockholders’ Equity— nine  months ended September 30, 2010        |       | 6        |
|                                         |       | Condensed Statements of Cash Flows — nine months ended  September 30, 2010 and 2009            |       | 7        |
|                                         |       | Notes to Condensed Financial Statements                                                                  |       |     |
|                                         |       |                                                                                                     |       |     |
| Item 2.                                      |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations              |       | 17       |
|                                         |       |                                                                                                     |       |     |
| Item 3.                                      |       | Quantitative  and Qualitative Disclosures About Market Risk                                              |       | 27       |
|                                         |       |                                                                                                     |       |     |
| Item 4.                                      |       | Controls and  Procedures                                                                                 |       | 27       |
|                                         |       |                                                                                                     |       |     |
| **PART II — OTHER INFORMATION**    |       | **27**                                                                                                   |
|                                         |       |                                                                                                     |       |     |
| Item 1.                                      |       | Legal Proceedings                                                                                        |       | 27       |
| Item 1A.                                |       | Risk Factors                                                                                             |       | 28       |
| Item 2.                                      |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                             |       | 28       |
| Item 3.                                      |       | Defaults  Upon Senior Securities                                                                         |       | 28       |
| Item 4.                                      |       | (Removed and  Reserved)                                                                                  |       | 28       |
| Item 5.                                      |       | Other Information                                                                                        |       | 28       |
| Item 6.                                      |       | Exhibits                                                                                                 |       | 29       |
|                                         |       |                                                                                                     |       |     |
| Signatures                                   |       |                                                                                                     |       | 29       |
|                                         |       |                                                                                                     |       |     |
| Exhibit Index                           |       |                                                                                                     |       |     |

 

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**PART I— FINANCIAL INFORMATION**

 

**Item 1.**                           **Financial Statements - Unaudited** .

 

**OSIRIS THERAPEUTICS, INC.**

**BALANCE SHEETS**

**(amounts in thousands)**

 
| ** **                                                                                                             | ** ** | **September 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                             | ** ** | **(unaudited)**                  | ** ** | ** **                      | ** ** |
| **Assets**                                                                                                             | ** ** | ** **                       |       |                            |       |
| Current  assets:                                                                                                       |       |                             |       |                            |       |
| Cash                                                                                                                   |       | $                                | 1,088      |                            | $          | 1,306 |   |
| Investments  available for sale                                                                                        |       | 75,168                           |       | 99,409                          |       |
| Accounts  receivable                                                                                                   |       | 262                              |       | 1,138                           |       |
| Inventory                                                                                                              |       | 321                              |       | —                          |       |
| Prepaid  expenses and other current assets                                                                             |       | 789                              |       | 948                             |       |
| Total  current assets                                                                                                  |       | 77,628                           |       | 102,801                         |       |
|                                                                                                                   |       |                             |       |                            |       |
| Property  and equipment, net                                                                                           |       | 3,266                            |       | 3,734                           |       |
| Restricted  cash                                                                                                       |       | 521                              |       | 666                             |       |
| Other  assets                                                                                                          |       | 3,142                            |       | 395                             |       |
| Total  assets                                                                                                          |       | $                                | 84,557     |                            | $          | 107,596 |   |
|                                                                                                                   |       |                             |       |                            |       |
| **Liabilities and Stockholders’  Equity**                                                                         | ** ** | ** **                       |       |                            |       |
|                                                                                                                   |       |                             |       |                            |       |
| Current  liabilities:                                                                                                  |       |                             |       |                            |       |
| Accounts  payable and accrued expenses                                                                                 |       | $                                | 7,057      |                            | $          | 9,013 |   |
| Deferred  revenue, current portion                                                                                     |       | 40,840                           |       | 41,011                          |       |
| Capital  lease obligations, current portion                                                                            |       | —                           |       | 3                               |       |
| Current  liabilities of discontinued operations                                                                        |       | —                           |       | 412                             |       |
| Total  current liabilities                                                                                             |       | 47,897                           |       | 50,439                          |       |
|                                                                                                                   |       |                             |       |                            |       |
| Deferred  revenue, net of current portion                                                                              |       | 13,543                           |       | 44,173                          |       |
| Other  long-term liabilities                                                                                           |       | 470                              |       | 424                             |       |
| Total  liabilities                                                                                                     |       | 61,910                           |       | 95,036                          |       |
|                                                                                                                   |       |                             |       |                            |       |
| Stockholders’  equity                                                                                             |       |                             |       |                            |       |
| Common  stock, $.001 par value, 90,000 shares authorized, 32,790 shares outstanding -  2010, 32,773 outstanding - 2009 |       | 33                               |       | 33                              |       |
| Additional  paid-in-capital                                                                                            |       | 274,242                          |       | 272,959                         |       |
| Accumulated  other comprehensive income (loss)                                                                         |       | 5                                |       | (88                             | )          |
| Accumulated  deficit                                                                                                   |       | (251,633                         | )          | (260,344                        | )          |
| Total  stockholders’ equity                                                                                       |       | 22,647                           |       | 12,560                          |       |
| Total  liabilities and stockholders’ equity                                                                       |       | $                                | 84,557     |                            | $          | 107,596 |   |

 

The accompanying notes arean integral part of these condensed financial statements.

 

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**OSIRIS THERAPEUTICS, INC.**

**CONDENSED STATEMENTS OF OPERATIONS**

**Unaudited**

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

 
| ** **                                                                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                             | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                             | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                                                   |       |                             |       |                            |       |   |   |   |   |
| **Product sales**                                                                      |       | $                                | 99         |                            | $          | — |   | $ | 99 |   | $ | — |   |
| Cost  of goods sold                                                                    |       | 34                               |       | —                          |       | 34 |   | — |   |
| Gross  profit                                                                          |       | 65                               |       | —                          |       | 65 |   | — |   |
|                                                                                   |       |                             |       |                            |       |   |   |   |   |
| **Revenue from collaborative research agreements, government  contract and royalties** |       | 10,659                           |       | 10,584                          |       | 32,340 |   | 33,779 |   |
|                                                                                   |       |                             |       |                            |       |   |   |   |   |
| Operating  expenses:                                                                   |       |                             |       |                            |       |   |   |   |   |
| Research  and development                                                              |       | 5,460                            |       | 16,247                          |       | 18,476 |   | 53,354 |   |
| General  and administrative                                                            |       | 1,268                            |       | 1,511                           |       | 4,677 |   | 6,745 |   |
|                                                                                   |       | 6,728                            |       | 17,758                          |       | 23,153 |   | 60,099 |   |
|                                                                                   |       |                             |       |                            |       |   |   |   |   |
| Income  (loss) from operations                                                         |       | 3,996                            |       | (7,174                          | )          | 9,252 |   | (26,320 | ) |
|                                                                                   |       |                             |       |                            |       |   |   |   |   |
| Other  income, net                                                                     |       | 27                               |       | 134                             |       | 151 |   | 387 |   |
|                                                                                   |       |                             |       |                            |       |   |   |   |   |
| Income  (loss) from continuing operations, before income taxes                         |       | 4,023                            |       | (7,040                          | )          | 9,403 |   | (25,933 | ) |
|                                                                                   |       |                             |       |                            |       |   |   |   |   |
| Income  tax benefit (expense)                                                          |       | 525                              |       | 238                             |       | (692 | ) | 2,636 |   |
| **Income (loss) from continuing operations**                                           |       | 4,548                            |       | (6,802                          | )          | 8,711 |   | (23,297 | ) |
|                                                                                   |       |                             |       |                            |       |   |   |   |   |
| **Discontinued operations:**                                                           |       |                             |       |                            |       |   |   |   |   |
| Income  (loss) from operations of discontinued operations, net of income taxes         |       | —                           |       | (28                             | )          | — |   | 1,069 |   |
| Gain  from sale of discontinued operations, net of income taxes                        |       | —                           |       | 636                             |       | — |   | 21,112 |   |
| **Income from discontinued operations**                                                |       | —                           |       | 608                             |       | — |   | 22,181 |   |
|                                                                                   |       |                             |       |                            |       |   |   |   |   |
| **Net income (loss)**                                                                  |       | $                                | 4,548      |                            | $          | (6,194 | ) | $ | 8,711 |   | $ | (1,116 | ) |
|                                                                                   |       |                             |       |                            |       |   |   |   |   |
| **Basic income (loss) per share**                                                      |       |                             |       |                            |       |   |   |   |   |
| Income  (loss) from continuing operations                                              |       | $                                | 0.14       |                            | $          | (0.21 | ) | $ | 0.27 |   | $ | (0.71 | ) |
| Income  from discontinued operations                                                   |       | —                           |       | 0.02                            |       | — |   | 0.68 |   |
| Basic  earnings (loss) per share                                                       |       | $                                | 0.14       |                            | $          | (0.19 | ) | $ | 0.27 |   | $ | (0.03 | ) |
|                                                                                   |       |                             |       |                            |       |   |   |   |   |
| **Diluted income (loss) per share**                                                    |       |                             |       |                            |       |   |   |   |   |
| Income  (loss) from continuing operations                                              |       | $                                | 0.14       |                            | $          | (0.21 | ) | $ | 0.26 |   | $ | (0.71 | ) |
| Income  from discontinued operations                                                   |       | —                           |       | 0.02                            |       | — |   | 0.68 |   |
| Diluted  earnings (loss) per share                                                     |       | $                                | 0.14       |                            | $          | (0.19 | ) | $ | 0.26 |   | $ | (0.03 | ) |
|                                                                                   |       |                             |       |                            |       |   |   |   |   |
| Weighted  Average Common Shares (basic)                                                |       | 32,789                           |       | 32,764                          |       | 32,781 |   | 32,731 |   |
|                                                                                   |       |                             |       |                            |       |   |   |   |   |
| Weighted  Average Common Shares (diluted)                                              |       | 33,100                           |       | 32,764                          |       | 33,095 |   | 32,731 |   |

 

The accompanying notes arean integral part of these condensed financial statements.

 

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**OSIRIS THERAPEUTICS, INC.**

**CONDENSED STATEMENT OF STOCKHOLDERS’ EQUITY**

**For the nine months ended September 30, 2010**

**Unaudited**

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

 
| ** **                                                                     | ** ** | ** **            | ** ** | ** **              | ** ** | ** **               | ** ** | **Accumulated**        | ** ** | ** **                    | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|--------------------------|------------|------------------------|------------|-------------------------------|------------|------------|------------|
| ** **                                                                     | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** ** | **Other  Comprehensive** | ** ** | **Accumulated**        | ** ** | **Total  Stockholders’** | ** ** |
| ** **                                                                     | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital**              | ** ** | **Income (Loss)** | ** ** | **Deficit**                   | ** ** | **Equity** | ** ** |
| **Balance at January 1, 2010**                             |       | 32,773,331            |       | $                       |  33   |                     | $          | 272,959                |       | $                             |  (88  | )          | $          | (260,344 | ) | $ |  12,560 |   |
|                                                                           |       |                  |       |                    |       |                     |       |                   |       |                          |       |       |       |
| Exercise  of options to purchase common stock ($0.40 per share)           |       | 5,188                 |       | —                  |       | 2                        |       | —                 |       | —                        |       | 2          |       |
|                                                                           |       |                  |       |                    |       |                     |       |                   |       |                          |       |       |       |
| Issuance  of common stock for services rendered by Directors ($6.46 per share) |       | 11,500                |       | —                  |       | 74                       |       | —                 |       | —                        |       | 74         |       |
|                                                                           |       |                  |       |                    |       |                     |       |                   |       |                          |       |       |       |
| Share-based  payment — employee compensation                              |       | —                |       | —                  |       | 1,207                    |       | —                 |       | —                        |       | 1,207      |       |
|                                                                           |       |                  |       |                    |       |                     |       |                   |       |                          |       |       |       |
| **Comprehensive Income:**                                                      |       |                  |       |                    |       |                     |       |                   |       |                          |       |       |       |
|                                                                           |       |                  |       |                    |       |                     |       |                   |       |                          |       |       |       |
| Net  income for the period                                                     |       | —                |       | —                  |       | —                   |       | —                 |       | 8,711                         |       | 8,711      |       |
|                                                                           |       |                  |       |                    |       |                     |       |                   |       |                          |       |       |       |
| Unrealized  gain on investments available for sale                             |       | —                |       | —                  |       | —                   |       | 93                     |       | —                        |       | 93         |       |
| **Total Comprehensive Income**                                                 |       |                  |       |                    |       |                     |       |                   |       |                          |       | 8,804      |       |
|                                                                           |       |                  |       |                    |       |                     |       |                   |       |                          |       |       |       |
| **Balance at September 30, 2010**                                              |       | 32,790,019            |       | $                       |  33   |                     | $          | 274,242                |       | $                             |  5    |       | $          | (251,633 | ) | $ |  22,647 |   |

 

The accompanying notes arean integral part of these condensed financial statements.

