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** **

 

** **

**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  the quarterly period ended September 30, 2009**                                                                                                                                                                                                                   |
|                                                                                                                                                                                                                                                                          |
| **or**                                                                                                                                                                                                                                                                        |
|                                                                                                                                                                                                                                                                          |
| **o**                                                                                                                                                                                                                                                                         | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                          |
| **For  the transition 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 November 5, 2009** |
|-------------------------------------------|------------|---------------------------------------------------------|
| Common Stock, par value  $0.001 per share |       | 32,772,331                                              |

 

 

 

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**OSIRISTHERAPEUTICS, INC.**

 

**INDEX**

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

 

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**PART I — FINANCIAL INFORMATION**

 

**Item1.****                             ****Financial Statements - Unaudited**.

 

**OSIRISTHERAPEUTICS, INC.**

**CondensedBalance Sheets**

**Amountsin thousands**

 
| ** **                                                                                                      | ** ** | **September 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                      | ** ** | **Unaudited**                | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                      |       |                         |       |                        |       |
| Current assets:                                                                                                 |       |                         |       |                        |       |
| Cash                                                                                                            |       | $                            | 1,572      |                        | $          | 940 |   |
| Investments available  for sale                                                                                 |       | 101,321                      |       | 61,298                      |       |
| Accounts receivable                                                                                             |       | 218                          |       | 61,287                      |       |
| Prepaid expenses and  other current assets                                                                      |       | 2,770                        |       | 2,060                       |       |
| Current assets of  discontinued operations                                                                      |       | —                       |       | 3,223                       |       |
| Total current assets                                                                                            |       | 105,881                      |       | 128,808                     |       |
|                                                                                                            |       |                         |       |                        |       |
| Property and equipment,  net                                                                                    |       | 3,797                        |       | 394                         |       |
| Restricted cash                                                                                                 |       | 666                          |       | 130                         |       |
| Other assets                                                                                                    |       | 453                          |       | 615                         |       |
| Long-term assets of  discontinued operations                                                                    |       | —                       |       | 7,520                       |       |
| Total assets                                                                                                    |       | $                            | 110,797    |                        | $          | 137,467 |   |
|                                                                                                            |       |                         |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**                                                                 |       |                         |       |                        |       |
| Current liabilities:                                                                                            |       |                         |       |                        |       |
| Accounts payable and  accrued expenses                                                                          |       | $                            | 16,192     |                        | $          | 10,513 |   |
| Deferred revenue,  current portion                                                                              |       | 40,660                       |       | 40,471                      |       |
| Capital lease  obligations, current portion                                                                     |       | 5                            |       | 6                           |       |
| Current liabilities of  discontinued operations                                                                 |       | 493                          |       | 7,219                       |       |
| Total current  liabilities                                                                                      |       | 57,350                       |       | 58,209                      |       |
|                                                                                                            |       |                         |       |                        |       |
| Deferred revenue, net  of current portion                                                                       |       | 54,158                       |       | 84,275                      |       |
| Other long-term  liabilities                                                                                    |       | 2,575                        |       | 3                           |       |
| Total liabilities                                                                                               |       | 114,083                      |       | 142,487                     |       |
|                                                                                                            |       |                         |       |                        |       |
| Stockholders’ deficit:                                                                                     |       |                         |       |                        |       |
| Common stock, $.001 par  value, 90,000 shares authorized 32,772 and 32,676 shares outstanding in 2009  and 2008 |       | 33                           |       | 33                          |       |
| Additional  paid-in-capital                                                                                     |       | 272,355                      |       | 269,830                     |       |
| Accumulated other  comprehensive income                                                                         |       | 358                          |       | 33                          |       |
| Accumulated deficit                                                                                             |       | (276,032                     | )          | (274,916                    | )          |
| Total stockholders’  deficit                                                                               |       | (3,286                       | )          | (5,020                      | )          |
| Total liabilities and  stockholders’ deficit                                                               |       | $                            | 110,797    |                        | $          | 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 September 30,** | ** **   | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------------------------------------------------------|------------|----------------------------------------------------------|--------------|---------------------------------------------------------|------------|
| ** **                                                                             | ** ** | **2009**                                                 | ** **   | **2008**                                                | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                                                                   |       |                                                     |         |                                                    |       |   |   |   |   |
| **Revenue from collaborative  research agreements, government contract and royalties** |       | $                                                        |  10,584 |                                                    | $          |  995 |   | $ |  33,779 |   | $ |  3,887 |   |
|                                                                                   |       |                                                     |         |                                                    |       |   |   |   |   |
| Operating expenses:                                                                    |       |                                                     |         |                                                    |       |   |   |   |   |
| Research and development                                                               |       | 16,247                                                   |         | 18,592                                                  |       | 53,354 |   | 54,334 |   |
| General and  administrative                                                            |       | 1,511                                                    |         | 1,887                                                   |       | 6,745 |   | 6,277 |   |
|                                                                                   |       | 17,758                                                   |         | 20,479                                                  |       | 60,099 |   | 60,611 |   |
|                                                                                   |       |                                                     |         |                                                    |       |   |   |   |   |
| Loss from operations                                                                   |       | (7,174                                                   | )            | (19,484                                                 | )          | (26,320 | ) | (56,724 | ) |
|                                                                                   |       |                                                     |         |                                                    |       |   |   |   |   |
| Interest income  (expense), net                                                        |       | 134                                                      |         | (419                                                    | )          | 387 |   | (800 | ) |
|                                                                                   |       |                                                     |         |                                                    |       |   |   |   |   |
| Loss from continuing  operations, before income taxes                                  |       | (7,040                                                   | )            | (19,903                                                 | )          | (25,933 | ) | (57,524 | ) |
|                                                                                   |       |                                                     |         |                                                    |       |   |   |   |   |
| Income tax benefit                                                                     |       | 238                                                      |         | —                                                  |       | 2,636 |   | — |   |
| **Loss from continuing operations**                                                    |       | (6,802                                                   | )            | (19,903                                                 | )          | (23,297 | ) | (57,524 | ) |
|                                                                                   |       |                                                     |         |                                                    |       |   |   |   |   |
| **Discontinued operations:**                                                           |       |                                                     |         |                                                    |       |   |   |   |   |
| Income (loss) from  operations of discontinued operations,net of income taxes          |       | (28                                                      | )            | (384                                                    | )          | 1,069 |   | 6,269 |   |
| Gain from sale of  discontinued operations, net ofincome taxes                         |       | 636                                                      |         | 25,539                                                  |       | 21,112 |   | 25,539 |   |
| **Income from discontinued  operations**                                               |       | 608                                                      |         | 25,155                                                  |       | 22,181 |   | 31,808 |   |
|                                                                                   |       |                                                     |         |                                                    |       |   |   |   |   |
| **Net income (loss)**                                                                  |       | $                                                        |  (6,194 | )                                                       | $          |  5,252 |   | $ |  (1,116 | ) | $ |  (25,716 | ) |
|                                                                                   |       |                                                     |         |                                                    |       |   |   |   |   |
| **Basic and diluted income (loss)  per share**                                         |       |                                                     |         |                                                    |       |   |   |   |   |
| Loss from continuing  operations                                                       |       | $                                                        |  (0.21  | )                                                       | $          |  (0.63 | ) | $ |  (0.71 | ) | $ |  (1.81 | ) |
| Income from  discontinued operations                                                   |       | 0.02                                                     |         | 0.80                                                    |       | 0.68 |   | 1.00 |   |
| Basic and diluted  earnings (loss) per share                                           |       | $                                                        |  (0.19  | )                                                       | $          |  0.17 |   | $ |  (0.03 | ) | $ |  (0.81 | ) |
|                                                                                   |       |                                                     |         |                                                    |       |   |   |   |   |
| Weighted Average Common  Shares (basic and diluted)                                    |       | 32,764                                                   |         | 31,808                                                  |       | 32,731 |   | 31,799 |   |

