** **

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

 

For The Quarterly Period Ended **September 30, 2006**

 

Commission file number—**001-32966**

 

**OSIRIS THERAPEUTICS, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

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

(Address of principal executive offices) (Zip code)

** **

**410-522-5005**

(Registrant’s telephone number, including area code)

** **

**None**

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

 

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

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

Large acceleratedfiler o            Acceleratedfiler o            Non-acceleratedfiler x

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act). Yes o   No x

Indicate the number of shares outstanding of each ofthe issuer’s classes of common stock as of the latest practicable date.

 

|                                           | **Class** | ** ** | ** ** | **Outstanding at November  6, 2006** |
|-------------------------------------------|-----------|------------|------------|-----------------------------------------------------|
| Common Stock,  par value $0.001 per share |      | 27,306,190 |

 

 

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**OSIRIS THERAPEUTICS, INC.**

**INDEX**

 
|                                          | ** ** | ** **                                                                                    | ** ** | **Page**   |
|------------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|------------|
| ** **                               | ** ** | ** **                                                                                    | ** ** | ** ** |
| **PART  I — FINANCIAL INFORMATION** | ** ** | ** **                                                                                    |
| ** **                               | ** ** | ** **                                                                                    | ** ** | ** ** |
| Item 1.                                  |       | Financial Statements — Unaudited                                                         |       |       |
|                                     |       | Condensed Balance Sheets — September 30, 2006 and  December 31, 2005                     |       | 3          |
|                                     |       | Condensed Statements of Operations — three months ended  September 30, 2006 and 2005     |       | 4          |
|                                     |       | Condensed Statements of Operations — nine months ended  September 30, 2006 and 2005      |       | 5          |
|                                     |       | Statement of Stockholders’ Equity (Deficit) — nine  months ended September 30, 2006 |       | 6          |
|                                     |       | Condensed Statements of Cash Flows — nine months ended  September 30, 2006 and 2005      |       | 7          |
|                                     |       | Notes to Condensed Financial Statements                                                       |       | 8          |
|                                     |       |                                                                                          |       |       |
| Item 2.                                  |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations   |       | 13         |
|                                     |       |                                                                                          |       |       |
| Item 3.                                  |       | Quantitative and Qualitative Disclosures About Market  Risk                                   |       | 17         |
|                                     |       |                                                                                          |       |       |
| Item 4.                                  |       | Controls and Procedures                                                                       |       | 18         |
|                                     |       |                                                                                          |       |       |
| **PART  II — OTHER INFORMATION**    | ** ** | ** **                                                                                    |
|                                     | ** ** | ** **                                                                                    | ** ** | ** ** |
| Item  1.                                 |       | Legal  Proceedings                                                                            |       | 19         |
| Item 1A.                            |       | Risk Factors                                                                                  |       | 19         |
| Item 2.                                  |       | Unregistered Sales of Equity Securities and Use of  Proceeds                                  |       | 19         |
| Item 3.                                  |       | Defaults Upon Senior Securities                                                               |       | 19         |
| Item 4.                                  |       | Submission of Matters to a Vote of Security Holders                                           |       | 19         |
| Item  5.                                 |       | Other  Information                                                                            |       | 19         |
| Item 6.                                  |       | Exhibits                                                                                      |       | 20         |
|                                     |       |                                                                                          |       |       |
| Signature                                |       |                                                                                          |
|                                     |       |                                                                                          |       |       |
| Exhibit Index                            |       |                                                                                          |

 

2

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**PARTI — FINANCIAL INFORMATION**

**Item1.****                          FinancialStatements - Unaudited**

**OSIRISTHERAPEUTICS, INC.Condensed Balance SheetsAmounts in thousands**

 
| ** **                                                                                                                                | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                | ** ** | **2006**               | ** ** | **2005**              | ** ** |
|                                                                                                                                      | ** ** | **(unaudited)**        |       |                  |       |
| **Assets**                                                                                                                                |       |                   |       |                  |       |
| Current assets:                                                                                                                           |       |                   |       |                  |       |
| Cash                                                                                                                                      |       | $                      | 1,565      |                  | $          | 597 |   |
| Short-term  investments                                                                                                                   |       | 51,993                 |       | 42,774                |       |
| Accounts  receivable                                                                                                                      |       | 1,008                  |       | 974                   |       |
| Inventory and  other current assets                                                                                                       |       | 1,946                  |       | 367                   |       |
| Total current  assets                                                                                                                     |       | 56,512                 |       | 44,712                |       |
|                                                                                                                                      |       |                   |       |                  |       |
| Property and equipment,  net                                                                                                              |       | 3,587                  |       | 3,792                 |       |
| Restricted cash                                                                                                                           |       | 303                    |       | 190                   |       |
| Deferred financing  costs, net                                                                                                            |       | 690                    |       | 2,050                 |       |
| Other assets                                                                                                                              |       | 348                    |       | 270                   |       |
| Total assets                                                                                                                              |       | $                      | 61,440     |                  | $          | 51,014 |   |
|                                                                                                                                      |       |                   |       |                  |       |
| **Liabilities  and Stockholders’ Equity (Deficit)**                                                                                  |       |                   |       |                  |       |
| Current liabilities:                                                                                                                      |       |                   |       |                  |       |
| Accounts payable  and accrued expenses                                                                                                    |       | $                      | 7,521      |                  | $          | 4,565 |   |
| Note payable,  current portion                                                                                                            |       | 20,665                 |       | 65                    |       |
| Capital lease  obligations, current portion                                                                                               |       | 1,103                  |       | 1,027                 |       |
| Deferred  revenue, current portion                                                                                                        |       | 952                    |       | 952                   |       |
| Total current  liabilities                                                                                                                |       | 30,241                 |       | 6,609                 |       |
|                                                                                                                                      |       |                   |       |                  |       |
| Note payable, net of  current portion                                                                                                     |       | 5,000                  |       | 47,411                |       |
| Capital lease  obligations, net of current portion                                                                                        |       | 1,189                  |       | 2,024                 |       |
| Deferred revenue, net  of current portion                                                                                                 |       | 635                    |       | 1,349                 |       |
| Long-term interest  payable and other liabilities                                                                                         |       | 1,020                  |       | 3,016                 |       |
| Mandatorily redeemable  convertible preferred stock Series D 3,750 shares designated, 3,213 shares  issued and outstanding in 2005        |       | —                 |       | 64,267                |       |
| Total  liabilities                                                                                                                        |       | 38,085                 |       | 124, 676              |       |
|                                                                                                                                      |       |                   |       |                  |       |
| Stockholders’ equity  (deficit):                                                                                                     |       |                   |       |                  |       |
| Convertible  Preferred Stock, $0.001 par value, 16,250 shares authorized, 12,250 shares  designated and 10,651 shares outstanding in 2005 |       | —                 |       | 32,746                |       |
| Common stock,  $.001 par value, 90,000 shares authorized 27,299 and 9,098 shares outstanding  in 2006 and 2005                            |       | 27                     |       | 9                     |       |
| Additional  paid-in-capital                                                                                                               |       | 198,163                |       | 36,404                |       |
| Deferred  compensation                                                                                                                    |       | —                 |       | (277                  | )          |
| Accumulated  deficit                                                                                                                      |       | (174,835               | )          | (142,544              | )          |
| Total  stockholders’ equity (deficit)                                                                                                |       | 23,355                 |       | (73,662               | )          |
| Total  liabilities and stockholders’ equity (deficit)                                                                                |       | $                      | 61,440     |                  | $          | 51,014 |   |

 

The accompanying notesare an integral part of these financial statements.

