Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

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

** **

**For thequarterly period ended June 30, 2009**

 

**or**

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

 

**For thetransition period from                   to                   **

 

**CommissionFile Number:  001-32966**

 

**OSIRISTHERAPEUTICS, INC.**

(Exact name of registrantas specified in its charter)

 

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

 

**443-545-1800**

(Registrant’s telephonenumber, including area code)

 

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

 

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

 

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

 

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

 

Indicate by check mark whether the registrant is 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 August 5, 2009** |
|-------------------------------------------|------------|-------------------------------------------------------|
| Common Stock, par value  $0.001 per share |       | 32,759,432                                            |

 

 

 

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Table of Contents

 

**OSIRISTHERAPEUTICS, INC.**

 

**INDEX**

 
| ** **                                   | ** **                                                                                             | **Page**   |
|----------------------------------------------|--------------------------------------------------------------------------------------------------------|------------|
| **PART I — FINANCIAL INFORMATION** | 3                                                                                                      |
| ** **                                   | ** **                                                                                             | ** ** |
| Item  1.                                     | Financial  Statements — Unaudited                                                                 | 3          |
|                                         | Condensed Balance Sheets —  June 30, 2009 and December 31, 2008                         | 3          |
|                                         | Condensed Statements of  Operations — three and six months ended June 30, 2009 and 2008      | 4          |
|                                         | Condensed Statement of  Stockholders’ Equity (Deficit) — six months ended June 30, 2009 | 5          |
|                                         | Condensed Statements of Cash  Flows — six months ended June 30, 2009 and 2008                | 6          |
|                                         | Notes to  Condensed Financial Statements                                                               | 7          |
|                                         |                                                                                                   |       |
| Item 2.                                      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations            | 18         |
|                                         |                                                                                                   |       |
| Item 3.                                      | Quantitative  and Qualitative Disclosures About Market Risk                                            | 26         |
|                                         |                                                                                                   |       |
| Item 4.                                      | Controls and Procedures                                                                                | 27         |
|                                         |                                                                                                   |       |
| **PART II — OTHER  INFORMATION**   | 27                                                                                                     |
|                                         |                                                                                                   |       |
| Item 1.                                      | Legal Proceedings                                                                                      | 27         |
| Item 1A.                                | Risk  Factors                                                                                          | 27         |
| Item 2.                                      | Unregistered  Sales of Equity Securities and Use of Proceeds                                           | 27         |
| Item 3.                                      | Defaults Upon  Senior Securities                                                                       | 27         |
| Item 4.                                      | Submission of  Matters to a Vote of Security Holders                                                   | 27         |
| Item 5.                                      | Other Information                                                                                      | 28         |
| Item  6.                                     | Exhibits                                                                                               | 28         |
|                                         |                                                                                                   |       |
| Signatures                                   |                                                                                                   | 29         |
|                                         |                                                                                                   |       |
| Exhibit Index                           |                                                                                                   |       |

 

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**PART I — FINANCIAL INFORMATION**

 

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

 

**OSIRISTHERAPEUTICS, INC.**

**CondensedBalance Sheets**

**Amountsin thousands**

 
| ** **                                                                                                      | ** ** | **June 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                                                                                                            |       | **Unaudited**           |       |                        |       |
| **ASSETS**                                                                                                      |       |                    |       |                        |       |
| Current assets:                                                                                                 |       |                    |       |                        |       |
| Cash                                                                                                            |       | $                       | 1,162      |                        | $          | 940 |   |
| Investments available  for sale                                                                                 |       | 50,800                  |       | 61,298                      |       |
| Accounts receivable                                                                                             |       | 68,815                  |       | 61,287                      |       |
| Prepaid expenses and  other current assets                                                                      |       | 4,144                   |       | 2,060                       |       |
| Current assets of  discontinued operations                                                                      |       | 64                      |       | 3,223                       |       |
| Total current assets                                                                                            |       | 124,984                 |       | 128,808                     |       |
|                                                                                                            |       |                    |       |                        |       |
| Property and equipment,  net                                                                                    |       | 3,975                   |       | 394                         |       |
| Restricted cash                                                                                                 |       | 666                     |       | 130                         |       |
| Other assets                                                                                                    |       | 337                     |       | 615                         |       |
| Long-term assets of  discontinued operations                                                                    |       | —                  |       | 7,520                       |       |
| Total assets                                                                                                    |       | $                       | 129,962    |                        | $          | 137,467 |   |
|                                                                                                            |       |                    |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY (DEFICIT)**                                                        |       |                    |       |                        |       |
| Current liabilities:                                                                                            |       |                    |       |                        |       |
| Accounts payable and  accrued expenses                                                                          |       | $                       | 15,475     |                        | $          | 10,513 |   |
| Deferred revenue,  current portion                                                                              |       | 40,480                  |       | 40,471                      |       |
| Capital lease  obligations, current portion                                                                     |       | 7                       |       | 6                           |       |
| Current liabilities of  discontinued operations                                                                 |       | 4,270                   |       | 7,219                       |       |
| Total current  liabilities                                                                                      |       | 60,232                  |       | 58,209                      |       |
|                                                                                                            |       |                    |       |                        |       |
| Deferred revenue, net  of current portion                                                                       |       | 64,053                  |       | 84,275                      |       |
| Other long-term  liabilities                                                                                    |       | 2,754                   |       | 3                           |       |
| Total liabilities                                                                                               |       | 127,039                 |       | 142,487                     |       |
|                                                                                                            |       |                    |       |                        |       |
| Stockholders’ equity  (deficit):                                                                           |       |                    |       |                        |       |
| Common stock, $.001 par  value, 90,000 shares authorized 32,759 and 32,676 shares outstanding in 2009  and 2008 |       | 33                      |       | 33                          |       |
| Additional paid-in capital                                                                                      |       | 272,129                 |       | 269,830                     |       |
| Accumulated other comprehensive  income                                                                         |       | 599                     |       | 33                          |       |
| Accumulated deficit                                                                                             |       | (269,838                | )          | (274,916                    | )          |
| Total stockholders’  equity (deficit)                                                                      |       | 2,923                   |       | (5,020                      | )          |
| Total liabilities and  stockholders’ equity (deficit)                                                      |       | $                       | 129,962    |                        | $          | 137,467 |   |

 

The accompanying notes are an integral part of thesecondensed financial statements.

 

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**OSIRISTHERAPEUTICS, INC.**

**CondensedStatements of Operations**

**Unaudited**

**Amountsin thousands, except per share data**

 
| ** **                                                                             | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                             | ** ** | **2009**                                            | ** ** | **2008**                                          | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                                                                   |       |                                                |       |                                              |       |   |   |   |   |
| **Revenue from collaborative  research agreements, government contract and royalties** |       | $                                                   | 10,469     |                                              | $          | 2,530 |   | $ | 23,195 |   | $ | 2,892 |   |
|                                                                                   |       |                                                |       |                                              |       |   |   |   |   |
| Operating expenses:                                                                    |       |                                                |       |                                              |       |   |   |   |   |
| Research and  development                                                              |       | 18,540                                              |       | 19,048                                            |       | 37,107 |   | 35,742 |   |
| General and  administrative                                                            |       | 2,321                                               |       | 1,782                                             |       | 5,234 |   | 4,390 |   |
|                                                                                   |       | 20,861                                              |       | 20,830                                            |       | 42,341 |   | 40,132 |   |
|                                                                                   |       |                                                |       |                                              |       |   |   |   |   |
| Loss from operations                                                                   |       | (10,392                                             | )          | (18,300                                           | )          | (19,146 | ) | (37,240 | ) |
|                                                                                   |       |                                                |       |                                              |       |   |   |   |   |
| Interest income  (expense), net                                                        |       | 155                                                 |       | (172                                              | )          | 253 |   | (381 | ) |
|                                                                                   |       |                                                |       |                                              |       |   |   |   |   |
| Loss from continuing  operations, before income taxes                                  |       | (10,237                                             | )          | (18,472                                           | )          | (18,893 | ) | (37,621 | ) |
|                                                                                   |       |                                                |       |                                              |       |   |   |   |   |
| Income tax benefit                                                                     |       | 1,650                                               |       | —                                            |       | 2,398 |   | — |   |
| **Loss from continuing operations**                                                    |       | (8,587                                              | )          | (18,472                                           | )          | (16,495 | ) | (37,621 | ) |
|                                                                                   |       |                                                |       |                                              |       |   |   |   |   |
| **Discontinued operations:**                                                           |       |                                                |       |                                              |       |   |   |   |   |
| Income (loss) from  operations of discontinued operations,net of income taxes          |       | (142                                                | )          | 3,104                                             |       | 1,097 |   | 6,653 |   |
| Gain (loss) from sale  of discontinued operations, net ofincome taxes                  |       | (952                                                | )          | —                                            |       | 20,476 |   | — |   |
| **Income (loss) from discontinued  operations**                                        |       | (1,094                                              | )          | 3,104                                             |       | 21,573 |   | 6,653 |   |
|                                                                                   |       |                                                |       |                                              |       |   |   |   |   |
| **Net income (loss)**                                                                  |       | $                                                   | (9,681     | )                                                 | $          | (15,368 | ) | $ | 5,078 |   | $ | (30,968 | ) |
|                                                                                   |       |                                                |       |                                              |       |   |   |   |   |
| **Basic and diluted income (loss)  per share**                                         |       |                                                |       |                                              |       |   |   |   |   |
| Loss from continuing  operations                                                       |       | $                                                   | (0.26      | )                                                 | $          | (0.58 | ) | $ | (0.50 | ) | $ | (1.19 | ) |
| Income (loss) from  discontinued operations                                            |       | (0.03                                               | )          | 0.10                                              |       | 0.66 |   | 0.21 |   |
| Basic and diluted  earnings (loss) per share                                           |       | $                                                   | (0.30      | )                                                 | $          | (0.48 | ) | $ | 0.16 |   | $ | (0.98 | ) |
|                                                                                   |       |                                                |       |                                              |       |   |   |   |   |
| Weighted Average Common  Shares (basic)                                                |       | 32,737                                              |       | 31,769                                            |       | 32,715 |   | 31,754 |   |

 

The accompanying notes are an integral part of thesecondensed financial statements.

 

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**OSIRISTHERAPEUTICS, INC.**

**CondensedStatement of Stockholders’ Equity (Deficit)**

**For thesix months ended June 30, 2009**

**Unaudited**

**Amountsin thousands, except for share and per share data**

 
| ** **                                                                      | ** ** | ** **            | ** ** | ** **              | ** ** | ** **               | ** ** | **Accumulated** | ** ** | ** **                    | ** ** | ** **                | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|--------------------------|------------|-----------------|------------|-------------------------------|------------|---------------------------|------------|
| ** **                                                                      | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** ** | **Other  Comprehensive** | ** ** | **Accumulated** | ** ** | **Total  Stockholders’** | ** ** |
| ** **                                                                      | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital**              | ** ** | **Income**      | ** ** | **Deficit**                   | ** ** | **Equity (Deficit)** | ** ** |
| **Balance  at January 1, 2009**                                            |       | 32,675,920            |       | $                       | 33         |                     | $          | 269,830         |       | $                             | 33         |                      | $          | (274,916 | ) | $ | (5,020 | ) |
|                                                                            |       |                  |       |                    |       |                     |       |            |       |                          |       |                      |       |
| Exercise of options to  purchase common stock ($0.40 - $13.33 per share)   |       | 62,012                |       | —                  |       | 430                      |       | —          |       | —                        |       | 430                       |       |
|                                                                            |       |                  |       |                    |       |                     |       |            |       |                          |       |                      |       |
| Issuance of common  stock for services rendered by directors ($18.60 per share) |       | 21,500                |       | —                  |       | 400                      |       | —          |       | —                        |       | 400                       |       |
|                                                                            |       |                  |       |                    |       |                     |       |            |       |                          |       |                      |       |
| Share-based payment —  employee compensation                               |       | —                |       | —                  |       | 1,469                    |       | —          |       | —                        |       | 1,469                     |       |
|                                                                            |       |                  |       |                    |       |                     |       |            |       |                          |       |                      |       |
| **Comprehensive  Income:**                                                      |       |                  |       |                    |       |                     |       |            |       |                          |       |                      |       |
|                                                                            |       |                  |       |                    |       |                     |       |            |       |                          |       |                      |       |
| Net income for the  period                                                      |       | —                |       | —                  |       | —                   |       | —          |       | 5,078                         |       | 5,078                     |       |
|                                                                            |       |                  |       |                    |       |                     |       |            |       |                          |       |                      |       |
| Unrealized gain on  investments available for sale                              |       | —                |       | —                  |       | —                   |       | 566             |       | —                        |       | 566                       |       |
| **Total  Comprehensive Income**                                                 |       |                  |       |                    |       |                     |       |            |       |                          |       | 5,644                     |       |
|                                                                            |       |                  |       |                    |       |                     |       |            |       |                          |       |                      |       |
| **Balance  at June 30, 2009**                                              |       | 32,759,432            |       | $                       | 33         |                     | $          | 272,129         |       | $                             | 599        |                      | $          | (269,838 | ) | $ | 2,923 |   |

 

The accompanying notes are an integral part of thesecondensed financial statements.