 

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**OSIRIS THERAPEUTICS, INC.**

**CONDENSED STATEMENTS OF CASH FLOWS**

**Unaudited**

**(amounts in thousands)**

 
| ** **                                                                                                            | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2010**                                            | ** ** | **2009** | ** ** |
| **Cash flows from operating  activities:**                                                                            |       |                                                |       |   |   |
| **Continuing operations**                                                                                             |       |                                                |       |   |   |
| Income (loss) from continuing operations                                                                              |       | $                                                   | 8,711      |   | $ | (23,297 | ) |
| **Adjustments to reconcile income  (loss) from continuing operations to net cash (used in) provided by  operations:** | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Depreciation and amortization                                                                                         |       | 566                                                 |       | 483 |   |
| Non cash share-based payments                                                                                         |       | 1,281                                               |       | 1,852 |   |
| **Changes in operating assets and  liabilities:**                                                                     |       |                                                |       |   |   |
| Accounts receivable                                                                                                   |       | 876                                                 |       | 56,101 |   |
| Prepaid expenses and other current assets                                                                             |       | (162                                                | )          | (710 | ) |
| Other assets                                                                                                          |       | (2,747                                              | )          | 162 |   |
| Accounts payable and accrued expenses                                                                                 |       | (1,938                                              | )          | 4,670 |   |
| Deferred revenue                                                                                                      |       | (30,801                                             | )          | (29,928 | ) |
| Net cash (used in) provided by continuing  operations                                                                 |       | (24,214                                             | )          | 9,333 |   |
| **Discontinued operations**                                                                                           |       |                                                |       |   |   |
| Income from discontinued operations                                                                                   |       | —                                              |       | 22,181 |   |
| **Adjustments to reconcile income  from discontinued operations to net cash used in discontinued operations:**        | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Non cash impact of the sale of discontinued  operations                                                               |       | —                                              |       | (26,595 | ) |
| Depreciation and amortization                                                                                         |       | —                                              |       | 210 |   |
| Provision for bad debts                                                                                               |       | —                                              |       | 45 |   |
| **Non cash share-based payments**                                                                                     |       | —                                              |       | 98 |   |
| **Changes in operating assets and  liabilities:**                                                                     |       |                                                |       |   |   |
| Accounts receivable                                                                                                   |       | —                                              |       | 1,516 |   |
| Inventory and other current assets                                                                                    |       | —                                              |       | 1,707 |   |
| Accounts payable and accrued expenses                                                                                 |       | (412                                                | )          | (3,108 | ) |
| Net cash used in discontinued operations                                                                              |       | (412                                                | )          | (3,946 | ) |
|                                                                                                                  |       |                                                |       |   |   |
| Net cash (used in) provided by operating  activities                                                                  |       | (24,626                                             | )          | 5,387 |   |
|                                                                                                                  |       |                                                |       |   |   |
| **Cash flows from investing  activities:**                                                                            |       |                                                |       |   |   |
| Purchases of property and equipment                                                                                   |       | (98                                                 | )          | (181 | ) |
| Proceeds from the sale of property and equipment                                                                      |       | —                                              |       | 17 |   |
| Proceeds from sale of discontinued operations, net                                                                    |       | —                                              |       | 9,797 |   |
| Proceeds from sale of investments available for  sale                                                                 |       | 24,598                                              |       | 35,578 |   |
| Purchases of investments available for sale                                                                           |       | (236                                                | )          | (50,000 | ) |
|                                                                                                                  |       |                                                |       |   |   |
| Net cash provided by (used in) investing  activities                                                                  |       | 24,264                                              |       | (4,789 | ) |
|                                                                                                                  |       |                                                |       |   |   |
| **Cash flows from financing  activities:**                                                                            |       |                                                |       |   |   |
| Principal payments on capital lease obligations  and notes payable                                                    |       | (3                                                  | )          | (5 | ) |
| Restricted cash                                                                                                       |       | 145                                                 |       | (536 | ) |
| Proceeds from the exercise of stock options                                                                           |       | 2                                                   |       | 575 |   |
|                                                                                                                  |       |                                                |       |   |   |
| Net cash provided by financing activities                                                                             |       | 144                                                 |       | 34 |   |
|                                                                                                                  |       |                                                |       |   |   |
| Net (decrease) increase in cash                                                                                       |       | (218                                                | )          | 632 |   |
| Cash at beginning of period                                                                                           |       | 1,306                                               |       | 940 |   |
|                                                                                                                  |       |                                                |       |   |   |
| Cash at end of period                                                                                                 |       | $                                                   | 1,088      |   | $ | 1,572 |   |

 

The accompanying notes arean integral part of these condensed financial statements.

 

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**OSIRIS THERAPEUTICS, INC.**

**NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009**

 

**1.**                    **Nature ofBusiness**

 

OsirisTherapeutics, Inc. (“we,” “us,” “our,” or the “Company”) is a Marylandcorporation headquartered in Columbia, Maryland. We began operations onDecember 23, 1992 and were a Delaware corporation until, with approval ofour stockholders; we reincorporated as a Maryland corporation on May 31,2010. We are a leading stem cell company focused on developing and marketingproducts to treat serious medical conditions in the inflammatory, autoimmune,orthopedic, and cardiovascular areas. Our biologic drug candidates utilizeadult human mesenchymal stem cells, or MSCs, which can selectivelydifferentiate, based on the tissue environment, into various tissue lineages,such as muscle, bone, cartilage, marrow stroma, tendon or fat. In addition,MSCs have anti-inflammatory properties and can prevent fibrosis or scarring,which gives MSCs the potential to treat a wide variety of medical conditions.Historically, our operations have consisted primarily of research, developmentand clinical activities to bring our biologic drug candidates to themarketplace. We have several research collaboration agreements and a governmentcontract for additional product development.  During 2009, we created aBiosurgery Division, focused on harnessing the ability of cells and novelconstructs to promote the body’s natural healing.

 

**2.**                    **SignificantAccounting Policies**

 

***Unaudited Interim Financial Statements***

 

The accompanying unauditedcondensed financial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America (“US GAAP”) forinterim financial information and with the instructions to Form 10-Q andRule 10-01 of Regulation S-X. Accordingly, they do not include all of theinformation and footnotes required by US GAAP for complete financialstatements. In the opinion of management, these statements include alladjustments (consisting of normal recurring adjustments) considered necessaryto present a fair statement of our results of operations, financial positionand cash flows. Operating results for any interim period are not necessarilyindicative of the results that may be expected for the full year. ThisQuarterly Report on Form 10-Q should be read in conjunction with our financialstatements and footnotes included in our Annual Report on Form 10-K forthe fiscal year ended December 31, 2009.

 

***Use of Estimates***

 

The preparation of financialstatements in conformity with US GAAP requires us to make estimates andassumptions that affect the amounts reported in the financial statements andaccompanying notes.  Due to the inherent uncertainty involved in makingthose assumptions, actual results could differ from those estimates.  Webelieve that the most significant estimates that affect our financialstatements are those that relate to revenue recognition associated with ourcollaborative agreements, deferred tax assets, and share-based compensation.

 

***Revenue Recognition***

 

We generate revenues fromcollaborative agreements, research licenses, and a government contract. Weevaluate revenues from agreements that have multiple elements to determinewhether the components of the arrangement represent separate units ofaccounting. To recognize a delivered item in a multiple element arrangement, thedelivered items must have value on a standalone basis, there must be objectiveand reliable evidence of fair value of the undelivered items, and the deliveryor performance must be probable and within our control for any delivered itemsthat have a right of return. The determination of whether multiple elements ofa collaboration agreement meet the criteria for separate units of accountingrequires us to exercise judgment.

 

Revenues from researchlicenses and government contracts are recognized as earned upon either theincurring of reimbursable expenses directly related to the particular researchplan or the completion of certain development milestones as defined within theterms of the agreement. Payments received in advance of research performed aredesignated as deferred revenue. Non-refundable upfront license fees and certainother related fees are recognized on a straight-line basis over the developmentperiods of the contract deliverables. Fees associated with substantive at riskperformance based milestones are recognized as revenue upon their completion,as defined in the respective agreements. Incidental assignment of technologyrights is recognized as revenue as it is earned and received.

 

In October 2008, weentered into a Collaboration Agreement with Genzyme Corporation (“Genzyme”) forthe development and commercialization of our biologic drug candidates,Prochymal® and Chondrogen®. Under the agreement, Genzyme has madenon-contingent, non-refundable cash payments to us, totaling$130.0 million, with $75.0 million paid during November 2008 and$55.0 million paid on July 1, 2009. The agreement provides Genzyme withcertain rights to intellectual property developed by us, and requires that wecontinue to perform certain development work related to the subject biologicdrug candidates. We have evaluated the deliverables related to these payments,and concluded that the various deliverables represent a single unit ofaccounting. For this reason, we have deferred the recognition of revenuerelated to the upfront payments, and are amortizing these amounts to revenue ona straight-line basis over the estimated delivery period of the

 

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**OSIRIS THERAPEUTICS, INC.**

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

**THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009**

 

required developmentservices, which extend through the first quarter of 2012. Accordingly, werecognized $10.0 million of revenue in each of the first three fiscalquarters of both 2010 and 2009 related to the amortization of the upfrontpayments. The balance of these payments has been recorded as $40.0 millionof current deferred revenue and $13.3 million of long-term deferredrevenue as of September 30, 2010. The agreement also provides forcontingent milestone payments of up to $1.25 billion in the aggregate, aswell as royalties to be paid to us on any sales by Genzyme. Consistent with ourrevenue recognition policies, we will recognize revenue from these contingentmilestone payments for which we have no continuing performance obligations uponachievement of the related milestone. For any milestone payments for which wehave a continuing performance obligation, the milestone payments will bedeferred and recognized as revenue over the term of the related performanceobligations.

 

In 2007, we partnered withGenzyme to develop Prochymal as a medical countermeasure to nuclear terrorismand other radiological emergencies. In January 2008, we were awarded acontract from the United States Department of Defense (“DoD”) pursuant to whichwe are seeking, in partnership with Genzyme, to develop and stockpile Prochymalfor the repair of gastrointestinal injury resulting from acute radiationexposure. We began recognizing revenue under this contract during the firstquarter of 2008, and we will complete our work under the contract during thesecond half of 2010. Contract revenue is recognized as the related costs areincurred, in accordance with the terms of the contract. We recognized $360,000and $470,000 in revenue from the DoD contract during the three and nine monthsended September 30, 2010, respectively, and $55,000 and $2.9 million,respectively, in revenue during the comparable periods of 2009.