3

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**OSIRIS THERAPEUTICS, INC.Condensed Statements of Operations(Unaudited)Amounts in thousands, except per share data**

 
| ** **                                               | ** ** | **Three Months Ended September 30,** | ** ** |
|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
| Revenues:                                                |       |                                                     |       |   |   |
| Product Sales                                            |       | $                                                        | 2,539      |   | $ | 284 |   |
| Cost of goods sold                                       |       | 1,113                                                    |       | 220 |   |
| Gross profit                                             |       | 1,426                                                    |       | 64 |   |
|                                                     |       |                                                     |       |   |   |
| Revenue from  collaborative research licenses and grants |       | 302                                                      |       | 1,001 |   |
|                                                     |       |                                                     |       |   |   |
| Operating  expenses:                                     |       |                                                     |       |   |   |
| Research and development                                 |       | 9,242                                                    |       | 3,464 |   |
| General and administrative                               |       | 5,300                                                    |       | 554 |   |
| Total operating expenses                                 |       | 14,542                                                   |       | 4,018 |   |
|                                                     |       |                                                     |       |   |   |
| Loss from operations                                     |       | (12,814                                                  | )          | (2,953 | ) |
|                                                     |       |                                                     |       |   |   |
| Interest  expense, net                                   |       | (2,751                                                   | )          | (1,725 |   |
|                                                     |       |                                                     |       |   |   |
| Net loss                                                 |       | $                                                        | (15,565    | ) | $ | (4,678 | ) |
|                                                     |       |                                                     |       |   |   |
| Basic and diluted net loss per share                     |       | $                                                        | (0.75      | ) | $ | (0.52 | ) |
|                                                     |       |                                                     |       |   |   |
| Weighted Average  Common Shares (basic and diluted)      |       | 20,769                                                   |       | 8,957 |   |

 

The accompanyingnotes are an integral part of these financial statements.

4

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**OSIRIS THERAPEUTICS, INC.Condensed Statements of Operations(Unaudited)Amounts in thousands, except per share data**

 
| ** **                                               | ** ** | **Nine Months Ended September  30,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                                      | ** ** | **2005** | ** ** |
| Revenues:                                                |       |                                                          |       |   |   |
| Product Sales                                            |       | $                                                             | 5,333      |   | $ | 284 |   |
| Cost of goods sold                                       |       | 2,364                                                         |       | 220 |   |
| Gross profit                                             |       | 2,969                                                         |       | 64 |   |
|                                                     |       |                                                          |       |   |   |
| Revenue from  collaborative research licenses and grants |       | 895                                                           |       | 2,725 |   |
|                                                     |       |                                                          |       |   |   |
| Operating  expenses:                                     |       |                                                          |       |   |   |
| Research and development                                 |       | 24,532                                                        |       | 9,713 |   |
| General and administrative                               |       | 7,647                                                         |       | 1,793 |   |
| Total operating expenses                                 |       | 32,179                                                        |       | 11,506 |   |
|                                                     |       |                                                          |       |   |   |
| Loss from operations                                     |       | (28,315                                                       | )          | (8,717 | ) |
|                                                     |       |                                                          |       |   |   |
| Interest  expense, net                                   |       | (3,976                                                        | )          | (3,223 | ) |
|                                                     |       |                                                          |       |   |   |
| Net loss                                                 |       | $                                                             | (32,291    | ) | $ | (11,940 | ) |
|                                                     |       |                                                          |       |   |   |
| Basic and diluted net loss per share                     |       | $                                                             | (2.47      | ) | $ | (1.33 | ) |
|                                                     |       |                                                          |       |   |   |
| Weighted Average  Common Shares (basic and diluted)      |       | 13,063                                                        |       | 8,953 |   |

 

The accompanyingnotes are an integral part of these financial statements.

5

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**OSIRISTHERAPEUTICS, INC.Statement of Stockholders’ Equity (Deficit )For the nine months ended September 30, 2006(Unaudited)Amounts in thousands, except for share and per share data**

 
| ** **                                                                         | ** ** | **Convertible**

**Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional**

**Paid-in** | ** ** | **Deferred** | ** ** | **Accumulated** | ** ** | **Total**

**Stockholders’** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|-----------------------|------------|-----------------------------|------------|--------------|------------|-----------------|------------|-----------------------------------|------------|
| ** **                                                                         | ** ** | **Shares**                                | ** ** | **Amount**            | ** ** | **Shares**                  | ** ** | **Amount**   | ** ** | **Capital**     | ** ** | **Compensation**                  | ** ** | **Deficit** | ** ** | **Equity (Deficit)** | ** ** |
| Balance at  January 1, 2006                                                        |       | 10,650,544                                |       | $                     | 32,746     |                        | 9,097,506  |         | $          | 9               |       | $                                 | 36,404     |   | $ | (277 | ) | $ | (142,544 | ) | $ | (73,662 | ) |
|                                                                               |       |                                      |       |                  |       |                        |       |         |       |            |       |                              |       |   |   |   |   |
| Exercise of  options to purchase common stock ($0.40 per share)                    |       |                                      |       |                  |       | 156,187                     |       | —       |       | 60              |       |                              |       |   |   | 60 |   |
| Exercise of  warrants to purchase common stock ($0.40 per share)                   |       |                                      |       |                  |       | 875,000                     |       | 1            |       | 349             |       |                              |       |   |   | 350 |   |
| Issuance of  common stock for services rendered by directors ($11.00 per share)    |       |                                      |       |                  |       | 22,807                      |       | —       |       | 198             |       |                              |       |   |   | 198 |   |
| Issuance of  common stock for services rendered by consultant ($6.84 per share)    |       |                                      |       |                  |       | 6,250                       |       | —       |       | 43              |       |                              |       |   |   | 43 |   |
| Reclassification  due to adoption of new accounting standard                       |       |                                      |       |                  |       |                        |       |         |       | (277            | )          | 277                               |       |   |   | — |   |
| Initial public  offering of common stock, net of offering costs ($11.00 per share) |       |                                      |       |                  |       | 3,500,000                   |       | 3            |       | 34,399          |       |                              |       |   |   | 34,402 |   |
| Conversion of  convertible preferred stock into common stock                       |       | (10,650,544                               | )          | (32,746               | )          | 2,833,914                   |       | 3            |       | 32,743          |       |                              |       |   |   | — |   |
| Conversion of  mandatorily redeemable preferred stock into common stock            |       |                                      |       |                  |       | 8,033,388                   |       | 8            |       | 64,259          |       |                              |       |   |   | 64,267 |   |
| Conversion of  convertible notes payable into common stock                         |       |                                      |       |                  |       | 2,774,076                   |       | 3            |       | 25,320          |       |                              |       |   |   | 25,323 |   |
|                                                                               |       |                                      |       |                  |       |                        |       |         |       |            |       |                              |       |   |   |   |   |
| Stock-based  compensation                                                          |       |                                      |       |                  |       |                        |       |         |       | 4,665           |       |                              |       |   |   | 4,665 |   |
|                                                                               |       |                                      |       |                  |       |                        |       |         |       |            |       |                              |       |   |   |   |   |
| Net loss                                                                           |       |                                      |       |                  |       |                        |       |         |       |            |       |                              |       | (32,291 | ) | (32,291 | ) |
| Balance at September 30,  2006                                                |       | —                                    |       | $                     | —     |                        | 27,299,128 |         | $          | 27              |       | $                                 | 198,163    |   | $ | — |   | $ | (174,835 | ) | $ | 23,355 |   |

 

The accompanyingnotes are an integral part of these financial statements.