 

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**OSIRISTHERAPEUTICS, INC.**

**CondensedStatements of Cash Flows**

**Unaudited**

**Amountsin thousands**

 
| ** **                                                                                                                    | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                                    | ** ** | **2009**                                          | ** ** | **2008** | ** ** |
|                                                                                                                          |       |                                              |       |   |   |
| **Cash  flows from operating activities:**                                                                                    |       |                                              |       |   |   |
| **Continuing  Operations:**                                                                                                   |       |                                              |       |   |   |
| Loss from continuing  operations                                                                                              |       | $                                                 | (16,495    | ) | $ | (37,621 | ) |
| **Adjustments  to reconcile loss from continuing operations to net cash used in continuing  operations:**                     |       |                                              |       |   |   |
| Depreciation and  amortization                                                                                                |       | 305                                               |       | 940 |   |
| Non cash share-based  payments                                                                                                |       | 1,771                                             |       | 887 |   |
| Non cash interest  expense                                                                                                    |       | —                                            |       | 130 |   |
| **Changes  in operating assets and liabilities:**                                                                             |       |                                              |       |   |   |
| Accounts receivable                                                                                                           |       | 892                                               |       | (995 | ) |
| Prepaid expenses and  other current assets                                                                                    |       | (2,083                                            | )          | (513 | ) |
| Other assets                                                                                                                  |       | 278                                               |       | 560 |   |
| Accounts payable and  accrued expenses                                                                                        |       | 4,220                                             |       | 9,736 |   |
| Deferred revenue                                                                                                              |       | (20,213                                           | )          | — |   |
| Long-term interest  payable and other liabilities                                                                             |       | —                                            |       | 9 |   |
| Net cash used in  continuing operations                                                                                       |       | (31,325                                           | )          | (26,867 | ) |
| **Discontinued  Operations:**                                                                                                 |       |                                              |       |   |   |
| Income from  discontinued operations                                                                                          |       | 21,573                                            |       | 6,653 |   |
| **Adjustments  to reconcile income from discontinued operations to net cash (used in)  provided by discontinued operations:** |       |                                              |       |   |   |
| Non cash impact of the  sale of discontinued operations                                                                       |       | (26,623                                           | )          | — |   |
| Depreciation and  amortization                                                                                                |       | 210                                               |       | 149 |   |
| Provision for bad debts                                                                                                       |       | 45                                                |       | — |   |
| Non cash share-based  payments                                                                                                |       | 98                                                |       | 78 |   |
| **Changes  in operating assets and liabilities:**                                                                             |       |                                              |       |   |   |
| Accounts receivable                                                                                                           |       | 519                                               |       | (1,684 | ) |
| Inventory and other  current assets                                                                                           |       | 1,707                                             |       | (546 | ) |
| Accounts payable and  accrued expenses                                                                                        |       | (669                                              | )          | 1,422 |   |
| Net cash (used in)  provided by discontinued operations                                                                       |       | (1,802                                            | )          | 6,072 |   |
| Net cash used in  operating activities                                                                                        |       | (33,127                                           | )          | (20,795 | ) |
|                                                                                                                          |       |                                              |       |   |   |
| **Cash  flows from investing activities:**                                                                                    |       |                                              |       |   |   |
| Purchases of property  and equipment                                                                                          |       | (181                                              | )          | (3,676 | ) |
| Proceeds from the sale  of property and equipment                                                                             |       | 17                                                |       | — |   |
| Proceeds from sale of  discontinued operations, net of transaction costs                                                      |       | 9,853                                             |       | — |   |
| Proceeds from sale of  investments available for sale                                                                         |       | 23,770                                            |       | 12,353 |   |
| Net cash provided by  investing activities                                                                                    |       | 33,459                                            |       | 8,677 |   |
|                                                                                                                          |       |                                              |       |   |   |
| **Cash  flows from financing activities:**                                                                                    |       |                                              |       |   |   |
| Principal payments on  capital lease obligations and notes payable                                                            |       | (4                                                | )          | (2,238 | ) |
| Restricted cash                                                                                                               |       | (536                                              | )          | — |   |
| Proceeds from  convertible and short-term notes payable                                                                       |       | —                                            |       | 16,000 |   |
| Proceeds from issuance  of common stock                                                                                       |       | 430                                               |       | 5 |   |
| Net cash (used in)  provided by financing activities                                                                          |       | (110                                              | )          | 13,767 |   |
|                                                                                                                          |       |                                              |       |   |   |
| Net increase in cash                                                                                                          |       | 222                                               |       | 1,649 |   |
| Cash at beginning of  period                                                                                                  |       | 940                                               |       | 704 |   |
|                                                                                                                          |       |                                              |       |   |   |
| **Cash at  end of period:**                                                                                                   |       | $                                                 | 1,162      |   | $ | 2,353 |   |

 

The accompanying notes are an integral part of thesecondensed financial statements.

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTESTO UNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND SIX MONTHS ENDED JUNE 30, 2009 AND 2008**

 

**1.**      **Nature of Business**

 

Osiris Therapeutics, Inc. (“we,” “our,” or the “Company”)is a Delaware corporation headquartered in Columbia, Maryland. We beganoperations on December 23, 1992. We are a stem cell therapeutic companyfocused on developing and marketing products to treat medical conditions in theinflammatory, orthopedic, and cardiovascular areas. Our biologic drugcandidates utilize adult human mesenchymal stem cells, or MSCs, which canselectively differentiate, based on the tissue environment, into various tissuelineages, such as muscle, bone, cartilage, marrow stroma, tendon or fat. Inaddition, MSCs have anti-inflammatory properties and can prevent fibrosis orscarring, which gives MSCs the potential to treat a wide variety of medicalconditions. Our operations consist primarily of research, development andclinical activities to bring our biologic drug candidates to the marketplace.We have several research collaboration agreements and a government contract foradditional product development.

 

**2.**      **Significant Accounting Policies and Recent AccountingPronouncements**

 

***Unaudited InterimFinancial Statements***

 

The accompanying unaudited condensed financialstatements have been prepared in accordance with accounting principlesgenerally accepted in the United States for interim financial information andwith the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.Accordingly, they do not include all of the information and footnotes requiredby accounting principles generally accepted in the United States of America forcomplete financial statements. In the opinion of management, these statementsinclude all adjustments (consisting of normal recurring adjustments) considerednecessary to present a fair statement of our results of operations, financialposition and cash flows. Operating results for any interim period are notnecessarily indicative of the results that may be expected for the full year.This Quarterly Report on Form 10-Q should be read in conjunction with ourfinancial statements and footnotes included in our Annual Report on Form 10-Kfor the fiscal year ended December 31, 2008.

 

***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 recognitionassociated with our collaborative agreements, deferred tax assets, andshare-based compensation.

 

***Revenue Recognition***

 

We generate revenues from collaborative agreements,research licenses, and a government contract. Our revenue recognition policiesare in accordance with the Securities and Exchange Commission’s (“SEC”) StaffAccounting Bulletin No. 101, *“Revenue Recognition in Financial Statements*,”as amended by SEC Staff Accounting Bulletin No. 104, *“Revenue Recognition*.”

 

Revenues from collaboration agreements are evaluatedunder Emerging Issues Task Force (“EITF”) Issue No. 07-01, *“Accounting forCollaboration Agreements*.” Management evaluates revenues fromagreements that have multiple elements to determine whether the components ofthe arrangement represent separate units of accounting as defined in EITF IssueNo. 00-21, *“Revenue Arrangements with Multiple Deliverables.”* To recognize adelivered item in a multiple element arrangement, EITF Issue No. 00-21requires that the delivered items have value to the customer on a stand alonebasis, that there is objective and reliable evidence of fair value of theundelivered items and that delivery or performance is probable and within ourcontrol for any delivered items that have a right of return. The determinationof whether multiple elements of a collaboration agreement meet the criteria forseparate units of accounting requires us to exercise our judgment.

 

Revenues from research licenses and governmentcontracts are recognized as earned upon either the incurring of reimbursableexpenses directly related to the particular research plan or the completion ofcertain development milestones as defined within the terms of the agreement.Payments received in advance of research performed are designated as deferredrevenue. Non-refundable upfront license fees and certain other related fees arerecognized on a straight-line basis over the development periods of thecontract deliverables. Fees associated with substantive at risk performancebased milestones are recognized as revenue upon their completion, as defined inthe respective agreements. Incidental assignment of technology rights isrecognized as revenue as it is earned and received.

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTES TOUNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND SIX MONTHS ENDED JUNE 30, 2009 AND 2008**

 

In October 2008, we entered into a CollaborationAgreement with Genzyme Corporation (“Genzyme”) for the development andcommercialization of our biologic drug candidates, Prochymal® and Chondrogen®. Under the agreement, Genzyme isobligated to pay to us non-contingent, non-refundable cash payments totaling$130.0 million, with $75.0 million paid during November 2008 and$55.0 million paid on July 1, 2009. The agreement provides Genzymewith certain rights to intellectual property developed by us, and requires thatwe continue to perform certain development work related to the subject biologicdrug candidates. Management has evaluated the deliverables related to thesepayments under EITF Issue No. 00-21 and concluded that the variousdeliverables represent a single unit of accounting. For this reason, we havedeferred the recognition of revenue related to the upfront payments, and areamortizing these amounts to revenue on a straight-line basis over the estimateddelivery period of the required development services, which extend through thefirst quarter of 2012. Accordingly, we recognized $10.0 million of revenuein each of the first two fiscal quarters of 2009 related to the amortization ofthe upfront payments. The balance of these payments has been recorded as$40.0 million of current deferred revenue and $63.3 million of longterm deferred revenue as of June 30, 2009. The agreement also provides forcontingent milestone payments of up to $1.25 billion in the aggregate, aswell as royalties to be paid to us on any sales by Genzyme. Consistent with ourrevenue recognition policies, we will recognize revenue from these contingentmilestone payments for which we have no continuing performance obligations uponachievement of the related milestone. For any milestone payments for which wehave a continuing performance obligation, the milestone payments will bedeferred and recognized as revenue over the term of the related performanceobligations.

 

In 2007, we partnered with Genzyme to developProchymal as a medical countermeasure to nuclear terrorism and otherradiological emergencies. In January 2008, we were awarded a contract fromthe United States Department of Defense (“DoD”) pursuant to which we areseeking in partnership with Genzyme to develop and stockpile Prochymal for therepair of gastrointestinal injury resulting from acute radiation exposure. Webegan recognizing revenue under this contract during the first quarter of 2008.Contract revenue is recognized as the related costs are incurred, in accordancewith the terms of the contract. We recognized $2.8 million in revenue fromthe DoD contract during the first half of 2009 and $0.8 million in revenueduring the first half of 2008.

 

In October 2007, we entered into a collaborativeagreement with the Juvenile Diabetes Research Foundation (“JDRF”) to conduct aPhase II clinical trial evaluating Prochymal as a treatment fortype 1 diabetes mellitus. This collaborative agreement provides for JDRFto provide up to $4.0 million of contingent milestone funding to supportthe development of Prochymal for the preservation of insulin production inpatients with newly diagnosed type 1 diabetes mellitus. The contingentmilestone payments under the agreement are amortized to revenue on a straightline basis over the duration of our obligations under the collaborativeagreement as they are received and earned. We received $2.0 million of thecontingent milestones during 2008 and expect to receive the remaining$2.0 million in 2009 and 2010. We began amortizing the $2.0 millionof funding received, resulting in $0.2 million of revenue during the firsthalf of 2009 under the agreement with JDRF. The remaining deferred revenueunder this agreement has been recorded as $0.5 million of current deferredrevenue and $0.7 million of long term deferred revenue as of June 30,2009.

 

We have also entered into several strategic agreementswith other pharmaceutical companies focusing on the development andcommercialization of our stem cell drug products. For example, in 2003, weentered into an agreement with JCR Pharmaceuticals Co., Ltd. (“JCR”)pertaining to our hematologic malignancies (GvHD) drugs for distribution inJapan.

 

We also earn royalties on the sale of humanmesenchymal stem cells sold for research purposes and recognize the revenue onthese sales as the sales are made. Our overall revenues include $153,000 and$134,000 of such royalty revenue during the first half of 2009 and 2008,respectively.

 

***Research andDevelopment Costs***

 

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

 

***Income (Loss) perCommon Share***

 

Basic income (loss) per common share is calculated bydividing net income (loss) by the weighted average number of common sharesoutstanding during the period.  Diluted loss per common share adjustsbasic loss per share for the potentially dilutive effects of common shareequivalents, using the treasury stock method.  All common shareequivalents resulting from assumed exercise of outstanding stock options andwarrants are excluded from the computation of diluted loss per share as theireffect is anti-dilutive.