 

In October 2007, weentered into a collaborative agreement with the Juvenile Diabetes ResearchFoundation (“JDRF”) to conduct a Phase 2 clinical trial evaluatingProchymal as a treatment for type 1 diabetes mellitus. This collaborativeagreement provides for JDRF to provide up to $4.0 million of contingentmilestone funding to support the development of Prochymal for the preservationof insulin production in patients with newly diagnosed type 1 diabetesmellitus. The contingent milestone payments under the agreement are amortizedto revenue on a straight line basis over the duration of our obligations underthe collaborative agreement as they are received and earned. We have received$3.5 million of the contingent milestones to date, and expect to receivethe remaining $500,000 during 2010. We are amortizing the funding received,resulting in $210,000 of revenue in each of the three fiscal quarters todate in 2010 under the agreement with JDRF. The remaining deferred revenueunder this agreement has been recorded as $840,000 of current deferred revenueand $210,000 of long-term deferred revenue as of September 30, 2010.

 

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

 

We also earn royalties on thesale of human mesenchymal stem cells sold for research purposes and recognizethe revenue as the sales are made. Our overall revenues include $70,000 and$218,000, respectively, of such royalty revenue during the three and ninemonths ended September 30, 2010.

 

As discussed in Note 5- *Segment Reporting* below, at the end of thethird quarter of 2009, we created a new Biosurgery Division, focused ondeveloping high-end biologic products for use in surgical procedures.  Wecommenced the manufacturing of our first Biosurgery product, a regenerativewound care product, during the first quarter of 2010.  During the first and second quarters of 2010,we distributed the product only for initial clinical evaluation. We launchedthe product for commercial sale during the third quarter of 2010, and revenueson such sales are recognized when legal title to the product has passed to thecustomer.  To date, we have recognizedrevenues of approximately $100,000 from the sales of Biosurgery products

 

***Research and Development Costs***

 

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

 

***Income per Common Share***

 

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

 

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** **

**OSIRIS THERAPEUTICS, INC.**

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

**THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009**

 

Potentially dilutive effectsof common share equivalents are calculated based upon the income (loss) fromcontinuing operations.  Accordingly, the 1,000,000 shares issuable uponthe assumed exercise of our outstanding warrant and all 1,055,074 of ouroutstanding options as of September 30, 2009 were excluded from thecalculation of diluted earnings per share, as their impact on our loss fromcontinuing operations is anti-dilutive.  As a result basic and dilutedincome per share are identical for those periods.

 

Diluted income per commonshare for the three months ended September 30, 2010 excludes 884,000 “out-ofthe money” stock options and the 1,000,000 shares issuable upon the assumedexercise of our outstanding warrant, as their effect is anti-dilutive. Similarly, diluted income per common share for the nine months endedSeptember 30, 2010 excludes 811,179 “out-of the money” stock options andthe 1,000,000 shares issuable upon the assumed exercise of our outstandingwarrant.

 

A reconciliation of basic todiluted weighted average common shares outstanding for the applicable periodsis as follows:

 
| ** **                                          | ** ** | **Three months  ended********September 30, 2010** | ** ** | **Nine months ended  September 30, 2010** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                          | ** ** | **(000s)**                                                       | ** ** | **(000s)**                                                    | ** ** |
| Basic  weighted average common shares outstanding   |       | 32,789                                                           |       | 32,781                                                        |       |
| Dilutive  weighted average options outstanding      |       | 311                                                              |       | 314                                                           |       |
| Dilutive  weighted average warrants outstanding     |       | —                                                           |       | —                                                        |       |
|                                                |       |                                                             |       |                                                          |       |
| Diluted  weighted average common shares outstanding |       | 33,100                                                           |       | 33,095                                                        |       |

 

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

 

Investments available forsale consist primarily of marketable securities with maturities varying betweenthree months and two years. Investments available for sale are valued at theirfair value, with unrealized gains and losses reported as a separate componentof stockholders’ equity in accumulated other comprehensive income. Gains orlosses on investments available for sale are classified as other income whenrealized.

 

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

 

***Share-Based Compensation***

 

Weaccount for share-based payments using the fair value method.

 

We recognize all share-basedpayments to employees and non-employee directors in our financial statementsbased on their grant date fair values, calculated using the Black-Scholesoption pricing model. Compensation expense related to share-based awards is recognizedon a straight-line basis based on the value of share awards that are expectedto vest during the requisite service period on the grant date, which is revisedif actual forfeitures differ from original expectations.

 

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**OSIRIS THERAPEUTICS, INC.**

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

**THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009**

 

A summary of the combinedactivity under both of our stock-based compensation plans as ofSeptember 30, 2010 and changes during the nine months then ended ispresented below.

 
| ** **                              | ** ** | **Number of  Shares** | ** ** | **Weighted Average  Exercise Price Per Share  at Grant Date** | ** ** | **Weighted Average  Remaining Term  (in Years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|-----------------------------------------|------------|----------------------------|------------|---------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|-------------------------------------|------------|
|                                    |       |                       |       |                                                                                        |       |                                                            | ** ** | **$(000)**                          | ** ** |
| Outstanding  at January 1, 2010    |       | 1,000,762                  |       | $                                                                                           | 10.78      |                                                            | 7.11       |                                | $          | 2,187 |   |
| Granted  at market value                |       | 406,500                    |       | 7.37                                                                                        |       |                                                            |       |                                |       |
| Exercised                               |       | (5,188                     | )          | 0.40                                                                                        |       |                                                            |       | 33                                  |       |
| Forfeited                               |       | (44,750                    | )          | 12.42                                                                                       |       |                                                            |       | —                              |       |
| Outstanding  at September 30, 2010 |       | 1,357,324                  |       | 9.74                                                                                        |       | 7.11                                                            |       | 2,298                               |       |
|                                    |       |                       |       |                                                                                        |       |                                                            |       |                                |       |
| Exercisable  at September 30, 2010 |       | 659,134                    |       | 8.26                                                                                        |       | 5.65                                                            |       | 2,201                               |       |
|                                         |            |                            |            |                                                                                             |            |                                                                 |            |                                     |            |  |  |

 

The weighted average grantdate fair value of options granted during the nine months ended September 30,2010 was $3.77 per share.  We received a total of $2,000 in cash fromthe exercise of options during the nine months ended September 30, 2010.

 

As of September 30,2010, approximately 803,000 shares of common stock remain available for futureshare awards under our Amended and Restated 2006 Omnibus Plan.

 

Share-based compensationexpense (including director compensation) included in our statements ofoperations for the three and nine months ended September 30, 2010 and 2009is allocable to our research and development activities, discontinuedoperations and general and administrative activities, as follows:

 
| ** **                  | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                  | ** ** | **2010**                                                 | ** ** | **2009**                                                | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                  | ** ** | **($000)**                                               | ** ** | **($000)**                                              | ** ** | **($000)** | ** ** | **($000)** | ** ** |
| Research  and development   |       | $                                                        | 248        |                                                    | $          | 222 |   | $ | 667 |   | $ | 708 |   |
| Discontinued  operations    |       | —                                                   |       | —                                                  |       | — |   | 98 |   |
| General  and administrative |       | 178                                                      |       | (141                                                    | )          | 614 |   | 1,144 |   |
| Total                       |       | $                                                        | 426        |                                                    | $          | 81 |   | $ | 1,281 |   | $ | 1,950 |   |

 

As of September 30,2010, there was approximately $1.9 million of total unrecognized share-basedcompensation cost related to options granted under our plans, which will berecognized over a weighted-average period of approximately 1.7 years, as theoptions vest.

 

***Supplemental Cash Flow Information***

 
| ** **                                             | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                             | ** ** | **2010**                                            | ** ** | **2009** | ** ** |
| ** **                                             | ** ** | **($000)**                                          | ** ** | **($000)** | ** ** |
| **Supplemental disclosure of cash flows information:** |       |                                                |       |   |   |
| Cash  paid for interest                                |       | $                                                   | —     |   | $ | 8 |   |
| Cash  paid for income taxes                            |       | 1,635                                               |       | 915 |   |
|                                                        |            |                                                     |            |  |  |  |  |

 

***Recent Accounting Guidance Not Yet Adopted at September 30, 2010***

 

In March 2010, ASU2010-17, *Revenue Recognition—MilestoneMethod* (Topic 605) *: MilestoneMethod of Revenue Recognition—a consensus of the FASB Emerging Issues TaskForce* (“ASU 2010-17”) was issued and will amend the accounting forrevenue arrangements under which a vendor satisfies its performance obligationsto a customer over a period of time, when the deliverable or unit of accountingis not within the scope of other authoritative literature, and when thearrangement consideration is contingent upon the achievement of a milestone.The amendment defines a milestone and clarifies whether an entity may recognizeconsideration earned from the achievement of a milestone in the period in whichthe milestone is achieved. This amendment is effective on a prospective basisfor milestones achieved on or after January 1, 2011, with early adoptionpermitted. The amendment may be applied retrospectively to all arrangements orprospectively for milestones achieved after the effective date. We expect toprospectively apply the amended guidance to milestones achieved on or afterJanuary 1, 2011.

 

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**OSIRIS THERAPEUTICS, INC.**

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

**THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009**

 

The new guidance isconsistent with our current revenue recognition policies for arrangements withmilestones. As a result, we do not believe the adoption of this ASU will have amaterial impact on our financial statements.

 

**3.      Collaboration Agreements and GovernmentContract**

 

We are a party to severalmaterial collaborative agreements and other contracts as fully described inNote 2 of our Annual Report on Form 10-K for the year endedDecember 31, 2009 (“2009 10-K”).  There have not been any materialchanges to any of these agreements during 2010

 

that requiredisclosure.  The accounting policies related to each of these contracts,including material impact on our financial statements, is included above underthe “Revenue Recognition” section of Note 2, Significant AccountingPolicies.

 

**4.**      **DiscontinuedOperations & Gain on Sale of Discontinued Operations**

 

In April 2008, wecommitted to a plan to sell our entire product line relating to the processing,manufacturing, marketing and selling of Osteocel® and Osteocel® XO, an allograftmaterial containing cancellous bone, used in spinal fusion and other surgicalprocedures. We refer to these assets as our Osteocel asset disposal group, andon May 2, 2008, we entered into an Asset Purchase Agreement to sell theseassets to NuVasive, Inc., a Delaware corporation. Not included among theOsteocel asset disposal group is Osteocel® XC, our second generation productcandidate under development for bone repair, utilizing culture expandedmesenchymal stem cells to create a synthetic version of Osteocel.

 

The Asset PurchaseAgreement, which was amended several times, provided for up to$85.0 million of total purchase price, all of which we ultimately earned.

 

We recognized a pre-tax gainof approximately $23.5 million on the sale of discontinued operations during2009, essentially all of which was recognized during the first fiscal quarterof that year.  Net of taxes, the gain on the sale was approximately $20.5million during 2009.

 

As stipulated under theAsset Purchase Agreement, we ceased manufacturing Osteocel on March 28,2009. As a result of this cessation of manufacturing, we committed to aworkforce reduction of the approximately 80 employees involved in the Osteocelbusiness. Employees directly affected by the workforce reduction receivednotification on March 30, 2009, and the workforce reduction wassubstantially completed in the second quarter of 2009. All of the affectedemployees received severance benefits, comprised principally of severance,benefits continuation costs and outplacement services. Total one-timetermination benefits for the reduction in force totaled approximately$1.4 million, which was recorded as a component of the gain on the sale ofdiscontinued operations in the first quarter of 2009.

 

We eliminated the Osteocelasset group from our ongoing operations as a result of the disposal transactionand have presented the group’s assets, liabilities, and the results of thegroup’s operations as a discontinued operation for all periods.

 

The net assets allocable tothe Osteocel asset group at December 31, 2009 were current liabilitiestotaling $412,000, all of which were paid during the first quarter of 2010.