6

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** **

**OSIRISTHERAPEUTICS, INC.Condensed Statements of Cash Flows (Unaudited)Amounts in thousands**

 
| ** **                                                                       | ** ** | **Nine Months Ending September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
|                                                                             |       |                                                     |       |   |   |
| Cash flows from  operations:                                                     |       |                                                     |       |   |   |
| Net loss                                                                         |       | $                                                        | (32,291    | ) | $ | (11,940 | ) |
| Adjustments to reconcile net loss to net cash used  in operations:               |       |                                                     |       |   |   |
| Depreciation and amortization                                                    |       | 1,139                                                    |       | 1,178 |   |
| Non cash compensation expense                                                    |       | 5,887                                                    |       | 193 |   |
| Non cash interest expense                                                        |       | 3,961                                                    |       | 2,464 |   |
| Increase (decrease) in cash resulting from changes  in assets and liabilities:   |       |                                                     |       |   |   |
| Accounts receivable                                                              |       | (39                                                      | )          | (692 | ) |
| Inventory and other current assets                                               |       | (1,579                                                   | )          | (595 | ) |
| Other assets                                                                     |       | (78                                                      | )          | 4 |   |
| Accounts payable and accrued expenses                                            |       | 2,956                                                    |       | 681 |   |
| Deferred revenue                                                                 |       | (714                                                     | )          | (714 | ) |
| Long-term interest payable and other liabilities                                 |       | (1,996                                                   | )          | (96 | ) |
| Net cash used in operations:                                                     |       | (22,754                                                  | )          | (9,517 | ) |
|                                                                             |       |                                                     |       |   |   |
| Cash flows from  investing activities:                                           |       |                                                     |       |   |   |
| Purchases of property and equipment                                              |       | (933                                                     | )          | (132 | ) |
| Proceeds from sale of short-term investments                                     |       | 26,586                                                   |       | — |   |
| Purchase of short-term investments                                               |       | (35,805                                                  | )          | (15,838 | ) |
| Net cash used in investing activities                                            |       | (10,152                                                  | )          | (15,970 | ) |
|                                                                             |       |                                                     |       |   |   |
| Cash flows from financing  activities:                                           |       |                                                     |       |   |   |
| Principal payments on capital lease obligations and  notes payable               |       | (808                                                     | )          | (664 | ) |
| Restricted cash                                                                  |       | (113                                                     | )          | 17 |   |
| Proceeds from notes payable                                                      |       | —                                                   |       | 16,903 |   |
| Proceeds from the issuance of common and preferred  stock, net of offering costs |       | 34,795                                                   |       | 11,661 |   |
| Payment of debt financing costs                                                  |       | —                                                   |       | (1,559 | ) |
| Net cash provided by financing activities                                        |       | 33,874                                                   |       | 26,358 |   |
|                                                                             |       |                                                     |       |   |   |
| Net increase in  cash                                                            |       | 968                                                      |       | 871 |   |
| Cash at  beginning of period                                                     |       | 597                                                      |       | 488 |   |
|                                                                             |       |                                                     |       |   |   |
| Cash at end of period                                                            |       | $                                                        | 1,565      |   | $ | 1,359 |   |

 

The accompanyingnotes are an integral part of these financial statements.

7

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

**1.            Basis of Presentation**

The accompanying unaudited financial statements ofOsiris Therapeutics, Inc. (the “Company”) have been prepared in accordance withgenerally accepted accounting principles in the United States and the rules andregulations of the Securities and Exchange Commission, (the “SEC”), for interimfinancial information.  Accordingly, they do not include all theinformation and footnotes required by generally accepted accounting principlesfor complete financial statements and should be read in conjunction with theCompany’s Registration Statement on Form S-1, as amended (Registration No.333-134037), which was declared effective by the SEC on August 3, 2006. The financial information as of September 30, 2006 and 2005 and for the threeand nine months then ended is unaudited, but in the opinion of management alladjustments, consisting only of normal recurring accruals, considered necessaryfor a fair statement of the results of these interim periods have beenincluded.  The results of the Company’s operations for any interim periodare not necessarily indicative of the results that may be expected for any otherinterim period or for a full fiscal year.

**2.            Initial Public Offering, Non-Cash Charges and Reverse Stock Split**

On August 9, 2006, the Company consummated its initialpublic offering, consisting of 3,500,000 shares of common stock at a publicoffering price of $11.00, resulting in net proceeds to the Company ofapproximately $34.4 million (after deducting payment of underwriters discountsand commissions, as well as offering expenses).

In connection with the initial public offering, theCompany effected a 1-for-4 reverse stock split of the issued and outstandingcommon stock.  Information relating to common stock and commonstock-equivalents set forth in this report (including the share numbers in thepreceding paragraph) have been restated to reflect this split for all periodspresented.  Upon consummation of the initial public offering, all sharesof the Company’s Class I, Series 2003, Series B, Series C, Series E and theMandatorily Redeemable Series D convertible preferred stock were converted intoan aggregate of 10,867,302 shares of our common stock.  In addition,approximately $21.8 million of our convertible notes payable, together withaccrued interest, were converted into an aggregate of 2,774,076 shares of ourcommon stock.

Immediately following the initial public offering, wehad 27,198,307 shares of common stock outstanding.

In the three months ended September 30, 2006, weincurred $7.0 million in non-recurring, non-cash charges relating to thecompletion of the initial public offering. Included in General and Administrative expenses is a charge of $0.8million for stock-based compensation related to the accelerated vesting ofcertain employee stock options pursuant to employment agreements.  We also recognized in General and Administrativeexpense a $3.5 million charge related to warrants that were priced upon thecompletion of the initial public offering. Interest expense for the threemonths ended September 30, 2006 includes $2.7 million in previously deferredfinancing costs and premiums that were expensed as a result of debt that wasconverted into common stock at the completion of the initial public offering.

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

***Use of estimates***

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

***Revenue recognition***

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

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

8

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***Cost of Goods Sold***

Costs of goods sold consists primarily of the costs toobtain tissue, direct labor and other chemicals and supplies for Osteocel,which we launched in July 2005.   Beginning in 2006, we estimate theportion of our facilities and general and administrative expenses that aredirectly attributable to our manufacturing activities, and include these costsin cost of goods sold.

***Loss per Common Share***

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

***Stock-Based Compensation***

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

In 1994, the Company adopted the Amended and Restated1994 Stock Incentive Plan (the 1994 Plan) under which 875,000 shares of commonstock have been reserved for issuance upon the exercise of options or otherequity grants that we issue from time to time.  In 2006, we adopted the2006 Omnibus Plan, under which we reserved 850,000 shares of common stockfor issuance upon the exercise of stock options or other equity grants. We stopped granting options under the 1994 Plan upon the completion of ourinitial public offering in August 2006.