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTES TOUNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND SIX MONTHS ENDED JUNE 30, 2009 AND 2008**

 

***InvestmentsAvailable for Sale and Other Comprehensive Income (Loss)***

 

Investments available for sale consist primarily ofmarketable securities with maturities varying between three months and oneyear. Investments available for sale are valued at their fair value, withunrealized gains and losses reported as a separate component of stockholders’equity in accumulated other comprehensive income. Gains or losses oninvestments available for sale are reclassified to earnings when realized.

 

Investments available for sale are evaluatedperiodically to determine whether a decline in their value is “other thantemporary.” The term “other than temporary” is not intended to indicate apermanent decline in value. Rather, it means that the prospects for near termrecovery of value are not necessarily favorable, or that there is a lack ofevidence to support fair values equal to, or greater than, the carrying valueof the security. Management reviews criteria such as the magnitude and durationof the decline, as well as the reasons for the decline, to predict whether theloss in value is other than temporary. If a decline in value is determined tobe other than temporary, the carrying value of the security is reduced and acorresponding charge to earnings is recognized.

 

***Share-BasedCompensation***

 

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement No. 123(R) *“Share -Based Payment*,”which is a revision of Statement No. 123, *“Accountingfor Stock Issued to Employees*.” Effective January 1, 2006, weadopted Statement No. 123(R) using the modified prospective methodunder which prior period amounts are not restated for comparative purposes.Under the modified prospective method, we recognized compensation cost for:

 

·                                          all share-based payments granted after January 1,2006 based upon the requirements of Statement No. 123(R); and

 

·                                          all unvested awards granted prior to January 1,2006 using the compensation cost calculated for pro forma disclosure purposesunder Statement No. 123.

 

Under Statement No. 123(R), we have recognizedall share-based payments to employees and non-employee directors in ourfinancial statements based on their grant date fair values, calculated usingthe Black-Scholes option pricing model. Compensation expense related toshare-based awards is recognized on a straight-line basis based on the value ofshare awards that are expected to vest during the requisite service period.Under Statement No. 123(R), share-based compensation expense is based onawards ultimately expected to vest and must be reduced for estimatedforfeitures.

 

A summary of the combined activity under both of ourstock-based compensation plans as of June 30, 2009 and changes during thesix months then ended is presented below.

 
| ** **                           | ** ** | **Number of  Shares** | ** ** | **Weighted Average  Exercise Price Per Share  at Grant Date** | ** ** | **Weighted Average  Remaining Term  (in Years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|--------------------------------------|------------|----------------------------|------------|---------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|-------------------------------------|------------|
|                                 |       |                       |       |                                                                                        |       |                                                            |       | **($000)**                          |       |
| Outstanding at  January 1, 2009 |       | 1,211,177                  |       | $                                                                                           | 10.66      |                                                            | 8.02       |                                | $          | 10,592 |   |
| Granted at market value              |       | 163,000                    |       | 17.87                                                                                       |       |                                                            |       |                                |       |
| Exercised                            |       | (62,012                    | )          | 6.93                                                                                        |       |                                                            |       | 458                                 |       |
| Forfeited or expired                 |       | (90,873                    | )          | 12.85                                                                                       |       |                                                            |       | 179                                 |       |
| Outstanding at  June 30, 2009   |       | 1,221,292                  |       | 11.65                                                                                       |       | 7.64                                                            |       | 4,896                               |       |
|                                 |       |                       |       |                                                                                        |       |                                                            |       |                                |       |
| Exercisable at  June 30, 2009   |       | 497,284                    |       | 6.58                                                                                        |       | 6.1                                                             |       | 4,160                               |       |
|                                      |            |                            |            |                                                                                             |            |                                                                 |            |                                     |            |  |  |

 

The weighted average grant date fair value of optionsgranted during the six months ended June 30, 2009 was $9.32 pershare.  We received a total of $430,000 in cash from the exercise ofoptions during the six months ended June 30, 2009.

 

Also during the three months ended March 31,2009, we granted 21,500 unrestricted shares of common stock to members of ourBoard of Directors under our Amended and Restated 2006 Omnibus Plan andrecognized $400,000 in share-based expense.  As of June 30, 2009,471,077 shares of common stock remain available for future share awards underour Amended and Restated 2006 Omnibus Plan.

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTES TOUNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND SIX MONTHS ENDED JUNE 30, 2009 AND 2008**

 

Share-based compensation expense (including directorcompensation) included in our statements of operations for the three and sixmonths ended June 30, 2009 and 2008 is allocable to our research anddevelopment activities, discontinued operations and general and administrativeactivities, as follows:

 

| ** **                  | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                  | ** ** | **2009**                                            | ** ** | **2008**                                          | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                  | ** ** | **($000)**                                          | ** ** | **($000)**                                        | ** ** | **($000)** | ** ** | **($000)** | ** ** |
| Research and  development   |       | $                                                   | 242        |                                              | $          | 101 |   | $ | 486 |   | $ | 330 |   |
| Discontinued operations     |       | (27                                                 | )          | 38                                                |       | 98 |   | 78 |   |
| General and  administrative |       | 511                                                 |       | 151                                               |       | 1,285 |   | 557 |   |
| Total                       |       | $                                                   | 726        |                                              | $          | 290 |   | $ | 1,869 |   | $ | 965 |   |

 

As of June 30, 2009, there was approximately $3.6million of total unrecognized share-based compensation cost related to optionsgranted under our plans, which will be recognized over a weighted-averageperiod of approximately 3 years, as the options vest.

 

***Supplemental CashFlow Information***

 

| ** **                                              | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                              | ** ** | **2009**                                      | ** ** | **2008** | ** ** |
| ** **                                              | ** ** | **($000)**                                    | ** ** | **($000)** | ** ** |
| **Supplemental  disclosure of cash flows information:** |       |                                          |       |   |   |
| Cash paid for interest                                  |       | $                                             | 4          |   | $ | 305 |   |
| Cash paid for income  taxes                             |       | —                                        |       | — |   |
|                                                         |            |                                               |            |  |  |  |  |

 

***Significant NewAccounting Pronouncements***

 

In April 2009, the FASB issued FASB StaffPosition No. FAS 107-1 and APB 28-1, “ *InterimDisclosures about Fair Value of Financial Instruments* ,” whichrequires disclosures about fair value of financial instruments for interimreporting periods of publicly traded companies as well as in annual financialstatements. This Staff Position is effective for interim reporting periodsending after June 15, 2009, with early adoption permitted for periodsending after March 15, 2009. We have adopted this Staff Position as of January 1,2009 and the required disclosures are included in this Quarterly Report on Form 10-Q.

 

In April 2009, the FASB issued FASB StaffPosition No. FAS 115-2 and FAS 124-2, “ *Recognitionand Presentation of Other-Than-Temporary Impairments* ,” which amendsthe other-than-temporary impairment guidance in U.S. GAAP for debt securitiesto make the guidance more operational and to improve the presentation anddisclosure of other-than-temporary impairments on debt and equity securities inthe financial statements. This Staff Position is effective for interim andannual reporting periods ending after June 15, 2009, with early adoptionpermitted for periods ending after March 15, 2009. The adoption of thisStaff Position did not have a material effect on our operations.

 

In April 2009, theFASB issued FSP No. FAS 157-4, *“Determining Fair Value When the Volume andLevel of Activity for the Asset or Liability Have Significantly Decreased andIdentifying Transactions That Are Not Orderly*,” to provideadditional guidance on estimating fair value when the volume and level ofactivity for an asset or liability have significantly decreased. The FSP alsoincludes guidance on identifying circumstances that indicate a transaction isnot orderly. The FSP emphasizes that, regardless of whether the volume andlevel of activity for an asset or liability have decreased significantly andregardless of which valuation technique was used, the objective of a fair valuemeasurement under FASB Statement 157, *“Fair Value Measurements,”*remains the same—to estimate the price that would be received to sell an assetor transfer a liability in an orderly transaction between market participantsat the measurement date under current market conditions.

 

The Company adopted FSPFAS 157-4 effective April 1, 2009. The adoption did not have a materialimpact on the Company’s financial condition and results of operations. Theadditional disclosures related to FSP FAS 157-4 are included in Note 7 — FairValue.

 

In May 2009, theFASB issued Statement 165, *“Subsequent Events,”*to incorporate the accounting and disclosure requirements for subsequent eventsinto U.S. generally accepted accounting principles. Statement 165 introducesnew terminology, defines a date through which management must evaluatesubsequent events, and lists the circumstances under which an entity mustrecognize and disclose events or transactions occurring after the balance-sheetdate. The Company adopted Statement 165 as of June 30, 2009, which was therequired effective date.

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTES TOUNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND SIX MONTHS ENDED JUNE 30, 2009 AND 2008**

 

**3.     CollaborationAgreements and Government Contract**

 

Below is a discussion of each of our materialcollaborative agreements and other contracts. This discussion is qualified inits entirety by the actual terms and provisions of the respective agreementsand contracts. The accounting policies related to each of these contracts,including material impact on our financial statements, is included above underthe “Revenue Recognition” section of Note 2, Significant AccountingPolicies and Recent Accounting Pronouncements.

 

***CollaborationAgreement with Genzyme Corporation***   On October 31, 2008, we entered intoa Collaboration Agreement with Genzyme for the development andcommercialization of Prochymal and Chondrogen. Under the terms of theagreement, we will retain the rights to commercialize Prochymal and Chondrogenin the United States and Canada, and Genzyme has been granted the exclusiveright and license to commercialize Prochymal and Chondrogen in all othercountries (the “Genzyme Territory”), except with respect to Prochymal for Graftvs. Host Disease (“GvHD”) in Japan, which has previously been licensed toanother pharmaceutical company. Genzyme has the right to “opt-out” of anyfurther Chondrogen development following receipt of the results of the plannedPhase II/III clinical trial for Chondrogen.  If Genzyme opts-out, allrights to Chondrogen will revert to us with no further obligations between thecompanies with regard to Chondrogen.  In the event that Genzyme does notopt-out but instead participates in the future development efforts forChondrogen, Genzyme would be entitled to retain rights and licenses to ourintellectual property related to Chondrogen in all countries outside the UnitedStates and Canada.

 

As partial consideration for the grant of these rights,the Collaboration Agreement provides for a non-contingent, non-refundable cashpayment to us of $130.0 million from Genzyme, with $75.0 million paidin November 2008 and $55.0 million paid on July 1, 2009. TheCollaboration Agreement also provides for contingent milestone payments of upto $1.25 billion in the aggregate, in addition to royalties on any salesby Genzyme, to be paid by Genzyme to us, as follows:

 

*Prochymal:*     As respectsProchymal, we are eligible to receive up to $500.0 million in developmentand regulatory milestone payments and up to $250.0 million in sales basedmilestone payments, as follows:

 

·                                          Total development milestones related to GvHD of up to$50.0 million, with $25.0 million payable upon marketing approvalfrom the United States Food & Drug Administration (“FDA”), and$25.0 million payable upon marketing approval from the European MedicinesAgency (“EMEA”).

 

·                                          Total development milestones of up to$180.0 million related to Crohn’s disease and Ulcerative Colitis,with $50.0 million payable upon achieving statistically significantendpoint(s) in a Phase III clinical trial for Crohn’s disease,$100.0 million payable upon marketing approval by the EMEA for Crohn’sdisease, $10.0 million payable upon achieving statistically significantendpoint(s) in a Phase II or Phase III clinical trialfor Ulcerative Colitis, and $20.0 million payable upon achievingmarketing approval for Ulcerative Colitis by the EMEA.

 

·                                          Total development milestones of up to$270.0 million related to the development of follow-on indications forProchymal, with $20.0 million payable upon each success in a Phase IIclinical trial for acute myocardial infarction, type 1 diabetes or otherfollow-on indications, as agreed to by the Company and Genzyme, and$40.0 million payable upon receipt of each marketing approval by the EMEAfor Prochymal for chronic obstructive pulmonary disease (“COPD”), acutemyocardial infarction, type 1 diabetes mellitus or other follow-onindications, as agreed to by the Company and Genzyme.

 

·                                          Total sales based milestones of up to$250.0 million for Prochymal, with $100.0 million payable when annualProchymal sales reach $500.0 million in the Genzyme Territory, and$150.0 million payable when annual Prochymal sales reach $1.0 billionin the Genzyme Territory.

 

*Chondrogen:*     Upon receipt ofthe results of the planned Phase II/III clinical trial of Chondrogen,Genzyme may elect to opt-out of any further Chondrogen development, at whichpoint all rights to Chondrogen will revert to us with no further obligationsbetween the companies with regard to Chondrogen. If Genzyme does not opt-out,we are eligible to receive up to $500.0 million in development, regulatoryand sales based milestone payments for Chondrogen, as follows:

 

·                                          Total development and regulatory milestones of up to$100.0 million, with $10.0 million payable if Genzyme does notopt-out, $10.0 million payable upon demonstration of disease modificationin the current clinical trial program, $40.0 million payable uponmarketing approval by either the FDA or EMEA for a pain reduction indication,and $40.0 million payable upon marketing approval by either the FDA orEMEA for a disease modification indication.