 

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

 

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**OSIRISTHERAPEUTICS, INC.**

**CondensedStatement of Stockholders’ Deficit**

**For thenine months ended September 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**                   | ** ** | **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)   |       | 74,911                |       | —                  |       | 575                      |       | —          |       | —                        |       | 575         |       |
|                                                                            |       |                  |       |                    |       |                     |       |            |       |                          |       |        |       |
| Issuance of common  stock for services rendered by directors ($18.60 per share) |       | 21,500                |       | —                  |       | 400                      |       | —          |       | —                        |       | 400         |       |
|                                                                            |       |                  |       |                    |       |                     |       |            |       |                          |       |        |       |
| Share-based payment —  employee compensation                               |       | —                |       | —                  |       | 1,550                    |       | —          |       | —                        |       | 1,550       |       |
|                                                                            |       |                  |       |                    |       |                     |       |            |       |                          |       |        |       |
| **Comprehensive  Loss:**                                                        |       |                  |       |                    |       |                     |       |            |       |                          |       |        |       |
|                                                                            |       |                  |       |                    |       |                     |       |            |       |                          |       |        |       |
| Net loss for the period                                                         |       | —                |       | —                  |       | —                   |       | —          |       | (1,116                        | )          | (1,116      | )          |
|                                                                            |       |                  |       |                    |       |                     |       |            |       |                          |       |        |       |
| Unrealized gain on investments  available for sale                              |       | —                |       | —                  |       | —                   |       | 325             |       | —                        |       | 325         |       |
| **Total  Comprehensive Loss**                                                   |       |                  |       |                    |       |                     |       |            |       |                          |       | (791        | )          |
|                                                                            |       |                  |       |                    |       |                     |       |            |       |                          |       |        |       |
| **Balance  at September 30, 2009**                                         |       | 32,772,331            |       | $                       |  33   |                     | $          | 272,355         |       | $                             |  358  |        | $          | (276,032 | ) | $ |  (3,286 | ) |

 

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

 

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**OSIRISTHERAPEUTICS, INC.**

**CondensedStatements of Cash Flows**

**Unaudited**

**Amountsin thousands**

 
|   ** **                                                                                                        |   | **Nine Months Ended September 30,** |       |
|-------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------------------|------------|
| ** **                                                                                                                    |   | **2009**                                                | ** ** | **2008** |   |
| **Cash  flows from operating activities:**                                                                                    |   |                                                    |       |   |   |
| **Continuing  Operations:**                                                                                                   |   |                                                    |       |   |   |
| Loss from continuing  operations                                                                                              |   | $                                                       | (23,297    | ) | $ | (57,524 | ) |
| **Adjustments  to reconcile loss from continuing operations to net cash provided by (used  in) continuing operations:**       |   |                                                    |       |   |   |
| Depreciation and  amortization                                                                                                |   | 483                                                     |       | 1,453 |   |
| Non cash share-based  payments                                                                                                |   | 1,852                                                   |       | 1,290 |   |
| Non cash interest  expense                                                                                                    |   | —                                                  |       | 130 |   |
| **Changes  in operating assets and liabilities:**                                                                             |   |                                                    |       |   |   |
| Accounts receivable                                                                                                           |   | 56,101                                                  |       | (177 | ) |
| Prepaid expenses and  other current assets                                                                                    |   | (710                                                    | )          | (169 | ) |
| Other assets                                                                                                                  |   | 162                                                     |       | 864 |   |
| Accounts payable and  accrued expenses                                                                                        |   | 4,670                                                   |       | (2,950 | ) |
| Deferred revenue                                                                                                              |   | (29,928                                                 | )          | — |   |
| Long-term interest  payable and other liabilities                                                                             |   | —                                                  |       | (839 | ) |
| Net cash provided by  (used in) continuing operations                                                                         |   | 9,333                                                   |       | (57,922 | ) |
| **Discontinued  Operations:**                                                                                                 |   |                                                    |       |   |   |
| Income from  discontinued operations                                                                                          |   | 22,181                                                  |       | 31,808 |   |
| **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                                                                       |   | (26,595                                                 | )          | (27,986 | ) |
| Depreciation and  amortization                                                                                                |   | 210                                                     |       | 295 |   |
| Provision for bad debts                                                                                                       |   | 45                                                      |       | 29 |   |
| Non cash share-based  payments                                                                                                |   | 98                                                      |       | 134 |   |
| **Changes  in operating assets and liabilities:**                                                                             |   |                                                    |       |   |   |
| Accounts receivable                                                                                                           |   | 1,516                                                   |       | 844 |   |
| Inventory and other  current assets                                                                                           |   | 1,707                                                   |       | 1,066 |   |
| Accounts payable and  accrued expenses                                                                                        |   | (3,108                                                  | )          | 4,256 |   |
| Long-term liabilities                                                                                                         |   | —                                                  |       | 873 |   |
| Net cash (used in)  provided by discontinued operations                                                                       |   | (3,946                                                  | )          | 11,319 |   |
| Net cash provided by  (used in) operating activities                                                                          |   | 5,387                                                   |       | (46,603 | ) |
|                                                                                                                          |   |                                                    |       |   |   |
| **Cash  flows from investing activities:**                                                                                    |   |                                                    |       |   |   |
| Purchases of property  and equipment                                                                                          |   | (181                                                    | )          | (4,029 | ) |
| Proceeds from the sale  of property and equipment                                                                             |   | 17                                                      |       | 104 |   |
| Proceeds from sale of  discontinued operations, net of transaction costs                                                      |   | 9,797                                                   |       | 33,636 |   |
| Proceeds from sale of  investments available for sale                                                                         |   | 35,578                                                  |       | 12,353 |   |
| Purchases of  investments available for sale                                                                                  |   | (50,000                                                 | )          | — |   |
| Net cash (used in)  provided by investing activities                                                                          |   | (4,789                                                  | )          | 42,064 |   |
|                                                                                                                          |   |                                                    |       |   |   |
| **Cash  flows from financing activities:**                                                                                    |   |                                                    |       |   |   |
| Principal payments on  capital lease obligations and notes payable                                                            |   | (5                                                      | )          | (8,277 | ) |
| Restricted cash                                                                                                               |   | (536                                                    | )          | 150 |   |
| Proceeds from  convertible and short-term notes payable                                                                       |   | —                                                  |       | 17,000 |   |
| Proceeds from exercise  of stock options                                                                                      |   | 575                                                     |       | 262 |   |
| Net cash provided by  financing activities                                                                                    |   | 34                                                      |       | 9,135 |   |
|                                                                                                                          |   |                                                    |       |   |   |
| Net increase in cash                                                                                                          |   | 632                                                     |       | 4,596 |   |
| Cash at beginning of  period                                                                                                  |   | 940                                                     |       | 704 |   |
|                                                                                                                          |   |                                                    |       |   |   |
| **Cash  at end of period:**                                                                                                   |   | $                                                       | 1,572      |   | $ | 5,300 |   |
|                                                                                                                               |        |                                                         |            |  |  |  |  |  |