A summary of the combined activity under both of ourstock-based compensation plans as of September 30, 2006 and changes duringthe nine months then ended is presented below.

 
| ** **                              | ** ** | **Number of  Shares** | ** ** | **Weighted Average  Exercise Price at  Grant Date** | ** ** | **Weighted Average  Remaining Term  (Years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|-----------------------------------------|------------|----------------------------|------------|-------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding at  December 31, 2005  |       | 566,480                    |       | $                                                                       | 0.40       |                                                    |       |                                |       |   |
| Granted                                 |       | 313,000                    |       | 4.01                                                                    |       |                                                    |       |                                |       |
| Exercised                               |       | (156,187                   | )          | 0.40                                                                    |       |                                                    |       |                                |       |
| Forfeited or expired                    |       | (5,563                     | )          | 0.40                                                                    |       |                                                    |       |                                |       |
| Outstanding at  September 30, 2006 |       | 717,730                    |       | $                                                                       | 1.97       |                                                    | 8.92       |                                | $          | 5,121 |   |
| Exercisable at  September 30, 2006 |       | 404,869                    |       | $                                                                       | 0.40       |                                                    | 7.91       |                                | $          | 3,889 |   |

 

The weighted average grant date fair value of optionsgranted during the nine months ended September 30, 2006 was $7.11 pershare. The total intrinsic value of options exercised during the nine monthsended September 30, 2006 was $4.5 million. We received a total of $60 incash from the exercises of options during the nine months endedSeptember 30, 2006.  At September30, 2006, options for 786,511 shares of common stock remain available forfuture grants under our 2006 Omnibus Plan.

Share-based compensation included in the statements ofoperations for the three and nine months ended September 30, 2006 wasapproximately $4.5 million and $4.7 million, respectively.  As ofSeptember 30, 2006, there was approximately $1.6 million of total unrecognizedshare-based compensation cost related to options granted under our plans thatwill be recognized over a weighted-average period of approximately 3-years.

*ProForma Information under SFAS 123 for Periods Prior to January 1, 2006*

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

9

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The following table summarizes the pro forma effect onthe net loss and per share data if the Company had applied the fair valuerecognition provisions of SFAS 123 to stock-based employee compensationfor the nine-month period ended September 30, 2005.

 

|                                                                                 | ** ** | **Nine Months  Ended  September 30, 2005** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Net loss                                                                        |       | $                                                         | (11,940    | ) |
| Add: Stock-based employee compensation expense  included in net loss            |       | 51                                                        |       |
| Less: Stock-based employee compensation expense  determined under SFAS 123 |       | (7                                                        | )          |
|                                                                            |       |                                                      |       |
| Pro forma net  loss                                                             |       | $                                                         | (11,896    | ) |
|                                                                            |       |                                                      |       |
| Net loss per  share:                                                            |       |                                                      |       |
| Basic and diluted, net loss as reported                                         |       | $                                                         | (1.33      | ) |
|                                                                            |       |                                                      |       |
| Pro forma basic  and diluted, net loss                                          |       | $                                                         | (1.33      | ) |

 

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

***Significant New Accounting Pronouncement***

In September 2006, the Financial Accounting StandardsBoard (“FASB”) issued SAFS No. 157, “Fair Value Measurements.”  SFAS 157 defines fair value, establishes aframework for measuring fair value, and expands disclosures about fair valuemeasurements.  SFAS 157 applies underother accounting pronouncements that require or permit fair value measurements,the FASB having previously concluded in those accounting pronouncements thatfair value is the relevant measurement attribute.  Accordingly, SFAS 157 does not require anynew fair value measurements, but may change current practice for someentities.  SFAS 157 is effective forfiscal years beginning after December 15, 2006. Our adoption of SFAS No. 157 is not expected to have a material effecton our financial position or results of operations.

In September, the Securities and Exchange Commissionissued Staff Accounting Bulletin, or SAB, No. 108, “Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements,” which provides interpretive guidance on theconsideration of the effects of prior year misstatements in quantifying currentyear misstatements for the purpose of a materiality assessment.  SAB No. 108 requires registrants to quantifymisstatements using both the balance sheet and income statement approaches andto evaluate whether either approach results in quantifying an error that ismaterial based on relevant quantitative and qualitative factors.  The guidance is effective for the firstfiscal period ending after November 15, 2006. We are currently evaluating the impact of adopting SAB No. 108 on ourfinancial position, results of operations and cash flows.

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

**5.            Long-Term Debt and Capital Lease Obligations**

 

|                                                                                                                                  | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                       | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| Bank Loan,  payable in quarterly installments and bearing interest at LIBOR plus  applicable margins, 6.64% - 7.14% in 2006      |       | $                      | 65         |                  | $          | 114 |   |
| Line of Credit,  8%, to be repaid from future product sales                                                                      |       | 5,000                  |       | 5,000                 |       |
| Term Note, 6%  redeemable at the option of the holder after the IPO, due in 2008  (redeemed by the Company in October 2006) |       | 20,600                 |       | 20,600                |       |
| **Long-term debt that did not convert at the  initial public offering**                                                          | ** ** | **25,665**             | ** ** | **25,714**            | ** ** |
| Term Note, 5%  convertible into Common stock at $6.00/share                                                                      |       | —                 |       | 2,000                 |       |
| Term Notes, 6%  convertible into common stock at initial public offering at specified prices                                     |       | —                 |       | 19,762                |       |
| **Long-term debt that converted upon the initial  public offering**                                                              | ** ** | **—**             | ** ** | **21,762**            | ** ** |
| Total long-term  debt                                                                                                            |       | 25,665                 |       | 47,476                |       |
| Less current portion                                                                                                             |       | (20,665                | )          | (65                   | )          |
| Long-term debt                                                                                                                   |       | $                      | 5,000      |                  | $          | 47,411 |   |
|                                                                                                                             |       |                   |       |                  |       |
| Total capital  lease obligations                                                                                                 |       | 2,292                  |       | 3,051                 |       |
| Less current portion                                                                                                             |       | (1,103                 | )          | (1,027                | )          |
| Capital lease  obligations, long-term                                                                                            |       | $                      | 1,189      |                  | $          | 2,024 |   |

 

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During June 1995, we borrowed $750 from a commercialbank in connection with the acquisition and renovation of our Baltimore,Maryland facilities.  This loan is partially guaranteed by an agency ofthe State of Maryland and matures in September 2007.  This loan bears interestat LIBOR plus 2.0% to 2.5% (7.13% to 7.63% at September 30, 2006). Compensating balance arrangements with Wachovia Bank require us to maintain acash balance of 105% of the non-guaranteed portion of this loan, which is shownas a component of restricted cash in the accompanying balance sheet.  AtSeptember 30, 2006, this compensating balance requirement was $22.

During 2005, we had issued convertible promissorynotes outstanding to twenty-six shareholders for a total of $19.8million.  These notes accrue interest at 6% per annum, and provide forredemption premiums starting at 9% of the principal amount and escalating up to27% of the principal amount, depending upon the date of redemption orconversion to Common Stock.  All twenty-six convertible promissory notes,together with accrued interest were subsequently converted into 2,376,223shares of our common stock upon the completion of our initial public offeringon August 9, 2006.