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTES TOUNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND SIX MONTHS ENDED JUNE 30, 2009 AND 2008**

 

·                                          Total sales milestones of up to $400.0 million,with $100.0 million payable when annual Chondrogen sales reach$500.0 million in the Genzyme Territory, $150.0 million payable whenannual Chondrogen sales reach $1.0 billion in the Genzyme territory, and $150.0 millionpayable when annual Chondrogen sales reach $2.0 billion in the GenzymeTerritory.

 

We will be solely responsible for ongoing clinicaltrial costs and future clinical trial costs with respect to both Prochymal andChondrogen through Phase II clinical trials. We will share with Genzymeall costs of future Phase III and Phase IV clinical trials foragreed-upon indications (assuming in the case of Chondrogen that Genzyme doesnot opt-out), with us being responsible for 60% of such costs and Genzymeresponsible for 40% of such costs.

 

Assuming successful development and marketing approval(and assuming in the case of Chondrogen that Genzyme does not opt-out) , wewill be entitled to receive escalating royalties on sales of Prochymal andChondrogen within the Genzyme Territory.

 

***Genzyme Partnershipand the United States Department of Defense Contract.***     In 2007, wepartnered with Genzyme to develop Prochymal as a medical countermeasure tonuclear terrorism and other radiological emergencies. In January 2008, wewere awarded a contract from the DoD pursuant to which we, in partnership withGenzyme, are seeking to develop and stockpile Prochymal for the repair ofgastrointestinal injury resulting from acute radiation exposure. Under theterms of the contract, the DoD will provide funding to us for the developmentof Prochymal for acute radiation syndrome (“ARS”). If we are successful inobtaining FDA approval for ARS, the contract provides for the purchase by theDoD, at its option, of up to 20,000 doses of Prochymal, at $10,000 per dose, infour 5,000 dose increments. Under the terms of our partnership with Genzyme, wecontribute Prochymal and corresponding safety and efficacy data to the effortand Genzyme lends its vast product development and large-scalecommercialization expertise. The agreement provides for Genzyme to receive aroyalty of 15% on sales of Prochymal, limited to those sales made undercontract to U.S. or allied governmental agencies for emergency preparedness.

 

***Juvenile DiabetesResearch Foundation Agreement.***     In 2007, we entered into acollaborative agreement with the JDRF which provides funding to support thedevelopment of Prochymal as a treatment for the preservation of insulinproduction in patients with newly diagnosed type 1 diabetes mellitus. Thiscollaborative agreement provides for JDRF to provide up to $4.0 million ofcontingent milestone funding. We initiated a Phase II clinical trialevaluating Prochymal as a treatment for type 1 diabetes in the fourth quarterof 2007, and received $2.0 million of the contingent milestones during2008 and expect to receive the remaining $2.0 million of contingentmilestones by 2010. Consistent with our revenue recognition policies for suchcontingent milestones, upon its receipt we began amortizing the$2.0 million received during 2008 and will continue to amortize thatamount over the remaining term of our obligations under the agreement. Futuremilestone payments received will be similarly amortized over the term of ourobligations beginning upon their receipt.

 

***JCR PharmaceuticalsAgreement.***    In 2003, we entered into a strategic alliance with JCR.Under the JCR agreement, we have granted JCR the exclusive right in Japan touse our technology in conjunction with the treatment of hematologicmalignancies using hematopoietic stem cell transplants. The JCR agreemententitles us to a licensing fee and to royalties on any resulting revenue. Uponcommencement of the agreement, JCR purchased 545,454 shares of our Series BConvertible Preferred Stock for $3.0 million. These shares were convertedinto 136,363 shares of our common stock concurrent with our initial publicoffering in August 2006. JCR has also paid us a total of $4.0 millionin licensing fees under the agreement.

 

**4.**      **Discontinued Operations & Gain on Sale ofDiscontinued Operations**

 

On May 8, 2008, we entered into an Asset PurchaseAgreement to sell our Osteocel® business to NuVasive, Inc., a Delawarecorporation.  Osteocel is a product that we developed and that wemanufactured beginning in July 2005, for regenerating bone in orthopedicindications. The agreement provided for the sale to be effected at two closings—a technology assets closing, for the transfer of technology and certain otherbusiness assets, and a manufacturing assets closing, for the transfer ofmanufacturing assets and facilities.  On July 24, 2008, we held aSpecial Meeting of Stockholders at which our stockholders overwhelminglyapproved the sale of the Osteocel business.  The technology assets closingalso occurred on that date, at which time we received an initial payment of$35.0 million. In December 2008, we earned another $5.0 million inadditional purchase price through the achievement of a production milestone.The agreements with NuVasive were amended several times during 2008, allwithout altering the potential purchase price of up to $85.0 million.

 

In March 2009, we entered into further amendmentsto the Asset Purchase Agreement and the related Manufacturing Agreement, as aresult of which the manufacturing assets closing was accelerated and allperformance conditions to receipt by us of $30.0 million of contingentmilestone payments were removed.  As a result, those payments becamepayable at specified dates, without regard to other conditions., either in cashor in shares of NuVasive stock, at the option of NuVasive  A finalmilestone payment of $15.0 million remains conditioned on at least $35.0million in cumulative Osteocel sales by NuVasive.

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTES TOUNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND SIX MONTHS ENDED JUNE 30, 2009 AND 2008**

 

The Asset Purchase Agreement, as amended, provides forup to $85.0 million of total purchase price, as follows:

 
| **Payments**                                                                                                                                | ** ** | **Amount** | ** ** | **Payment  Date**            | ** **     |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------------------------|----------------|
| ** **                                                                                                                                  | ** ** | **($000)** | ** ** | ** **                   | ** **     |
| Initial cash payment                                                                                                                        |       | $          | 35,000     |                         | July 2008 |   |
| Cumulative sales to  NuVasive of 75,000 ccs of Osteocel, paid in cash                                                                       |       | 5,000      |       | Paid in January 2009    |           |
| Accelerated  Manufacturing Assets Closing, paid in cash                                                                                     |       | 5,000      |       | Paid March 2009         |           |
| Installment paid in  stock                                                                                                                  |       | 12,500     |       | Paid June 30, 2009      |           |
| Installment payable in  cash or stock                                                                                                       |       | 12,500     |       | Due September 30,  2009 |           |
| Contingent milestone  payment due upon NuVasive achieving at least $35.0 million in cumulative  sales of Osteocel, payable in cash or stock |       | 15,000     |       | Upon achievement             |           |
|                                                                                                                                        |       |       |       |                         |           |
| Total  possible purchase price                                                                                                              |       | $          | 85,000     |                         |           |   |

 

The $30.0 million of payments that became payable atspecified dates (March, June and September 2009, respectively) as aresult of the March 2009 amendments, net of direct expenses ofapproximately $0.2 million, were recorded as a component of the gain on thesale of discontinued operations in the first quarter of 2009.  The $12.5 millionpayment due June 30, 2009, was paid in shares of common stock issued byNuVasive.  We have since sold all ofthese shares of NuVasive common stock and received approximately $12.5 millionin the aggregate in cash. At June 30, 2009, this stock is shown as acomponent of Investments Available for Sale on our balance sheet. If and whenthe requisite events related to the final $15.0 million contingent milestoneoccur, we will recognize those milestone proceeds as a component of gain (loss)from the sale of discontinued operations. Title to the fixed assets to betransferred to NuVasive passed on April 9, 2009, and was recorded asassets of discontinued operations held for sale in the accompanying condensedbalance sheet.

 

Concurrent with the March 2009 amendments, weexecuted a Supply Agreement with AlloSource to facilitate the complete transferof the Osteocel business, whereby we would transfer to AlloSource our entireOsteocel work-in-process inventory at specified prices on the date of themanufacturing assets closing with NuVasive.  The aggregate purchase pricefor the Osteocel work-in-process inventory was approximately $3.7 million,payable by AlloSource in cash installments over the 90-days following theexecution of the Supply Agreement. The sale of the work-in-process inventory toAlloSource occurred on April 9, 2009. At June 30, 2009, we hadreceivables of $950,000 from AlloSource which were paid in July 2009.

 

As stipulated under the March 2009 amendments, weceased manufacturing Osteocel on March 28, 2009.    As aresult of this cessation of manufacturing, we committed to a workforcereduction of the approximately 80-employees involved in the Osteocelbusiness.  Employees directly affected by the workforce reduction receivednotification on March 30, 2009, and the workforce reduction wassubstantially completed in the second quarter of 2009.  All of theaffected employees received severance benefits, comprised principally ofseverance, benefits continuation costs and outplacement services.  Totalone-time termination benefits for the reduction in force totaled approximately$1.4 million, which was recorded as a component of the gain on the sale ofdiscontinued operations in the first quarter of 2009.

 

Also in connection with the March 2009 amendments,we relieved NuVasive of its obligation to assume the lease for our Columbia,Maryland facility.  As a result of the combination of our cessation ofOsteocel manufacturing and retaining the lease obligations for the Columbia,Maryland facility, we have conducted an analysis of our future minimum leasepayments for the facility in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 146, *“Accounting for Costs Associated with Exit or DisposalActivities,*” and recorded an impairment charge of approximately $3.2million related to our future minimum lease payments.  Additionally, werecorded an impairment of the leasehold improvements specifically related toOsteocel production of approximately $3.0 million.  Both of these impairmentswere recorded as components of the gain on the sale of discontinued operationsin the first quarter of 2009.

 

Also as a result of acceleration of the manufacturingassets closing, during the first quarter of 2009 we reversed approximately $2.5million of concessionary pricing reserves for future Osteocel production thathad been established under the original Manufacturing Agreement.

 

The fair value of the property that we transferred onthe date of the manufacturing assets closing in April 2009, including boththe manufacturing assets transferred to NuVasive and the inventory transferredto AlloSource, was approximately $5.1 million.

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTES TOUNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND SIX MONTHS ENDED JUNE 30, 2009 AND 2008**

 

As detailed above, we recognized a pre-tax gain ofapproximately $23.5 million on the sale of discontinued operations during thefirst quarter of 2009.  Net of taxes, the gain on the sale wasapproximately $21.4 million during the quarterly period ending March 31,2009. During the quarterly period ended June 30, 2009, we determined thatour effective tax rate was higher than estimated at the end of the firstquarter of 2009, resulting in a $950,000 reduction in the gain on the sale ofdiscontinued operations during the quarter then ended.

 

In connection with this transaction, we recognized again on the sale of discontinued operations of $30.4 million during the fiscalyear ended December 31, 2008, as detailed in our Annual Report on Form 10-Kfor the fiscal year ended December 31, 2008.

 

We eliminated the Osteocel asset disposal group fromour ongoing operations as a result of the disposal transaction and havepresented the group’s assets, liabilities, and the results of the group’soperations as a discontinued operation for all periods.

 

The net assets allocable to the Osteocel assetdisposal group included on our balance sheet at June 30, 2009 and December 31,2008 were as follows:

 

| ** **                                           | ** ** | **2009**   | ** ** | **2008**   | ** ** |
|------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                           | ** ** | **($000)** | ** ** | **($000)** | ** ** |
| Accounts receivable,  net                            |       | $          | 64         |       | $          | 1,516 |   |
| Inventory and other  current assets                  |       | —     |       | 1,707      |       |
|                                                 |       |       |       |       |       |
| Current assets of  discontinued operations           |       | 64         |       | 3,223      |       |
|                                                 |       |       |       |       |       |
| Property and equipment,  net                         |       | —     |       | 7,520      |       |
|                                                 |       |       |       |       |       |
| Liabilities of  discontinued operations              |       | (4,270     | )          | (7,219     | )          |
|                                                 |       |       |       |       |       |
| Net assets  (liabilities) of discontinued operations |       | $          | (4,206     | )          | $          | 3,524 |   |

 

Summarized operating results of the Osteocel assetdisposal group are as follows:

 

| ** **                                                                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                     | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                                     | ** ** | **2009**                         | ** ** | **2008**                       | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                                     | ** ** | **($000)**                       | ** ** | **($000)**                     | ** ** | **($000)** | ** ** | **($000)** | ** ** |
| Product sales                                                                  |       | $                                | 29         |                           | $          | 8,955 |   | $ | 6,296 |   | $ | 16,466 |   |
| Cost of goods sold                                                             |       | 128                              |       | 4,786                          |       | 4,915 |   | 8,567 |   |
| Gross profit (loss)                                                            |       | (99                              | )          | 4,169                          |       | 1,381 |   | 7,899 |   |
|                                                                           |       |                             |       |                           |       |   |   |   |   |
| Selling,  general & administrative expenses                           |       | —                           |       | 1,065                          |       | 124 |   | 1,246 |   |
| Income (loss) from  operations of discontinued operations, before income taxes |       | (99                              | )          | 3,104                          |       | 1,257 |   | 6,653 |   |
| Income taxes                                                                   |       | 43                               |       | —                         |       | 160 |   | — |   |
| Income (loss) from  operations of discontinued operations                      |       | $                                | (142       | )                              | $          | 3,104 |   | $ | 1,097 |   | $ | 6,653 |   |

 

**5.     Earnings(Loss) Per Common Share**

 

Basic earnings (loss) per common share is based on theweighted average number of shares of common stock outstanding during theperiod. Dilutive shares are computed using the treasury stock method andinclude the incremental effect of shares that would be issued upon the assumedexercise of stock options and warrants. All common share equivalents resultingfrom assumed exercise of outstanding stock options and warrants are excludedfrom the computation of diluted loss per share as their effect isanti-dilutive.    At June 30, 2009,dilutive common stock equivalents excluded from the calculation of basic lossfrom continuing operations per share were 497,284 common stock equivalentsrelated to in-the-money stock options and 160,458 common stock equivalentsrelated to our outstanding warrant.