 

Summarized operating resultsof the Osteocel asset disposal group for the three and nine months endedSeptember 30, 2009 are as follows:

 
| ** **                                                                     | ** ** | **Three Months********Ended********September 30, 2009** | ** ** | **Nine Months********Ended********September 30,  2009** | ** ** |
|--------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **($000)**                                                             | ** ** | **($000)**                                                        | ** ** |
| Product  sales                                                                 |       | $                                                                      |  (1   | )                                                                 | $          |  6,295 |   |
| Cost  of goods sold                                                            |       | 70                                                                     |       | 4,985                                                             |       |
| Gross  profit (loss)                                                           |       | (71                                                                    | )          | 1,310                                                             |       |
|                                                                           |       |                                                                   |       |                                                              |       |
| Selling,  general & administrative expenses                           |       | —                                                                 |       | 124                                                               |       |
| Income  (loss) from operations of discontinued operations, before income taxes |       | (71                                                                    | )          | 1,186                                                             |       |
| Income  tax benefit                                                            |       | 43                                                                     |       | 117                                                               |       |
| Income  (loss) from operations of discontinued operations                      |       | $                                                                      |  (28  | )                                                                 | $          |  1,069 |   |

 

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**OSIRIS THERAPEUTICS, INC.**

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

**THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009**

 

**5.**                    **SegmentReporting**

 

At the end of the thirdquarter of 2009, we created a Biosurgery Division, focused on developinghigh-end biologic products for use in surgical procedures.

 

In 2010, we began to manageour business in two reportable operating segments: the Therapeutics segment andthe Biosurgery segment. Our Therapeutics segment focuses on developing andmarketing products to treat medical conditions in the inflammatory, autoimmune,orthopedic and cardiovascular areas. Its operations have focused on clinicaltrials and discovery efforts to identify additional medical indications. OurTherapeutics segment does not presently have any products approved for sale andits revenues consist of collaborative research agreements and royalties as describedin Note 2- *Significant Accounting Policies*.

 

Our Biosurgery segment isfocused on the development, manufacture and sale of biologic products designedto promote the body’s natural healing process and improve surgicaloutcomes.  We commenced the manufacturing of our first Biosurgery product,a regenerative wound care product, during the first quarter of 2010.  During the first and second quarters of 2010,we distributed the product only for initial clinical evaluation. We launchedthe product for commercial sale during the third quarter of 2010, andrecognized revenues of approximately $100,000 from the sales of Biosurgeryproducts.  Accordingly, we have incurredresearch, development, manufacturing, general, and administrative costs relatedto the Biosurgery segment throughout 2010, but have recognized revenue fromsales only during the third quarter of 2010. As a result of these start up costs, any measure of segmentprofitability from our Biosurgery segment for 2010 is not indicative of thesegment’s expected future results.

 

Therefore, although we havehistorically managed our business based primarily on the costs specificallyattributable to each of our segments, we expect to begin managing our businessbased on more traditional measures of segment income as we increase ourproduction and sales levels for our Biosurgery products.

 

The costs specificallyattributable to each of our segments for the three and nine months endedSeptember 30, 2010 are as follows:

 
| ** **                                                                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|----------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                                             | ** ** | **September 30, 2010** | ** ** | **September 30, 2010** | ** ** |
| ** **                                                                             | ** ** | **Therapeutics**                 | ** ** | **Biosurgery**                   | ** ** | **Total** | ** ** | **Therapeutics** | ** ** | **Biosurgery** | ** ** | **Total** | ** ** |
|                                                                                   |       |                             |       |                             |       |   |   |   |   |   |   |   |   |
| **Product sales**                                                                      |       | $                                | —     |                             | $          | 99 |   | $ | 99 |   | $ | — |   | $ | 99 |   | $ | 99 |   |
| Cost  of goods sold                                                                    |       | —                           |       | 34                               |       | 34 |   | — |   | 34 |   | 34 |   |
| Gross  profit                                                                          |       | —                           |       | 65                               |       | 65 |   | — |   | 65 |   | 65 |   |
| ** **                                                                             |       |                             |       |                             |       |   |   |   |   |   |   |   |   |
| **Revenue from collaborative research agreements, government  contract and royalties** |       | 10,659                           |       | —                           |       | 10,659 |   | 32,340 |   | — |   | 32,340 |   |
|                                                                                   |       |                             |       |                             |       |   |   |   |   |   |   |   |   |
| Operating  expenses:                                                                   |       |                             |       |                             |       |   |   |   |   |   |   |   |   |
| Research  and development                                                              |       | 4,639                            |       | 821                              |       | 5,460 |   | 15,231 |   | 3,245 |   | 18,476 |   |
| General  and administrative                                                            |       | 1,084                            |       | 184                              |       | 1,268 |   | 4,185 |   | 492 |   | 4,677 |   |
|                                                                                   |       | 5,723                            |       | 1,005                            |       | 6,728 |   | 19,416 |   | 3,737 |   | 23,153 |   |
|                                                                                   |       |                             |       |                             |       |   |   |   |   |   |   |   |   |
| Segment  income (loss)                                                                 |       | $                                | 4,936      |                             | $          | (940 | ) | $ | 3,996 |   | $ | 12,924 |   | $ | (3,672 | ) | $ | 9,252 |   |

 

In general, our totalassets, including long-lived assets such as property and equipment, and ourcapital expenditures are not specifically allocated to any particular operatingsegment. Accordingly, capital expenditures and total asset information byreportable segment is not presented. The only assets that are allocated to theindividual segments are the inventory and accounts receivable specificallyrelated to each segment.

 

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**OSIRIS THERAPEUTICS, INC.**

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

**THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009**

 

The assets specificallyattributable to each of our segments as of September 30, 2010 are asfollows:

 
| ** **               | ** ** | **September 30, 2010  ($000)** | ** ** |
|--------------------------|------------|------------------------------------------|------------|
| ** **               | ** ** | **Biologic Drug  Candidates**       | ** ** | **Biosurgery** | ** ** |
| **Segment assets:**      |       |                                     |       |   |   |
| Accounts  receivable     |       | $                                        | 168        |   | $ | 94 |   |
| Inventory                |       | —                                   |       | 321 |   |
| **Total segment assets** | ** ** | **$**                                    | **168**    | ** ** | **$** | **415** | ** ** |

 

**6.**                     **Income Tax (Benefit) Expense**

 

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

 

The tax expense for the ninemonths ended September 30, 2010 reflects an effective tax rate of 7.4%compared to a U.S statutory tax rate of 35%. The effective tax rate reflectsour estimated annual effective tax rate, which reflects our expectation that aportion of our income will be subject to the Federal alternative minimum tax.

 

During the three and ninemonths ended September 30, 2010 and 2009, we recognized the followingincome tax expense (benefit):

 
| ** **                                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                | ** ** | **2010**                                             | ** ** | **2009**                                            | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                | ** ** | **($000)**                                           | ** ** | **($000)**                                          | ** ** | **($000)** | ** ** | **($000)** | ** ** |
| Tax  expense (benefit) to continuing operations           |       | $                                                    | (525       | )                                                   | $          | (238 | ) | $ | 692 |   | $ | (2,636 | ) |
| Tax  expense of operations of discontinued operations     |       | —                                               |       | 43                                                  |       | — |   | 117 |   |
| Tax  expense (benefit) of sale of discontinued operations |       | —                                               |       | (660                                                | )          | — |   | 2,317 |   |
|                                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Total  income tax expense (benefit)                       |       | $                                                    | (525       | )                                                   | $          | (855 | ) | $ | 692 |   | $ | (202 | ) |

 

At September 30, 2010, thebalance of our net operating loss and tax credit carryforwards is $92.8million.  During the quarter ended September 30, 2010, we released aportion of valuation allowance in the amount of $2.9 million to reflect ourexpectation of being able to utilize net operating loss and tax creditcarryforwards in 2011. Our remaining deferred tax assets have been fullyreserved in both 2010 and 2009 since their ultimate future realization cannotbe assured.

 

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**OSIRIS THERAPEUTICS, INC.**

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

**THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009**

 

**7.**                     **Investments Available for Sale**

 

Investments available forsale consisted of the following as of September 30, 2010 andDecember 31, 2009:

 
| ** **                                             | ** ** | **September 30, 2010  $000** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                             | ** ** | ** **                             | ** ** | **Unrealized** | ** ** | ** ** | ** ** |
| ** **                                             | ** ** | **Cost**                               | ** ** | **Gain** | ** ** | **Loss** | ** ** | **Fair Value** | ** ** |
| **Cash equivalents:**                                  |       |                                   |       |   |   |   |   |   |   |
| Money market funds & certificates of  deposit |       | $                                      | 13,728     |   | $ | — |   | $ | (3 | ) | $ | 13,725 |   |
| Commercial paper                                       |       | 9,597                                  |       | — |   | — |   | 9,597 |   |
|                                                   |       | 23,325                                 |       | 0 |   | (3 | ) | 23,322 |   |
| **Short term investments:**                            |       |                                   |       |   |   |   |   |   |   |
| Corporate notes and bonds                              |       | 47,641                                 |       | 12 |   | (8 | ) | 47,645 |   |
| US government agencies                                 |       | 4,197                                  |       | 4 |   | — |   | 4,201 |   |
|                                                   |       | 51,838                                 |       | 16 |   | (8 | ) | 51,846 |   |
|                                                   |       |                                   |       |   |   |   |   |   |   |
| **Total investments available for  sale**              | ** ** | **$**                                  | **75,163** | ** ** | **$** | **16** | ** ** | **$** | **(11** | **)** | **$** | **75,168** | ** ** |

 
| ** **                                             | ** ** | **December 31, 2009  $000** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                             | ** ** | ** **                            | ** ** | **Unrealized** | ** ** | ** ** | ** ** |
| ** **                                             | ** ** | **Cost**                              | ** ** | **Gain** | ** ** | **Loss** | ** ** | **Fair Value** | ** ** |
| **Cash equivalents:**                                  |       |                                  |       |   |   |   |   |   |   |
| Money market funds & certificates of  deposit |       | $                                     | 23,706     |   | $ | 1 |   | $ | — |   | $ | 23,707 |   |
| Commercial paper                                       |       | 19,393                                |       | — |   | — |   | 19,393 |   |
|                                                   |       | 43,099                                |       | 1 |   | — |   | 43,100 |   |
| **Short term investments:**                            |       |                                  |       |   |   |   |   |   |   |
| Common stock                                           |       | 573                                   |       | — |   | (84 | ) | 489 |   |
| Corporate notes and bonds                              |       | 42,586                                |       | 36 |   | (44 | ) | 42,578 |   |
| US government agencies                                 |       | 13,239                                |       | 6 |   | (3 | ) | 13,242 |   |
|                                                   |       | 56,398                                |       | 42 |   | (131 | ) | 56,309 |   |
|                                                   |       |                                  |       |   |   |   |   |   |   |
| **Total investments available for  sale**              | ** ** | **$**                                 | **99,497** | ** ** | **$** | **43** | ** ** | **$** | **(131** | **)** | **$** | **99,409** | ** ** |

 

The following tablesummarizes maturities of our investments available for sale as ofSeptember 30, 2010 and December 31, 2009:

 
| ** **                               | ** ** | **September 30, 2010  ($000)** | ** ** | **December 31, 2009  ($000)** | ** ** |
|------------------------------------------|------------|------------------------------------------|------------|-----------------------------------------|------------|
| ** **                               | ** ** | **Cost**                                 | ** ** | **Fair Value**                     | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| **Maturities:**                          |       |                                     |       |                                    |       |   |   |   |   |
| Within  3-months                         |       | $                                        | 63,160     |                                    | $          | 63,159 |   | $ | 28,330 |   | $ | 28,240 |   |
| Between  3—12 months           |       | 4,508                                    |       | 4,510                                   |       | 65,824 |   | 65,819 |   |
| Between  1—2 years             |       | 7,495                                    |       | 7,499                                   |       | 5,343 |   | 5,350 |   |
| **Total investments available for sale** | ** ** | **$**                                    | **75,163** | ** **                              | **$**      | **75,168** | ** ** | **$** | **99,497** | ** ** | **$** | **99,409** | ** ** |

 

Realized gains and lossesand investment income earned on investments available for sale were $27,000 and$151,000, respectively, for the three and nine months ended September 30,2010, and have been included as a component of “Other income, net” in theaccompanying financial statements.