In December 2004, we issued a convertible promissorynote to a foreign investor for $2.0 million.  This note bore interest at5% and the principal and accrued interest was converted into 397,853 shares ofour common stock upon the completion of our initial public offering on August9, 2006.

In November 2005, we issued a $20.6 million promissorynote to a foreign investor.  This note bears interest at 6% and hasredemption premiums that start at 9% and increase over time up to 27%. Interest payments are due in November 2006, 2007 and upon maturity in November2008.  This note was convertible into our common stock only if the initialpublic offering took place after December 2006.  The note also containsdemand features whereby the holder can request redemption and early repaymentat any time after the completion of an initial public offering, and thereforethis note is classified as a current liability in the condensed balance sheetat September 30, 2006.

In October 2006, we issued $20.0 million inconvertible promissory notes in a private placement to Swiss investors and usedthe proceeds from these notes, plus $3.6 million in cash to redeem the $20.6million promissory note.  See theSubsequent Events footnote for a more complete description of thesetransactions.

**6.            Preferred Stock Conversion**

All our convertible preferred stock was converted intocommon stock upon the completion of our initial public offering in August 2006,as follows:
| ** **                                                                                                                              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **No. Shares of  Common Stock  Issued Upon  Conversion at IPO  (Aggregate  Liquidation  Preference /  Conversion Price** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                              | ** ** | **2006**               | ** ** | **2005**              | ** ** | **Per Share**                                                                                                                                               | ** ** |
| Convertible  preferred stock, Class I, Series 2003, $0.001 par value, 2,000,000 shares  designated, issued and outstanding in 2005      |       | $                      | —     |                  | $          | 10,000                                                                                                                                                           |       | 500,000 |   |
| Convertible  preferred stock, Series B, $0.001 par value, 750,000 shares designated,  545,454 shares issued and outstanding in 2005     |       | —                 |       | 3,000                 |       | 136,364                                                                                                                                                          |       |
| Convertible  preferred stock, Series C, $0.001 par value, 3,500,000 shares designated,  548,090 shares issued and outstanding in 2005   |       | —                 |       | 2,243                 |       | 308,300                                                                                                                                                          |       |
| Convertible preferred  stock, Series E, $0.001 par value, 8,000,000 shares designated, 7,557,000  shares issued and outstanding in 2005 |       | —                 |       | 17,503                |       | 1,889,250                                                                                                                                                        |       |
|                                                                                                                                    |       | $                      | —     |                  | $          | 32,746                                                                                                                                                           |       | 2,833,914 |   |

 

We issued 2,000,000 shares of our Class I, Series 2003convertible preferred stock to a collaborative partner as part of an agreementrelated to product development, clinical trials and FDA approval.  Theseshares were converted into 500,000 shares of our common stock at the conversionprice of $20.00 per share.

We issued 545,454 shares of our Series B convertiblepreferred stock in 2003, as part of a collaborative agreement.  Theseshares were converted into 136,364 shares of our common stock at the conversionprice of $22.00 per share.

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We issued 548,090 shares of our Series C convertiblepreferred stock in 2004 at the price of $4.50 per share.  These shareswere converted into 308,300 shares of our common stock at the conversion priceof $8.00 per share.

We issued 7,557,000 shares of our Series E convertiblepreferred stock in 2005 at a price of $2.50 per share.  These shares wereconverted into 1,889,250 shares of our common stock at the conversion price of$10.00 per share.

Also in 2005, we issued3,213,335 shares of Series D Mandatorily Redeemable Convertible PreferredStock at a price of $2.00 per share. These shares were converted into 8,033,388shares of our common stock at the conversion price of $0.80 per share.

These Series D shares included a mandatory redemptionfeature whereby if the Company did not complete an initial public offeringprior to June 1, 2007 and the shares were not previously converted intocommon stock, the Company must then redeem the shares at a price of $20.00 pershare. The Series D Mandatorily Redeemable Convertible Preferred Stock isrecorded as a liability in the balance sheet at December 31, 2005, inaccordance with SFAS No. 150 “Accounting for Certain Financial Instrumentswith Characteristics of Both Liabilities and Equity.” In addition to theinitial net proceeds of $6.0 million from the Series D offering, aredemption premium of $58.3 million was recorded as a liability.

**7.            Warrants**

At September 30, 2006, the Company had warrants topurchase its common stock outstanding as shown in the following table.

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

 

In connection with a 2004 financing arrangement, weissued warrants to purchase 1,250,000 shares of our common stock at $0.40per share.  In the first half of 2006, these warrants werecancelled.  In May 2006, we issued warrants to Peter Friedli, the chairmanof our board of directors, to purchase 1,000,000 shares of our common stock atthe price our stock was offered to the public in the initial publicoffering.  These warrants have a five-year life and entitle Mr. Friedli topurchase up to 1,000,000 shares of our common stock for $11.00 per share at anytime prior to expiration.

In August 2006, when the price of the warrant wasdetermined, we computed its value using the Black-Scholes option pricingmethod, using a risk free interest rate of 4.80% (5-year US Treasury interestrate), the expected life of 2.5-years and a stock volatility factor of44.66%.  Since the Company just recentlycompleted its initial public offering and previously its stock did not trade,we determined the volatility by selecting a comparable public company in thebiotech industry and tracking its stock prices over the past 2.5-years.  The value of these warrants was determined tobe $3.5 million which as been recorded in the accompanying income statement asGeneral and Administrative expenses.

The 875,000 warrants that were exercisable at $0.40per share as of January 1, 2006 were all exercised concurrent with the closingof our initial public offering in August 2006.

**8.            Subsequent Events**

In October 2006, subsequent to the end of the thirdfiscal quarter, we issued $20.0 million in convertible promissory notes in aprivate placement to several Swiss investors. The notes bear interest at a rate of 10%, with semi-annual payments ofaccrued interest becoming due and payable on April 30 and October 30 of eachcalendar year, until maturity on April 30, 2009.  The notes are convertible at the option ofthe respective holders at any time after February 9, 2007, into shares ofcommon stock at the conversion price of $18.00 per share.   The notes automatically convert into commonstock at the same conversion price, if at any time after February 9, 2007, theclosing price of the Company’s common stock for ten consecutive trading daysequals $25.00 per share or greater.  Thenotes provide for redemption at any time at the option of the Company, with30-day written notice.

The net proceeds from these notes have been applied tothe repayment in full of the $20.6 million convertible promissory note issuedin November 2005 to a foreign investor. Repayment of this note in October 2006, allowed the Company to avoid anincrease in the premium obligation of up to 18% or $3.7 million, which wouldhave been payable had the prior note been held to maturity.  After accounting for costs to refinance andinterest rate differences, total net savings to the Company over the prior note’sfull term are estimated to be $3.2 million.