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTES TOUNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND SIX MONTHS ENDED JUNE 30, 2009 AND 2008**

 

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

 

The tax benefit for the six months ended June 30,2009 reflects an effective tax rate for continuing operations of 12.7% comparedto a U.S. statutory tax rate of 35%.  The effective tax rate reflectsour estimated annual effective tax rate, which reflects our expectation that aportion of our income will be subject to the Federal alternative minimum tax in2009.  During the three and six months ended June 30, 2009, werecognized the following income tax expense (benefit):

 
| ** **                                            | ** ** | **Quarter  Ended**      | ** ** | **Six  Months Ended**   | ** ** |
|-------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                            | ** ** | **June 30,  2009** | ** ** | **June 30,  2009** | ** ** |
| ** **                                            | ** ** | **($000)**              | ** ** | **($000)**              | ** ** |
| Tax  benefit to continuing operations                 |       | $                       | (1,650     | )                       | $          | (2,398 | ) |
| Tax  expense of operations of discontinued operations | 43         |                    | 160        |                    |
| Tax  expense of sale of discontinued operations       |       | 950                     |       | 2,977                   |       |
|                                                  |       |                    |       |                    |       |
| Total  income tax expense (benefit)                   |       | $                       | (657       | )                       | $          | 739 |   |

 

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 losscarry-forwards of approximately $71 million and research and development andorphan drug tax credit carry-forwards of approximately $60 million.  Inthe event that we become profitable within the next several years, we have netdeferred tax assets of approximately $148.0 million that may be utilized priorto us having to recognize any income tax expense or make payments to the taxingauthorities.  However, utilization of our net operating loss and taxcredit carry-forwards in any one year may be limited under Internal RevenueCode Sections 382 and 383. In addition, even if certain of our net deferred taxassets are not subject to limitations, we may be subject to the Federalalternative minimum tax in future years.

 

**7.**     **Investments Availablefor Sale**

 

On June 30, 2009, NuVasive, Inc. paid us the$12.5 million milestone payment in free-trading shares of its common stock, asprovided for under the amended Asset Purchase Agreement.  The number of shares delivered to us wasdetermined based upon the average closing price of NuVasive’s common stock overa ten-day period, resulting in our recognizing an unrealized gain of $552,000at June 30, 2009, as a component of Other Comprehensive Income.  We began selling the NuVasive common stock onJune 30, 2009 and have since sold all the shares and have receivedapproximately $12.5 million in aggregate cash, which as been invested inaccordance with our Investment Policy.

 

Investments available for sale consisted of thefollowing as of June 30, 2009 and December 31, 2008:

** **
| ** **                                             | ** ** | **June 30,  2009********($000)** | ** ** | **December 31,  2008********($000)** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------------|------------|
| ** **                                             | ** ** | **Cost**                              | ** ** | **Fair  Value**                           | ** ** | **Cost** | ** ** | **Fair  Value** | ** ** |
| **Cash  equivalents:**                                 |       |                                  |       |                                      |       |   |   |   |   |
| Money market  funds & certificates of deposit |       | $                                     | 5,775      |                                      | $          | 5,797 |   | $ | 33,436 |   | $ | 33,436 |   |
| Commercial paper                                       |       | 7,195                                 |       | 7,195                                     |       | 11,187 |   | 11,195 |   |
|                                                   |       | 12,970                                |       | 12,992                                    |       | 44,623 |   | 44,631 |   |
| **Short  term investments:**                           |       |                                  |       |                                      |       |   |   |   |   |
| Auction rate  certificates                             |       | —                                |       | —                                    |       | 3,100 |   | 3,100 |   |
| Common stock                                           |       | 11,857                                |       | 12,409                                    |       | — |   | — |   |
| Corporate notes and  bonds                             |       | 5,238                                 |       | 5,186                                     |       | 1,921 |   | 1,921 |   |
| US government agencies                                 |       | 20,136                                |       | 20,213                                    |       | 11,621 |   | 11,646 |   |
|                                                   |       | 37,231                                |       | 37,808                                    |       | 16,642 |   | 16,667 |   |
|                                                   |       |                                  |       |                                      |       |   |   |   |   |
| **Total  investments available for sale**              | ** ** | **$**                                 | 50,201     | ** **                                | **$**      | 50,800 | ** ** | **$** | **61,265** | ** ** | **$** | **61,298** | ** ** |

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTES TOUNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND SIX MONTHS ENDED JUNE 30, 2009 AND 2008**

 

The following table summarizes maturities of ourinvestments available for sale as of June 30, 2009 and December 31,2008:

 
| ** **                                | ** ** | **June 30,  2009********($000)** | ** ** | **December 31,  2008********($000)** | ** ** |
|-------------------------------------------|------------|---------------------------------------|------------|-------------------------------------------|------------|
| ** **                                | ** ** | **Cost**                              | ** ** | **Fair Value**                       | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| **Maturities:**                           |       |                                  |       |                                      |       |   |   |   |   |
| Within 3-months                           |       | $                                     | 18,031     |                                      | $          | 18,602 |   | $ | 46,826 |   | $ | 46,832 |   |
| Between  3—12 months            |       | 24,308                                |       | 24,299                                    |       | 10,208 |   | 10,190 |   |
| Between 1—2 years               |       | 7,862                                 |       | 7,899                                     |       | 4,231 |   | 4,276 |   |
| **Total  investments available for sale** | ** ** | **$**                                 | 50,201     | ** **                                | **$**      | 50,800 | ** ** | **$** | **61,265** | ** ** | **$** | **61,298** | ** ** |

 

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

 

Fair value is defined as the price at which an assetcould be exchanged or a liability transferred (an exit price) in an orderlytransaction between knowledgeable, willing parties in the principal or mostadvantageous market for the asset or liability. Where available, fair value isbased on observable market prices or parameters or derived from such prices orparameters. Where observable prices or inputs are not available, valuationmodels are applied.

 

Financial assets recorded at fair value in theaccompanying financial statements are categorized based upon the level ofjudgment associated with the inputs used to measure their fair value.Hierarchical levels, defined by SFAS No. 157 *“Fair Value Measurements”* and directlyrelated to the amount of subjectivity associated with the inputs to fairvaluation of these assets and liabilities, are as follows:

 
| *Level 1* | Inputs are unadjusted, quoted prices in active  markets for identical assets at the reporting date. Active markets are those  in which transactions for the asset or liability occur in sufficient  frequency and volume to provide pricing information on an ongoing basis.                                                                                                                                                  |
|----------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| * *       | * *                                                                                                                                                                                                                                                                                                                                                                                                                      |
|           | The fair valued assets we hold that are generally  included in this category are money market securities where fair value is  based on publicly quoted prices.                                                                                                                                                                                                                                                                |
|           |                                                                                                                                                                                                                                                                                                                                                                                                                          |
| *Level 2* | Inputs are other than quoted prices included in  Level 1, which are either directly or indirectly observable for the  asset or liability through correlation with market data at the reporting date  and for the duration of the instrument’s anticipated life.                                                                                                                                                     |
| * *       | * *                                                                                                                                                                                                                                                                                                                                                                                                                      |
|           | The fair valued assets we hold that are generally  included in this category are investment grade short-term securities.                                                                                                                                                                                                                                                                                                      |
|           |                                                                                                                                                                                                                                                                                                                                                                                                                          |
| *Level 3* | Unobservable inputs that are supported by little or  no market activity and that are significant to the fair value of the assets  or liabilities and which reflect management’s best estimate of what market  participants would use in pricing the asset or liability at the reporting  date. Consideration is given to the risk inherent in the valuation technique  and the risk inherent in the inputs to the model. |
| * *       | * *                                                                                                                                                                                                                                                                                                                                                                                                                      |
|           | We carry no investments classified as Level 3                                                                                                                                                                                                                                                                                                                                                                            |

 

Assets and liabilities measured at fair value on arecurring basis are summarized below:

 
| ** **                             | ** ** | **June 30,  2009  ($000)** | ** ** | **December 31,  2008  ($000)** | ** ** |
|----------------------------------------|------------|---------------------------------|------------|-------------------------------------|------------|
| ** **                             | ** ** | **Level 1**                     | ** ** | **Level 2**                         | ** ** | **Total** | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Total** | ** ** |
| Assets:                                |       |                            |       |                                |       |   |   |   |   |   |   |   |   |
| Overnight securities  included in Cash |       | $                               | —     |                                | $          | — |   | $ | — |   | $ | 929 |   | $ | — |   | $ | 929 |   |
| Investments available  for sale        |       | 50,800                          |       | —                              |       | 50,800 |   | 61,298 |   | — |   | 61,298 |   |
|                                   |       |                            |       |                                |       |   |   |   |   |   |   |   |   |
| Total assets                           |       | $                               | 50,800     |                                | $          | — |   | $ | 50,800 |   | $ | 62,227 |   | $ | — |   | $ | 62,227 |   |

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTES TOUNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND SIX MONTHS ENDED JUNE 30, 2009 AND 2008**

 

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

 

We have evaluated our June 30, 2009 financialstatements for subsequent events through the date the financial statements wereavailable to be issued, which was July 31, 2009.  Other than the receipt of the remainder ofthe non-contingent, non-refundable upfront payment of $55.0 million in cashfrom Genzyme Corporation on July 1, 2009, as discussed in Note 1 to thesecondensed financial statements, we are not aware of any other subsequent eventswhich would require recognition or disclosure in the financial statements.

 

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**Item2.**         **Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

 

**Forward-LookingInformation**

 

This Quarterly Report includes “forward-lookingstatements” within the meaning of Section 21E of the Securities ExchangeAct of 1934, or the Exchange Act. Forward-looking statements include statementsconcerning our plans, objectives, goals, strategies, future events, futurerevenues or performance, capital expenditures, compensation arrangements,financing needs, plans or intentions relating to acquisitions, business trendsand other information that is not historical information and, in particular,may appear under the headings “Risk Factors” in our Annual Report on Form 10-Kunder Part I—Item 1A, “Part II—Item 7.  Management’s Discussionand Analysis of Financial Condition and Results of Operations” and the otherdocuments we file with the United States Securities and Exchange Commission, orSEC, including, among others, this and other of our quarterly reports on Form 10-Qand any amendments thereto.  When used in this Quarterly Report, the words*estimates, expects, anticipates, projects,plans, intends, believes, forecasts* and variations of such words orsimilar expressions are intended to identify forward-looking statements. Examples of forward-looking statements include, but are not limited to,statements regarding the following: our product development efforts; ourclinical trials and anticipated regulatory requirements; the success of ourproduct candidates in development; status of the regulatory process for ourbiologic drug candidates; implementation of our corporate strategy; ourfinancial performance; our product research and development activities andprojected expenditures, including our anticipated timeline and clinicalstrategy for mesenchymal stem cells and biologic drug candidates (including theanticipated timeline and clinical strategy for Prochymal and Chondrogen); ourcash needs; patents and proprietary rights; ability of our potential productsto treat disease; our plans for sales and marketing; our plans regardingfacilities; types of regulatory frameworks we expect will be applicable to ourpotential products; results of our scientific research; our ability to benefitfrom the sale of our Osteocel business and to earn milestone payments; and ourability to benefit from our collaborations with Genzyme and other collaborationsand to earn milestone payments and perform under and derive royalty and otherrevenue thereunder.  Risks and uncertainties related to the sale of ourOsteocel assets and related transactions include typical business transactionalrisks, the risk of changing relationships with customers, suppliers oremployees; and the risk that we may not be able to fully perform or generate orreceive contingent milestone payments. Risks and uncertainties related to ourCollaboration Agreement with Genzyme for the development and commercializationof Prochymal and Chondrogen include, among others:  typical businesstransactional risks; risks related to product development and clinical trialdesign, performance and completion; uncertainty of the success of Prochymal andChondrogen in clinical trials and their ability to treat disease; Genzyme’searly termination and opt-out rights; the ability of Osiris and Genzyme tosuccessfully navigate regulatory requirements and to manufacture andcommercialize products; and the uncertainty as to our ability, and the abilityand willingness of Genzyme to successfully perform our respective obligationsunder the collaborative arrangement, and our ability to earn milestone androyalty payments thereunder.  All forward-looking statements, including,without limitation, management’s examination of historical operating trends,are based upon our current expectations and various assumptions.  Ourexpectations, beliefs and projections are expressed in good faith and webelieve there is a reasonable basis for them. However, there can be noassurance that management’s expectations, beliefs or projections will result orbe achieved, and you should not unduly rely on forward-looking statements.