 

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

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTESTO UNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008**

 

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

 

Osiris Therapeutics, Inc. (“we,” “us,” “our,” orthe “Company”) is a Delaware corporation headquartered in Columbia, Maryland.We began operations on December 23, 1992. We are a stem cell therapeuticcompany focused on developing and marketing products to treat medicalconditions in the inflammatory, orthopedic, and cardiovascular areas. Ourbiologic drug candidates utilize adult human mesenchymal stem cells, or MSCs,which can selectively differentiate, based on the tissue environment, intovarious tissue lineages, such as muscle, bone, cartilage, marrow stroma, tendonor fat. In addition, MSCs have anti-inflammatory properties and can preventfibrosis or scarring, which gives MSCs the potential to treat a wide variety ofmedical conditions. Our operations consist primarily of research, developmentand clinical activities to bring our biologic drug candidates to themarketplace. We have several research collaboration agreements and a governmentcontract for additional product development.

 

**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 of America (“US GAAP”) for interimfinancial information and with the instructions to Form 10-Q and Rule 10-01of Regulation S-X. Accordingly, they do not include all of the information andfootnotes required by US GAAP for complete financial statements. In the opinionof management, these statements include all adjustments (consisting of normalrecurring adjustments) considered necessary to present a fair statement of ourresults of operations, financial position and cash flows. Operating results forany interim period are not necessarily indicative of the results that may beexpected for the full year. This Quarterly Report on Form 10-Q should beread in conjunction with our financial statements and footnotes included in ourAnnual Report on Form 10-K for the fiscal year ended December 31,2008.

 

***Use of Estimates***

 

The preparation of financial statements in conformitywith US GAAP requires us to make estimates and assumptions that affect theamounts reported in the financial statements and accompanying notes.  Dueto the inherent uncertainty involved in making those assumptions, actualresults could differ from those estimates.  We believe that the mostsignificant estimates that affect our financial statements are those thatrelate to revenue recognition associated with our collaborative agreements,deferred tax assets, and share-based compensation.

 

***Revenue Recognition***

 

We generate revenues from collaborative agreements,research licenses, and a government contract. We evaluate revenues fromagreements that have multiple elements to determine whether the components ofthe arrangement represent separate units of accounting*.* To recognize a delivered item in amultiple element arrangement, the delivered items must have value on a standalone basis, there must be objective and reliable evidence of fair value of theundelivered items, and the delivery or performance must be probable and withinour control for any delivered items that have a right of return. Thedetermination of whether multiple elements of a collaboration agreement meetthe criteria for separate units of accounting requires us to exercise 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. Paymentsreceived in advance of research performed are designated as deferred revenue.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 NINE MONTHS ENDED SEPTEMBER 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 has paidto 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. We have evaluated the deliverables related to these payments,and concluded that the various deliverables represent a single unit of accounting.For this reason, we have deferred the recognition of revenue related to theupfront payments, and are amortizing these amounts to revenue on astraight-line basis over the estimated delivery period of the requireddevelopment services, which extend through the first quarter of 2012.Accordingly, we recognized $10.0 million of revenue in each of the firstthree fiscal quarters of 2009 related to the amortization of the upfrontpayments. The balance of these payments has been recorded as $40.0 millionof current deferred revenue and $53.3 million of long-term deferredrevenue as of September 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 $2.9 million in revenue fromthe DoD contract during the nine months ended September 30, 2009 and $1.7million in revenue during the comparable period 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 $0.8 million during 2009.  We expect to receive the remaining$1.2 million during the remainder of 2009 and 2010. We are amortizing thefunding received, resulting in $0.7 million of revenue to date in 2009under the agreement with JDRF. The remaining deferred revenue under thisagreement has been recorded as $0.7 million of current deferred revenueand $0.8 million of long-term deferred revenue as of September 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 asthe sales are made. Our overall revenues include $218,000 and $189,000 of suchroyalty revenue during the nine months ended September 30, 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 income per common share adjustsbasic income 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 NINE MONTHS ENDED SEPTEMBER 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’deficit 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. We review criteria such as the magnitude and duration of thedecline, as well as the reasons for the decline, to predict whether the loss invalue is other than temporary. If a decline in value is determined to be otherthan temporary, the carrying value of the security is reduced and acorresponding charge to earnings is recognized.

 

***Share-BasedCompensation***

 

We account forshare-based payments using the fair value method.

 

We recognize all share-based payments to employees andnon-employee directors in our financial statements based on their grant datefair values, calculated using the Black-Scholes option pricing model.Compensation expense related to share-based awards is recognized on astraight-line basis based on the value of share awards that are expected tovest during the requisite service period on the grant date, which is revised ifactual forfeitures differs materially from original expectations.

 

A summary of the combined activity under both of ourstock-based compensation plans as of September 30, 2009 and changes duringthe nine 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                               |       | (74,911                    | )          | 7.69                                                                                        |        |                                                            |       | 490                                 |       |
| Forfeited or expired                    |       | (243,692                   | )          | 14.38                                                                                       |        |                                                            |       | 203                                 |       |
| Outstanding at  September 30, 2009 |       | 1,055,574                  |       | 11.07                                                                                       |        | 7.11                                                            |       | 2,026                               |       |
|                                    |       |                       |       |                                                                                        |        |                                                            |       |                                |       |
| Exercisable at  September 30, 2009 |       | 542,193                    |       | 7.03                                                                                        |        | 5.84                                                            |       | 1,932                               |       |
|                                         |            |                            |            |                                                                                             |             |                                                                 |            |                                     |            |  |  |

 

The weighted average grant date fair value of optionsgranted during the nine months ended September 30, 2009 was $9.32 pershare.  We received a total of $575,000 in cash from the exercise ofoptions during the nine months ended September 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 September 30,2009, 623,000 shares of common stock remain available for future share awardsunder our Amended and Restated 2006 Omnibus Plan.

 

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

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTES TOUNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008**

 
| ** **                  | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                  | ** ** | **2009**                                                 | ** ** | **2008**                                                | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                  | ** ** | **($000)**                                               | ** ** | **($000)**                                              | ** ** | **($000)** | ** ** | **($000)** | ** ** |
| Research and  development   |       | $                                                        |  222  |                                                    | $          |  192 |   | $ |  708 |   | $ |  522 |   |
| Discontinued operations     |       | —                                                   |       | 55                                                      |       | 98 |   | 134 |   |
| General and  administrative |       | (141                                                     | )          | 213                                                     |       | 1,144 |   | 768 |   |
| Total                       |       | $                                                        |  81   |                                                    | $          |  460 |   | $ |  1,950 |   | $ |  1,424 |   |

 

As of September 30, 2009, there was approximately$2.1 million of total unrecognized share-based compensation cost related tooptions granted under our plans, which will be recognized over aweighted-average period of approximately 3 years, as the options vest.