 

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**ITEM 2.****  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

***Introduction and Overview.***

**Forward-lookingStatements**

This report containsforward-looking statements. Forward-looking statements provide our currentexpectations or forecasts of future events. Forward-looking statements includestatements about our expectations, beliefs, plans, objectives, intentions,assumptions and other statements that are not historical facts. Words orphrases such as “anticipate,” “believe,” “continue,” “ongoing,” “estimate,” “expect,”“intend,” “may,” “plan,” “potential,” “predict,” “project” or similar words orphrases, or the negatives of those words or phrases, may identifyforward-looking statements, but the absence of these words does not necessarilymean that a statement is not forward-looking. Examples of forward-lookingstatements include, but are not limited to, statements regarding the following:our product development efforts; our clinical trials and anticipated regulatoryrequirements; the success of our product candidates in development; status ofthe regulatory process for our biologic drug candidates; implementation of ourcorporate strategy; our financial performance; our product research anddevelopment activities and projected expenditures, including our anticipatedtimeline and clinical strategy for Mesenchymal stem cells or MSCs and biologicdrug candidates; our cash needs; patents and proprietary rights; ability of ourpotential products to treat disease; our plans for sales and marketing; ourplans regarding our facilities; types of regulatory frameworks we expect willbe applicable to our potential products; and results of our scientificresearch. Forward-looking statements are subject to known and unknown risks anduncertainties and are based on potentially inaccurate assumptions that couldcause actual results to differ materially from those expected or implied by theforward-looking statements. Our actual results could differ materially fromthose anticipated in forward-looking statements for many reasons, including thefactors described in the section entitled “Risk Factors” in our RegistrationStatement on Form S-1, File No: 333-134037, as filed with the United StatesSecurities and Exchange Commission and declared effective on August 3, 2006.Accordingly, you should not unduly rely on these forward-looking statements. Weundertake no obligation to publicly revise any forward-looking statement toreflect circumstances or events after the date of this report or to reflect theoccurrence of unanticipated events.

**Overview**

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

We have incurred annual operating losses sinceinception and expect to incur substantial operating losses in the future inconnection with the development of our core products. As of September 30, 2006,we had an accumulated deficit of $174.8 million.

**FinancialOperations Overview**

*Revenue*

Osteocel is our only commercial product. Sales ofOsteocel generated revenue of approximately $5.3 million for the nine monthsended September 30, 2006. In prior years, we have entered into strategicagreements with other companies for the development and commercialization ofselect stem cell biologic drug candidates for specific indications andgeographic markets. In 2003, we entered into an agreement with a majorpharmaceutical company relating to the development of our cardiac biologic drugcandidate, and we received a $5.0 million fee for licensing the use of ourtechnology. This fee is being recognized as revenue over a 63-month period,$0.7 million of which was recognized in the first nine months of 2006 and 2005.Also in 2003, we entered into an agreement with a foreign pharmaceuticalcompany granting it exclusive rights to Prochymal for the treatment of GvHD inJapan. We recognized $0.5 million of revenue during the nine months endedSeptember 2005 related to this agreement. We do not expect to enter intocollaborations in the future.

Historically, we have also recognized revenue fromgovernmental grants for research and in the first nine months of 2005, werecorded $1.4 million in grant revenues from three separate grants. Revenuefrom research grants is recognized as the related research expenditures areincurred. During 2006, we did not have any active government grants and, we donot expect to solicit governmental grants in the future.

Other than Osteocel, we have no commercial products forsale. A substantial portion of our revenue in the future will be dependent onthe approval and sale of our biologic drug candidates. Our revenue may varysubstantially from quarter to quarter and from year to year. We believe thatperiod-to-period comparisons of our results of operations are not meaningfuland should not be relied upon as indicative of our future performance.

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*Cost of Goods Sold*

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

*Research and Development Costs*

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

Consistent with our focus on the development ofbiologic drug candidates with potential uses in multiple indications, many ofour costs are not attributable to a specifically identified product. We use ouremployee and infrastructure resources across several projects. Accordingly, wedo not account for internal research and development costs on aproject-by-project basis. As a result, we cannot state precisely the totalcosts incurred for each of our clinical and preclinical projects on aproject-by-project basis. From inception through September 30, 2006, weincurred aggregate research and development costs of approximately $168million.

We expect our research and development expenses toincrease substantially in the future, as we expand our clinical trial activity,as our biologic drug candidates advance through the development cycle and as weinvest in additional product opportunities and research programs. Clinicaltrials and preclinical studies are time-consuming and expensive. Ourexpenditures on current and future preclinical and clinical developmentprograms are subject to many uncertainties. We test our products in severalpreclinical studies, and we then conduct clinical trials for those biologicdrug candidates that we determine to be the most promising. As we obtainresults from clinical trials, we may elect to discontinue or delay trials forsome biologic drug candidates in order to focus our resources on more promisingbiologic drug candidates. Completion of clinical trials may take several yearsor more, but the length of time generally varies substantially according to thetype, size of trial and intended use of a biologic drug candidate. The cost ofclinical trials may vary significantly over the life of a project as a resultof a variety of factors, including:

·                    thenumber of patients who participate in the trials;

·                    thenumber of sites included in the trials;

·                    thelength of time required to enroll trial participants;

·                    theduration of patient treatment and follow-up;

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

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

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

As a result of theuncertainties discussed above, we are unable to determine with any significantdegree of certainty the duration and completion costs of our research anddevelopment projects or when and to what extent we will generate revenues fromthe commercialization and sale of any of our biologic drug candidates.

*General and Administrative Expenses*

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

*Interest Expense, Net*

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

*IncomeTaxes*

We have not recognized any deferred tax assets orliabilities in our financial statements since we cannot assure their futurerealization. Because realization of deferred tax assets is dependent uponfuture earnings, a full valuation allowance has been recorded on the netdeferred tax assets, which relate primarily to net operating losscarryforwards. In the event that we become profitable within the next severalyears, we have net deferred tax assets of approximately $60 million that may beutilized prior to us having to recognize any income tax expense or makepayments to the taxing authorities. Utilization of our net operating losscarryforwards in any one year may be limited however, and we could be subjectto the alternative minimum tax.

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**CriticalAccounting Policies**

The preparation of our consolidated financialstatements requires us to make estimates and assumptions that affect thereported amounts of assets and liabilities and the disclosure of contingentassets and liabilities as of the date of our financial statements as well asthe reported revenues and expenses during the reported periods.  We baseour estimates on historical experience and on various other factors that webelieve are reasonable under the circumstances, the results of which form thebasis for making judgments about the carrying value of assets and liabilitiesthat are not apparent from other sources.  Actual results may differ fromthese estimates under different assumptions or conditions.

Our significant accounting policies are described inthe notes to our audited financial statements for the year ended December 31,2005 included in the Registration Statement on Form S-1, as amended(Registration No. 333-134037), which was declared effective by the SEC onAugust 3, 2006.

**ResultsOf Operations**

*Comparisonof Quarters ended September 30, 2006 and 2005*

*Revenue*

Total revenues increased 121% to $2.8 million forthe quarter ended September 30, 2006, compared to $1.3 million in thethird quarter of 2005. Our revenues in 2006 resulted primarily from$2.5 million generated from the sale of Osteocel and the recognition of$0.3 million in licensing fees and royalties. In the quarter endedSeptember 30, 2005, we recognized $0.3 million in Osteocel sales and $1.0 millionin license fees and grants.

*Costof Goods Sold*

Cost of goods sold were $1.1 million for thequarter ended September 30, 2006 compared to $0.2 million in the third quarterof 2005. The cost of goods sold associated with sales of Osteocel was comprisedof payments to tissue banks, direct labor costs and the costs of processing,testing and preserving Osteocel, as well as allocations of our facilities andoverhead costs.  The gross margin onOsteocel sales in the third quarter of 2006 was 56%.  The gross margin for the third quarter of2005 was 23%, reflecting the start-up of commercial activities in July 2005.