 

You should read the following management’s discussionand analysis of our financial condition and results of operations inconjunction with our audited Financial Statements and related notes thereto andother disclosures included as part of our Annual Report on Form 10-K forthe year ended December 31, 2008, and our unaudited Condensed FinancialStatements for the three and six months ended June 30, 2009 and otherdisclosures included in this Quarterly Report on Form 10-Q.  OurCondensed Financial Statements have been prepared in accordance with U.S. generallyaccepted accounting principles and are presented in U.S. dollars.

 

There are a number of risks and uncertainties thatcould cause our actual results to differ materially from the forward-lookingstatements contained in this report. Some of the important factors that couldcause our actual results to differ materially from the forward-lookingstatements we make in this report are set forth in our Annual Report on Form 10-Kfor the fiscal year ended December 31, 2008 under Part I — Item 1A “RiskFactors.” There may be other factors that may cause our actual results todiffer materially from the forward-looking statements.

 

All forward-looking statements attributable to us orpersons acting on our behalf apply only as of the date of this Quarterly Reportand are expressly qualified in their entirety by the cautionary statementsincluded herein.  We undertake no obligation to publicly update or reviseany forward-looking statements to reflect subsequent events or circumstancesand do not intend to do so.

 

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

 

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**Introductionand Overview**

 

The following is a discussion and analysis of ourfinancial condition and results of operations for the three and six monthperiods ended June 30, 2009 and 2008.  You should read thisdiscussion together with the accompanying unaudited condensed financialstatements and notes and with our Annual Report on Form 10-K for the yearended December 31, 2008.  Historical results and any discussion ofprospective results may not indicate our future performance.  See “ForwardLooking Information.”

 

We are a stem cell therapeutic company headquarteredin Columbia, Maryland, focused on developing and marketing products to treatmedical conditions in the inflammatory, orthopedic, and cardiovascularareas.  We were incorporated in Delaware in April 2002.  Ourpredecessor company was organized in 1992.  Our lead biologic drugcandidate, Prochymal®, is being evaluated in Phase III clinical trials forfour indications, including acute and steroid refractory GvHD, Crohn’s diseaseand acute radiation syndrome, and is the only stem cell therapeutic currentlygranted both Orphan Drug and Fast Track status by the U.S. Food and DrugAdministration (“FDA”).  Prochymal is also being developed for the repairof heart tissue following a heart attack, the protection of pancreatic isletcells in patients with type 1 diabetes mellitus, and the treatment ofpatients with COPD.  Our pipeline of internally developed biologic drugcandidates under evaluation also includes Chondrogen for osteoarthritis in theknee.

 

As discussed more fully in Note 3 to the accompanyingCondensed Financial Statements, on October 31, 2008, we entered into aCollaboration Agreement with Genzyme Corporation (“Genzyme”) for the globaldevelopment and commercialization of our biologic drug candidates, Prochymaland Chondrogen.  Under the terms of the Collaboration Agreement, we retainthe right to commercialize Prochymal and Chondrogen in the United States andCanada, and Genzyme is granted the exclusive right and license to commercializethe products in all other countries (except with respect to GvHD in Japan whereProchymal has previously been licensed to another pharmaceutical company). In July 2007,we separately partnered with Genzyme for the development of effectivecountermeasures to nuclear terrorism and other radiological emergencies. In January 2008, we were awarded a contract from the U.S. Department ofDefense (“DoD”), pursuant to which we are seeking, in partnership with Genzyme,to develop and stockpile Prochymal for the repair of gastrointestinal injuryresulting from acute radiation exposure.   Additionally, we havepartnered with the Juvenile Diabetes Research Foundation (“JDRF”) for thedevelopment of Prochymal as a treatment for the preservation of insulinproduction in patients with newly diagnosed type 1 diabetes mellitus.

 

In April 2008, we committed to a plan to sell ourassets related to Osteocel, a product that we produced and marketed beginningin July 2005, for regenerating bone in orthopedic indications.  On May 8,2008, we entered into an Asset Purchase Agreement to sell those assets,including our entire product line relating to the processing, manufacturing,marketing and selling of Osteocel and Osteocel XO, to NuVasive, Inc. The first of two scheduled closings in connection with this transaction, the “technologyassets closing”, occurred on July 24, 2008, at which time we received aninitial payment of $35.0 million.  Concurrent with the technology assetsclosing, we entered into a Manufacturing Agreement with NuVasive, under whichwe continued to manufacture Osteocel until March 28, 2009 when allmanufacturing activities ceased. In March 2009, we entered into amendmentsto the Asset Purchase Agreement and amendments to the related ManufacturingAgreement that stipulated that all of our responsibilities would be consideredfulfilled upon consummation of the second and final closing, the “manufacturingassets closing.” The manufacturing assets closing occurred on April 9,2009.  Upon execution of the amendments, we received $5.0 million ofadditional purchase price in cash and on June 30, 2009, we received $12.5million in NuVasive’s common stock, and will receive an additional $12.5million in either cash or NuVasive stock on September 30, 2009.  Weare also entitled to receive a contingent milestone payment of $15.0 million incash or NuVasive stock if and when NuVasive achieves cumulative sales revenuefrom Osteocel of at least $35.0 million.  We presently expect to earn thiscontingent milestone before the end of the current fiscal year, although noassurance can be given that this will occur.

 

We are a fully integrated company, having developedcapabilities in research, development, manufacturing, marketing anddistribution of stem cell products. We have developed an extensive intellectualproperty portfolio to protect our technology in the United States and a numberof foreign countries, including 49 U.S. and 268 foreign patents owned orlicensed.  We believe that our biologic drug candidates have advantagesover other stem cell therapeutics in development for at least the followingreasons:

 

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

 

·                                          **Ability to Mass Produce.**   Through our proprietarymanufacturing methods, we can grow mesenchymal stem cells (“MSCs”) in acontrolled fashion to produce up to 10,000 treatments of our biologic drugcandidates from a single bone marrow donation. Our ability to produce a largequantity of treatments from one donation provides us with manufacturingefficiencies and product consistency that are essential to commercialization.

 

·                                          **Universal Compatibility.**   Many stem cell therapiesunder development can elicit a rejection response in the recipient andtherefore require donor-to-recipient matching or potentially harmfulimmunosuppression. This greatly reduces manufacturing efficiencies and createsa risk of mismatch which can result in an acute inflammatory response and,potentially, in death. Based on our clinical experience, we believe that ourbiologic drug candidates are not rejected by the patient’s immune system andso, 

 

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like type O negative blood, do not requiredonor-to-recipient matching. This universal compatibility allows us to producea standardized product available to all patients in almost any medical setting.

 

·                                          **Treatment on Demand.**   Our biologic drug candidatescan be stored frozen at end-user medical facilities until they are needed. Weanticipate that medical facilities will be able to prescribe and dispense theseproducts in much the same way as conventional drugs. In contrast, other stemcell technologies under development require weeks to prepare after a patient’sneed is identified. This is a key feature of our technology, as many patientsin the critical care setting require prompt treatment.

 

The following table summarizes key information aboutour biologic drug candidates.

 

| **Product/Candidate** | ** ** | **Indication**                                 | ** ** | **Status**                   |
|-----------------------|------------|------------------------------------------------|------------|------------------------------|
| **Prochymal**         |       | Steroid Refractory Acute GvHD                  |       | Phase III               |
|                  |       | First Line Treatment of Acute GvHD             |       | Phase III               |
|                  |       | Biologics Refractory Crohn’s Disease      |       | Phase III               |
|                  |       | Type I Diabetes Mellitus                  |       | Phase II                |
|                  |       | Acute Myocardial Infarction                    |       | Phase II                |
|                  |       | Chronic Obstructive Pulmonary Disease          |       | Phase II                |
|                  |       | Acute Radiation Syndrome                       |       | Phase III (Animal Rule) |
|                  |       |                                           |       |                         |
| **Chondrogen**        |       | Osteoarthritis & Cartilage Protection |       | Phase II                |

 

***Prochymal*** is our lead biologic drug candidate andis being evaluated in Phase III clinical trials for four indications, includingthe first line treatment of acute GvHD, steroid refractory acute GvHD,biologics refractory Crohn’s disease, and acute radiation syndrome, and is theonly stem cell therapeutic currently designated by the FDA as both an OrphanDrug and Fast Track product.

 

*Phase III ClinicalTrial—Steroid Refractory Acute GvHD*

 

GvHD is a life threatening immune system reaction thatcommonly affects the skin, gastrointestinal tract, and liver in patients whohave received a bone marrow transplant.   Our Phase IIItrial to evaluate Prochymal as a treatment for steroid refractory GvHD is arandomized, double blind, placebo controlled study. The trial has completedenrollment with a total of 244 patients. The trial is investigating patientresponse to eight infusions of Prochymal administered twice per week for fourconsecutive weeks. The primary trial endpoint is complete resolution of GvHDfor at least 28 day duration. Each patient is also monitored for safetyfor up to 180 days after their first treatment with Prochymal. Six-monthsurvival is a key secondary endpoint. This trial is being conducted in 72centers in the United States, Canada, Europe and Australia.

 

*Phase III Clinical Trial—FirstLine Treatment of Acute GvHD.*

 

In April 2008, we completed enrollment in aPhase III trial evaluating Prochymal as an add-on therapy to steroids forthe first-line treatment of acute GvHD.   This randomized,double blind, placebo controlled study has completed enrollment with a total of192 patients. The trial is investigating patient response to a total of sixinfusions during the first four weeks of the study. The primary trial endpointis the proportion of patients who achieve a complete response at day 28 and whosurvive to day 90 without the addition of a second line therapy. The study isbeing conducted at approximately 50 centers in the United States andCanada.

 

*Phase III ClinicalTrial—Biologics Refractory Crohn’s Disease.*

 

Based on our clinical observations of the effects ofProchymal on the gastrointestinal symptoms of patients with GvHD, we aredeveloping Prochymal for the treatment of Crohn’s disease. Crohn’s disease is achronic condition that results in inflammation of the gastrointestinal tract.We completed patient enrollment in a Phase II trial for Crohn’s diseaseunder an Investigational New Drug (“IND”) exemption for Crohn’s disease. Wereceived Fast Track designation from the FDA for the development of Prochymalfor patients with moderate to severe Crohn’s disease that is refractory tostandard therapies, including biologics.

 

On March 27, 2009, we announced that we hadelected to end enrollment at 207 patients in our Phase III clinical trialevaluating Prochymal for the treatment of moderate to severe Crohn’s diseasethat is refractory to biological therapy and immunosuppressives.  We endedenrollment because we believe that there was a design flaw in the trialresulting in significantly higher than expected placebo response rates. The decision was made after the trial’s final scheduled interim analysis showedthat one of the two Prochymal dose arms had crossed a futility boundary. The dose arm was unlikely to achieve the primary endpoint of remission becauseof the high placebo response rate.  This analysis continued to show noserious safety concerns with the therapy and safety was not a factor in the decisionto stop enrollment.   After careful discussion with the United StatesFood and Drug Administration, we elected to discontinue enrollment rather thanattempt to re-power the trial.  We will keep the trial blinded and expectdata for use in designing future trials in Crohn’s disease and to bolsterProchymal’s overall safety database.    The Prochymal Crohn’s programconsisted of two separate but related trials.  The first trial, describedabove, evaluates patients’ initial response to two dose levels of Prochymal ascompared to placebo.  This trial was originally designed to enroll 270subjects.  

 

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Patients responding to the initial therapy were theneligible to participate in a second, longer-term trial evaluating Prochymal asa maintenance therapy.  Because the current standard for determiningresponse of Crohn’s patients is largely subjective, there may have beenresponse bias in order to meet the eligibility requirements for continuation oftherapy in the longer-term maintenance trial.  Accordingly, enrollment inthe second trial has also ended.

 

*Phase II Clinical Trial—AcuteMyocardial Infarction.*

 

Prochymal is also being evaluated for the repair ofheart muscle in patients who have suffered a heart attack.  In February 2009we reported positive two-year data on the Phase I clinical trial forProchymal to evaluate its safety and efficacy to restore heart function inpatients experiencing a first time myocardial infarction (MI). Based on thesepositive findings, we have received approval from the FDA to initiate aPhase II trial.   We recently initiated this Phase II trial, which isexpected to include approximately 220 patients to be treated at approximately40 sites in the United States and Canada. The first patient in the Phase IItrial was treated in April 2009.