 

***Supplemental CashFlow Information***

 
| ** **                                              | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                              | ** ** | **2009**                                            | ** ** | **2008** | ** ** |
| ** **                                              | ** ** | **($000)**                                          | ** ** | **($000)** | ** ** |
| **Supplemental  disclosure of cash flows information:** |       |                                                |       |   |   |
| Cash paid for interest                                  |       | $                                                   |  8    |   | $ |  577 |   |
| Cash paid for income  taxes                             |       | 915                                                 |       | — |   |
|                                                         |            |                                                     |            |  |  |  |  |

 

***Significant NewAccounting Pronouncements***

 

In September 2006,the Financial Accounting Standards Board (“FASB”) issued new accountingguidance related to fair value measurements and related disclosures. This newguidance defines fair value, establishes a framework for measuring fair value,and expands disclosures about fair value measurements. We adopted this newguidance on January 1, 2008, as required for our financial assets andfinancial liabilities. However, the FASB deferred the effective date of thisnew guidance for one year as it relates to fair value measurement requirementsfor nonfinancial assets and nonfinancial liabilities that are not recognized ordisclosed at fair value on a recurring basis. We adopted these remainingprovisions on January 1, 2009. The adoption of this accounting guidancedid not have a material impact on our financial statements.

 

In April 2009, theFASB issued new accounting guidance related to interim disclosures about thefair values of financial instruments. This guidance requires disclosures aboutthe fair value of financial instruments whenever a public company issuesfinancial information for interim reporting periods. This guidance is effectivefor interim reporting periods ending after June 15, 2009. We adopted thisguidance upon its issuance, and it had no material impact on our financialstatements. See Note 8 - “Fair Value Measurements” for these disclosures.

 

In May 2009, theFASB issued new accounting guidance related to the accounting and disclosuresof subsequent events. This guidance incorporates the subsequent events guidancecontained in the auditing standards literature into authoritative accountingliterature. It also requires entities to disclose the date through which they haveevaluated subsequent events and whether the date corresponds with the releaseof their financial statements. This guidance is effective for all interim andannual periods ending after June 15, 2009. We adopted this guidance uponits issuance and it had no material impact on our financial statements. SeeNote 9 - “Subsequent Events” for this new disclosure.

 

In June 2009, theFASB issued new accounting guidance to improve financial reporting by companiesinvolved with variable interest entities and to provide more relevant andreliable information to users of financial statements. This guidance iseffective for fiscal years beginning after November 15, 2009. We arecurrently evaluating the impact that the adoption of this guidance will have onour financial statements.

 

In August 2009, theFASB issued new accounting guidance to provide clarification on measuringliabilities at fair value when a quoted price in an active market is notavailable. This guidance became effective for us on October 1, 2009. We adoptedthis guidance on October 1, 2009, and it had no material impact on ourfinancial statements.

 

In October 2009, theFASB issued new accounting guidance to modify the revenue recognitionassociated with multiple-deliverable revenue arrangements. This guidance iseffective prospectively for revenue arrangements entered into or materiallymodified in fiscal years beginning on or after June 15, 2010. We adoptedthis guidance on October 1, 2009, and it had no material impact on ourfinancial statements.

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTES TOUNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008**

 

**3.    Collaboration Agreements 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 theserights, the Collaboration Agreement provides for a non-contingent,non-refundable cash payment to us of $130.0 million from Genzyme, with$75.0 million paid in November 2008 and $55.0 million paid on July 1,2009. The Collaboration Agreement also provides for contingent milestonepayments of up to $1.25 billion in the aggregate, in addition to royaltieson any sales by 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 NINE MONTHS ENDED SEPTEMBER 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), we willbe 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”). Under the terms of ourpartnership with Genzyme, we contribute Prochymal and corresponding safety andefficacy data to the effort and Genzyme lends its vast product development andlarge-scale commercialization expertise. The agreement provides for Genzyme toreceive a royalty of 15% on sales of Prochymal, limited to those sales madeunder contract to U.S. or allied governmental agencies for emergencypreparedness.

 

***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 insulin productionin 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 fourthquarter of 2007, and received $2.0 million of the contingent milestonesduring 2008 and $0.8 million in September 2009.  We expect to receive the remaining$1.2 million of contingent milestones by 2010. Consistent with our revenuerecognition policies for such contingent milestones, we began amortizing eachmilestone payment as it was received and will continue to amortize the paymentsover 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, The JCR agreement also provides foradditional contingent milestone payments totaling $3.0 million, which will berecorded as revenue if and when the milestone events occur.

 

**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  The finalmilestone payment of $15.0 million was conditioned on at least $35.0 million incumulative Osteocel sales by NuVasive. This final milestone was achieved in October 2009and we were paid $15.0 million in NuVasive common stock in November 2009.

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTES TOUNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND NINE MONTHS ENDED SEPTEMBER 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 in March 2009      |
| Installment paid in  stock                                                                                            |       | 12,500     |       | Paid in June 2009       |
| Installment paid in  stock                                                                                            |       | 12,500     |       | Paid in  September 2009 |
| Milestone payment due  upon NuVasive achieving at least $35.0 million in cumulative sales of  Osteocel, paid in stock |       | 15,000     |       | Paid in  November 2009  |
|                                                                                                                  |       |       |       |                         |
| 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 $12.5million payments due June 30, 2009 and September 30, 2009 were paidin shares of common stock issued by NuVasive. We have since sold all of these shares of NuVasive common stock andreceived approximately $25.3 million in the aggregate in cash. At September 30,2009, the $12.5 million in stock received on September 30, 2009 is shownas a component of Investments Available for Sale on our balance sheet. Therequisite events related to the final $15.0 million contingent milestone wereachieved in October 2009, and we will recognize the correspondingmilestone payment, paid in stock in early November 2009, as a component ofthe gain on the sale of discontinued operations in the fourth quarter of 2009.Title to the fixed assets to be transferred to NuVasive passed on April 9,2009.

 

Concurrent with the March 2009 amendments to theAsset Purchase Agreement with NuVasive, we executed a Supply Agreement withAlloSource to facilitate the complete transfer of the Osteocel business,pursuant to which we transferred to AlloSource our entire Osteocelwork-in-process inventory at specified prices on the date of the manufacturingassets closing with NuVasive.  The aggregate purchase price for theOsteocel work-in-process inventory was approximately $3.7 million, paid byAlloSource in cash installments over the 90-days following the execution of theSupply Agreement.

 

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 workforce reductionof the approximately 80 employees involved in the Osteocel business. Employees directly affected by the workforce reduction received notification onMarch 30, 2009, and the workforce reduction was substantially completed inthe second quarter of 2009.  All of the affected employees receivedseverance benefits, comprised principally of severance, benefits continuationcosts and outplacement services.  Total one-time termination benefits forthe reduction in force totaled approximately $1.4 million, which was recordedas a component of the gain on the sale of discontinued operations in the firstquarter of 2009.