*Researchand Development Expenses*

Research and development expenses were approximately$9.2 million for the quarter ended September 30, 2006 compared to$3.5 million in the prior year. The increase in research and developmentexpenses in 2006 reflects the increased number of clinical trials in processverses the prior year. In 2006, we incurred costs associated with theenrollment of a Phase II trial for Prochymal as an add-on therapy to steroidsfor the first-line treatment of acute GvHD, a Phase II trial for Prochymal fortreatment of steroid refractory GvHD, a Phase II trial for Prochymal fortreatment of Crohn’s Disease, a Phase I/II clinical trial for Chondrogen, and aPhase I clinical trial for Provacel.

*Generaland Administrative Expenses*

General and administrative expenses were$5.3 million for the quarter ended September 30, 2006 compared to$0.6 million in the third quarter of 2006.  The 2006 expenses include$4.4 million in non-cash stock-based compensation charges related to certainoptions that vested upon the completion of the initial public offering,pursuant to employment agreements and the value of a warrant that becamedeterminable upon the completion of the initial public offering.  General and administrative expenses,exclusive of these non-cash charged during the third quarter of 2006 were $0.9million, compared to $0.6 million in the prior year. The increase in generaland administrative expenses was attributable to additional personnel andrelated costs to support the company’s growth and greater costs incurred inconnection with being a public company.

*InterestExpense, Net*

Interest expense, net was $2.8 million for thequarter ended September 30, 2006, and includes the recognition of previouslydeferred financing costs and premiums associated the debt that was convertedinto common stock at the completion of the initial public offering.  Excluding items related to the initial publicoffering, net interest expense for the third quarter of 2006 was $0.1 million,compared to $1.7 million in the prior year. The reduction is the result of higher interest income from the proceedsof the initial public offering that were invested in investment-gradeshort-term securities and the conversion of $21.8 million of interest bearingdebt to common stock in August 2006.

*Comparisonof Nine Months ended September 30, 2006 and 2005*

*Revenue*

Total revenues increased 107% to $6.2 million forthe nine months ended September 30, 2006, compared to $3.0 million in thecorresponding period in 2005. Our revenues in 2006 resulted primarily from$5.3 million generated from the sale of Osteocel and the recognition of$0.9 million in licensing fees and royalties. In the nine months endedSeptember 30, 2005, we recognized $0.3 million from the sale of Osteocel and$2.7 million in license fees and grants.

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*Costof Goods Sold*

Cost of goods sold were $2.4 million for the ninemonths ended September 30, 2006 compared to $0.2 in the prior year. The cost ofgoods sold associated with sales of Osteocel was comprised of payments totissue banks, direct labor costs and the costs of processing, testing andpreserving Osteocel, plus allocated costs of our facilities and overhead. Thegross margin on Osteocel sales for the nine months ended September 30, 2006 was56%, compared with 23% for 2005.  The2005 gross margin reflects the start-up of commercial operations.

*Researchand Development Expenses*

Research and development expenses were approximately$24.5 million for the nine months ended September 30, 2006 compared to$9.7 million in the prior year. The increase in research and developmentexpenses in 2006 reflects the increased number of clinical trials in processverses the prior year. In 2006, we incurred costs associated with theenrollment of a Phase II trial for Prochymal as an add-on therapy to steroidsfor the first-line treatment of acute GvHD, a Phase II trial for Prochymal fortreatment of steroid refractory GvHD, a Phase II trial for Prochymal fortreatment of Crohn’s Disease, a Phase I/II clinical trial for Chondrogen, and aPhase I clinical trial for Provacel.

*Generaland Administrative Expenses*

General and administrative expenses were$7.6 million for the nine months ended September 30, 2006 compared to$1.8 million in the prior year.  The increase in 2006 includes $4.4million of non-cash charges associated with the completion of our initialpublic offering.  Exclusive of thesecharges, general and administrative expenses in 2006 were $3.2 million and theincrease over the prior year was attributable to additional personnel andrelated costs to support the company’s growth and costs incurred in connectionwith being a public company.

*InterestExpense, Net*

Interest expense, net was $4.0 million for thenine months ended September 30, 2006 compared to $3.2 million in the prioryear. The 2006 costs include $2.7 million of previously deferred debt financingcosts and premiums associated with debt that was converted into common stockupon the completion of our initial public offering.  Exclusive of these charges, net interestexpense during 2006 was $1.3 million, a decrease of $1.9 million compared to2005.  This decrease is the result ofhigher interest income related to the investment of the proceeds of the initialpublic offering and the $21.8 million decrease in debt, which was convertedinto common stock upon the completion of the initial public offering in earlyAugust 2006.

**Liquidityand Capital Resources**

***Liquidity***

At September 30, 2006, we had $1.6 million in cash and$52.0 million in short-term investments.  In addition to the sourcesdescribed above, at September 30, 2006, we had drawn only $5.0 million ofthe $50.0 million line of credit available for the development of Provacelunder a loan agreement with a pharmaceutical company. In connection with thisline of credit, we have granted the pharmaceutical company a security interestin the intellectual property, equipment and books and records involved in thedevelopment, manufacture and distribution of Provacel. The pharmaceuticalcompany is also obligated to make additional investments in our Company and paylicensing fees up to $45.0 million to us upon completion of certainmilestones.

In addition to the $5.0 million balance on theline of credit, at September 30, 2006 our debt included approximately$20.6 million of a convertible promissory note due in 2008. SinceSeptember 30, 2006, we issued $20.0 million of 10% convertible promissorynotes that mature in 2009.  These notesare convertible into common stock any time after February 9, 2007, at theconversion price of $18 per share.  Thenotes are automatically converted into common stock at the same conversionprice if, after February 9, 2007, our common stock closes at $25 per share orgreater for ten consecutive trading dates. We used the proceeds of these notes, plus $3.6 million in cash to redeemthe $20.6 million 6% convertible promissory note.  The prior note accrued interest at 6%together with premium payments of 9% initially and increasing to 27% if thenote was held to maturity.  Repayment ofthe prior note allowed the Company to avoid an increase in the premiumobligation of up to 18%, or $3.7 million, which would have been payable had theprior note been held to maturity.  Afteraccounting for costs to refinance and interest rate differences, total netsavings to the Company over the prior note’s full term are expected to beapproximately $3.2 million.

***Cash Flows***

Net cash used in operating activities was$22.8 million for the nine months ended September 30, 2006 primarilyreflecting our net loss of $32.3 million, partially offset by $0.5 millionin favorable working capital, $4.0 million in non-cash interest and $5.9in stock-based compensation expense and $1.1 million in depreciation andamortization. Other long-term liabilities decreased by $2.0 million, reflectingthe reclassification of the accrued interest and principal on the $20.6 millionconvertible note payable that was redeemed in October 2006. Net cash used foroperating activities was $9.5 million for the nine months ended September 30,2005. Net cash used in operating activities for 2005 primarily reflects our netloss of $11.9 million, partially offset by $2.5 million in non-cashinterest expense.