 

*Phase II Clinical Trial—EarlyOnset Type 1 Diabetes.*

 

We initiated a Phase II, 60 patient, placebocontrolled study in the United States for the treatment of early onsettype 1 diabetes in individuals 12 to 30 years old.  Primaryefficacy will be measured at one year—the primary endpoint is the marker ofinsulin response in response to glucose stimulation. We have entered into acollaborative agreement with the Juvenile Diabetes Research Foundation (“JDRF”)for this study. This agreement provides for JDRF to fund $4.0 million ofclinical study costs for 2008 through 2010. During 2008, we received $2.0 millionfrom JDRF to fund clinical costs, and expect to receive the remaining$2.0 million during 2009 and 2010.

 

*Phase II Clinical Trial—ChronicObstructive Pulmonary Disease*

 

We are evaluating the safety and efficacy of Prochymalin conjunction with standard of care for improving pulmonary function inpatients with moderate to severe COPD in a Phase II clinical trial. This trialof 62 enrolled patients is a double-blind, placebo-controlled study. Patientswere randomized to either Prochymal or placebo at a 1:1 ratio and received 4infusions over the course of 90 days. Measurements used in the trial todetect potential improvements in subjects treated with Prochymal includepulmonary function tests, exercise capability, and quality of life assessments.In addition, exacerbations and hospitalizations due to COPD will be monitoredfor both safety and efficacy. Patients will be evaluated over the course of twoyears following initial Prochymal or placebo infusion.  On June 23, 2009, weannounced the interim six-month data from this trial.  The six-months datashowed that the trial met its primary goal of demonstrating the safety ofProchymal in patients with compromised pulmonary function at the six-monthevaluation point; Prochymal significantly decreased systemic inflammation inpatients when compared to those receiving placebo, as determined by C-reativeprotein; and despite the reduction in inflammation, pulmonary function inpatients receiving Prochymal was not significantly improved compared to thosereceiving placebo.

 

*Phase III Clinical Trial—AnimalRule—Acute Radiation Syndrome.*

 

In 2007, we partnered with Genzyme Corporation todevelop Prochymal as a medical countermeasure to nuclear terrorism and otherradiological emergencies. In January 2008, we were awarded a contract fromthe United States Department of Defense (“DoD”) for the development andstockpiling of Prochymal for the treatment of acute radiation syndrome (“ARS”).The fully funded value of the contract, assuming FDA approval of Prochymal forARS and exercise by DoD of all of its purchase options for up to 20,000 dosesof Prochymal at a price of $10,000 per dose, is up to $224.7 million. Weare carrying out this contract in collaboration with Genzyme.

 

***Chondrogen*** is our biologic drug candidate for thetreatment of osteoarthritis and the reduction of pain in theknee.    We completed enrollment of a randomizeddouble-blind, placebo controlled Phase I/II clinical trial evaluatingChondrogen for safety and preliminary efficacy based upon regeneration ofmeniscus at six-months. In November 2007, we reported one-year data forthe Phase I/II Chondrogen trial. The data continued to show improvementsin joint condition that correlated with a clinically and statisticallysignificant improvement in pain in patients with osteoarthritis (OA) whoreceived Chondrogen as compared to those treated with the control, hyaluronicacid (HA). Patients receiving the control were 3.5 times more likely toexperience degenerative bone changes associated with OA as compared to thosereceiving Chondrogen. The effects were dose dependent and pain scores improvedfrom six months to one year following treatment, suggesting Chondrogen caused abiological modification of patients’ OA.

 

**FinancialOperations Overview**

 

*Revenue*

 

In 2008, we entered into a Collaboration Agreementwith Genzyme for the development and commercialization of Prochymal andChondrogen, and providing for non-contingent, non-refundable up front paymentsof $130.0 million and contingent milestone payments. This CollaborationAgreement has multiple deliverables, and consistent with our accounting policyfor such transactions, we are amortizing these amounts into revenue on astraight-line basis over the estimated completion period of the deliverables,which extend through the first quarter of 2012. We recognized$10.0 million of revenue in each of the first two quarters of 2009 relatedto this agreement. Contingent milestone payments earned and for which we haveno continuing performance obligations will be recognized as revenue uponachievement of the related 

 

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milestone, while milestone payments for which we havea continuing performance obligation will be deferred when received andamortized to revenue over the term of the related performance obligations.

 

Under the DoD contract awarded to us in January 2008,we are seeking, in partnership with Genzyme, to develop and stockpile Prochymalfor the repair of gastrointestinal injury resulting from acute radiationexposure. Under the terms of the contract, the DoD provides funding to us fordevelopment. If we are successful in obtaining FDA approval of Prochymal fortreatment of acute radiation syndrome, the contract provides for the purchase,at the option of DoD, of up to 20,000 doses of Prochymal, at $10,000 per dose,in four 5,000 dose increments. We recognized $2.8 million in revenue underthe terms of this contract in the first half of 2009, on a cost reimbursementbasis.

 

In prior years, we have entered into strategicagreements with others for the development and commercialization of select stemcell biologic drug candidates for specific indications and geographic markets.In 2007, we entered into a collaborative agreement with the JDRF to conduct aPhase II clinical trial evaluating Prochymal as a treatment fortype 1 diabetes mellitus. Under this collaborative agreement,  JDRFwill provide up to $4.0 million of contingent milestone funding to supportthe development of Prochymal for the preservation of insulin production inpatients with newly diagnosed type 1 diabetes mellitus. The contingentmilestone payments under the agreement are amortized into revenue on a straightline basis over the duration of our obligations under the collaborativeagreement as they are received and earned. We recognized $0.2 million inrevenue during the first half of 2009 under this agreement.

 

In 2003, we entered into an agreement with a foreignpharmaceutical company granting it exclusive rights to Prochymal for thetreatment of GvHD in Japan.

 

*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 a project-by-projectbasis. From inception in December 1992 through June 30, 2009, weincurred aggregate research and development costs of approximately$342 million.

 

We expect our research and development expenses tocontinue to increase in the future, as we expand our clinical trial activityfor our existing biologic drug candidates as they advance through thedevelopment cycle and as we invest in additional product opportunities andresearch programs. Clinical trials and preclinical studies are time-consumingand expensive. Our expenditures on current and future preclinical and clinicaldevelopment programs are subject to many uncertainties. We test our products inseveral preclinical studies, and we then conduct clinical trials for thosebiologic drug candidates that we determine to be the most promising. As weobtain results from clinical trials, we may elect to discontinue or delaytrials for some biologic drug candidates in order to focus our resources onmore promising biologic drug candidates. Completion of clinical trials may takeseveral years or more, but the length of time generally varies substantiallyaccording to the type, size of trial and intended use of a biologic drugcandidate. The cost of clinical trials may vary significantly over the life ofa project as a result of a variety of factors, including:

 

·                                                             the number of patients who participate inthe trials;

 

·                                                             the number of sites included in thetrials;

 

·                                                             the length of time required to enrolltrial participants;

 

·                                                             the duration of patient treatment andfollow-up;

 

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

 

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

 

·                                                             the costs and timing of, and the abilityto secure, regulatory approvals.

 

As a result of these uncertainties, we are unable todetermine with any significant degree of certainty the duration and completioncosts of our research and development projects or when and to what extent wewill generate revenues from the commercialization and sale of any of ourbiologic drug candidates.

 

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*General and Administrative Expenses*

 

General and administrative expenses consist primarilyof the costs associated with our general management, including salaries,allocations of facilities and related costs, and professional fees such aslegal and accounting expenses. We have increased our general and administrativeexpense for legal and accounting compliance costs, investor relations and otheractivities associated with operating as a publicly traded company andstrengthened our administrative capabilities as we approach the commerciallaunch of Prochymal for an initial indication. Continued increases will alsolikely result from the hiring of additional operational, financial, accounting,facilities engineering and information systems personnel.

 

*Interest Income (Expense), Net*

 

Interest income consists of interest earned on ourcash and investments available for sale. Interest expense consists of interestincurred on capital leases and other debt financings. We pay interest on ourpromissory notes, capital leases and convertible long-term debt. We do notexpect to incur material interest expense in the near future as we hadextinguished all of our outstanding debt as of December 31, 2008, and haveinvested our excess cash in investments available for sale.

 

*Income Taxes*

 

During the six months ended June 30, 2009, werecognized an income tax benefit to continuing operations of $2.4 million, andincome tax expense of $3.1 million against the income from discontinuingoperations. We have not recognized any deferred tax assets or liabilities inour financial statements above these amounts since we cannot assure theirfuture realization.  Because realization of deferred tax assets isdependent upon future earnings, a full valuation allowance has been recorded onthe net deferred tax assets, which relate primarily to net operating losscarry-forwards and research and development and orphan drug tax creditcarry-forwards.  In the event that we become profitable within the nextseveral years, we have net deferred tax assets of approximately $140 millionthat may be utilized prior to us having to recognize any income tax expense ormake payments to the taxing authorities.  However, utilization of our netoperating loss and tax credit carry-forwards in any one year may be limited underInternal Revenue Code Sections 382 and 383, and may expire prior to our abilityto utilize them. In addition, even if certain of our net deferred tax assetsare not subject to limitations, we may be subject to the Federal alternativeminimum tax in future years.

 

The tax benefit for the six months ended June 30,2009, reflects an effective tax rate for continuing operations of 12.7%compared to a U.S. statutory tax rate of 35%.  The effective tax ratereflects our estimated annual effective tax rate, which reflects ourexpectation that a portion of our income will be subject to the Federalalternative minimum tax in 2009.

 

**Critical Accounting Policies**

 

There have been no material changes in our criticalaccounting policies, estimates and judgments during the six months ended June 30,2009 compared to the disclosures in Part II, Item 7 of our AnnualReport on Form 10-K for the year ended December 31, 2008, other thanas disclosed herein.

 

**Resultsof Operations**

 

***Comparison of Three Months Ended June 30, 2009 and 2008***

 

*Revenuesfrom Continuing Operations*

 

Revenues from continuing operations were $10.5 millionfor the three months ended June 30, 2009 compared to $2.5 million for thesecond quarter of fiscal 2008.  During the three months ended June 30,2009, we recognized $10.0 million in revenue from our collaborative agreementwith Genzyme and $0.1 million from our collaborative agreement with JDRF. Ourrevenues for the three month period also include $0.3 million from our contractwith the DoD to develop Prochymal for the treatment of acute radiationsyndrome, plus $0.1 million in royalties on MSCs sold for researchpurposes.  Revenues from continuing operations for the three months ended June 30,2008 were $2.5 million, and consisted primarily of the recognition of milestonepayments received from JDRF as provided for under our collaborative agreementto develop Prochymal for the treatment of Type 1 diabetes, and revenuerecognized on our contract with DoD to develop Prochymal as a medicalcountermeasure to nuclear terrorism.

 

*Research and Development Expenses*

 

Research and development expenses for the three monthsended June 30, 2009 were $18.5 million, as compared to research anddevelopment expenses of $19.0 million for the same period last year.  At June 30,2009, we were conducting three Phase III clinical trials in severalinflammatory disease indications, and Phase II clinical trials for acutemyocardial infarction, type 1 diabetes mellitus, and COPD.  In addition,we were conducting animal studies in accordance with the FDA Animal Rule foracute radiation syndrome.  Over the past several years increased clinicaltrial activities have increased the demand for clinical batches of our biologicdrug candidates and we have experienced 

 

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increased costs in our contract manufacturingactivities.  We are also incurring research and development expenses inconnection with the preparation of our biologic license application as weprepare filings with the FDA towards the commercialization of Prochymal for aninitial indication.

 

*General and Administrative Expenses(excluding discontinued operations)*

 

General and administrative expenses were $2.3 millionfor the three months ended June 30, 2009 compared to $1.8 million for thecomparable period in fiscal 2008.  The increase in general andadministrative expenses is primarily attributable to increases in ourprofessional staff in the areas of intellectual property and businessdevelopment and increases in legal costs related to our intellectual propertyportfolio. The non cash charge for share-based compensation allocated togeneral and administrative expenses during the fiscal quarter ended June 30,2009 was $0.5 million as compared to $0.2 million for the same period lastyear.

 

*Interest Income (Expense), Net*

 

Interest income, net was $0.2 million for the threemonths ended June 30, 2009 compared to net interest expense of $0.2 millionin the corresponding period in fiscal 2008.  During 2009, we have not hadany short or long-term debt, and interest expense consists of financing chargeson capital leases for equipment.  We earn interest income on ourinvestments available for sale.

 

***Income (Loss) fromDiscontinued Operations***

 

Loss from operations of the Osteocel asset disposalgroup was $0.1 million for the three months ended June 30, 2009 comparedto earnings of $3.1 million for the comparable period of fiscal 2008.  The loss during the second fiscal quarter of2009 was primarily the effect of the increase in the estimated effective incometax rate for the full fiscal year, which increased to 12.7% in the secondquarter when it was estimated to be 8.6% during the quarter ended March 31,2009.  Osteocel manufacturing activitiesceased in March 2009.

 

Also during the second quarter of 2009, we reported aloss from the sale of discontinued operations of $1.0 million, which reflectsthe increase in the estimated annual effective income tax rate for the fullfiscal year.