 

Also in connection with the March 2009amendments, we relieved NuVasive of its obligation to assume the lease for ourColumbia, Maryland facility.  As a result of the combination of ourcessation of Osteocel manufacturing and retaining the lease obligations for theColumbia, Maryland facility, we conducted an analysis of our future minimumlease payments for the facility, related to unutilized space, and recorded animpairment charge of approximately $3.2 million related to our future minimumlease payments.  Additionally, we recorded an impairment of the leaseholdimprovements specifically related to Osteocel production of approximately $3.0 million. Both of these impairments were recorded as components of the gain on the saleof discontinued operations in 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 NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008**

 

As detailed above, we recognized a gain ofapproximately $21.1 million, net of income taxes, on the sale of discontinuedoperations during the nine months ended September 30, 2009.  Inconnection with this transaction, we recognized a gain on the sale ofdiscontinued operations of $30.4 million during the fiscal year ended December 31,2008, as detailed in our Annual Report on Form 10-K for the fiscal yearended 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 September 30, 2009 and December 31,2008 were as follows:

 
| ** **                                           | ** ** | **2009**   | ** **   | **2008**   | ** ** |
|------------------------------------------------------|------------|------------|--------------|------------|------------|
| ** **                                           | ** ** | **($000)** | ** **   | **($000)** | ** ** |
| Accounts receivable,  net                            |       | $          |    |       | $          | 1,516 |   |
| Inventory and other  current assets                  |       | —     |         | 1,707      |       |
|                                                 |       | —     |         |       |       |
| Current assets of  discontinued operations           |       | —     |         | 3,223      |       |
|                                                 |       |       |         |       |       |
| Property and equipment,  net                         |       | —     |         | 7,520      |       |
|                                                 |       |       |         |       |       |
| Liabilities of  discontinued operations              |       | (493       | )            | (7,219     | )          |
|                                                 |       |       |         |       |       |
| Net assets  (liabilities) of discontinued operations |       | $          | (493         | )          | $          | 3,524 |   |

 

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

 
| ** **                                                                     | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                     | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                     | ** ** | **2009**                         | ** ** | **2008**                        | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                                     | ** ** | **($000)**                       | ** ** | **($000)**                      | ** ** | **($000)** | ** ** | **($000)** | ** ** |
| Product sales                                                                  |       | $                                | (1         | )                               | $          | 2,872 |   | $ | 6,295 |   | $ | 19,338 |   |
| Cost of goods sold                                                             |       | 70                               |       | 3,035                           |       | 4,985 |   | 11,602 |   |
| Gross profit (loss)                                                            |       | (71                              | )          | (163                            | )          | 1,310 |   | 7,736 |   |
|                                                                           |       |                             |       |                            |       |   |   |   |   |
| Selling,  general & administrative expenses                           |       | —                           |       | 221                             |       | 124 |   | 1,467 |   |
| Income (loss) from  operations of discontinued operations, before income taxes |       | (71                              | )          | (384                            | )          | 1,186 |   | 6,269 |   |
| Income tax expense  (benefit)                                                  |       | (43                              | )          | —                          |       | 117 |   | — |   |
| Income (loss) from  operations of discontinued operations                      |       | $                                | (28        | )                               | $          | (384 | ) | $ | 1,069 |   | $ | 6,269 |   |

 

**5.**                                                              **Earnings (Loss) PerCommon Share**

 

Basic earnings (loss) per common share is computedbased on the weighted average number of shares of common stock outstandingduring the period. Dilutive shares are computed using the treasury stock methodand include the incremental effect of shares that would be issued upon theassumed exercise of stock options and warrants. All common share equivalentsresulting from assumed exercise of outstanding stock options and warrants areexcluded from the computation of diluted loss per share as their effect isanti-dilutive.    For the nine months ended September 30,2009, these common share equivalents are comprised of 409,023 common stockequivalents related to in-the-money stock options , 133,169 common stockequivalents related to out-of-the-money stock options, and 226,592 common stockequivalents related to an outstanding warrant.   For the three monthsended September 30, 2009, such common share equivalents are comprised of329,133 common stock equivalents related to in-the-money stock options ,213,060 common stock equivalents related to out-of-the-money stock options, and9,455 common stock equivalents related to an outstanding warrant.

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTES TOUNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008**

 

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

 

The tax benefit for the nine months ended September 30,2009 reflects an effective tax rate for continuing operations of 9.9% 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 nine months ended September 30, 2009, werecognized the following income tax expense (benefit):

 
| ** **                                                      | ** ** | **Quarter  Ended**           | ** ** | **Nine  Months Ended**       | ** ** |
|-----------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                      | ** ** | **September 30,  2009** | ** ** | **September 30,  2009** | ** ** |
| ** **                                                      | ** ** | **($000)**                   | ** ** | **($000)**                   | ** ** |
| Tax  benefit to continuing operations                           |       | $                            | (235       | )                            | $          | (2,633 | ) |
| Tax  expense (benefit) of operations of discontinued operations |       | (43                          | )          | 117                          |       |
| Tax  expense (benefit) of sale of discontinued operations       |       | (663                         | )          | 2,314                        |       |
|                                                            |       |                         |       |                         |       |
| Total  income tax expense (benefit)                             |       | $                            | (941       | )                            | $          | (202 | ) |

 

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 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 $55.5 millionthat may be utilized prior to us having to recognize any income tax expense or makepayments to the taxing authorities.  However, utilization of our netoperating loss and tax credit carry-forwards in any one year may be limitedunder Internal Revenue Code Sections 382 and 383. In addition, even if certainof our net deferred tax assets are not subject to limitations, we may besubject to the Federal alternative minimum tax in future years.

 

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

 

On September 30, 2009, NuVasive, Inc. paidus the $12.5 million milestone payment in freely tradable shares of its commonstock, as provided 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. This average price was less than the fair value of NuVasive’scommon stock at September 30, 2009 and we recorded an unrealized gain of$298,000 at September 30, 2009, as a component of Other ComprehensiveIncome.  We began selling the NuVasivecommon stock on September 30, 2009, and have since sold all the shares andhave received approximately $12.7 million in aggregate cash, which as beeninvested in accordance with our Investment Policy.

 

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

** **
| ** **                                             | ** ** | **September 30,  2009********($000)** | ** **  | **December 31,  2008**** ****($000)** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|-------------|-------------------------------------------------|------------|
| ** **                                             | ** ** | **Cost**                                   | ** **  | **Fair  Value**                                 | ** ** | **Cost** | ** ** | **Fair  Value** | ** ** |
| **Cash  equivalents:**                                 |       |                                       |        |                                            |       |   |   |   |   |
| Money market  funds & certificates of deposit |       | $                                          | 29,244      |                                            | $          | 29,245 |   | $ | 33,436 |   | $ | 33,436 |   |
| Commercial paper                                       |       | 18,694                                     |        | 18,692                                          |       | 11,187 |   | 11,195 |   |
|                                                   |       | 47,938                                     |        | 47,937                                          |       | 44,623 |   | 44,631 |   |
| **Short  term investments:**                           |       |                                       |        |                                            |       |   |   |   |   |
| Auction rate  certificates                             |       | —                                     |        | —                                          |       | 3,100 |   | 3,100 |   |
| Common stock                                           |       | 10,470                                     |        | 10,766                                          |       | — |   | — |   |
| Corporate notes and  bonds                             |       | 4,173                                      |        | 4,180                                           |       | 1,921 |   | 1,921 |   |
| US government agencies                                 |       | 38,382                                     |        | 38,438                                          |       | 11,621 |   | 11,646 |   |
|                                                   |       | 53,025                                     |        | 53,384                                          |       | 16,642 |   | 16,667 |   |
|                                                   |       |                                       |        |                                            |       |   |   |   |   |
| **Total  investments available for sale**              | ** ** | **$**                                      | **100,963** | ** **                                      | **$**      | **101,321** | ** ** | **$** | **61,265** | ** ** | **$** | **61,298** | ** ** |

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTES TOUNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008**

 