 

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**OSIRIS THERAPEUTICS, INC.**

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

**THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009**

 

**8.**                     **Fair Value**

 

Fair value is defined as theprice at which an asset could be exchanged or a liability transferred (an exitprice) in an orderly transaction between knowledgeable, willing parties in theprincipal or most advantageous market for the asset or liability. Whereavailable, fair value is based on observable market prices or parameters orderived from such prices or parameters. Where observable prices or inputs arenot available, valuation models are applied.

 

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

 

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

 

The fair valued assets wehold that are generally included in this category are money market securitieswhere fair value is based on publicly quoted prices.

 

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

 

Thefair valued assets we hold that are generally included in this category areinvestment grade short-term securities.

 

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

 

We carry no investmentsclassified as Level 3.

 

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

 

Effective January 1,2010, we adopted the FASB’s updated guidance related to fair value measurementsand disclosures, which requires a reporting entity to disclose separately theamounts of significant transfers in and out of Level 1 and Level 2 fair valuemeasurements and to describe the reasons for the transfers. In addition, in thereconciliation for fair value measurements using significant unobservableinputs, or Level 3, a reporting entity should disclose separately informationabout purchases, sales, issuances and settlements. The updated guidance alsorequires that an entity should provide fair value measurement disclosures foreach class of assets and liabilities and disclosures about the valuationtechniques and inputs used to measure fair value for both recurring andnon-recurring fair value measurements for Level 2 and Level 3 fair valuemeasurements. The guidance is effective for interim or annual financialreporting periods beginning after December 15, 2009, except for thedisclosures about purchases, sales, issuances and settlements in the rollforward activity in Level 3 fair value measurements, which are effective forfiscal years beginning after December 15, 2010 and for interim periodswithin those fiscal years. Therefore, the Company has not yet adopted theguidance with respect to the roll forward activity in Level 3 fair valuemeasurements. The adoption of the updated guidance for Levels 1 and 2 fairvalue measurements did not have an impact on the Company’s consolidated resultsof operations or financial condition, as there were no transfers to or fromLevels 1 and 2 to date in 2010.

 

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**OSIRIS THERAPEUTICS, INC.**

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

**THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009**

 

Assets and liabilitiesmeasured at fair value on a recurring basis are summarized below as ofSeptember 30, 2010 and December 31, 2009:

 
| ** **                                       | ** ** | **September 30, 2010  ($000s)** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                       | ** ** | **Level I**                          | ** ** | **Level II** | ** ** | **Level III** | ** ** | **Total** | ** ** |
| **Assets**                                       |       |                                      |       |   |   |   |   |   |   |
| Cash Equivalents                                 |       | $                                         | 12,878     |   | $ | — |   | $ | — |   | $ | 12,878 |   |
| Government Obligations                           |       | 2,203                                     |       | — |   | — |   | 2,203 |   |
| Certificates of Deposit                          |       | —                                    |       | 847 |   | — |   | 847 |   |
| Agency Obligations                               |       | —                                    |       | 43,229 |   | — |   | 43,229 |   |
| Corporate Debt Securities & Commercial Paper |       | —                                    |       | 15,081 |   | — |   | 15,081 |   |
| Municipal Securities                             |       | —                                    |       | — |   | — |   | — |   |
| Foreign Bonds                                    |       | —                                    |       | 930 |   | — |   | 930 |   |
| Common Stock                                     |       | —                                    |       | — |   | — |   | — |   |
|                                             |       |                                      |       |   |   |   |   |   |   |
| **Short Term Investments Available  for Sale**   | ** ** | **$**                                     | **15,081** | ** ** | **$** | **60,087** | ** ** | **$** | **—** | ** ** | **$** | **75,168** | ** ** |

 
| ** **                                       | ** ** | **December 31, 2009  ($000s)** | ** ** |
|--------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                       | ** ** | **Level I**                         | ** ** | **Level II** | ** ** | **Level III** | ** ** | **Total** | ** ** |
| **Assets**                                       |       |                                     |       |   |   |   |   |   |   |
| Cash Equivalents                                 |       | $                                        | 18,456     |   | $ | — |   | $ | — |   | $ | 18,456 |   |
| Government Obligations                           |       | 11,367                                   |       | — |   | — |   | 11,367 |   |
| Certificates of Deposit                          |       | —                                   |       | 5,251 |   | — |   | 5,251 |   |
| Agency Obligations                               |       | —                                   |       | 38,691 |   | — |   | 38,691 |   |
| Corporate Debt Securities & Commercial Paper |       | —                                   |       | 23,795 |   | — |   | 23,795 |   |
| Municipal Securities                             |       | —                                   |       | 101 |   | — |   | 101 |   |
| Foreign Bonds                                    |       | —                                   |       | 1,259 |   | — |   | 1,259 |   |
| Common Stock                                     |       | —                                   |       | 489 |   | — |   | 489 |   |
|                                             |       |                                     |       |   |   |   |   |   |   |
| **Short Term Investments Available  for Sale**   | ** ** | **$**                                    | **29,823** | ** ** | **$** | **69,586** | ** ** | **$** | **—** | ** ** | **$** | **99,409** | ** ** |

 

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

 

We evaluated ourSeptember 30, 2010 financial statements for subsequent events through thedate the financial statements were issued. We are not aware of any subsequentevents which would require recognition or disclosure in the financialstatements.

 

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

 

**CautionaryStatements About Forward-Looking Information**

 

This Quarterly Reportincludes “forward-looking statements” within the meaning of Section 21E ofthe Securities Exchange Act of 1934, or the Exchange Act. Statements includedor incorporated herein which are not historical facts are forward-lookingstatements. When used in this Quarterly Report, the words *estimates, expects, anticipates, projects, plans,intends, believes, forecasts* and variations of such words or similarexpressions are intended to identify forward-looking statements, but theseterms are not the exclusive means of identifying forward-looking statements.

 

Forward-looking statementsreflect management’s current views with respect to future events andperformance and are based on currently available information and management’sassumptions regarding future events. While management believes that itsassumptions are reasonable, forward-looking statements are subject to variousknown and unknown risks and uncertainties and actual results may differmaterially from those expressed or implied herein. In connection with the “safeharbor provisions” of the Private Securities Litigation Reform Act of 1995, theCompany notes that certain factors, among others, which could cause futureresults to differ materially from the forward-looking statements, expectationsand assumptions expressed or implied herein are discussed in greater detail inour Annual Report on Form 10-K under Part I - Item 7; “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andItem 1A “Risk Factors,” and may be discussed elsewhere herein or in otherdocuments we file with the Securities and Exchange Commission, or SEC. Examplesof forward-looking statements may include, without limitation, statementsregarding any of the following: our product development efforts; our clinicaltrials and anticipated regulatory requirements, and our ability to successfullynavigate these requirements; the success of our product candidates indevelopment; status of the regulatory process for our biologic drug candidates;implementation of our corporate strategy; our financial performance; ourproduct research and development activities and projected expenditures,including our anticipated timeline and clinical strategy for mesenchymal stemcells (MSCs) and biologic drug candidates (including Prochymal® andChondrogen®); our cash needs; patents, trademarks and other proprietary rights;the safety and ability of our potential products to treat disease; our abilityto supply a sufficient amount of our product candidates and, if approved, productsto meet demand; our costs to comply with governmental regulations; ourrelationship with collaborating partners; our ability to maintain and benefitfrom our collaborative arrangements; our ability to benefit from governmentcontracts; our plans for sales and marketing; our plans regarding facilities;types of regulatory frameworks we expect will be applicable to our potentialproducts; and results of our scientific research.

 

Readers are cautioned thatall forward-looking statements attributable to us or persons acting on ourbehalf apply only as of the date of this Quarterly Report and are expresslyqualified in their entirety by the cautionary statements included herein. Weundertake no obligation to publicly update or revise any forward-looking statementsto reflect subsequent events or circumstances and do not intend to do so.

 

You should read thefollowing management’s discussion and analysis of our financial condition andresults of operations in conjunction with our audited Financial Statements andrelated notes thereto and other disclosures included as part of our AnnualReport on Form 10-K for the year ended December 31, 2009, and ourunaudited Condensed Financial Statements for the three and nine months endedSeptember 30, 2010 and 2009 and other disclosures included in thisQuarterly Report on Form 10-Q.  Our Condensed Financial Statementshave been prepared in accordance with U.S. generally accepted accountingprinciples and are presented in U.S. dollars.

 

There are a number of risksand uncertainties that could cause our actual results to differ materially fromthe forward-looking statements contained in this report. Some of the importantfactors that could cause our actual results to differ materially from theforward-looking statements we make in this report are set forth in our AnnualReport on Form 10-K for the fiscal year ended December 31, 2009 underPart I — Item 1A “Risk Factors” and in our Quarterly Report on Form 10-Qfor the quarterly period ended June 30, 2010 under Part II — Item 1A “RiskFactors.” There may be other factors that may cause our actual results todiffer materially from the forward-looking statements.

 

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

 

**Introduction and Overview**

 

The following is adiscussion and analysis of our financial condition and results of operationsfor the three and nine month periods ended September 30, 2010 and2009.  You should read this discussion together with the accompanyingunaudited condensed financial statements and notes and with our Annual Reporton Form 10-K for the year ended December 31, 2009.  Historicalresults and any discussion of prospective results may not indicate our futureperformance.  See “Cautionary Statements About Forward-LookingInformation.”

 

We are a leading stem cellcompany headquartered in Columbia, Maryland and focused on developing andmarketing products to treat serious medical conditions in the inflammatory,autoimmune, orthopedic, and cardiovascular areas.  We believe our stemcell products have significant therapeutic potential because of their abilityto regulate inflammation, promote tissue regeneration and prevent pathologicalscar formation. We were incorporated in Maryland in March 2010. Ourpredecessor company was organized in 1992. We have two business segments,Therapeutics and Biosurgery.  Our Therapeutics business is focused ondeveloping biologic stem cell drug candidates from a readily available andnon-controversial source — adult bone marrow. Our Biosurgery division works toharness the ability of cells and novel

 

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constructs to promote thebody’s natural healing with the goals of improving surgical outcomes andoffering better treatment options for patients and physicians.

 

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

 

In the fourth quarter of2008, we entered into a collaboration agreement with Genzyme Corporation forthe development and commercialization of Prochymal and Chondrogen. Under theterms of the agreement, we retained the rights to commercialize Prochymal andChondrogen in the United States and Canada and Genzyme has been grantedexclusive rights to commercialize Prochymal and Chondrogen in all othercountries, except with respect to GvHD in Japan, where Prochymal has previouslybeen licensed to another pharmaceutical company. Under the agreement, we werepaid $130.0 million for these rights. The agreement also provides forcontingent milestone payments of up to $1.25 billion in the aggregate inaddition to royalties on any sales by Genzyme to be paid by Genzyme to us.

 

We have also partnered withGenzyme Corporation to develop Prochymal as a medical countermeasure to nuclearterrorism and other radiological emergencies. In January 2008 we wereawarded a contract from the U.S. Department of Defense, pursuant to which we,in partnership with Genzyme, are seeking to develop and stockpile Prochymal forthe repair of gastrointestinal injury resulting from acute radiation exposure.Additionally, we have partnered with the Juvenile Diabetes Research Foundation(“JDRF”) for the development of Prochymal as a treatment for the preservationof insulin production in patients with newly diagnosed type 1 diabetesmellitus.

 

In April 2008, wecommitted to a plan to sell our assets related to Osteocel®, a product that wehad produced and marketed since July 2005, for regenerating bone inorthopedic indications. On May 8, 2008, we entered into an Asset PurchaseAgreement to sell our entire product line relating to the processing,manufacturing, marketing and selling of Osteocel to NuVasive, Inc. Thetotal proceeds from the sale of Osteocel were $85.0 million, all of whichhas been received by us. The assets and operations related to Osteocel arereported as discontinued operations in the condensed financial statementsincluded in this Quarterly Report on Form 10-Q for all periods.