 

***Comparison of Six Months Ended June 30, 2009 and 2008***

 

*Revenuesfrom Continuing Operations*

 

Revenues from continuing operations were $23.2 millionfor the six months ended June 30, 2009 compared to $2.9 million for thefirst half of fiscal 2008.  During the six months ended June 30,2009, we recognized $20.0 million in revenue from our collaborative agreementwith Genzyme and $0.2 million from our collaborative agreement with JDRF. Ourrevenues for the six month period also include $2.8 million from our contractwith the DoD to develop Prochymal for the treatment of acute radiationsyndrome, plus $0.2 million in royalties on MSCs sold for researchpurposes.  Revenues from continuing operations for the six months ended June 30,2008 were $2.9 million, and consisted primarily of the recognition of milestonepayments received from JDRF as provided for under our collaborative agreementto develop Prochymal for the treatment of Type 1 diabetes, and revenuerecognized on our contract with DoD to develop Prochymal as a medicalcountermeasure to nuclear terrorism.

 

*Research and Development Expenses*

 

Research and development expenses for the six monthsended June 30, 2009 were $37.1 million, as compared to research anddevelopment expenses of $35.7 million for the same period last year.

 

*General and Administrative Expenses(excluding discontinued operations)*

 

General and administrative expenses were $5.2 millionfor the six months ended June 30, 2009 compared to $4.4 million for thecomparable period in fiscal 2008.  The non cash charge for share-basedcompensation allocated to general and administrative expenses during the firsthalf of this fiscal year was $1.3 million as compared to $0.6 million for thesame period last year.

 

*Interest Income (Expense), Net*

 

Interest income, net was $0.3 million for the sixmonths ended June 30, 2009 compared to net interest expense of $0.4million in the corresponding period in fiscal 2008.  During 2009, we havenot had any short or long-term debt, and interest expense consists of financingcharges on capital leases for equipment.  We earn interest income on ourinvestments available for sale.

 

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***Income fromDiscontinued Operations***

 

Income from operations of the Osteocel asset disposalgroup was $1.1 million for the six months ended June 30, 2009 compared toearnings of $6.7 million for the comparable period of fiscal 2008.  Osteocel manufacturing activities ceased in March 2009.

 
| ** **                                                    | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                    | ** ** | **June 30,**              | ** ** |
| ** **                                                    | ** ** | **2009**                       | ** ** | **2008** | ** ** |
| ** **                                                    | ** ** | **($000)**                     | ** ** | **($000)** | ** ** |
| Product sales                                                 |       | $                              | 6,296      |   | $ | 16,466 |   |
| Cost of goods sold                                            |       | 4,915                          |       | 8,567 |   |
| Gross profit                                                  |       | 1,381                          |       | 7,899 |   |
|                                                          |       |                           |       |   |   |
| Selling, general &  administrative expenses          |       | 124                            |       | 1,246 |   |
| Income from operations  of discontinued operations before tax |       | 1,257                          |       | 6,653 |   |
| Income tax                                                    |       | 160                            |       | — |   |
| Income from operations  of discontinued operations            |       | $                              | 1,097      |   | $ | 6,653 |   |

 

In April 2008, we committed to a plan to sell ourbiologic tissue business, consisting of the Osteocel asset disposalgroup.  On May 8, 2008 we entered into an Asset Purchase Agreementfor the sale of the Osteocel asset disposal group to NuVasive, Inc., andon July 24, 2008, the first of two scheduled closings, the “technologyassets closing,” occurred and we received a $35.0 million payment. Duringthe fourth quarter of 2008, we earned additional purchase price of $5.0 millionupon the achievement of production milestones.  Concurrent with the technologyassets closing, we entered into a Manufacturing Agreement with NuVasive, underwhich we continued to manufacture Osteocel until March 28, 2009 when allmanufacturing activities ceased. In March 2009, we entered into amendmentsto the Asset Purchase Agreement and amendments to the related ManufacturingAgreement which stipulated that, upon consummation of the second and finalclosing (the “manufacturing assets closing”) under the Asset Purchase Agreementall of our responsibilities would be deemed fulfilled.  The manufacturingassets closing occurred on April 9, 2009.  Upon execution of theamendments, we received $5.0 million of additional purchase price in cash andthen received an additional $12.5 million in NuVasive common stock on June 30,2009, and are scheduled to receive an additional $12.5 million in either cashor NuVasive stock on September 30, 2009.  We are also entitled toreceive a contingent milestone payment of $15.0 million, in cash or NuVasivestock, if and when NuVasive achieves cumulative sales revenue from Osteocel ofat least $35.0 million.  We presently expect to earn this contingentmilestone payment prior to the end of the current fiscal year.

 

**Liquidity and Capital Resources**

 

***Liquidity***

 

The current global financial crisis — which hasincluded, among other things, significant reductions in available capital andliquidity from banks and other providers of credit, substantial reductionsand/or fluctuations in equity and currency values worldwide, significantdecreases in consumer confidence and consumer and business spending, andconcerns that the worldwide economy may enter into a prolonged recessionaryperiod — may materially adversely affect our access to capital.  Inaddition, the current global financial crisis may materially adversely affectthe liquidity and access to capital of parties with which we from time to timecollaborate, which may in turn adversely impact their ability or desire toparticipate or perform under their collaborations with us.  Thesepotential effects of the current global financial crisis are difficult toforecast and mitigate. Should additional capital be required to pursue ourbusiness plan, but not be available, as a result of the global economic crisisor otherwise, our business and financial condition would be materially andadversely affected.

 

At June 30, 2009, we had $52.0 million in cashand investments available for sale and $68.8 million of short-termreceivables.  We presently estimate that we have sufficient liquidity onhand as of June 30, 2009 to fund our operations through the initialcommercialization of Prochymal for an initial indication.

 

***Cash Flows***

 

Net cash used in operating activities of continuingoperations was $31.3 million for the six months ended June 30, 2009,primarily reflecting our loss from continuing operations of $16.5 million,which was partially offset by $2.1 million of non cash charges included in theloss.  Adding to our use of cash in the operating activities of continuingoperations was $16.9 million of unfavorable working capital changes, consistingprimarily of the $20.2 million of the amortization of the deferred revenuerelated to the Genzyme and JDRF collaborations. During the comparable period offiscal 2008, net cash used in operating activities of continuing operations was$26.9 million, consisting of our loss from continuing operations of $37.6million, partially offset by non cash charges of $2.0 million and net favorablevariances in working capital of $8.8 million, primarily in accounts payable andaccrued expenses.

 

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Net cash used in the operating activities ofdiscontinued operations was $1.8 million for the six months ended June 30,2009, which reflects the $26.6 million non cash impact related to the sale ofdiscontinued operations and $2.9 million of favorable changes in workingcapital income, offset by $21.6 million income from the discontinuedoperations.  For fiscal 2008, net cash provided by operating activities ofdiscontinued operations was $6.1 million, which is primarily made up of theincome from discontinued operations of $6.7 million, partially offset by the$0.8 million of unfavorable working capital changes during the period.

 

Net cash provided by investing activities was $33.5million for the six months ended June 30, 2009, consisting of $9.9 millionof net proceeds from the sale of discontinued operations and $23.8 million ofproceeds from the sale of investments available for sale that we had purchasedto efficiently utilize our excess cash at the end of 2008. Net cash provided byinvesting activities during the comparable period of fiscal 2008 was $8.7million, which was comprised of the sale of $12.4 million of investmentsavailable for sale, partially offset by $3.7 million of capital expendituresfor the expansion of our Columbia, Maryland manufacturing facilities that wascompleted during the third quarter of 2008.

 

Net cash used in financing activities was $0.1 millionfor the six months ended June 30, 2009, representing the increase inrestricted cash of $0.5 million offset by $0.4 million of proceeds from theexercise of stock options.  As discussed in our Annual Report on Form 10-Kfor the fiscal year ended December 31, 2008, our financial position whenentering fiscal 2009 allowed us to be involved in only minimal financingactivities during the first quarter of 2009. During 2008, net cash provided byfinancing activities was $13.8 million, which primarily resulted from theissuance of $16.0 million of convertible and short term notes payable,partially offset by $2.2 million of scheduled payments on our debt and capitallease obligations.

 

***Capital Resources***

 

Our future capital requirements will depend on manyfactors, including:

 

·                                          the scope and results of our research and preclinicaldevelopment programs;

 

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

 

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

 

·                                          the timing and achievement of contingent milestonepayments under the NuVasive agreement and the Genzyme collaboration agreement;

 

·                                          the costs of maintaining, expanding and protecting ourintellectual property portfolio, including possible litigation costs andliabilities; and

 

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

 

As of December 31, 2008, we had completelyextinguished our outstanding debt. As a result of our financial position andforecasts as of that date, we believe that we have sufficient liquidity on handto fund our operations through the anticipated date of initialcommercialization of Prochymal for an initial indication.

 

**Off-BalanceSheet Arrangements.**

 

We have no off-balance sheet financing arrangementsand we have not entered into any transactions involving unconsolidatedsubsidiaries or special purpose entities.

 

**Item 3.**                         **Quantitative andQualitative 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.

 

We believe that the interest rate risk related to ouraccounts receivable is not significant.  We manage the risk associatedwith these accounts through periodic reviews of the carrying value fornon-collectability and establishment of appropriate allowances in connectionwith our internal controls and policies.

 

We do not enter into hedging or derivative instrumentarrangements.

 

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**Item4.**                         **Controls and Procedures.**

 

***Evaluation of DisclosureControls and Procedures.*** An evaluation of the effectiveness of the design andoperation of our “disclosure controls and procedures” (as defined in Rule 13a-15(e) underthe Securities Exchange Act of 1934, as amended), as of the end of the periodcovered by this Quarterly Report on Form 10-Q was made under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer.  A control system, nomatter how well designed and operated, can provide only reasonable, notabsolute, assurance that the control system’s objectives will be met. Based upon this evaluation, our Chief Executive Officer and Chief FinancialOfficer have concluded that our disclosure controls and procedures (a) areeffective to ensure that information required to be disclosed by us in reportsfiled or submitted under the Securities Exchange Act of 1934 is timelyrecorded, processed, summarized and reported and (b) include, withoutlimitation, controls and procedures designed to ensure that informationrequired to be disclosed by us in reports filed or submitted under theSecurities Exchange Act of 1934 is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate to allow timely decisions regarding required disclosure.

 

***Changes in InternalControl over Financial Reporting.*** There have not been any changes in our internalcontrol over financial reporting that occurred during the quarter ended June 30,2009 that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

**PART II - OTHER INFORMATION**

 

**Item1.****                        ****Legal Proceedings**.

 

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

 

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

 

There have not been any material changes in the riskfactors previously disclosed under the heading “Risk Factors” in Part I —Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31,2008, filed with the Securities and Exchange Commission on March 16, 2009.

 

**Item2.****                        ****Unregistered Sales ofEquity Securities and Use of Proceeds**.

 

None.

 

**Item3.**                         **Defaults Upon SeniorSecurities**.

 

None.

 

**Item4.**                         **Submission of Matters toa Vote of Security Holders**.

 

***Annual Meeting***. We held our Annual Meeting ofStockholders on May 22, 2009.  Of the 32,715,382 shares of commonstock outstanding as of the record date of the Annual Meeting, 25,155,600shares, or 76.9% of the total shares eligible to vote at the Annual Meeting,were represented in person or by proxy.  Two proposals were submitted toour stockholders and approved at the Annual Meeting, as follows:

 

*Election of Director.*   Peter Friedli was elected toserve as a member of the board of directors for a term expiring at our AnnualMeeting of Stockholders to be held in 2012 and until his successor is dulyelected and qualified.  The number of votes cast for or withheld from thenominee, both in person and by proxy, was as follows:

 
| Peter Friedli |   | 24,031,449 FOR |   | 1,124,151 WITHHOLD |
|---------------|--------|----------------|--------|--------------------|

 

The term of office of each C. Randal Mills, FelixGutzwiller, Jay M. Moyes and Gregory H. Barnhill continued following themeeting.

 

*Ratify Independent Registered PublicAccountants.*  The appointment of Grant Thornton LLP, independent registered publicaccountants, to act as our independent auditors for the fiscal year ending December 31,2009 was ratified, as follows:

 
| FOR     |   | 25,127,777 |
|---------|--------|------------|
| AGAINST |   | 21,945     |
| ABSTAIN |   | 5,878      |

 

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**Item5.****                        ****Other Information**.

 

None.

 

**Item6.****                        ****Exhibits.**

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

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
| ** **                | **Osiris Therapeutics, Inc.**                        |
|---------------------------|-----------------------------------------------------------|
|                      |                                                      |
| Date: August 7, 2009 | /s/ RICHARD W. HUNT                                       |
|                      | Richard W. Hunt                                           |
|                      | Chief Financial Officer (Principal Financial  Officer)    |
|                      |                                                      |
| Date: August 7, 2009 | /s/ PHILIP R. JACOBY, JR.                                 |
|                      | Philip R. Jacoby, Jr.                                |
|                      | Vice President of Finance (Principal Accounting  Officer) |

 

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