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

 
| ** **                                | ** ** | **September 30,  2009**** ****($000)** | ** **  | **December 31,  2008**** ****($000)** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------|-------------|-------------------------------------------------|------------|
| ** **                                | ** ** | **Cost**                                         | ** **  | **Fair Value**                             | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| **Maturities:**                           |       |                                             |        |                                            |       |   |   |   |   |
| Within 3-months                           |       | $                                                | 60,373      |                                            | $          | 60,840 |   | $ | 46,826 |   | $ | 46,832 |   |
| Between  3—12 months            |       | 34,697                                           |        | 34,376                                          |       | 10,208 |   | 10,190 |   |
| Between 1—2 years               |       | 5,893                                            |        | 6,105                                           |       | 4,231 |   | 4,276 |   |
| **Total  investments available for sale** | ** ** | **$**                                            | **100,963** | ** **                                      | **$**      | **101,321** | ** ** | **$** | **61,265** | ** ** | **$** | **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. Thelevels are directly related to the amount of subjectivity associated with theinputs to fair valuation of these assets and liabilities, and are as follows:

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

 

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

 
| ** **                             | ** ** | **September 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        |       | 101,321                              |       | —                              |       | 101,321 |   | 61,298 |   | — |   | 61,298 |   |
|                                   |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |
| Total assets                           |       | $                                    | 101,321    |                                | $          | — |   | $ | 101,321 |   | $ | 62,227 |   | $ | — |   | $ | 62,227 |   |

 

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**OSIRISTHERAPEUTICS, INC.**

**NOTES TOUNAUDITED CONDENSED FINANCIAL STATEMENTS**

**THREEAND NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008**

 

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

 

We evaluated our September 30,2009 financial statements for subsequent events through the date the financialstatements were available to be issued, which was November 4, 2009.NuVasive, Inc. has advised us that, in the latter part of October 2009,it achieved at least $35.0 million in cumulative sales of Osteocel, whichtriggered its obligation under the Asset Purchase Agreement for payment of thefinal milestone payment of $15.0 million. NuVasive has further advised us thatpursuant to its rights under the Asset Purchase Agreement, it intends to makethis payment through delivery of shares of its common stock having equivalentvalue. Upon receipt (anticipated on November 6, 2009), we will record thispayment as a component of gain from the sale of discontinued operations duringthe fourth quarter of 2009. We are not aware of any other subsequent eventswhich would require recognition or disclosure in the financial statements.

 

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**Item2.**         **Management’s Discussion and Analysis of Financial Condition and Resultsof 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 othercollaborations and to earn milestone payments and perform under and deriveroyalty and other revenue thereunder.  Risks and uncertainties related tothe sale of our Osteocel assets and related transactions include typicalbusiness transactional risks, the risk of changing relationships withcustomers, suppliers or employees; and the risk that we may not be able tofully perform or generate or receive contingent milestone payments. Risks anduncertainties related to our Collaboration Agreement with Genzyme for thedevelopment and commercialization of Prochymal and Chondrogen include, amongothers:  typical business transactional risks; risks related to productdevelopment and clinical trial design, performance and completion; uncertaintyof the success of Prochymal and Chondrogen in clinical trials and their abilityto treat disease; Genzyme’s early termination and opt-out rights; the abilityof Osiris and Genzyme to successfully navigate regulatory requirements and tomanufacture and commercialize products; and the uncertainty as to our ability,and the ability and willingness of Genzyme to successfully perform ourrespective obligations under the collaborative arrangement, and our ability toearn milestone and royalty payments thereunder.  All forward-lookingstatements, including, without limitation, management’s examination ofhistorical operating trends, are based upon our current expectations andvarious assumptions.  Our expectations, beliefs and projections areexpressed in good faith and we believe there is a reasonable basis for them.However, there can be no assurance that management’s expectations, beliefs orprojections will result or be achieved, and you should not unduly rely onforward-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 nine months ended September 30, 2009 andother disclosures included in this Quarterly Report on Form 10-Q. Our Condensed Financial Statements have been prepared in accordance with U.S.generally accepted accounting principles and are presented in U.S. dollars.

 

There are a number of risks and uncertainties 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.

 

**Introductionand Overview**

 

The following is a discussion and analysis of ourfinancial condition and results of operations for the three and nine monthperiods ended September 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.  Our 

 

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predecessor company was organized in 1992.  Ourlead biologic drug candidate, Prochymal®, is being evaluated in Phase IIIclinical trials for four indications, including acute and steroid refractoryGvHD, Crohn’s disease and acute radiation syndrome, and is the only stem celltherapeutic currently granted both Orphan Drug and Fast Track status by theU.S. Food and Drug Administration (“FDA”).  Prochymal is also beingdeveloped for the repair of heart tissue following a heart attack, theprotection of pancreatic islet cells in patients with type 1 diabetesmellitus, and the treatment of patients with COPD.  Our pipeline ofinternally developed biologic drug candidates under evaluation also includesChondrogen for osteoarthritis in the knee.

 

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 and September 30,2009, we received $12.5 million in NuVasive’s common stock.  NuVasive hasadvised us that, in the latter part of October 2009, it achieved $35.0million in cumulative sales of Osteocel, which triggered its obligation underthe Asset Purchase Agreement for payment of the final milestone payment of$15.0 million. NuVasive has further advised us that it intends to make thispayment in stock in early November 2009.

 

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, like type O negative blood, do not require donor-to-recipientmatching. This universal compatibility allows us to produce a standardizedproduct 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.

 

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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.

 

On September 8, 2009, we announced preliminaryresults for our two Phase III GvHD trials (steroid refractory acute GvHD andfirst line treatment of acute GvHD), noting that while Prochymal showedsignificant improvements in response rates in difficult-to-treat lever andgastrointestinal GvHD, neither trial reached its primary endpoint.

 

Key findings from the GvHD trials include:

 

·                  There was nostatistical difference between Prochymal and placebo on the primary endpointsfor either the steroid-refractory (35% vs. 30%, n=260) or the first-line (45%vs. 46%, n=192) GvHD trials.

 

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

 

·                  In patientswith steroid-refractory liver GvHD, treatment with Prochymal significantlyimproved response (76% vs. 47%, p=0.026, n=61) and durable complete response(29% vs. 5%, p=0.046).

 

·                  Prochymalsignificantly improved response rates in patients with steroid-refractorygastrointestinal GvHD (88% vs. 64%, p=0.018, n=71).

 

·                  In pediatricpatients, Prochymal showed a strong trend of improvement in response rates (86%vs. 57%, p=0.094, n=28).

 

The data are still preliminary and further analysis isongoing to gain a full appreciation of the results of these rigorous,double-blind, placebo-controlled trials.

 

*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 ourPhase 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 completed enrollment with a total of 192patients. All patients are being followed-up for safety until day 365post-randomization. The trial is investigating patient response to a total ofsix infusions during the first four weeks of the study. The primary trialendpoint is the proportion of patients who achieve a complete response at day28 and who survive to day 90 without the addition of a second line therapy. Thestudy is being conducted at approximately 50 centers in the United Statesand Canada.