 

In August 2009, weannounced the creation of a Biosurgery Division focused on developing andmarketing high-end biological products for use in surgical procedures. Weintend to build on the success of our first generation implantable product,Osteocel, which generated over $40 million of revenue for us before beingsold for $85.0 million in 2008. We introduced our first biologic productfrom the Biosurgery Division during March 2010 for clinical evaluation andbegan commercial sales during the third fiscal quarter of 2010.

 

We are a fully integratedcompany, having developed capabilities in research, development, manufacturing,marketing and distribution of stem cell products. We have developed anextensive intellectual property portfolio to protect our technology including49 U.S. and 299 foreign patents owned or licensed. We have 23 U.S. patentapplications pending and 73 foreign patent applications pending.

 

Our two biologic drugcandidates utilize human mesenchymal stem cells, or MSCs. MSCs can selectivelydifferentiate, based on the tissue environment, into various tissue lineagessuch as bone, muscle, fat, tendon, ligament, cartilage and bone marrow stroma.In addition, MSCs have anti-inflammatory properties and can prevent fibrosis orscarring. These characteristics give MSCs the potential to treat a wide varietyof medical conditions. We believe that our biologic drug candidates haveadvantages over other stem cell therapeutics in development for the followingreasons:

 

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

 

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

 

·                                          **U****niversal Compatibility.**  Many stem celltherapies under development can elicit a rejection response in the recipientand therefore require donor-to-recipient matching or potentially harmfulimmunosuppression. This greatly reduces manufacturing efficiencies and createsa risk of mismatch which can result in an acute inflammatory response leadingto serious medical complications and can even be fatal. Based on our clinicalexperience, we believe that our biologic drug candidates are not rejected bythe patient’s immune system and so, like type O negative blood, do not requirematching. This universal compatibility allows us to produce a standardizedproduct available to all patients in almost any medical setting.

 

·                                          **Treatment on Demand.**  Our biologicdrug candidates can be stored frozen at end-user medical facilities until theyare needed. We anticipate that medical facilities will be able to prescribe anddispense these products in much the same way as

 

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conventional drugs. Incontrast, other stem cell technologies under development require weeks toprepare after a patient’s need is identified. This is a key feature of ourtechnology, as many patients in the critical care setting require prompttreatment.

 

The following tablesummarizes key information about our biologic drug candidates.

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

 

***Prochymal,*** our lead biologic drug candidate, is beingevaluated in Phase 3 trials for a number of indications including acutegraft versus host disease (“GvHD”), Crohn’s disease, acute myocardialinfarction, type 1 diabetes, pulmonary disease and gastrointestinal injuryresulting from radiation exposure (animal rule). Prochymal is the only stemcell therapeutic currently designated by the FDA as both an Orphan Drug andFast Track product.

 

*Prochymalfor Treatment-Resistant GvHD*

 

GvHD is a life threateningimmune system reaction that commonly affects one or more of the followingorgans: skin, gastrointestinal tract, and liver, in patients who have receiveda bone marrow transplant. Although in the U.S. there are no drugs approved fortreating GvHD, the disease is commonly treated off-label with steroids. GvHDthat does not respond to this treatment is known as steroid refractory GvHD. Alarge majority of steroid refractory GvHD patients die within six months. In aPhase 2 trial for treatment refractory GvHD, we enrolled patients that didnot respond to treatment with steroids and at least one second line therapy. Ofthese patients, all responded to treatment with Prochymal, and 59% achievedcomplete resolution of their disease. Prochymal has been granted Fast Trackstatus by FDA as well as Orphan Drug status by FDA and the European MedicinesAgency for GvHD.

 

In May 2008, wereceived clearance from the FDA to initiate an expanded access treatmentprogram making Prochymal available to children with life threatening GvHD.Under the program, children, 2 months to 17 years of age, with GradesB-D acute GvHD that hasn’t responded to steroids are eligible for treatment. Uponcompletion of enrollment of the two Phase 3 trials evaluating Prochymal inadults with GvHD, as described below, the expanded access program was broadenedto include patients 18 to 70 years of age. The expanded access programsfor Prochymal in treating adult and pediatric patients with refractory GvHD areongoing.

 

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

 

In September 2009, weannounced the preliminary results for the two Phase 3 trials evaluatingProchymal in adults with GvHD, as described below. While the trials did notreach significance in their primary endpoints, the studies did reveal severalimportant findings:

 

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

 

·                                                             Prochymalsignificantly improved response in steroid-refractory liver (76% vs. 47%,p=0.03) and gastrointestinal GvHD (82% vs. 68%, p=0.03);

 

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

 

·                                                             Childrenreceiving Prochymal had an overall response rate of 64% compared to 36% inpatients receiving placebo; and

 

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

 

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In July 2010, weannounced that the Biologics and Genetic Therapies Directorate of Health Canadahas completed its initial evaluation and accepted for full review our New DrugSubmission of Prochymal for the treatment of GvHD. Health Canada has notifiedus that the application has been granted Priority Review, shortening thescheduled examination period from 300 to 180 days. Heath Canada also informedus that it plans to add Prochymal to its Register of Innovative Drugs, subjectto a final review upon approval. This registration would confer eight years ofmarket exclusivity, beginning on the date of Prochymal’s approval forcommercial sale in Canada. This registration also generally provides that,during such period of market exclusivity, no submission for a generic versionof Prochymal would be approved by Health Canada for GvHD.

* *

*Phase 3 Clinical Trial—Steroid Refractory Acute GvHD*

 

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

 

The primary endpoint,durable complete response, for the per-protocol population in the Phase 3trial evaluating Prochymal in steroid-refractory GvHD approached but did notreach statistical significance, with 40% of patients receiving Prochymal, ascompared to 28% of placebo patients, achieving a durable complete response. Theper-protocol patient population refers to the group of patients that met all ofthe study protocol requirements, such as inclusion and exclusion criteria. Theaddition of Prochymal to standard of care significantly improved response insteroid-refractory liver (76% vs. 47%, p=0.03) and gastrointestinal (82% vs.68%, p=0.03) GvHD. In the sickest patients—those with GvHD affecting all threeorgans—skin, liver and gastrointestinal tract—treatment with Prochymal resultedin a 63% overall response rate, while none of the placebo-treated patientsresponded (p<0.05). Prochymal also demonstrated a positive safety profilerelative to placebo.

 

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

 

Our previous Phase 2trial for treatment of newly diagnosed acute GvHD completed enrollment in 2009and indicated that patients were twice as likely to have total clinicalresolution of their disease when Prochymal was added to steroid therapy,compared to reported results for treatment with steroids alone. Twenty-nine of31 patients, or 94%, responded in the Phase 2 trial, after receiving twoinfusions of Prochymal, with 24 patients, or 77% achieving a complete response,meaning the patients had experienced total clinical resolution of the disease.At six months, 61% of all patients treated with Prochymal still had a durableresponse requiring no additional immunosuppressive therapy, clinicalintervention, or increased steroid use. Of these, 95% were alive at six months.

 

The Phase 3 trial toevaluate Prochymal as a first line treatment for GvHD is a randomized, doubleblind, placebo controlled study that completed enrollment in 2009 with 192patients from 52 leading transplant centers across the United States, Canadaand Australia. Patients received a total of six infusions during the first fourweeks of the study. The majority of patients enrolled in this trial weresuffering from skin GvHD, which was well-controlled with steroids, particularlywhen given at a uniform controlled dose as prescribed in the protocol. The highresponse rates diminished the potential for Prochymal to demonstrate an effect.

 

*Phase 3 Clinical Trial—Biologics Refractory Crohn’sDisease.*

 

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

 

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

 

Asa result of the encouraging data from the Phase 2 trial, a Phase 3 trialevaluating Prochymal for the treatment of refractory moderate to severe Crohn’sdisease was initiated. The placebo-controlled, double-blind study was designedto enroll 270 patients, 18 to 70 years of age with a CDAI greater than250. The primary endpoint of this trial is the proportion of patients with CDAIof less than 150 (clinical remission) at day 28. Patients were enrolled atapproximately 60 leading centers in the U.S. and Canada.

 

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In April 2010, weannounced that we would resume enrollment in our Phase 3 Crohn’s program,following its suspension in 2009 over concerns about the trial design. The Crohn’s program had initially consisted of two linked trials — one aimed atinducing remission (Protocol 603) and the other at maintaining response(Protocol 610) in patients who had failed other available treatments for thedisease.  The primary endpoint for Protocol 603, which included a placeboand two Prochymal dose arms, is the proportion of patients experiencing diseaseremission within 28 days of initiation of therapy with Prochymal, compared tothose patients receiving placebo.  For a patient to reach the primaryend-point of disease remission, their CDAI score must fall to below 150. Concerns that the trial design would make it difficult to detect a treatmenteffect led to the April 2009 suspension.  The trial remained blinded followingsuspension, however, to permit an interim analysis of the 207 patients enrolledin the study at that time.  The findings of the interim analysis showedthat the majority of patients enrolled prior to suspension had failed at leasttwo immunomodulators and two biological agents before commencement of treatmentin the trial.  The trial design requires patients to complete a “washout”period prior to study entry, to ensure that residual benefit from prior therapydoes not influence their response.  There were no differences in averageCrohn’s Disease Activity Index (CDAI) scores at entry, which exceeded 350 inall arms prior to treatment, indicating the patients had very debilitatingdisease. For the primary endpoint of disease remission, the interim analysisrevealed that one dose arm for Prochymal approached statistical significance inthe intent to treat (ITT) population, and reached significance in the perprotocol population.  Additionally, the analysis showed that Prochymalcontinued to demonstrate a benign safety profile with no significantdifferences in any of the pre-defined safety outcomes compared to placebo.These results showed that, despite the initial concerns, the effect size or thedifference between the Prochymal and placebo response rates, of one dose arm ofProchymal is consistent with the original statistical assumptions of theprotocol and is significantly outperforming placebo. As a result, enrollment inthis clinical trial evaluating Prochymal for patients with treatment resistantCrohn’s disease was resumed.

 

The decision to resumeenrollment was made following discussions with the Food and Drug Administration(FDA) about the results of the interim analysis.  Enrollment is nowongoing with the best-performing Prochymal dose arm as determined by theinterim analysis and the placebo arm, according to the pre-specified adaptivetrial design.  The trial has been repowered to compensate for thestatistical penalty incurred by the interim analysis in the ITTpopulation.  The follow-on maintenance trial (Protocol 610) has beendiscontinued to remove the potential for bias.

 

*Phase 2 Clinical Trial—Acute Myocardial Infarction.*

 

Prochymal is also beingevaluated as a therapy to improve heart function in patients who have suffereda heart attack. Based on statistics published in 2005 by the American StrokeAssociation and the American Heart Association, approximately 700,000individuals in the United States each year experience their first heart attack.According to these same statistics, approximately 20% of these patients sufferextensive damage to their heart muscle leading to heart failure within sixyears. In preclinical studies in animal models, Prochymal targeted the damagedarea of the heart following a single intravenous infusion. These studies also indicatethat Prochymal prevents scar formation that typically occurs after a heartattack and improves cardiac function eight to ten weeks after itsadministration.

 

Positive two-year data wasreported for a Phase 1 clinical trial evaluating the safety and efficacyof the intravenous administration of Prochymal in patients who experiencedtheir first acute myocardial infarction (“AMI”). In the 53-patient,double-blind, placebo-controlled trial, patients receiving the therapy hadsignificantly lower rates of adverse events, such as cardiac arrhythmias, aswell as significant improvements in heart, lung and global function.Administration of Prochymal was found to be well tolerated at all dose levels.In December 2009, results from the study were published in the *Journal of the American College of Cardiology*.Based on these positive findings, we received approval from the FDA to initiatea Phase 2 trial.