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Net cash used in investing activities was $10.2million for the nine months ended September 30, 2006.  Net cash used ininvesting activity for the nine months ended September 30, 2005 was $16.0million. Net cash used in investing activities in 2006 includes cash flows fromthe purchase of $35.8 million of short-term investment, partially offset by thesale of $26.6 million of short-term investments.  In 2005, we purchased $15.9 million ofshort-term investments during the first nine-months of the year.

Net cash provided by financing activities was $33.9million for the nine months ended September 30, 2006. Net cash provided byfinancing activities was $26.4 million for the nine months ended September 30,2005 and consisted principally of $16.9 million in net proceeds from theissuance of convertible notes and $11.6 million in net proceeds from theissuance of common and preferred stock. The cash provided by financing activities in the first nine months of2006 was primarily from the proceeds of our initial public offering in August2006.

***Capital Resources.***

Our future capital requirements will depend on manyfactors, including:

·                    thelevel of cash flows from Osteocel sales;

·                    thescope and results of our research and preclinical development programs;

·                    thescope and results of our clinical trials, particularly regarding the number ofpatients required for our Phase III trial for Prochymal;

·                    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;

·                    thecosts of building and operating our manufacturing facilities, both in the nearterm to support Osteocel sales and our clinical activities and also inanticipation of expanding our commercialization activities;

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

·                    thecosts of repaying our debt; and

·                    the costs ofenlarging our work force consistent with expanding our business and operationsand status as a public company, and as necessary to enhance and train our salesnetwork in anticipation of the approval of our biologic drug candidates forcommercial sale.

As aresult of these factors, we may need or choose to seek additional funding priorto our becoming cash flow positive on an operational basis. We would likelyseek such funding through public or private financings or some combination ofthem. Although not our current focus, we might also seek funding throughcollaborative arrangements if determined to be necessary or appropriate.Additional funding may not be available to us on acceptable terms, or at all.If we obtain capital through collaborative arrangements, these arrangementscould require us to relinquish rights to our technologies or biologic drugcandidates. If we raise capital through the sale of equity, or securitiesconvertible into equity, dilution to our then existing stockholders wouldresult. If we raise additional capital through the incurrence of debt, we wouldlikely become subject to covenants restricting our business activities, andholders of debt  instruments would have rights and privileges senior tothose of our equity investors. In addition, servicing the interest and repaymentobligations under these borrowings would divert funds that would otherwise beavailable to support research and development, clinical or commercializationactivities.

If we are unable to obtain adequate financing on atimely basis, we may be required to delay, reduce the scope of or eliminate oneor more of our programs, any of which could have a material adverse effect onour business, financial condition and results of operations.

We expect that our available cash and interest income,including that raised in the initial public offering of our common stock, willbe sufficient to finance currently planned activities through early 2008,although no assurance can be given that changes will not occur that wouldconsume available capital resources before such time and we may need or want toraise additional financing within this period of time. These estimates arebased on certain assumptions, which could be negatively impacted by the factorsdiscussed above and under “Risk Factors” included in the Registration Statementon Form S-1, as amended (Registration No. 333-134037), which was declaredeffective by the SEC on August 3, 2006.

**Off-BalanceSheet Arrangements.**

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

**Item3.  Quantitative and Qualitative Disclosures About Market Risk**

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

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Webelieve that the interest rate risk related to our accounts receivable is notsignificant. We manage the risk associated with these accounts through periodicreviews of the carrying value for non-collect ability and establishment ofappropriate allowances in connection with our internal controls and policies.

We do not enter into hedging or derivative instrumentarrangements.

**Item4.****  Controlsand Procedures**

***Evaluation ofDisclosure Controls and Procedures.*** An evaluation of theeffectiveness of the design and operation of our “disclosure controls andprocedures” (as defined in Rule 13a-15(e) under the Securities Exchange Act of1934, as amended), as of the end of the period covered by this quarterly reporton Form 10-Q was made under the supervision and with the participation of ourmanagement, including our Chief Executive Officer and Chief Financial Officer.Based upon this evaluation, our Chief Executive Officer and Chief FinancialOfficer have concluded that our disclosure controls and procedures (a) areeffective to ensure that information required to be disclosed by us in reportsfiled or submitted under the Securities Exchange Act of 1934 is timely recorded,processed, summarized and reported and (b) include, without limitation,controls and procedures designed to ensure that information required to bedisclosed by us in reports filed or submitted under the Securities Exchange Actof 1934 is accumulated and communicated to our management, including our ChiefExecutive Officer and Chief Financial Officer, as appropriate to allow timelydecisions regarding required disclosure.

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

 

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**PART II— OTHER INFORMATION**

**Item1.****  LegalProceedings**

From time to time, we receive threats or may besubject to routine litigation matters related to our business. However, we arenot currently a party to any material pending legal proceedings.

**Item1A.****  Risk Factors**

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

**Item2.****  UnregisteredSales of Equity Securities and Use of Proceeds**

None

**        InitialPublic Offering and Use of Proceeds from Sales of Registered Securities**

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

We registered3,500,000 shares of our common stock in connection with the initial publicoffering and the aggregate offering amount was $38.5 million.  We paid approximately $2.7 million inunderwriting discounts and commissions to the underwriter.  We also incurred other expenses in connectionwith the offering of approximately $1.4 million, including registration fees,accounting and legal, printing and engraving and other expenses.

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

After deductingthe underwriting discounts and commissions and these other estimated offeringexpenses, our net proceeds from the offering were approximately $34.4million.  We have deposited the netproceeds in two highly rated financial institutions in the United States.

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

**Item3.****  DefaultsUpon Senior Securities**

None

**Item4.****  Submissionof Matters to a Vote of Security Holders**

None

**Item5.****  OtherInformation**

None

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**Item6.****  Exhibits**

 
| Exhibit  Number | ** ** | **Description of Exhibit**                                                                                                                                                                     |
|-----------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                                                           |
| 31.1            |       | Certification of Principal Executive Officer  pursuant to Rule 13a-14(a) and 15D-14(a) under the Securities Exchange Act of  1934, as amended (Section 302 of the Sarbanes-Oxley Act of 2002). |
|            |       |                                                                                                                                                                                           |
| 31.2            |       | Certification of Principal Financial Officer  pursuant to Rule 13a-14(a) and 15D-14(a) under the Securities Exchange Act of  1934, as amended (Section 302 of the Sarbanes-Oxley Act of 2002). |
|            |       |                                                                                                                                                                                           |
| 32              |       | Certification of Principal Executive Officer and  Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.       |

 

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The certification attached as Exhibit 32 thataccompanies this Quarterly Report on Form 10-Q is not deemed filed with theSecurities and Exchange Commission and is not to be incorporated by referenceinto any filing of Osiris Therapeutics, Inc. under the Securities Act of 1933,as amended, or the Securities Exchange Act of 1934, as amended, whether madebefore or after the date of this Quarterly Report on Form 10-Q, irrespective ofany general incorporation language contained in such filing.

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**SIGNATURE**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                          | ** ** | **Osiris Therapeutics, Inc.** |
|--------------------------|------------|-------------------------------|
|                     |       |                          |
|                     |       |                          |
| Date: November  13, 2006 |       | /s/ Cary J. Claiborne         |
|                     |       | Cary J. Claiborne             |
|                     |       | Chief Financial Officer       |

 

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