 

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*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. This analysis continued to show no serious safety concerns with the therapy andsafety was not a factor in the decision to stop enrollment.   Aftercareful discussion with the United States Food and Drug Administration, weelected to discontinue enrollment rather than attempt to re-power thetrial.  We will keep the trial blinded and expect data for use indesigning future trials in Crohn’s disease and to bolster Prochymal’s overallsafety database.    The Prochymal Crohn’s program consisted of twoseparate but related trials.  The first trial, described above, evaluatespatients’ initial response to two dose levels of Prochymal as compared toplacebo.  This trial was originally designed to enroll 270 subjects. Patients responding to the initial therapy were then eligible to participate ina second, trial evaluating Prochymal as a maintenance therapy.  Becausethe current standard for determining response of Crohn’s patients is largelysubjective, there may have been response bias in order to meet the eligibilityrequirements for continuation of therapy in the maintenance trial. Accordingly, enrollment in the 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 2009,we 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 million from JDRF to fund clinical costs. We received a $750,000milestone payment from JDRF during the third quarter of 2009 and expect toreceive the remaining $1.2 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, we announced the interim six-month data from this trial.  Thesix-months data showed that the trial met its primary goal of demonstrating thesafety of Prochymal in patients with compromised pulmonary function at thesix-month evaluation point; Prochymal significantly decreased systemicinflammation in patients when compared to those receiving placebo, asdetermined by C-reative protein; and despite the reduction in inflammation,pulmonary function in patients receiving Prochymal was not significantlyimproved compared to those receiving 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 ofProchymal for the treatment of acute radiation syndrome (“ARS”). We arecarrying out this contract in collaboration with Genzyme.

 

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***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 the up front payments into revenue ona straight-line basis over the estimated completion period of the deliverables,which extend through the first quarter of 2012. We recognized$10.0 million of revenue in each of the first three quarters of 2009related to this agreement. Contingent milestone payments earned and for whichwe have no continuing performance obligations will be recognized as revenueupon achievement of the related milestone, while milestone payments for whichwe have a 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 Prochymal for therepair of gastrointestinal injury resulting from acute radiation exposure.Under the terms of the contract, the DoD provides funding to us fordevelopment. We recognized $2.9 million in revenue under the terms of thiscontract in the first nine months of 2009, on a cost reimbursement basis.

 

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 $0.7 million inrevenue during the first nine months 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 aproject-by-project basis. From inception in December 1992 through September 30,2009, we incurred aggregate research and development costs of approximately$358 million.

 

We expect our research and development expenses tocontinue to be substantial in the future, as we continue our clinical trialactivity for 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:

 

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·                                                                                          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.

 

*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 nine months ended September 30, 2009,we recognized an income tax benefit to continuing operations of $2.6 million,and income tax expense of $2.4 million against the income from discontinuedoperations. 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 limitedunder Internal Revenue Code Sections 382 and 383, and may expire prior to ourability to utilize them. 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.

 

The tax benefit for the nine months ended September 30,2009, reflects an effective tax rate for continuing operations of 9.9% 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.

 

**Critical Accounting Policies**

 

There have been no material changes in our criticalaccounting policies, estimates and judgments during the nine months ended September 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.

 

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**Resultsof Operations**

 

***Comparison of Three Months Ended September 30, 2009 and2008***

 

*Revenuesfrom Continuing Operations*

 

Revenues from continuing operations were $10.6 millionfor the three months ended September 30, 2009 compared to $1.0 million forthe third quarter of fiscal 2008.  During the three months ended September 30,2009, we recognized $10.0 million in revenue from our collaborative agreementwith Genzyme and $0.4 million from our collaborative agreement with JDRF. Ourrevenues for the three month period also include $0.1 million from our contractwith the DoD to develop Prochymal for the treatment of acute radiationsyndrome, plus royalties on MSCs sold for research purposes.  Revenuesfrom continuing operations for the three months ended September 30, 2008were $1.0 million, and consisted primarily of revenue recognized on ourcontract with DoD to develop Prochymal as a medical countermeasure to nuclearterrorism.

 

*Research and Development Expenses*

 

Research and development expenses for the three monthsended September 30, 2009 were $16.2 million as compared to research anddevelopment expenses of $18.6 million for the same period last year.  At September 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.  The reduction in research and developmentexpenses during the third quarter of 2009 when compared to the comparableperiod of the prior year reflects the completion of enrollment in our threePhase III clinical trials and the associated reduction in site and patientcosts.  We also incur research and development expenses in connection withthe preparation of our biologic license application as we prepare filings withthe FDA towards the commercialization of Prochymal for an initial indication.

 

*General and Administrative Expenses(excluding discontinued operations)*

 

General and administrative expenses were $1.5 millionfor the three months ended September 30, 2009 compared to $1.9 million forthe comparable period in fiscal 2008.  The decrease in general andadministrative expenses is primarily attributable to reductions in our non cashshare-based compensation expense related to the departure of two officersduring the fiscal quarter, partially offset by increases in our professionalstaff in the areas of intellectual property and business development and increasesin legal costs related to our intellectual property portfolio. The non cashcharge for share-based compensation allocated to general and administrativeexpenses during the fiscal quarter ended September 30, 2009 was ($0.1)million as compared to $0.5 million for the same period last year.

 

*Interest Income (Expense), Net*

 

Interest income, net was $0.1 million for the threemonths ended September 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.

 

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

 

Loss from operations of the Osteocel asset disposalgroup was $28,000 for the three months ended September 30, 2009 comparedto a loss of $0.4 million for the comparable period of fiscal 2008.  Osteocel manufacturing activities ceased in March 2009 and the loss incurredduring the third quarter of 2009 reflect miscellaneous costs associated withthe wind-down of this business.

 

Also during the third quarter of 2009, we reported again from the sale of discontinued operations of $0.6 million, which reflectsthe decrease in the estimated annual effective income tax rate for the fullfiscal year.

 

***Comparison of Nine Months Ended September 30, 2009 and2008***

 

*Revenuesfrom Continuing Operations*

 

Revenues from continuing operations were $33.8 millionfor the nine months ended September 30, 2009 compared to $3.9 million forthe first nine months of fiscal 2008.  During the nine months ended September 30,2009, we recognized $30.0 million in revenue from our collaborative agreementwith Genzyme and $0.7 million from our collaborative agreement with JDRF. Ourrevenues for this nine month period also include $2.9 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 research purposes. Revenues from continuing operations for the nine months ended September 30,2008 were $3.9 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.

 

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*Research and Development Expenses*

 

Research and development expenses for the nine monthsended September 30, 2009 were $53.4 million, as compared to research anddevelopment expenses of $54.3 million for the same period last year.  Our rate of spending on our Phase IIIclinical trials are slowing down as we complete enrollment in these trials andincur lower patient treatment and site costs.

 

*General and Administrative Expenses(excluding discontinued operations)*

 

General and administrative expenses were $6.7 millionfor the nine months ended September 30, 2009 compared to $6.3 million forthe comparable period in fiscal 2008.  The non cash charge for share-basedcompensation allocated to general and administrative expenses during the firstnine months of this fiscal year was $1.1 million as compared to $0.8 millionfor the same period last year.

 

*Interest Income (Expense), Net*

 

Interest income, net was $0.4 million for the ninemonths ended September 30, 2009 compared to net interest expense of $0.8million 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.