 

A Phase 2 double-blind,placebo-controlled trial to evaluate the safety and efficacy of Prochymal inconjunction with standard of care to improve heart function in patients whoexperience a first heart attack is currently enrolling patients. The trial isbeing conducted at leading institutions and academic research centers in theUnited States and Canada. Target enrollment is 220 patients and thoseparticipating will be randomized to Prochymal or placebo at a 1:1 ratio.

 

*Phase 2 Clinical Trial—Early Onset Type 1 DiabetesMellitus.*

 

In early 2010, enrollmentwas completed for 63 patients in our Phase 2, double-blind,placebo-controlled study evaluating Prochymal for the treatment of early onsettype 1 diabetes in individuals 12 to 35 years old. We believethat based upon their mechanism of action, MSCs may home to the pancreas andinhibit the local immune and inflammatory responses, preventing the destructionof pancreatic islets and promoting the repair of pancreatic tissue damage.Patients were enrolled within 2 to 20 weeks of being diagnosed withtype 1 diabetes and received three infusions of Prochymal over the courseof 60 days. The primary efficacy endpoint, the measurement of C-peptideproduced after glucose stimulation, will be measured at one year. We haveentered into a collaborative agreement with the Juvenile Diabetes ResearchFoundation (“JDRF”) for this study. This agreement provides for JDRF to fund$4.0 million of clinical study costs. To date, we received$3.5 million from JDRF to fund clinical costs, and expect to receive theremaining $500,000 during the fourth quarter of 2010.

 

*Phase 2 Clinical Trial—Chronic Obstructive PulmonaryDisease*

 

Enrollment in the 62-patientPhase 2 clinical trial evaluating the safety and efficacy of Prochymal inconjunction with standard of care for improving pulmonary function in patientswith moderate to severe Chronic Obstructive Pulmonary Disease (“COPD”) wascompleted in the second half of 2008. Patients in the double-blind,placebo-controlled study were randomized to either Prochymal or placebo at a1:1 ratio and

 

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received 4 infusions overthe course of 90 days. Measurements used in the trial to detect potentialimprovements in subjects treated with Prochymal include pulmonary functiontests, exercise capability, systemic inflammation and quality of lifeassessments. In addition, exacerbations and hospitalizations due to COPD willbe monitored for both safety and efficacy. Patients were evaluated over thecourse of two years following initial Prochymal or placebo infusion.

 

At the six-month interimanalysis, the trial met its primary goal of demonstrating the safety ofProchymal in patients with compromised pulmonary function. Prochymalsignificantly decreased systemic inflammation in patients when compared tothose receiving placebo, as determined by C-reactive protein (CRP). Despitethis reduction in inflammation, however, pulmonary function in patientsreceiving Prochymal was not significantly improved compared to those receivingplacebo.

 

*Phase 3 Development—Animal Rule—Acute RadiationSyndrome.*

 

In 2007, we partnered withGenzyme Corporation to develop Prochymal as a medical countermeasure to nuclearterrorism and other radiological emergencies. In January 2008, we wereawarded a contract from the United States Department of Defense (“DoD”) for thedevelopment and stockpiling of Prochymal for the treatment of acute radiationsyndrome (“ARS”). Assuming FDA approval of Prochymal for ARS, the DoD mayexercise purchase options for up to 20,000 doses of Prochymal at a price of$10,000 per dose.

 

***Chondrogen*** is our biologic drug candidate for thetreatment of osteoarthritis and the reduction of pain in the knee. In 2006, wecompleted enrollment of a randomized double-blind, placebo controlledPhase 1/2 clinical trial evaluating Chondrogen for safety and preliminaryefficacy based upon regeneration of meniscus at six-months. InNovember 2007, we reported one-year data for the Phase 1/2 Chondrogentrial. The data continued to show improvements in joint condition thatcorrelated with a clinically and statistically significant improvement in painin patients with osteoarthritis (OA) who received Chondrogen as compared tothose treated with the control, hyaluronic acid (HA). Patients receiving thecontrol were 3.5 times more likely to experience degenerative bone changesassociated with OA as compared to those receiving Chondrogen. The effects weredose dependent and pain scores improved from six months to one year followingtreatment, suggesting that Chondrogen caused a biological modification ofpatients’ OA.

 

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** **

**FinancialOperations Overview**

 

*Revenue*

 

In 2008, we entered into aCollaboration Agreement with Genzyme for the development and commercializationof Prochymal and Chondrogen, and providing for non-contingent, non-refundableupfront payments to us of $130.0 million and contingent milestonepayments. This Collaboration Agreement has multiple deliverables, andconsistent with our accounting policy for such transactions, we are amortizingthe up front payments into revenue on a straight-line basis over the estimatedcompletion period of the deliverables, which extend through the first quarterof 2012. We recognized $10.0 million of revenue in each of the first threequarters of 2010 and 2009, related to this agreement.

 

Contingent milestonepayments earned and for which we have no continuing performance obligationswill be recognized as revenue upon achievement of the related milestone, whilemilestone payments for which we have a continuing performance obligation willbe deferred when received and amortized to revenue over the term of the relatedperformance obligations.

 

In 2003, we entered into anagreement with JCR Pharmaceuticals (“JCR”), granting it exclusive rights toProchymal for the treatment of GvHD and other hematological malignancies inJapan. During the first quarter of 2010, we achieved a $1 million milestonefrom JCR for development progress in Japan.  The collaboration with JCRalso provides for additional milestone payments of up to $8.5 million forregulatory and sales milestones, as well as royalty payments on sales of thedrug in Japan.

 

Under the DoD contractawarded to us in January 2008, we are seeking, in partnership withGenzyme, to develop Prochymal for the repair of gastrointestinal injuryresulting from acute radiation exposure. Under the terms of the contract, theDoD provides funding to us for development. We recognized $470,000 in revenueunder the terms of this contract in the first three fiscal quarters of 2010, ona cost reimbursement basis.

 

In prior years, we haveentered into strategic agreements with others for the development andcommercialization of select stem cell biologic drug candidates for specificindications and geographic markets. In 2007, we entered into a collaborativeagreement with the JDRF to conduct a Phase 2 clinical trial evaluating Prochymalas a treatment for type 1 diabetes mellitus. Under this collaborativeagreement,  JDRF will provide up to $4.0 million of contingentmilestone funding to support the development of Prochymal for the preservationof insulin production in patients with newly diagnosed type 1 diabetesmellitus. The contingent milestone payments under the agreement are amortizedinto revenue on a straight line basis over the duration of our obligationsunder the collaborative agreement as they are received and earned. We recognized$630,000 in revenue during the first nine months of 2010 under this agreement.

 

*Researchand Development Costs*

 

Our research and developmentcosts consist of expenses incurred in identifying, developing and testingbiologic drug candidates. These expenses consist primarily of salaries andrelated expenses for personnel, fees paid to professional service providers forindependent monitoring and analysis of our clinical trials, costs of contractresearch and manufacturing, costs of facilities, and the costs of manufacturingclinical batches of biologic drug candidates, quality control supplies andmaterial to expand biologic drug candidates.

 

Consistent with our focus onthe development of biologic drug candidates with potential uses in multipleindications, many of our costs are not attributable to a specificallyidentified product. We use our employee and infrastructure resources acrossseveral projects. Accordingly, we do not account for internal research anddevelopment costs on a project-by-project basis. From inception in December1992 through September 30, 2010, we incurred aggregate research anddevelopment costs of approximately $385 million.

 

We expect our research anddevelopment expenses to continue to be substantial in the future, as we continueour clinical trial activity for our existing biologic drug candidates as theyadvance through 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 of clinicaltrials may take several years or more, but the length of time generally variessubstantially according to the type, size of trial and intended use of abiologic drug candidate. The cost of clinical trials may vary significantlyover the life of a project as a result of a variety of factors, including:

 

·                                          the number ofpatients who participate in the trials;

 

·                                          the number ofsites included in the trials;

 

·                                          the length oftime required to enroll trial participants;

 

·                                          the duration ofpatient treatment and follow-up;

 

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·                                          the costs ofproducing supplies of the biologic drug candidates needed for clinical trials andregulatory submissions;

 

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

 

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

 

As a result of theseuncertainties, we are unable to determine with any significant degree ofcertainty the duration and completion costs of our research and developmentprojects or when and to what extent we will generate revenues from thecommercialization and sale of any of our biologic drug candidates.

 

*Generaland Administrative Expenses*

 

General and administrativeexpenses consist primarily of the costs associated with our general management,including salaries, allocations of facilities and related costs, andprofessional fees such as legal and accounting expenses. We have increased ourgeneral and administrative expense for legal and accounting compliance costs,investor relations and other activities associated with operating as a publiclytraded company and strengthened our administrative capabilities as we approachthe commercial launch of Prochymal for an initial indication. Continuedincreases will also likely result from the hiring of additional operational,financial, accounting, facilities engineering and information systemspersonnel.

 

*OtherIncome (Expense), Net*

 

Investment income consistsof interest earned on our cash and investments available for sale and realizedgains and losses incurred on the sale of these investments. Interest expenseconsists of interest incurred on capital leases. We do not expect to incur materialinterest expense in the near future as we had extinguished all of ouroutstanding debt as of December 31, 2008, and have invested our excesscash in investments available for sale.

 

*IncomeTaxes*

 

Historically, we have notrecognized any deferred tax assets or liabilities in our financial statementssince we cannot assure their future realization. Because realization ofdeferred tax assets is dependent upon future earnings, a full valuationallowance has been recorded on the net deferred tax assets, which relateprimarily to net operating loss and research and development carry-forwards. Inthe event that we become profitable within the next several years, we have netdeferred tax assets (before a 100% valuation allowance) of approximately$92.8 million that may be utilized prior to us having to recognize anyincome tax expense or make payments to the taxing authorities other than thealternative minimum tax. The income tax accounting for the upfront fees wereceived from Genzyme Corporation require us to recognize revenue for incometax purposes several years earlier than we recognize this revenue for financialstatement purposes, resulting in current income tax liabilities that we expectto exceed our ultimate aggregate income tax expense.  During the third quarter of 2010, we releaseda portion of the valuation allowance in the amount of $2.9 million to reflectour expectation of being able to utilize net operating loss and tax creditcarryforwards in 2011.

 

In fiscal 2010 and 2009, werecorded a provision for income taxes to recognize the U.S. Federal alternativeminimum tax on our taxable income.

 

The tax provision for thethree and nine months ended September 30, 2010, reflects an effective tax ratefor continuing operations of 7.4% compared to a U.S. statutory tax rate of35%.  The effective tax rate reflects our estimated annual effectivetax rate, which reflects our expectation that a portion of our income will besubject to the Federal alternative minimum tax in 2010.

 

**CriticalAccounting Policies**

 

There have been no materialchanges in our critical accounting policies, estimates and judgments during thenine months ended September 30, 2010 compared to the disclosures inPart II, Item 7 of our Annual Report on Form 10-K for theyear ended December 31, 2009, other than as disclosed herein.

 

**Results of Operations**

 

***Comparison of Three Months EndedSeptember 30, 2010 and 2009***

 

*Revenues from Collaborative Research Licenses &Grants*

 

Revenues from collaborativeresearch licenses and grants were $10.7 million for the three months endedSeptember 30, 2010 compared to $10.6 million for the third quarter offiscal 2009.  During the three months ended September 30, 2010, werecognized $10.0 million in revenue from our collaborative agreement withGenzyme and $210,000 from our collaborative agreement with JDRF. Our revenuesfor the three month period also include $360,000 from our contract with the DoDto develop Prochymal for the treatment of acute radiation

 

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syndrome, plus royalties onMSCs sold for research purposes.  Revenues from continuing operations forthe three months ended September 30, 2009 consisted of $10.0 million fromthe Genzyme agreement, $465,000 from the JDRF collaboration and $55,000 fromthe DoD contract, plus other minor royalties.

 

*Biosurgery Product Sales*

 

During the three monthsended September 30, 2010, we launched commercial sales of wound care productsmanufactured by our Biosurgery Division and recognized $99,000 in revenue andgross profit of $65,000. We are continuing to distribute the majority of theseproducts for clinical evaluation and expect commercial sales to ramp up slowlyuntil we obtain reimbursement approvals.

 

*Researchand Development Expenses*

 

Research and developmentexpenses for the three months ended September 30, 2010 were $5.5 millionas compared to research and development expenses of $16.2 million for the sameperiod of 2009.  The third quarter 2010 expenses include $821,000 ofdevelopment and initial manufacturing costs associated with our BiosurgeryDivision. The reduction in research and development expenses during thethird quarter of 2010 when compared to the comparable period of the prior yearreflects the completion of enrollment in our Phase 3 clinical trials and theassociated reduction in site and patient costs, and reductions in our contractmanufacturing activities as a result of the need for fewer clinical batches ofProchymal.  We also incur research and development expenses in connectionwith the preparation of our applications for marketing approval as we worktowards the commercialization of Prochymal for an initial indication.

 

*Generaland Administrative Expenses*

 

General and administrativeexpenses were $1.3 million for the three months ended September 30, 2010compared to $1.5 million for the comparable period in fiscal 2009.  Thenon cash charge for share-based compensation allocated to general and administrativeexpenses during the fiscal quarter ended September 30, 2010 was $178,000as compared to a credit of $141,000 for the same period last year (reflectingforfeitures of options related to employee turnover).

 

*OtherIncome (Expense), Net*

 

Investment income, net was$27,000 for the three months ended September 30, 2010, compared to$134,000 in the corresponding period in fiscal 2009.  Our investmentsavailable for sale consist of relatively short-term, investment gradesecurities with a focus on avoiding market risk. Interest expense wasimmaterial in both periods.

 

*Income(Loss) from Discontinued Operations*

 

Our Osteocel operations weresold during fiscal 2009 for $85.0 million, all of which was received during2009.  During the third quarter of fiscal 2009, we recognized $608,000 ofincome from discontinued operations. The income from discontinued operations inthe third fiscal quarter of 2009 was primarily the effect of the decrease inthe estimated effective income tax rate for the full fiscal year.

 

***Comparison of Nine Months EndedSeptember 30, 2010 and 2009***

 

*Revenues from Collaborative Research Licenses &Grants*

 

Revenues from collaborativeresearch licenses and grants were $32.3 million for the nine months endedSeptember 30, 2010 compared to $33.8 million for the first nine months offiscal 2009.  During the nine months ended September 30, 2010, werecognized $30.0 million in revenue from our collaborative agreement withGenzyme, $1.0 million from our collaboration with JCR, and $630,000 from ourcollaborative agreement with JDRF. Our revenues for the nine month period alsoinclude $470,000 from our contract with the DoD to develop Prochymal for thetreatment of acute radiation syndrome, plus royalties on MSCs sold for researchpurposes.  Revenues for the nine months ended September 30, 2009 consistedof $30.0 million from the Genzyme agreement, $630,000 from the JDRFcollaboration and $2.9 million from the DoD contract, plus other royalties.

 

*Researchand Development Expenses*

 

Research and development expensesfor the nine months ended September 30, 2010 were $18.5 million ascompared to research and development expenses of $53.4 million for the sameperiod of 2009.  The first nine months of 2010 expenses include $3.2million of development and initial manufacturing costs associated with ourBiosurgery Division. The reduction in research and development expensesduring the first nine months of 2010 when compared to the comparable period ofthe prior year reflects the completion of enrollment in several of our Phase 3clinical trials and the associated reduction in site and patient costs, andreductions in our contract manufacturing activities as a result of the need forfewer clinical batches of Prochymal. .  We also incur research anddevelopment expenses in connection with the preparation ofour applications for marketing approval as we work towards thecommercialization of Prochymal for an initial indication.

 

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*Generaland Administrative Expenses*

 

General and administrativeexpenses were $4.7 million for the nine months ended September 30, 2010compared to $6.7 million for the comparable period in fiscal 2009.  Thedecrease in general and administrative expenses is primarily attributable toreductions in incentive compensation, non cash share-based compensation expenseand reductions in our legal expenses related to our intellectual property. Thenon cash charge for share-based compensation, including share grants to membersof our Board of Directors, allocated to general and administrative expensesduring the nine months ended September 30, 2010 was $614,000 as comparedto $1.1 million for the same period last year

 

*OtherIncome (Expense), Net*

 

Investment income, net was$151,000 for the nine months ended September 30, 2010, compared to$386,000 in the corresponding period in fiscal 2009.  Our investmentsavailable for sale consist of relatively short-term, investment gradesecurities with a focus on avoiding market risk. Interest expense wasimmaterial in both periods.

 

***Income from Discontinued Operations***

 

Our Osteocel operations weresold during fiscal 2009 for $85.0 million, all of which was received during2009.  During the first nine months of fiscal 2009, we recognized $22.2million of income from discontinued operations.

 

**Liquidityand Capital Resources**

 

***Liquidity***

 

At September 30, 2010,we had $76.3 million in cash and investments available for sale.  We didnot have any outstanding debt at any time during fiscal 2010 to date, or duringall of fiscal 2009. Although there can be no assurance, we believe that we havesufficient liquidity on hand as of September 30, 2010 to fund ouroperations through the commercialization of our first biological drugcandidate.

 

***Cash Flows***

 

***Comparison of Nine Months Ended September 30, 2010 and 2009***

 

Cashused in operating activities of continuing operations for the nine months endedSeptember 30, 2010 was $24.2 million compared cash provided by continuingoperations of $9.3 million in the corresponding fiscal period of the prioryear.  The 2010 income from continuing operations of $7.3 million wasoffset by net decreases in working capital, primarily accounts payable, accruedexpenses, and deferred revenue.  Cash provided by operating activities ofcontinuing operations during the first nine months of 2009 reflect our lossfrom continuing operations of $23.3 million, which was increased primarily by areduction in deferred revenue, which was offset by $56.1 million in netreductions in accounts receivable, primarily reflecting the $55.0 millionpayment to us from Genzyme.

 

Cashused by operating activities of discontinued operations for the first ninemonths of fiscal 2010 was $412,000, compared to cash used in operatingactivities of discontinued operations of $3.9 million in the same period of theprior year.  The 2010 amount represents the final settlement of thecurrent liabilities of discontinued operations that had been outstanding as ofDecember 31, 2009.  The 2009 amount reflects the cash portion of theincome from discontinued operations generated in 2009, offset by a decrease inreceivables and inventory.

 

Cashprovided by investing activities during the first nine months of 2010 was $24.3million compared to net cash used in investing activities of $4.8 million inthe same period of the prior year.  The 2010 amount primarily reflects thenet sale of investments and minor property and equipment purchases.  Inthe comparable period of fiscal 2009, we made net purchases of $14.4 million ofinvestments and realize $9.9 million in net proceeds from the sale of ourOsteocel business.

 

Cashprovided by financing activities during the first nine months of 2010 was$144,000, and primarily reflects reductions in restricted cash used tocollateralize letters of credit. Cash provided by financing activities duringthe first nine months of 2009 was $34,000, and consisted of the $536,000increase in restricted cash to collateralize letters of credit, offset by theproceeds from the issuance of common stock pursuant to option exercises.

 

***Capital Resources***

 

Our future capitalrequirements will depend on many factors, including:

 

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

 

·                                       the scope andresults of our clinical trials, particularly regarding the number of patientsrequired for our Phase 3 trials;

 

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

 

·                                           thetiming and achievement of contingent milestone payments under the Genzyme andJCR collaboration agreements;

 

·                                           thecosts of maintaining, expanding and protecting our intellectual propertyportfolio, including possible litigation costs and liabilities; and

 

·                                           thecosts of expanding our work force consistent with expanding our business andoperations and status as a public company.

 

**Off-Balance Sheet Arrangements.**

 

We have no off-balance sheetfinancing arrangements and we have not entered into any transactions involvingunconsolidated subsidiaries or special purpose entities.

 

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

 

*InterestRate Risk*

 

Due to the short duration ofour investment portfolio and the high quality of our investments, an immediate10% change in interest rates would not have a material effect on the value ofour portfolio. Therefore, we would not expect our operating results or cashflows to be affected to any material degree by the effect of a sudden change inmarket interest rates on our securities portfolio.

 

We believe that the interestrate risk related to our accounts receivable is not significant. We manage therisk associated with these accounts through periodic reviews of the carryingvalue for non-collectability and establishment of appropriate allowances inconnection with our internal controls and policies.

 

*ForeignCurrent Exchange Rate Risk*

 

We conduct clinical trialactivities in areas that operate in a functional currency other than the UnitedStates dollar (USD). As a result, when the USD rises and falls against thefunctional currencies of these other nations, our costs will either increase ordecrease by the relative change in the exchange rate. Foreign currency gainsand losses were not significant during the three and nine months endedSeptember 30, 2010 or 2009, and at the present time, we have elected notto hedge our exposure to foreign currency fluctuations.

 

*DerivativeInstruments*

 

We do not enter into hedgingor derivative instrument arrangements.

 

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

 

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

 

***Changes in Internal Control over Financial Reporting.*** There have notbeen any changes in our internal control over financial reporting that occurredduring the quarter ended September 30, 2010 that have materially affected,or are reasonably likely to materially affect, our internal control overfinancial reporting.

 

**PART II- OTHER INFORMATION**

 

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

 

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

 

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

 

There have not been anymaterial changes in the risk factors previously disclosed under the heading “RiskFactors” in Part I — Item 1A of our Annual Report on Form 10-K for thefiscal year ended December 31, 2009, as filed with the Securities andExchange Commission on March 12, 2010 (the “Annual Report”), except aspreviously reported in Part II Item 1A of our Quarterly Report on Form 10-Q forthe quarter ended June 30, 2010 filed on August 6, 2010, pursuant to when therisk factors found in our Annual Report under the subheadings “Certainprovisions of Delaware law and of our charter and bylaws contain provisionsthat could delay and discourage takeover attempts and any attempts to replaceour current management by stockholders” and “Concentration of ownership of ourcommon stock among our existing executive officers, directors and principalstockholders may prevent new investors from influencing significant corporatedecisions”, both under the heading “Risks Related to our Common Stock” , werereplaced in response to our reincorporation in Maryland.

 

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

 

None.

 

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

 

None.

 

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

 

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

 

None.

 

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

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                                                                                |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                |
| 31.1.1              |       | Certification of Principal  Executive Officer pursuant to Rule 13a-14(a) and  15d-14(a) under the Securities Exchange Act of 1934, as amended  (Section 302 of the Sarbanes-Oxley Act of 2002). |
|                |       |                                                                                                                                                                                                                |
| 31.2.1              |       | Certification of Principal  Financial Officer pursuant to Rule 13a-14(a) and 15d-14(a) under  the Securities Exchange Act of 1934, as amended (Section 302 of the  Sarbanes-Oxley Act of 2002). |
|                |       |                                                                                                                                                                                                                |
| 32.1                |       | Certification of Principal  Executive Officer and Principal Financial Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                 |

 

**SIGNATURES**

 

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

 
|                   | **Osiris  Therapeutics, Inc.**                    |
|------------------------|--------------------------------------------------------|
|                   |                                                   |
| Date: November 5, 2010 | /s/ PHILIP R. JACOBY, JR.                              |
|                   | Philip R. Jacoby, Jr.                             |
|                   | Chief Financial Officer  (Principal Financial Officer) |
|                   |                                                   |
| Date: November 5, 2010 | /s/ MATTHEW NEUMAYER                                   |
|                   | Matthew Neumayer                                       |
|                   | Corporate Controller  (Principal Accounting Officer)   |

 

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