 

***Income fromDiscontinued Operations***

 

Income from operations of the Osteocel asset disposalgroup was $1.1 million for the nine months ended September 30, 2009compared to earnings of $6.3 million for the comparable period of fiscal2008.  Osteocel manufacturing activities ceased in March 2009.

 
| ** **                                                    | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                    | ** ** | **September 30,**          | ** ** |
| ** **                                                    | ** ** | **2009**                        | ** ** | **2008** | ** ** |
| ** **                                                    | ** ** | **($000)**                      | ** ** | **($000)** | ** ** |
| Product sales                                                 |       | $                               | 6,295      |   | $ | 19,338 |   |
| Cost of goods sold                                            |       | 4,985                           |       | 11,602 |   |
| Gross profit                                                  |       | 1,310                           |       | 7,736 |   |
|                                                          |       |                            |       |   |   |
| Selling,  general & administrative expenses          |       | 124                             |       | 1,467 |   |
| Income from operations  of discontinued operations before tax |       | 1,186                           |       | 6,269 |   |
| Income tax                                                    |       | 117                             |       | — |   |
| Income from operations  of discontinued operations            |       | $                               | 1,069      |   | $ | 6,269 |   |

 

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 thetechnology assets closing, we entered into a Manufacturing Agreement withNuVasive, under which we continued to manufacture Osteocel until March 28,2009 when all manufacturing activities ceased. In March 2009, we enteredinto amendments to the Asset Purchase Agreement and amendments to the relatedManufacturing Agreement which stipulated that, upon consummation of the secondand final closing (the “manufacturing assets closing”) under the Asset PurchaseAgreement all of our responsibilities would be deemed fulfilled.  Themanufacturing assets closing occurred on April 9, 2009.  Uponexecution of the amendments, we received $5.0 million of additional purchaseprice in cash and then received an additional $12.5 million in NuVasive commonstock on June 30, 2009 and September 30, 2009.  We subsequentlysold all the shares of NuVasive common stock and received proceeds ofapproximately $25.3 million in cash. We are also entitled to receive acontingent milestone payment of $15.0 million in early November 2009, as aresult of achievement by NuVasive of cumulative sales revenue from Osteocel ofat least $35.0 million. NuVasive has advised that this payment will bemade in shares of NuVasive stock.

 

**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 

 

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are difficult to forecast and mitigate. Shouldadditional capital be required to pursue our business plan, but not beavailable, as a result of the global economic crisis or otherwise, our businessand financial condition would be materially and adversely affected.

 

At September 30, 2009, we had $102.9 million incash and investments available for sale.  We presently estimate that wehave sufficient liquidity on hand as of September 30, 2009 to fund ouroperations through the anticipated date of initial commercialization ofProchymal for an initial indication.

 

***Cash Flows***

 

***Comparison of ThreeMonths Ended September 30, 2009 and 2008***

 

Cash provided byoperating activities of continuing operations for the three months ended September 30,2009 was $40.7 million compared to cash used by operating activities ofcontinuing operations of $31.1 million in the same quarter of the prioryear.  The third quarter 2009 loss fromcontinuing operations of $6.8 million was offset by the $55.2 million reductionin receivables, reflecting the payment from Genzyme Corporation of the balanceof the non-contingent, non-refundable upfront fees, net of amortization ofdeferred revenue and other minor changes in working capital.  Cash used by operating activities of continuingoperations during the third fiscal quarter of 2008 reflect our loss fromcontinuing operations of $19.9 million, which was increased primarily by the$12.7 reduction in payables and accrued expenses.

 

Cash used by operatingactivities of discontinued operations for the third quarter of fiscal 2009 was$2.1 million compared to cash provided by operating activities of discontinuedoperations of $5.2 million in the same period of the prior year.  The 2009 amounts reflect the net increase inthe gain on sale of discontinued operations of $0.6 million, which resultedprimarily from the cumulative effect of the reduction in our estimatedeffective income tax rate for 2009, offset by decreases in both receivables andpayables as we wrap up the final accounts of the Osteocel business.

 

Cash used in investingactivities during the third quarter of 2009 was $38.2 million compared to cashprovided by investing activities of $33.4 million in the same period of theprior year.  The 2009 amount reflects thepurchase of $50.0 million of short-term investments from the proceeds of theGenzyme payment, net of $11.8 million of sales of short-term investments tofund operating activities.  The 2008amounts reflect the net cash proceeds from the sale of our Osteocel business inJuly 2008.

 

Cash provided from financingactivities during the third quarter of 2009 was $0.1 million, which reflectsthe proceeds from the exercise of stock options.  Cash used in financing activities during thethird quarter of 2008 was $4.6 million, which was primarily the result of the netpayment of short-term debt.

 

***Comparison of Nine Months Ended September 30, 2009 and2008***

 

Cash provided byoperating activities of continuing operations for the nine months ended September 30,2009 was $9.3 million compared to cash used in operating activities ofcontinuing operations of $57.9 million. The 2009 amount reflects the loss from continuing operations of $23.3million, increased by the $29.9 million of net amortization of deferredrevenue, which was offset by the collection of $56.1 million of receivables(primarily the $55.0 payment from Genzyme) and $4.7 million increase inpayables.  Non cash expenses of $2.3million were incurred during the first nine months of 2009.  The 2008 amounts reflect the loss fromcontinuing operations of $57.5 million, reduced by non cash expenses of $2.7million and net changes in working capital.

 

Cash used by operatingactivities of discontinued operations during the first three quarters of fiscal2009 was $3.9 million which reflects the wrapping up of the business activitiesof our former Osteocel activities. During the comparable period of the prior year, $11.3 million of cashwas provided by the operating activities of discontinued operations.

 

Cash used in investingactivities during the nine months ended September 30, 2009 was $4.8million compared to cash provided by investing activities of $42.1 million inthe same period of the prior year.  The2009 amounts reflect the purchase of $50.0 million in short-term investments,offset by the sale of $35.6 million of short-term investments to fundoperations and the net cash proceeds from the sale of discontinued operation of$9.8 million.  The 2008 amounts reflectthe net cash proceeds of $33.6 million from the sale of our Osteocel business,the sale of $12.4 million of short-term investments, net of $4.0 million ofproperty additions.

 

Cash provided byfinancing activities during the first three quarters of fiscal 2009 was$34,000, reflecting the $0.6 million proceeds from the exercise of stockoptions, offset by the $0.5 million increase in restricted cash used tocollateralize a letter of credit used in lieu of a security deposit on ourfacilities lease.  Cash provided byfinancing activities during the same period of the prior year was $9.1 million,consisting primarily of borrowing of $10.5 million of convertible promissorynotes and $6.5 million of short-term promissory notes, netted against $8.3million of debt payments.

 

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***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.

 

**Item3.****                                  ****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 September 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**.

 

None.

 

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

 

None.

 

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

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                   |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Employment Separation Agreement and Release dated  September 8, 2009 by and between the Registrant and Richard W. Hunt  (Incorporated by reference to Exhibit 10.1 to the Current Report on  Form 8-K filed by the Registrant with the SEC on September 11,  2009) |
|                |       |                                                                                                                                                                                                                                                                                   |
| 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: November 6, 2009 | /s/ PHILIP R. JACOBY, JR.                              |
|                        | Philip R. Jacoby, Jr.                             |
|                        | Chief Financial Officer (Principal Financial  Officer) |
|                        |                                                   |
| Date: November 6, 2009 | /s/ MATTHEW NEUMAYER                                   |
|                        | Matthew Neumayer                                       |
|                        | Corporate Controller (Principal Accounting Officer)    |

 

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